Income Taxes (APSC)

12 Months Ended

Dec. 31, 2012

Income Taxes

4. Income Taxes

Certain assets and liabilities are reported differently for income tax purposes than they are for financial statements purposes.  The tax effect of these differences is recorded as deferred taxes.  We calculate deferred taxes using the currently enacted income tax rates.

APS has recorded regulatory assets and regulatory liabilities related to income taxes on its Balance Sheets in accordance with accounting guidance for regulated operations.  The regulatory assets are for certain temporary differences, primarily the allowance for equity funds used during construction and pension and other postretirement benefits.  The regulatory liabilities primarily relate to deferred taxes resulting from investment tax credits (“ITC”) and the change in income tax rates.

In accordance with regulatory requirements, APS investment tax credits are deferred and are amortized over the life of the related property with such amortization applied as a credit to reduce current income tax expense in the statement of income.

The $70 million long-term income tax receivable on the Consolidated Balance Sheets represents the anticipated refunds related to an APS tax accounting method change approved by the IRS in the third quarter of 2009.  This amount is classified as long-term, as there remains uncertainty regarding the timing of this cash receipt.  Further clarification of the timing is expected from the IRS within the next twelve months.

Net income associated with the Palo Verde sale leaseback variable interest entities is not subject to tax (see Note 20).  As a result, there is no income tax expense associated with the VIEs recorded on the Consolidated Statements of Income.

During the first quarter of 2010, the Company reached a settlement with the IRS with regard to the examination of tax returns for the years ended December 31, 2005 through 2007.  As a result of this settlement, net uncertain tax positions decreased $62 million, including approximately $3 million which decreased our effective tax rate.  Additionally, the settlement resulted in the recognition of net interest benefits of approximately $4 million through the effective tax rate.

The following is a tabular reconciliation of the total amounts of unrecognized tax benefits, excluding interest and penalties, at the beginning and end of the year that are included in accrued taxes and unrecognized tax benefits (dollars in thousands):

	2012			2011			2010
Total unrecognized tax benefits, January 1	$	136,005		$	127,595		$	201,216
Additions for tax positions of the current year	5,167			10,915			7,551
Reductions for tax positions of prior years for:
Changes in judgment	(7,729		)	(1,555		)	(11,017		)
Settlements with taxing authorities	—			(124		)	(62,199		)
Lapses of applicable statute of limitations	(21		)	(826		)	(7,956		)
Total unrecognized tax benefits, December 31	$	133,422		$	136,005		$	127,595

Included in the balances of unrecognized tax benefits at December 31, 2012, 2011 and 2010 were approximately $10 million, $8 million and $7 million, respectively, of tax positions that, if recognized, would decrease our effective tax rate.

As of the balance sheet date, the tax year ended December 31, 2008 and all subsequent tax years remain subject to examination by the IRS.  With a few exceptions, we are no longer subject to state income tax examinations by tax authorities for years before 2008.

It is reasonably possible that within the next twelve months the IRS will finalize the examination of tax returns for the years ended December 31, 2008 and 2009.  At this time, a reasonable estimate of the range of possible change in the uncertain tax position cannot be made.  However, we do not expect the ultimate outcome of this examination to have a material adverse impact on our financial position or results of operations.

We reflect interest and penalties, if any, on unrecognized tax benefits in the Consolidated Statements of Income as income tax expense.  The amount of interest recognized in the Consolidated Statements of Income related to unrecognized tax benefits was a pre-tax expense of $4 million for 2012, a pre-tax expense of $3 million for 2011 and a pre-tax benefit of $2 million for 2010.

The total amount of accrued liabilities for interest recognized in the Consolidated Balance Sheets related to unrecognized tax benefits was $13 million as of December 31, 2012, $9 million as of December 31, 2011 and $6 million as of December 31, 2010.  To the extent that matters are settled favorably, this amount could reverse and decrease our effective tax rate.  Additionally, as of December 31, 2012, we have recognized $5 million of interest income to be received on the overpayment of income taxes for certain adjustments that we have filed, or will file, with the IRS.

The components of income tax expense are as follows (dollars in thousands):

	Year Ended December 31,
	2012			2011			2010
Current:
Federal	$	(3,493	)	$	(310	)	$	(108,827	)
State	8,395			15,140			25,545
Total current	4,902			14,830			(83,282		)
Deferred:
Federal	200,322			159,566			260,236
State	28,280			16,626			10,911
Discontinued operations	—			—			(10,736		)
Total deferred	228,602			176,192			260,411
Total income tax expense	233,504			191,022			177,129
Less: income tax expense (benefit) on discontinued operations	(3,813		)	7,418			16,260
Income tax expense — continuing operations	$	237,317		$	183,604		$	160,869

The following chart compares pretax income from continuing operations at the 35% federal income tax rate to income tax expense — continuing operations (dollars in thousands):

	Year Ended December 31,
	2012			2011			2010
Federal income tax expense at 35% statutory rate	$	229,709		$	188,733		$	177,002
Increases (reductions) in tax expense resulting from: State income tax net of federal income tax benefit	23,819			19,594			17,485
Credits and favorable adjustments related to prior years resolved in current year	—			—			(17,300		)
Medicare Subsidy Part-D	483			823			1,311
Allowance for equity funds used during construction (see Note 1)	(6,158		)	(6,881		)	(6,563		)
Palo Verde VIE noncontrolling interest (see Note 20)	(11,065		)	(9,636		)	(7,057		)
Other	529			(9,029		)	(4,009		)
Income tax expense — continuing operations	$	237,317		$	183,604		$	160,869

The following table shows the net deferred income tax liability recognized on the Consolidated Balance Sheets (dollars in thousands):

	December 31,
	2012			2011
Current asset	$	152,191		$	130,571
Long-term liability	(2,151,371		)	(1,925,388		)
Deferred income taxes — net	$	(1,999,180	)	$	(1,794,817	)

On February 17, 2011, Arizona enacted legislation (H.B. 2001) that included a four year phase-in of corporate income tax rate reductions beginning in 2014.  As a result of these tax rate reductions, Pinnacle West has revised the tax rate applicable to reversing temporary items in Arizona.  In accordance with accounting for regulated companies, the benefit of this rate reduction is substantially offset by a regulatory liability.  As of December 31, 2012, APS has recorded a regulatory liability of $69 million, with a corresponding decrease in accumulated deferred income tax liabilities, to reflect the impact of this change in tax law.

The American Taxpayer Relief Act of 2012, signed into law on January 2, 2013, includes provisions making qualified property placed into service in 2013 eligible for 50% bonus depreciation for federal income tax purposes.  Full recognition of the cash benefit of this provision would delay realization of approximately $79 million in federal general business income tax credit carryforwards which are classified as current assets as of December 31, 2012.

The components of the net deferred income tax liability were as follows (dollars in thousands):

	December 31,
	2012			2011
DEFERRED TAX ASSETS
Risk management activities	$	72,243		$	117,765
Regulatory liabilities:
Asset retirement obligation and removal costs	238,669			236,739
Renewable energy standard	—			19,722
Unamortized investment tax credits	53,837			31,460
Other	33,764			33,155
Pension and other postretirement liabilities	408,764			501,202
Renewable energy incentives	66,941			57,901
Credit and loss carryforwards	139,022			171,915
Other	68,844			73,759
Total deferred tax assets	1,082,084			1,243,618
DEFERRED TAX LIABILITIES
Plant-related	(2,584,166		)	(2,446,908		)
Risk management activities	(23,940		)	(30,171		)
Regulatory assets:
Allowance for equity funds used during construction	(37,899		)	(33,347		)
Deferred fuel and purchased power	(28,858		)	(10,884		)
Deferred fuel and purchased power — mark-to-market	(15,796		)	(30,559		)
Pension and other postretirement benefits	(316,757		)	(408,716		)
Other	(68,170		)	(73,087		)
Other	(5,678		)	(4,763		)
Total deferred tax liabilities	(3,081,264		)	(3,038,435		)
Deferred income taxes — net	$	(1,999,180	)	$	(1,794,817	)

As of December 31, 2012, the deferred tax assets for credit and loss carryforwards relate to federal general business credits of $111 million and federal net operating losses of $21 million, both of which first begin to expire in 2031, and other federal and state loss carryforwards of $7 million which first begin to expire in 2017.

ARIZONA PUBLIC SERVICE COMPANY

Income Taxes

S-1. Income Taxes

APS is included in Pinnacle West’s consolidated tax return.  However, when Pinnacle West allocates income taxes to APS, it is done based upon APS’s taxable income computed on a stand-alone basis, in accordance with the tax sharing agreement.

Certain assets and liabilities are reported differently for income tax purposes than they are for financial statements purposes.  The tax effect of these differences is recorded as deferred taxes.  We calculate deferred taxes using currently enacted tax rates.

APS has recorded regulatory assets and regulatory liabilities related to income taxes on its Balance Sheets in accordance with accounting guidance for regulated operations.  The regulatory assets are for certain temporary differences, primarily the allowance for equity funds used during construction and pension and other postretirement benefits.  The regulatory liabilities primarily relate to deferred taxes resulting from ITCs and the change in income tax rates.

In accordance with regulatory requirements, APS investment tax credits are deferred and are amortized over the life of the related property, with such amortization applied as a credit to reduce current income tax expense in the statement of income.

The $71 million long-term income tax receivable on APS’s Consolidated Balance Sheets represents the anticipated refunds related to an APS tax accounting method change approved by the IRS in the third quarter of 2009.  This amount is classified as long-term, as there remains uncertainty regarding the timing of this cash receipt.  Further clarification of the timing is expected from the IRS within the next twelve months.

Net income associated with the Palo Verde sale leaseback variable interest entities is not subject to tax (see Note 20).  As a result, there is no income tax expense associated with the VIEs recorded on APS’s Consolidated Statements of Income.

During the first quarter of 2010, the Company reached a settlement with the IRS with regard to the examination of tax returns for the years ended December 31, 2005 through 2007.  As a result of this settlement, net uncertain tax positions decreased $62 million, including approximately $3 million which decreased our effective tax rate.  Additionally, the settlement resulted in the recognition of net interest benefits of approximately $4 million through the effective tax rate.

The following is a tabular reconciliation of the total amounts of unrecognized tax benefits, excluding interest and penalties, at the beginning and end of the year that are included in accrued taxes and unrecognized tax benefits (dollars in thousands):

	2012			2011			2010
Total unrecognized tax benefits, January 1	$	135,824		$	126,698		$	199,887
Additions for tax positions of the current year	5,167			10,915			7,551
Reductions for tax positions of prior years for:
Changes in judgment	(7,729		)	(1,555		)	(10,964		)
Settlements with taxing authorities	—			(124		)	(61,820		)
Lapses of applicable statute of limitations	(21		)	(110		)	(7,956		)
Total unrecognized tax benefits, December 31	$	133,241		$	135,824		$	126,698

Included in the balance of unrecognized tax benefits at December 31, 2012, 2011 and 2010 were approximately $10 million, $8 million and $6 million, respectively, of tax positions that, if recognized, would decrease our effective tax rate.

As of the balance sheet date, the tax year ended December 31, 2008 and all subsequent tax years remain subject to examination by the IRS.  With few exceptions, we are no longer subject to state income tax examinations by tax authorities for years before 2008.

It is reasonably possible that within the next twelve months the IRS will finalize the examination of tax returns for the years ended December 31, 2008 and 2009.  At this time, a reasonable estimate of the range of possible change in the uncertain tax position cannot be made.  However, we do not expect the ultimate outcome of this examination to have a material adverse impact on our financial position or results of operations.

We reflect interest and penalties, if any, on unrecognized tax benefits in the Statements of Income as income tax expense.  The amount of interest recognized in the Statements of Income related to unrecognized tax benefits was a pre-tax expense of $4 million for 2012, a pre-tax expense of $3 million for 2011 and a pre-tax benefit of $2 million for 2010.

The total amount of accrued liabilities for interest recognized in the Balance Sheets related to unrecognized tax benefits was $13 million as of December 31, 2012, $9 million as of December 31, 2011 and $6 million as of December 31, 2010.  To the extent that matters are settled favorably, this amount could reverse and decrease our effective tax rate.  Additionally, as of December 31, 2012, we have recognized $5 million of interest income to be received on the overpayment of income taxes for certain adjustments that we have filed, or will file, with the IRS.

The components of APS’s income tax expense are as follows (dollars in thousands):

	Year Ended December 31,
	2012			2011		2010
Current:
Federal	$	(11,650	)	$	4,633	$	(71,036	)
State	12,308			19,104		17,406
Total current	658			23,737		(53,630		)
Deferred:
Federal	216,367			154,632		207,334
State	27,371			14,173		16,761
Total deferred	243,738			168,805		224,095
Total income tax expense	$	244,396		$	192,542	$	170,465

On the APS Statements of Income, federal and state income taxes are allocated between operating income and other income.

The following chart compares APS’s pretax income at the 35% federal income tax rate to income tax expense (dollars in thousands):

	Year Ended December 31,
	2012			2011			2010
Federal income tax expense at 35% statutory rate	$	235,027		$	194,710		$	184,202
Increases (reductions) in tax expense resulting from:
State income tax net of federal income tax benefit	25,379			21,139			19,186
Credits and favorable adjustments related to prior years resolved in current year	—			—			(17,300		)
Medicare Subsidy Part-D	483			823			889
Allowance for equity funds used during construction (see Note 1)	(6,158		)	(6,880		)	(6,563		)
Palo Verde VIE noncontrolling interest (see Note 20)	(11,065		)	(9,633		)	(7,057		)
Other	730			(7,617		)	(2,892		)
Income tax expense	$	244,396		$	192,542		$	170,465

The following table shows the net deferred income tax liability recognized on the APS Balance Sheets (dollars in thousands):

	December 31,
	2012			2011
Current asset	$	74,420		$	111,503
Long-term liability	(2,133,976		)	(1,952,608		)
Deferred income taxes — net	$	(2,059,556	)	$	(1,841,105	)

On February 17, 2011, Arizona enacted legislation (H.B. 2001) that included a four year phase-in of corporate income tax rate reductions beginning in 2014.  As a result of these tax rate reductions, Pinnacle West has revised the tax rate applicable to reversing temporary items in Arizona.  In accordance with accounting for regulated companies, the benefit of this rate reduction is substantially offset by a regulatory liability.  As of December 31, 2012, APS has recorded a regulatory liability of $69 million, with a corresponding decrease in accumulated deferred income tax liabilities, to reflect the impact of this change in tax law.

The American Taxpayer Relief Act of 2012, signed into law on January 2, 2013, includes provisions making qualified property placed into service in 2013 eligible for 50% bonus depreciation for federal income tax purposes.  Full recognition of the cash benefit of this provision would delay realization of approximately $4 million in federal general business income tax credit carryforwards which are classified as current assets as of December 31, 2012.

The components of the net deferred income tax liability were as follows (dollars in thousands):

	December 31,
	2012			2011
DEFERRED TAX ASSETS
Regulatory liabilities:
Asset retirement obligation and removal costs	$	238,669		$	236,739
Renewable energy standard	—			19,722
Unamortized investment tax credits	53,837			31,460
Other	33,764			33,155
Risk management activities	72,243			117,765
Pension and other postretirement liabilities	392,486			494,744
Renewable energy incentives	66,941			57,901
Credit and loss carryforwards	52,441			106,668
Other	111,327			99,176
Total deferred tax assets	1,021,708			1,197,330
DEFERRED TAX LIABILITIES
Plant-related	(2,584,166		)	(2,446,908		)
Risk management activities	(23,940		)	(30,171		)
Regulatory assets:
Allowance for equity funds used during construction	(37,899		)	(33,347		)
Deferred fuel and purchased power	(28,858		)	(10,884		)
Deferred fuel and purchased power — mark-to-market	(15,796		)	(30,559		)
Pension and other postretirement benefits	(316,757		)	(408,716		)
Other	(68,170		)	(73,087		)
Other	(5,678		)	(4,763		)
Total deferred tax liabilities	(3,081,264		)	(3,038,435		)
Deferred income taxes — net	$	(2,059,556	)	$	(1,841,105	)

As of December 31, 2012, the deferred tax assets for credit and loss carryforwards relate to federal general business credits ($50 million) which first begin to expire in 2031 and other federal and state loss carryforwards ($2 million) which first begin to expire in 2017.