Note 11 – Income Taxes

Valuation Allowance

We review the need to maintain the deferred tax asset valuation allowance on a quarterly basis. We analyze several factors, among which are the severity and frequency of operating losses, our capacity for the carryback or carryforward of any losses, the existence and current level of taxable operating income, operating results, on a three year cumulative basis, the expected occurrence of future income or loss, the expiration dates of the carryforwards, the cyclical nature of our operating results, and available tax planning strategies. Based on our analysis, we continue to reduce our benefit from income tax through the recognition of a valuation allowance.

It is reasonably possible that the valuation allowance will be reversed in the foreseeable future. Specifically, if we continue to recognize meaningful levels of sustainable pre-tax income, it is likely that the valuation allowance will be reversed in 2015. Currently, our analysis of the severity of previous operating losses shows, on a three year cumulative basis, a loss from operations, adjusted for permanent tax differences, which is considered to be unfavorable evidence with respect to the realization of deferred tax assets and is difficult to overcome with projections of future results. As a result of this analysis, and consideration of other factors, we concluded that it was appropriate to maintain the valuation allowance at this time. In the period in which the valuation allowance is reversed, we would recognize a tax benefit which will increase our earnings for that period. In future years with taxable income, after the valuation allowance has been reversed and until such time as our net operating loss carryforwards are exhausted or expired, our provision for income tax would substantially exceed the amount of cash tax payments.

The effect of the change in valuation allowance on the provision for income taxes was as follows:

	Three months ended June 30,						Six months ended June 30,
	2015			2014			2015			2014
	(In thousands)

Provision for income tax	$	39,991		$	17,172		$	87,874		$	40,292
Change in valuation allowance		(38,669	)		(16,054	)		(83,167	)		(38,448	)

Provision for income taxes	$	1,322		$	1,118		$	4,707		$	1,844

The change in the valuation allowance that was included in other comprehensive income for the three months ended June 30, 2015 and 2014 was an increase of $22.0 million and a decrease of $14.6 million, respectively. The change in the valuation allowance that was included in other comprehensive income for the six months ended June 30, 2015 and 2014 was an increase of $15.6 million and a decrease of $27.9 million, respectively. The total valuation allowance as of June 30, 2015 and December 31, 2014 was $834.7 million and $902.3 million, respectively.

We have approximately $2.2 billion of net operating loss carryforwards on a regular tax basis and $1.3 billion of net operating loss carryforwards for computing the alternative minimum tax as of June 30, 2015. Any unutilized carryforwards are scheduled to expire at the end of tax years 2029 through 2033.

Tax Contingencies

As previously disclosed, the Internal Revenue Service (“IRS”) completed examinations of our federal income tax returns for the years 2000 through 2007 and issued proposed assessments for taxes, interest and penalties related to our treatment of the flow-through income and loss from an investment in a portfolio of residual interests of Real Estate Mortgage Investment Conduits (“REMICs”). The IRS indicated that it did not believe that, for various reasons, we had established sufficient tax basis in the REMIC residual interests to deduct the losses from taxable income. We appealed these assessments within the IRS and in August 2010, we reached a tentative settlement agreement with the IRS which was not finalized.

On September 10, 2014, we received Notices of Deficiency (commonly referred to as “90 day letters”) covering the 2000-2007 tax years. The Notices of Deficiency reflect taxes and penalties related to the REMIC matters of $197.5 million and at June 30, 2015, there would also be interest related to these matters of approximately $175.5 million. In 2007, we made a payment of $65.2 million to the United States Department of the Treasury which will reduce any amounts we would ultimately owe. The Notices of Deficiency also reflect additional amounts due of $261.4 million, which are primarily associated with the disallowance of the carryback of the 2009 net operating loss to the 2004-2007 tax years. We believe the IRS included the carryback adjustments as a precaution to keep open the statute of limitations on collection of the tax that was refunded when this loss was carried back, and not because the IRS actually intends to disallow the carryback permanently.

We filed a petition with the U.S. Tax Court contesting most of the IRS' proposed adjustments reflected in the Notices of Deficiency and the IRS has filed an answer to our petition which continues to assert their claim. Litigation to resolve our dispute with the IRS could be lengthy and costly in terms of legal fees and related expenses. We can provide no assurance regarding the outcome of any such litigation or whether a compromised settlement with the IRS will ultimately be reached and finalized. Depending on the outcome of this matter, additional state income taxes and state interest may become due when a final resolution is reached. As of June 30, 2015, those state taxes and interest would approximate $48.1 million. In addition, there could also be state tax penalties. Our total amount of unrecognized tax benefits as of June 30, 2015 is $106.7 million, which represents the tax benefits generated by the REMIC portfolio included in our tax returns that we have not taken benefit for in our financial statements, including any related interest. We continue to believe that our previously recorded tax provisions and liabilities are appropriate. However, we would need to make appropriate adjustments, which could be material, to our tax provision and liabilities if our view of the probability of success in this matter changes, and the ultimate resolution of this matter could have a material negative impact on our effective tax rate, results of operations, cash flows, available assets and statutory capital. In this regard, see Note 1 – “Nature of Business – Capital-GSEs.”

In October 2014, we received a Revenue Agent’s Report from the IRS related to the examination of our federal income tax returns for the years 2011 and 2012. The result of the examination had no material effect on the financial statements.

The total amount of the unrecognized tax benefits, related to our aforementioned REMIC issue that would affect our effective tax rate is $94.1 million, after taking into account the effect of NOL carrybacks. We recognize interest accrued and penalties related to unrecognized tax benefits in income taxes. As of June 30, 2015 and December 31, 2014, we had accrued $27.4 million and $26.9 million, respectively, for the payment of interest.