Income Taxes

The components of our consolidated income tax provision are as follows:



	Year Ended December 31,
(In thousands)	2012		2011		2010
Current	$	1,271	$	59,604	$	(155,219	)
Deferred	6,000		6,758		381,408
Total income tax provision	$	7,271	$	66,362	$	226,189

The reconciliation of taxes computed at the statutory tax rate of 35% for 2012, 2011 and 2010 to the provision for income taxes is as follows:



	Year Ended December 31,
(In thousands)	2012			2011			2010
(Benefit) provision for income taxes computed at the statutory tax rate	$	(155,469	)	$	128,979		$	(552,887	)
Change in tax resulting from:
Tax-exempt municipal bond interest and dividends received deduction (net of proration)	(3,101		)	(5,237		)	(15,592		)
Foreign tax expense (benefit)	146			(13,496		)	(10,397		)
State tax expense (benefit)	4,003			(6,224		)	(15,692		)
Unrecognized tax (benefit) expense	(2,906		)	17,860			(25,915		)
Deferred inventory adjustment related to fair value of derivatives and other financial instruments	(23,217		)	—			—
Valuation allowance	188,290			(50,582		)	844,975
Other, net	(475		)	(4,938		)	1,697
Provision for income taxes	$	7,271		$	66,362		$	226,189

The significant components of our net deferred tax assets and liabilities are summarized as follows:



	December 31,
(In thousands)	2012		2011
Deferred tax assets:
Accrued expenses	$	51,049	$	41,011
Unearned premiums	36,060		14,327
PDR	1,290		1,275
NOL	666,633		666,407
Differences in fair value of derivative and other financial instruments	54,335		—
Rescission premium	16,797		20,015
State NOL carryforward	31,744		31,825
Foreign tax credit carryforward	26,292		26,884
Depreciation	5,478		5,037
Partnership investments	65,704		64,544
Loss reserves	39,540		—
Residual interest in LPV	24,084		—
Other	53,319		57,127
Total deferred tax assets	1,072,325		928,452
Deferred tax liabilities:
Deferred policy acquisition costs	30,882		48,969
Convertible debt	28,449		32,091
Differences in fair value of derivative and other financial instruments	—		3,591
Net unrealized gain on investments	8,783		4,191
Loss reserves	—		9,744
Foreign currency	18		22
Other	14,536		16,169
Total deferred tax liabilities	82,668		114,777
Valuation allowance	989,657		797,700
Net DTA	$	—	$	15,975

As of December 31, 2012, we recorded a net current income tax payable of approximately $132.7 million, which primarily consists of liabilities related to applying the standards of accounting for uncertainty in income taxes and a current federal income tax recoverable of approximately $8.1 million. For federal income tax purposes, we have approximately $1.9 billion of NOL carryforwards and $26.3 million of foreign tax credit carryforwards as of December 31, 2012. To the extent not utilized, the NOL carryforwards will expire during tax years 2028 through 2032 and the foreign tax credit carryforwards will expire during tax years 2018 through 2020. Certain entities within our consolidated group have also generated DTAs of approximately $31.7 million relating to state and local NOL carryforwards, which if unutilized, will expire during various future tax periods. During 2011, we recognized approximately $728.0 million of estimated cancellation of indebtedness taxable income resulting from our partnership interest in C-BASS, which filed for Subchapter 11 bankruptcy protection on November 12, 2010 and was formally liquidated pursuant to the Plan of Liquidation that was confirmed on April 25, 2011. During 2012, C-BASS amended its 2011 federal tax return and, as a result, our share of cancellation of indebtedness taxable income decreased to approximately $667.0 million. Such cancellation of indebtedness income was fully offset by our NOLs.

A valuation allowance of approximately $989.7 million and $797.7 million was recorded against our net DTA of approximately $989.7 million and $813.7 million at December 31, 2012 and 2011, respectively. The remaining DTA of approximately $16.0 million at December 31, 2011 represented our NOL carryback, which we expected to utilize as part of an overall settlement of proposed Internal Revenue Service (”IRS”) adjustments relating to tax years 2000 through 2007. For the year ended December 31, 2012, our valuation allowance increased by approximately $192.0 million, of which approximately $3.7 million of the increase was included in other comprehensive income. Additionally, approximately $16.0 million of the 2012 increase resulted from recent developments regarding our IRS Office of Appeals (”Appeals”) settlement efforts, which leads us to believe that a settlement with Appeals is no longer likely, as discussed in more detail below.

Our ability to fully use our tax assets such as NOLs and tax credit carryforwards would be substantially limited if we experience an “ownership change” within the meaning of Section 382 of the IRC of 1986, as amended (“Section 382”). Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, in general, an ownership change would occur if our five percent shareholders, as defined under Section 382, collectively increase their ownership by more than 50 percentage points over a rolling three-year period. As of December 31, 2012, we have not experienced an ownership change under Section 382. However, if we were to experience a change in ownership under Section 382 in a future period, then we may be limited in our ability to fully utilize our NOL and tax credit carryforwards in future periods.

On October 8, 2009, our board of directors adopted a Tax Benefit Preservation Plan, which, as amended, was approved by our stockholders at the 2010 annual meeting. We also adopted certain amendments to our amended and restated bylaws and our stockholders approved at the 2010 annual meeting certain amendments to our amended and restated certificate of incorporation. The plan, the bylaw amendment and the charter amendment were implemented in order to protect our ability to utilize our NOLs and other tax assets and prevent an “ownership change” under U.S. federal income tax rules. These provisions restrict or discourage certain transfers of our common stock that would: (i) create or result in a person becoming a five-percent shareholder under Section 382; or (ii) increase the stock ownership of any existing five-percent shareholder under Section 382.

We are currently contesting proposed adjustments resulting from the examination by the IRS of our 2000 through 2007 tax years. The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of non-economic REMIC residual interests and has proposed adjustments denying the associated tax benefits of these items. The proposed adjustments relating to the 2000 through 2007 tax years, if sustained, will result in additional income taxes of approximately $128 million plus proposed penalties of approximately $42 million. Additionally, we would incur interest on any sustained adjustments. We appealed these proposed adjustments to Appeals and made “qualified deposits” with the U.S. Department of the Treasury in the amount of approximately $85.0 million in June 2008 relating to the 2000 through 2004 tax years and approximately $4.0 million in May 2010 relating to the 2005 through 2007 tax years in order to avoid the accrual of above-market-rate interest with respect to the proposed adjustments. In late December 2010, we reached a tentative settlement agreement with Appeals. However, because we had claimed a refund of approximately $105.0 million with respect to our 2006 and 2007 taxable years based on a carryback of an NOL generated from our 2008 taxable year, review of the tentative settlement agreement by the Joint Committee on Taxation (“JCT”) was required. After the JCT completed its review, Appeals reconsidered the tentative settlement and informed us that it was no longer willing to enter into a settlement based on the originally proposed terms.

We have made several attempts to reach a compromised settlement with Appeals, but in January 2013, we were notified that Appeals had rejected our latest settlement offer and plans to issue a formal notice of deficiency within three to six months. Based on these recent developments, we do not currently believe that a settlement is likely. Upon receipt of the notice of deficiency, we will have ninety days to either pay the assessed tax liabilities, penalties and interest (the “deficiency amount”) in full or petition the U.S. Tax Court to litigate the deficiency amount. Litigation of the deficiency amount may result in substantial legal expenses and the litigation process could take several years to resolve. After discussions with outside counsel about the issues raised in the examination we believe that an adequate provision for income taxes has been made for the potential liabilities that may result from this matter. However, if the ultimate resolution of this matter produces a result that differs materially from our current expectations, there could be a material impact on our effective tax rate, results of operations and cash flows. See further discussion below concerning unrecognized tax benefits relating to this IRS matter.

As of December 31, 2012, we have approximately $59.0 million of unrecognized tax benefits that, if recognized, would affect the effective tax rate. Our policy for the recognition of interest and penalties associated with uncertain tax positions is to record such items as a component of our income tax provision. The table below details the cumulative effect of applying the provisions of the standard relating to accounting for uncertainty of income taxes as of December 31, 2012.

The effect of unrecognized tax benefits on our consolidated balance sheets and results of operations is as follows:



(In thousands)	December 31, 2011		Decrease			December 31, 2012
Unrecognized tax benefits	$	125,757	$	(11,744	)	$	114,013
Unrecognized tax benefits that, if recognized, would affect the effective tax rate	$	61,901	$	(2,907	)	$	58,994
Interest and penalties accrued	$	53,842	$	(840	)	$	53,002
Interest and penalties charged to income tax benefit						$	(840	)

A reconciliation of the beginning and ending unrecognized tax benefits is as follows:



	Year Ended December 31,
(In thousands)	2012			2011
Balance at beginning of period	$	125,757		$	92,845
Tax positions related to the current year:
Increases	1,209			1,268
Decreases	(1,624		)	(2,005		)
Tax positions related to prior years:
Increases	27,302			51,480
Decreases	(4,243		)	(17,831		)
Lapses of applicable statute of limitation	(34,388		)	—
Balance at end of period	$	114,013		$	125,757

We have taken a position in various jurisdictions that we are not required to remit taxes with regard to the income generated from our investment in certain partnership interests. Although we believe that these tax positions are more likely than not to succeed if adjudicated in a court of last resort, measurement under this standard of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Our net unrecognized tax benefits related to prior years increased by approximately $23.0 million. This net increase primarily reflects the impact of unrecognized tax benefits associated with our recognition of certain premium income. Although unrecognized tax benefits for this item decreased by approximately $23.3 million due to the expiration of the applicable statute of limitations for the taxable period ended December 31, 2008, the related amounts continued to impact subsequent years resulting in a corresponding increase to the unrecognized tax benefits related primarily to the 2009 taxable year.

In January 2013, we were notified that Appeals rejected our latest settlement offer and plans to issue a formal notice of deficiency within three to six months. Based on these recent developments, we do not currently believe that a settlement is likely, in which case we would likely litigate the disputed amounts. Over the next twelve months, if we determine that a compromised settlement cannot be reached with Appeals, then it is estimated that approximately $65.2 million of unrecognized tax benefits in the above tabular reconciliation may be reversed pursuant to the accounting standard for uncertain tax positions.

In the event we are not successful in defense of our tax positions taken for U.S. Federal income tax purposes, and for which we have recorded unrecognized tax benefits, then such adjustments originating in NOL or NOL carryback years may serve as a reduction to our existing NOL.

The following calendar tax years, listed by major jurisdiction, remain subject to examination:



U.S. Federal Corporation Income Tax	2000 - 2007(1), 2009 - 2011
Significant State and Local Jurisdictions (2)	1999 - 2011

_________________________

(1)

We are currently contesting proposed adjustments resulting from the examination by the IRS of our 2000 through 2007 tax years. As part of this process, we have agreed to extend all relevant statute of limitations for the assessment of tax to June 30, 2013. All such statute of limitation extensions have limited the scope of the examinations to the recognition of certain tax benefits that relate to our investment in a portfolio of non-economic REMIC residual interests.


(2)	Arizona, California, Florida, Georgia, New York, Ohio, Pennsylvania, Texas and New York City.