Note 19 — Income Taxes
A. Income Tax Expense
The components of income taxes for the years ended December 31 were as follows:
| (In millions) | 2013 | 2012 | 2011 | |||
| Current taxes | ||||||
| U.S. income taxes | $ | 382 | $ | 604 | $ | 320 |
| Foreign income taxes | 77 | 72 | 58 | |||
| State income taxes | 42 | 43 | 20 | |||
| 501 | 719 | 398 | ||||
| Deferred taxes (benefits) | ||||||
| U.S. income taxes | 152 | 131 | 193 | |||
| Foreign income taxes | 46 | 4 | 23 | |||
| State income taxes | (1) | (1) | 1 | |||
| 197 | 134 | 217 | ||||
| Total income taxes | $ | 698 | $ | 853 | $ | 615 |
Total income taxes for the years ended December 31 were different from the amount computed using the nominal federal income tax rate of 35% for the following reasons:
| (In millions) | 2013 | 2012 | 2011 | |||
| Tax expense at nominal rate | $ | 761 | $ | 867 | $ | 657 |
| Tax advantaged investments | (30) | (31) | (33) | |||
| Effect of indefinitely reinvested foreign earnings | (42) | (37) | (17) | |||
| Resolution of federal tax matters | (18) | - | (30) | |||
| State income tax (net of federal income tax benefit) | 27 | 28 | 14 | |||
| Other | - | 26 | 24 | |||
| Total income taxes | $ | 698 | $ | 853 | $ | 615 |
Consolidated pre-tax income from the Company's foreign operations was approximately 12% in 2013, 8% in 2012 and 10% in 2011.
Indefinite Reinvestment of Foreign Earnings
The Company continues to indefinitely reinvest overseas the undistributed earnings of certain foreign operations, including those of its Korea operations. As a result, income taxes are provided on the earnings of these operations using the respective foreign jurisdictions' tax rate, as compared to the higher U.S. statutory tax rate. The Company continues to evaluate this reinvestment of foreign earnings for additional jurisdictions.
The indefinite reinvestment of earnings of foreign operations resulted in an increase to shareholders' net income of $42 million in 2013 and $37 million in 2012. The Company has accumulated indefinitely reinvested foreign earnings of $1.1 billion with cumulative unrecognized deferred tax liabilities of $160 million through December 31, 2013.
Completion of IRS Examinations
In the third quarter of 2013, the Internal Revenue Service (“IRS”) completed its examination of the Company's 2009 and 2010 consolidated federal income tax returns, resulting in an increase to shareholders' net income of $18 million.
In 2011, the IRS completed its examination of the Company's 2007 and 2008 consolidated federal income tax returns, resulting in an increase to shareholders' net income of $24 million.
B. Deferred Income Taxes
Deferred income tax assets and liabilities as of December 31 are as follows:
| (In millions) | 2013 | 2012 | ||
| Deferred tax assets | ||||
| Employee and retiree benefit plans | $ | 422 | $ | 765 |
| Investments, net | 25 | 84 | ||
| Other insurance and contractholder liabilities | 407 | 486 | ||
| Deferred gain on sale of businesses | 39 | 39 | ||
| Policy acquisition expenses | 142 | 147 | ||
| Other accrued liabilities | 157 | 164 | ||
| Bad debt expense | 24 | 21 | ||
| Other | 40 | 42 | ||
| Deferred tax assets before valuation allowance | 1,256 | 1,748 | ||
| Valuation allowance for deferred tax assets | (49) | (42) | ||
| Deferred tax assets, net of valuation allowance | 1,207 | 1,706 | ||
| Deferred tax liabilities | ||||
| Depreciation and amortization | 700 | 704 | ||
| Foreign operations, net | 162 | 147 | ||
| Unrealized appreciation on investments and foreign currency translation | 253 | 481 | ||
| Total deferred tax liabilities | 1,115 | 1,332 | ||
| Net deferred income tax assets | $ | 92 | $ | 374 |
Management believes that consolidated taxable income expected to be generated in the future will be sufficient to realize the Company's net deferred tax asset. Substantially all of the Company's deferred tax benefits may be carried forward indefinitely. The Company establishes a valuation allowance when it determines it is more likely than not that a deferred tax asset will not be realized. Valuation allowances have been established for certain deferred tax assets that are evaluated for realization on a separate entity basis, rather than considering consolidated results.
C. Uncertain Tax Positions
A reconciliation of unrecognized tax benefits for the years ended December 31 is as follows:
| (In millions) | 2013 | 2012 | 2011 | |||
| Balance at January 1, | $ | 51 | $ | 52 | $ | 177 |
| Decrease due to prior year positions | (35) | (5) | (113) | |||
| Increase due to current year positions | 6 | 7 | 7 | |||
| Reduction related to settlements with taxing authorities | - | - | (17) | |||
| Reduction related to lapse of applicable statute of limitations | (5) | (3) | (2) | |||
| Balance at December 31, | $ | 17 | $ | 51 | $ | 52 |
Unrecognized tax benefits decreased $34 million in 2013 of which $16 million increased shareholders' net income. The decrease was primarily attributable to completion of the IRS examination of the Company's 2009 and 2010 consolidated federal income tax returns.
The Company classifies net interest expense on uncertain tax positions and any applicable penalties as a component of income tax expense, but excludes these amounts from the liability for uncertain tax positions. The Company's liability for net interest and penalties was immaterial at December 31, 2013, 2012 and 2011.
D. Federal Income Tax Examinations, Litigation and Other Matters
The Company's long-standing dispute with the IRS for tax years 2004 through 2006, regarding the appropriate reserve methodology for certain reinsurance contracts, has been resolved. On February 28, 2013, the United States Tax Court entered its decision on this matter for the 2004 tax year, finding the Company had an overpayment of federal income tax for the period. The refund was received on June 24, 2013. On January 9, 2013, the United States Tax Court entered its decision on this matter for the 2005 and 2006 tax years, finding that the Company had no additional tax liability for these years. There are no outstanding IRS related matters with regard to the 2007 and 2008 tax years.
The IRS has completed their examination of the Company's 2009 and 2010 tax years. Two issues could not be resolved at the examination level that related to the timing of income tax deductions. On October 22, 2013, the Company filed a formal protest challenging the IRS positions on the two disputed matters. The IRS has since agreed to withdraw its challenge relating to one of these matters and is expected to re-issue the revenue agents report. The Company continues efforts to resolve the second matter.
The Company conducts business in numerous state and foreign jurisdictions, and may be engaged in multiple audit proceedings at any given time. Generally, no further state audit activity is expected for tax years prior to 2009, and prior to 2003 for foreign audit activity.