Chesapeake Energy (CHK)

Income Taxes

Chesapeake recorded income tax expense of $387 million in 2008 compared to income tax expense of $892 million in 2007 and $1.247 billion in 2006. Of the income tax expense recorded in 2008, $423 million is reflected as current income tax expense and $36 million is reflected as deferred income tax benefit. The divestitures that closed during 2008 are projected to generate sufficient taxable income for the year to exhaust all our non-limited NOLs and result in a current tax liability for the tax year ended December 31, 2008. Of the $505 million decrease in 2008, $515 million was the result of the decrease in net income before taxes which was offset by $10 million as the result of an increase in the effective tax rate. Our effective income tax rate was 39% in 2008 compared to 38% in 2007 and 38.5% in 2006. Our effective tax rate fluctuates as a result of the impact of state income taxes and permanent differences between our accounting for certain revenue or expense items and their corresponding treatment for income tax purposes. We expect our effective income tax rate to be 39% in 2009.

At December 31, 2008, Chesapeake had federal income tax net operating loss (NOL) carryforwards of approximately $12 million. We also had approximately $3 million of alternative minimum tax (AMT) NOL carryforwards available as a deduction against future AMT income. The NOL carryforwards expire from 2019 through 2026. The value of the remaining carryforwards depends on the ability of Chesapeake to generate taxable income. In addition, for AMT purposes, only 90% of AMT income in any given year may be offset by AMT NOLs.

The ability of Chesapeake to utilize NOL carryforwards to reduce future federal taxable income and federal income tax is subject to various limitations under the Internal Revenue Code of 1986, as amended. The utilization of such carryforwards may be limited upon the occurrence of certain ownership changes, including the issuance or exercise of rights to acquire stock, the purchase or sale of stock by 5% stockholders, as defined in the Treasury regulations, and the offering of stock by us during any three-year period resulting in an aggregate change of more than 50% in the beneficial ownership of Chesapeake.

In the event of an ownership change (as defined for income tax purposes), Section 382 of the Code imposes an annual limitation on the amount of a corporation’s taxable income that can be offset by these carryforwards. The limitation is generally equal to the product of (i) the fair market value of the equity of the company multiplied by (ii) a percentage approximately equivalent to the yield on long-term tax exempt bonds during the month in which an ownership change occurs. In addition, the limitation is increased if there are recognized built-in gains during any post-change year, but only to the extent of any net unrealized built-in gains (as defined in the Code) inherent in the assets sold. Certain NOLs acquired through various acquisitions are also subject to limitations. The following table summarizes our net operating losses as of December 31, 2008 and any related limitations:

As of December 31, 2008, we do not believe that an ownership change has occurred. Future equity transactions by Chesapeake or by 5% stockholders (including relatively small transactions and transactions beyond our control) could cause an ownership change and therefore a limitation on the annual utilization of NOLs. Following an ownership change, the amount of Chesapeake’s NOLs available for use each year will depend upon future events that cannot currently be predicted and upon interpretation of complex rules under Treasury regulations.

If less than the full amount of the annual limitation is utilized in any given year, the unused portion may be carried forward and may be used in addition to successive years’ annual limitation.

We expect to utilize our NOL carryforwards and other tax deductions and credits to offset taxable income in the future. However, there is no assurance that the Internal Revenue Service will not challenge these carryforwards or their utilization.

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In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109. FIN 48 provides guidance for recognizing and measuring uncertain tax positions, as defined in SFAS 109, Accounting for Income Taxes. FIN 48 prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. FIN 48 became effective for fiscal years beginning after December 15, 2006.

Chesapeake adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, Chesapeake recognized a $7 million liability for accrued interest associated with uncertain tax positions which was accounted for as a reduction in the January 1, 2007 balance of retained earnings, net of tax. At the date of adoption and at December 31, 2007, we had approximately $142 million and $133 million, respectively, of unrecognized tax benefits related to alternative minimum tax (AMT) associated with uncertain tax positions. As of December 31, 2008, the amount of unrecognized tax benefits related to regular tax liabilities and AMT associated with uncertain tax positions was $60 million. Of this amount, $48 million is related to regular tax liabilities and $12 million is related to AMT. These unrecognized tax benefits are associated with temporary differences. If these unrecognized tax benefits are disallowed and we are required to pay additional taxes, the reversal of the temporary differences associated with the regular tax liabilities will increase our tax basis which will increase our future tax deductions. Any AMT payments can be utilized as credits against future regular tax liabilities. The uncertain tax positions identified would not have a material effect on the effective tax rate. At December 31, 2008, we had an accrued liability of $3 million for interest related to these uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

Chesapeake files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, Chesapeake is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years prior to 2005. The Internal Revenue Service (IRS) completed an examination of Chesapeake’s U.S. income tax returns for 2005 and 2006 in December 2008. This examination resulted in additional AMT liabilities of $1 million. These AMT liabilities will be utilized as credits against current regular tax liabilities. The adjustments in the examination did not result in a material change to our financial position, results of operations or cash flows.

Income Taxes

Chesapeake recorded income tax expense of $463 million in 2008 compared to income tax expense of $890 million in 2007 and $1.252 billion in 2006. Of the income tax expense recorded in 2008, $423 million is reflected as current income tax expense and $40 million is reflected as deferred income tax expense. The divestitures that closed during 2008 are projected to generate sufficient taxable income for the year to exhaust all our non-limited NOLs and result in a current tax liability for the tax year ended December 31, 2008. Of the $427 million decrease in 2008, $439 million was the result of the decrease in net income before taxes which was offset by $12 million as the result of an increase in the effective tax rate. Our effective income tax rate was 39% in 2008 compared to 38% in 2007 and 38.5% in 2006. Our effective tax rate fluctuates as a result of the impact of state income taxes and permanent differences between our accounting for certain revenue or expense items and their corresponding treatment for income tax purposes. We expect our effective income tax rate to be 39% in 2009.

At December 31, 2008, Chesapeake had federal income tax net operating loss (NOL) carryforwards of approximately $12 million. We also had approximately $3 million of alternative minimum tax (AMT) NOL carryforwards available as a deduction against future AMT income. The NOL carryforwards expire from 2019 through 2026. The value of the remaining carryforwards depends on the ability of Chesapeake to generate taxable income. In addition, for AMT purposes, only 90% of AMT income in any given year may be offset by AMT NOLs.

The ability of Chesapeake to utilize NOL carryforwards to reduce future federal taxable income and federal income tax is subject to various limitations under the Internal Revenue Code of 1986, as amended. The utilization of such carryforwards may be limited upon the occurrence of certain ownership changes, including the

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issuance or exercise of rights to acquire stock, the purchase or sale of stock by 5% stockholders, as defined in the Treasury regulations, and the offering of stock by us during any three-year period resulting in an aggregate change of more than 50% in the beneficial ownership of Chesapeake.

In the event of an ownership change (as defined for income tax purposes), Section 382 of the Code imposes an annual limitation on the amount of a corporation’s taxable income that can be offset by these carryforwards. The limitation is generally equal to the product of (i) the fair market value of the equity of the company multiplied by (ii) a percentage approximately equivalent to the yield on long-term tax exempt bonds during the month in which an ownership change occurs. In addition, the limitation is increased if there are recognized built-in gains during any post-change year, but only to the extent of any net unrealized built-in gains (as defined in the Code) inherent in the assets sold. Certain NOLs acquired through various acquisitions are also subject to limitations. The following table summarizes our net operating losses as of December 31, 2008 and any related limitations:

As of December 31, 2008, we do not believe that an ownership change has occurred. Future equity transactions by Chesapeake or by 5% stockholders (including relatively small transactions and transactions beyond our control) could cause an ownership change and therefore a limitation on the annual utilization of NOLs. Following an ownership change, the amount of Chesapeake’s NOLs available for use each year will depend upon future events that cannot currently be predicted and upon interpretation of complex rules under Treasury regulations.

If less than the full amount of the annual limitation is utilized in any given year, the unused portion may be carried forward and may be used in addition to successive years’ annual limitation.

We expect to utilize our NOL carryforwards and other tax deductions and credits to offset taxable income in the future. However, there is no assurance that the Internal Revenue Service will not challenge these carryforwards or their utilization.

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109. FIN 48 provides guidance for recognizing and measuring uncertain tax positions, as defined in SFAS 109, Accounting for Income Taxes. FIN 48 prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. FIN 48 became effective for fiscal years beginning after December 15, 2006.

Chesapeake adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, Chesapeake recognized a $7 million liability for accrued interest associated with uncertain tax positions which was accounted for as a reduction in the January 1, 2007 balance of retained earnings, net of tax. At the date of adoption and at December 31, 2007, we had approximately $142 million and $133 million, respectively, of unrecognized tax benefits related to alternative minimum tax (AMT) associated with uncertain tax positions. As of December 31, 2008, the amount of unrecognized tax benefits related to regular tax liabilities and AMT associated with uncertain tax positions was $60 million. Of this amount, $48 million is related to regular tax liabilities and $12 million is related to AMT. These unrecognized tax benefits are associated with temporary differences. If these unrecognized tax benefits are disallowed and we are required to pay additional taxes, the reversal of the temporary differences associated with the regular tax liabilities will increase our tax basis which

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will increase our future tax deductions. Any AMT payments can be utilized as credits against future regular tax liabilities. The uncertain tax positions identified would not have a material effect on the effective tax rate. At December 31, 2008, we had an accrued liability of $3 million for interest related to these uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

Chesapeake files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, Chesapeake is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years prior to 2005. The Internal Revenue Service (IRS) completed an examination of Chesapeake’s U.S. income tax returns for 2005 and 2006 in December 2008. This examination resulted in additional AMT liabilities of $1 million. These AMT liabilities will be utilized as credits against current regular tax liabilities. The adjustments in the examination did not result in a material change to our financial position, results of operations or cash flows.

Income Taxes

Income Taxes

Chesapeake adopted the provisions of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 on January 1, 2007. As of September 30, 2008, the company estimates we have uncertain tax positions which could result in AMT liabilities of $140 million. If the outcome of these uncertain tax positions results in AMT liabilities, they can be utilized as credits against future regular tax liabilities; therefore, we are only required to establish an interest accrual associated with these liabilities. The uncertain tax positions identified would not have an effect on the effective tax rate. At September 30, 2008, we had a liability of $11 million for interest related to these same uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

Income Taxes

Chesapeake adopted the provisions of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 on January 1, 2007. As of September 30, 2008, the company estimates we have uncertain tax positions which could result in AMT liabilities of $140 million. If the outcome of these uncertain tax positions results in AMT liabilities, they can be utilized as credits against future regular tax liabilities; therefore, we are only required to establish an interest accrual associated with these liabilities. The uncertain tax positions identified would not have an effect on the effective tax rate. At September 30, 2008, we had a liability of $11 million for interest related to these same uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

Income Taxes

Chesapeake adopted the provisions of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 on January 1, 2007. As of June 30, 2008, the amount of unrecognized tax benefits related to AMT liabilities associated with uncertain tax positions was $134 million. These AMT liabilities can be utilized as credits against future regular tax liabilities. The uncertain tax positions identified would not have an effect on the effective tax rate. At June 30, 2008, we had a liability of $9 million for interest related to these same uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

Income Taxes

Chesapeake adopted the provisions of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 on January 1, 2007. As of March 31, 2008, the amount of unrecognized tax benefits related to AMT liabilities associated with uncertain tax positions was $136 million. These AMT liabilities can be utilized as credits against future regular tax liabilities. The uncertain tax positions identified would not have an effect on the effective tax rate. At March 31, 2008, we had a liability of $7 million for interest related to these same uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

Chesapeake files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, Chesapeake is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years prior to 2004. In March 2008, the IRS commenced an examination of Chesapeake’s U.S. income tax returns for 2005 and 2006 which we expect will be completed in 2009. We do not anticipate that the outcome of this examination would result in a material change to our financial position, results of operations or cash flows.

Income Taxes

Chesapeake recorded income tax expense of $890 million in 2007 compared to income tax expense of $1.252 billion in 2006 and $545 million in 2005. Of the $362 million decrease in 2007, $347 million was the result of the decrease in net income before taxes and $15 million was the result of a decrease in the effective tax rate. Our effective income tax rate was 38% in 2007 compared to 38.5% in 2006 and 36.5% in 2005. Our effective tax rate fluctuates as a result of the impact of state income taxes and permanent differences between our accounting for certain revenue or expense items and their corresponding treatment for income tax purposes. We expect our effective income tax rate to be 38.5% in 2008.

At December 31, 2007, Chesapeake had federal income tax net operating loss (NOL) carryforwards of approximately $238 million and approximately $29 million of percentage depletion carryforwards. We also had approximately $5 million of alternative minimum tax (AMT) NOL carryforwards available as a deduction against future AMT income. The NOL carryforwards expire from 2019 through 2026. The value of the remaining carryforwards depends on the ability of Chesapeake to generate taxable income. In addition, for AMT purposes, only 90% of AMT income in any given year may be offset by AMT NOLs.

The ability of Chesapeake to utilize NOL carryforwards to reduce future federal taxable income and federal income tax is subject to various limitations under the Internal Revenue Code of 1986, as amended. The utilization of such carryforwards may be limited upon the occurrence of certain ownership changes, including the issuance or exercise of rights to acquire stock, the purchase or sale of stock by 5% stockholders, as defined in the Treasury regulations, and the offering of stock by us during any three-year period resulting in an aggregate change of more than 50% in the beneficial ownership of Chesapeake.

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Index to Financial Statements

In the event of an ownership change (as defined for income tax purposes), Section 382 of the Code imposes an annual limitation on the amount of a corporation’s taxable income that can be offset by these carryforwards. The limitation is generally equal to the product of (i) the fair market value of the equity of the company multiplied by (ii) a percentage approximately equivalent to the yield on long-term tax exempt bonds during the month in which an ownership change occurs. In addition, the limitation is increased if there are recognized built-in gains during any post-change year, but only to the extent of any net unrealized built-in gains (as defined in the Code) inherent in the assets sold. Certain NOLs acquired through various acquisitions are also subject to limitations. The following table summarizes our net operating losses as of December 31, 2007 and any related limitations:

As of December 31, 2007, we do not believe that an ownership change has occurred. Future equity transactions by Chesapeake or by 5% stockholders (including relatively small transactions and transactions beyond our control) could cause an ownership change and therefore a limitation on the annual utilization of NOLs. Following an ownership change, the amount of Chesapeake’s NOLs available for use each year will depend upon future events that cannot currently be predicted and upon interpretation of complex rules under Treasury regulations. If less than the full amount of the annual limitation is utilized in any given year, the unused portion may be carried forward and may be used in addition to successive years’ annual limitation.

We expect to utilize our NOL carryforwards and other tax deductions and credits to offset taxable income in the future. However, there is no assurance that the Internal Revenue Service will not challenge these carryforwards or their utilization.

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109. FIN 48 provides guidance for recognizing and measuring uncertain tax positions, as defined in SFAS 109, Accounting for Income Taxes. FIN 48 prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. FIN 48 became effective for fiscal years beginning after December 15, 2006.

Chesapeake adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, Chesapeake recognized a $7 million liability for accrued interest associated with uncertain tax positions which was accounted for as a reduction in the January 1, 2007 balance of retained earnings, net of tax. At the date of adoption, we had approximately $142 million of unrecognized tax benefits related to alternative minimum tax (AMT) associated with uncertain tax positions. As of December 31, 2007, the amount of unrecognized tax benefits related to AMT associated with uncertain tax positions was $133 million. If these unrecognized tax benefits are disallowed and we are ultimately required to pay additional AMT liabilities, any payments can be utilized as credits against future regular tax liabilities. The uncertain tax positions identified would not have a material effect on the effective tax rate. At December 31, 2007, we had a liability of $5 million for interest related to these same uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

Chesapeake files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, Chesapeake is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years prior to 2004. The Internal Revenue Service (IRS) completed an examination of Chesapeake’s U.S. income tax returns for 2003 and 2004 in September 2007. This examination resulted in

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Index to Financial Statements

additional AMT liabilities of $9 million. These AMT liabilities can be utilized as credits against future regular tax liabilities. The adjustments in the examination did not result in a material change to our financial position, results of operations or cash flows.

Income Taxes

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109. FIN 48 provides guidance for recognizing and measuring uncertain tax positions, as defined in SFAS 109, Accounting for Income Taxes. FIN 48 prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006.

Chesapeake adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, Chesapeake recognized a $7 million liability for accrued interest associated with uncertain tax positions which was accounted for as a reduction in the January 1, 2007 balance of retained earnings, net of tax. At the date of adoption, we had approximately $142 million of unrecognized tax benefits related to alternative minimum tax (AMT) associated with uncertain tax positions. As of September 30, 2007, the amount of unrecognized tax benefits related to AMT associated with uncertain tax positions was $84 million. These AMT liabilities can be utilized as credits against future regular tax liabilities. The uncertain tax positions identified would not have a material effect on the effective tax rate. At September 30, 2007, we had a liability of $7 million for interest related to these same uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Chesapeake files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, Chesapeake is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years prior to 2004. The Internal Revenue Service (IRS) completed an examination of Chesapeake’s U.S. income tax returns for 2003 and 2004 in September 2007. This examination resulted in additional AMT liabilities of $9 million. These AMT liabilities can be utilized as credits against future regular tax liabilities. The adjustments in the examination did not result in a material change to our financial position, results of operations or cash flows.

Income Taxes

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109. FIN 48 provides guidance for recognizing and measuring uncertain tax positions, as defined in SFAS 109, Accounting for Income Taxes. FIN 48 prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006.

Chesapeake adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, Chesapeake recognized a $7 million liability for accrued interest associated with uncertain tax positions which was accounted for as a reduction to the January 1, 2007 balance of retained earnings, net of tax. At the date of adoption, we had approximately $142 million of unrecognized tax benefits related to alternative minimum tax (AMT) associated with uncertain tax positions. As of June 30, 2007, the amount of unrecognized tax benefits related to AMT associated with uncertain tax positions was $154 million. These AMT liabilities can be utilized as credits against future regular tax liabilities. The uncertain tax positions identified would not have a material effect on the effective tax rate. At June 30, 2007, we had a liability of $10 million for interest related to these same uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Chesapeake files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, Chesapeake is no longer subject to the U.S. federal, state and local income tax examinations by tax authorities for years prior to 2003. The Internal Revenue Service (IRS) commenced an examination of Chesapeake’s U.S. income tax returns for 2003 and 2004 in 2006 that is anticipated to be completed by the end of 2007. As of June 30, 2007, the IRS has proposed a limited number of adjustments. We are currently evaluating the proposed adjustments, but we do not anticipate that the adjustments would result in a material change to our financial position, results of operations or cash flows.

Income Taxes

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109. FIN 48 provides guidance for recognizing and measuring uncertain tax positions, as defined in SFAS 109, Accounting for Income Taxes. FIN 48 prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006.

Chesapeake adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, Chesapeake recognized a $7 million liability for accrued interest associated with uncertain tax positions which was accounted for as a reduction to the January 1, 2007 balance of retained earnings, net of tax. At the date of adoption, we had approximately $142 million of alternative minimum tax liabilities associated with uncertain tax positions. These AMT liabilities can be utilized as credits against future regular tax liabilities. The uncertain tax positions identified would not have a material effect on the effective tax rate. At March 31, 2007, we had a liability of $9 million for interest related to these same uncertain tax positions. Chesapeake recognizes interest related to uncertain tax positions in interest expense. Penalties, if any, related to uncertain tax positions would be recorded in other expenses.

Chesapeake files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, Chesapeake is no longer subject to the U.S. federal, state and local income tax examinations by tax authorities for years prior to 2003. The Internal Revenue Service (IRS) commenced an examination of Chesapeake’s U.S. income tax returns for 2003 and 2004 in 2006 that is anticipated to be completed by early 2008. As of March 31, 2007, the IRS has proposed a limited number of adjustments. We are currently evaluating the

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CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

proposed adjustments, but we do not anticipate that the adjustments would result in a material change to our financial position, results of operations or cash flows.

Income Taxes

Chesapeake recorded income tax expense of $1.252 billion in 2006 compared to income tax expense of $545.1 million in 2005 and $289.8 million in 2004. Of the $706.9 million increase in 2006, $643.1 million was the result of the increase in net income before taxes and $63.8 million was the result of an increase in the effective tax rate. Our effective income tax rate was 38.5% in 2006 compared to 36.5% in 2005 and 36% in 2004. The increase in 2006 reflected the impact state income taxes and permanent differences had on our overall effective rate along with the effect of a Texas tax law change. In May 2006, Texas eliminated the existing franchise tax and replaced it with a new income-based margin tax. The new tax is effective for tax returns due on or after January 1, 2008 for our 2007 business activity. We recorded a $15 million liability in 2006 to reflect the impact that this change had on our liability for additional deferred income taxes at the date of enactment. We expect our effective income tax rate to be 38% in 2007.

At December 31, 2006, Chesapeake had federal income tax net operating loss (NOL) carryforwards of approximately $631.1 million. We also had approximately $3.6 million of alternative minimum tax (AMT) NOL carryforwards available as a deduction against future AMT income and approximately $15.9 million of percentage depletion carryforwards. The NOL carryforwards expire from 2011 through 2026. The value of the remaining carryforwards depends on the ability of Chesapeake to generate taxable income. In addition, for AMT purposes, only 90% of AMT income in any given year may be offset by AMT NOLs.

The ability of Chesapeake to utilize NOL carryforwards to reduce future federal taxable income and federal income tax is subject to various limitations under the Internal Revenue Code of 1986, as amended. The utilization of such carryforwards may be limited upon the occurrence of certain ownership changes, including the

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Index to Financial Statements

issuance or exercise of rights to acquire stock, the purchase or sale of stock by 5% stockholders, as defined in the Treasury regulations, and the offering of stock by us during any three-year period resulting in an aggregate change of more than 50% in the beneficial ownership of Chesapeake.

In the event of an ownership change (as defined for income tax purposes), Section 382 of the Code imposes an annual limitation on the amount of a corporation’s taxable income that can be offset by these carryforwards. The limitation is generally equal to the product of (i) the fair market value of the equity of the company multiplied by (ii) a percentage approximately equivalent to the yield on long-term tax exempt bonds during the month in which an ownership change occurs. In addition, the limitation is increased if there are recognized built-in gains during any post-change year, but only to the extent of any net unrealized built-in gains (as defined in the Code) inherent in the assets sold. Certain NOLs acquired through various acquisitions are also subject to limitations. The following table summarizes our net operating losses as of December 31, 2006 and any related limitations:

As of December 31, 2006, we do not believe that an ownership change has occurred. Future equity transactions by Chesapeake or by 5% stockholders (including relatively small transactions and transactions beyond our control) could cause an ownership change and therefore a limitation on the annual utilization of NOLs. Following an ownership change, the amount of Chesapeake’s NOLs available for use each year will depend upon future events that cannot currently be predicted and upon interpretation of complex rules under Treasury regulations. If less than the full amount of the annual limitation is utilized in any given year, the unused portion may be carried forward and may be used in addition to successive years’ annual limitation.

We expect to utilize our NOL carryforwards and other tax deductions and credits to offset taxable income in the future. However, there is no assurance that the Internal Revenue Service will not challenge these carryforwards or their utilization.

Income Taxes

Chesapeake recorded income tax expense of $545.1 million in 2005 compared to income tax expense of $289.8 million in 2004 and $191.8 million in 2003. Our effective income tax rate was 36.5% in 2005 compared to 36% in 2004 and 38% in 2003. The increase in 2005 reflected the impact state income taxes and permanent differences had on our overall effective rate. We expect our effective income tax rate will increase to 38% in 2006 to reflect our current assessment of expected increases in state income taxes and permanent differences.

At December 31, 2005, Chesapeake had federal income tax net operating loss (NOL) carryforwards of approximately $564.5 million. We also had approximately $169.6 million of alternative minimum tax (AMT) NOL carryforwards available as a deduction against future AMT income and approximately $12.3 million of percentage depletion carryforwards. The NOL carryforwards expire from 2012 through 2025. The value of the remaining carryforwards depends on the ability of Chesapeake to generate taxable income. In addition, for AMT purposes, only 90% of AMT income in any given year may be offset by AMT NOLs.

The ability of Chesapeake to utilize NOL carryforwards to reduce future federal taxable income and federal income tax is subject to various limitations under the Internal Revenue Code of 1986, as amended. The utilization of such carryforwards may be limited upon the occurrence of certain ownership changes, including the issuance or exercise of rights to acquire stock, the purchase or sale of stock by 5% stockholders, as defined in the Treasury regulations, and the offering of stock by us during any three-year period resulting in an aggregate change of more than 50% in the beneficial ownership of Chesapeake.

In the event of an ownership change (as defined for income tax purposes), Section 382 of the Code imposes an annual limitation on the amount of a corporation’s taxable income that can be offset by these carryforwards. The limitation is generally equal to the product of (i) the fair market value of the equity of the company multiplied by (ii) a percentage approximately equivalent to the yield on long-term tax exempt bonds during the month in which an ownership change occurs. In addition, the limitation is increased if there are recognized built-in gains during any post-change year, but only to the extent of any net unrealized built-in gains (as defined in the Code) inherent in the assets sold. Certain NOLs acquired through various acquisitions are also subject to limitations. The following table summarizes our net operating losses as of December 31, 2005 and any related limitations:

Although no assurances can be made, we do not believe that an ownership change has occurred as of December 31, 2005. Future equity transactions by Chesapeake or by 5% stockholders (including relatively small transactions and transactions beyond our control) could cause an ownership change and therefore a limitation on the annual utilization of NOLs. Following an ownership change, the amount of Chesapeake’s NOLs available for use each year will depend upon future events that cannot currently be predicted and upon interpretation of complex

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rules under Treasury regulations. If less than the full amount of the annual limitation is utilized in any given year, the unused portion may be carried forward and may be used in addition to successive years’ annual limitation.

We expect to utilize our NOL carryforwards and other tax deductions and credits to offset taxable income in the future. However, there is no assurance that the Internal Revenue Service will not challenge these carryforwards or their utilization.

Income Taxes

The Company and its largest subsidiary, CNR, were each established as a Single Member Limited Liability Company (LLC), thus the LLC is not recognized for federal and, if applicable, state and local income tax purposes. As such, the Company is not subject to federal and state income taxes. Two subsidiaries, CNRC and TEL, are subject to federal income tax and, if applicable, state and local income tax. There were no significant deferred tax assets or liabilities as of December 31, 2004 or 2003. Income tax expense reported on the consolidated statements of operations for the year ended December 31, 2004, represented income tax expense for TEL from

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Columbia Energy Resources, LLC (a wholly owned

subsidiary of Triana Energy Holdings, LLC)

Notes to Consolidated Financial Statements (continued)

2. Critical Accounting Policies and Estimates (continued)

earnings. Income tax expense for the four months ended December 31, 2003, included $26,000 of income tax expense for TEL from earnings and approximately $85,000 of alternative minimum tax related to the dissolution of Triana Energy, Inc.