Pepco Holdings (POM)

FIN 48, “Accounting for Uncertainty in Income Taxes”

As disclosed in Note (2), “Significant Accounting Policies,” PHI adopted FIN 48 effective January 1, 2007. Upon adoption, PHI recorded the cumulative effect of the change in accounting principle of $7 million as a decrease in retained earnings. Also upon adoption, PHI had $187 million of unrecognized tax benefits and $24 million of related accrued interest.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits

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Unrecognized Benefits That If Recognized Would Affect the Effective Tax Rate

Unrecognized tax benefits represent those tax benefits related to tax positions that have been taken or are expected to be taken in tax returns that are not recognized in the financial statements because, in accordance with FIN 48, management has either measured the tax benefit at an amount less than the benefit claimed or expected to be claimed, or has concluded that it is not more likely than not that the tax position will be ultimately sustained.

For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. Unrecognized tax benefits at December 31, 2008, included $18 million that, if recognized, would lower the effective tax rate.

Interest and Penalties

PHI recognizes interest and penalties relating to its uncertain tax positions as an element of income tax expense. For the years ended December 31, 2008 and 2007, PHI recognized $25 million of interest income before tax ($15 million after-tax) and $4 million of interest expense before tax ($2 million after-tax), respectively, as a component of income tax expense. As of December 31, 2008 and 2007, PHI had $16 million and $31 million, respectively, of accrued interest payable related to effectively settled and uncertain tax positions.

Possible Changes to Unrecognized Tax Benefits

It is reasonably possible that the amount of the unrecognized tax benefit with respect to some of PHI’s uncertain tax positions will significantly increase or decrease within the next 12 months. The possible settlement of the cross-border energy lease investments issue, the final resolution of the Mixed Service Cost issue, or other federal or state audits could impact the balances significantly. At this time, other than the Mixed Service Cost issue, an estimate of the range of reasonably possible outcomes cannot be determined. The unrecognized benefit related to the Mixed Service Cost issue could decrease by $55 million within the next 12 months upon the final resolution of the tentative settlement with the IRS and the obligation becomes certain. See Note (16), “Commitments and Contingencies,” for additional information.

Tax Years Open to Examination

PHI and the majority of its subsidiaries file a consolidated federal income tax return. PHI’s federal income tax liabilities for Pepco legacy companies for all years through 2000, and for Conectiv legacy companies for all years through 1999, have been determined by the IRS, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. The open tax years for the significant states where PHI files state income tax returns (District of Columbia, Maryland, Delaware, New Jersey, Pennsylvania and Virginia) are the same as noted above.

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FIN 48, “Accounting for Uncertainty in Income Taxes”

As disclosed in Note (2), “Summary of Significant Accounting Policies”, PHI adopted FIN 48 effective January 1, 2007. Upon adoption, PHI recorded the cumulative effect of the change in accounting principle of $7.4 million as a decrease in retained earnings. Also upon adoption, PHI had $186.9 million of unrecognized tax benefits and $24.3 million of related accrued interest.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits

As of December 31, 2007, PHI had $26.4 million of accrued interest related to unrecognized tax benefits.

Unrecognized Benefits That If Recognized Would Affect the Effective Tax Rate

Unrecognized tax benefits represent those tax benefits related to tax positions that have been taken or are expected to be taken in tax returns that are not recognized in the financial statements because, in accordance with FIN 48, management has either measured the tax benefit at an amount less than the benefit claimed or expected to be claimed or has concluded that it is not more likely than not that the tax position will be ultimately sustained.

For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. Unrecognized tax benefits at December 31, 2007, included $11.2 million that, if recognized, would lower the effective tax rate.

Interest and Penalties

PHI recognizes interest and penalties relating to its unrecognized tax benefits as an element of tax expense. For the year ended December 31, 2007, PHI recognized $2.1 million of interest expense and penalties, net, as a component of tax expense.

Possible Changes to Unrecognized Benefits

Total unrecognized tax benefits that may change over the next twelve months include the matter of Mixed Service Costs. See discussion in Note (12), “Commitments and Contingencies—IRS Mixed Service Cost Issue.”

Tax Years Open to Examination

PHI and the majority of its subsidiaries file a consolidated federal income tax return. PHI’s federal income tax liabilities for Pepco legacy companies for all years through 2000, and for Conectiv legacy companies for all years through 1999, have been determined by the IRS, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. The open tax years for the significant states where PHI files state income tax returns (District of Columbia, Maryland, Delaware, New Jersey, Pennsylvania and Virginia), are the same as noted above.

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FIN 48, “Accounting for Uncertainty in Income Taxes”

On July 13, 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with SFAS No. 109, “Accounting for Income Taxes,” and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity’s tax benefits must be “more likely than not” of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the “more likely than not” standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

FIN 48 is effective the first fiscal year beginning after December 15, 2006 (year ending December 31, 2007 for Pepco Holdings). Pepco Holdings has completed its evaluation of FIN 48, which resulted in an immaterial impact to its retained earnings at January 1, 2007, and no impact on its results of operations and cash flows.