UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2008

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

 

Reynolds American Inc.

(Exact name of registrant as specified in its charter)

North Carolina		20-0546644
(State or other jurisdiction of		(I.R.S. Employer Identification Number)
incorporation or organization)

401 North Main Street
Winston-Salem, NC 27101
(Address of principal executive offices) (Zip Code)

(336) 741-2000
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed from last report)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one):

Large accelerated filer þ		Accelerated filer o		Non-accelerated filer o		Smaller reporting company o

(Do not check if a smaller reporting company)

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: 295,317,770 shares of common stock, par value $.0001 per share, as of April 11, 2008

 

 

INDEX

				Page
Part I — Financial Information
Item 1.		Financial Statements
		Condensed Consolidated Statements of Income (Unaudited) — Three Months Ended March 31, 2008 and 2007			3
		Condensed Consolidated Statements of Cash Flows (Unaudited) — Three Months Ended March 31, 2008 and 2007			4
		Condensed Consolidated Balance Sheets (Unaudited) — March 31, 2008 and December 31, 2007			5
		Notes to Condensed Consolidated Financial Statements (Unaudited)			6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			55
Item 3.		Quantitative and Qualitative Disclosures about Market Risk			70
Item 4.		Controls and Procedures			70
Part II — Other Information
Item 1.		Legal Proceedings			71
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			71
Item 6.		Exhibits			72
Signature					73
Exhibit 10.6
Exhibit 10.10
Exhibit 10.11
Exhibit 10.12
Exhibit 10.13
Exhibit 10.14
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1

PART I — Financial Information

Item 1. Financial Statements

REYNOLDS AMERICAN INC.

		For the Three Months
		Ended March 31,
		2008				2007
Net sales1		$	1,944			$	2,018
Net sales, related party			113				130
Net sales			2,057				2,148
Costs and expenses:
Cost of products sold1, 2, 3			1,164				1,175
Selling, general and administrative expenses			382				393
Amortization expense			5				6
Operating income			506				574
Interest and debt expense			72				89
Interest income			(22	)			(38	)
Gain on termination of joint venture			(328	)			—
Other income, net			(12	)			(1	)
Income before income taxes			796				524
Provision for income taxes			291				196
Net income		$	505			$	328
Basic income per share:
Net income		$	1.72			$	1.11
Diluted income per share:
Net income		$	1.71			$	1.11
Dividends declared per share		$	0.85			$	0.75

See Notes to Condensed Consolidated Financial Statements (Unaudited)

REYNOLDS AMERICAN INC.

		For the Three Months Ended
		March 31,
		2008				2007
Cash flows from (used in) operating activities:
Net income		$	505			$	328
Adjustments to reconcile to net cash flows from (used in) continuing operating activities:
Depreciation and amortization			33				34
Gain on termination of joint venture			(328	)			—
Deferred income tax expense (benefit)			143				(4	)
Other changes, that provided (used) cash:
Accounts and other receivables			(39	)			(31	)
Inventories			43				7
Related party, net			(7	)			—
Accounts payable			(49	)			(68	)
Accrued liabilities including income taxes and other working capital			(35	)			(10	)
Tobacco settlement accruals			646				(474	)
Pension and postretirement			(23	)			(306	)
Other, net			(11	)			(16	)
Net cash flows from (used in) operating activities			878				(540	)
Cash flows (used in) from investing activities:
Purchases of short-term investments			(1	)			(1,958	)
Proceeds from sale of short-term investments			2				2,441
Capital expenditures			(39	)			(28	)
Distributions from equity investees			—				5
Other, net			2				—
Net cash flows (used in) from investing activities			(36	)			460
Cash flows (used in) from financing activities:
Dividends paid on common stock			(251	)			(222	)
Repayment of long-term debt			—				(4	)
Excess tax benefit from stock-based compensation			—				1
Repurchase of common stock			—				(60	)
Net cash flows used in financing activities			(251	)			(285	)
Net change in cash and cash equivalents			591				(365	)
Cash and cash equivalents at beginning of period			2,215				1,433
Cash and cash equivalents at end of period		$	2,806			$	1,068
Income taxes paid, net of refunds		$	56			$	31
Interest paid		$	26			$	49

See Notes to Condensed Consolidated Financial Statements (Unaudited)

REYNOLDS AMERICAN INC.

		March 31,				December 31,
		2008				2007
Assets
Current assets:
Cash and cash equivalents		$	2,806			$	2,215
Short-term investments			330				377
Accounts receivable, net of allowance (2008 — $1; 2007 — $1)			78				73
Accounts receivable, related party			77				80
Notes receivable			169				1
Other receivables			65				25
Inventories			1,153				1,196
Deferred income taxes, net			836				845
Prepaid expenses and other			153				180
Total current assets			5,667				4,992
Property, plant and equipment, net of accumulated depreciation (2008 — $1,536; 2007 — $1,517)			1,075				1,073
Trademarks, net of accumulated amortization (2008 — $526; 2007 — $524)			3,405				3,407
Goodwill			8,174				8,174
Other intangibles, net of accumulated amortization (2008 — $76; 2007 — $73)			199				202
Other assets and deferred charges			1,090				781
		$	19,610			$	18,629
Liabilities and shareholders’ equity
Current liabilities:
Accounts payable		$	169			$	218
Tobacco settlement accruals			3,088				2,449
Due to related party			5				7
Deferred revenue, related party			27				35
Other current liabilities			1,138				1,194
Total current liabilities			4,427				3,903
Long-term debt			4,571				4,515
Deferred income taxes, net			1,326				1,184
Long-term retirement benefits (less current portion)			1,163				1,167
Other noncurrent liabilities			383				394
Commitments and contingencies:
Shareholders’ equity:
Common stock (shares issued: 2008 — 295,312,770; 2007 — 295,007,327)			—				—
Paid-in capital			8,657				8,653
Accumulated deficit			(619	)			(873	)
Accumulated other comprehensive loss (defined benefit pension and post- retirement plans: 2008 — $(302) and 2007 — $(306), net of tax)			(298	)			(314	)
Total shareholders’ equity			7,740				7,466
		$	19,610			$	18,629

See Notes to Condensed Consolidated Financial Statements (Unaudited)

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1 — Business and Summary of Significant Accounting Policies

Overview

          The condensed consolidated financial statements (unaudited) include the accounts of Reynolds American Inc., referred to as RAI, and its wholly owned subsidiaries. RAI’s wholly owned subsidiaries include its operating subsidiaries, R. J. Reynolds Tobacco Company; Santa Fe Natural Tobacco Company, Inc., referred to as Santa Fe; Lane, Limited, referred to as Lane; R. J. Reynolds Global Products, Inc., referred to as GPI; and Conwood Company, LLC, Conwood Sales Co., LLC, Scott Tobacco LLC and Rosswil LLC, collectively referred to as the Conwood companies.

          RAI was incorporated as a holding company in the state of North Carolina on January 5, 2004, and its common stock is listed on the NYSE under the symbol “RAI.” RAI was created to facilitate the transactions on July 30, 2004, to combine the U.S. assets, liabilities and operations of Brown & Williamson Holdings, Inc., formerly known as Brown & Williamson Tobacco Corporation and referred to as B&W, an indirect, wholly owned subsidiary of British American Tobacco p.l.c., referred to as BAT, with R. J. Reynolds Tobacco Company, a wholly owned operating subsidiary of R.J. Reynolds Tobacco Holdings, Inc., referred to as RJR. These July 30, 2004, transactions generally are referred to as the B&W business combination.

          References to RJR Tobacco prior to July 30, 2004, relate to R. J. Reynolds Tobacco Company, a New Jersey corporation and a wholly owned subsidiary of RJR. References to RJR Tobacco on and subsequent to July 30, 2004, relate to the combined U.S. assets, liabilities and operations of B&W and R. J. Reynolds Tobacco Company, a North Carolina corporation.

          RAI’s reportable operating segments are RJR Tobacco and Conwood. RJR Tobacco consists of the primary operations of R. J. Reynolds Tobacco Company. Conwood consists of the Conwood companies and Lane. RAI’s wholly owned operating subsidiaries Santa Fe and GPI, among others, are included in All Other. The segments were identified based on how RAI’s chief operating decision maker allocates resources and assesses performance.

Basis of Presentation

          The accompanying interim condensed consolidated financial statements (unaudited) have been prepared in accordance with accounting principles generally accepted in the United States of America, referred to as GAAP, for interim financial information and, in management’s opinion, contain all adjustments, consisting only of normal recurring items, necessary for a fair presentation of the results for the periods presented. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. For interim reporting purposes, certain costs and expenses are charged to operations in proportion to the estimated total annual amount expected to be incurred primarily based on sales volumes. The results for the interim period ended March 31, 2008, are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.

          The equity method is used to account for investments in businesses that RAI does not control, but has the ability to significantly influence operating and financial policies. The cost method is used to account for investments in which RAI does not have the ability to significantly influence operating and financial policies. RAI has no investments in entities greater than 20% for which it accounts by the cost method, and has no investments in entities greater than 50% for which it accounts by the equity method. All material intercompany balances have been eliminated.

          The condensed consolidated financial statements (unaudited) should be read in conjunction with the consolidated financial statements and related footnotes, which appear in RAI’s Annual Report on Form 10-K for the year ended December 31, 2007. Certain reclassifications were made to conform prior years’ financial statements to the current presentation. All dollar amounts, other than per share amounts, are presented in millions, except for amounts set forth in note 10 and as otherwise noted.

Pension and Postretirement

          Recognized gains or losses are annual changes in the amount of either the benefit obligation or the market-related value of plan assets resulting from experience different from that assumed or from changes in assumptions. The minimum amortization of unrecognized gains or losses, as described in Statement of Financial Accounting Standards, referred to as SFAS, No. 87, “Employers’ Accounting for Pensions,” was included in pension expense, and as

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

described in SFAS No. 106, “Employers’ Accounting for Postretirement Benefits other than Pensions,” was included in the postretirement benefit cost. Prior service costs, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the average remaining service period for active employees. The market-related value of plan assets recognizes changes in fair value in a systematic and rational manner over five years.

          The components of the total pension and postretirement benefits are set forth below:

		For The Three Months Ended March 31,
										Postretirement
		Pension Benefits								Benefits
		2008				2007				2008				2007
Service cost		$	10			$	10			$	1			$	1
Interest cost			80				78				23				23
Expected return on plan assets			(113	)			(109	)			(6	)			(7	)
Amortization of prior service cost (credit)			5				—				5				(3	)
Amortization of net loss (income)			—				10				(3	)			6
Total benefit (income) cost		$	(18	)		$	(11	)		$	20			$	20

Employer Contributions

          RAI disclosed in its financial statements for the year ended December 31, 2007, that it expected to contribute $7 million to its pension plans in 2008. Of this amount, RAI contributed $2 million to its pension plans during the first three months of 2008.

Recently Adopted Accounting Pronouncements

          Effective January 1, 2008, RAI adopted SFAS No. 157, “Fair Value Measurements,” for financial assets and financial liabilities. SFAS No. 157 does not require any new fair value measurements but provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. RAI will adopt SFAS No. 157 for nonfinancial assets and nonfinancial liabilities on January 1, 2009. The adoption of SFAS No. 157 on financial assets and financial liabilities did not have a material impact on RAI’s consolidated results of operations, financial position or cash flows. RAI is currently assessing the impact of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities on its consolidated results of operations, financial position or cash flows.

Recently Issued Accounting Pronouncements

          In March 2008, the Financial Accounting Standards Board, referred to as FASB, issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133.” SFAS No. 161 seeks qualitative disclosures about the objectives and strategies for using derivatives, quantitative data about the fair value of and gains and losses on derivative contracts, and details of credit-risk-related contingent features in hedged positions. SFAS No. 161 also seeks enhanced disclosure around derivative instruments in financial statements, accounting under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and how hedges affect an entity’s financial position, financial performance and cash flows. SFAS No. 161 is effective for RAI as of January 1, 2009. RAI does not expect the adoption of SFAS No. 161 to have a material impact on its results of operations, financial position or cash flows.

Note 2—Intangible Assets

          The changes in the carrying amount of trademarks by segment during the three months ended March 31, 2008, were as follows:

		RJR Tobacco								Conwood								All Other
		Indefinite				Finite				Indefinite				Finite				Indefinite
		Life				Life				Life				Life				Life				Consolidated
Balance as of January 1, 2008		$	1,826			$	41			$	1,374			$	11			$	155			$	3,407
Amortization expense			—				(2	)			—				—				—				(2	)
Balance as of March 31, 2008		$	1,826			$	39			$	1,374			$	11			$	155			$	3,405

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          The changes in the carrying amount of other intangibles by segment during the three months ended March 31, 2008, were as follows:

		RJR Tobacco								All Other
		Indefinite								Indefinite
		Life				Finite Life				Life				Consolidated
Balance as of January 1, 2008		$	55			$	100			$	47			$	202
Amortization expense			—				(3	)			—				(3	)
Balance as of March 31, 2008		$	55			$	97			$	47			$	199

          Indefinite-lived intangibles include acquired trademarks and distribution rights and agreements. Finite-lived intangible assets as of March 31, 2008, were as follows:

						Accumulated
		Gross				Amortization				Net
Contract manufacturing		$	151			$	55			$	96
Technology-based			3				2				1
Total other intangibles			154				57				97
Trademarks			95				45				50
		$	249			$	102			$	147

          As of March 31, 2008, the estimated remaining amortization associated with finite-lived intangible assets was expected to be expensed as follows:

Year		Amount
Remainder of 2008		$	17
2009			22
2010			20
2011			20
2012			19
2013			18
Thereafter			31
		$	147

Note 3—Termination of Joint Venture

          In 2002, R.J. Reynolds Tobacco C.V., an indirect wholly owned subsidiary of RAI and referred to as RJRTCV, and an affiliate of Gallaher Group Plc, referred to as Gallaher, formed a joint venture, with each party owning a 50% membership interest. The joint venture, R. J. Reynolds-Gallaher International Sarl, marketed American-blend cigarettes primarily in Italy, France and Spain.

          On April 18, 2007, an affiliate of Japan Tobacco Inc. acquired Gallaher, and Gallaher subsequently notified RJRTCV that the acquisition constituted a change of control of Gallaher within the meaning of the joint venture agreement. Pursuant to the terms of the joint venture agreement, RJRTCV elected to terminate the joint venture prior to its expiration date. The joint venture was terminated on December 31, 2007.

          The joint venture agreement provides that upon a termination of the joint venture, the value of all the trademarks each joint venture member or its affiliate licensed to the joint venture, other than NATURAL AMERICAN SPIRIT, would be calculated and that the party whose licensed trademarks were determined to be of greater value would be required to pay the other party an amount, referred to as the Termination Amount, equal to one-half of the difference between the values of the parties’ respective trademarks. On February 20, 2008, following the parties’ negotiations regarding the trademarks’ values, RJRTCV and Gallaher Limited, an affiliate of Gallaher, entered into a valuation payment settlement agreement, pursuant to which Gallaher Limited agreed to pay RJRTCV a Termination Amount equal to euros 265 million, or approximately $388 million using a February 20, 2008, exchange rate of 1.4625. Of this amount, 40% is to be paid on or before April 20, 2008, and the remaining 60% is to be paid in six equal annual installments commencing April 2009. Of this receivable, $168 million and $210 million are included in notes

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

receivable and other assets and deferred charges, respectively, in RAI’s condensed consolidated balance sheet (unaudited) as of March 31, 2008. Related to the gain on termination of the joint venture of $328 million, approximately $118 million of deferred tax was recorded and included in deferred income taxes, net in the noncurrent liability section of the condensed consolidated balance sheet (unaudited) as of March 31, 2008.

          In the first quarter of 2008 an indirect subsidiary of RJR Tobacco sold the AUSTIN trademark, a brand formerly sold through the joint venture, resulting in a gain of $6 million. GPI continues to sell NATURAL AMERICAN SPIRIT to the primary markets of the former joint venture in addition to other international markets.

Note 4—Income Per Share

          The components of the calculation of income per share were as follows:

		For the Three Months
		Ended March 31,
		2008				2007
Net income		$	505			$	328
Basic weighted average shares, in thousands1			294,206				295,038
Effect of dilutive potential shares:
Options			232				253
Restricted stock			426				167
Diluted weighted average shares, in thousands			294,864				295,458

Note 5—Fair Value Measurement

          On January 1, 2008, RAI adopted SFAS No. 157, “Fair Value Measurements,” for financial assets and financial liabilities. SFAS No. 157 provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. SFAS No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances.

          SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, essentially an exit price.

          The levels of the fair value hierarchy established by SFAS No. 157 are:

Level 1: inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2: inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. A Level 2 input must be observable for substantially the full term of the asset or liability.

Level 3: inputs are unobservable and reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          Financial assets carried at fair value as of March 31, 2008, were as follows:

		Level 1				Level 2				Level 3				Total
Money market funds		$	2,058			$	—			$	—			$	2,058
Federal agency securities and treasury bills and notes			208				—				—				208
Auction rate notes			—				—				122				122
Mortgage-backed securities			—				—				38				38
Assets held in grantor trusts			16				—				—				16
Interest rate swaps			—				175				—				175
Total assets at fair value		$	2,282			$	175			$	160			$	2,617

          The fair value for the interest rate swaps, classified as a Level 2, was derived using the notional amount of the interest rate swap multiplied by the observable inputs of time to maturity, interest rates and credit spreads.

          The fair values for the auction securities, classified as a Level 3, were based upon calculating the weighted average present value of future cash payments, given the probability of certain events occurring within the market. This methodology incorporated the inclusion of current data, including, but not limited to, relevant interest rate curves and relevant corporate credit spreads, ratings and market valuations. The modeling scenarios also included assumptions about default probabilities, recovery potential and rating downgrades for the securities, as well as the underlying collateral. The fair values for the mortgage-backed securities, also classified as a Level 3, were based upon the actual, or modeled, market pricing of the specific collateral, depending on availability.

          The changes in the Level 3 of investments as of March 31, 2008, were as follows:

		Auction Rate Notes												Mortgage-Backed Securities
						Gross												Gross
						Unrealized				Estimated								Unrealized				Estimated
		Cost				Loss				Fair Value				Cost				Loss				Fair Value
Balance as of January 1, 2008		$	145			$	(18	)		$	127			$	45			$	(1	)		$	44
Unrealized losses			—				(5	)			(5	)			—				(3	)			(3	)
Settlements			—				—				—				(3	)			—				(3	)
Balance as of March 31, 2008		$	145			$	(23	)		$	122			$	42			$	(4	)		$	38

Note 6—Short-Term Investments

          Short-term investments classified as available-for-sale were as follows:

		March 31, 2008												December 31, 2007
						Gross												Gross
						Unrealized				Estimated								Unrealized				Estimated
		Cost				Loss				Fair Value				Cost				Loss				Fair Value
Federal agency securities and treasury bills and notes		$	208			$	—			$	208			$	206			$	—			$	206
Auction rate notes			145				(23	)			122				145				(18	)			127
Mortgage-backed securities			—				—				—				45				(1	)			44
		$	353			$	(23	)		$	330			$	396			$	(19	)		$	377

          The mortgage-backed securities have been reclassified to a long-term investment, included in other assets and deferred charges in RAI’s condensed consolidated balance sheet (unaudited) as of March 31, 2008, as a result of a restructuring with the original issuer. This restructured investment extends the life of the security, but is supported by the same underlying collateral that carries the same economic risk.

          The investments in auction rate notes are instruments with long-term contractual maturities, but are typically highly liquid. They have historically repriced at intervals ranging from 7 to 49 days, and therefore, historically, the fair values have approximated carrying values. The individual securities are generally held 28 to 35 days depending on the cash needs for operations. However, during 2007, adverse changes in the financial markets caused certain auction rate notes to revalue lower than their carrying value and become less liquid.

          The funds associated with the auction rate notes will not be accessible until a successful auction occurs or a buyer is found. RAI intends, and has the ability, to hold the auction rate notes for a period of time sufficient to allow for

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

the anticipated recovery in fair value. These investments will be evaluated on a quarterly basis. The contractual maturities of securities, other than auction rate notes, average less than one year. RAI reviews impairments associated with the above in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and FASB Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” to determine the classification of the impairment as temporary or other-than-temporary. RAI considers these investments to be temporarily impaired as of March 31, 2008, with the unrealized loss included in accumulated other comprehensive loss in the condensed consolidated balance sheet (unaudited) as of March 31, 2008. Such unrealized loss did not reduce net income for the three-month period ended March 31, 2008.

Note 7—Inventories

          The major components of inventories were as follows:

		March 31,				December 31,
		2008				2007
Leaf tobacco		$	906			$	967
Other raw materials			52				45
Work in process			53				48
Finished products			177				163
Other			24				24
Total			1,212				1,247
Less LIFO allowance			59				51
		$	1,153			$	1,196

          RJR Tobacco recorded $2 million and $1 million of expense from expected LIFO layer liquidations for the three months ended March 31, 2008 and 2007, respectively. RJR Tobacco will perform its annual LIFO inventory valuation at December 31, 2008, and interim periods represent an estimate of the expected annual valuation.

Note 8—Income Taxes

          The provision for income taxes in the first quarter of 2008 was $291 million, or an effective rate of 36.6%, compared with $196 million, or an effective rate of 37.4%, in the first quarter of 2007. The effective rate for the first quarter of 2008 was favorably impacted by a lower tax rate related to the gain on the termination of the Reynolds-Gallaher International Sarl joint venture.

          The effective rate exceeds the federal statutory rate of 35% primarily due to the impact of state taxes and certain other nondeductible items, offset by the estimated domestic production credit of the American Jobs Creation Act enacted on October 22, 2004.

          The gross accruals for unrecognized income tax benefits, including interest and penalties, reflected in other noncurrent liabilities were $158 million and $172 million at March 31, 2008, and December 31, 2007, respectively. RAI accrues interest and penalties related to accruals for income taxes and reflects these amounts in tax expense. The gross amount of interest accrued at March 31, 2008, and December 31, 2007, was $48 million and $49 million, respectively. The gross amount of penalties of $12 million was accrued at each of March 31, 2008, and December 31, 2007.

          Gross increases in unrecognized tax benefits related to tax positions were $4 million for the three months ended March 31, 2008, consisting of $3 million attributable to current year tax positions and $1 million attributable to prior year tax positions.

          Gross decreases in unrecognized tax benefits were $17 million for the three months ended March 31, 2008, consisting of $3 million attributable to prior year tax positions, $13 million attributable to settlements with taxing authorities and $1 million attributable to statute of limitation expirations.

          As of March 31, 2008, $58 million of unrecognized tax benefits and $42 million of interest and penalties, if recognized, would affect the effective tax rate.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          Included in the provision for income taxes for the first quarter of 2008, was $8 million of additional tax expense including $1 million of interest expense, net of federal benefit and penalties associated with unrecognized tax benefits, compared with $4 million of additional tax expense including $2 million of interest expense, net of federal benefit and penalties in the first quarter of 2007.

          RAI and its subsidiaries are subject to income taxes in the United States, certain foreign jurisdictions and multiple state jurisdictions. A number of years may elapse before a particular matter for which RAI has established an accrual is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. RAI’s major taxing jurisdictions and related open tax audits are discussed below.

          The IRS completed its examination and issued an assessment for the years 2002 and 2003. RAI filed a protest in 2006, and a formal settlement agreement was signed during the first quarter of 2008. Overpayments from prior year audits exceed the settlement agreement amount, and a refund of approximately $2 million is expected in 2008. Amended state returns will be prepared in 2008 to reflect these federal adjustments. The additional state income tax associated with these returns is reflected in the FIN No. 48 liability balance.

          RAI has filed a federal consolidated income tax return for the years 2004 through 2006 for which the statute of limitations remains open. There are no IRS examinations scheduled at this time for these open years.

          In December 2007, North Carolina completed its examination of RJR Tobacco for years 2000 through 2002 and issued a total assessment of $37 million: $21 million related to tax, $8 million related to interest and $8 million related to penalties. RJR Tobacco filed a protest in January 2008. RJR Tobacco will continue to work with North Carolina to resolve issues identified and assessed for years 2000 through 2002. A complete resolution is not anticipated within the next 12 months. However, in the event a complete resolution of this audit is reached during the next 12 months, RJR Tobacco could recognize additional expense of up to $12 million, inclusive of tax, interest, net of federal benefit and penalties.

          It is expected that the amount of unrecognized tax benefits will change in the next 12 months. Excluding the impact of North Carolina’s assessment for years 2000 through 2002, RAI does not expect the change to have a significant impact on its consolidated results of operations, financial position or cash flows.

Note 9—Financial Instruments

          RAI and RJR use interest rate swaps to manage interest rate risk on a portion of their respective debt obligations. When entered into, these financial instruments are designated as hedges of underlying exposures.

          Swaps existed on $1.6 billion principal amount of debt as of March 31, 2008. Including the impact of swaps, the average interest rate on the principal amount of RAI’s consolidated $4.4 billion long-term debt was 5.99% as of March 31, 2008.

          The interest rate swaps’ notional amounts and termination dates match those of the corresponding outstanding notes. As of March 31, 2008, these fair value hedges were perfectly effective, resulting in no recognized net gain or loss. The unrealized gain on the hedges resulting from the change in the hedges’ fair value was $175 million and $119 million at March 31, 2008, and December 31, 2007, respectively, included in other assets and deferred charges and was equal to the increase in the fair value of the hedged long-term debt.

          Under certain conditions, any fair value that results in a liability position of certain interest rate swaps may require full collateralization with cash or securities.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Note 10—Commitments and Contingencies

Tobacco Litigation — General

Introduction

          Various legal proceedings or claims, including litigation claiming that cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RAI’s operating subsidiaries’ products, are pending or may be instituted against RJR Tobacco, the Conwood companies or their affiliates, including RAI and RJR, or indemnitees, including B&W. These legal proceedings include claims relating to cigarette products manufactured by RJR Tobacco or certain of its affiliates and indemnitees, as well as claims relating to smokeless tobacco products manufactured by the companies. A discussion of the legal proceedings relating to cigarette products is set forth below under the heading “— Litigation Affecting the Cigarette Industry.” All of the references under that heading to tobacco-related litigation, smoking and health litigation and other similar references are references to legal proceedings relating to cigarette products and are not references to legal proceedings involving smokeless tobacco products, and case numbers under that heading include only cases involving cigarette products. The legal proceedings relating to the smokeless tobacco products manufactured by the Conwood companies are discussed separately under the heading “— Smokeless Tobacco Litigation” below.

          In connection with the B&W business combination, RJR Tobacco has agreed to indemnify B&W and its affiliates against certain liabilities, costs and expenses incurred by B&W or its affiliates arising out of the U.S. cigarette and tobacco business of B&W. As a result of this indemnity, RJR Tobacco has assumed the defense of pending B&W-specific tobacco-related litigation, has paid the judgments and costs related to certain pre-business combination tobacco-related litigation of B&W, and has posted bonds on behalf of B&W, where necessary, in connection with cases decided since the B&W business combination. In addition, pursuant to this indemnity, RJR Tobacco expensed less than one million during the first quarter of 2008 and $1 million in the first quarter of 2007, for funds to be reimbursed to BAT for costs and expenses incurred arising out of certain tobacco-related litigation.

Certain Terms and Phrases

          Certain terms and phrases used in this disclosure may require some explanation. The term “judgment” or “final judgment” refers to the final decision of the court resolving the dispute and determining the rights and obligations of the parties. At the trial court level, for example, a final judgment generally is entered by the court after a jury verdict and after post-verdict motions have been decided. In most cases, the losing party can appeal a verdict only after a final judgment has been entered by the trial court.

          The term “damages” refers to the amount of money sought by a plaintiff in a complaint, or awarded to a party by a jury or, in some cases, by a judge. “Compensatory damages” are awarded to compensate the prevailing party for actual losses suffered, if liability is proved. In cases in which there is a finding that a defendant has acted willfully, maliciously or fraudulently, generally based on a higher burden of proof than is required for a finding of liability for compensatory damages, a plaintiff also may be awarded “punitive damages.” Although damages may be awarded at the trial court stage, a losing party generally may be protected from paying any damages until all appellate avenues have been exhausted by posting a supersedeas bond. The amount of such a bond is governed by the law of the relevant jurisdiction and generally is set at the amount of damages plus some measure of statutory interest, modified at the discretion of the appropriate court or subject to limits set by court or statute.

          The term “settlement” refers to certain types of cases in which cigarette manufacturers, including RJR Tobacco and B&W, have agreed to resolve disputes with certain plaintiffs without resolving the case through trial. The principal terms of certain settlements entered into by RJR Tobacco and B&W are explained below under “— Accounting for Tobacco-Related Litigation Contingencies.”

Theories of Recovery

          The plaintiffs seek recovery on a variety of legal theories, including negligence, strict liability in tort, design defect, special duty, voluntary undertaking, breach of warranty, failure to warn, fraud, misrepresentation, unfair trade practices, conspiracy, unjust enrichment, medical monitoring, public nuisance and violations of state and federal antitrust laws. In certain of these cases, the plaintiffs claim that cigarette smoking exacerbated injuries caused by exposure to asbestos.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          The plaintiffs seek various forms of relief, including compensatory and punitive damages, treble or multiple damages and statutory damages and penalties, creation of medical monitoring and smoking cessation funds, disgorgement of profits, and injunctive and other equitable relief. Although alleged damages often are not determinable from a complaint, and the law governing the pleading and calculation of damages varies from state to state and jurisdiction to jurisdiction, compensatory and punitive damages have been specifically pleaded in a number of cases, sometimes in amounts ranging into the hundreds of millions and even billions of dollars.

Defenses

          The defenses raised by RJR Tobacco, the Conwood companies and their affiliates and indemnitees include, where applicable and otherwise appropriate, preemption by the Federal Cigarette Labeling and Advertising Act of some or all claims arising after 1969, or by the Comprehensive Smokeless Tobacco Health Education Act, the lack of any defect in the product, assumption of the risk, contributory or comparative fault, lack of proximate cause, remoteness, lack of standing and statutes of limitations or repose. RAI and RJR have asserted additional defenses, including jurisdictional defenses, in many of the cases in which they are named.

Accounting for Tobacco-Related Litigation Contingencies

          In accordance with GAAP, RAI and its subsidiaries, including RJR Tobacco and the Conwood companies, as applicable, record any loss concerning litigation at such time as an unfavorable outcome becomes probable and the amount can be reasonably estimated. As of December 31, 2007, RJR Tobacco recorded a $6 million accrual related to unfavorable judgments in two individual plaintiff’s cases tried in conjunction with the Engle v. R. J. Reynolds Tobacco Co. case. With the exception of two Engle-related verdicts, and for the reasons set forth below, RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, or the loss of any particular claim concerning the use of smokeless tobacco against the Conwood companies, when viewed on an individual basis, is not probable.

          RJR Tobacco and its affiliates believe that they have valid defenses to the smoking and health tobacco litigation claims against them, as well as valid bases for appeal of adverse verdicts against them. RAI, RJR Tobacco and their affiliates and indemnitees have, through their counsel, filed pleadings and memoranda in pending smoking and health tobacco litigation that set forth and discuss a number of grounds and defenses that they and their counsel believe have a valid basis in law and fact. RJR Tobacco and its affiliates and indemnitees continue to win the majority of smoking and health tobacco litigation claims that reach trial, and a very high percentage of the tobacco-related litigation claims brought against them continue to be dismissed at or before trial. Based on their experience in the smoking and health tobacco litigation against them and the strength of the defenses available to them in such litigation, RJR Tobacco and its affiliates believe that their successful defense of smoking and health tobacco litigation in the past will continue in the future.

          No liability for pending smoking and health tobacco litigation was recorded in RAI’s consolidated balance sheet (unaudited) as of March 31, 2008. RJR has liabilities totaling $94 million that were recorded in 1999 in connection with certain indemnification claims not related to smoking and health asserted by Japan Tobacco, Inc., referred to as JTI, against RJR and RJR Tobacco relating to certain activities of Northern Brands International, Inc., a now inactive, indirect subsidiary of RAI formerly involved in the international tobacco business, referred to as Northern Brands. For further information on Northern Brands and related litigation and the indemnification claims of JTI, see “— Litigation Affecting the Cigarette Industry — Other Litigation and Developments” and “— Other Contingencies and Guarantees” below.

          Generally, RJR Tobacco and its affiliates and indemnitees have not settled, and currently RJR Tobacco and its affiliates do not intend to settle, any smoking and health tobacco litigation claims. It is the policy of RJR Tobacco and its affiliates to vigorously defend all tobacco-related litigation claims.

          The only smoking and health tobacco litigation claims settled by RJR Tobacco and B&W involved:

     • the Master Settlement Agreement and other settlement agreements with the states of Mississippi, Florida, Texas and Minnesota, and the funding by various tobacco companies of a $5.2 billion trust fund contemplated by the Master Settlement Agreement to benefit tobacco growers; and

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

     • the original Broin flight attendant case discussed below under “— Litigation Affecting the Cigarette Industry — Class-Action Suits.”

          The circumstances surrounding the MSA and the funding of a trust fund to benefit the tobacco growers are readily distinguishable from the current categories of smoking and health cases involving RJR Tobacco or its affiliates and indemnitees. The claims underlying the MSA were brought on behalf of the states to recover funds paid for health-care and medical and other assistance to state citizens suffering from diseases and conditions allegedly related to tobacco use. The MSA settled all the health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions and contain releases of various additional present and future claims. In accordance with the MSA, various tobacco companies agreed to fund a $5.2 billion trust fund to be used to address the possible adverse economic impact of the MSA on tobacco growers. A discussion of the MSA, and a table depicting the related payment schedule, is set forth below under “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — MSA.”

          The states were a unique set of plaintiffs and are not involved in any of the smoking and health cases remaining against RJR Tobacco or its affiliates and indemnitees. Although RJR Tobacco and certain of its affiliates and indemnitees continue to be defendants in health-care cost recovery cases similar in theory to the state cases but involving other plaintiffs, such as hospitals, Native American tribes and foreign governments, the vast majority of such cases have been dismissed on legal grounds. RJR Tobacco and its affiliates, including RAI, believe that the same legal principles that have resulted in dismissal of health-care cost recovery cases either at the trial court level or on appeal should compel dismissal of the similar pending cases.

          The pending U.S. Department of Justice case brought against various industry members, including RJR Tobacco and B&W, discussed below under “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases,” also can be distinguished from the circumstances surrounding the MSA. Under its Medical Care Recovery Act and Medicare Secondary Payer Act claims, the federal government made arguments similar to the states and sought to recover federal funds expended in providing health care to smokers who have developed diseases and injuries alleged to be smoking-related. These claims were dismissed, and the only claim remaining in the case involves alleged violations of civil provisions of the federal Racketeer Influenced and Corrupt Organizations Act, referred to as RICO. A comprehensive discussion of this case is set forth below under “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases.”

          As with claims that were resolved by the MSA, the other cases settled by RJR Tobacco can be distinguished from existing cases pending against RJR Tobacco and its affiliates and indemnitees. The original Broin case, discussed below under “— Litigation Affecting the Cigarette Industry — Class-Action Suits,” was settled in the middle of trial during negotiations concerning a possible nation-wide settlement of claims similar to those underlying the MSA.

          DeLoach v. Philip Morris Cos., Inc., an antitrust case, was brought by a unique class of plaintiffs: a class of all tobacco growers and tobacco allotment holders. The class asserted that the defendants, including RJR Tobacco and B&W, engaged in bid-rigging of U.S. burley and flue-cured tobacco auctions. Despite valid legal defenses, RJR Tobacco and B&W separately settled this case to avoid a long and contentious trial with the tobacco growers. The few antitrust cases pending against RJR Tobacco and B&W involve different types of plaintiffs and different theories of recovery under the antitrust laws.

          Finally, as discussed under “— Litigation Affecting the Cigarette Industry — MSA - Enforcement and Validity,” RJR Tobacco and B&W each has settled certain cases brought by states concerning the enforcement of the MSA. Despite valid legal defenses, these cases were settled to avoid further contentious litigation with the states involved. Each MSA enforcement action involves alleged breaches of the MSA based on specific actions taken by the particular defendant. Accordingly, any future MSA enforcement action will be reviewed by RJR Tobacco on the merits and should not be affected by the settlement of prior MSA enforcement cases.

          The Conwood companies also believe that they have valid defenses to the smokeless tobacco litigation against them. The Conwood companies have asserted and will continue to assert some or all of these defenses in each case at the time and in the manner deemed appropriate by the Conwood companies and their counsel. No verdict or judgment has been returned or entered against the Conwood companies on any claim for personal injuries allegedly resulting from the use of smokeless tobacco. The Conwood companies intend to defend vigorously all smokeless tobacco litigation claims asserted against them. No liability for pending smokeless tobacco litigation was recorded in RAI’s consolidated balance sheet (unaudited) as of March 31, 2008.

Cautionary Statement

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          Even though RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, or the loss of any particular case concerning the use of smokeless tobacco against the Conwood companies, when viewed on an individual basis, is not probable, the possibility of material losses related to such litigation is more than remote. Litigation is subject to many uncertainties, and generally it is not possible to predict the outcome of any particular litigation pending against RJR Tobacco, the Conwood companies or their affiliates or indemnitees, or to reasonably estimate the amount or range of any possible loss.

          Although RJR Tobacco believes that it has valid bases for appeals of adverse verdicts in its pending cases, and RJR Tobacco and RAI believe they have valid defenses to all actions, and intend to defend all actions vigorously, it is possible that there could be further adverse developments in pending cases, and that additional cases could be decided unfavorably against RAI, RJR Tobacco or their affiliates or indemnitees. Determinations of liability or adverse rulings in such cases or in similar cases involving other cigarette manufacturers as defendants, even if such judgments are not final, could materially adversely affect the litigation against RJR Tobacco or its affiliates or indemnitees and could encourage the commencement of additional tobacco-related litigation. In addition, a number of political, legislative, regulatory and other developments relating to the tobacco industry and cigarette smoking have received wide media attention. These developments may negatively affect the outcomes of tobacco-related legal actions and encourage the commencement of additional similar litigation.

          Although it is impossible to predict the outcome of such events on pending litigation and the rate new lawsuits are filed against RJR Tobacco or its affiliates or indemnitees, a significant increase in litigation or in adverse outcomes for tobacco defendants could have a material adverse effect on any or all of these entities. Moreover, notwithstanding the quality of defenses available to it and its affiliates and indemnitees in litigation matters, it is possible that RAI’s results of operations, cash flows or financial position could be materially adversely affected by the ultimate outcome of certain pending litigation matters against RJR Tobacco or its affiliates or indemnitees.

          Similarly, smokeless tobacco litigation is subject to many uncertainties. Notwithstanding the quality of defenses available to the Conwood companies, it is possible that RAI’s results of operations, cash flows or financial position could be materially adversely affected by the ultimate outcome of certain pending litigation matters against the Conwood companies.

Litigation Affecting the Cigarette Industry

Overview

          Introduction. In connection with the business combination of RJR Tobacco and the U.S. cigarette and tobacco business of B&W on July 30, 2004, RJR Tobacco agreed to indemnify B&W and its affiliates against, among other things, certain litigation liabilities, costs and expenses incurred by B&W or its affiliates arising out of the U.S. cigarette and tobacco business of B&W. Accordingly, the cases discussed below include cases brought solely against RJR Tobacco and its affiliates, including RAI and RJR; cases brought against both RJR Tobacco, its affiliates and B&W; and cases brought solely against B&W and assumed by RJR Tobacco in the business combination.

          During the first quarter of 2008, 1,437 tobacco-related cases, primarily Engle Progeny Cases, defined below, were served against RJR Tobacco or its affiliates or indemnitees. On March 31, 2008, there were 2,802 cases, including 686 individual smoker cases pending in West Virginia state court as a consolidated action and 1,897 Engle Progeny Cases, involving 8,103 individual plaintiffs, pending in the United States against RJR Tobacco or its affiliates or indemnitees, as compared with 1,238 total cases on March 31, 2007, and 1,281 total cases on March 31, 2006, pending in the United States against RJR Tobacco or its affiliates or indemnitees.

     As of April 11, 2008, 933 tobacco-related cases were pending against RJR Tobacco or its affiliates or indemnitees: 928 in the United States; one in Puerto Rico; three in Canada; and one in Israel. Of the 928 total U.S. cases, 27 cases are pending against B&W that are not also pending against RJR Tobacco. The U.S. case number does not include the 2,621 Broin II or the 1,931 Engle Progeny Cases, as discussed below, pending as of April 11, 2008. The following table lists the number of U.S. tobacco-related cases by state that were pending against RJR Tobacco or its affiliates or indemnitees as of April 11, 2008, exclusive of the Broin II and Engle Progeny Cases:

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

		Number of
State		U.S. Cases
West Virginia			692	*
Florida			27
New York			25
Missouri			23
Maryland			22
Mississippi			21
Louisiana			17
California			13
Illinois			8
Washington			5
New Jersey			4
Connecticut			4
Ohio			4
Pennsylvania			4
Kentucky			4
Delaware			3
District of Columbia			3
Georgia			3
Alabama			2
Kansas			2
Maine			2
Michigan			2
Minnesota			2
New Mexico			2
North Carolina			2
Oregon			2
South Carolina			2
South Dakota			2
Tennessee			2
Vermont			2
Wisconsin			2
Arizona			1
Alaska			1
Arkansas			1
Colorado			1
Hawaii			1
Idaho			1
Indiana			1
Iowa			1
Mariana Islands			1
Massachusetts			1
Montana			1
Nebraska			1
Nevada			1
New Hampshire			1
North Dakota			1
Oklahoma			1
Rhode Island			1
Utah			1
Virginia			1
Wyoming			1
Total			928	**

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          The following table lists the categories of the U.S. tobacco-related cases pending against RJR Tobacco or its affiliates or indemnitees as of April 11, 2008, compared with the number of cases pending against RJR Tobacco, its affiliates or indemnitees as of February 1, 2008, as reported in RAI’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007, filed with the SEC on February 27, 2008, and a cross-reference to the discussion of each case type.

						Change in Number
		RJR Tobacco’s				of Cases Since
		Case Numbers as of				February 1, 2008
Case Type		April 11, 2008				Increase/(Decrease)				Page Reference
Individual Smoking and Health			830				(42	)			23
Engle Progeny (Number of Plaintiffs)*			1,931 (8,178	)			1,065				25
Broin II			2,621				(1	)			25
Class-Action			17				(1	)			25
Health-Care Cost Recovery			3			No Change					31
MSA-Enforcement and Validity			62				1				35
Antitrust			3			No Change					37
Other Litigation			11			No Change					37

          Three pending cases against RJR Tobacco and B&W have attracted significant media attention: the Florida state court class-action case, Engle v. R. J. Reynolds Tobacco Co., the federal RICO case brought by the U.S. Department of Justice, and the federal lights class action Schwab [McLaughlin] v. Philip Morris USA, Inc.

          In 2000, a jury in Engle rendered a punitive damages verdict in favor of the “Florida class” of approximately $145 billion against all defendants. On July 6, 2006, the Florida Supreme Court, among other things, affirmed an appellate court’s reversal of the punitive damages award, decertified the class going forward, preserved several class-wide findings from the trial, including that nicotine is addictive and cigarettes are defectively designed, and authorized class members to avail themselves of these findings in individual lawsuits under certain conditions. After subsequent motions were resolved, the Florida Supreme Court issued its mandate on January 11, 2007, thus beginning a one-year period in which former class members were permitted to file individual lawsuits. On October 1, 2007, the U.S. Supreme Court denied the defendants’ petition for writ of certiorari. As of April 11, 2008, RJR Tobacco had been served in 1,931 Engle Progeny Cases in both state and federal courts in Florida. These cases include approximately 8,178 plaintiffs. The number of cases will increase due to a delay in the processing of cases in the Florida court system.

          In the U.S. Department of Justice case, brought in 1999 in the U.S. District Court for the District of Columbia, the government sought, among other forms of relief, the disgorgement of profits pursuant to the civil provisions of RICO. The U.S. Court of Appeals for the District of Columbia ruled in 2005 that disgorgement is not an available remedy in the case. The bench trial ended in June 2005, and the court, in August 2006, issued its ruling, among other things, finding certain defendants, including RJR Tobacco and B&W, liable for the RICO claims, imposing no direct financial penalties on the defendants, but ordering the defendants to make certain “corrective communications” in a variety of media and enjoining the defendants from using certain brand descriptors. Both sides have appealed to the

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

U.S. Court of Appeals for the District of Columbia, and the trial court’s order has been stayed pending the appeal. Briefing is scheduled to conclude on May 19, 2008.

          In September 2006, the U.S. District Court for the Eastern District of New York in Schwab certified a nation-wide class of “lights” smokers. On November 16, 2006, the U.S. Court of Appeals for the Second Circuit granted the defendants’ motions to stay the district court proceedings and for review of the class certification ruling. On April 3, 2008, the Second Circuit decertified the class.

          For a detailed description of these cases, see “— Class-Action Suits — Engle Case,” “— Health-Care Cost Recovery Cases — Department of Justice Case” and “— Class-Action Suits — ‘Lights’ Cases” below.

          In November 1998, the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, entered into the MSA with 46 U.S. states and certain U.S. territories and possessions. These cigarette manufacturers previously settled four other cases, brought on behalf of Mississippi, Florida, Texas and Minnesota, by separate agreements with each state. The MSA, including the four other state settlement agreements:

     • settled all health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions;

     • released the major U.S. cigarette manufacturers from various additional present and potential future claims;

     • imposed payment obligations in perpetuity on RJR Tobacco, B&W and other major U.S. cigarette manufacturers; and

     • placed significant restrictions on their ability to market and sell cigarettes.

          MSA payments are subject to adjustments for, among other things, the volume of cigarettes sold, market share and inflation. See “— Health-Care Cost Recovery Cases — MSA” below for a detailed discussion of the MSA, including RAI’s operating subsidiaries’ monetary obligations under these agreements. RJR Tobacco records the allocation of settlement charges as products are shipped.

          Scheduled Trials. Trial schedules are subject to change, and many cases are dismissed before trial. The following table lists the trial schedule, as of April 11, 2008, for RJR Tobacco or its affiliates and indemnitees through March 31, 2009.

Trial Date		Case Name/Type		Defendant(s)		Jurisdiction
July 7, 2008		Washington v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Superior Court
		[MSA Enforcement]				King County
						(Seattle, WA)
August 25, 2008		Smith v. R.J. Reynolds Tobacco Co.		RJR Tobacco		U.S. District Court
		[Individual]				Eastern District
						(New Orleans, LA)
August 29, 2008		Nichols v. Philip Morris USA, Inc.		RJR Tobacco		Superior Court
		[Individual]				San Diego County
						(San Diego, CA)
September 8, 2008		Fabiano v. Philip Morris, Inc.		RJR Tobacco, B&W		NY Supreme Court
		[Individual]				New York County
						(New York, NY)
September 8, 2008		Hausrath v. Philip Morris USA, Inc.		B&W		NY Supreme Court
		[Individual]				Erie County
						(Buffalo, NY)
December 17, 2008		Williams v. Brown & Williamson		RJR Tobacco, B&W		Circuit Court
		[Individual]				City of St. Louis (St. Louis, MO)

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Trial Date		Case Name/Type		Defendant(s)		Jurisdiction
January 5, 2009		Workman v. R.J. Reynolds Tobacco Co.		RJR Tobacco		U.S. District Court
		[Individual]				Southern District
						(Miami, FL)
January 5, 2009		Hargroves v. R.J. Reynolds Tobacco Co.		RJR Tobacco		Circuit Court
		[Engle Progeny]				Hillsborough County
						(Miami, FL)
January 20, 2009		Suzanne Lombardi v. R.J. Reynolds Tobacco Co.		RJR Tobacco		U.S. District Court
		[Engle Progeny]				Southern District
						(Miami, FL)
February 2, 2009		Goldberg v. Brown & Williamson		RJR Tobacco, B&W		U.S. District Court
		[Individual]				Southern District
						(West Palm Beach, FL)

          Trial Results. From January 1, 1999 through April 11, 2008, 54 smoking and health and health-care cost recovery cases in which RJR Tobacco or B&W were defendants were tried. Verdicts in favor of RJR Tobacco, B&W and, in some cases, RJR Tobacco, B&W and other defendants, were returned in 37 cases, including four mistrials, tried in Florida (11), New York (4), Missouri (4), Tennessee (3), Mississippi (2), California (2), West Virginia (2), Ohio (2), Connecticut (1), Louisiana (1), New Jersey (1), Pennsylvania (1), South Carolina (1), Texas (1) and Washington (1).

          Additionally, from January 1, 1999 through April 11, 2008, verdicts were returned in 22 smoking and health cases in which RJR Tobacco, B&W, or their respective affiliates were not defendants. Verdicts were returned in favor of the defendants in 13 cases — five in Florida, three in California, and one in each of New Hampshire, New York, Pennsylvania, Rhode Island and Tennessee. Verdicts in favor of the plaintiffs were returned in nine cases — four in California, two in each of Florida and Oregon and one in Illinois.

          No cases were tried in the first quarter of 2008 in which RJR Tobacco was a defendant.

          The following chart reflects the verdicts and post-trial developments in the smoking and health cases that have been tried and remain pending as of April 11, 2008, in which verdicts have been returned in favor of the plaintiffs and against RJR Tobacco or B&W, or both.

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
July 7, 1999-Phase I April 7, 2000-Phase II July 14, 2000-Phase III		Engle v. R. J. Reynolds Tobacco Co. [Class Action]		Circuit Court, Miami-Dade County (Miami, FL)		$12.7 million compensatory damages against all the defendants; $145 billion punitive damages against all the defendants, of which approximately $36.3 billion and $17.6 billion was assigned to RJR Tobacco and B&W, respectively.		On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court and remanded the case to the Miami-Dade County Circuit Court with instructions to decertify the class. The Florida Supreme Court on July 6, 2006, affirmed the dismissal of the punitive damages award and decertified, on a going-forward basis, the class. The court preserved a number of class-wide findings from Phase I of the Engle trial, and authorized class members to avail themselves of those findings in individual lawsuits, provided they commence those lawsuits within one year of the date the court’s

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
								decision becomes final. In addition, the court reinstated compensatory damage verdicts in favor of two plaintiffs in the amounts of $2.85 million and $4.023 million, respectively. On October 1, 2007, the U.S. Supreme Court denied the defendants’ petition for writ of certiorari. On November 26, 2007, the defendants’ petition for rehearing with the U.S. Supreme Court was denied. As a result, on February 8, 2008, RJR Tobacco paid approximately $5.9 million relating to the damages verdicts mentioned above, which was determined using the total amount of the verdicts together with accrued interest beginning November 7, 2000.
June 11, 2002		Lukacs v. R. J. Reynolds Tobacco Co. [Engle class member]		Circuit Court, Miami-Dade County (Miami, FL)		$500,000 economic damages, $24.5 million non-economic damages and $12.5 million loss of consortium damages against Philip Morris, B&W and Lorillard, of which B&W was assigned 22.5% of liability. Court has not entered final judgment for damages. RJR Tobacco was dismissed from the case in May 2002, prior to trial.		Judge reduced damages to $25.125 million of which B&W’s share is approximately $6 million. On January 2, 2007, the defendants moved to set aside the June 11, 2002, verdict and to dismiss the plaintiffs’ punitive damages claim. On January 3, 2007, the plaintiffs filed a motion for entry of judgment, which the court deferred until the U.S. Supreme Court completed review of Engle and after further submissions by the parties. On January 28, 2008, the defendants filed a submission asking the court to set aside the verdict and to dismiss the case.
December 18, 2003		Frankson v. Brown & Williamson Tobacco Corp. [Individual]		Supreme Court, Kings County (Brooklyn, NY)		$350,000 compensatory damages; 50% fault assigned to B&W and two industry organizations; $20 million in punitive damages, of which $6 million was assigned to B&W, $2 million to a predecessor company and $12 million to two industry organizations.		On January 21, 2005, the plaintiff stipulated to the court’s reduction in the amount of punitive damages from $20 million to $5 million, apportioned as follows: $0 to American Tobacco; $4 million to B&W; $500,000 to the Council for Tobacco Research and $500,000

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Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
								to the Tobacco Institute. On June 26, 2007, final judgment was entered in the amount of approximately $6.8 million, including interest and costs. The defendants filed a notice of appeal on July 3, 2007. Briefing is underway. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the amount of $8.018 million on July 5, 2007.
May 21, 2004		Scott v. American Tobacco Co. [Class Action]		District Court, Orleans Parish (New Orleans, LA)		$591 million against RJR Tobacco, B&W, Philip Morris, Lorillard, and the Tobacco Institute, jointly and severally, for a smoking cessation program.		On September 29, 2004, the defendants posted a $50 million bond and noticed their appeal to the Louisiana Court of Appeal. RJR Tobacco posted $25 million toward the bond. On February 7, 2007, the Louisiana Court of Appeal limited the size of the class, and rejected the award of pre-judgment interest and most of the specific components of the smoking cessation program. However, the court upheld the class certification and found the defendants responsible for funding smoking cessation for eligible class members. The defendants filed an application for writ of certiorari with the Louisiana Supreme Court on April 2, 2007, which was denied on January 7, 2008. On March 24, 2008, the defendants also filed with the Louisiana Supreme Court a motion to stay the case pending application to the U.S. Supreme Court, which was denied on April 2, 2008. The defendants filed their petition for writ of certiorari with the U.S. Supreme Court on April 7, 2008.
February 2, 2005		Smith v. Brown & Williamson Tobacco Corp. [Individual]		Circuit Court, Jackson County (Independence, MO)		$2 million in compensatory damages which was reduced to $500,000 because of jury’s findings that the plaintiff was 75% at fault; $20 million in punitive damages.		On June 1, 2005, B&W filed its notice of appeal. On July 31, 2007, the Missouri Court of Appeals affirmed the compensatory damages

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Date of Verdict		Case Name/Type		Jurisdiction		Verdict		Post-Trial Status
								award but ordered a new trial on punitive damages. The Missouri Supreme Court accepted transfer of the case from the court of appeals. Oral argument was heard on February 13, 2008. A decision is pending.
March 18, 2005		Rose v. Brown & Williamson Tobacco Corp. [Individual]		Supreme Court, New York County (Manhattan, NY)		RJR Tobacco found not liable; $3.42 million in compensatory damages against B&W and Philip Morris, of which $1.71 million was assigned to B&W; $17 million in punitive damages against Philip Morris only.		On August 18, 2005, B&W filed its notice of appeal. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the amount of $2.058 million on February 7, 2006. On April 10, 2008, the New York Supreme Court, Appellate Division reversed the judgment in the plaintiffs’ favor and dismissed the case.
August 17, 2006		United States v. Philip Morris USA, Inc. [Governmental Health-Care Cost Recovery]		U.S. District Court, District of Columbia (Washington, DC)		RJR Tobacco and B&W were found liable for civil RICO claims; were enjoined from using certain brand descriptors and from making certain misrepresentations; and were ordered to make corrective communications on five subjects, including smoking and health and addiction, to reimburse the U.S. Department of Justice appropriate costs associated with the lawsuit, and to maintain document web sites.		On September 11, 2006, RJR Tobacco and B&W filed their notices of appeal. On October 16, 2006, the government filed its notice of appeal. The court of appeals granted the defendants’ motion to stay the district court’s order on October 31, 2006. Briefing is scheduled to conclude on May 19, 2008.
May 2, 2007		Whiteley v. R.J. Reynolds Tobacco Co. [Individual]		Superior Court, San Francisco County, (San Francisco, CA)		$2.46 million in compensatory damages jointly against RJR Tobacco and Philip Morris; $250,000 punitive damages against RJR Tobacco only.		On September 5, 2007, the court denied RJR Tobacco’s motion for judgment notwithstanding the verdict or, in the alternative, for a new trial. RJR Tobacco filed its notice of appeal on October 3, 2007. On March 21, 2008, the court entered a third stipulation and order for stay against enforcement of judgment until June 6, 2008.

Individual Smoking and Health Cases

          As of April 11, 2008, 830 individual cases, including 687 individual smoker cases in West Virginia state court in a consolidated action, were pending in the United States against RJR Tobacco, B&W, as its indemnitee, or both. This category of cases includes smoking and health cases alleging personal injury brought by or on behalf of individual plaintiffs, but does not include the Broin II or Engle Progeny Cases discussed below. A total of 824 of the individual

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cases are brought by or on behalf of individual smokers or their survivors, while the remaining six cases are brought by or on behalf of individuals or their survivors alleging personal injury as a result of exposure to ETS.

          Below is a description of the individual smoking and health cases against RJR Tobacco or B&W, or both, which went to trial or were decided during the period from January 1, 2008, to March 31, 2008, or remained on appeal as of March 31, 2008.

          In Whiteley v. R. J. Reynolds Tobacco Co., the retrial of Whiteley v. Raybestos-Manhattan, a case filed in April 1999 in Superior Court, San Francisco County, California and originally tried in 2000, the jury awarded the plaintiff $2.46 million in compensatory damages jointly against RJR Tobacco and Philip Morris on May 2, 2007, and returned a punitive damages verdict award of $250,000 against RJR Tobacco on May 9, 2007. RJR Tobacco’s motion for judgment notwithstanding the verdict or, in the alternative, for a new trial was denied on September 5, 2007. RJR Tobacco filed its notice of appeal to the Court of Appeal for the State of California, First Appellate District, on October 3, 2007. On March 21, 2008, the court entered a third stipulation and order for stay against enforcement of judgment until June 6, 2008.

          On August 15, 2003, a jury returned a verdict in favor of B&W in Eiser v. Brown & Williamson Tobacco Corp., a case filed in March 1999 in the Court of Common Pleas, Philadelphia County, Pennsylvania. The plaintiff, Lois Eiser, sought compensatory and punitive damages in an amount in excess of $50,000, together with interest, costs and attorneys’ fees in this wrongful death action against B&W. On January 19, 2006, the Superior Court of Pennsylvania affirmed the verdict. On September 22, 2006, the Pennsylvania Supreme Court granted the plaintiff’s petition to appeal. On December 28, 2007, the Pennsylvania Supreme Court remanded the case to the Eastern District of the Superior Court for further review.

          On December 18, 2003, in Frankson v. Brown & Williamson Tobacco Corp., a case filed in August 2000 in Supreme Court, Kings County, New York, a jury awarded $350,000 in compensatory damages against B&W and two former tobacco industry organizations, the Tobacco Institute and the Council for Tobacco Research, in an action brought against the major U.S. cigarette manufacturers, including RJR Tobacco, who was dismissed prior to trial, and B&W, seeking $270 million in compensatory damages, unspecified punitive damages, attorneys’ fees, costs and disbursements. Other manufacturers were dismissed before trial. The plaintiff, Gladys Frankson, alleged that Mr. Frankson became addicted to nicotine, was unable to cease smoking, developed lung cancer and died as a result. The defendants as a group and the deceased smoker were each found to be 50% at fault. On January 8, 2004, the jury awarded $20 million in punitive damages, assigning $6 million to B&W, $2 million to American Tobacco, a predecessor company to B&W, and $6 million to each of the Council for Tobacco Research and the Tobacco Institute. On June 22, 2004, the trial judge granted a new trial unless the parties consented to an increase in compensatory damages to $500,000 and a decrease in punitive damages to $5 million, of which $4 million would be assigned to B&W. On January 21, 2005, the plaintiff stipulated to the reduction in punitive damages.

          After all post-trial motions, and appeals therefrom, were denied, judgment was entered in favor of the plaintiffs for $175,000 in compensatory damages, the original jury award reduced by 50%, and $5 million in punitive damages, the amount to which the plaintiff stipulated. On June 26, 2007, final judgment was entered against the defendants in the amount of approximately $6.8 million, including interest and costs. The defendants filed a notice of appeal to the Appellate Division, New York Supreme Court, Second Department on July 3, 2007. Briefing is underway. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the amount of $8.018 million on July 5, 2007.

          On February 1, 2005, a jury returned a split verdict in Smith v. Brown & Williamson Tobacco Corp., a case filed in May 2003 in Circuit Court, Jackson County, Missouri, finding in favor of B&W on two counts, fraudulent concealment and conspiracy, and finding in favor of the plaintiff on negligence, which incorporates failure to warn and product defect claims. The plaintiff, Lincoln Smith, claimed that the defendant’s tobacco products caused Mrs. Smith’s death from lung cancer and sought an unspecified amount of compensatory and punitive damages. The plaintiff was awarded $2 million in compensatory damages and $20 million in punitive damages; however, the jury found the plaintiff to be 75% at fault, and B&W 25% at fault, and thus the compensatory award was reduced to $500,000. B&W appealed to the Missouri Court of Appeals, and on July 31, 2007, the court affirmed the compensatory damages and ordered a new trial on punitive damages. The Missouri Supreme Court agreed to accept transfer of the case from the court of appeals. Oral argument was heard on February 13, 2008. A decision is pending.

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          On March 18, 2005, in Rose v. Brown & Williamson Tobacco Corp., a case filed in December 1996 in New York Supreme Court, County of New York, a jury returned a verdict in favor of RJR Tobacco, but returned a $3.42 million compensatory damages verdict against B&W and Philip Morris, of which $1.71 million was assigned to B&W. A punitive damages verdict of $17 million against Philip Morris only was returned by the jury on March 28, 2005. The action was brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover $15 million in compensatory damages and $35 million in punitive damages. The plaintiffs, Norma Rose and Leonard Rose, allege that their use of the defendants’ products caused them to become addicted to nicotine and develop lung cancer, chronic obstructive pulmonary disease and other smoking related conditions and/or diseases. Oral argument on B&W’s appeal in the Appellate Division, New York Supreme Court, First Department occurred on December 12, 2006. Pursuant to its agreement to indemnify B&W, RJR Tobacco posted a supersedeas bond in the amount of $2.058 million on February 7, 2006. On April 10, 2008, the Appellate Division reversed the judgment in the plaintiffs’ favor and dismissed the case.

Engle Progeny Cases

          Pursuant to the Florida Supreme Court’s July 6, 2006, ruling in Engle v. R. J. Reynolds Tobacco Co., which decertified the class, former class members had one year from January 11, 2007, in which to file individual lawsuits. In addition, some individuals who filed suit prior to January 11, 2007, and who claim they meet the conditions in Engle, also are attempting to avail themselves of the Engle ruling. Lawsuits by individuals requesting the benefit of the Engle ruling, whether filed before or after the January 11, 2007, mandate, are referred to as the Engle Progeny Cases. As of April 11, 2008, RJR Tobacco had been served in 1,931 Engle Progeny Cases in both state and federal courts in Florida. These cases include approximately 8,178 plaintiffs. For further information on the Engle case, see “— Class-Action Suits — Engle Case,” below.

Broin II Cases

          As of April 11, 2008, there were 2,621 lawsuits pending in Florida brought by individual flight attendants for personal injury as a result of illness allegedly caused by exposure to ETS in airplane cabins, referred to as the Broin II cases. In these lawsuits, filed pursuant to the terms of the settlement of the Broin v. Philip Morris, Inc. class action, discussed below under “— Class-Action Suits,” each individual flight attendant will be required to prove that he or she has a disease and that the individual’s exposure to ETS in airplane cabins caused the disease. Punitive damages are not available in these cases.

          On October 5, 2000, the Broin court entered an order applicable to all Broin II cases that the terms of the Broin settlement agreement do not require the individual Broin II plaintiffs to prove the elements of strict liability, breach of warranty or negligence. Under this order, there is a rebuttable presumption in the plaintiffs’ favor on those elements, and the plaintiffs bear the burden of proving that their alleged adverse health effects actually were caused by exposure to ETS in airplane cabins, that is, specific causation. Below is a description of the Broin II cases against RJR Tobacco and B&W that went to trial or were decided during the period from January 1, 2008 to March 31, 2008, or remained on appeal or were otherwise pending as of March 31, 2008.

          In Janoff v. Philip Morris, Inc., a case filed in February 2000 in Circuit Court, Miami-Dade County, Florida, a jury found in favor of the defendants, including RJR Tobacco and B&W, on September 5, 2002, in an action brought against the major U.S. cigarette manufacturers seeking to recover compensatory damages pursuant to the Broin settlement. The plaintiff, Suzette Janoff, alleged that as a result of exposure to ETS in airline cabins, she suffered from, among other illnesses, chronic sinusitis, chronic bronchitis and other respiratory and pulmonary problems. The judge granted the plaintiff’s motion for a new trial on January 8, 2003.

          In Menchini v. Philip Morris USA, Inc., a case filed in August 2000 in Circuit Court, Miami-Dade County, Florida, a jury returned a verdict in favor of the defendants, including RJR Tobacco and B&W, on November 16, 2007, in an action brought against the major U.S. cigarette manufacturers seeking to recover compensatory damages pursuant to the Broin settlement. A stipulation of discontinuance was filed on March 12, 2008.

Class-Action Suits

          Overview. As of April 11, 2008, 17 class-action cases, exclusive of antitrust class actions, were pending in the United States against RJR Tobacco or its affiliates or indemnitees. In May 1996, in Castano v. American Tobacco Co., the Fifth Circuit Court of Appeals overturned the certification of a nation-wide class of persons whose claims related to

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

alleged addiction to tobacco products. Since this ruling by the Fifth Circuit, most class-action suits have sought certification of state-wide, rather than nation-wide, classes. Class-action suits based on claims similar to those asserted in Castano or claims that class members are at a greater risk of injury or injured by the use of tobacco or exposure to ETS are pending against RJR Tobacco and its affiliates and indemnitees in state or federal courts in California, Florida, Illinois, Louisiana, Minnesota, Missouri, New York, Oregon and West Virginia. All pending class-action cases are discussed below.

          The pending class-actions against RJR Tobacco or its affiliates or indemnitees include eight cases alleging that the use of the term “lights” constitutes unfair and deceptive trade practices under state law or violates the federal RICO statute. Such suits are pending in state or federal courts in Florida, Illinois, Minnesota, Missouri and New York.

          Finally, certain third-party payers have filed health-care cost recovery actions in the form of class-actions.

          Few smoker class-action complaints have been certified or, if certified, have survived on appeal. Eighteen federal courts, including two courts of appeals, and most state courts that have considered the issue have rejected class certification in such cases. Apart from the Castano case discussed above, only two smoker class actions have been certified by a federal court: In re Simon (II) Litigation and Schwab [McLaughlin] v. Philip Morris USA, Inc., discussed below under “— ‘Lights’ Cases,” both of which were filed in the U.S. District Court for the Eastern District of New York and ultimately decertified.

          Medical Monitoring and Smoking Cessation Cases. On November 5, 1998, in Scott v. American Tobacco Co., a case filed in May 1996 in District Court, Orleans Parish, Louisiana, the trial court certified a medical monitoring or smoking cessation class of Louisiana residents who were smokers on or before May 24, 1996, in an action brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover an unspecified amount of compensatory and punitive damages. The plaintiffs allege that their use of the defendants’ products caused them to become addicted to nicotine. On July 28, 2003, the jury returned a verdict in favor of the defendants on the plaintiffs’ claim for medical monitoring and found that cigarettes were not defectively designed. However, the jury also made certain findings against the defendants on claims relating to fraud, conspiracy, marketing to minors and smoking cessation. Notwithstanding these findings, this portion of the trial did not determine liability as to any class member or class representative. What primarily remained in the case was a class-wide claim that the defendants pay for a program to help people stop smoking.

          On March 31, 2004, phase two of the trial began to address only the scope and cost of smoking cessation programs. On May 21, 2004, the jury returned a verdict in the amount of $591 million on the class’s claim for a smoking cessation program. On September 29, 2004, the defendants posted a $50 million bond, pursuant to legislation that limits the amount of the bond to $50 million collectively for MSA signatories, and noticed their appeal. RJR Tobacco posted $25 million, that is, the portions for RJR Tobacco and B&W, towards the bond. On February 7, 2007, the Louisiana Court of Appeals upheld the class certification and found the defendants responsible for funding smoking cessation for eligible class members. The appellate court also ruled, however, that the defendants were not liable for any post-1988 claims, rejected the award of prejudgment interest and struck eight of the 12 components of the smoking cessation program. In particular, the appellate court ruled that no class member, who began smoking after September 1, 1988, could receive any relief, and that only those smokers, whose claims accrued on or before September 1, 1988, would be eligible for the smoking cessation program. Plaintiffs have expressly represented to the trial court that none of their claims accrued before 1988 and that the class claims did not accrue until around 1996, when the case was filed. There is currently no final judgment for a specific amount of damages to be paid for smoking cessation, and the appellate court remanded the case to the trial court for further proceedings, which will likely lead to additional appellate review if any new judgment is entered. On March 2, 2007, the defendants’ application for rehearing and clarification was denied. The defendants’ application for writ of certiorari with the Louisiana Supreme Court was denied on January 7, 2008. On April 2, 2008, the defendants’ motion to stay proceedings pending application to the U.S. Supreme Court was denied. The defendants filed their petition for writ of certiorari with the U.S. Supreme Court on April 7, 2008.

          In addition to the Scott case, one other medical monitoring class-action remains pending against RJR Tobacco, B&W, and other cigarette manufacturers. In Lowe v. Philip Morris, Inc., a case filed in November 2001 in Circuit Court, Multnomah County, Oregon, a judge dismissed the complaint on November 4, 2003, for failure to state a claim in an action seeking creation of a court-supervised program of medical monitoring, smoking cessation and education, and recovery of attorneys’ fees. On September 6, 2006, the Court of Appeals affirmed the trial court’s dismissal. The Oregon Supreme Court heard argument on September 5, 2007. A decision is pending.

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          Engle Case. Trial began in July 1998 in Engle v. R. J. Reynolds Tobacco Co., a case filed in May 1994, and pending in Circuit Court, Miami-Dade County, Florida, in which a class consisting of Florida residents, or their survivors, alleges diseases or medical conditions caused by their alleged “addiction” to cigarettes. The action was brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking actual damages and punitive damages in excess of $100 billion each and the creation of a medical fund to compensate individuals for future health-care costs. On July 7, 1999, the jury found against RJR Tobacco, B&W and the other cigarette-manufacturer defendants in the initial phase, which included common issues related to certain elements of liability, general causation and a potential award of, or entitlement to, punitive damages.

          The second phase of the trial, which consisted of the claims of three of the named class representatives, began on November 1, 1999. On April 7, 2000, the jury returned a verdict against all the defendants. It awarded plaintiff Mary Farnan $2.85 million, the estate of plaintiff Angie Della Vecchia $4.023 million and plaintiff Frank Amodeo $5.831 million.

          The trial court also ordered the jury in the second phase of the trial to determine punitive damages, if any, on a class-wide basis. On July 14, 2000, the jury returned a punitive damages verdict in favor of the “Florida class” of approximately $145 billion against all the defendants, with approximately $36.3 billion and $17.6 billion being assigned to RJR Tobacco and B&W, respectively.

          On November 6, 2000, the trial judge denied all post-trial motions and entered judgment. In November 2000, RJR Tobacco and B&W posted appeal bonds in the amount of $100 million each and initiated the appeals process. On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court’s final judgment and remanded the case to the Miami-Dade County Circuit Court with instructions to decertify the class. The class appealed, and the Florida Supreme Court accepted the case on May 12, 2004.

          On July 6, 2006, the court affirmed the dismissal of the punitive damages award and decertified the class, on a going-forward basis. The court preserved a number of class-wide findings from Phase I of the trial, including that cigarettes can cause certain diseases, that nicotine is addictive and that defendants placed defective and unreasonably dangerous cigarettes on the market, and authorized former class members to avail themselves of those findings under certain conditions in individual lawsuits, provided they commence those lawsuits within one year of the date the court’s decision became final. The court specified that the class is confined to those Florida citizen residents who suffered or died from smoking-related illnesses that “manifested” themselves on or before November 21, 1996, and that were caused by an addiction to cigarettes. In addition, the court reinstated the compensatory damages awards of $2.85 million to Mary Farnan and $4.023 million to Angie Della Vecchia, but ruled that the claims of Frank Amodeo were barred by the statute of limitations. Finally, the court reversed the Third District Court of Appeal’s 2003 ruling that class counsel’s improper statements during trial required reversal.

          On August 7, 2006, RJR Tobacco and the other defendants filed a rehearing motion arguing, among other things, that the findings from the Engle trial are not sufficiently specific to serve as the basis for further proceedings and that the Florida Supreme Court’s decision denied defendants due process. On the same day, the plaintiffs also filed a rehearing motion arguing that some smokers who became sick after November 21, 1996, and who are therefore not class members, should nevertheless have the statute of limitations tolled since they may have refrained from filing suit earlier in the mistaken belief that they were Engle class members. On December 21, 2006, the Florida Supreme Court withdrew its July 6, 2006, decision and issued a revised opinion, in which it set aside the jury’s findings of a conspiracy to misrepresent and clarified that the Engle jury’s finding on express warranty were preserved for use by eligible plaintiffs. The court also denied the plaintiffs’ motion and confirmed that the class was limited to those individuals who developed alleged smoking-related illnesses that manifested themselves on or before November 21, 1996. The court issued its mandate on January 11, 2007, which began the one-year period for former class members to file individual lawsuits. As of April 11, 2008, 1,931 individual cases were filed in Florida as a result of the Engle decision. These cases include approximately 8,178 plaintiffs. For further information on the individual cases, see “— Engle Progeny Cases” above.

          On April 17, 2007, RJR Tobacco’s motions for discharge of RJR Tobacco’s and B&W’s civil supersedeas bonds related to the punitive damages award were granted. During the second quarter of 2007, RJR Tobacco received the full amount of the $100 million cash collateral that it had posted. On October 1, 2007, the defendants’ petition for writ of certiorari with the U.S. Supreme Court was denied. On November 26, 2007, the defendants’ petition for rehearing with the U.S. Supreme Court was denied. As a result, the verdicts in favor of Mary Farnan and Angie Della Vecchia, mentioned above, became final. On February 8, 2008, RJR Tobacco paid approximately $5.9 million relating to the compensatory damages verdicts mentioned above, which amount was determined using the total amount of the

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verdicts together with accrued interest beginning November 7, 2000. A final computation of interest due on those judgments will be determined by the trial court in 2008.

          Prior to the Florida Supreme Court ruling on July 6, 2006, RJR Tobacco and/or B&W were named as a defendant(s) in several individual cases filed by members of the Engle class. One such case, Lukacs v. Philip Morris, Inc., a case filed in February 2001, and pending in Circuit Court, Miami-Dade County, Florida, was tried against Philip Morris, Liggett and B&W, and resulted in a verdict for the plaintiffs on June 11, 2002, in a personal injury action brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover an unspecified amount in compensatory and punitive damages. The plaintiff alleged that his use of the defendants’ brands caused his development of bladder, throat, oral cavity and tongue cancer. RJR Tobacco was voluntarily dismissed on May 1, 2002. The Florida state court jury awarded the plaintiffs a total of $37.5 million in compensatory damages. The jury assigned 22.5% fault to B&W, 72.5% fault to the other defendants and 5% fault to plaintiff John Lukacs. On April 1, 2003, the Miami-Dade County Circuit Court granted in part the defendants’ motion for remittitur and reduced the jury’s award to plaintiff Yolanda Lukacs, on the loss of consortium claim, from $12.5 million to $0.125 million decreasing the total award to $25.125 million. On August 2, 2006, the plaintiff filed a motion for entry of partial judgment and notice of jury trial on punitive damages. On January 2, 2007, the defendants asked the court to set aside the jury’s June 11, 2002, verdict for the plaintiffs and to dismiss the plaintiffs’ punitive damages claim. On January 3, 2007, the plaintiffs filed a motion for entry of judgment, which the court deferred until the U.S. Supreme Court has completed its review of Engle and after further submissions by the parties. On January 28, 2008, the defendants filed a submission asking the court to set aside the verdict and to dismiss the case.

          California Business and Professions Code Cases. On November 30, 2000, in Daniels v. Philip Morris Cos., Inc., a case filed in April 1998 in Superior Court, San Diego County, California, a judge, based on a California unfair business practices statute, certified a class consisting of all persons who, as California resident minors, smoked one or more cigarettes in California between April 2, 1994 and December 1, 1999. The action had been brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover an unspecified amount of compensatory and punitive damages, restitution to each member of the class and to the general public, and an injunction prohibiting the defendants from engaging in further violation of California Business and Professions Code § 17200 and § 17500. The plaintiffs alleged that due to the deceptive practices of the defendants, they became addicted to cigarettes as teenagers. The court granted the defendants’ motions for summary judgment on preemption and First Amendment grounds and dismissed the action on October 21, 2002. On October 6, 2004, the California Court of Appeal affirmed the trial court. On August 2, 2007, the California Supreme Court affirmed the California Court of Appeal. On March 17, 2008, the plaintiffs’ petition for writ of certiorari with the U.S. Supreme Court was denied.

          On April 11, 2001, in Brown v. American Tobacco Co., Inc., a case filed in June 1997 in Superior Court, San Diego County, California, the same judge as in Daniels granted in part the plaintiffs’ motion for certification of a class composed of residents of California who smoked at least one of the defendants’ cigarettes from June 10, 1993 through April 23, 2001, and who were exposed to the defendants’ marketing and advertising activities in California. The action was brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, seeking to recover restitution, disgorgement of profits and other equitable relief under California Business and Professions Code § 17200 et seq. and § 17500 et seq. Certification was granted as to the plaintiffs’ claims that the defendants violated § 17200 of the California Business and Professions Code pertaining to unfair competition. The court, however, refused to certify the class under the California Legal Remedies Act and on the plaintiffs’ common law claims. On March 7, 2005, the court granted the defendants’ motion to decertify the class. On September 5, 2006, the California Court of Appeal affirmed the judge’s order decertifying the class. On November 1, 2006, the plaintiffs’ petition for review with the California Supreme Court was granted. Supplemental briefing is complete. A decision is pending.

          “Lights” Cases. As noted above, “lights” class-action cases are pending against RJR Tobacco or B&W in Illinois (2), Missouri (2), Minnesota (2), Florida (1) and New York (1). The classes in these cases generally seek to recover $50,000 to $75,000 per class member for compensatory and punitive damages, injunctive and other forms of relief, and attorneys’ fees and costs from RJR Tobacco and/or B&W. In general, the plaintiffs allege that RJR Tobacco or B&W made false and misleading claims that “lights” cigarettes were lower in tar and nicotine and/or were less hazardous or less mutagenic than other cigarettes. The cases typically are filed pursuant to state consumer protection and related statutes.

          The seminal “lights” class-action case involved RJR Tobacco’s competitor, Philip Morris, Inc. Trial began in Price v. Philip Morris, Inc. in January 2003. In March 2003, the trial judge entered judgment against Philip Morris in the amount of $7.1 billion in compensatory damages and $3 billion in punitive damages to the State of Illinois. Based on Illinois law, the bond required to stay execution of the judgment was set initially at $12 billion. Philip Morris

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

pursued various avenues of relief from the $12 billion bond requirement. In December 2005, the Illinois Supreme Court reversed the lower court’s decision and sent the case back to the trial court with instructions to dismiss the case. In December 2006, the defendants’ motion to dismiss and for entry of final judgment was granted, and the case was dismissed with prejudice the same day. The plaintiffs’ motion to vacate and/or withhold judgment was dismissed by the court on August 30, 2007.

          In Turner v. R. J. Reynolds Tobacco Co., a case filed in February 2000 in Circuit Court, Madison County, Illinois, a judge certified a class on November 14, 2001. On June 6, 2003, RJR Tobacco filed a motion to stay the case pending Philip Morris’s appeal of the Price v. Philip Morris Inc. case mentioned above, which the judge denied on July 11, 2003. On October 17, 2003, the Illinois Fifth District Court of Appeals denied RJR Tobacco’s emergency stay/supremacy order request. On November 5, 2003, the Illinois Supreme Court granted RJR Tobacco’s motion for a stay pending the court’s final appeal decision in Price. On October 11, 2007, the Illinois Fifth District Court of Appeals dismissed RJR Tobacco’s appeal and remanded the case to the circuit court.

          In Howard v. Brown & Williamson Tobacco Corp., another case filed in February 2000 in Circuit Court, Madison County, Illinois, a judge certified a class on December 18, 2001. On June 6, 2003, the trial judge issued an order staying all proceedings pending resolution of the Price v. Philip Morris, Inc. case mentioned above. The plaintiffs appealed this stay order to the Illinois Fifth District Court of Appeals, which affirmed the Circuit Court’s stay order on August 19, 2005.

          In the event RJR Tobacco and its affiliates or indemnitees lose the Turner or Howard cases, or one or more of the other pending “lights” class-action suits, RJR Tobacco could face bonding difficulties depending upon the amount of damages ordered, if any, which could have a material adverse effect on RJR Tobacco’s, and consequently RAI’s, results of operations, cash flows or financial position.

          Schwab [McLaughlin] v. Philip Morris USA, Inc., a nation-wide “lights” class-action, was filed on May 11, 2004, in the U.S. District Court for the Eastern District of New York, against RJR Tobacco and B&W, as well as other tobacco manufacturers. The plaintiffs brought the case pursuant to RICO, challenging the practices of the defendants in connection with the manufacturing, marketing, advertising, promotion, distribution and sale of cigarettes that were labeled as “lights” or “light.” On September 25, 2006, the court issued its decision, among other things, granting class certification. On November 16, 2006, the U.S. Court of Appeals for the Second Circuit granted the defendants’ motions to stay the district court proceedings and for review of the class certification ruling. On April 3, 2008, the Second Circuit decertified the class.

          A “lights” class-action case is pending against each of RJR Tobacco and B&W in Missouri. In Collora v. R. J. Reynolds Tobacco Co., a case filed in May 2000 in Circuit Court, St. Louis County, Missouri, a judge in St. Louis certified a class on December 31, 2003. On April 9, 2007, the court granted the plaintiffs’ motion to reassign Collora and the following cases to a single general division: Craft v. Philip Morris Companies, Inc. and Black v. Brown & Williamson Tobacco Corp., discussed below. On April 16, 2008, the court stayed the case pending U.S. Supreme Court review in Good v. Altria Group, Inc., a “lights” class-action pending against Altria and PM USA.

          In Black v. Brown & Williamson Tobacco Corp., a case filed in November 2000 in Circuit Court, City of St. Louis, Missouri, B&W removed the case to the U.S. District Court for the Eastern District of Missouri on September 23, 2005. On October 25, 2005, the plaintiffs filed a motion to remand, which was granted on March 17, 2006. On April 16, 2008, the court stayed the case pending U.S. Supreme Court review in Good v. Altria Group, Inc.

          In Dahl v. R. J. Reynolds Tobacco Co., a case filed in April 2003, and pending in District Court, Hennepin County, Minnesota, a judge dismissed the case on May 11, 2005, ruling the “lights” claims are preempted by the Federal Cigarette Labeling and Advertising Act. On July 11, 2005, the plaintiffs filed a notice of appeal with the Minnesota Court of Appeals for the Fourth Judicial District. During the pendency of the appeal, RJR Tobacco removed the case to the U.S. District Court for the District of Minnesota. On February 28, 2007, the Eighth Circuit remanded the case to the Minnesota Court of Appeals, which on December 4, 2007, reversed the judgment in favor of the defendants on preemption grounds and remanded the case to the District Court of Hennepin County. On January 28, 2008, RJR Tobacco filed a motion to stay its January 3, 2008 petition for review until the completion of the U.S. Supreme Court review in Good v. Altria Group, Inc. This motion was granted on February 27, 2008.

          In Thompson v. R. J. Reynolds Tobacco Co., a case filed in February 2005 in District Court, Hennepin County, Minnesota, RJR Tobacco removed the case on September 23, 2005 to the U.S. District Court for the District of Minnesota. On August 7, 2006, the parties filed a stipulation to stay the case pending resolution of the appeal in Dahl v.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

R. J. Reynolds Tobacco Co. On October 29, 2007, the U.S. District Court remanded the case to the District Court for Hennepin County. On February 1, 2008, the court stayed the case until the completion of the appeal in Dahl v. R. J. Reynolds Tobacco Co.

          Rios v. R. J. Reynolds Tobacco Co., a case filed in February 2002 in Circuit Court, Palm Beach County, Florida is dormant pending plaintiffs’ counsel’s attempt to appeal the Florida Fourth District Court of Appeal’s decertification in Hines v. Philip Morris, Inc., a “lights” class-action case filed in February 2001 in Circuit Court, Palm Beach County, Florida against Phillip Morris only. On January 14, 2008, the Florida Supreme Court refused to hear plaintiff’s appeal in Hines v. Philip Morris, Inc. The plaintiffs in Rios brought the action against RJR Tobacco and RJR.

          Finally, in Rivera v. Brown & Williamson Tobacco Corp., a case filed in October 2006 in Circuit Court, Broward County, Florida, B&W removed the case to the U.S. District Court for the Southern District of Florida on November 15, 2006, and answered the complaint on November 22, 2006. On September 10, 2007, the court stayed the case until disposition of Hines v. Philip Morris, Inc. On March 10, 2008, the court dismissed the case with prejudice.

          Other Class Actions. In Cleary v. Philip Morris, Inc., a case filed in June 1998, and pending in Circuit Court, Cook County, Illinois, the plaintiffs filed their motion for class certification on December 21, 2001, in an action brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W. The case is brought on behalf of persons who have allegedly been injured by (1) the defendants’ purported conspiracy pursuant to which defendants concealed material facts regarding the addictive nature of nicotine, (2) the defendants’ alleged acts of targeting its advertising and marketing to minors, and (3) the defendants’ claimed breach of the public right to defendants’ compliance with the laws prohibiting the distribution of cigarettes to minors. The plaintiffs request that the defendants be required to disgorge all profits unjustly received through its sale of cigarettes to plaintiffs and the class, which in no event will be greater than $75,000 per each class member, inclusive of punitive damages, interest and costs. On March 27, 2006, the court dismissed count V, public nuisance, and count VI, unjust enrichment. On July 11, 2006, the plaintiffs filed a motion for class certification.

          Young v. American Tobacco Co., Inc., a case filed in November 1997 in Circuit Court, Orleans Parish, Louisiana, is an ETS class action against U.S. cigarette manufacturers, including RJR Tobacco and B&W, and parent companies of U.S. cigarette manufacturers, including RJR, on behalf of all residents of Louisiana who, though not themselves cigarette smokers, have been exposed to secondhand smoke from cigarettes which were manufactured by the defendants, and who allegedly suffered injury as a result of that exposure. The plaintiffs seek to recover an unspecified amount of compensatory and punitive damages. On October 13, 2004, the trial court stayed this case pending the outcome of the appeal in Scott v. American Tobacco Co., Inc., discussed above under “— Medical Monitoring and Smoking Cessation Cases.”

          In Parsons v. A C & S, Inc., a case filed in February 1998 in Circuit Court, Ohio County, West Virginia, the plaintiff sued asbestos manufacturers, U.S. cigarette manufacturers, including RJR Tobacco and B&W, and parent companies of U.S. cigarette manufacturers, including RJR, seeking to recover $1,000,000 in compensatory and punitive damages individually and an unspecified amount for the class in both compensatory and punitive damages. The class is brought on behalf of persons who allegedly have personal injury claims arising from their exposure to respirable asbestos fibers and cigarette smoke. The plaintiffs allege that Mrs. Parsons’ use of tobacco products and exposure to asbestos products caused her to develop lung cancer and to become addicted to tobacco. The case has been stayed pending a final resolution of the plaintiffs’ motion to refer tobacco litigation to the judicial panel on multi-district litigation filed in In Re: Tobacco Litigation in the Supreme Court of Appeals of West Virginia. On December 26, 2000, three defendants, Nitral Liquidators, Inc., Desseaux Corporation of North American and Armstrong World Industries, filed bankruptcy petitions in the U.S. Bankruptcy Court for the District of Delaware, In re Armstrong World Industries, Inc. Pursuant to section 362(a) of the Bankruptcy Code, Parsons is automatically stayed with respect to all defendants.

          Finally, in Jones v. American Tobacco Co., Inc., a case filed in December 1998 in Circuit Court, Jackson County, Missouri, the defendants removed the case to the U.S. District Court for the Western District of Missouri on February 16, 1999. The action was brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, and parent companies of U.S. cigarette manufacturers, including RJR, on behalf of tobacco product users and purchasers on behalf of all similarly situated Missouri consumers. The plaintiffs allege that their use of the defendants’ tobacco products has caused them to become addicted to nicotine. The plaintiffs seek to recover an unspecified amount of compensatory and punitive damages. The case was remanded to the Circuit Court on February 17, 1999. There has been limited activity in this case.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          Broin Settlement. RJR Tobacco, B&W and other cigarette manufacturer defendants settled Broin v. Philip Morris, Inc. in October 1997. This case had been brought in Florida state court on behalf of flight attendants alleged to suffer from diseases or ailments caused by exposure to ETS in airplane cabins. The settlement agreement required the participating tobacco companies to pay a total of $300 million in three annual $100 million installments, allocated among the companies by market share, to fund research on the early detection and cure of diseases associated with tobacco smoke. It also required those companies to pay a total of $49 million for the plaintiffs’ counsel’s fees and expenses. RJR Tobacco’s portion of these payments was approximately $86 million; B&W’s portion of these payments was approximately $57 million. The settlement agreement bars class members from bringing aggregate claims or obtaining punitive damages and also bars individual claims to the extent that they are based on fraud, misrepresentation, conspiracy to commit fraud or misrepresentation, RICO, suppression, concealment or any other alleged intentional or willful conduct. The defendants agreed that, in any individual case brought by a class member, the defendant will bear the burden of proof with respect to whether ETS can cause certain specifically enumerated diseases, referred to as “general causation.” With respect to all other issues relating to liability, including whether an individual plaintiff’s disease was caused by his or her exposure to ETS in airplane cabins, referred to as “specific causation,” the individual plaintiff will have the burden of proof. On September 7, 1999, the Florida Supreme Court approved the settlement. The Broin II cases, discussed above, arose out of the settlement of this case.

Health-Care Cost Recovery Cases

          Health-care cost recovery cases have been brought by a variety of plaintiffs. Other than certain governmental actions, these cases largely have been unsuccessful on remoteness grounds, which means that one who pays an injured person’s medical expenses is legally too remote to maintain an action against the person allegedly responsible for the injury.

          As of April 11, 2008, three health-care cost recovery cases were pending in the United States against RJR Tobacco, B&W, as its indemnitee, or both, as discussed below after the Master Settlement Agreement discussion.

          MSA. In June 1994, the Mississippi attorney general brought an action, Moore v. American Tobacco Co., against various industry members, including RJR Tobacco and B&W. This case was brought on behalf of the state to recover state funds paid for health care and other assistance to state citizens suffering from diseases and conditions allegedly related to tobacco use. Most other states, through their attorneys general or other state agencies, sued RJR Tobacco, B&W and other U.S. cigarette manufacturers based on similar theories. The cigarette manufacturer defendants, including RJR Tobacco and B&W, settled the first four of these cases scheduled for trial — Mississippi, Florida, Texas and Minnesota — by separate agreements with each such state.

          On November 23, 1998, the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, entered into the Master Settlement Agreement with attorneys general representing the remaining 46 states, the District of Columbia, Puerto Rico, Guam, the Virgin Islands, American Samoa and the Northern Marianas. Effective on November 12, 1999, the Master Settlement Agreement settled all the health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions and released various additional present and future claims.

          In the settling jurisdictions, the MSA released RJR Tobacco, B&W, and their affiliates and indemnitees, including RAI, from:

     • all claims of the settling states and their respective political subdivisions and other recipients of state health-care funds, relating to past conduct arising out of the use, sale, distribution, manufacture, development, advertising, marketing or health effects of, the exposure to, or research, statements or warnings about, tobacco products; and

     • all monetary claims of the settling states and their respective political subdivisions and other recipients of state health-care funds, relating to future conduct arising out of the use of or exposure to, tobacco products that have been manufactured in the ordinary course of business.

          Set forth below are tables depicting the unadjusted tobacco industry settlement payment schedule and the settlement payment schedule for RAI’s operating subsidiaries under the MSA, including the settlement agreements with the states of Mississippi, Florida, Texas and Minnesota, and related information for 2006 and beyond:

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Unadjusted Original Participating Manufacturers’ Settlement Payment Schedule

																										2012 and
		2006				2007				2008				2009				2010				2011				thereafter
First Four States’ Settlements: (1)
Mississippi Annual Payment		$	136			$	136			$	136			$	136			$	136			$	136			$	136
Florida Annual Payment			440				440				440				440				440				440				440
Texas Annual Payment			580				580				580				580				580				580				580
Minnesota Annual Payment			204				204				204				204				204				204				204
Remaining States’ Settlement:
Annual Payments (1)			7,004				7,004				8,004				8,004				8,004				8,004				8,004
Base Foundation Funding			25				25				25				—				—				—				—
Growers’ Trust (2)			500				500				500				295				295				—				—
Offset by federal tobacco buyout (2)			(500	)			(500	)			(500	)			(295	)			(295	)			—				—
Total		$	8,389			$	8,389			$	9,389			$	9,364			$	9,364			$	9,364			$	9,364

RAI’s Operating Subsidiaries’ Settlement Expenses and Payment Schedule

Settlement expenses		$	2,611			$	2,821				—				—				—				—				—
Settlement cash payments		$	2,631			$	2,616				—				—				—				—				—
Projected settlement expenses			—				—			$	>2,700			$	>2,650			$	>2,650			$	>2,650			$	>2,650
Projected settlement cash payments			—				—			$	>2,800			$	>2,650			$	>2,650			$	>2,650			$	>2,650

          The MSA also contains provisions restricting the marketing of cigarettes. Among these provisions are restrictions or prohibitions on the use of cartoon characters, brand-name sponsorships, apparel and other merchandise, outdoor and transit advertising, payments for product placement, free sampling and lobbying. Furthermore, the MSA required the dissolution of three industry-sponsored research and trade organizations.

          The MSA has materially adversely affected RJR Tobacco’s shipment volumes. RAI believes that these settlement obligations may materially adversely affect the results of operations, cash flows or financial position of RAI and RJR Tobacco in future periods. The degree of the adverse impact will depend, among other things, on the rate of decline in U.S. cigarette sales in the premium and value categories, RJR Tobacco’s share of the domestic premium and value cigarette categories, and the effect of any resulting cost advantage of manufacturers not subject to the MSA.

          Department of Justice Case. On September 22, 1999, the U.S. Department of Justice brought an action against RJR Tobacco, B&W and other tobacco companies in the U.S. District Court for the District of Columbia. The government initially sought to recover federal funds expended by the federal government in providing health care to

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

smokers who developed diseases and injuries alleged to be smoking-related. In addition, the government sought, pursuant to the civil provisions of RICO, disgorgement of profits the government contends were earned as a consequence of a RICO racketeering “enterprise.” In September 2000, the court dismissed the government’s claims asserted under the Medical Care Recovery Act as well as those under the Medicare Secondary Payer provisions of the Social Security Act, but did not dismiss the RICO claims. In February 2005, the U.S. Court of Appeals for the District of Columbia ruled that disgorgement is not an available remedy in this case. The government’s petition for writ of certiorari with the U.S. Supreme Court was denied in October 2005. The non-jury, bench trial began in September 2004, and closing arguments concluded on June 10, 2005.

          On August 17, 2006, the court found certain defendants, including RJR Tobacco and B&W, liable for the RICO claims, but did not impose any direct financial penalties. The court instead enjoined the defendants from committing future racketeering acts, participating in certain trade organizations, making misrepresentations concerning smoking and health and youth marketing, and using certain brand descriptors such as “low tar,” “light,” “ultra light,” “mild” and “natural.” The court also ordered defendants to issue “corrective communications” on five subjects, including smoking and health and addiction, and to comply with further undertakings, including maintaining web sites of historical corporate documents and disseminating certain marketing information on a confidential basis to the government. In addition, the court placed restrictions on the ability of the defendants to dispose of certain assets for use in the United States, unless the transferee agrees to abide by the terms of the court’s order, and ordered the defendants to reimburse the U.S. Department of Justice its taxable costs incurred in connection with the case.

          Certain defendants, including RJR Tobacco, filed notices of appeal to the U.S. Court of Appeals for the District of Columbia on September 11, 2006. The government filed its notice of appeal on October 16, 2006. In addition, the defendants, including RJR Tobacco, filed joint motions asking the district court to clarify and to stay its order pending the defendants’ appeal. On September 28, 2006, the district court denied the defendants’ motion to stay. On September 29, 2006, the defendants, including RJR Tobacco, filed a motion asking the court of appeals to stay the district court’s order pending the defendants’ appeal. The court granted the motion on October 31, 2006.

          On November 28, 2006, the court of appeals stayed the appeals pending the trial court’s ruling on the defendants’ motion for clarification. The defendants’ motion for clarification was granted in part and denied in part on March 16, 2007. The defendants’ motion as to the meaning and applicability of the general injunctive relief of the August 17, 2006 order was denied. The request for clarification as to the scope of the provisions in the order prohibiting the use of descriptors and requiring corrective statements at retail point of sale was granted. The court also ruled that the provisions prohibiting the use of express or implied health messages or descriptors do apply to the actions of the defendants taken outside of the United States. The defendants filed amended notices of appeal in March 2007. In May 2007, the court of appeals issued a briefing schedule that extends through May 19, 2008.

          The stay of the district court’s order suspends the enforcement of the order pending the outcome of the defendants’ appeal. RJR Tobacco does not know the timing of an appellate decision or, if the order is affirmed, the compliance deadlines that will be imposed. If the order is affirmed without modification, then RJR Tobacco believes that certain provisions of the order, such as the ban on certain brand style descriptors and the corrective advertising requirements, would have adverse business effects on the marketing of RJR Tobacco’s current product portfolio and that such effects could be material. Also, if the order is affirmed, then RJR Tobacco would incur costs in connection with complying with the order, such as the costs of changing its current packaging to conform to the ban on certain brand descriptors and the costs of corrective communications. Given the uncertainty over the timing and substance of an appellate decision, RJR Tobacco currently is not able to estimate reasonably the costs of such compliance. Moreover, if the order were ultimately affirmed and RJR Tobacco were to fail to comply with the order on a timely basis, then RJR Tobacco could be subject to substantial monetary fines or penalties.

          International Cases. A number of foreign countries have filed suit against RJR Tobacco, B&W and other tobacco industry defendants to recover funds for health-care, medical and other assistance paid by those foreign governments to their citizens. No such cases currently are pending against RJR Tobacco and its affiliates or indemnitees in the United States.

          Two health-care reimbursement cases are pending against RJR Tobacco or B&W outside the United States, one in each of Canada and Israel. Pursuant to the terms of the 1999 sale of RJR Tobacco’s international tobacco business, JTI assumed RJR Tobacco’s liability, if any, in the health-care cost recovery cases brought by foreign countries.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

          On November 12, 1998, the government of British Columbia enacted legislation creating a civil cause of action permitting the government to recover the costs of health-care benefits incurred for B.C. residents arising from tobacco-related disease. The government’s subsequent suit against Canadian defendants and foreign defendants, including RJR Tobacco was dismissed in February 2000, when the B.C. Supreme Court ruled that the legislation was unconstitutional and set aside service ex juris against the foreign defendants for that reason. The government then enacted a revised statute and brought a new action, filed in January 2001, and pending in Supreme Court, British Columbia. The plaintiff seeks to recover the present value of the total expenditure by the government for health-care benefits provided for insured persons resulting from tobacco-related disease or the risk of tobacco-related disease, the present value of the estimated total expenditure by the government for health-care benefits that reasonably could be expected to be provided for those insured persons resulting from tobacco-related disease or the risk of tobacco-related disease, court ordered interest, and costs, or in the alternative, special or increased costs. The plaintiff alleges that the defendants are liable under the following theories: defective product, failure to warn, sale of cigarettes to children and adolescents, strict liability, deceit and misrepresentation, and violation of trade practice and competition acts. Trial is scheduled for September 6, 2010.

          On September 1, 1998, the General Health Services filed a statement of claim against certain cigarette manufacturers, including RJR Tobacco and B&W, in the District Court of Jerusalem, Israel. The plaintiff seeks to recover the past and future value of the total expenditures for health-care services provided to residents of Israel resulting from tobacco-related disease, court ordered interest for past expenditures from date of filing the statement of claim, increased and/or punitive and/or exemplary damages and costs. The plaintiff alleges that the defendants are liable under the following theories: negligence, public nuisance, fraud, misleading advertisement, defective product, failure to warn, sale of cigarettes to children and adolescents, strict liability, deceit, concealment, misrepresentation and conspiracy. In 2002, the plaintiff obtained leave to serve RJR Tobacco and B&W outside the jurisdiction. On behalf of RJR Tobacco, JTI filed a motion challenging the grant of leave, which was denied. JTI appealed the decision to the Supreme Court of Israel. A hearing occurred on March 28, 2005. A decision is pending.

          Native American Tribe Cases. As of April 11, 2008, one Native American tribe case was pending before a tribal court in South Dakota against RJR Tobacco and B&W, Crow Creek Sioux Tribe v. American Tobacco Co., a case filed in September 1997 in Tribal Court, Crow Creek Sioux, South Dakota. The plaintiffs seek to recover actual and punitive damages, restitution, funding of a clinical cessation program, funding of a corrective public education program, and disgorgement of unjust profits from sales to minors. The plaintiffs claim that the defendants are liable under the following theories: unlawful marketing and targeting of minors, contributing to the delinquency of minors, unfair and deceptive acts or practices, unreasonable restraint of trade and unfair method of competition, negligence, negligence per se, conspiracy and restitution of unjust enrichment. The case is dormant.

          Hospital Cases. As of April 11, 2008, one case brought by hospitals was pending against cigarette manufacturers, including RJR Tobacco and B&W: City of St. Louis v. American Tobacco Co., Inc., filed in November 1998, and pending in the Circuit Court of the City of St. Louis, Missouri. This case seeks recovery of uncompensated, unreimbursed health-care costs expended or to be expended by hospitals on behalf of patients who suffer, or have suffered, from illnesses allegedly resulting from the use of cigarettes. On June 28, 2005, the court granted the defendants’ motion for summary judgment as to claims for damages which accrued prior to November 16, 1993. The claims for damages which accrued after November 16, 1993, are still pending. The case is in discovery. Trial is scheduled for January 11, 2010.

          Other Cases. On August 4, 2005, the United Seniors Association filed a case against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, in the U.S. District Court for the District of Massachusetts. The case sought to recover for the Medicare program all of the expenditures that the Medicare program made from August 4, 1999, to present for the health-care services rendered to Medicare’s beneficiaries for the treatment of diseases attributable to smoking. The plaintiff alleged that the defendants concealed, denied and manipulated the addictive properties of their cigarettes; and engaged in tortious and other wrongful conduct. On October 24, 2005, the defendants filed a motion to dismiss or, in the alternative, transfer the case to the U.S. District Court for the Middle District of Florida, where a virtually identical case against Philip Morris and Liggett was dismissed. On August 28, 2006, the defendants’ motion to dismiss was granted. The plaintiff’s appeal to the U.S. Court of Appeals for the First Circuit was denied on August 20, 2007. On November 14, 2007, the plaintiff filed a writ of certiorari with the U.S. Supreme Court, which was denied on January 22, 2008.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

MSA-Enforcement and Validity

          As of April 11, 2008, there were 62 cases concerning the enforcement, validity or interpretation of the MSA in which RJR Tobacco or B&W is a party. This number includes those cases, discussed below, relating to disputed payments under the MSA.

          On April 7, 2004, a class-action lawsuit, Sanders v. Philip Morris USA, Inc., was filed in the Superior Court of Los Angeles County against RJR, RJR Tobacco, Philip Morris, Altria and B&W. The case was brought on behalf of California residents who purchased cigarettes in California from April 2, 2000 to the present. The plaintiff generally alleged that the MSA was anticompetitive in that the defendants used the terms of the MSA to reduce competition and to raise the price of cigarettes. The plaintiff voluntarily dismissed this case and, on June 9, 2004, filed a new action in the U.S. District Court for the Northern District of California. The defendants are RJR Tobacco, B&W, Philip Morris, Lorillard and Bill Lockyer, in his capacity as Attorney General for the State of California. The plaintiff asserts claims for declaratory and injunctive relief based on preemption and Supremacy Clause grounds, alleging that the MSA supposedly is inconsistent with the federal antitrust laws, for injunctive relief based on claimed violations of the Sherman Act, for damages and injunctive relief based on claimed violations of California’s state antitrust law, the Cartwright Act, for an accounting of profits based on claimed statutory and common law theories of unfair competition, and for restitution based on claimed unjust enrichment. On March 29, 2005, the U.S. District Court for the Northern District of California granted the defendants’ motion to dismiss with prejudice. The plaintiff appealed, and on September 26, 2007, the U.S. Court of Appeals for the Ninth Circuit affirmed the dismissal of the lawsuit. On January 25, 2008, the plaintiffs filed a petition for a writ of certiorari with the U.S. Supreme Court. Briefing is underway.

          On March 28, 2005, the National Association of Attorneys General, referred to as NAAG, sent a notice, signed by 40 Attorneys General that one or more of the states intended to initiate proceedings against RJR Tobacco for violating Section III (r) of the MSA, the various Consent Decrees implementing the MSA and/or consumer fraud statutes in various states, all in connection with RJR Tobacco’s advertisements for Eclipse cigarettes. After a June 2005 meeting between representatives of RJR Tobacco and NAAG, the Vermont Attorney General filed suit in July 2005, in the Vermont Superior Court, Chittenden County, alleging that certain advertising for the Eclipse cigarette brand violated both the MSA and the Vermont Consumer Fraud Statute. The State of Vermont is seeking declaratory, injunctive, and monetary relief. On April 25, 2007, the court denied the State of Vermont’s motion to strike defendants’ demand for trial by jury. Trial is not expected to begin earlier than the fourth quarter of 2008.

          On April 13, 2005, the Mississippi Attorney General notified B&W of its intent to seek approximately $3.9 million in additional payments under the Mississippi Settlement Agreement. The Mississippi Attorney General asserts that B&W failed to report in its net operating profit or its shipments cigarettes manufactured by B&W under contract for Star Tobacco or its parent, Star Scientific, Inc. On April 28, 2005, B&W advised the state that it did not owe the state any money. On August 11, 2005, the Mississippi Attorney General filed in the Chancery Court of Jackson County, Mississippi, a Notice of Violation, Motion to Enforce Settlement Agreement, and Request for an Accounting by Defendant Brown & Williamson Holdings, Inc., formerly known as Brown & Williamson Tobacco Corporation. In this filing, Mississippi estimated that its damages now exceed $5.0 million. This matter is currently in the discovery phase.

          On May 17, 2006, the State of Florida filed a motion, in the Circuit Court of the Fifteenth Judicial Circuit, in and for Palm Beach County, Florida, to enforce the Settlement Agreement, for an Accounting by Brown & Williamson Holdings, Inc., and for an Order of Contempt, raising substantially the same issues as raised by the Mississippi Attorney General and seeking approximately $12.4 million in additional payments under the Florida Settlement Agreement, as well as $17.0 million in interest payments. Discovery in this matter is underway.

          On October 18, 2006, RJR Tobacco filed a suit in federal district court in the Western District of Washington, R.J. Reynolds Tobacco Company v. Seattle-King Co. Dept. of Public Health. In that litigation, RJR Tobacco sued the Department of Public Health of King County, Washington and the City of Seattle, Washington, seeking to invalidate, as a violation of the First Amendment and the Federal Cigarette Labeling and Advertising Act, ordinances banning the sampling of cigarettes. On December 21, 2006, the State of Washington moved to intervene, seeking to assert a claim against RJR Tobacco under the MSA. On February 6, 2007, the Court denied the State’s motion to intervene, and it granted RJR Tobacco’s motion for summary judgment against the original defendants. On March 6, 2007, the State appealed that decision to the U.S. Court of Appeals for the Ninth Circuit. That appeal is pending. On a parallel track with this federal litigation, on January 18, 2007, the State of Washington filed suit against RJR Tobacco in State Superior Court in King County, Washington, alleging that RJR Tobacco’s federal litigation against King County and Seattle violated Section V of the MSA, which prohibits participating manufacturers from bringing facial challenges to

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

the constitutionality or enforceability of certain tobacco control laws and regulations that predate the MSA. In this state litigation, State of Washington v. R.J. Reynolds Tobacco Company, RJR Tobacco’s motion to dismiss the complaint was denied on August 3, 2007. This state litigation otherwise is in its initial stages, and the parties have yet to conduct discovery. Trial is scheduled to begin on July 7, 2008.

     In December, 2007, the states of California, Connecticut, Illinois, Maine, Maryland, New York, Ohio, Pennsylvania and Washington sued RJR Tobacco in their respective state courts under the MSA consent decree claiming, among other things, that a Rolling Stone magazine editorial section and an adjacent Camel Farm advertisement included cartoon images prohibited under the MSA. The states are seeking monetary sanctions resulting from RJR Tobacco’s alleged violation of the MSA and the related Consent Decree, injunctive relief and attorney’s fees and costs. A hearing on the State of Ohio’s claims occurred on January 17, 2008 and February 8, 2008. The judge has taken the issue under advisement. Activity continues in each state. In Stewart v. RJR Tobacco, two artists groups filed a class-action lawsuit on December 17, 2007, in California state court against RJR Tobacco and Rolling Stone’s publisher, Wenner Media, claiming their mention in the editorial section violated their right of publicity. The plaintiffs seek to recover actual damages in the amount of $750.00 per violation, per plaintiff and per each class member and punitive damages in an unspecified amount.

     NPM Adjustment.  The MSA includes an adjustment, referred to as an NPM Adjustment, that potentially reduces the annual payment obligations of RJR Tobacco and the other participating manufacturers, with all participating manufacturers referred to as PMs. Certain requirements must be satisfied before the NPM Adjustment for a given year is available: (1) an independent auditor designated under the MSA must determine that the PMs have experienced a market share loss beyond a triggering threshold to those manufacturers that do not participate in the MSA, such non-participating manufacturers referred to as NPMs, and (2) in a binding arbitration proceeding, a firm of independent economic consultants must find that the disadvantages of the MSA were a significant factor contributing to the loss. When these two requirements are satisfied, the MSA provides that the NPM Adjustment applies to reduce the annual payment obligation of the PMs. However, an individual settling state may avoid its share of the NPM Adjustment if it had in place and diligently enforced during the entirety of the relevant year a “Qualifying Statute” that imposes escrow obligations on NPMs that are comparable to what the NPMs would have owed if they had joined the MSA. In such event, the state’s share of the NPM Adjustment is reallocated to other settling states, if any, that did not have in place and diligently enforce a Qualifying Statute.

     NPM Adjustment Claim for 2003.  For 2003, the MSA independent auditor determined that the PMs suffered a market share loss sufficient to trigger an NPM Adjustment. In March 2006, the independent economic consulting firm issued a final, non-appealable determination that the disadvantages of the MSA were “a significant factor contributing” to the 2003 market share loss. Based on these determinations, on April 17, 2006, RJR Tobacco placed approximately $647 million of its MSA payment into a disputed payments account, in accordance with a procedure established by the MSA. That amount represented RJR Tobacco’s share of the 2003 NPM Adjustment as calculated by the MSA independent auditor. On March 28, 2007, the independent auditor issued revised calculations that reduced RJR Tobacco’s share of the NPM Adjustment for 2003 to approximately $615 million. As a result, on April 19, 2007, RJR Tobacco instructed the independent auditor to release to the settling states approximately $32 million from the disputed payments account.

     Following RJR Tobacco’s payment of a portion of its 2006 MSA payment into the disputed payments account, 37 of the settling states filed legal proceedings in their respective MSA courts seeking declaratory orders that they diligently enforced their Qualifying Statutes during 2003 and/or orders compelling RJR Tobacco and the other PMs that placed money in the disputed payments account to pay the disputed amounts to the settling states. In response, RJR Tobacco and other PMs, pursuant to the MSA’s arbitration provisions, moved to compel arbitration of the parties’ dispute concerning the 2003 NPM Adjustment, including the states’ diligent enforcement claims, before a single, nationwide arbitration panel of three former federal judges. The settling states opposed these motions, arguing, among other things, that the issue of diligent enforcement must be resolved by MSA courts in each of the 52 settling states and territories.

     As of April 16, 2008, 47 out of 48 courts that had addressed the question whether the dispute concerning the 2003 NPM Adjustment is arbitrable had ruled that arbitration is required under the MSA. In 35 states, the orders compelling arbitration are final and/or non-appealable.

     At this time, it is not possible to estimate a date by which arbitration of the dispute concerning the 2003 NPM Adjustment will commence or how many states will ultimately participate.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

     NPM Adjustment Claim for 2004.  During 2006, proceedings were initiated with respect to an NPM Adjustment for 2004. The MSA independent auditor again determined that the PMs had suffered a market share loss sufficient to trigger an NPM Adjustment for 2004. On April 17, 2006, RJR Tobacco and other PMs initiated the “significant factor” proceeding before the independent economic consultant called for under the MSA with respect to the 2004 NPM Adjustment. On February 12, 2007, the independent economic consulting firm issued a final, non-appealable determination that the disadvantages of the MSA were “a significant factor contributing” to the 2004 market share loss. On April 16, 2007, RJR Tobacco placed approximately $561 million of its 2007 MSA payment into the disputed payments account. That amount represented RJR Tobacco’s share of the 2004 NPM Adjustment as calculated by the MSA independent auditor.

     NPM Adjustment Claim for 2005.  During 2007, proceedings were initiated with respect to an NPM Adjustment for 2005. The MSA independent auditor again determined that the PMs had suffered a market share loss sufficient to trigger an NPM Adjustment for 2005. On April 18, 2007, RJR Tobacco and other PMs initiated the “significant factor” proceeding called for under the MSA with respect to the 2005 NPM Adjustment. On February 7, 2008, the independent economic consulting firm issued a final, non-appealable determination that the disadvantages of the MSA were “a significant factor contributing” to the 2005 market share loss. On April 15, 2008, RJR Tobacco placed approximately $431 million of its 2008 MSA payment into the disputed payments account. That amount represented RJR Tobacco’s share of the 2005 NPM Adjustment as calculated by the MSA independent auditor, net of certain slight adjustments to reflect revised independent auditor calculations of RJR Tobacco’s share of the 2003 and 2004 NPM Adjustments.

     Due to the uncertainty over the final resolution of the NPM Adjustment claims asserted by RJR Tobacco, no assurances can be made related to the amounts, if any, that will be realized.

Antitrust Cases

     A number of tobacco wholesalers and consumers have sued U.S. cigarette manufacturers, including RJR Tobacco and B&W, in federal and state courts, alleging that cigarette manufacturers combined and conspired to set the price of cigarettes in violation of antitrust statutes and various state unfair business practices statutes. In these cases, the plaintiffs asked the court to certify the lawsuits as class-actions on behalf of other persons who purchased cigarettes directly or indirectly from one or more of the defendants. As of April 11, 2008, all of the federal and state court cases on behalf of indirect purchasers have been dismissed, except for one state court case pending in each of Kansas and in New Mexico.

     In Smith v. Philip Morris Cos., Inc., a case filed in February 2000, and pending in District Court, Seward County, Kansas, the court granted class certification on November 15, 2001, in an action brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, and the parent companies of the major U.S. cigarette manufacturers, including RJR, seeking to recover an unspecified amount in actual and punitive damages. The plaintiffs allege that the defendants participated in a conspiracy to fix or maintain the price of cigarettes sold in the United States. On December 17, 2007, the Seward County District Court stayed the matter.

     In Romero v. Philip Morris Cos., Inc., a case filed in April 2000 in District Court, Rio Arriba County, New Mexico, the court granted class certification on May 14, 2003, in an action brought against the major U.S. cigarette manufacturers, including RJR Tobacco and B&W, and the parent companies of the major U.S. cigarette manufacturers, including RJR, seeking to recover an amount not to exceed $74,000 per class member in actual and punitive damages, exclusive of interest and costs. The plaintiffs allege that the defendants conspired to fix, raise, advance and/or stabilize prices for cigarettes in the State of New Mexico from at least as early as January 1, 1998, through the present. On June 30, 2006, the court granted the defendants’ motion for summary judgment. On August 14, 2006, the plaintiff appealed to the New Mexico Court of Appeals. The parties completed briefing of the issues on appeal on August 27, 2007, and await a decision.

Other Litigation and Developments

     By purchase agreement dated May 12, 1999, referred to as the 1999 Purchase Agreement, RJR and RJR Tobacco sold the international tobacco business to JTI. RJR and RJR Tobacco retained certain liabilities relating to the activities of Northern Brands, including those relating to a 1998 guilty plea entered in the U.S. District Court for the Northern District of New York, as well as an investigation conducted by the Royal Canadian Mounted Police, referred

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

to as RCMP, for possible violations of Canadian law related to the activities that led to the Northern Brands guilty plea and certain conduct by Stanley Smith, a former executive of RJR-Macdonald, Inc., referred to as RJR-MI, which led to the termination of his severance agreement. Under its reading of the indemnification provisions of the 1999 Purchase Agreement, JTI has requested indemnification for any damages arising out of the matters described below.

	•		In February 2003, the RCMP filed criminal charges in the Province of Ontario against, and purported to serve summonses on, JTI-Macdonald Corp., referred to as JTI-MC, Northern Brands, R. J. Reynolds Tobacco International, Inc., referred to as RJR-TI, R. J. Reynolds Tobacco Co., Puerto Rico, referred to as RJR-PR, and eight individuals associated with RJR-MI and/or RJR-TI during the period January 1, 1991, through December 31, 1996. The charges allege fraud and conspiracy to defraud Canada and the Provinces of Ontario and Quebec in connection with the purchase, sale, export, import and/or re-export of cigarettes and/or fine cut tobacco. In October 2003, Northern Brands, RJR-TI and RJR-PR each challenged both the propriety of the service of the summonses and the jurisdiction of the court. On February 9, 2004, the Superior Court of Justice ruled in favor of these companies. The government filed a notice of appeal from that ruling on February 18, 2004, but did not perfect its appeal until May 8, 2007. At the oral argument on October 29, 2007, the Court of Appeal announced a unanimous decision in favor of the companies’ position and dismissed the government’s appeal. A final written order dismissing the appeal was entered by the Court of Appeal on December 3, 2007.
			A preliminary hearing was commenced on April 11, 2005, for the purpose of determining whether the Canadian prosecutor had sufficient evidence supporting the criminal charges to justify a trial of the defendants that had been properly served to date. On May 30, 2007, the court announced its decision to issue an order committing two of the accused, JTI-MC and Edward Lang, to stand trial on the charges filed in February 2003 and discharging the other six accused. JTI-MC and Mr. Lang have separately filed papers seeking an order quashing the order committing them to stand trial, and the government has filed papers seeking an order quashing the order discharging six of the accused. On December 19, 2007, JTI-MC abandoned its effort to have the order committing it to trial quashed. On February 19, 2008, the Superior Court of Justice in Ontario denied Mr. Lang’s request to quash the order committing him to trial. The court granted the government’s request to quash the order discharging six individuals and remanded the matter to the preliminary hearing judge for reconsideration. No appeals were taken from that decision.
			On July 31, 2007, each of the accused companies, including RJR-TI, RJR-PR and Northern Brands, and each of the seven accused individuals were given notice that the Canadian prosecutor had requested the Attorney General of Ontario to consent to the issuance of preferred indictments against each of them. RJR-TI, RJR-PR and Northern Brands as well as the other accused filed written submissions with the Attorney General opposing the issuance of the indictments against them. That decision has been deferred until any appeals from the court’s May 30, 2007, ruling have been concluded.
	•		In July 2003, a Statement of Claim was filed against JTI-MC and others in the Superior Court of Justice, Ontario, Canada by Leslie and Kathleen Thompson. Mr. Thompson is a former employee of Northern Brands and JTI-MC’s predecessor, RJR-MI. Mr. and Mrs. Thompson have alleged breach of contract, breach of fiduciary duty and negligent misrepresentation, among other claims. They are seeking lost wages and other damages, including punitive damages, in an aggregate amount exceeding $12 million.
	•		On September 18, 2003, RJR, RJR Tobacco, RJR-TI, RJR-PR, and Northern Brands were served with a Statement of Claim filed in August 2003 by the Attorney General of Canada in the Superior Court of Justice, Ontario, Canada. Also named as defendants are JTI and a number of its affiliates. The Statement of Claim seeks to recover taxes and duties allegedly not paid as a result of cigarette smuggling and related activities. As filed, the Attorney General’s Statement of Claim seeks to recover $1.5 billion Canadian in compensatory damages and $50 million Canadian in punitive damages, as well as equitable and other forms of relief. However, in the Companies’ Creditor Arrangement Act proceeding described below, the Attorney General amended and increased Canada’s claim to $4.3 billion Canadian. The parties have agreed to a stay of all proceedings pending in the Superior Court of Justice, subject to notice by one of the parties that it wishes to terminate the stay. On January 19, 2007, the court ordered that the case be scheduled for trial no later than December 31, 2008, subject to further order of the court.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

	•		In August 2004, the Quebec Ministry of Revenue (1) issued a tax assessment, covering the period January 1, 1990, through December 31, 1998, against JTI-MC for alleged unpaid duties, penalties and interest in an amount of about $1.36 billion Canadian; (2) issued an order for the immediate payment of that amount; and (3) obtained an ex parte judgment to enforce the payment of that amount. On August 24, 2004, JTI-MC applied for protection under the Companies’ Creditor Arrangement Act in the Ontario Superior Court of Justice, Toronto, Canada, referred to as CCAA Proceedings, and the court entered an order staying the Quebec Ministry of Revenue’s proceedings as well as other claims and proceedings against JTI-MC. The stay has been extended to May 30, 2008. In November 2004, JTI-MC filed a motion in the Superior Court, Province of Quebec, District of Montreal, seeking a declaratory judgment to set aside, annul and declare inoperative the tax assessment and all ancillary enforcement measures and to require the Quebec Minister of Revenue to reimburse JTI-MC for funds unduly appropriated, along with interest and other relief. Pursuant to a court-imposed deadline, Canada and several Provinces filed Crown claims against JTI-MC in the CCAA Proceedings in the following amounts: Canada, $4.3 billion Canadian; Ontario, $1.5 billion Canadian; New Brunswick, $1.5 billion Canadian; Quebec, $1.4 billion Canadian; British Columbia, $450 million Canadian; Nova Scotia, $326 million Canadian; Prince Edward Island, $75 million Canadian and Manitoba, $23 million Canadian. In the CCAA Proceedings, the Canadian federal government and some of the provincial governments have asserted that they can make the same tax and related claims against RJR and certain of its subsidiaries, including RJR Tobacco. To date, none of those provincial governments have filed and served RJR or any of its affiliates with a formal Statement of Claim like the Canadian federal government did in August and September 2003.
	•		On November 17, 2004, a Statement of Claim was filed against JTI-MC in the Supreme Court of British Columbia by Stanley Smith, a former executive of RJR-MI, for alleged breach of contract and other legal theories. Mr. Smith is claiming $840,000 Canadian for salary allegedly owed under his severance agreement with RJR-MI, as well as other unspecified compensatory and punitive damages.
	•		In a letter dated March 31, 2006, counsel for JTI stated that JTI would be seeking indemnification under the 1999 Purchase Agreement for any damages it may incur or may have incurred arising out of a Southern District of New York grand jury investigation, a now-terminated Eastern District of North Carolina grand jury investigation, and various actions filed by the European Community and others in the U.S. District Court for the Eastern District of New York, referred to as the EDNY, against RJR Tobacco and certain of its affiliates on November 3, 2000, August 6, 2001, and (as discussed in greater detail below) October 30, 2002, and against JTI on January 11, 2002.
	•		On December 14, 2007, the European Community and 26 of its member states entered into a series of agreements with JTI and/or its subsidiaries regarding, principally, contraband and counterfeit cigarettes bearing JTI trademarks in the European Community. Collectively, those agreements resolved, in pertinent part, all claims that the European Community and the member states either had or might have had prior to December 14, 2007 against JTI and/or its subsidiaries with respect to any such contraband and counterfeit cigarettes and claims for which JTI could become the subject of a claim for indemnity by RJR under the terms of the 1999 Purchase Agreement. In addition, the European Community and signatory member states agreed to release RJR and its affiliates from those same claims.

     Although RJR and RJR Tobacco recognize that, under certain circumstances, they may have indemnification obligations to JTI under the 1999 Purchase Agreement, RJR and RJR Tobacco disagree with JTI as to whether the circumstances relating to any of these matters give rise to any indemnification obligation by RJR and RJR Tobacco. RJR and RJR Tobacco conveyed their position to JTI, and the parties have agreed to resolve their differences at a later time. In the interim, RJR and RJR Tobacco are paying defense costs and expenses in connection with certain of the Canadian litigation described above. In addition, RJR has liabilities of $94 million that were recorded in 1999 in connection with certain of the indemnification claims asserted by JTI. For further information on the JTI indemnification claims, see “— Other Contingencies and Guarantees” below.

     On May 15, 2007, RAI was served with a subpoena issued by the U.S. District Court for the Middle District of North Carolina. The subpoena seeks documents relating primarily to the business of RJR-TI regarding the manufacture and sale of Canadian brand cigarettes during the period 1990 through 1996. The subpoena was issued at the request of Canada pursuant to a Mutual Legal Assistance Treaty between the United States and Canada.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

     On October 30, 2002, the European Community and ten of its member states filed a complaint in the EDNY against RJR, RJR Tobacco and several currently and formerly related companies. The complaint contains many of the same or similar allegations found in an earlier complaint, now dismissed, filed in August 2001 and also alleges that the defendants, together with certain identified and unidentified persons, engaged in money laundering and other conduct violating civil RICO and a variety of common laws. The complaint also alleges that the defendants manufactured cigarettes that were eventually sold in Iraq in violation of U.S. sanctions. The plaintiffs seek compensatory, punitive and treble damages among other types of relief. This matter has been stayed. The European Community and the member states have recently suggested that they may file similar claims regarding the U.S. tobacco business of B&W, which was acquired in 2004 in the B&W business combination.

     RJR Tobacco was named a defendant in a number of lawsuits originally filed in various federal courts in 2002 by plaintiffs alleging descent from persons held in slavery in the United States and seeking damages from numerous corporate defendants for having allegedly profited from historic slavery. In October 2002, those actions were consolidated by the Judicial Panel on Multidistrict Litigation for pre-trial proceedings in the U.S. District Court for the Northern District of Illinois. On July 6, 2005, the court dismissed the entire action on a variety of grounds. On December 13, 2006, the U.S. Court of Appeals for the Seventh Circuit affirmed dismissal in all respects but one. It remanded some cases for further proceedings limited to the claims by some plaintiffs that present-day representations about historic ties to slavery by some defendants violated state consumer fraud laws. On October 1, 2007, the U.S. Supreme Court denied plaintiffs’ petition for a writ of certiorari. The plaintiffs in all but one of the cases either voluntarily dismissed their claims or otherwise abandoned the litigation. Defendants filed a motion to dismiss the remaining case for failure to state a claim. That motion is currently pending.

     On May 23, 2001, and July 30, 2002, Star Scientific, Inc., referred to as Star, filed two patent infringement actions, which have been consolidated, against RJR Tobacco in the U.S. District Court for the District of Maryland. Both patents at issue are entitled “Method of Treating Tobacco to Reduce Nitrosamine Content, and Products Produced Thereby,” and bear U.S. Patent Nos. 6,202,649 and 6,425,401. The plaintiffs sought: the entry of an injunction restraining RJR Tobacco from further acts of infringement, inducement of infringement, or contributory infringement of the patents; an award of damages to compensate the plaintiff’s lost profits; an award of enhanced damages on account that the defendant’s conduct was willful; an award of pre-judgment interest and a further award of post-judgment interest; an award of reasonable attorneys’ fees; and an order requiring RJR Tobacco to deliver up to the court for destruction all products manufactured from any process which infringes upon, directly or indirectly or otherwise, any claim of such patent. RJR Tobacco filed counterclaims seeking a declaration that the claims of the two Star patents are invalid, unenforceable and not infringed by RJR Tobacco. Between January 31 and February 8, 2005, the court held a first bench trial on RJR Tobacco’s affirmative defense and counterclaim based upon inequitable conduct. Additionally, in response to the court’s invitation, RJR Tobacco filed two summary judgment motions on January 20, 2005.

     On January 19, 2007, the court released decisions on RJR Tobacco’s two summary judgment motions. The court granted RJR Tobacco’s motion for summary judgment of invalidity based on indefiniteness. The court granted in part and denied in part RJR Tobacco’s other summary judgment motion concerning the effective filing date of the patents in suit. On June 26, 2007, the court ruled that Star’s patents are unenforceable due to inequitable conduct by Star and its representatives in the U.S. Patent & Trademark Office. On June 26, 2007, the court also entered final judgment in favor of RJR Tobacco and against Star, dismissing all of Star’s claims with prejudice. On June 27, 2007, Star filed a notice of appeal with the U.S. Court of Appeals for the Federal Circuit. Oral argument occurred on March 7, 2008, and the judges asked for a letter brief concerning the inequitable conduct issue addressing circumstances regarding intent to deceive and circumstances surrounding the transfer of files during Star’s patent procurement activities. A decision is pending. On July 9, 2007, RJR Tobacco filed a bill of costs seeking reimbursement of its recoverable costs as the prevailing party, and a motion seeking reimbursement of its attorneys’ fees and excess costs incurred in defending Star’s lawsuit. The trial court has deferred that motion pending the appeal.

     A Civil Investigative Demand, referred to as the CID, was issued by the Federal Trade Commission, referred to as the FTC, to RJR Tobacco on August 23, 2007, to determine whether RJR Tobacco’s advertising and marketing related to the Camel No. 9 cigarette brand may violate the FTC Act. The CID requires RJR Tobacco to produce documents and answer interrogatories. On January 7, 2008, RJR Tobacco certified as complete its production of documents to the FTC.

     Finally, in the first quarter of 2005, Commonwealth Brands, Inc., referred to as Commonwealth, was served with an individual smoking and health case, Croft v. Akron Gasket in Cuyahoga County, Ohio. Commonwealth requested indemnity from RJR Tobacco pursuant to the Asset Purchase Agreement dated July 24, 1996, between

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Commonwealth and B&W, referred to as the 1996 Purchase Agreement. As a result of the B&W business combination, RJR Tobacco agreed to indemnify Commonwealth for this claim to the extent, if any, required by the 1996 Purchase Agreement. The scope of the indemnity will be at issue and has not been determined.

Smokeless Tobacco Litigation

     As of April 11, 2008, the Conwood companies were a defendant in six actions brought by individual plaintiffs in West Virginia state court seeking damages in connection with personal injuries allegedly sustained as a result of the usage of the Conwood companies’ smokeless tobacco products. These actions are pending before the same West Virginia court as the 687 consolidated individual smoker cases against RJR Tobacco, B&W, as RJR Tobacco’s indemnitee, or both. Pursuant to the Court’s December 3, 2001 order, the smokeless tobacco claims and the defendants remain severed.

     Pursuant to a second amended complaint filed in September 2006, the Conwood companies are a defendant in Vassallo v. United States Tobacco Company, pending in the Eleventh Circuit Court in Miami-Dade County, Florida. The individual plaintiff in this case alleges that he sustained personal injuries, including addiction and cancer, as a result of his use of smokeless tobacco products, allegedly including products manufactured by the Conwood companies. The plaintiff seeks unspecified compensatory and consequential damages in an amount greater than $15,000. There is not presently a punitive damages demand in this case, though the plaintiff retains the right to seek leave of court to add such a demand later. Discovery is underway.

Tobacco Buyout Legislation and Related Litigation

     On October 22, 2004, the President signed the Fair and Equitable Tobacco Reform Act of 2004, referred to as FETRA, eliminating the U.S. government’s tobacco production controls and price support program. The buyout of tobacco quota holders provided for in FETRA is funded by a direct quarterly assessment on every tobacco product manufacturer and importer, on a market-share basis measured on volume to which federal excise tax is applied. The aggregate cost of the buyout to the industry is approximately $9.9 billion, including approximately $9.6 billion payable to quota tobacco holders and growers through industry assessments over ten years and approximately $290 million for the liquidation of quota tobacco stock. As a result of the tobacco buyout legislation, the MSA Phase II obligations established in 1999 will be continued as scheduled through the end of 2010, but will be offset against the tobacco quota buyout obligations. RAI’s operating subsidiaries’ annual expense under FETRA, excluding the tobacco stock liquidation assessment, is estimated to be approximately $230 million to $280 million. RAI’s operating subsidiaries incurred $81 million in 2005 related to assessments from quota tobacco stock liquidation. In the first quarter of 2006, a $9 million favorable adjustment was recorded relating to the tobacco stock liquidation assessment. Remaining contingent liabilities for liquidation of quota tobacco stock, if any, will be recorded when an assessment is made.

     RAI’s operating subsidiaries will record the FETRA assessment on a quarterly basis as cost of goods sold. RAI’s operating subsidiaries estimate that their overall share of the buyout will approximate $2.4 billion to $2.9 billion prior to the deduction of permitted offsets under the MSA. In addition, future market pricing could impact the carrying value of inventory, and adversely affect RJR Tobacco’s financial position and results of operations.

     As noted above, the MSA Phase II obligations will be offset against the tobacco quota buyout obligations. Because growers in two states, Maryland and Pennsylvania, did not participate in the quota system, they are not eligible for payments under FETRA. Given that the assessments paid by tobacco product manufacturers and importers under FETRA would fully offset their MSA Phase II payment obligations, the growers in Maryland and Pennsylvania would no longer receive payments under the MSA Phase II program. Thus, the growers in these two states would not receive payment under either FETRA or the MSA Phase II program.

     On December 17, 2004, Maryland and Pennsylvania filed in the North Carolina Business Court a Motion for Clarification or Modification of the Trust, that is, the Growers Trust that created the MSA Phase II obligations. They later supplemented this filing with a Statement of Claim, filed on June 24, 2005. Maryland and Pennsylvania contend that they are entitled to relief from the operation of the tax offset adjustment provision of the Growers Trust and that payments under the Growers Trust to the growers in their states should continue. Following discovery, the parties filed cross-motions for summary judgment on May 5, 2006. On August 17, 2007, the Business Court issued an Order and Opinion granting summary judgment in favor of Maryland and Pennsylvania and denying summary judgment to the tobacco manufacturers, including RJR Tobacco, that were the settlors of the Growers Trust. The Business Court ruled that the Growers Trust, as written and without judicial modification, requires continuing payments to the Growers Trust

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

for the benefit of tobacco growers in Maryland and Pennsylvania. RJR Tobacco and the other tobacco manufacturer/settlors filed their Notice of Appeal on September 14, 2007. On January 14, 2008, RJR Tobacco and the other tobacco manufacturer/settlors filed a petition seeking direct discretionary review by the North Carolina Supreme Court. A ruling on this motion is pending.

ERISA Litigation

     On May 13, 2002, in Tatum v. The R.J.R. Pension Investment Committee of the R. J. Reynolds Tobacco Company Capital Investment Plan, an employee of RJR Tobacco filed a class-action suit in the U.S. District Court for the Middle District of North Carolina, alleging that the defendants, RJR, RJR Tobacco, the RJR Employee Benefits Committee and the RJR Pension Investment Committee, violated the Employee Retirement Income Security Act of 1974, referred to as ERISA. The actions about which the plaintiff complains stem from a decision made in 1999 by RJR Nabisco Holdings Corp., subsequently renamed Nabisco Group Holdings Corp., referred to as NGH, to spin off RJR, thereby separating NGH’s tobacco business and food business. As part of the spin-off, the 401(k) plan for the previously related entities had to be divided into two separate plans for the now separate tobacco and food businesses. The plaintiff contends that the defendants violated ERISA by not overriding an amendment to RJR’s 401(k) plan requiring that, prior to February 1, 2000, the stock funds of the companies involved in the food business, NGH and Nabisco Holdings Corp., referred to as Nabisco, be eliminated as investment options from RJR’s 401(k) plan. In his complaint, the plaintiff requests, among other things, that the court require the defendants to pay as damages to the RJR 401(k) plan an amount equal to the subsequent appreciation that was purportedly lost as a result of the liquidation of the NGH and Nabisco funds.

     On July 29, 2002, the defendants filed a motion to dismiss, which the court granted on December 10, 2003. On December 14, 2004, the U.S. Court of Appeals for the Fourth Circuit reversed the dismissal of the complaint and remanded the case for further proceedings. On January 20, 2005, the defendants filed a second motion to dismiss on other grounds. On March 7, 2007, the court granted the plaintiff leave to file an amended complaint and denied all pending motions as moot. On April 6, 2007, the defendants moved to dismiss the amended complaint. On May 31, 2007, the court granted the motion in part and denied it in part, dismissing all claims against the RJR Employee Benefits Committee and the RJR Pension Investment Committee. The remaining defendants, RJR and RJR Tobacco, filed their answer and affirmative defenses on June 14, 2007. On June 28, 2007, the plaintiff filed a motion to amend the complaint to add as parties defendant the six members of the RJR Pension Investment Committee and the RJR Employee Benefits Committee. On March 13, 2008, the court denied this motion, and the plaintiff thereafter filed a motion for reconsideration. On November 19, 2007, the plaintiff filed a motion for class certification. This motion is fully briefed. Court ordered mediation is scheduled for May 15, 2008.

Employment Litigation

     On March 19, 2007, in Marshall v. R.J. Reynolds Tobacco Co., the plaintiff filed a collective action complaint against RJR Tobacco in the U.S. District Court for the Western District of Missouri alleging violations of the Fair Labor Standards Act. The allegations include failure to keep accurate records of all hours worked by RJR Tobacco’s employees and failure to pay wages and overtime compensation to non-exempt retail representatives. As of April 11, 2008, 302 additional retail representatives opted into the lawsuit. The opt-in period to join the collective action will end on May 1, 2008.

     Two new cases were filed in February 2008. Radcliffe v. R.J. Reynolds Tobacco Co., filed on February 14, 2008, in federal court in California, has not been served. Dinino v. R.J. Reynolds Tobacco Co., filed on February 29, 2008, in federal court in New York, was served on April 18, 2008. Both cases allege violations of the Fair Labor Standards Act.

Environmental Matters

     RAI and its subsidiaries are subject to federal, state and local environmental laws and regulations concerning the discharge, storage, handling and disposal of hazardous or toxic substances. Such laws and regulations provide for significant fines, penalties and liabilities, sometimes without regard to whether the owner or operator of the property knew of, or was responsible for, the release or presence of hazardous or toxic substances. In addition, third parties may make claims against owners or operators of properties for personal injuries and property damage associated with releases of hazardous or toxic substances. In the past, RJR Tobacco has been named a potentially responsible party with third parties under the Comprehensive Environmental Response, Compensation and Liability Act with respect to several

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

superfund sites. RAI and its subsidiaries are not aware of any current environmental matters that are expected to have a material adverse effect on the business, results of operations or financial position of RAI or its subsidiaries.

     Regulations promulgated by the U.S. Environmental Protection Agency and other governmental agencies under various statutes have resulted in, and likely will continue to result in, substantial expenditures for pollution control, waste treatment, plant modification and similar activities. RAI and its subsidiaries are engaged in a continuing program to comply with federal, state and local environmental laws and regulations, and dependent upon the probability of occurrence and reasonable estimation of cost, accrue or disclose any material liability. Although it is difficult to reasonably estimate the portion of capital expenditures or other costs attributable to compliance with environmental laws and regulations, RAI does not expect such expenditures or other costs to have a material adverse effect on the business, results of operations or financial position of RAI or its subsidiaries.

Other Contingencies and Guarantees

     In connection with the sale of the international tobacco business to JTI, on May 12, 1999, pursuant to the purchase agreement, RJR and RJR Tobacco agreed to indemnify JTI against:

	•		any liabilities, costs and expenses arising out of the imposition or assessment of any tax with respect to the international tobacco business arising prior to the sale, other than as reflected on the closing balance sheet;
	•		any liabilities, costs and expenses that JTI or any of its affiliates, including the acquired entities, may incur after the sale with respect to any of RJR’s or RJR Tobacco’s employee benefit and welfare plans; and
	•		any liabilities, costs and expenses incurred by JTI or any of its affiliates arising out of certain activities of Northern Brands.

     As described above in “— Litigation Affecting the Cigarette Industry — Other Litigation and Developments,” RJR Tobacco has received several claims for indemnification from JTI. Although RJR and RJR Tobacco recognize that, under certain circumstances, they may have indemnification obligations to JTI under the 1999 Purchase Agreement, RJR and RJR Tobacco disagree whether the circumstances described in such claims give rise to any indemnification obligations by RJR and RJR Tobacco. RJR and RJR Tobacco have conveyed their position to JTI, and the parties have agreed to resolve their differences at a later date. RJR has liabilities totaling $94 million that were recorded in 1999 in connection with these indemnification claims.

     RJR Tobacco, Santa Fe, the Conwood companies and Lane have entered into agreements to indemnify certain distributors and retailers from liability and related defense costs arising out of the sale or distribution of their products. Additionally, Santa Fe has entered into an agreement to indemnify a supplier from liability and related defense costs arising out of the sale or use of Santa Fe’s products. The cost has been, and is expected to be, insignificant. RJR Tobacco, Santa Fe, the Conwood companies and Lane believe that the indemnified claims are substantially similar in nature and extent to the claims that they are already exposed to by virtue of their having manufactured those products.

     Under certain circumstances, any fair value that results in a liability position of certain interest rate swaps may require full collateralization with cash or securities.

     Except as otherwise noted above, RAI is not able to estimate the maximum potential amount of future payments, if any, related to these guarantees and indemnification obligations.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Note 11–Shareholders’ Equity

														Accumulated
														Other				Total
		Common				Paid-In				Accumulated				Comprehensive				Shareholders’				Comprehensive
		Stock				Capital				Deficit				Loss				Equity				Income
Balance as of December 31, 2007		$	—			$	8,653			$	(873	)		$	(314	)		$	7,466
Net income			—				—				505				—				505			$	505
Retirement benefits SFAS No. 158, net of $3 million tax expense			—				—				—				4				4				4
Unrealized loss on short-term investments, net of $3 million tax benefit			—				—				—				(5	)			(5	)			(5	)
Cumulative translation adjustment			—				—				—				16				16				16
Other			—				—				—				1				1				1
Total comprehensive income			—				—				—				—							$	521
Dividends — $0.85 per share			—				—				(251	)			—				(251	)
Equity incentive award plan and stock-based compensation			—				4				—				—				4
Balance as of March 31, 2008		$	—			$	8,657			$	(619	)		$	(298	)		$	7,740

     On February 5, 2008, the board of directors of RAI authorized the repurchase of up to $30 million of outstanding shares of RAI common stock to offset the dilution from shares issued under certain equity-based benefit plans.

     On February 5, 2008, the board of directors of RAI approved a grant, to key employees of RAI and its subsidiaries, of shares of restricted RAI common stock under the Reynolds American Inc. Long-Term Incentive Plan, referred to as the LTIP, effective March 6, 2008. The 321,991 restricted shares were granted based on the per share closing price of RAI common stock on March 6, 2008, of $61.89. The shares of the restricted RAI common stock generally will vest on March 6, 2011. As an equity-based grant, compensation expense includes the vesting period elapsed. Dividends on shares of outstanding restricted stock, which are paid concurrently with dividends on outstanding unrestricted shares of stock, are recognized as a reduction of equity.

     On February 5, 2008, RAI’s board of directors declared a quarterly cash dividend of $0.85 per common share, or $3.40 on an annualized basis, to shareholders of record as of March 10, 2008.

     For further information related to RAI’s board of directors share repurchase authorizations subsequent to March 31, 2008, see note 16.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Note 12–Segment Information

     RAI’s reportable operating segments are RJR Tobacco and Conwood. The RJR Tobacco segment consists of the primary operations of R. J. Reynolds Tobacco Company. The Conwood segment consists of the Conwood companies and Lane. RAI’s wholly owned operating subsidiaries Santa Fe and GPI, among others, are included in All Other. The segments were identified based on how RAI’s chief operating decision maker allocates resources and assesses performance.

     RAI’s largest reportable operating segment, RJR Tobacco, is the second largest cigarette manufacturer in the United States. RJR Tobacco’s largest selling cigarette brands, CAMEL, KOOL, PALL MALL, DORAL and WINSTON, are five of the ten best-selling brands of cigarettes in the United States as of March 31, 2008. Those brands, and its other brands, including SALEM, MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. RJR Tobacco also manages contract manufacturing of cigarettes and tobacco products through arrangements with BAT affiliates. On January 1, 2008, the contract manufacturing business of GPI was transferred to RJR Tobacco.

     RAI’s other reportable operating segment, Conwood, is the second largest smokeless tobacco products manufacturer in the United States. Conwood’s primary brands include its largest selling moist snuff brands, GRIZZLY and KODIAK, two of the six best-selling brands of moist snuff in the United States. Conwood’s other products include loose leaf chewing tobacco, dry snuff, plug and twist tobacco products. Conwood’s products currently hold the first or second position in market share in each category. In addition, Conwood also distributes a variety of other tobacco products including WINCHESTER and CAPTAIN BLACK little cigars, and BUGLER roll-your-own tobacco.

     Santa Fe manufactures and markets cigarettes and other tobacco products under the NATURAL AMERICAN SPIRIT brand. As of January 1, 2008, the management of RJR Tobacco’s super premium brands, including DUNHILL and STATE EXPRESS 555, was transferred to Santa Fe. GPI manufactures and exports tobacco products to U.S. territories, U.S. duty-free shops and U.S. overseas military bases and manages the international businesses of Conwood and Santa Fe. The financial position and results of operations of these operating segments do not meet the materiality criteria to be reportable.

     The amounts presented for prior periods have been reclassified to reflect the current segment composition.

     Intersegment revenues and items below the operating income line of the consolidated statements of income are not presented by segment, since they are excluded from the measure of segment profitability reviewed by RAI’s chief operating decision maker.

     Segment Data:

		For the Three Months
		Ended March 31,
		2008				2007
Net sales:
RJR Tobacco		$	1,787			$	1,907
Conwood			167				155
All Other			103				86
Consolidated net sales		$	2,057			$	2,148
Operating income:
RJR Tobacco		$	415			$	488
Conwood			81				80
All Other			36				35
Corporate expense			(26	)			(29	)
Consolidated operating income		$	506			$	574

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

		For the Three Months
		Ended March 31,
		2008				2007
Reconciliation to income before income taxes:
Operating income		$	506			$	574
Interest and debt expense			72				89
Interest income			(22	)			(38	)
Gain on termination of joint venture			(328	)			—
Other income, net			(12	)			(1	)
Income before income taxes		$	796			$	524

		March 31,				December 31,
		2008				2007
Assets:
RJR Tobacco		$	16,494			$	15,956
Conwood			4,459				4,559
All Other			1,456				1,104
Corporate			16,357				16,336
Elimination adjustments			(19,156	)			(19,326	)
Consolidated assets		$	19,610			$	18,629

Note 13–Related Party Transactions

     RAI’s operating subsidiaries engage in transactions with related parties in the normal course of business. The following is a summary of balances and transactions with affiliates.

		March 31,				December 31,
		2008				2007
Balances:
Accounts receivable, BAT		$	77			$	80
Due to BAT			5				7
Deferred revenue, BAT			27				35