So what a day, spent about half my weekend trying to install AX 2012 reporting services extension installed on my machine which had SQL Server 2008 R2 with SP2.
The trouble started when I found out that AX 2012 Reporting Server Extensions (RSE) cannot be installed on SSRS in SharePoint Integrated Mode.
The solution was simple to use reporting services configuration manager and recreate reporting databases in native mode.
However I wasn't aware I had this option till I spoke to my colleague (after I had already uninstalled SSRS from my VM - argh). I then installed Reporting Services however it was not patched with SP1 and SP2.
So AX installer recommended me to install Sql Server 2008 R2 CU3. However this did not work for me as I got a message saying that no instances or shared components found upgradeable.
Hoping this will help someone in similar situation