Income Taxes
On December 22, 2017, the Tax Act was signed into law. The Tax Act changes existing United States tax law and includes numerous provisions that will impact the Company, including reducing the corporate tax rate to 21% from 35% for years beginning after December 31, 2017. The Tax Act also introduces prospective changes beginning in 2018, including repeal of the domestic manufacturing deduction, acceleration of tax revenue recognition and additional limitations on executive compensation. The Company is continuing to evaluate the impact of the Tax Act on our business and results of operations.
In accordance with Staff Accounting Bulletin No. 118 ("SAB 118"), which provides SEC staff guidance for the application of ASC Topic 740, Income Taxes, in the reporting period in which the Tax Act was signed into law, the Company recognized the income tax effects of the Tax Act in its 2017 financial statements. The income tax effects of the Tax Act that have been accounted for in 2017 are based on reasonable estimates. If the Company was able to make reasonable estimates for the effects of the Tax Act for which the Company's analysis was not complete, the Company recorded provisional adjustments in accordance with SAB 118.
The Company believes the reduction of the U.S. corporate income tax rate as a result of the Tax Act will have the most significant impact on the Company’s federal income taxes. The Company measures deferred tax assets and liabilities using enacted tax rates that will apply in the years in which the temporary differences are expected to be recovered or paid. The company recognized income tax expense of $39 million for the year ended December 31, 2017 and a corresponding $39 million decrease in net deferred tax assets as of December 31, 2017 related to the remeasurement of deferred tax assets and liabilities to reflect the reduction in the U.S. corporate income tax rate from 35% to 21%, both which are complete under SAB 118.
The Company’s accounting for the following effects of the Tax Act are not complete: (1) cost recovery, (2) limitation on the deductibility of certain executive compensation, (3) recovery of Alternative Minimum Tax credits and (4) valuation allowances against state tax attribute carryforwards. The Company was able to make reasonable estimates of certain effects and, therefore recorded provisional adjustments for such effects, none of which were material. The Company expects to finalize all provisional and non-estimable amounts within the measurement period as described in SAB 118.
Income Tax Expense
Substantially all of the Company’s income from continuing operations before income taxes for the three years ended December 31, 2017 was earned in the United States. The provision for income taxes related to continuing operations for each of the three years ended December 31, 2017 included the following:
|
| | | | | | | | | | | | |
| | Year Ended December 31, 2017 |
| Year Ended December 31, 2016 |
| Nine Months Ended December 31, 2015 |
| | (in millions) |
Current: | | | | | | |
Federal | | $ | 75 |
| | $ | 63 |
| | $ | 28 |
|
State | | 9 |
| | 2 |
| | 2 |
|
Non-US | | — |
| | 4 |
| | — |
|
Deferred: | | | | | | |
Federal | | 72 |
| | 39 |
| | 55 |
|
State | | (4 | ) | | 3 |
| | 2 |
|
Income taxes | | $ | 152 |
| | $ | 111 |
| | $ | 87 |
|
Differences between the federal statutory rate and the Company's effective rate related to the following:
|
| | | | | | | | | |
| | Year Ended December 31, 2017 | | Year Ended December 31, 2016 | | Nine Months Ended December 31, 2015 |
Statutory federal income tax rate | | 35.0 | % | | 35.0 | % | | 35.0 | % |
State income taxes, net of federal impact | | 3.3 |
| | 2.8 |
| | 2.1 |
|
Domestic manufacturing deduction | | (1.9 | ) | | (2.3 | ) | | (1.5 | ) |
True-up of prior year taxes | | (3.2 | ) | | (2.6 | ) | | 0.1 |
|
Research and development tax credit | | (9.3 | ) | | (12.6 | ) | | (5.2 | ) |
Change in prior year contingent tax liabilities | | (1.3 | ) | | 0.1 |
| | 1.0 |
|
Impacts related to the 2017 Tax Act | | 8.4 |
| | — |
| | — |
|
Other, net | | (0.1 | ) | | 0.1 |
| | (1.2 | ) |
Change in valuation allowance | | 2.1 |
| | 7.0 |
| | 1.6 |
|
Income tax provision | | 33.0 | % | | 27.5 | % | | 31.9 | % |
Deferred Income Taxes
Deferred income taxes arise because of temporary differences in the timing of the recognition of income and expense items for financial statement reporting and income tax purposes. The net effect of these temporary differences are classified in the consolidated financial statements of financial position as noncurrent assets or liabilities.
Deferred income tax assets and liabilities resulting from temporary differences related to the following:
|
| | | | | | | | |
| | December 31, |
| | 2017 | | 2016 |
| | (in millions) |
Deferred income tax assets: | | | | |
Retirement benefits | | $ | 169 |
| | $ | 271 |
|
Federal carryforwards | | 31 |
| | 13 |
|
State carryforwards | | 73 |
| | 50 |
|
Other | | 8 |
| | 19 |
|
Other reserves | | 10 |
| | 21 |
|
Accruals for employee benefits | | 25 |
| | 40 |
|
Inventory | | 13 |
| | 25 |
|
Contract method of revenue recognition | | 42 |
| | 80 |
|
Total deferred income tax assets before valuation allowance | | 371 |
| | 519 |
|
Valuation allowance | | (62 | ) | | (42 | ) |
Total deferred income tax assets | | 309 |
| | 477 |
|
Deferred income tax liabilities: | | | | |
Intangible assets | | (47 | ) | | (86 | ) |
Property, plant and equipment | | (104 | ) | | (127 | ) |
Debt-related | | (3 | ) | | (10 | ) |
Total deferred income tax liabilities | | (154 | ) | | (223 | ) |
Net deferred income tax assets | | $ | 155 |
| | $ | 254 |
|
The Company believes it is more likely than not that the recorded deferred benefits will be realized through the reduction of future taxable income. The Company's recorded valuation allowance of $62 million at December 31, 2017 relates to certain capital loss, tax credits and net operating losses that are not expected to be realized before their expiration.
Included in the net deferred tax asset are net operating loss and credit carryovers of $35 million, net of valuation allowances, which expire in years ending from December 31, 2018 through December 31, 2038, and a $9 million federal AMT tax credit that will be utilized or fully refunded prior to 2022.
The following summarizes activity related to valuation allowances for deferred tax assets:
|
| | | | | | | | | | | |
| Year Ended December 31, 2017 | | Year Ended December 31, 2016 | | Nine Months Ended December 31, 2015 |
| (in millions) |
Beginning Balance | $ | 42 |
| | $ | 13 |
| | $ | 9 |
|
Additions, charged to expense | 21 |
| | 37 |
| | 5 |
|
Deductions | (1 | ) | | (8 | ) | | (1 | ) |
Ending Balance | $ | 62 |
| | $ | 42 |
| | $ | 13 |
|
The Company has significant deferred tax assets in the U.S. against which valuation allowances have been established to reduce such deferred tax assets to an amount that is more likely than not to be realized. The establishment of valuation allowances requires significant judgment and is impacted by various estimates. Both positive and negative evidence, as well as the objectivity and verifiability of that evidence, is considered in determining the appropriateness of recording a valuation allowance on deferred tax assets. While the Company believes positive evidence exists with regard to the realizability of these deferred tax assets, it is not considered sufficient to outweigh the objectively verifiable negative evidence.
Unrecognized Tax Benefits
Unrecognized tax benefits consist of the carrying value of the Company's recorded uncertain tax positions as well as the potential tax benefits that could result from other tax positions that have not been recognized in the financial statements under current authoritative guidance. At December 31, 2017 and December 31, 2016, unrecognized tax benefits that have not been recognized in the financial statements amounted to $137 million and $121 million, respectively, of which $125 million and $106 million, respectively, would affect the effective tax rate, if recognized. The remaining balance is related to deferred tax items which only impact the timing of tax payments. Although the timing and outcome of audit settlements are uncertain, it is reasonably possible that a $30 million reduction of the uncertain tax benefits will occur in the next 12 months. The settlement of these unrecognized tax benefits could result in earnings from $0 million to $27 million.
Changes in unrecognized tax benefits, excluding interest and penalties, were as follows:
|
| | | | | | | | | | | | |
| | Year Ended
December 31, 2017 | | Year Ended
December 31, 2016 | | Nine Months Ended December 31, 2015 |
| | (in millions) |
Unrecognized tax benefits, beginning of period | | $ | 119 |
| | $ | 81 |
| | $ | 34 |
|
Gross increases—tax positions in prior periods | | 6 |
| | 30 |
| | 42 |
|
Gross decreases—tax positions in prior periods | | (2 | ) | | (4 | ) | | (1 | ) |
Gross increases—current-period tax positions | | 21 |
| | 18 |
| | 6 |
|
Settlements | | — |
| | (5 | ) | | — |
|
Lapse of statute of limitations | | (10 | ) | | (1 | ) | | — |
|
Unrecognized tax benefits, end of period | | $ | 134 |
| | $ | 119 |
| | $ | 81 |
|
The Company reports income tax-related interest income within income taxes. Penalties and tax-related interest expense are also reported as a component of income taxes. At December 31, 2017 and December 31, 2016, $3 million and $2 million of income tax-related interest and an immaterial amount of penalties were included in accrued income taxes, respectively.
The Company or one of its subsidiaries files income tax returns in the U.S. federal, various U.S. state and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or foreign income tax examinations by tax authorities for years prior to 2011. The IRS has completed the audits of the Company through fiscal 2014 and is currently auditing the Company's income tax returns for fiscal year 2015 and calendar year 2015. The Company believes appropriate provisions for all outstanding issues have been made for all remaining open years in all jurisdictions.