Income Taxes
Substantially all of the Company’s operations are held through Charter Holdings and its direct and indirect subsidiaries. Charter Holdings and the majority of its subsidiaries are generally limited liability companies that are not subject to income tax. However, certain of these limited liability companies are subject to state income tax. In addition, the subsidiaries that are corporations are subject to income tax. Generally, the taxable income, gains, losses, deductions and credits of Charter Holdings are passed through to its members, Charter and A/N. Charter is responsible for its share of taxable income or loss of Charter Holdings allocated to it in accordance with the Charter Holdings Limited Liability Company Agreement ("LLC Agreement") and partnership tax rules and regulations. As a result, Charter's primary deferred tax component recorded in the consolidated balance sheets relates to its excess financial reporting outside basis, excluding amounts attributable to nondeductible goodwill, over Charter's tax basis in the investment in Charter Holdings.
Charter Holdings, the indirect owner of the Company’s cable systems, generally allocates its taxable income, gains, losses, deductions and credits proportionately according to the members’ respective ownership interests, except for special allocations required under Section 704(c) of the Internal Revenue Code and the Treasury Regulations (“Section 704(c)”). Pursuant to Section 704(c) and the LLC Agreement, each item of income, gain, loss and deduction with respect to any property contributed to the capital of the partnership shall, solely for tax purposes, be allocated among the members so as to take into account any variation between the adjusted basis of such property to the partnership for U.S. federal income tax purposes and its initial gross asset value using the “traditional method” as described in the Treasury Regulations.
Income Tax Benefit
For the years ended December 31, 2017, 2016, and 2015, the Company recorded deferred income tax benefit as shown below. The tax provision in future periods will vary based on current and future temporary differences, as well as future operating results.
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| | Year Ended December 31, |
| | 2017 | | 2016 | | 2015 |
Current expense: | | | | | | |
Federal income taxes | | $ | (4 | ) | | $ | (4 | ) | | $ | (1 | ) |
State income taxes | | (25 | ) | | (29 | ) | | (4 | ) |
Current income tax expense | | (29 | ) | | (33 | ) | | (5 | ) |
| | | | | | |
Deferred benefit: | | | | | | |
Federal income taxes | | 9,082 |
| | 2,549 |
| | 53 |
|
State income taxes | | 34 |
| | 409 |
| | 12 |
|
Deferred income tax benefit | | 9,116 |
| | 2,958 |
| | 65 |
|
Income tax benefit | | $ | 9,087 |
| | $ | 2,925 |
| | $ | 60 |
|
Income tax benefit for the year ended December 31, 2017 was recognized primarily as a result of the enactment of Tax Reform in December 2017. Among other things, the primary provisions of Tax Reform impacting us are the reductions to the U.S. corporate income tax rate from 35% to 21% and temporary 100% bonus depreciation for certain assets. The change in tax law required the Company to remeasure existing net deferred tax liabilities using the lower rate in the period of enactment resulting in an income tax benefit of approximately $9.3 billion to reflect these changes in the year ended December 31, 2017. The Company has reported provisional amounts for the income tax effects of Tax Reform for which the accounting is incomplete but a reasonable estimate could be determined. There were no specific impacts of Tax Reform that could not be reasonably estimated which the Company accounted for under prior tax law. Based on a continued analysis of the estimates and further guidance on the application of the law, it is anticipated that additional revisions may occur throughout the allowable measurement period. Overall, the changes due to Tax Reform will favorably affect income tax expense on future U.S. earnings. Income tax benefit for the year ended December 31, 2017 was also increased by approximately $88 million due to the recognition of excess tax benefits resulting from share based compensation as a component of the provision for income taxes following the prospective application of Accounting Standards Update (“ASU”) No. 2016-09, Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”) on January 1, 2017. See Note 22.
Income tax benefit for the year ended December 31, 2016 was recognized primarily through the reversal of approximately $3.3 billion of valuation allowance (see further discussion below), net of tax effect of permanent differences, a decrease to the anticipated blended state rate applied to Legacy Charter deferred tax balances as a result of the Transactions, a change in a state tax law, and prior to the closing of the Transactions, increases (decreases) in deferred tax liabilities related to Charter’s franchises which are characterized as indefinite-lived for book financial reporting purposes.
Prior to July 2, 2015, Charter Communications Holding Company, LLC ("Charter Holdco") was treated as a partnership for tax purposes. Effective on July 2, 2015, Charter elected to treat two of its wholly owned subsidiaries as disregarded entities for federal and state income tax purposes (the “Election”). The subsidiaries that made the Election were two of the three partners in Charter Holdco. This Election resulted in a deemed liquidation of Charter Holdco into Charter solely for federal and state income tax purposes, and resulted in a net increase of $638 million to the tax basis of Charter Holdco’s amortizable and depreciable assets. After the Election, all taxable income, gains, losses, deductions and credits of Charter Holdco and its indirect limited liability company subsidiaries were treated as income of Charter. In addition, the indirect subsidiaries of Charter Holdco that are corporations joined the Charter consolidated group. The impact of the Election to the Charter income tax provision, net of valuation allowance, was $187 million of income tax benefit recorded as a discrete tax event during the year ended December 31, 2015.
The Company’s effective tax rate differs from that derived by applying the applicable federal income tax rate of 35% for the years ended December 31, 2017, 2016, and 2015, respectively, as follows:
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| | | | | | | | | | | | |
| | Year Ended December 31, |
| | 2017 | | 2016 | | 2015 |
Statutory federal income taxes | | $ | (360 | ) | | $ | (288 | ) | | $ | 116 |
|
Statutory state income taxes, net | | (34 | ) | | (36 | ) | | (4 | ) |
Nondeductible expenses | | (21 | ) | | (62 | ) | | (12 | ) |
Net income attributable to noncontrolling interest | | 84 |
| | 78 |
| | — |
|
Change in valuation allowance | | 14 |
| | 3,171 |
| | (250 | ) |
Excess stock compensation | | 88 |
| | — |
| | — |
|
Organizational restructuring | | — |
| | — |
| | 187 |
|
Federal tax credits | | 21 |
| | 16 |
| | 18 |
|
Tax rate changes | | 9,293 |
| | 65 |
| | 4 |
|
Other | | 2 |
| | (19 | ) | | 1 |
|
Income tax benefit | | $ | 9,087 |
| | $ | 2,925 |
| | $ | 60 |
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The change in the valuation allowance above differs from the change between the beginning and ending valuation allowance below due to a change in certain deferred tax assets and the corresponding establishment of a valuation allowance which results in no impact to the consolidated statements of operations.
Deferred Tax Assets (Liabilities)
The tax effects of these temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2017 and 2016 are presented below.
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| | | | | | | | |
| | December 31, |
| | 2017 | | 2016 |
Deferred tax assets: | | | | |
Loss carryforwards | | $ | 2,657 |
| | $ | 4,127 |
|
Accrued and other | | 287 |
| | 243 |
|
Total gross deferred tax assets | | 2,944 |
| | 4,370 |
|
Less: valuation allowance | | (137 | ) | | (200 | ) |
Deferred tax assets | | $ | 2,807 |
| | $ | 4,170 |
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| | | | |
Deferred tax liabilities: | | | | |
Investment in partnership | | $ | (20,107 | ) | | $ | (30,832 | ) |
Accrued and other | | (14 | ) | | (3 | ) |
Deferred tax liabilities | | (20,121 | ) | | (30,835 | ) |
Net deferred tax liabilities | | $ | (17,314 | ) | | $ | (26,665 | ) |
The deferred tax liabilities on the investment in partnership above includes approximately $32 million and $25 million net deferred tax liabilities relating to certain indirect subsidiaries that file separate state income tax returns at December 31, 2017 and 2016, respectively.
Valuation Allowance
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. In evaluating the need for a valuation allowance, management takes into account various factors, including the expected level of future taxable income, available tax planning strategies and reversals of existing taxable temporary differences. Due to Legacy Charter’s history of losses, Legacy Charter was historically unable to assume future taxable income in its analysis and accordingly valuation allowances were established against the deferred tax assets, net of deferred tax liabilities, from definite-lived assets for book accounting purposes. However, as a result of the TWC Transaction, deferred tax liabilities resulting from the book fair value adjustment increased significantly and future taxable income that will result from the reversal of existing temporary differences for which deferred tax liabilities are recognized, is sufficient to conclude it is more likely than not that the Company will realize substantially all of its deferred tax assets. As a result, Charter reversed approximately $3.3 billion of its valuation allowance and recognized a corresponding income tax benefit in the consolidated statements of operations for the year ended December 31, 2016. As of December 31, 2017 and 2016, approximately $87 million and $145 million, respectively, of the valuation allowance is associated with federal tax net operating loss carryforwards acquired in the TWC Transaction and approximately $50 million and $55 million, respectively, of the valuation allowance is associated with state tax loss carryforwards and tax credits.
Net Operating Loss Carryforwards
As of December 31, 2017, Charter had approximately $10.9 billion of federal tax net operating loss carryforwards resulting in a gross deferred tax asset of approximately $2.3 billion. Federal tax net operating loss carryforwards expire in the years 2018 through 2035. These losses resulted from the operations of Charter Holdco and its subsidiaries. In addition, as of December 31, 2017, Charter had state tax net operating loss carryforwards, resulting in a gross deferred tax asset (net of federal tax benefit) of approximately $359 million. State tax net operating loss carryforwards generally expire in the years 2018 through 2037.
Upon closing of the TWC Transaction, Charter experienced a third “ownership change” as defined in Section 382 of the Internal Revenue Code; resulting in a third set of limitations on Charter’s use of its existing federal and state net operating losses, capital losses, and tax credit carryforwards. Both the first ownership change limitations that applied as a result of Legacy Charter’s emergence from bankruptcy in 2009 and second ownership change limitations that applied as a result of Liberty Media Corporation’s purchase in 2013 of a 27% beneficial interest in Legacy Charter will also continue to apply. As of December 31, 2017, all of Charter's federal tax loss carryforwards are subject to Section 382 and other restrictions. Pursuant to these restrictions, Charter estimates that approximately $8.7 billion in 2018, $654 million in 2019 and an additional $226 million annually over each of the next five years of federal tax loss carryforwards should become unrestricted and available for Charter’s use. An additional $415 million is currently subject to a valuation allowance. Since the limitation amounts accumulate for future use to the extent they are not utilized in any given year, Charter believes its loss carryforwards should become fully available to offset future taxable income. Charter’s state loss carryforwards are subject to similar, but varying, limitations on their future use. If Charter was to experience another “ownership change” in the future, its ability to use its loss carryforwards could be subject to further limitations.
Tax Receivable Agreement
Under the LLC Agreement, A/N has rights to: (1) convert at any time some or all of its preferred units in Charter Holdings for common units in Charter Holdings, and (2) exchange at any time some or all of its common units in Charter Holdings for Charter’s Class A common stock or cash, at Charter’s option. Pursuant to a Tax Receivable Agreement ("TRA") between Charter and A/N, Charter must pay to A/N 50% of the tax benefit when realized by Charter from the step-up in tax basis resulting from any future exchange or sale of the preferred and common units. Charter did not record a liability for this obligation as of the acquisition date since the tax benefit is dependent on uncertain future events that are outside of Charter’s control, such as the timing of a conversion or exchange. A future exchange or sale is not based on a fixed and determinable date and the exchange or sale is not certain to occur. If all of A/N's partnership units were to be exchanged or sold in the future, the undiscounted value of the obligation is currently estimated to be in the range of zero to $3 billion depending on measurement of the tax step-up in the future and Charter’s ability to realize the tax benefit in the periods following the exchange or sale. Factors impacting these calculations include, but are not limited to, the fair value of the equity at the time of the exchange and the effective tax rates when the benefits are realized.
In connection with the Letter Agreement between Charter and A/N (see Note 19) whereby 1.3 million and 1.9 million Charter Holdings common units held by A/N during the year ended December 31, 2017 and 2016, respectively, were exchanged for shares of Charter Class A common stock for an aggregate purchase price of $400 million and $537 million, respectively, an immediate step-up of $487 million and $580 million, respectively, in the tax basis of the assets of Charter Holdings occurred. As it relates to the exchange and tax step-up, a net deferred tax asset of approximately $85 million and $82 million, respectively, was recorded and a resulting TRA liability owed to A/N of $118 million and $137 million, respectively, which, as a transaction with a shareholder, was recorded directly to additional paid in capital, net of tax during the year ended December 31, 2017 and 2016. The TRA liability is recorded on an iterative, undiscounted basis. The TRA liability was remeasured as a result of the enactment of Tax Reform resulting in a $101 million benefit recorded to other operating expenses, net. See Note 15. Following such remeasurement, the TRA liability of $154 million is reflected in other long-term liabilities on the consolidated balance sheets as of December 31, 2017 and 2016.
Uncertain Tax Positions
In connection with the TWC Transaction, the Company assumed $181 million of gross unrecognized tax benefits, exclusive of interest and penalties, which are recorded within other long-term liabilities. The net amount of the unrecognized tax benefits recorded as of December 31, 2017 that could impact the effective tax rate is $171 million. The Company has determined that it is reasonably possible that its existing reserve for uncertain tax positions as of December 31, 2017 could decrease by approximately $58 million during the year ended December 31, 2018 related to various ongoing audits, settlement discussions and expiration of statute of limitations with various state and local agencies; however, various events could cause the Company’s current expectations to change in the future. These uncertain tax positions, if ever recognized in the financial statements, would be recorded in the consolidated statements of operations as part of the income tax provision. A reconciliation of the beginning and ending amount of unrecognized tax benefits, exclusive of interest and penalties, included in other long-term liabilities on the accompanying consolidated balance sheets of the Company is as follows:
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BALANCE, December 31, 2015 | $ | 5 |
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Additions on prior year tax positions | 1 |
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Additions on current year tax positions | 7 |
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Additions on tax positions assumed in the TWC Transaction | 181 |
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Reductions on settlements and expirations with taxing authorities | (22 | ) |
| |
BALANCE, December 31, 2016 | $ | 172 |
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Additions on prior year tax positions | 1 |
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Additions on current year tax positions | 12 |
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Reductions on settlements and expirations with taxing authorities | (21 | ) |
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BALANCE, December 31, 2017 | $ | 164 |
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The Company recognizes interest and penalties accrued on uncertain income tax positions as part of the income tax provision. Interest and penalties included in other long-term liabilities on the accompanying consolidated balance sheets of the Company were $39 million and $34 million as of December 31, 2017 and 2016, respectively.
No tax years for Charter, Charter Holdings, or Charter Communications Holding Company, LLC for income tax purposes, are currently under examination by the Internal Revenue Service ("IRS"). Charter and Charter Holdings' 2016 and 2017 tax years remain open for examination and assessment. Legacy Charter’s tax years ending 2014 through the short period return dated May 17, 2016 remain subject to examination and assessment. Years prior to 2014 remain open solely for purposes of examination of Legacy Charter’s loss and credit carryforwards. The IRS is currently examining Legacy TWC’s income tax returns for 2011 through 2014. Legacy TWC’s tax year 2015 remains subject to examination and assessment. Prior to Legacy TWC’s separation from Time Warner Inc. (“Time Warner”) in March 2009 (the “Separation”), Legacy TWC was included in the consolidated U.S. federal and certain state income tax returns of Time Warner. The IRS is currently examining Time Warner’s 2008 through 2010 income tax returns. Time Warner’s income tax returns for 2005 to 2007, which are periods prior to the Separation, were settled with the exception of an immaterial item that has been referred to the IRS Appeals Division. The Company does not anticipate that these examinations will have a material impact on the Company’s consolidated financial position or results of operations. In addition, the Company is also subject to ongoing examinations of the Company’s tax returns by state and local tax authorities for various periods. Activity related to these state and local examinations did not have a material impact on the Company’s consolidated financial position or results of operations during the year ended December 31, 2017, nor does the Company anticipate a material impact in the future.