VMWARE, INC.

Income Taxes

The domestic and foreign components of income (loss) before provisions (benefits) for income taxes were as follows (table in millions):



							Transition Period
	For the Year Ended						January 1 to
	February 2,		December 31,		December 31,		February 3,
	2018		2016		2015		2017
Domestic	$	676	$	478	$	257	$	(51	)
Foreign	1,125		995		956		17
Total income (loss) before income tax	$	1,801	$	1,473	$	1,213	$	(34	)

VMware’s provision (benefit) for income taxes consisted of the following (table in millions):



										Transition Period
	For the Year Ended									January 1 to
	February 2,			December 31,			December 31,			February 3,
	2018			2016			2015			2017
Federal:
Current	$	690		$	153		$	142		$	207
Deferred	373			5			(33		)	(234		)
	1,063			158			109			(27		)
State:
Current	6			14			9			16
Deferred	12			(5		)	(1		)	(21		)
	18			9			8			(5		)
Foreign:
Current	151			128			96			6
Deferred	(1		)	(8		)	3			—
	150			120			99			6
Total provision (benefit) for income taxes	$	1,231		$	287		$	216		$	(26	)

The 2017 Tax Act introduces significant changes to U.S. income tax law including a mandatory one-time transition tax on accumulated earnings of foreign subsidiaries and a reduction of the U.S. statutory corporate income tax rate from 35% to 21%, effective January 1, 2018, which resulted in a blended rate of 34% during the year ended February 2, 2018. During December 2017, the SEC staff issued SAB 118, which allows recognition of provisional tax amounts during a measurement period not to extend beyond one year of the enactment date. Due to the timing of the enactment and the complexity involved in applying the provisions of the 2017 Tax Act, the Company made reasonable estimates of the effects and recorded provisional amounts in its consolidated financial statements for the year ended February 2, 2018.

Federal income tax increased during the year ended February 2, 2018, primarily due to the 2017 Tax Act. As a result of the transition tax, VMware recorded a provisional estimate for income tax expense of approximately $800 million that was calculated on a separate tax return basis. In addition, the Company recorded a provisional estimate for tax expense of approximately $170 million related to the remeasurement of its deferred tax assets and liabilities, which resulted from the reduction of the U.S. statutory corporate income tax rate.

Provisional taxes relating to the effect of the tax law changes, including the estimated transition tax and the remeasurement of U.S. deferred tax assets and liabilities, among others, were recognized during the year ended February 2, 2018. As VMware completes its analysis of the 2017 Tax Act, collects and prepares necessary data, and interprets any additional guidance issued by the U.S. Treasury Department, the IRS, and other standard-setting bodies and relevant authorities, the Company may make adjustments to provisional amounts that it has recorded that may materially impact its provision for income taxes in the period in which the adjustments are made. VMware expects to complete its analysis within the measurement period permitted under SAB 118.

A reconciliation of VMware’s income tax rate to the statutory federal tax rate is as follows:



							Transition Period
	For the Year Ended						January 1 to
	February 2,		December 31,		December 31,		February 3,
	2018		2016		2015		2017
Statutory federal tax rate⁽¹⁾	34	%	35	%	35	%	35	%
State taxes, net of federal benefit	1	%	1	%	1	%	13	%
Tax rate differential for non-U.S. jurisdictions	(13	)%	(16	)%	(20	)%	(1	)%
U.S. tax credits	(4	)%	(3	)%	(2	)%	—	%
Excess tax benefits from stock-based compensation⁽²⁾	(6	)%	—	%	—	%	—	%
Transition Tax due to 2017 Tax Act⁽³⁾	44	%	—	%	—	%	—	%
Rate Change due to 2017 Tax Act⁽³⁾	10	%	—	%	—	%	—	%
Permanent items	2	%	4	%	3	%	27	%
Other	—	%	(2	)%	1	%	2	%
Effective tax rate	68	%	19	%	18	%	76	%

⁽¹⁾The 2017 Tax Act reduced the U.S. statutory corporate income tax rate from 35% to 21%, effective January 1, 2018, which resulted in a blended U.S. statutory corporate tax rate of 34% during the year ended February 2, 2018.


⁽²⁾	VMware adopted ASU No. 2016-09 during the first quarter of fiscal 2018. As a result, net excess tax benefits recognized in connection with stock-based awards are included in the income tax provision on the consolidated statements of income (loss). Prior to adopting the updated standard, such amounts were recognized in additional paid-in capital on the Company’s consolidated balance sheets.

⁽³⁾ The effective tax rate was impacted by key components of the 2017 Tax Act, including the mandatory one-time transition tax on accumulated earnings of foreign subsidiaries, and the remeasurement of VMware’s deferred tax assets and liabilities due to the reduction in the U.S. statutory corporate tax rate.

Deferred tax assets and liabilities are recognized for future tax consequences resulting from differences between the carrying amounts of assets and liabilities and their respective tax bases using enacted tax rates in effect for the year in which the differences are expected to be reversed. Significant deferred tax assets and liabilities consisted of the following (table in millions):



	February 2,			February 3,
	2018			2017
Deferred tax assets:
Unearned revenue	$	223		$	566
Accruals and other	48			63
Stock-based compensation	52			85
Tax credit and net operating loss carryforwards	254			169
Other assets, net	27			34
Intangible and other non-current assets	—			58
Basis difference on investment in business	13			20
Gross deferred tax assets	617			995
Valuation allowance	(200		)	(161		)
Total deferred tax assets	417			834
Deferred tax liabilities:
Property, plant and equipment, net	(67		)	(118		)
Intangibles and other assets, net	(4		)	—
Total deferred tax liabilities	(71		)	(118		)
Net deferred tax assets	$	346		$	716

The decrease in net deferred tax assets from February 3, 2017 to February 2, 2018 was driven in part by the remeasurement of the deferred tax balances resulting from the reduction in the U.S. statutory corporate income tax rate under the 2017 Tax Act. In addition, deferred tax assets related to unearned revenue were higher as of February 3, 2017, primarily due to the Dell Acquisition and VMware’s change in fiscal year.

VMware has U.S. federal net operating loss carryforwards of $195 million and $90 million as of February 2, 2018 and February 3, 2017, respectively, from acquisitions made since 2007. These operating loss carryforwards expire at different periods through 2037. Portions of these carryforwards are subject to annual limitations. VMware expects to be able to fully utilize these net operating losses against future income. VMware also has state net operating loss carryforwards of $187 million and $116 million as of February 2, 2018 and February 3, 2017, respectively, resulting from acquisitions since 2007, expiring at different periods through 2037.

VMware has California research and development (“R&D”) credit carryforwards for income tax purposes of $168 million and $110 million as of February 2, 2018 and February 3, 2017, respectively, that can be carried over indefinitely. VMware also has R&D credit carryforwards for Massachusetts and Georgia which were not material as of February 2, 2018 and February 3, 2017 and expire at different periods through 2032. In addition, VMware has foreign tax credit carryforwards of $10 million as of February 2, 2018 which expire in 2029. There were no foreign tax credit carryforwards as of February 3, 2017. VMware has non-U.S. net operating losses of $16 million as of February 3, 2017 resulting from certain foreign operations and non-U.S. acquisitions in 2014. The non-U.S. net operating losses as of February 2, 2018 were not material. These net operating losses have various carryforward periods, including certain portions that can be carried over indefinitely.

VMware determined that the realization of deferred tax assets relating to portions of the state net operating loss carryforwards, state R&D tax credits and capital losses did not meet the more-likely-than-not threshold. Accordingly, a valuation allowance of $183 million and $134 million was recorded as of February 2, 2018 and February 3, 2017, respectively. If, in the future, new evidence supports the realization of the deferred tax assets related to these items, the valuation allowance will be reversed and a tax benefit will be recorded accordingly.

VMware believes it is more-likely-than-not that the net deferred tax assets as of February 2, 2018 and February 3, 2017, will be realized in the foreseeable future as VMware believes that it will generate sufficient taxable income in future years. VMware's ability to generate sufficient taxable income in future years in appropriate tax jurisdictions will determine the amount of net deferred tax asset balances to be realized in future periods. During the year ended February 2, 2018, the total change in the valuation allowance was $39 million, which was primarily due to California R&D credits generated during the year ended February 2, 2018.

For the periods presented, VMware’s rate of taxation in non-U.S. jurisdictions was lower than the U.S. tax rate. VMware’s non-U.S. earnings are primarily earned by its subsidiaries organized in Ireland, where the statutory rate is 12.5%. Prior to the year ended February 2, 2018, the Company did not recognize a deferred tax liability related to undistributed foreign earnings of its subsidiaries because such earnings were considered to be indefinitely reinvested in its foreign operations, or were remitted substantially free of U.S. tax. Under the 2017 Tax Act, all foreign earnings are subject to U.S. taxation. As a result, the Company expects to repatriate a substantial portion of its foreign earnings over time, to the extent that the foreign earnings are not restricted by local laws or result in significant incremental costs associated with repatriating the foreign earnings. The Company has recorded a provisional estimate for the transition tax on these earnings. Further developments in non-U.S. tax jurisdictions and unfavorable changes in non-U.S. tax laws and regulations, such as foreign tax laws enacted in response to the 2017 Tax Act, could result in adverse changes to global taxation and materially affect VMware’s financial position, results of operations, or annual effective tax rate.

Tax Sharing Agreement with Dell

On September 6, 2016, VMware entered into an amended tax sharing agreement with Dell, in connection with, and effective as of, the Dell Acquisition.

Although VMware’s results are included in the Dell consolidated return for U.S. federal income tax purposes, VMware’s income tax provision is calculated primarily as though VMware were a separate taxpayer. However, under certain circumstances, transactions between VMware and Dell are assessed using consolidated tax return rules.

VMware has made payments to Dell pursuant to the tax sharing agreement. The following table summarizes the payments made during the periods presented (table in millions):



							Transition Period
	For the Year Ended						January 1 to
	February 2,		December 31,		December 31,		February 3,
	2018		2016		2015		2017
Payments from VMware to Dell, net	$	54	$	373	$	144	$	—

Payments from VMware to Dell under the tax sharing agreement relate to VMware’s portion of federal income taxes on Dell’s consolidated tax return as well as state tax payments for combined states. The timing of the tax payments due to and from related parties is governed by the tax sharing agreement. The amounts that VMware pays to Dell for its portion of federal income taxes on Dell’s consolidated tax return differ from the amounts VMware would owe on a separate tax return basis and the difference is recognized as a component of additional paid-in capital, generally in the period in which the consolidated return is filed. The difference between the amount of tax calculated on a separate return basis and the amount of tax calculated pursuant to the tax sharing agreement was not significant during the year ended February 2, 2018 and during the Transition Period. During the years ended December 31, 2016 and December 31, 2015, the difference between the amount of tax calculated on a separate return basis and the amount of tax calculated pursuant to the tax sharing agreement was recorded in additional paid-in capital as an increase of $15 million and $13 million, respectively.

As a result of the activity under the tax sharing agreement with Dell, amounts due to and from Dell, net as of the periods presented consisted of the following (table in millions):



	February 2,		February 3,
	2018		2017
Income tax due to Dell	$	781	$	21

Income tax due to Dell as of February 2, 2018, primarily related to VMware’s estimated tax obligation resulting from the mandatory one-time transition tax on accumulated earnings of foreign subsidiaries under the 2017 Tax Act. The 2017 Tax Act includes a deferral election for an eight-year installment payment method on transition tax obligations. The Company currently expects to pay its transition tax obligation over a period of eight years.

Unrecognized Tax Benefits

A reconciliation of the beginning and ending amount of gross unrecognized tax benefits, excluding interest and penalties associated with unrecognized tax benefits, is as follows (table in millions):



										Transition Period
	For the Year Ended									January 1 to
	February 2,			December 31,			December 31,			February 3,
	2018			2016			2015			2017
Balance, beginning of the year/period	$	263		$	245		$	190		$	260
Tax positions related to current year/period:
Additions	63			45			41			3
Tax positions related to prior years/period:
Additions	1			9			54			—
Reductions	(2		)	(8		)	(14		)	(1		)
Settlements	(9		)	(16		)	(12		)	—
Reductions resulting from a lapse of the statute of limitations	(24		)	(14		)	(11		)	—
Foreign currency effects	10			(1		)	(3		)	1
Balance, end of the year/period	$	302		$	260		$	245		$	263

Of the net unrecognized tax benefits, including interest and penalties, of $208 million and $281 million as of February 2, 2018 and February 3, 2017, respectively, approximately $185 million and $263 million, respectively, would, if recognized, benefit VMware's annual effective income tax rate. The $208 million and $281 million of net unrecognized tax benefits are included in income tax payable on the consolidated balance sheets as of February 2, 2018 and February 3, 2017, respectively. VMware includes interest expense and penalties related to income tax matters in the income tax provision. VMware had accrued $41 million and $45 million of interest and penalties associated with unrecognized tax benefits as of February 2, 2018 and of February 3, 2017, respectively. Income tax expense included interest and penalties associated with uncertain tax positions, which were not significant during the year ended February 2, 2018 and the Transition Period, and were $10 million and $13 million during the years ended December 31, 2016 and December 31, 2015, respectively.

The Dell-owned EMC consolidated group is routinely under audit by the Internal Revenue Service (“IRS”). All U.S. federal income tax matters have been concluded for years through 2011, except for any matters under appeal. In addition, VMware is under corporate income tax audits in various states and non-U.S. jurisdictions. Consistent with the Company’s historical practices under the tax sharing agreement with EMC, when VMware becomes subject to federal tax audits as a member of Dell’s consolidated group, the tax sharing agreement provides that Dell has authority to control the audit and represent Dell’s and VMware’s interests to the IRS.

Open tax years subject to examinations for larger non-U.S. jurisdictions vary beginning in 2008. Open tax years for Ireland, the largest non-U.S. jurisdiction, begin in 2010. Audit outcomes and the timing of audit settlements are subject to significant uncertainty. When considering the outcomes and the timing of tax examinations, the expiration of statutes of limitations for specific jurisdictions, or the timing and result of ruling requests from taxing authorities, it is reasonably possible that total net unrecognized tax benefits could be potentially reduced by approximately $23 million within the next 12 months.