ROCKWELL COLLINS INC

Income Taxes

Income tax expense from continuing operations was calculated based on the following components of income before income taxes:



(in millions)	2017		2016		2015
U.S. income	$	688	$	824	$	835
Non-U.S. income	243		111		127
Total	$	931	$	935	$	962

The components of income tax expense from continuing operations are as follows:



(in millions)	2017			2016		2015
Current:
U.S. federal	$	97		$	120	$	169
Non-U.S.	68			29		38
U.S. state and local	18			11		11
Total current	183			160		218
Deferred:
U.S. federal	48			47		49
Non-U.S.	(5		)	—		(4		)
U.S. state and local	—			1		5
Total deferred	43			48		50
Income tax expense	$	226		$	208	$	268

The effective income tax rate from continuing operations differed from the U.S. statutory tax rate as detailed below:



	2017		2016		2015
Statutory tax rate	35.0	%	35.0	%	35.0	%
Foreign rate differential	(5.5	)	(0.7	)	(1.0	)
State and local income taxes	1.6		1.1		1.2
Research and development credit	(5.0	)	(6.4	)	(3.2	)
Domestic manufacturing deduction	(2.1	)	(2.0	)	(2.0	)
Tax settlements	(0.1	)	—		(1.6	)
Change in valuation allowance	0.1		(4.5	)	—
Other	0.3		(0.3	)	(0.5	)
Effective income tax rate	24.3	%	22.2	%	27.9	%

The Company's operations in the Philippines have been granted various tax incentives that will begin to expire in 2018, unless extended. The tax holiday allows for tax-free operations through various dates based on product lines, followed by a reduced income tax rate of 5 percent. Net income for 2017 increased $8 million ($0.05 per share) as a result of the tax holiday.

Net long-term deferred income tax benefits (liabilities) consist of the tax effects of temporary differences related to the following:



	September 30
(in millions)	2017			2016
Inventory	$	(276	)	$	(282	)
Product warranty costs	45			29
Customer incentives	66			68
Contract reserves	49			6
Retirement benefits	400			549
Intangibles	(602		)	(171		)
Capital lease liability	19			20
Property	(196		)	(179		)
Stock-based compensation	37			33
Deferred compensation	27			16
Capital loss carryover	—			41
Compensation and benefits	38			28
Research and development credit carryforward	25			—
Valuation allowance	(23		)	—
Other	81			60
Deferred income taxes, net	$	(310	)	$	218

Management believes it is more likely than not that the deferred tax assets, except for certain net operating loss carryforwards and tax credit carryforwards, will be realized through the reduction of future taxable income. Significant factors considered by management in its determination of the probability of the realization of the deferred tax assets include: (a) the historical operating results of the Company ($2.007 billion of U.S. taxable income over the past three years), (b) expectations of future earnings, (c) the extended period of time over which the retirement benefit liabilities will be paid and (d) our ability to implement tax planning strategies.

As of September 30, 2017, the Company had state net operating loss carryforwards of $102 million which begin expiring in 2018, state tax credit carryforwards of $32 million which begin expiring in 2022, and a foreign tax credit carryforward of $68 million which will expire in 2027.

Changes in the valuation allowance for deferred tax assets are summarized as follows:



	September 30
(in millions)	2017		2016			2015
Balance at beginning of year	$	—	$	42		$	43
Charged to costs and expenses	1		—			—
B/E Aerospace acquisition	22		—			—
Deductions⁽¹⁾	—		(42		)	(1		)
Balance at September 30	$	23	$	—		$	42

⁽¹⁾ 2016 deduction of $42 million was primarily due to the creation of a tax planning strategy

The Company's U.S. Federal income tax returns for the tax year ended September 30, 2013 and prior years have been audited by the IRS and are closed to further adjustments by the IRS. The IRS is currently auditing the Company's tax returns for the years ended September 30, 2014 and 2015. The IRS is currently auditing the legacy tax filings of certain acquired subsidiaries for the 2014 calendar year. The Company is also currently under audit in various U.S. states and non-U.S. jurisdictions. The U.S. states and non-U.S. jurisdictions have statutes of limitations generally ranging from 3 to 5 years. The Company believes it has adequately provided for any tax adjustments that may result from the various audits.

No provision has been made as of September 30, 2017 for U.S. federal or state income taxes, or additional non-U.S. income taxes related to approximately $972 million of undistributed earnings of non-U.S. subsidiaries which have been or are intended to be permanently reinvested. Thus, it is not practicable to estimate the amount of tax that might be payable on the undistributed earnings.

The Company had net income tax payments of $230 million, $130 million and $182 million in 2017, 2016 and 2015, respectively.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:



	September 30
(in millions)	2017			2016			2015
Beginning balance	$	45		$	39		$	48
Additions for tax positions related to the current year	73			11			8
Additions for tax positions of prior years	1			7			6
Additions for tax positions related to acquisitions	86			—			—
Reductions for tax positions of prior years	(1		)	(10		)	(17		)
Reductions for tax positions of prior years related to lapse of statute of limitations	—			—			(1		)
Reductions for tax positions related to settlements with taxing authorities	(3		)	(2		)	(5		)
Ending balance	$	201		$	45		$	39

The total amount of unrecognized tax benefits that, if recognized, would affect the effective income tax rate was $169 million, $20 million and $11 million as of September 30, 2017, 2016 and 2015, respectively. Although the timing and outcome of tax settlements are uncertain, it is reasonably possible that during the next 12 months a reduction in unrecognized tax benefits may occur in the range of $0 to $23 million based on the outcome of tax examinations or as a result of the expiration of various statutes of limitations.

The Company includes income tax-related interest and penalties in income tax expense. The total amount of interest and penalties recognized within Other Liabilities in the Consolidated Statement of Financial Position were $8 million and $2 million as of September 30, 2017 and 2016, respectively. The total amount of interest and penalties recorded as an expense or (income) within Income tax expense in the Consolidated Statement of Operations was not significant for the years ended September 30, 2017, 2016 and 2015.