NOTE 9. INCOME TAXES
The components of income from continuing operations before income taxes consisted of the following:
| (In millions) | 2017 | 2016 | 2015 | |||||||||
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United States |
$ | 295 | $ | 445 | $ | 122 | ||||||
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Foreign |
4 | 14 | (7 | ) | ||||||||
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Total income from continuing operations before income taxes |
$ | 299 | $ | 459 | $ | 115 | ||||||
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The income tax expense related to income from continuing operations consisted of the following:
| (In millions) | 2017 | 2016 | 2015 | |||||||||
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Current: |
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Federal |
$ | 4 | $ | 17 | $ | 18 | ||||||
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State |
3 | 6 | 4 | |||||||||
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Foreign |
9 | 3 | 1 | |||||||||
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Deferred: |
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Federal |
152 | (210 | ) | (1 | ) | |||||||
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State |
(17 | ) | (37 | ) | 2 | |||||||
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Foreign |
2 | 1 | (1 | ) | ||||||||
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Total income tax expense (benefit) |
$ | 153 | $ | (220 | ) | $ | 23 | |||||
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The following is a reconciliation of income taxes at the U.S. Federal statutory rate to the provision for income taxes:
| (In millions) | 2017 | 2016 | 2015 | |||||||||
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Federal tax computed at the statutory rate |
$ | 105 | $ | 160 | $ | 40 | ||||||
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State taxes, net of Federal benefit |
12 | (20 | ) | 5 | ||||||||
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Foreign income taxed at rates other than Federal |
2 | — | 6 | |||||||||
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Increase (decrease) in valuation allowance |
(36 | ) | (349 | ) | (46 | ) | ||||||
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Non-deductible Merger expenses |
3 | — | 11 | |||||||||
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Other non-deductible expenses |
— | 3 | 4 | |||||||||
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Non-taxable income and additional deductible expenses |
(4 | ) | (13 | ) | (2 | ) | ||||||
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Change in unrecognized tax benefits |
— | (3 | ) | — | ||||||||
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Impact of Tax Reform |
68 | — | — | |||||||||
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Impact of stock compensation shortfall |
3 | — | — | |||||||||
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Repatriation of foreign earnings |
3 | — | 6 | |||||||||
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Subpart F and dividend income, net of foreign tax credits |
— | 2 | 1 | |||||||||
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Other items, net |
(3 | ) | — | (2 | ) | |||||||
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Income tax expense (benefit) |
$ | 153 | $ | (220 | ) | $ | 23 | |||||
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The Company’s effective tax rates have varied considerably from period to period as a result of several factors, including 1) the mix of income and losses across U.S. and non-U.S. jurisdictions, and 2) the recognition of valuation allowances against deferred tax assets that were not more-likely-than-not realizable in the U.S. and certain non-U.S. jurisdictions. During 2017 and 2016 the majority of our deferred tax assets that previously were not realizable, became realizable, thereby, causing significant reductions in previously established valuation allowances. These factors have resulted in the Company’s effective tax rates being 51% for 2017, (48%) for 2016 and 20% for 2015, respectively.
On December 22, 2017, President Trump signed into law the legislation generally known as Tax Cut and Jobs Act of 2017. The tax law includes significant changes to the U.S. corporate tax systems including a rate reduction from 35% to 21% beginning in January of 2018, a change in the treatment of foreign earnings going forward and a deemed repatriation transition tax. In accordance with ASC 740, “Income Taxes”, the impact of a change in tax law is recorded in the period of enactment. During the fourth quarter of 2017, the Company recorded a material, non-cash, change in its net deferred income tax balances of approximately $68 million related to the tax rate change. The Company estimates that its deemed repatriation liability will not be material due to its limited International operations.
During the third quarter of 2017 and 2016, the Company concluded that it was more likely than not that a benefit from a significant portion of its U.S. federal and state deferred tax assets would be realized. These conclusions were based on detailed evaluations of all available positive and negative evidence and the weight of such evidence, the current financial position and results of operations for the current and preceding years, and the expectation of continued earnings. The Company determined that approximately $36 million of its U.S. federal and state valuation allowance should be reduced in 2017. The Company determined that approximately $382 million of its U.S. federal and state valuation allowance should be reduced in 2016.
The Company operates in several foreign jurisdictions with income tax rates that differ from the U.S. Federal statutory rate, which resulted in an expense for all years presented in the effective tax rate reconciliation. Significant foreign tax jurisdictions for which the Company realized such expense are Canada and Puerto Rico after the sale of the other international operations.
The components of deferred income tax assets and liabilities consisted of the following:
| (In millions) |
December 30, 2017 |
December 31, 2016 |
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U.S. and foreign loss carryforwards |
$ | 253 | $ | 275 | ||||
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Deferred rent credit |
33 | 61 | ||||||
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Pension and other accrued compensation |
50 | 134 | ||||||
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Accruals for facility closings |
8 | 29 | ||||||
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Inventory |
13 | 20 | ||||||
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Self-insurance accruals |
24 | 29 | ||||||
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Deferred revenue |
20 | 24 | ||||||
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U.S. and foreign income tax credit carryforwards |
237 | 197 | ||||||
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Allowance for bad debts |
4 | 5 | ||||||
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Accrued expenses |
19 | 28 | ||||||
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Basis difference in fixed assets |
46 | 69 | ||||||
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Other items, net |
— | 5 | ||||||
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Gross deferred tax assets |
707 | 876 | ||||||
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Valuation allowance |
(144) | (140) | ||||||
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Deferred tax assets |
563 | 736 | ||||||
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Internal software |
6 | 5 | ||||||
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Installment gain on sale of timberlands |
172 | 260 | ||||||
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Intangibles |
96 | — | ||||||
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Undistributed foreign earnings |
5 | 8 | ||||||
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Deferred tax liabilities |
279 | 273 | ||||||
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Net deferred tax assets |
$284 | $463 | ||||||
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As of December 30, 2017, and December 31, 2016, deferred income tax liabilities amounting to $21 million and $3 million, respectively, are included in Deferred income taxes and other long-term liabilities.
As of December 30, 2017, the Company has utilized all of its U.S. Federal net operating loss (“NOL”) carryforwards with the exception the NOLs acquired as part of the CompuCom acquisition. The Company has $155 million of Federal, $98 million of foreign and $1.3 billion of state NOL carryforwards. Of the Federal NOL carryforwards, $5 million will expire in 2018 with the remainder expiring between 2019 and 2033. Of the foreign NOL carryforwards, $41 million can be carried forward indefinitely, none will expire in 2018 and the remaining balance will expire between 2019 and 2037. Of the state NOL carryforwards, $15 million will expire in 2018, and the remaining balance will expire between 2019 and 2037. The Company has Federal capital loss carryover available to offset future capital gains generated of $559 million which expires in 2021 and 2022, and state capital loss carryforwards of $519 million which expire in 2021 and 2022. The Company also has $89 million of U.S. Federal alternative minimum tax credit carryforwards, which can be used to reduce future regular federal income tax, if any, over an indefinite period. In addition, due to the enactment of new legislation, a portion of the credits can be refunded in future tax years.
Additionally, the Company has $134 million of U.S. Federal foreign tax credit carryforwards, which expire between 2019 and 2027, and $14 million of state and foreign tax credit carryforwards, $2 million of which can be carried forward indefinitely, and the remaining balance will expire between 2023 and 2027.
As of December 30, 2017, the Company has not triggered an “ownership change” as defined in Internal Revenue Code Section 382 or other similar provisions that would limit the use of NOL and tax credit carryforwards. However, the Company did acquire certain NOLs and other credit carryforwards that may be limited as a result of the purchase. However, if the Company were to experience an ownership change in future periods, the Company’s deferred tax assets and income tax expense may be negatively impacted. Deferred income taxes have been provided on all undistributed earnings of foreign subsidiaries.
The following summarizes the activity related to valuation allowances for deferred tax assets:
| (In millions) | 2017 | 2016 | 2015 | |||||||||
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Beginning balance |
$ | 140 | $ | 522 | $ | 571 | ||||||
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Additions, charged to expense |
4 | — | — | |||||||||
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Acquired via Merger |
1 | — | — | |||||||||
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Impact of Tax Reform |
40 | — | — | |||||||||
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Reductions |
(41 | ) | (382 | ) | (49 | ) | ||||||
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Ending balance |
$ | 144 | $ | 140 | $ | 522 | ||||||
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The Company had significant deferred tax assets in the U.S. against which valuation allowances have been established to reduce such deferred tax assets to the 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. An accumulation of recent pre-tax losses is considered strong negative evidence in that evaluation. As of the third quarter of 2016, the Company concluded that it was more likely than not that a benefit from a substantial portion of its U.S. federal and state deferred tax assets would be realized. This conclusion was based on a detailed evaluation of all available positive and negative evidence and the weight of such evidence, the current financial position and results of operations for the current and preceding years, and the expectation of continued earnings. The Company determined that approximately $382 million of its U.S. federal and state valuation allowance should be reduced in 2016.
After the 2016 reduction, the Company had a U.S. valuation allowance for certain U.S. federal credits and certain state tax attributes. The remaining valuation allowances relate to deferred tax assets that require certain types of income or for income to be earned in certain jurisdictions in order to be realized. It is reasonably possible that a portion of the remaining valuation allowance may be released in the future based upon continued profitability. The Company will continue to assess the realizability of its deferred tax assets in the U.S. and remaining foreign jurisdictions in future periods.
The Company’s total valuation allowance increased during 2017 due to several factors. A portion of the deferred assets acquired as part of the CompuCom deal had existing valuation allowances that increased the Company’s balance. The Company recognized a net income tax benefit of $36 million associated with the reduction of valuation allowances in the U.S. federal and state jurisdictions offset by the establishment of valuation allowances in the U.S. and certain jurisdictions that the Company does not expect to be profitable. As a result of the recently enacted legislation, the Company reestablished a valuation allowance of $40 million on certain of its Federal credits offset by a reduction in the required valuation allowances due to the statutory rate change.
The following table summarizes the activity related to unrecognized tax benefits:
| (In millions) | 2017 | 2016 | 2015 | |||||||||
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Beginning balance |
$ | 14 | $ | 18 | $ | 22 | ||||||
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Increase related to current year tax positions |
— | 1 | 1 | |||||||||
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Increase related to merger |
8 | — | 1 | |||||||||
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Decrease related to prior year tax positions |
(1 | ) | — | (5 | ) | |||||||
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Decrease related to lapse of statute of limitations |
— | — | (1 | ) | ||||||||
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Decrease related to settlements with taxing authorities |
(1 | ) | (5 | ) | — | |||||||
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Ending balance |
$ | 20 | $ | 14 | $ | 18 | ||||||
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Due to the completion of the Internal Revenue Service (“IRS”) examination for 2014, the Company’s balance of unrecognized tax benefits decreased by $4 million during 2016, which did impact income tax expense by $3 million due to an offsetting change in valuation allowance. Included in the balance of $20 million at December 30, 2017, are $10 million of unrecognized tax benefits that, if recognized, would affect the effective tax rate. The difference of $10 million primarily results from tax positions which if sustained would be offset by changes in deferred tax assets. It is not anticipated that certain tax positions will be resolved within the next 12 months, which would decrease the Company’s balance of unrecognized tax benefits. As part of the CompuCom acquisition, the Company’s unrecognized tax benefits increased by $8 million. Approximately, $3 million of the unrecognized tax benefit is currently covered under an indemnification agreement with a predecessor owner of CompuCom. Additionally, the Company anticipates that it is reasonably possible that new issues will be raised or resolved by tax authorities that may require changes to the balance of unrecognized tax benefits; however, an estimate of such changes cannot reasonably be made.
The Company recognizes interest related to unrecognized tax benefits in interest expense and penalties in the provision for income taxes. The Company recognized immaterial interest and penalty expense in 2017 and interest and penalty expense of $3 million and $2 million in 2016 and 2015, respectively. The Company had approximately $7 million accrued for the payment of interest and penalties as of December 30, 2017, including $1 million acquired as part of the CompuCom merger, which is not included in the table above.
The Company files a U.S. federal income tax return and other income tax returns in various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal and state and local income tax examinations for years before 2014 and 2009, respectively. During 2015, the IRS examination of the OfficeMax 2012 U.S. federal income tax return concluded, which resulted in a $6 million decrease in tax credit carryforwards. Such decrease had no impact on income tax expense due to an offsetting change in valuation allowance. The acquired OfficeMax U.S. consolidated group is no longer subject to state and local income tax examinations for years before 2007, respectively. The U.S. federal income tax returns for 2016 are currently under review. Generally, the Company is subject to routine examination for years 2009 and forward in its international tax jurisdictions.