INCOME TAXES
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| | | | | | | | | | | | |
millions | | 2017 | | 2016 | | 2015 |
Loss before income taxes: | | | | | | |
U.S. | | $ | (1,012 | ) | | $ | (2,429 | ) | | $ | (1,420 | ) |
Foreign | | 31 |
| | 34 |
| | 35 |
|
Total | | $ | (981 | ) | | $ | (2,395 | ) | | $ | (1,385 | ) |
| | |
| | |
| | |
|
Income tax benefit: | | |
| | |
| | |
|
Current: | | |
| | |
| | |
|
Federal | | $ | 9 |
| | $ | 13 |
| | $ | 11 |
|
State and local | | (3 | ) | | 16 |
| | 20 |
|
Foreign | | 13 |
| | 18 |
| | 17 |
|
Total current | | 19 |
| | 47 |
| | 48 |
|
| | | | |
| | |
|
Deferred: | | | | |
| | |
|
Federal | | (429 | ) | | (87 | ) | | (239 | ) |
State and local | | (187 | ) | | (134 | ) | | (66 | ) |
Foreign | | (1 | ) | | — |
| | — |
|
Total deferred | | (617 | ) | | (221 | ) | | (305 | ) |
Total | | $ | (598 | ) | | $ | (174 | ) | | $ | (257 | ) |
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| | | | | | | | | |
| | 2017 | | 2016 | | 2015 |
Effective tax rate reconciliation: | | | | | | |
Federal income tax rate (benefit rate) | | (33.7 | )% | | (35.0 | )% | | (35.0 | )% |
State and local tax (benefit) net of federal tax benefit | | (11.8 | ) | | (3.0 | ) | | (1.8 | ) |
Federal tax rate change | | (22.6 | ) | | — |
| | — |
|
Federal and state valuation allowance | | 21.2 |
| | 41.1 |
| | 37.4 |
|
Land and indefinite-lived intangibles | | (12.1 | ) | | (0.2 | ) | | (16.9 | ) |
Impairment of indefinite-lived trade names | | (1.8 | ) | | (6.0 | ) | | (4.9 | ) |
Loss disallowance | | — |
| | — |
| | 3.5 |
|
Tax credits | | (0.4 | ) | | (0.3 | ) | | (0.7 | ) |
Resolution of income tax matters | | (0.8 | ) | | — |
| | (0.3 | ) |
Adjust foreign statutory rates | | (1.0 | ) | | 0.1 |
| | (0.3 | ) |
Repatriation toll charge | | 1.8 |
| | — |
| | — |
|
Tax benefit resulting from other comprehensive income allocation | | — |
| | (2.9 | ) | | — |
|
Other | | 0.2 |
| | (1.1 | ) | | 0.4 |
|
| | (61.0 | )% | | (7.3 | )% | | (18.6 | )% |
|
| | | | | | | | |
millions | | February 3,
2018 | | January 28,
2017 |
Deferred tax assets and liabilities: | | | | |
Deferred tax assets: | | | | |
Federal benefit for state and foreign taxes | | $ | 117 |
| | $ | 148 |
|
Accruals and other liabilities | | 142 |
| | 135 |
|
Net operating loss carryforwards | | 1,736 |
| | 2,255 |
|
Pension and postretirement benefit plans | | 972 |
| | 1,244 |
|
Property and equipment | | 139 |
| | 231 |
|
Deferred income | | 266 |
| | 479 |
|
Credit carryforwards | | 899 |
| | 875 |
|
Other | | 208 |
| | 218 |
|
Total deferred tax assets | | 4,479 |
| | 5,585 |
|
Valuation allowance | | (4,187 | ) | | (5,519 | ) |
Net deferred tax assets | | 292 |
| | 66 |
|
| | |
| | |
|
Deferred tax liabilities: | | |
| | |
|
Trade names/Intangibles | | 285 |
| | 573 |
|
Inventory | | 105 |
| | 193 |
|
Other | | 28 |
| | 43 |
|
Total deferred tax liabilities | | 418 |
| | 809 |
|
Net deferred tax liability | | $ | (126 | ) | | $ | (743 | ) |
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the "Tax Act"). The Tax Act makes broad and complex changes to the U.S. tax code that will affect our fiscal year ended February 3, 2018, including, but not limited to, (1) reducing the U.S. federal corporate tax rate to 21%, (2) requiring a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries that is payable over eight years and (3) various other miscellaneous changes that are effective in fiscal 2017. With the lower U.S. federal corporate rate effective beginning January 1, 2018, our U.S. federal corporate tax rate for 2017 is a blended rate of 33.717%.
In addition to the 21% reduced federal corporate tax rate, the Tax Act also establishes new tax laws that will affect fiscal 2018, including, but not limited to, (1) the creation of the base erosion anti-abuse tax ("BEAT"), a new minimum tax; (2) a general elimination of U.S. federal income taxes on dividends from foreign subsidiaries; (3) a new provision designed to tax global intangible low-taxed income ("GILTI"); (4) a new limitation on deductible interest expense; (5) limitations on the deductibility of certain executive compensation; (6) limitations on the use of foreign tax credits ("FTCs") to reduce the U.S. income tax liability; and (7) limitations on net operating losses ("NOLs") generated in tax years beginning after December 31, 2017, to 80% of taxable income with indefinite carryovers.
The SEC staff issued Staff Accounting Bulletin ("SAB") 118, which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting in accordance with accounting standards applicable to income taxes. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under accounting standards applicable to income taxes is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply accounting standards applicable to income taxes on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.
The income tax benefit for the period ended February 3, 2018 included a tax benefit of approximately $470 million related to the impacts of the Tax Act. The impacts of the Tax Act primarily consist of a net benefit for the corporate rate reduction of $222 million, a net tax benefit for the valuation allowance release of $270 million, and a net expense for the transition tax of $11 million.
For various reasons that are discussed below, our accounting for the following elements of the Tax Act is incomplete. However, we were able to make reasonable estimates of certain effects and, therefore, recorded provisional adjustments as follows:
Reduction of U.S. federal corporate tax rate: As a result of the reduced corporate rate, our deferred tax assets, liabilities and valuation allowance decreased. Further, as we had a net deferred tax liability after valuation allowance, these decreases resulted in a deferred income tax benefit of $222 million for the year ended February 3, 2018. While we were able to make a reasonable estimate of the impact of the reduction in the corporate rate, it may be affected by other analyses related to the Tax Act, including, but not limited to, our calculation of deemed repatriation of deferred foreign income and state tax effect of adjustments made to federal temporary differences.
Deemed Repatriation Transition Tax: The Deemed Repatriation Transition Tax ("Transition Tax") is a tax on previously untaxed accumulated and current earnings and profits ("E&P") of certain of our foreign subsidiaries. To determine the amount of the Transition Tax, we must determine, in addition to other factors, the amount of post-1986 E&P of the relevant subsidiaries, as well as the amount of non-U.S. income taxes paid on such earnings. We are able to make a reasonable estimate of the Transition Tax and recorded a provisional Transition Tax obligation of $6 million and a provisional withholding tax obligation of $11 million. As a result of our valuation allowance on NOLs, only the $11 million withholding tax obligation resulted in a current tax expense. However, we are continuing to gather additional information to more precisely compute the amount of the Transition Tax.
Valuation Allowances: The Company assessed whether its valuation allowance analyses are affected by various aspects of the Tax Act (e.g., deemed repatriation of deferred foreign income, new categories of FTCs, and other miscellaneous provisions of the Tax Act), any corresponding determination of the need for or change in a valuation allowance is also provisional.
Global Intangible Low Taxes Income (GILTI): The Tax Act creates a new requirement that certain income (i.e., GILTI) earned by controlled foreign corporations ("CFCs") must be included currently in the gross income of the CFC’s U.S. shareholder. GILTI is the excess of the shareholder’s "net CFC tested income" over the net deemed tangible income return, which is currently defined as the excess of (1) 10% of the aggregate of the U.S. shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder over (2) the amount of certain interest expense taken into account in the determination of net CFC-tested income.
Because of the complexity of the new GILTI tax rules, we are continuing to evaluate this provision of the Tax Act and the application of accounting standards applicable to income taxes. In accordance with accounting standards applicable to income taxes, we are allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the "period cost method") or (2) factoring such amounts into a company’s measurement of its deferred taxes (the "deferred method"). We selected the period cost method.
Income tax expense or benefit from continuing operations is generally determined without regard to other categories of earnings, such as discontinued operations and other comprehensive income ("OCI"). An exception is provided in the authoritative accounting guidance when there is income from categories other than continuing operations and a loss from continuing operations in the current year. In this case, the tax benefit allocated to continuing operations is the amount by which the loss from continuing operations reduces the tax expense recorded with respect to the other categories of earnings, even when a valuation allowance has been established against the deferred tax assets. In instances where a valuation allowance is established against current year losses, income from other sources, including gain from pension and other postretirement benefits recorded as a component of OCI and creation of a deferred tax liability through additional paid in capital, is considered when determining whether sufficient future taxable income exists to realize the deferred tax assets. As a result, for the year ended January 28, 2017, the Company recorded a tax expense of $71 million in OCI related to the net gain on pension and other postretirement benefits, and recorded a corresponding tax benefit of $71 million in continuing operations. The Company did not have this situation for the year ended February 3, 2018.
Accounting standards for income taxes require that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the financial reporting and tax bases of recorded assets and liabilities. Accounting standards also require that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion of or all of the deferred tax asset will not be realized.
Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to use the existing deferred tax assets. A significant piece of objective negative evidence evaluated was the cumulative loss incurred over the three-year periods ended February 3, 2018, January 28, 2017 and January 30, 2016. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future income.
On the basis of this analysis and the significant negative objective evidence, the Company has a valuation allowance to record only the portion of the deferred tax asset that more likely than not will be realized. For the year ended January 30, 2016, the valuation allowance increased by $279 million of which $63 million was recorded through other comprehensive income. For the year ended January 28, 2017, the valuation allowance increased by $762 million of which $3 million was recorded through other comprehensive income and paid in capital. For the year ended February 3, 2018, the valuation allowance decreased by $1.3 billion, primarily due to the reduction of the U.S. corporate tax rate from 35% to 21% and the re-characterization of future net operating losses to indefinite life resulting in a valuation allowance release of 80% of our remaining indefinite life deferred tax liability. Included within the net decrease in the valuation allowance was an increase of $62 million recorded through other comprehensive income.
At February 3, 2018 and January 28, 2017, we had a valuation allowance of $4.2 billion and $5.5 billion, respectively. The amount of the deferred tax asset considered realizable, however, could be adjusted in the future if estimates of future taxable income during the carryforward period are reduced or increased, or if the objective negative evidence in the form of cumulative losses is no longer present and additional weight may be given to subjective evidence such as our projections for growth. We will continue to evaluate our valuation allowance in future years for any change in circumstances that causes a change in judgment about the realizability of the deferred tax asset.
At the end of 2017 and 2016, respectively, we had a federal and state net operating loss ("NOL") deferred tax asset of $1.7 billion and $2.3 billion, which will expire predominately between 2019 and 2037. We have credit carryforwards of $899 million, which will expire between 2018 and 2037.
In connection with the Craftsman Sale in the first quarter of 2017, the Company realized a tax benefit of $101 million on the deferred taxes related to the indefinite-life intangible for the trade name sold to Stanley Black & Decker. In addition, the Company incurred a taxable gain of approximately $963 million. There was no federal income tax payable resulting from the taxable gain due to the utilization of NOL tax attributes of approximately $361 million with a valuation allowance release of the same amount. However, there was state income tax of $4 million payable after the utilization of state tax attributes.
In July, 2016, the Company sold shares of an investment for $106 million. The sale resulted in a U.S. taxable gain of $105 million, but no current income tax is payable due to the utilization of NOL attributes of $37 million with a valuation allowance release of the same amount.
On July 7, 2015, Holdings completed the Seritage transaction. As part of the transaction, Holdings sold 235 properties to Seritage along with Holdings' 50% interests in the JVs, which hold an additional 31 properties (See Note 11 for additional information and defined terms).
In connection with the Seritage transaction and the JV transactions, the Company realized a tax benefit of $229 million on the deferred taxes related to the indefinite-life assets associated with the property sold. In addition, the Company incurred a taxable gain of approximately $2.2 billion, taking into account any related party loss disallowance, on these transactions. There was no federal income tax payable resulting from the taxable gain due to the utilization of NOL tax attributes of approximately $856 million with a valuation allowance release of the same amount. However, there was a minor amount of state and city income tax payable of $4 million after the utilization of state and city tax attributes. As a result of all the effects from the Seritage transaction and the JV transactions in 2015, the impact to the net valuation allowance was a release of approximately $500 million.
Accounting for Uncertainties in Income Taxes
We are present in a large number of taxable jurisdictions, and at any point in time, can have audits underway at various stages of completion in any of these jurisdictions. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by federal, foreign and/or local authorities and may not be fully sustained, despite our belief that the underlying tax positions are fully supportable. Unrecognized tax benefits are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law, and closing of statute of limitations. Such adjustments are reflected in the tax provision as appropriate. While we do not expect material changes, it is possible that the amount of unrecognized benefit with respect to our uncertain tax positions will significantly increase or decrease within the next 12 months related to the audits described above. At this time, our estimated range of impact on the balance of unrecognized tax benefits for 2018 is a change of $1 million to $14 million, which would impact the effective tax rate by $1 million to $11 million. A reconciliation of the beginning and ending amount of gross unrecognized tax benefits ("UTB") is as follows:
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| | | | | | | | | | | | |
| | Federal, State and Foreign Tax |
millions | | February 3,
2018 | | January 28,
2017 | | January 30, 2016 |
Gross UTB Balance at Beginning of Period | | $ | 142 |
| | $ | 137 |
| | $ | 131 |
|
Tax positions related to the current period: | | |
| | |
| | |
|
Gross increases | | 20 |
| | 12 |
| | 14 |
|
Gross decreases | | — |
| | — |
| | — |
|
Tax positions related to prior periods: | | | | |
| | |
|
Gross increases | | — |
| | — |
| | — |
|
Gross decreases | | (26 | ) | | — |
| | — |
|
Settlements | | (1 | ) | | — |
| | — |
|
Lapse of statute of limitations | | (5 | ) | | (7 | ) | | (8 | ) |
Gross UTB Balance at End of Period | | $ | 130 |
| | $ | 142 |
| | $ | 137 |
|
At the end of 2017, we had gross unrecognized tax benefits of $130 million. Of this amount, $103 million would, if recognized, impact our effective tax rate, with the remaining amount being comprised of unrecognized tax benefits related to indirect tax benefits. During 2017 and 2016, the gross unrecognized tax benefits increased by $20 million and $12 million, respectively, due to current year accruals for existing tax positions. We expect that our unrecognized tax benefits could decrease up to $10 million over the next 12 months for tax audit settlements and the expiration of the statute of limitations for certain jurisdictions.
We classify interest expense and penalties related to unrecognized tax benefits and interest income on tax overpayments as components of income tax expense. At February 3, 2018 and January 28, 2017, the total amount of interest and penalties recognized within the related tax liability in our Consolidated Balance Sheet was $51 million ($40 million net of federal benefit) and $61 million ($40 million net of federal benefit), respectively. The total amount of net interest benefit recognized in our Consolidated Statements of Operations was $6 million in 2017. The total amount of net interest expense recognized in our Consolidated Statements of Operations was $3 million and $4 million in 2016 and 2015, respectively.
We file income tax returns in both the United States and various foreign jurisdictions. The U.S. Internal Revenue Service ("IRS") has completed its examination of all federal tax returns of Holdings through the 2009 return, and all matters arising from such examinations have been resolved. In addition, Holdings and Sears are under examination by various state, local and foreign income tax jurisdictions for the years 2003 through 2016, and Kmart is under examination by such jurisdictions for the years 2006 through 2016.