INCOME TAXES
Tax Reform - The Tax Act, signed into law on December 22, 2017, provides for significant changes to U.S. federal income tax law, including a provision that allows for full expensing of certain qualified property, reduction of the federal corporate income tax rate from 35.0% to 21.0%, repeal of the manufacturing deduction, and further limitations on the deductibility of certain executive compensation. The Tax Act contains other provisions that are not expected to materially affect the Company, including requiring a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries that is payable over eight years, limitations on the deductibility of interest expense, and the creation of the base erosion anti-abuse tax.
The SEC staff issued Staff Accounting Bulletin ("SAB") 118, which provides guidance on accounting for the tax effects of the Tax Act, including a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under Accounting Standards Codification ("ASC") 740, 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 ASC 740 is complete. Provisional estimates for the income tax effects of the Tax Act can be recorded where a company’s accounting is incomplete but a reasonable estimate can be determined. If a company cannot determine a provisional estimate for the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax law that were in effect immediately before enactment of the Tax Act.
There are no material elements of the Tax Act for which the Company’s accounting is complete. While the Company's accounting for the following elements of the Tax Act is incomplete, the Company was able to make reasonable estimates of certain effects of such elements. Accordingly, the Company recorded provisional adjustments for the following significant items:
Reduction of the U.S. federal corporate income tax rate: Beginning January 1, 2018, the Company’s income will be taxed at a 21.0% federal rate, in contrast to the previous rate of 35.0%. Under ASC 740, Income Taxes, deferred tax assets or liabilities must be recalculated as of the enactment date using current tax laws and rates expected to be in effect when the deferred tax items reverse in future periods. Consequently, the Company has recorded provisional decreases in its deferred tax assets and deferred tax liabilities of $252 million and $196 million, respectively, with a corresponding net adjustment to deferred income tax expense of $56 million for the year ended December 31, 2017. While the Company is able to make a reasonable estimate of the impact of the reduction in the U.S. federal rate, it may be affected by other analyses related to the Tax Act, including, but not limited to, accounting method changes for tax purposes that could result in adjustments to federal temporary differences.
Acceleration of Depreciation: While the Company has not completed its determination of all capital expenditures that qualify for immediate expensing, for the year ended December 31, 2017, the Company recorded a provisional benefit of $8 million based on its current intent to fully expense all qualifying expenditures. This resulted in a decrease of approximately $8 million to the Company's current income taxes payable and a corresponding decrease in its net deferred tax asset excluding the effect of the reduction in the U.S. federal corporate tax rate.
The Company’s accounting for the following element of the Tax Act is incomplete and the Company is not yet able to make a reasonable estimate of the effect. Accordingly, no provisional adjustment was recorded.
Executive Compensation: Effective January 1, 2018, the performance-based compensation exception to the $1 million deduction limitation of Internal Revenue Code Section 162(m) is repealed and the employees subject to the $1 million deduction limitation are revised to include the chief executive officer, the chief financial officer, and the next three most highly compensated employees required to be reported in the Company’s proxy statement. The only exception to this rule is for compensation that is paid pursuant to a binding contract in effect on November 2, 2017 that would have otherwise been deductible under prior Section 162(m) rules. Accordingly, any compensation paid in the future pursuant to new compensation arrangements entered into after November 2, 2017, even if performance based, will count toward the $1 million annual deduction limit if paid to an executive subject to Section 162(m). The Company has not yet completed an analysis of the binding contract requirement on the Company's various compensation plans to determine the impact of the law change.
The Company's earnings are primarily domestic and its effective tax rate on earnings from operations for the year ended December 31, 2017, was 38.0%, compared with 26.9% and 36.1% for 2016 and 2015, respectively.
For the year ended December 31, 2017, the Company's effective tax rate differed from the federal statutory rate primarily as a result of the increase in deferred federal tax expense attributable to the recalculation of the Company's net deferred tax asset to reflect the impact of the federal tax rate decrease included in the Tax Act, partially offset by the income tax benefits resulting from stock award settlement activity and the domestic manufacturing deduction. For the year ended December 31, 2016, the Company’s effective tax rate differed from the federal statutory rate primarily as a result of the adoption of ASU 2016-09, which reduced income tax expense by the income tax benefits resulting from stock award settlement activity, a remeasurement of uncertain tax positions that resulted in a decrease in cumulative unrecognized tax benefits, and the domestic manufacturing deduction. The Company’s effective tax rate for the year ended December 31, 2015, differed from the federal statutory rate primarily as a result of the amount of the goodwill impairment that is not amortizable for tax purposes and other non-deductible expenses, partially offset by the domestic manufacturing deduction.
Non-current state income taxes include deferred state income taxes, which reflect the change in deferred state tax assets and liabilities, and the tax expense or benefit associated with changes in state uncertain tax positions in the relevant period. These amounts are recorded within operating income. Current period state income tax expense is charged to contract costs and included in cost of sales and service revenues in segment operating income.
In connection with the spin-off from Northrop Grumman, HII entered into a Tax Matters Agreement with Northrop Grumman, which governs the respective rights, responsibilities, and obligations of Northrop Grumman and the Company with respect to tax liabilities and benefits, tax attributes, tax contests, and other tax sharing regarding U.S. federal, state, local, and foreign income taxes, other taxes, and related tax returns. The Company is severally liable with Northrop Grumman for its income taxes for periods before the spin-off. HII is obligated to indemnify Northrop Grumman for tax adjustments that increase the Company's taxable income for periods before the spin-off and are of a nature that could result in a correlative reduction in HII's taxable income for periods after the spin-off. Northrop Grumman is obligated to indemnify HII for tax adjustments that decrease the Company's taxable income for periods before the spin-off and are of a nature that could result in a correlative increase in HII's taxable income for periods after the spin-off. These payment obligations only apply once the aggregate tax liability related to tax adjustments exceeds $5 million. Once the aggregate amount is exceeded, only the amount in excess of $5 million is ultimately required to be paid. In 2016 and prior years, HII incurred non-cash federal and state tax adjustments for items governed by the Tax Matters Agreement. The federal tax expense (benefit) adjustment is reported as a component of tax expense, while the state tax expense (benefit) adjustment is treated as an allowable cost in the applicable period under the terms of the Company's existing contracts and is included in general and administrative expenses. In 2016, Northrop Grumman settled with the IRS for the years 2007 through the date of the spin-off, during which HII was part of its consolidated tax returns. Northrop Grumman’s 2007 through 2011 federal tax returns are currently subject to examination due to the filing of refund claims for those years.
Federal and foreign income tax expense for the years ended December 31, 2017, 2016, and 2015, consisted of the following:
|
| | | | | | | | | | | | |
| | Year Ended December 31 |
($ in millions) | | 2017 | | 2016 | | 2015 |
Income Taxes on Operations | | | | | | |
Federal and foreign income taxes currently payable | | $ | 121 |
| | $ | 134 |
| | $ | 242 |
|
Change in deferred federal and foreign income taxes | | 172 |
| | 77 |
| | (14 | ) |
Total federal and foreign income taxes | | $ | 293 |
| | $ | 211 |
| | $ | 228 |
|
Earnings and income tax from foreign operations are not material for all periods presented.
Income tax expense differed from the amount based on the statutory federal income tax rate applied to earnings (loss) before income taxes due to the following:
|
| | | | | | | | | | | | |
| | Year Ended December 31 |
($ in millions) | | 2017 | | 2016 | | 2015 |
Income tax expense (benefit) on operations at statutory rate | | $ | 270 |
| | $ | 274 |
| | $ | 221 |
|
Provisional deferred tax asset revaluation - Tax Act | | 56 |
| | — |
| | — |
|
Goodwill impairment | | — |
| | — |
| | 11 |
|
Stock compensation - net excess tax benefits | | (25 | ) |
| (29 | ) |
| — |
|
Manufacturing deduction | | (12 | ) | | (21 | ) | | (10 | ) |
Uncertain tax positions | | — |
|
| (15 | ) |
| — |
|
Other, Net | | 4 |
| | 2 |
| | 6 |
|
Total federal and foreign income taxes | | $ | 293 |
| | $ | 211 |
| | $ | 228 |
|
Unrecognized Tax Benefits - Unrecognized tax benefits represent the gross value of the Company's uncertain tax positions that have not been reflected in the consolidated statements of operations. If the income tax benefits from federal tax positions are ultimately realized, such realization would affect the Company's income tax expense, while the realization of state tax benefits would be recorded in general and administrative expenses.
The changes in unrecognized tax benefits (exclusive of interest and penalties) for the years ended December 31, 2017, 2016, and 2015 are summarized in the following table:
|
| | | | | | | | | | | | |
| | December 31 |
($ in millions) | | 2017 | | 2016 | | 2015 |
Unrecognized tax benefits at beginning of the year | | $ | 2 |
| | $ | 27 |
| | $ | 19 |
|
Additions based on tax positions related to the current year | | — |
| | 1 |
| | 8 |
|
Additions based on tax positions of prior years | | — |
| | 2 |
| | 3 |
|
Reductions based on tax positions of prior years | | — |
| | (15 | ) | | — |
|
Settlements | | — |
| | (11 | ) | | (1 | ) |
Statute of limitation expirations | | (2 | ) | | (2 | ) | | (2 | ) |
Net change in unrecognized tax benefits | | (2 | ) | | (25 | ) | | 8 |
|
Unrecognized tax benefits at end of the year | | $ | — |
| | $ | 2 |
| | 27 |
|
As of December 31, 2017 and 2016, the estimated amounts of the Company's uncertain tax positions, excluding interest and penalties, were liabilities of less than $1 million and $2 million, respectively. Assuming sustainment of these positions, as of December 31, 2017 and 2016, the reversal of less than $1 million and $2 million, respectively, of the amounts accrued would favorably affect the Company's effective federal income tax rate in future periods.
In 2016, the Company settled a state uncertain tax position through agreement with the applicable taxing authority. The net impact of the settlement was not material to HII’s consolidated financial position, results of operations, or cash flows.
The Company recognizes interest and penalties related to unrecognized tax benefits as income tax expense. Related to the unrecognized tax benefits noted above, there was a net decrease in income tax expense of $1 million in 2017 for interest and penalties, resulting in no material liability for interest and penalties as of December 31, 2017. The 2017 changes in interest and penalties related to statute of limitation expirations. In 2016, there was a net decrease in income tax expense of $2 million for interest and penalties, resulting in a total liability of $1 million for interest and penalties as of December 31, 2016. The 2016 changes in interest and penalties related to reductions in prior year tax positions and settlement with a taxing authority. There were no material changes to accrued interest or penalties during 2015, and, as of December 31, 2015, the Company's liability for interest and penalties was $3 million.
The following table summarizes the tax years that are either currently under examination or remain open under the applicable statute of limitations and subject to examination by the major tax jurisdictions in which the Company operates:
|
| | | | | | |
Jurisdiction | | Years |
United States | | 2011 | | - | | 2016 |
Connecticut | | 2016 | | - | | 2016 |
Mississippi | | 2012 | | - | | 2016 |
Virginia | | 2012 | | - | | 2016 |
Although the Company believes it has adequately provided for all uncertain tax positions, amounts asserted by taxing authorities could be greater than the Company's accrued position. Accordingly, additional provisions for federal and state income tax related matters could be recorded in the future as revised estimates are made or the underlying matters are effectively settled or otherwise resolved. Conversely, the Company could settle positions with the tax authorities for amounts lower than have been accrued. The Company believes that it is reasonably possible that during the next 12 months the Company's liability for uncertain tax positions may decrease by less than $1 million due to resolution of a federal uncertain tax position.
During 2013 the Company entered into the pre-Compliance Assurance Process with the IRS for years 2011 and 2012. The Company is part of the IRS Compliance Assurance Process program for the 2014 through 2018 tax years. Open tax years related to state jurisdictions remain subject to examination.
Deferred Income Taxes - Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and for income tax purposes. As described above, deferred tax assets and liabilities are calculated as of the balance sheet date using current tax laws and rates expected to be in effect when the deferred tax items reverse in future periods. As a result of the reduction in the corporate income tax rate from 35.0% to 21.0% under the Tax Act, the Company revalued its net deferred tax assets as of December 31, 2017. Net deferred tax assets are classified as long-term deferred tax assets in the consolidated statements of financial position.
The tax effects of significant temporary differences and carry-forwards that gave rise to year-end deferred tax balances, as presented in the consolidated statements of financial position, were as follows:
|
| | | | | | | | |
| | December 31 |
($ in millions) | | 2017 | | 2016 |
Deferred Tax Assets | | | | |
Retirement benefits | | $ | 263 |
| | $ | 568 |
|
Workers' compensation | | 167 |
| | 251 |
|
Reserves not currently deductible for tax purposes | | 44 |
| | 56 |
|
Stock-based compensation | | 11 |
| | 16 |
|
Net operating losses and tax credit carry-forwards | | 21 |
| | 22 |
|
Other | | — |
| | 7 |
|
Gross deferred tax assets | | 506 |
| | 920 |
|
Less valuation allowance | | 12 |
| | 11 |
|
Net deferred tax assets | | 494 |
| | 909 |
|
Deferred Tax Liabilities | | | | |
Depreciation and amortization | | 223 |
| | 320 |
|
Contract accounting differences | | 51 |
| | 108 |
|
Purchased intangibles | | 106 |
| | 167 |
|
Gross deferred tax liabilities | | 380 |
| | 595 |
|
Total net deferred tax assets | | $ | 114 |
| | $ | 314 |
|
As of December 31, 2017, the Company had gross state income tax credit carry-forwards of approximately $20 million, which expire from 2018 through 2020. A deferred tax asset of approximately $16 million (net of federal benefit) has been established related to these state income tax credit carry-forwards, with a valuation allowance of $7 million against such deferred tax asset as of December 31, 2017. The Company had a gross state net operating loss carry-forward of $39 million, which expires in 2027. A deferred tax asset of approximately $3 million (net of federal benefit) has been established for the net operating loss carry-forward, with a full valuation allowance as of December 31, 2017. Other state and foreign net operating loss carry-forwards are separately and cumulatively immaterial to the Company’s deferred tax balances and expire between 2026 and 2036.