Xylem Inc.

The source of pre-tax income and the components of income tax expense are as follows:



�	Year Ended December 31,
(in millions)	2017			�	2016			�	2015
Income components:	�			�	�			�	�
Domestic	$	162		�	$	80		�	$	116
Foreign	304			�	260			�	287
Total pre-tax income	$	466		�	$	340		�	$	403
Income tax expense components:	�			�	�			�	�
Current:	�			�	�			�	�
Domestic � federal	$	109		�	$	19		�	$	32
Domestic � state and local	9			�	5			�	6
Foreign	51			�	42			�	34
Total Current	169			�	66			�	72
Deferred:	�			�	�			�	�
Domestic � federal	$	(29	)	�	$	19		�	$	1
Domestic � state and local	10			�	1			�	1
Foreign	(14		)	�	(6		)	�	(11		)
Total Deferred	(33		)	�	14			�	(9		)
Total income tax provision	$	136		�	$	80		�	$	63
Effective income tax rate	29.2		%	�	23.5		%	�	15.6		%

Reconciliations between taxes at the U.S. federal income tax rate and taxes at our effective income tax rate on earnings before income taxes are as follows:



�	Year Ended December 31,
�	2017		�	2016		�	2015
Tax provision at U.S. statutory rate	35.0	�%	�	35.0	�%	�	35.0	�%
Increase (decrease) in tax rate resulting from:	�		�	�		�	�
State income taxes	1.6		�	0.8		�	1.0
Settlements of tax examinations	1.6		�	(6.4	)	�	0.5
Valuation allowance	3.3		�	18.5		�	8.6
Tax exempt interest	(10.6	)	�	(14.3	)	�	(13.1	)
Foreign tax rate differential	(6.7	)	�	(7.9	)	�	(7.2	)
Repatriation of foreign earnings, net of foreign tax credits	37.0		�	5.9		�	0.2
Tax incentives	(6.6	)	�	(8.9	)	�	(7.8	)
Other � net	(2.5	)	�	0.8		�	(1.6	)
Rate change	(22.9	)	�	�		�	�
Effective income tax rate	29.2	�%	�	23.5	�%	�	15.6	�%

We operate under tax incentives, which are effective January 2013 through December 2023 and may be extended if certain additional requirements are satisfied. The tax incentives are conditional upon our meeting and maintaining certain employment thresholds. The inability to meet the thresholds would have a prospective impact and at this time we continue to believe we will meet the requirements.

Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted tax rates in effect for the year in which we expect the differences will reverse.

The following is a summary of the components of the net deferred tax assets and liabilities recognized in the Consolidated Balance Sheets:



�	December 31,
(in millions)	2017			�	2016
Deferred tax assets:	�			�	�
Employee benefits	$	108		�	$	126
Accrued expenses	34			�	53
Loss and other tax credit carryforwards	419			�	387
Inventory	8			�	6
Other	24			�	�
�	593			�	572
Valuation allowance	(350		)	�	(311		)
Net deferred tax asset	$	243		�	$	261
Deferred tax liabilities:	�			�	�
Intangibles	$	300		�	$	434
Investment in foreign subsidiaries	20			�	4
Property, plant, and equipment	57			�	61
Other	49			�	48
Total deferred tax liabilities	$	426		�	$	547

Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to realize existing deferred tax assets. On the basis of this evaluation, as of December�31, 2017, a valuation allowance of $350 million has been established to reduce the deferred income tax asset related to certain U.S. and foreign net operating losses and U.S. and foreign capital loss carryforwards.

A reconciliation of our valuation allowance on deferred tax assets is as follows:



(in millions)	2017			�	2016			�	2015
Valuation allowance � January�1	$	311		�	$	248		�	$	427
Change in assessment (a)	(28		)	�	17			�	(5		)
Current year operations	48			�	38			�	39
Foreign currency and other (b)	19			�	(32		)	�	(213		)
Acquisitions	�			�	40			�	�
Valuation allowance � December�31	$	350		�	$	311		�	$	248

Deferred taxes are classified net of unrecognized tax benefits in the Consolidated Balance Sheets as follows:



�	December 31,
(in millions)	2017			�	2016
Non-current assets	$	69		�	$	66
Non-current liabilities	(252		)	�	(352		)
Total net deferred tax liabilities	$	(183	)	�	$	(286	)

Tax attributes available to reduce future taxable income begin to expire as follows:



(in millions)	December 31, 2017		�	First�Year�of�Expiration
U.S. net operating loss	$	8	�	December 31, 2024
State net operating loss	124		�	December�31, 2017
U.S. tax credits	12		�	December�31, 2024
State tax credits	2		�	Indefinitely
Foreign net operating loss	1,523		�	December�31, 2018

The Company intends to distribute a portion of the earnings taxed under the Tax Act and, as of December�31, 2017, has provided a provisional deferred tax liability of $20 million for foreign withholding taxes and state income taxes on $769 million of earnings expected to be repatriated to the U.S. parent. The Company currently does not intend to distribute approximately $2 billion taxed under the Tax Act, and has not recorded any deferred taxes related to such amounts as the determination of the amount is not practicable.

We recognize tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:



(in millions)	2017		�	2016			�	2015
Unrecognized tax benefits � January�1	$	67	�	$	47		�	$	44
Current year tax positions	56		�	12			�	4
Prior year tax positions	7		�	(22		)	�	1
Acquisitions	�		�	30			�	�
Settlements	�		�	�			�	(2		)
Unrecognized tax benefits � December�31	$	130	�	$	67		�	$	47

The amount of unrecognized tax benefits at December�31, 2017 which, if ultimately recognized, will reduce our annual effective tax rate is $130 million. We do not believe that the unrecognized tax benefits will significantly change within the next 12 months.

The following table summarizes our earliest open tax years by major jurisdiction:



Jurisdiction	�	Earliest Open�Year
Italy	�	2012
Luxembourg	�	2014
Sweden	�	2012
Germany	�	2010
United Kingdom	�	2010
United States	�	2014
Switzerland	�	2012

We classify interest relating to unrecognized tax benefits as a component of other non-operating (expense) income, net and tax penalties as a component of income tax expense in our Consolidated Income Statements. The amount of accrued interest relating to unrecognized tax benefits as of December 31, 2017 and 2016 was $4 million.

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, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time transition tax on certain unrepatriated foreign earnings of foreign subsidiaries; (3) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (4) requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; (5) eliminating the corporate alternative minimum tax (AMT) and changing how existing AMT credits can be realized; (6) creating the base erosion anti-abuse tax (BEAT), a new minimum tax; (7) creating a new limitation on deductible

The SEC staff issued SAB118, which expresses views of the staff regarding application of ASC740 in the reporting period that includes December 22, 2017. SAB118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC740 is complete. To the extent that a company�s accounting for certain income tax effects of the Tax Act is incomplete but it is able to record 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 ASC740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.

We are still performing our accounting for the tax effects of the Tax Act because all the necessary information is not currently available, prepared, or analyzed. As permitted by SAB118, we have made a reasonable estimate of the effects of the Tax Act on our financial results (see below). As we perform our analysis of the accounting for the tax effects of enactment of the Tax Act, we will recognize additional provisional amounts or adjustments to provisional amounts as discrete items in the periods in which the respective analyses are performed.

In connection with our initial analysis of the impact of the Tax Act, we have recorded a provisional tax expense of $46 million as a discrete item. This net income tax expense primarily consists of a provisional tax benefit for the corporate tax rate reduction of $107 million and a provisional tax expense for the repatriation transition tax of $153 million. For various reasons that are discussed in detail below, we have completed our accounting for the income tax effects of certain elements of the Tax Act, and therefore, have recorded provisional estimates related to these items. For certain items, a provisional estimate could not be determined, and therefore, we have continued accounting for them in accordance with ASC 740 on the basis of the tax laws in effect before the Tax Act.

Our accounting for the following elements of the Tax Act is incomplete. However, we were able to make reasonable estimates for these elements and, therefore, recorded provisional adjustments as follows:

Reduction of U.S. federal corporate tax rate: The Tax Act reduces the corporate tax rate to 21 percent, effective January 1, 2018. Consequently, we have adjusted our deferred taxes to account for the rate change, and have recorded a provisional decrease related to net deferred tax liabilities (DTLs) of $107 million, respectively, with a corresponding net adjustment to deferred tax benefit for the year ended December 31, 2017. Additional work is necessary for a more detailed analysis of our deferred tax assets and liabilities.

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 foreign subsidiaries. To determine the amount of the Transition Tax, we determined in addition to other factors, the amount of post 1986 E&P of the relevant subsidiaries, as well as the amount of the 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 liability of $153 million. This provisional amount may materially change due to additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued, and actions the Company may take as a result of the Tax Act.

Our accounting for the following elements of the Tax Act is incomplete, and we have not yet been able to make reasonable estimates of the effects. Therefore, no provisional adjustments were recorded as of December 31, 2017.

Global intangible low taxed 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 CFCs� 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 percent 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 ASC740. According to clarifications from FASB, 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 measurement of deferred taxes (the �deferred method�). Our selection of an accounting policy with respect to the new GILTI tax rules will depend, in part, on analyzing our global income to determine any future U.S. inclusions in taxable income related to GILTI and the related impact. Because whether we expect to have future U.S. inclusions in taxable


(a)	Decrease in assessment in 2017 is primarily attributable to Foreign Tax Credit utilization resulting from the Tax Act. Increase in assessment in 2016 is primarily attributable to Foreign Tax Credits resulting from additional indebtedness from the Sensus acquisition.