INCOME TAXES
In connection with the Separation, SHO and Sears Holdings entered into a Tax Sharing Agreement with Sears Holdings that governs the rights and obligations of the parties with respect to pre-Separation and post-Separation tax matters. Under the Tax Sharing Agreement, Sears Holdings is responsible for any federal, state or foreign income tax liability relating to tax periods ending on or before the Separation. For all periods after the Separation, the Company is responsible for any federal, state or foreign tax liability. Current income taxes payable for any federal, state or foreign income tax returns is reported in the period incurred.
We account for uncertainties in income taxes according to accounting standards for uncertain tax positions. The Company is present in a large number of taxable jurisdictions and, at any point in time, can have audits underway at various stages of completion in one or more of these jurisdictions. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by local authorities and may not be fully sustained, despite the 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 closings of statutes of limitation. Such adjustments are reflected in the tax provision as appropriate. Pursuant to the Tax Sharing Agreement, Sears Holdings is responsible for any unrecognized tax liabilities or benefits through the date of the Separation and the Company is responsible for any uncertain tax positions after the Separation. For 2016, 2015 and 2014, no unrecognized tax benefits have been identified and reflected in the financial statements.
We classify interest expense and penalties related to unrecognized tax benefits and interest income on tax overpayments as components of income tax expense. As no unrecognized tax benefits have been identified and reflected in the consolidated financial statements, no interest or penalties related to unrecognized tax benefits are reflected in the consolidated balance sheets or statements of operations.
As of January 28, 2012 the assets and liabilities of the Sears Hometown and Hardware and Sears Outlet businesses were owned by subsidiaries of Sears Holdings. On August 31, 2012, through a series of intercompany transactions Sears Holdings and several of its subsidiaries transferred the assets and liabilities comprising the Sears Hometown and Hardware and Sears Outlet businesses to SHO. In connection with the intercompany transactions, for tax purposes the transferred assets and liabilities were stepped up to their estimated fair market values as of August 31, 2012, but for financial statement purposes the book value of the assets and liabilities remained unchanged at their historical cost bases. This tax adjustment related to the Separation was accounted for as an equity contribution that increased net deferred tax assets by $80.4 million reflecting the stepped-up tax basis in excess of the book basis that occurred in connection with the intercompany transactions described above, primarily for merchandise inventories, favorable leases, fixed assets, and royalty-free licenses to use the "Sears" name. In 2015, a property that was not included in the 2012 valuation was revalued to its estimated 2012 fair market value. The increase in tax basis related to this property was recorded in 2015 as an increase to deferred tax assets of $7.6 million with the offset reflected as an equity contribution. Because this non-cash adjustment only impacts the balance sheet in each of the years it was unrecorded and its impact is not material to the consolidated financial statements based on management’s assessment of SEC Staff Accounting Bulletin No. 99, this correction was recorded in 2015 and no prior periods were adjusted.
The provisions for income tax expense for 2016, 2015 and 2014 consist of the following:
|
| | | | | | | | | | | | | | |
| | | | Fiscal Year Ended |
thousands | | | | 2016 | | 2015 | | 2014 |
Income (loss) before income taxes: | | | | | | |
| U.S. | | | $ | (51,588 | ) | | $ | (41,643 | ) | | $ | (172,829 | ) |
| Foreign | | 1,160 |
| | (770 | ) | | 958 |
|
| | Total | | $ | (50,428 | ) | | $ | (42,413 | ) | | $ | (171,871 | ) |
Income tax expense (benefit): | | | | | | |
Current: | | | | | | | |
| Federal | | $ | (155 | ) | | $ | (9,758 | ) | | $ | 2,872 |
|
| State | | 1,001 |
| | 605 |
| | 608 |
|
| Foreign | | 542 |
| | 432 |
| | 584 |
|
| | Total | | 1,388 |
| | (8,721 | ) | | 4,064 |
|
Deferred: | | | | | | | |
| Federal | | 67,463 |
| | (4,666 | ) | | (6,037 | ) |
| State | | 12,640 |
| | (1,765 | ) | | (1,093 | ) |
| Foreign | | — |
| | — |
| | — |
|
| | Total | | $ | 80,103 |
| | $ | (6,431 | ) | | $ | (7,130 | ) |
| | | | | | | | |
Income tax expense (benefit) | | $ | 81,491 |
| | $ | (15,152 | ) | | $ | (3,066 | ) |
The provisions for income taxes for financial reporting purposes is different from the tax provision computed by applying the statutory federal tax rate. The reconciliation of the tax rate follows:
|
| | | | | | | | | |
| | Fiscal Year Ended |
| | 2016 | | 2015 | | 2014 |
Federal tax rate | | 35.0 | % | | 35.0 | % | | 35.0 | % |
State income tax (net of federal benefit) | | 1.7 | % | | 1.8 | % | | 0.2 | % |
Goodwill | | — | % | | — | % | | (34.0 | )% |
Valuation allowance | | (198.5 | )% | | (1.6 | )% | | 0.1 | % |
Other | | 0.2 | % | | 0.5 | % | | 0.5 | % |
Effective tax rate | | (161.6 | )% | | 35.7 | % | | 1.8 | % |
The major components of the deferred tax assets and liabilities as of January 28, 2017 and January 30, 2016 are as follows:
|
| | | | | | | | | |
| | | Fiscal Year Ended |
thousands | | January 28, 2017 |
| | January 30, 2016 |
|
Deferred tax assets | |
| Bad Debts | $ | 3,487 |
| | $ | 4,735 |
|
| Deferred Compensation | 468 |
| | 1,454 |
|
| Inventory | 3,159 |
| | 4,100 |
|
| Net Operating Loss | 39,169 |
| | 9,873 |
|
| Property | 296 |
| | 4,986 |
|
| Royalty-free License | 44,280 |
| | 48,513 |
|
| Other | 11,230 |
| | 7,063 |
|
| | Sub-total deferred tax assets | $ | 102,089 |
| | $ | 80,724 |
|
| | Valuation allowance | (100,906 | ) | | (830 | ) |
| | Total deferred tax assets | $ | 1,183 |
| | $ | 79,894 |
|
Deferred tax liabilities | | | |
| Property | — |
| | — |
|
| Other | (1,183 | ) | | (753 | ) |
| | Total deferred tax liabilities | (1,183 | ) | | (753 | ) |
Net deferred tax assets | — |
| | $ | 79,141 |
|
We account for income taxes in accordance with accounting standards for such taxes, which 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 assets 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. In performing the assessment for 2016, a significant piece of negative evidence evaluated was the cumulative loss incurred over the three-year period ended January 28, 2017. The loss was evaluated as book income/loss adjusted for non-deductible and non-recurring items such as goodwill impairment, sale of property, store closing costs, franchise income/expense and software expenses. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future growth.
On the basis of this analysis and significant negative objective evidence, for the year ended January 28, 2017, a valuation allowance of $100.1 million has been recorded for the full amount of the net deferred tax assets. The valuation allowance was recorded as a non-cash charge to income tax expense. A valuation allowance of $0.7 million and $0.1 million was recognized through tax expense for the years ended January 30, 2016 and January 31, 2015, respectively due to the estimated future foreign taxable income available to use the foreign tax credit and the Puerto Rico AMT credit carryforwards. 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 assets.
At the end of 2016 and 2015, we had a federal net operating losses (“NOL”) of $99.4 million and $22.7 million, respectively, which will expire between 2036 and 2037. At the end of 2016 and 2015, we had state NOLs of $6.8 million and $2.9 million, respectively, which will expire between 2019 and 2037. We have credit carryforwards of $3.1 million which will expire between 2023 and 2037.
We file federal, state and city income tax returns in the United States and foreign tax returns in Puerto Rico. SHO was also a part of the Sears Holdings' combined state returns for the years ended February 2, 2013 and February 1, 2014. Currently, the Company is under audit for the years ended February 2, 2013 and February 1, 2014 as part of the Sears Holdings' combined return audits, as well as the Company's federal tax return for the year ended January 30, 2016.