INCOME TAXES
Certain amounts below have been adjusted to reflect the retrospective application of the Company's change in inventory accounting methods, as described in Notes 1 and 14.
Eaton Corporation plc is domiciled in Ireland. Income (loss) before income taxes and income tax (benefit) expense are summarized below based on the geographic location of the operation to which such earnings and income taxes are attributable.
|
| | | | | | | | | | | |
| Income (loss) before income taxes |
| 2017 | | 2016 | | 2015 |
Ireland | $ | (1,090 | ) | | $ | (923 | ) | | $ | (608 | ) |
Foreign | 4,458 |
| | 3,041 |
| | 2,741 |
|
Total income before income taxes | $ | 3,368 |
| | $ | 2,118 |
| | $ | 2,133 |
|
|
| | | | | | | | | | | |
| Income tax expense (benefit) |
| 2017 | | 2016 | | 2015 |
Current | | | | | |
Ireland | $ | 1 |
| | $ | 2 |
| | $ | 8 |
|
Foreign | | | | | |
United States | 123 |
| | 93 |
| | 110 |
|
Non-United States | 234 |
| | 209 |
| | 240 |
|
Total current income tax expense | 358 |
| | 304 |
| | 358 |
|
| | | | | |
Deferred | | | | | |
Ireland | — |
| | 2 |
| | 1 |
|
Foreign | | | | | |
United States | 82 |
| | (77 | ) | | (76 | ) |
Non-United States | (58 | ) | | (30 | ) | | (124 | ) |
Total deferred income tax expense (benefit) | 24 |
| | (105 | ) | | (199 | ) |
Total income tax expense | $ | 382 |
| | $ | 199 |
| | $ | 159 |
|
Reconciliations of income taxes from the Ireland national statutory rate of 25% to the consolidated effective income tax rate follow:
|
| | | | | | | | |
| 2017 | | 2016 | | 2015 |
Income taxes at the applicable statutory rate | 25.0 | % | | 25.0 | % | | 25.0 | % |
| | | | | |
Ireland operations | | | | | |
Ireland tax on trading income | — | % | | (0.3 | )% | | (0.4 | )% |
Nondeductible interest expense | 8.2 | % | | 11.5 | % | | 7.9 | % |
| | | | | |
Foreign operations |
| |
| |
|
United States operations (earnings taxed at other than the applicable statutory rate) | 1.7 | % | | 0.1 | % | | (0.6 | )% |
U.S. federal tax rate change | (7.5 | )% | | — | % | | — | % |
U.S. tax on foreign earnings | 4.8 | % | | — | % | | — | % |
U.S. foreign tax credit | (3.9 | )% | | 0.6 | % | | (0.8 | )% |
Credit for research activities | (0.5 | )% | | (0.8 | )% | | (0.8 | )% |
U.S. Other - net | 3.2 | % | | 2.5 | % | | 5.4 | % |
Non-U.S. operations (earnings taxed at other than the applicable statutory tax rate) | (22.9 | )% | | (26.8 | )% | | (25.1 | )% |
Non-U.S. operations - other items | 0.4 | % | | 0.9 | % | | (0.5 | )% |
| | | | | |
Worldwide operations |
| |
| |
|
Adjustments to tax liabilities | (1.8 | )% | | (2.5 | )% | | (1.4 | )% |
Adjustments to valuation allowances | 4.6 | % | | (0.8 | )% | | (1.2 | )% |
Effective income tax expense rate | 11.3 | % | | 9.4 | % | | 7.5 | % |
During 2017, income tax expense of $382 was recognized (an effective tax rate of 11.3%) compared to income tax expense of $199 for 2016 (an effective tax rate of 9.4%) and income tax expense of $159 for 2015 (an effective tax rate of 7.5%). The 2017 effective tax rate includes tax expense of $234 on the gain related to the sale of business discussed in Note 2 and a tax benefit of $62 related to the U.S. Tax Cuts and Jobs Act (TCJA) which is discussed in further detail below. Excluding the gain and related tax impact on the sale of business, and the impact of the TCJA, the effective tax rate for 2017 was expense of 9.2%. The decrease from 9.4% for 2016 compared to 9.2% for 2017 was due to the resolution of tax contingencies in various tax jurisdictions and the excess tax benefits recognized for employee share-based payments pursuant to the adoption of Accounting Standards Update 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The increase from 7.5% for 2015 compared to 9.4% for 2016 is primarily due to greater levels of income earned in higher tax jurisdictions, partially offset by net decreases in worldwide tax liabilities.
The U.S. Tax Cuts and Jobs Act was enacted on December 22, 2017. The TCJA reduces the U.S. federal corporate tax rate from 35% to 21% and requires a one-time transition tax on certain unremitted earnings of non-U.S. subsidiaries owned directly or indirectly by U.S. subsidiaries of the Company. For 2017, we have recorded a provisional tax benefit amount of $62 for the impact on our deferred tax balances and the one-time transition tax.
The Company remeasured certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21%. Additionally, given the significant changes included in the TCJA, the Company re-evaluated the realizability of certain deferred tax assets, including foreign tax credits and interest deferral, and determined that valuation allowances needed to be adjusted. The Company is still analyzing certain aspects of the TCJA, including interpretations by state and local tax authorities, and additional Treasury guidance may be issued which could potentially affect the measurement of these balances or give rise to new deferred tax amounts. The Company recorded a provisional $79 tax benefit for the remeasurement of deferred tax balances and related valuation allowances.
The one-time transition tax is based on post-1986 unremitted earnings and profits (E&P) of non-U.S. subsidiaries owned directly or indirectly by U.S. subsidiaries of the Company which have been previously deferred from U.S. income taxes. The amount of the transition tax also depends on the amount of E&P held in cash or other specified assets. The Company recorded a provisional tax expense of $17 for the transition tax. This amount may change when Treasury issues additional guidance and the Company finalizes the calculation of E&P, including the amounts held in cash or other specified assets, and finalizes the calculation of available foreign tax credits.
No provision has been made for income taxes on undistributed earnings of foreign subsidiaries of approximately $22.1 billion at December 31, 2017, since it is the Company's intention to indefinitely reinvest undistributed earnings of its foreign subsidiaries. It is not practicable to estimate the additional income taxes and applicable withholding taxes that would be payable on the remittance of such undistributed earnings.
The Company expects to deploy capital to those markets which offer particularly attractive growth opportunities. The cash that is permanently reinvested is typically used to expand operations either organically or through acquisitions. In addition, the Company expects that minimal to no Irish tax would apply to dividends paid to the Irish parent due to the impact of the Irish foreign tax credit system. The Company's public dividends and share repurchases are funded primarily from Non-U.S. operations.
Worldwide income tax payments, net of tax refunds, follow:
Deferred Income Tax Assets and Liabilities
Components of noncurrent deferred income taxes follow:
|
| | | | | | | |
| 2017 | | 2016 |
| Noncurrent assets and liabilities | | Noncurrent assets and liabilities |
Accruals and other adjustments | | | |
Employee benefits | $ | 430 |
| | $ | 761 |
|
Depreciation and amortization | (1,324 | ) | | (1,823 | ) |
Other accruals and adjustments | 380 |
| | 761 |
|
Ireland income tax loss carryforwards | 1 |
| | 1 |
|
Foreign income tax loss carryforwards | 1,962 |
| | 1,796 |
|
Foreign income tax credit carryforwards | 404 |
| | 277 |
|
Valuation allowance for income tax loss and income tax credit carryforwards | (1,992 | ) | | (1,728 | ) |
Other valuation allowances | (146 | ) | | (41 | ) |
Total deferred income taxes | $ | (285 | ) | | $ | 4 |
|
At December 31, 2017, Eaton Corporation plc and certain Irish subsidiaries had tax loss carryforwards that are available to reduce future taxable income and tax liabilities. These carryforwards and their respective expiration dates are summarized below:
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| | | | | | | | | | | | | | | | | | | | | | | |
| 2018 through 2022 | | 2023 through 2027 | | 2028 through 2032 | | 2033 through 2037 | | Not subject to expiration | | Valuation allowance |
Ireland income tax loss carryforwards | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | 8 |
| | $ | — |
|
Ireland deferred income tax assets for income tax loss carryforwards | — |
| | — |
| | — |
| | — |
| | 1 |
| | (1 | ) |
At December 31, 2017, the Company's foreign subsidiaries, including all U.S. and non-U.S. subsidiaries, had income tax loss carryforwards and income tax credit carryforwards that are available to reduce future taxable income or tax liabilities. These carryforwards and their respective expiration dates are summarized below:
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| | | | | | | | | | | | | | | | | | | | | | | |
| 2018
through
2022 | | 2023
through
2027 | | 2028
through
2032 | | 2033
through
2037 | | Not subject to expiration | | Valuation allowance |
Foreign income tax loss carryforwards | $ | 918 |
| | $ | 7,528 |
| | $ | 14 |
| | $ | 545 |
| | $ | 4,047 |
| | $ | — |
|
Foreign deferred income tax assets for income tax loss carryforwards | 112 |
| | 721 |
| | 14 |
| | 175 |
| | 1,047 |
| | (1,830 | ) |
Foreign deferred income tax assets for income tax loss carryforwards after ASU 2013-11 | 101 |
| | 715 |
| | 14 |
| | 86 |
| | 1,047 |
| | (1,830 | ) |
Foreign income tax credit carryforwards | 86 |
| | 205 |
| | 78 |
| | 115 |
| | 64 |
| | (161 | ) |
Foreign income tax credit carryforwards after ASU 2013-11 | 82 |
| | 168 |
| | 27 |
| | 94 |
| | 33 |
| | (161 | ) |
Recoverability of Deferred Income Tax Assets
Eaton is subject to the income tax laws in the jurisdictions in which it operates. In order to determine its income tax provision for financial statement purposes, Eaton must make significant estimates and judgments about its business operations in these jurisdictions. These estimates and judgments are also used in determining the deferred income tax assets and liabilities that have been recognized for differences between the financial statement and income tax basis of assets and liabilities, and income tax loss carryforwards and income tax credit carryforwards.
Management evaluates the realizability of deferred income tax assets for each of the jurisdictions in which it operates. If the Company experiences cumulative pretax income in a particular jurisdiction in the three-year period including the current and prior two years, management normally concludes that the deferred income tax assets will more likely than not be realizable and no valuation allowance is recognized, unless known or planned operating developments, or changes in tax laws, would lead management to conclude otherwise. However, if the Company experiences cumulative pretax losses in a particular jurisdiction in the three-year period including the current and prior two years, management then considers a series of factors in the determination of whether the deferred income tax assets can be realized. These factors include historical operating results, known or planned operating developments, the period of time over which certain temporary differences will reverse, consideration of the utilization of certain deferred income tax liabilities, tax law carryback capability in the particular country, prudent and feasible tax planning strategies, changes in tax laws, and estimates of future earnings and taxable income using the same assumptions as those used for the Company's goodwill and other impairment testing. After evaluation of these factors, if the deferred income tax assets are expected to be realized within the tax carryforward period allowed for that specific country, management would conclude that no valuation allowance would be required. To the extent that the deferred income tax assets exceed the amount that is expected to be realized within the tax carryforward period for a particular jurisdiction, management would establish a valuation allowance.
Applying the above methodology, valuation allowances have been established for certain deferred income tax assets to the extent they are not expected to be realized within the particular tax carryforward period.
Unrecognized Income Tax Benefits
A summary of gross unrecognized income tax benefits follows:
|
| | | | | | | | | | | |
| 2017 | | 2016 | | 2015 |
Balance at January 1 | $ | 629 |
| | $ | 584 |
| | $ | 493 |
|
Increases and decreases as a result of positions taken during prior years | | | | | |
Transfers from valuation allowances | — |
| | — |
| | — |
|
Other increases, including currency translation | 10 |
| | 21 |
| | 34 |
|
Other decreases, including currency translation | (30 | ) | | (24 | ) | | (34 | ) |
Balances related to acquired businesses | — |
| | — |
| | (1 | ) |
Increases as a result of positions taken during the current year | 162 |
| | 90 |
| | 109 |
|
Decreases relating to settlements with tax authorities | (10 | ) | | (19 | ) | | — |
|
Decreases as a result of a lapse of the applicable statute of limitations | (26 | ) | | (23 | ) | | (17 | ) |
Balance at December 31 | $ | 735 |
| | $ | 629 |
| | $ | 584 |
|
Eaton's long-term policy has been to enter into tax planning strategies only if it is more likely than not that the benefit would be sustained upon audit. For example, the Company does not enter into any of the United States Internal Revenue Service (IRS) Listed Transactions as set forth in Treasury Regulation 1.6011-4.
If all unrecognized tax benefits were recognized, the net impact on the provision for income tax expense would be $652.
As of December 31, 2017 and 2016, Eaton had accrued approximately $80 and $94, respectively, for the payment of worldwide interest and penalties, which are not included in the table of unrecognized income tax benefits above. Eaton recognizes interest and penalties related to unrecognized income tax benefits in the provision for income tax expense. The Company has accrued penalties in jurisdictions primarily where they are automatically applied to any deficiency, regardless of the merit of the position.
As part of Eaton’s broader efforts to streamline operations, accelerate organic growth, and increase administrative efficiencies, the Company centralized certain activities and assets, which resulted in an increase in current income taxes payable, prepaid tax, and unrecognized tax benefits for 2017. These changes did not impact the Company’s 2017 effective tax rate.
The resolution of the majority of Eaton's unrecognized income tax benefits is dependent upon uncontrollable factors such as the prospect of retroactive regulations; new case law; and the willingness of the income tax authority to settle the issue, including the timing thereof. Therefore, for the majority of unrecognized income tax benefits, it is not reasonably possible to estimate the increase or decrease in the next 12 months. For each of the unrecognized income tax benefits where it is possible to estimate the increase or decrease in the balance within the next 12 months, the Company does not anticipate any significant change.
Eaton or its subsidiaries file income tax returns in Ireland and many countries around the world. With only few exceptions, Irish and non-United States subsidiaries of Eaton are no longer subject to examinations for years before 2007.
The United States Internal Revenue Service (“IRS”) has completed its examination of Eaton Corporation and Includible Subsidiaries’ (Eaton Corp.) United States income tax returns for 2005 through 2010 and has issued Statutory Notices of Deficiency (Notices) as discussed below. The statute of limitations on these tax years remains open until the matters are resolved. The IRS is currently examining tax years 2011 through 2013. The statute of limitations for tax years 2011 through 2013 is open until August 31, 2018. Tax years 2014 through 2016 are still subject to examination by the IRS.
Eaton is also under examination for the income tax filings in various states and localities of the United States. With only a few exceptions, Eaton Corp. is no longer subject to income tax examinations from states and localities within the United States for years before 2012. Income tax returns of states and localities within the United States will be reopened to the extent of United States federal income tax adjustments, if any, going back to 2005 when those audit years are finalized. Some states and localities may not limit their assessment to the United States federal adjustments, and may require the opening of the entire tax year. In addition, with only a few exceptions, BZ Holdings Inc. and Includible Subsidiaries (the former U.S. holding company for Cooper Industries) are no longer subject to United States state and local income tax examinations for years before 2012.
In 2011, the IRS issued a Notice for Eaton Corp. for the 2005 and 2006 tax years (the 2011 Notice). The 2011 Notice proposed assessments of $75 in additional taxes plus $52 in penalties related primarily to transfer pricing adjustments for products manufactured in the Company's facilities in Puerto Rico and the Dominican Republic and sold to affiliated companies located in the U.S.. Eaton Corp. has set its transfer prices for products sold between these affiliates at the same prices that Eaton Corp. sells such products to third parties as required by two successive Advance Pricing Agreements (APAs) Eaton Corp. entered into with the IRS that governed the 2005-2010 tax years. The Company has continued to apply the arms-length transfer pricing methodology for 2011 through the current reporting period. Immediately prior to the 2011 Notice being issued, the IRS sent a letter stating that it was retrospectively canceling the APAs. Eaton Corp. contested the proposed assessments in United States Tax Court. The case involved both whether the APAs should be enforced and, if not, the appropriate transfer pricing methodology. On July 26, 2017, the United States Tax Court issued a ruling in which it agreed with Eaton Corp. that the IRS must abide by the terms of the APAs for the tax years 2005-2006. The Tax Court’s ruling on the APAs did not have a material impact on Eaton’s consolidated financial statements.
In 2014, Eaton Corp. received a Notice from the IRS for the 2007 through 2010 tax years (the 2014 Notice) proposing assessments of $190 in additional taxes plus $72 in penalties, net of agreed credits and deductions, which the company has also contested in Tax Court. The proposed assessments pertain primarily to the same transfer pricing issues and APA for which the Tax Court has issued its ruling during 2017 as noted above. The Company believes that the Tax Court’s ruling for tax years 2005-2006 will also be applicable to the 2007-2010 years. Following the issuance of the Tax Court’s ruling, Eaton and the IRS recognized that the ruling on the enforceability of the APAs did not address a secondary issue regarding the transfer pricing for a certain royalty paid from 2006-2010. Eaton Corp. reported a consistent royalty rate for 2006-2010. The IRS has agreed to the royalty rate as reported by Eaton Corp. in 2006. Although the IRS has not proposed an alternative rate, it has not agreed to apply the same royalty rate in the 2007-2010 years.
The 2014 Notice also includes a separate proposed assessment involving the recognition of income for several of Eaton Corp.’s controlled foreign corporations. The Company believes that the proposed assessment is without merit. Eaton and the IRS have both moved for partial summary judgment on this issue. The Tax Court heard oral arguments on the motions in January 2018, following which the Court ordered further briefing.
During 2010, the Company received a tax assessment of $49 (translated at the December 31, 2017 exchange rate), plus interest and penalties, in Brazil for the tax years 2005 through 2008 that relates to the amortization of certain goodwill generated from the acquisition of third-party businesses and corporate reorganizations. The Company is contesting the assessment, which is under review at the administrative appeals level. During 2013, the Brazilian tax authorities began an audit of tax years 2009 through 2012. During 2014, the Company received a tax assessment of $37 (translated at the December 31, 2017 exchange rate), plus interest and penalties, for the 2009 through 2012 tax years (primarily relating to the same issues concerning the 2005 through 2008 tax years), which the Company is also contesting and is under review at the administrative appeals level. Multiple outside advisors have stated that Brazilian tax authorities are raising the issue for most clients with similar facts and that the matter is expected to require at least 10 years to resolve. The Company continues to believe that final resolution of the assessments will not have a material impact on its consolidated financial statements.