Note 17 – Income Taxes
Prior to October 31, 2016, our operations have historically been included in the U.S. federal and U.S. state income tax returns filed by YUM. Our foreign income tax returns, primarily those filed by our China subsidiaries, are filed on an individual entity basis. The Company has calculated its provision using the separate return method in these Consolidated and Combined Financial Statements. Under this method, the Company is assumed to have filed hypothetical tax returns on a standalone basis separate from YUM in the relevant tax jurisdictions.
Subsequent to October 31, 2016, the Company became a separate taxpayer and started preparing its own consolidated U.S. federal income tax return and U.S. state income tax filings. As of December 31, 2017 and 2016, the current and deferred taxes, including carryforwards and tax credits, are reflective of the Company’s actual balances subsequent to the separation.
In December 2017, the U.S. enacted the Tax Act, which included a broad range of tax reforms, including, but not limited to, the establishment of a flat corporate income tax rate of 21%, the elimination or reduction of certain business deductions, and the imposition of tax on deemed repatriation of accumulated undistributed foreign earnings. The Tax Act has impacted Yum China in two material aspects: all of the foreign-source dividends received by Yum China from its foreign subsidiaries will be exempted from taxation starting from tax year beginning after December 31, 2017 and Yum China recorded additional income tax expense in the fourth quarter of 2017, including an estimated one-time transition tax on its deemed repatriation of accumulated undistributed foreign earnings and additional tax related to revaluation of certain deferred tax assets.
Based on the information currently available, we have made a reasonable estimate of the effects and recorded the provisional amount of $163.9 million as an additional income tax expense in the fourth quarter of 2017. This amount includes an estimated one-time transition tax of $129.8 million on the deemed repatriation of accumulated undistributed foreign earnings, $4.5 million primarily related to the remeasurement of certain deferred tax assets based on the rates at which they are expected to reverse in the future, and the valuation allowance of $29.6 million for certain deferred tax assets. After utilizing existing qualified foreign tax credits, the total payable of the estimated one-time transition tax was $83.0 million as of December 31, 2017 of which $6.6 million was included in Income taxes payable and $76.4 million was included in Other liabilities and deferred credits.
The Tax Act requires complex computations with significant estimates to be performed, significant judgments to be made in interpretation of the provisions, and the preparation and analysis of information not previously relevant or regularly produced. The U.S. Treasury Department, the IRS, the SEC and other standard-setting bodies could interpret or issue guidance on how provisions of the Tax Act will be applied or otherwise administered that is different from our current interpretation. As we complete our analysis of the Tax Act, collect and prepare necessary data, and interpret any additional guidance, we may make adjustments to provisional amounts that we have recorded that may materially impact our provision for income taxes in the period in which the adjustments are made. We expect to complete our analysis within the measurement period not exceeding one year from the enactment date.
U.S. and foreign income before taxes are set forth below:
|
|
|
2017 |
|
|
2016 |
|
|
2015 |
|
|||
|
U.S. |
|
$ |
(13 |
) |
|
$ |
5 |
|
|
$ |
(7 |
) |
|
China |
|
|
818 |
|
|
|
659 |
|
|
|
502 |
|
|
Other Foreign |
|
|
5 |
|
|
|
8 |
|
|
|
1 |
|
|
|
|
$ |
810 |
|
|
$ |
672 |
|
|
$ |
496 |
|
The details of our income tax provision (benefit) are set forth below:
|
|
|
|
|
2017 |
|
|
2016 |
|
|
2015 |
|
|||
|
Current: |
|
Federal |
|
$ |
85 |
|
|
$ |
(2 |
) |
|
$ |
7 |
|
|
|
|
Foreign |
|
|
232 |
|
|
|
200 |
|
|
|
132 |
|
|
|
|
|
|
$ |
317 |
|
|
$ |
198 |
|
|
$ |
139 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Deferred: |
|
Federal |
|
$ |
77 |
|
|
$ |
(36 |
) |
|
$ |
(7 |
) |
|
|
|
Foreign |
|
|
(13 |
) |
|
|
(4 |
) |
|
|
36 |
|
|
|
|
|
|
$ |
64 |
|
|
$ |
(40 |
) |
|
$ |
29 |
|
|
|
|
|
|
$ |
381 |
|
|
$ |
158 |
|
|
$ |
168 |
|
The reconciliation of income taxes calculated at the U.S. federal statutory rate to our effective tax rate is set forth below:
|
|
|
2017 |
|
|
2016 |
|
|
2015 |
|
|||||||||||||||
|
U.S. federal statutory rate |
|
$ |
284 |
|
|
|
35.0 |
% |
|
$ |
235 |
|
|
|
35.0 |
% |
|
$ |
173 |
|
|
|
35.0 |
% |
|
Impact from the Tax Act |
|
|
164 |
|
|
|
20.2 |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
|
— |
|
|
Statutory rate differential attributable to foreign operations |
|
|
(61 |
) |
|
|
(7.5 |
) |
|
|
(55 |
) |
|
|
(8.4 |
) |
|
|
(15 |
) |
|
|
(3.1 |
) |
|
Adjustments to reserves and prior years |
|
|
(1 |
) |
|
|
(0.2 |
) |
|
|
16 |
|
|
|
2.4 |
|
|
|
3 |
|
|
|
0.6 |
|
|
Change in valuation allowances |
|
|
2 |
|
|
|
0.2 |
|
|
|
— |
|
|
|
— |
|
|
|
12 |
|
|
|
2.4 |
|
|
Tax benefit from Little Sheep restructuring |
|
|
— |
|
|
|
— |
|
|
|
(26 |
) |
|
|
(3.8 |
) |
|
|
— |
|
|
|
— |
|
|
Other, net |
|
|
(7 |
) |
|
|
(0.8 |
) |
|
|
(12 |
) |
|
|
(1.7 |
) |
|
|
(5 |
) |
|
|
(1.0 |
) |
|
Effective income tax rate |
|
$ |
381 |
|
|
|
46.9 |
% |
|
$ |
158 |
|
|
|
23.5 |
% |
|
$ |
168 |
|
|
|
33.9 |
% |
Statutory rate differential attributable to foreign operations. This item includes local taxes, withholding taxes, and shareholder-level taxes, net of foreign tax credits. The favorable impact is primarily attributable to a majority of our income being earned in China where it is subject to a 25% tax rate, which is lower than the historical U.S. federal statutory rate of 35%.
In 2017, 2016 and 2015, this benefit was negatively impacted by the actual and deemed repatriation of current year foreign earnings to the U.S. as we recognized additional tax expense, resulting from the related effective tax rate being lower than the U.S. federal statutory rate.
Adjustments to reserves and prior years. This item includes: (1) changes in tax reserves, including interest thereon, established for potential exposure we may incur if a taxing authority takes a position on a matter contrary to our position; and (2) the effects of reconciling income tax amounts recorded in our Consolidated and Combined Statements of Income to amounts reflected on our tax returns, including any adjustments to the Consolidated Balance Sheets. The impact of certain effects or changes may offset items reflected in the ‘Statutory rate differential attributable to foreign operations’ line.
In 2016, this item was negatively impacted by the additional amount recorded for uncertain tax positions in China.
Change in valuation allowances. This item relates to changes for deferred tax assets generated or utilized during the current year and changes in our judgment regarding the likelihood of using deferred tax assets that existed at the beginning of the year. The change in valuation allowance as a result of the Tax Act in the amount of $29.6 million was included in ‘Impact from the Tax Act’. The impact of certain changes may offset items reflected in ‘Statutory rate differential attributable to foreign operations’.
In 2015, $12 million of net tax expense was driven by valuation allowances recorded against deferred tax assets generated during the current year.
Tax benefit from Little Sheep restructuring. In 2016, we recognized tax benefit of $26 million as a result of Little Sheep legal entity restructuring completed prior to the separation. The cash tax savings associated with this benefit will be realized as we recognize future U.S. taxable income. In 2017, this tax benefit was remeasured as a result of the Tax Act, and a valuation allowance of $19.5 million was recognized as part of valuation allowance recorded and reflected in ‘Impact from the Tax Act’.
Other. This item primarily includes the impact of permanent differences related to current year earnings as well as U.S. tax credits and deductions.
In 2016, this item was favorably impacted by non-taxable gain from changes in fair value of financial instruments associated with the Investors’ strategic investment in Yum China. See Note 13.
The details of 2017 and 2016 deferred tax assets (liabilities) are set forth below:
|
|
|
2017 |
|
|
2016 |
|
||
|
Operating losses and tax credit carryforwards |
|
$ |
43 |
|
|
$ |
86 |
|
|
Tax benefit from Little Sheep restructuring |
|
|
20 |
|
|
|
26 |
|
|
Employee benefits |
|
|
5 |
|
|
|
4 |
|
|
Share-based compensation |
|
|
6 |
|
|
|
8 |
|
|
Deferred escalating minimum rent |
|
|
45 |
|
|
|
42 |
|
|
Other liabilities |
|
|
10 |
|
|
|
8 |
|
|
Deferred income and other |
|
|
43 |
|
|
|
35 |
|
|
Gross deferred tax assets |
|
|
172 |
|
|
|
209 |
|
|
Deferred tax asset valuation allowances |
|
|
(68 |
) |
|
|
(41 |
) |
|
Net deferred tax assets |
|
$ |
104 |
|
|
$ |
168 |
|
|
Intangible assets |
|
|
(25 |
) |
|
$ |
(22 |
) |
|
Property, plant and equipment |
|
|
(2 |
) |
|
|
(1 |
) |
|
Other |
|
|
(10 |
) |
|
|
(9 |
) |
|
Gross deferred tax liabilities |
|
$ |
(37 |
) |
|
$ |
(32 |
) |
|
Net deferred tax assets |
|
$ |
67 |
|
|
$ |
136 |
|
|
Reported in Consolidated Balance Sheets as: |
|
|
|
|
|
|
|
|
|
Deferred income taxes |
|
|
99 |
|
|
$ |
162 |
|
|
Other liabilities and deferred credits |
|
|
(32 |
) |
|
|
(26 |
) |
|
|
|
$ |
67 |
|
|
$ |
136 |
|
We have investments in our foreign subsidiaries where the carrying values for financial reporting exceed the tax basis. We have not provided deferred tax on the portion of the excess that we believe is indefinitely reinvested, as we have the ability and intent to indefinitely postpone the basis differences from reversing with a tax consequence. The Company’s separation from YUM was intended to qualify as a tax-free reorganization for U.S. income tax purposes resulting in the excess of financial reporting basis over tax basis in our investment in the China business continuing to be indefinitely reinvested. The excess of financial reporting basis over tax basis as of December 31, 2017 was subject to the one-time transition tax under the Tax Act as a deemed repatriation of accumulated undistributed earnings from the foreign subsidiaries. However, we continue to believe that the portion of the excess of financial reporting basis over tax basis (including earnings and profits subject to the one-time transition tax) is indefinitely reinvested in our foreign subsidiaries for foreign withholding tax purposes. We estimate that our total temporary difference for which we have not provided foreign withholding taxes is approximately $2.0 billion at December 31, 2017. However, it is not practicable to determine the deferred tax liability on this amount due to uncertainty with regard to the timing or manner of repatriation and the related impact on foreign taxes.
At December 31, 2017, the Company had operating loss carryforwards of $165 million, primarily related to our Little Sheep business, all of which will expire by 2022. These losses are being carried forward in jurisdictions where we are permitted to use tax losses from prior periods to reduce future taxable income.
As of December 31, 2016, the Company had U.S. tax credit carryforwards of $46 million, which represents Yum China’s foreign tax credit carryforwards as a result of the separation. This was attributable to the distributions from the Company’s China business to YUM after Yum China was incorporated and became the parent of the Company’s operating entities in China. The tax credit of $47 million at the end of 2017 was fully utilized to offset the one-time transition tax.
Cash payments for tax liabilities on income tax returns filed in China were $232 million, $182 million and $143 million in 2017, 2016 and 2015, respectively.
We recognize the benefit of positions taken or expected to be taken in tax returns in the financial statements when it is more likely than not that the position would be sustained upon examination by tax authorities. A recognized tax position is measured at the largest amount of benefit that is greater than 50% likely of being realized upon settlement.
A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
|
|
|
2017 |
|
|
2016 |
|
||
|
Beginning of Year |
|
$ |
26 |
|
|
$ |
15 |
|
|
Additions on tax positions |
|
|
8 |
|
|
|
14 |
|
|
Reductions due to statute expiration |
|
|
(6 |
) |
|
|
(3 |
) |
|
End of Year |
|
$ |
28 |
|
|
$ |
26 |
|
In 2017 and 2016, we increased our unrecognized tax benefits by $8 million and $14 million, respectively, related to uncertainty with regard to the deductibility of certain business expenses incurred during the year. The unrecognized tax benefits balance as of December 31, 2017 was $28 million, all of which, if recognized upon audit settlement or statute expiration, would affect the effective tax rate. The Company believes it is reasonably possible its unrecognized tax benefits may decrease by approximately $8 million in the next twelve months, if recognized, would affect the 2018 effective tax rate.
The accrued interest and penalties related to income taxes at December 31, 2017 and 2016 are set forth below:
|
|
|
2017 |
|
|
2016 |
|
||
|
Accrued interest and penalties |
|
$ |
7 |
|
|
$ |
5 |
|
During 2017, 2016 and 2015, a net expense of $2 million, $3 million and $1 million, respectively, for interest and penalties was recognized in our Consolidated and Combined Statements of Income as components of our income tax provision.
The Company’s results are subject to examination in the U.S. federal jurisdiction as well as various U.S. state jurisdictions as part of YUM’s and our own income tax filings, and separately in foreign jurisdictions. Any liability arising from these examinations related to periods prior to the separation is expected to be settled among the Company, YCCL and YUM in accordance with the tax matters agreement we entered into in connection with the separation.
The Company’s operations in foreign jurisdictions generally remain subject to examination for tax years as far back as 2006, and some of which years are currently under audit by local tax authorities. Currently we are under a national audit on transfer pricing by the Chinese State Administration of Taxation (“SAT”) regarding our related party transactions for the period from 2006 to 2015. A few meetings with the SAT took place to discuss the progress of the audit, and it is reasonably possible that there could be significant development within the next 12 months. The ultimate assessment will depend upon further review of the information provided and ongoing discussions with the SAT and in-charge local tax authorities, and therefore it is not possible to estimate the potential impact. We will continue to defend our transfer pricing position. However, if the SAT prevails in the assessment of additional tax due based on its ruling, the assessed tax, interest and penalties, if any, could have a material adverse impact on our financial position, results of operations and cash flows.