Engility Holdings, Inc.

7. Income Taxes

The Tax Act was signed into law on December 22, 2017. The Tax Act changed many aspects of U.S. corporate income taxation and included reduction of the corporate income tax rate from 35% to 21%. As a result, we recognized provisional tax effects in the year ended December 31, 2017 of $60 million in tax expense relating almost entirely to the remeasurement of our net deferred tax assets using the new 21% tax rate. Upon completion of our 2017 U.S. income tax return in 2018, we may identify additional remeasurement adjustments to our recorded net deferred tax assets and liabilities. We will continue to assess our provision for income taxes as future guidance is issued but do not currently anticipate significant revisions will be necessary.

On December 22, 2017, Staff Accounting Bulletin No. 118 (SAB 118) was issued to address the application of US GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. In accordance with SAB 118, the Company has determined that approximately $1 million related to foreign tax credits may not be realized and has maintained a valuation allowance. Additional work is necessary to do a more detailed analysis of historical foreign earnings as well as potential correlative adjustments. As mentioned above, additional remeasurement adjustments may result from our deferred taxes upon completion of the 2017 U.S. income tax return in 2018.

Income (loss) before income taxes is summarized in the table below.

	Year Ended December 31,
	2017		2016			2015
Domestic	$	49,114	$	(9,285	)	$	(298,644	)
Foreign		627		486			338
Income before income taxes	$	49,741	$	(8,799	)	$	(298,306	)

The components of our current and deferred portions of the provision for income taxes are presented in the table below.

	Year Ended December 31,
	2017			2016			2015
Current income tax provision (benefit):
Federal	$	(2,678	)	$	(4,030	)	$	(29,632	)
State and local		301			107			(1,569	)
Foreign		105			(14	)		727
Subtotal		(2,272	)		(3,937	)		(30,474	)
Deferred income tax provision (benefit):
Federal		84,464			2,252			(31,830	)
State and local		(1,836	)		(1,089	)		(5,718	)
Foreign		—			44			(45	)
Subtotal		82,628			1,207			(37,593	)
Total provision (benefit) for income taxes	$	80,356		$	(2,730	)	$	(68,067	)

A reconciliation of the statutory Federal income tax rate to our effective income tax rate is presented in the table below.

	Year Ended December 31,
	2017			2016			2015
Statutory Federal income tax rate		35.0	%		35.0	%		35.0	%
State and local income taxes, net of Federal income tax benefit		3.0			6.6			1.7
Goodwill impairment		5.0			(33.2	)		(18.0	)
Non-controlling interest		(3.2	)		18.8			0.6
Non-deductible acquisition costs		3.4			—			(0.3	)
Federal tax credits		(0.8	)		2.5			0.1
Tax audit settlements and return adjustments		0.5			(3.3	)		—
Uncertain tax positions		(2.0	)		1.3			3.9
Valuation allowance		—			3.9			—
Impacts of '17 Tax Cuts and Jobs Act		120.5			—			—
Other, net		0.1			(0.6	)		(0.2	)
Effective income tax rate		161.5	%		31.0	%		22.8	%

The significant components of our deferred tax assets and liabilities are presented in the table below.

	December 31,
	2017			2016
Deferred tax assets:
Compensation and benefits	$	18,048		$	26,371
Unrecognized tax benefits		30,331			32,808
Fixed assets		5,101			6,627
Deferred revenue		7,732			12,917
Reserves		8,115			14,396
Pension		10,138			17,958
Net operating losses		113,615			171,969
Income recognition on contracts in process		7,335			-
Other		12,963			21,089
Gross deferred tax assets		213,378			304,135
Deferred tax liabilities:
Goodwill and other intangible assets		54,754			49,976
Income recognition on contracts in process		—			7,119
Other		7,015			13,769
Gross deferred tax liabilities		61,769			70,864
Valuation allowance		(1,074	)		(988	)
Net deferred tax assets	$	150,535		$	232,283

The valuation allowance on deferred tax assets of approximately $1 million as of December 31, 2017 and 2016 consists of state deferred tax assets, foreign tax credits and charitable donations. Included in the above table, we have approximately $1 million of foreign income tax credits that will expire beginning in 2025.

We and our subsidiaries filed income tax returns in various state and foreign jurisdictions. The Company has available at December 31, 2017, unused Federal and state operating loss carry forwards of $436 million and $421 million, respectively, that may be applied against taxable income and that expire in the years as indicated in the table below.

Year of Expiration	Federal		State
2018-2028	$	—	$	4,997
2029-2031		100,876		84,958
2032-2034		187,519		162,444
2035-2037		147,133		168,658
	$	435,528	$	421,057

The following table presents a reconciliation of the beginning and ending amounts of unrecognized tax benefits, excluding potential interest and penalties:

	Year Ended December 31,
	2017			2016			2015
Balance at January 1	$	55,274		$	58,360		$	67,927
Additions/reductions for tax positions related to the current year		65			151			4,139
Additions/reductions for tax positions related to prior years		—			—			(11,542	)
Lapse of statute of limitations		(2,551	)		(3,237	)		(2,164	)
Balance at December 31	$	52,788		$	55,274		$	58,360

The balance of unrecognized tax benefits, exclusive of interest and penalties, was $53 million, $55 million and $58 million at December 31, 2017, 2016 and 2015, respectively. At December 31, 2017, 2016 and 2015, we had $9 million, $10 million and $10 million of interest and penalty accrued related to unrecognized tax benefits. It is expected that $9 million of unrecognized tax benefits at December 31, 2017 would affect earnings if recognized.

The statutes of limitations for our U.S. Federal income tax returns remain open for the years 2012 and onward. The statute of limitations for L3’s U.S. Federal income tax return for the year ended December 31, 2012 remains open as of December 31, 2017. Foreign and U.S. state jurisdictions have statutes of limitations generally ranging from three to five years. As of December 31, 2017, we anticipate that uncertain tax positions will decrease by approximately $27 million over the next 12 months of which $26 million relates to the resolution of a foreign uncertain tax position. The reversal of the foreign reserve will have a net impact of between $2 million and $3 million benefiting our provision for income taxes in the period resolved. The actual amount could vary significantly depending on the ultimate timing and nature of any settlements.

At December 31, 2017 and 2016, non-current income taxes payable included accrued potential interest of $9 million and 10 million, respectively. With respect to the interest related items, our income tax provision included a benefit of $1 million, $1 million and $2 million for the years ended December 31, 2017, 2016 and 2015, respectively.