INCOME TAXES
For the years ended September 30, income tax expense consisted of the following:
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| | | | | | | | | | | |
(In millions) | 2017 | | 2016 | | 2015 |
Current | | | | | |
Federal | $ | 47 |
| | $ | 99 |
| | $ | 81 |
|
State | 8 |
| | 24 |
| | 16 |
|
Foreign | 14 |
| | 12 |
| | 13 |
|
| 69 |
| | 135 |
| | 110 |
|
Deferred | | | | | |
Federal (a) | 106 |
| | 14 |
| | (5 | ) |
State (b) | 12 |
| | 2 |
| | (1 | ) |
Foreign | (1 | ) | | (3 | ) | | (3 | ) |
| 117 |
| | 13 |
| | (9 | ) |
Income tax expense | $ | 186 |
| | $ | 148 |
| | $ | 101 |
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(a) Federal deferred income taxes of $106 million net of $96 million operating loss generated in the current year.
(b) State deferred income taxes of $12 million net of $10 million operating loss generated in the current year and a $4 million valuation allowance release.
Deferred income taxes are provided for income and expense items recognized in different years for tax and financial reporting purposes. As of September 30, 2017, management intends to indefinitely reinvest approximately $47 million of foreign earnings. Because these earnings are considered indefinitely reinvested, no U.S. tax provision has been accrued related to the repatriation of these earnings, and it is not practicable to estimate the amount of U.S. tax that might be payable if these earnings were ever to be remitted.
Temporary differences that give rise to significant deferred tax assets and liabilities are presented in the following table as of September 30:
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| | | | | | | |
(In millions) | 2017 | | 2016 |
Deferred tax assets | | | |
Federal net operating loss carryforwards (a) | $ | 96 |
| | $ | — |
|
Foreign net operating loss carryforwards (b) | 1 |
| | 1 |
|
State net operating loss carryforwards (c) | 28 |
| | 18 |
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Employee benefit obligations | 132 |
| | 351 |
|
Compensation accruals | 29 |
| | 17 |
|
Environmental, self-insurance and litigation reserves (net of receivables) | 6 |
| | 10 |
|
Credit carryforwards (d) | 13 |
| | 20 |
|
Other items | 7 |
| | 5 |
|
Valuation allowances (e) | (8 | ) | | (12 | ) |
Total deferred tax assets | 304 |
| | 410 |
|
Deferred tax liabilities | | | |
Goodwill and other intangibles (f) | 3 |
| | — |
|
Property, plant and equipment | 17 |
| | 21 |
|
Unremitted earnings | 3 |
| | 2 |
|
Total deferred tax liabilities | 23 |
| | 23 |
|
Net deferred tax asset | $ | 281 |
| | $ | 387 |
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(a) | Gross federal net operating loss carryforwards of $273 million will expire in 2037. |
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(b) | Gross foreign net operating loss carryforwards of $5 million will expire in the years 2020 to 2037. |
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(c) | Apportioned net operating loss carryforwards of $620 million will expire in future years as follows: $8 million in 2019, and the remaining balance in the years 2020 to 2037. |
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(d) | Credit carryforwards consist primarily of foreign tax credits of $5 million expiring in 2027, research and development credits of $7 million expiring in the years 2034 to 2037 and alternative minimum tax credits of $1 million with no expiration date. |
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(e) | Valuation allowances primarily relate to certain state and foreign net operating loss carryforwards, and certain other deferred tax assets. |
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(f) | The total gross amount of goodwill as of September 30, 2017 expected to be deductible for tax purposes is $79 million. |
As of September 30, 2017 and 2016, valuation allowances of $8 million and $12 million, respectively, were recorded on the Consolidated Balance Sheets related to deferred tax assets that are not expected to be realized or realizable.
The U.S. and foreign components of income before income taxes and a reconciliation of the statutory federal income tax with the provision for income taxes follow.
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| | | | | | | | | | | |
(In millions) | 2017 | | 2016 | | 2015 |
Income before income taxes | | | | | |
United States (a) | $ | 433 |
| | $ | 382 |
| | $ | 245 |
|
Foreign | 57 |
| | 39 |
| | 52 |
|
Total income before income taxes | $ | 490 |
| | $ | 421 |
| | $ | 297 |
|
| | | | | |
Income taxes computed at U.S. statutory rate (35%) | $ | 171 |
| | $ | 147 |
| | $ | 104 |
|
Increase (decrease) in amount computed resulting from | | | | | |
Uncertain tax positions | 2 |
| | 3 |
| | 1 |
|
State taxes | 17 |
| | 16 |
| | 9 |
|
International rate differential | (7 | ) | | (5 | ) | | (8 | ) |
Permanent items (b) | (8 | ) | | (11 | ) | | (5 | ) |
Tax Matters Agreement activity | 10 |
| | — |
| | — |
|
Other items | 1 |
| | (2 | ) | | — |
|
Income tax expense | $ | 186 |
| | $ | 148 |
| | $ | 101 |
|
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(a) | A significant component of the fluctuations within this caption relates to the remeasurements of the U.S. pension and other postretirement plans. |
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(b) | Permanent items in each year relate primarily to the domestic manufacturing deduction and income from equity affiliates. Further, 2017 includes adjustments related to certain non-deductible separation costs of $2 million, and 2015 includes adjustments related to the sale of the Venezuela joint venture of $6 million. |
Income tax expense for the year ended September 30, 2017 was $186 million or an effective tax rate of 38.0% compared to an expense of $148 million or an effective tax rate of 35.2% for the year ended September 30, 2016 and expense of $101 million or an effective tax rate of 34.0% for the year ended September 30, 2015. The increase in the 2017 and 2016 effective tax rates is partially due to the increase in income from pension and other postretirement benefits that generated significant income amounts in higher tax rate jurisdictions. Additionally, in fiscal 2017, the effective tax rate was impacted by income tax expense resulting from the Tax Matters Agreement activity with Ashland, certain non-deductible separation costs, and the partial loss of certain tax deductions from the $394 million voluntary contribution to the U.S. qualified pension plan, partially offset by a benefit from a state valuation allowance release. For fiscal years 2017 through 2015, the effective tax rate was impacted favorably by the lower tax rate on foreign earnings and net favorable permanent items. These favorable items are offset by the unfavorable impact of state taxes, and these adjustments net to an immaterial overall impact to the effective tax rate for each year.
Unrecognized tax benefits
U.S. GAAP prescribes a recognition threshold and measurement attribute for the accounting and financial statement disclosure of tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process. The first step requires Valvoline to determine whether it is more likely than not that a tax position will be sustained upon examination based on the technical merits of the position. The second step requires Valvoline to recognize in the financial statements each tax position that meets the more likely than not criteria, measured at the amount of benefit that has a greater than 50% likelihood of being realized. Valvoline had $10 million and $8 million of unrecognized tax benefits at September 30, 2017 and 2016, respectively. As of September 30, 2017, the total amount of unrecognized tax benefits that, if recognized, would affect the tax rate was $10 million. The remaining unrecognized tax benefits relate to tax positions for which ultimate deductibility is highly certain but for which there is uncertainty as to the timing of such deductibility. Recognition of these tax benefits would not have an impact on the effective tax rate.
Valvoline recognizes interest and penalties related to uncertain tax positions as a component of income tax expense in the Consolidated Statements of Comprehensive Income. Such interest and penalties were immaterial in each of the years ended September 30, 2017, 2016 and 2015. Valvoline had $1 million in interest and penalties related to unrecognized tax benefits accrued as of September 30, 2017 and 2016.
The table below is a rollforward of the changes in gross unrecognized tax benefits for the past three fiscal years:
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| | | |
(In millions) | |
Balance at September 30, 2014 | $ | 4 |
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Increases related to positions taken on items from prior years | 1 |
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Balance at September 30, 2015 | 5 |
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Increases related to positions taken on items from prior years | 2 |
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Increases related to positions taken in the current year | 1 |
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Balance at September 30, 2016 | 8 |
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Increases related to positions taken in the current year | 2 |
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Balance at September 30, 2017 | $ | 10 |
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From a combination of statute expirations and audit settlements in the next twelve months, Valvoline expects no significant decrease in the amount of accrual for uncertain tax positions. For the remaining balance as of September 30, 2017, it is reasonably possible that there could be changes to the amount of uncertain tax positions due to activities of the taxing authorities, settlement of audit issues, reassessment of existing uncertain tax positions, or the expiration of applicable statute of limitations; however, Valvoline is not able to estimate the impact of these items at this time.
Valvoline or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions, or it is included in a consolidated return in these jurisdictions. Foreign taxing jurisdictions significant to Valvoline include Australia, Canada, Mexico, China, Singapore, India and the Netherlands. Valvoline is subject to U.S. federal income tax examinations, either directly or as part of a consolidated return, by tax authorities for periods after September 30, 2011 and U.S. state income tax examinations by tax authorities for periods after September 30, 2006. With respect to countries outside of the United States, with certain exceptions, Valvoline’s foreign subsidiaries are subject to income tax audits for years after 2006.
Tax Matters Agreement
For the periods prior to the separation from Ashland and Distribution, Valvoline is included in Ashland’s consolidated U.S. and state income tax returns and in tax returns of certain Ashland international subsidiaries (collectively, the “Ashland Group Returns”). Under the Tax Matters Agreement between Valvoline and Ashland that was entered into on September 22, 2016, Ashland will generally make all necessary tax payments to the relevant tax authorities with respect to Ashland Group Returns, and Valvoline will make tax sharing payments to Ashland, inclusive of tax attributes utilized. The amount of the tax sharing payments will generally be determined as if Valvoline and each of its relevant subsidiaries included in the Ashland Group Returns filed their own consolidated, combined or separate tax returns for the period from the IPO to Distribution that include only Valvoline and/or its relevant subsidiaries, as the case may be. During fiscal 2017, Valvoline made $48 million in net tax-sharing payments to Ashland for the period prior to Distribution. In addition, Valvoline recognized a $16 million benefit in Selling, general and administrative expense for a reduction in amounts due to Ashland under the Tax Matters Agreement as a result of Ashland’s estimated utilization of Valvoline tax attributes in the Ashland Group Returns. This benefit was offset by additional income tax expense of $16 million.
For taxable periods that begin on or after the day after the date of Distribution, Valvoline is not included in any Ashland Group Returns and will file tax returns that include only Valvoline and/or its subsidiaries, as appropriate. Valvoline will not be required to make tax sharing payments to Ashland for those taxable periods. Nevertheless, Valvoline has (and will continue to have following Distribution) joint and several liability with Ashland to the U.S. Internal Revenue Service (“IRS”) for the consolidated U.S. federal income taxes of the Ashland consolidated group for the taxable periods in which Valvoline was part of the Ashland consolidated group.
The Tax Matters Agreement also generally provides that Valvoline has indemnified Ashland for the following items:
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• | Taxes of Valvoline for all taxable periods that begin on or after the day after the date of the Distribution; |
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• | Taxes of Valvoline for the period between the IPO and full separation from Ashland and Distribution that are not attributable to Ashland Group Returns; |
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• | Taxes for the pre-IPO period that arise on audit or examination and are directly attributable to the Valvoline business; |
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• | Certain U.S. federal, state or local taxes for the pre-IPO period of Ashland and/or its subsidiaries for that period that arise on audit or examination and are directly attributable to neither the Valvoline business nor the Ashland chemicals business; |
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• | Certain tax attributes inherited from Ashland as the result of the Contribution from Ashland; and |
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• | Transaction Taxes (as defined below) that are allocated to Valvoline under the Tax Matters Agreement. |
Total liabilities related to these and other obligations owed to Ashland under the Tax Matters Agreement are $62 million and $66 million at September 30, 2017 and 2016, respectively. The net liability at September 30, 2017 consisted of $1 million recorded in Accrued expenses and other liabilities and $61 million recorded in Other noncurrent liabilities in the Consolidated Balance Sheets. As of September 30, 2016, the net liability consisted of $5 million of receivables recorded in Other current assets and $71 million recorded in Other noncurrent liabilities in the Consolidated Balance Sheets.
The Tax Matters Agreement also provides that Valvoline indemnify Ashland for any taxes (and reasonable expenses) resulting from the failure of the Distribution to qualify for non-recognition of gain and loss or certain reorganization transactions related to the Contribution or the Distribution to qualify for their intended tax treatment (“Transaction Taxes”), where the taxes result from (1) breaches of covenants (including covenants containing the restrictions described below that are designed to preserve the tax-free nature of the Stock Distribution), (2) the application of certain provisions of U.S. federal income tax law to the Distribution with respect to acquisitions of Valvoline’s common stock or (3) any other actions that Valvoline knows or reasonably should expect would give rise to such taxes. The Tax Matters Agreement also requires Valvoline to indemnify Ashland for a portion of certain other Transaction Taxes allocated to Valvoline based on Valvoline’s market capitalization relative to the market capitalization of Ashland.
Valvoline will have either sole control, or joint control with Ashland, over any audit or examination related to taxes for which Valvoline is required to indemnify Ashland.
The Tax Matters Agreement imposes certain restrictions on Valvoline and its subsidiaries (including restrictions on share issuances or repurchases, business combinations, sales of assets and similar transactions) that are designed to preserve the tax-free nature of the Distribution. These restrictions will apply for the two-year period after the Distribution. However, Valvoline will be able to engage in an otherwise restricted action if Valvoline obtains an appropriate opinion from counsel or ruling from the IRS.