Notes to the Consolidated Financial Statements
(Dollars in millions, except per-share data and unless otherwise indicated)
Note 15 – Income and Other Taxes
Income before income taxes for the three years ended December 31, 2007 were as follows (in millions):
| 2007 | 2006 | 2005 | |||||||
|
Domestic income |
$ | 667 | $ | 429 | $ | 386 | |||
|
Foreign income |
771 | 379 | 444 | ||||||
|
Income before income taxes |
$ | 1,438 | $ | 808 | $ | 830 | |||
Provisions (benefits) for income taxes for the three years ended December 31, 2007 were as follows (in millions):
| 2007 | 2006 | 2005 | |||||||||
|
Federal income taxes |
|||||||||||
|
Current |
$ | 30 | $ | (448 | ) | $ | (94 | ) | |||
|
Deferred |
92 | 94 | (59 | ) | |||||||
|
Foreign income taxes |
|||||||||||
|
Current |
144 | 50 | 95 | ||||||||
|
Deferred |
120 | (9 | ) | 37 | |||||||
|
State income taxes |
|||||||||||
|
Current |
2 | 11 | 9 | ||||||||
|
Deferred |
12 | 14 | 7 | ||||||||
| Total | $ | 400 | $ | (288 | ) | $ | (5 | ) | |||
A reconciliation of the U.S. federal statutory income tax rate to the consolidated effective income tax rate for the three years ended December 31, 2007 was as follows:
| 2007 | 2006 | 2005 | |||||||
|
U.S. federal statutory income tax rate |
35.0 | % | 35.0 | % | 35.0 | % | |||
|
Nondeductible expenses |
0.9 | 1.4 | 3.4 | ||||||
|
Effect of tax law changes |
1.1 | (1.8 | ) | 0.3 | |||||
|
Change in valuation allowance for deferred tax assets |
1.0 | 1.4 | (4.6 | ) | |||||
|
State taxes, net of federal benefit |
1.3 | 1.8 | 1.6 | ||||||
|
Audit and other tax return adjustments |
(4.2 | ) | (62.5 | ) | (25.5 | ) | |||
|
Tax-exempt income |
(0.6 | ) | (0.9 | ) | (0.7 | ) | |||
|
Other foreign, including earnings taxed at different rates |
(7.4 | ) | (10.5 | ) | (10.3 | ) | |||
|
Other |
0.7 | 0.5 | 0.2 | ||||||
| Effective income tax rate | 27.8 | % | (35.6 | )% | (0.6 | )% | |||
On a consolidated basis, we paid a total of $104, $76, and $186 in income taxes to federal, foreign and state jurisdictions in 2007, 2006 and 2005, respectively.
Total income tax expense (benefit) for the three years ended December 31, 2007 was allocated as follows (in millions):
| 2007 | 2006 | 2005 | ||||||||||
|
Pre-tax income |
$ | 400 | $ | (288 | ) | $ | (5 | ) | ||||
|
Common shareholders’ equity: |
||||||||||||
|
Defined benefit plans/minimum pension liability(1) |
222 | (432 | ) | (18 | ) | |||||||
|
Stock option and incentive plans, net |
(22 | ) | (25 | ) | (12 | ) | ||||||
|
Translation adjustments and other |
24 | (9 | ) | (12 | ) | |||||||
| Total | $ | 624 | $ | (754 | ) | $ | (47 | ) | ||||
| (1) 2006 includes the effects of the adoption of FAS 158-see Note 1 for further information. |
Unrecognized Tax Benefits and Audit Resolutions
Due to the extensive geographical scope of our operations, we are subject to ongoing tax examinations in numerous jurisdictions. Accordingly, we may record incremental tax expense based upon the more-likely-than-not outcomes of any uncertain tax positions. In addition, when applicable, we adjust the previously recorded tax expense to reflect examination results when the position is effectively settled. Our ongoing assessments of the more-likely-than-not outcomes of the examinations and related tax positions require judgment and can increase or decrease our effective tax rate, as well as impact our operating results. The specific timing of when the resolution of each tax position will be reached is uncertain. As of December 31, 2007, we do not believe that there are any positions for which it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months.
Unrecognized Tax Benefits: A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in millions):
|
Balance at January 1, 2007 |
$ | 287 | ||
|
Additions from acquisitions |
4 | |||
|
Additions related to current year |
33 | |||
|
Additions related to prior years positions |
78 | |||
|
Reductions related to prior years positions |
(33 | ) | ||
|
Settlements with taxing authorities (1) |
(66 | ) | ||
|
Reductions related to lapse of statute of limitations |
(14 | ) | ||
|
Currency |
14 | |||
|
Balance at December 31, 2007 |
$ | 303 | ||
| (1) Majority of settlements resulted in utilization of deferred tax assets. |
Included in the balance at January 1, 2007 and as of December 31, 2007 are $93 and $137, respectively, of tax positions that are highly certain of realizability but for which there is uncertainty about the timing or may be reduced through an indirect benefit from other taxing jurisdictions. Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of these positions would not affect the annual effective tax rate.
We have filed claims in certain jurisdictions to assert our position should the law be clarified by judicial means. At this point in time, we believe it is unlikely that we will receive any benefit from these types of claims but we will continue to analyze as the issues develop. Accordingly, we have not included any benefit for these types of claims in the amount of unrecognized tax benefits.
Upon the adoption of FIN 48, we recognize interest and penalties accrued on unrecognized tax benefits as well as interest received from favorable settlements within income tax expense. In 2007, net interest and penalties were less than $1. We had $28 and $23 accrued for the payment of interest and penalties associated with unrecognized tax benefits at January 1, 2007 and December 31, 2007, respectively.
We file income tax returns in the U.S. federal jurisdiction and various foreign jurisdictions. In the U.S. we are no longer subject to U.S. federal income tax examinations by tax authorities for years before 2006. With respect to our major foreign jurisdictions, we are no longer subject to tax examinations by tax authorities before 2000.
2006 Audit Resolution: In the first quarter 2006, we recognized an income tax benefit of $24 from the favorable resolution of certain tax issues associated with our 1999-2003 Internal Revenue Service (“IRS”) audit which at the time had not yet been finalized. In the second quarter 2006, we recognized an income tax benefit of $46 related to the favorable resolution of certain tax matters associated with the finalization of foreign tax audits. In the third quarter 2006, we received notice that the U.S. Joint Committee on Taxation had completed its review of our 1999-2003 IRS audit and as a result of that review our audit for those years had been finalized. Accordingly, we recorded an aggregate income tax benefit of $448 associated with the favorable resolution of certain tax matters from this audit. The recorded benefit did not result in a significant cash refund, but it did increase tax credit carryforwards and reduce taxes otherwise potentially due.
2005 Audit Resolution: In the second quarter of 2005, the 1996-1998 IRS audit was finalized. As a result, we recorded an aggregate second quarter 2005 net income benefit of $343. $260 of this benefit, which includes an after-tax benefit of $33 for interest ($54 pre-tax benefit), is the result of a change in tax law that allowed us to recognize a benefit for $1.2 billion of capital losses associated with the disposition of our insurance group operations in those years. The claim of additional losses and related tax benefits required review by the U.S. Joint Committee on Taxation, which was completed in June 2005. The benefit did not result in a significant cash refund, but increased tax credit carryforwards and reduced taxes otherwise potentially due.
Deferred Income Taxes
In substantially all instances, deferred income taxes have not been provided on the undistributed earnings of foreign subsidiaries and other foreign investments carried at equity. The amount of such earnings included in consolidated retained earnings at December 31, 2007 was approximately $7.5 billion. These earnings have been indefinitely reinvested and we currently do not plan to initiate any action that would precipitate the payment of income taxes thereon. It is not practicable to estimate the amount of additional tax that might be payable on the foreign earnings. Our 2001 sale of half of our ownership interest in Fuji Xerox resulted in our investment no longer qualifying as a foreign corporate joint venture. Accordingly, deferred taxes are required to be provided on the undistributed earnings of Fuji Xerox, arising subsequent to such date, as we no longer have the ability to ensure indefinite reinvestment.
The tax effects of temporary differences that give rise to significant portions of the deferred taxes at December 31, 2007 and 2006 were as follows (in millions):
| 2007 | 2006 | |||||||
|
Tax effect of future tax deductions |
||||||||
|
Research and development |
$ | 895 | $ | 1,133 | ||||
|
Post-retirement medical benefits |
577 | 602 | ||||||
|
Depreciation |
292 | 261 | ||||||
|
Net operating losses |
576 | 553 | ||||||
|
Other operating reserves |
216 | 185 | ||||||
|
Tax credit carryforwards |
434 | 354 | ||||||
|
Deferred compensation |
249 | 232 | ||||||
|
Allowance for doubtful accounts |
100 | 108 | ||||||
|
Restructuring reserves |
15 | 70 | ||||||
|
Pension |
58 | 274 | ||||||
|
Other |
181 | 138 | ||||||
| 3,593 | 3,910 | |||||||
|
Valuation allowance |
(747 | ) | (647 | ) | ||||
|
Total deferred tax assets |
$ | 2,846 | $ | 3,263 | ||||
|
Tax effect of future taxable income |
||||||||
|
Unearned income and installment sales |
$ | (1,283 | ) | $ | (1,277 | ) | ||
|
Intangibles and goodwill |
(142 | ) | – | |||||
|
Other |
(40 | ) | (28 | ) | ||||
|
Total deferred tax liabilities |
(1,465 | ) | (1,305 | ) | ||||
|
Total deferred taxes, net |
$ | 1,381 | $ | 1,958 | ||||
The above amounts are classified as current or long-term in the Consolidated Balance Sheets in accordance with the asset or liability to which they relate or, when applicable, based on the expected timing of the reversal. Current deferred tax assets at December 31, 2007 and 2006 amounted to $200 and $271, respectively.
The deferred tax assets for the respective periods were assessed for recoverability and, where applicable, a valuation allowance was recorded to reduce the total deferred tax asset to an amount that will, more likely than not, be realized in the future. The net change in the total valuation allowance for the years ended December 31, 2007 and 2006 was an increase of $100 and an increase of $57, respectively. The valuation allowance relates primarily to certain net operating loss carryforwards, tax credit carryforwards and deductible temporary differences for which we have concluded it is more likely than not that these items will not be realized in the ordinary course of operations.
Although realization is not assured, we have concluded that it is more-likely-than-not that the deferred tax assets for which a valuation allowance was determined to be unnecessary, will be realized in the ordinary course of operations based on the available positive and negative evidence, including scheduling of deferred tax liabilities and projected income from operating activities. The amount of the net deferred tax assets considered realizable, however, could be reduced in the near term if actual future income or income tax rates are lower than estimated, or if there are differences in the timing or amount of future reversals of existing taxable or deductible temporary differences.
At December 31, 2007, we had tax credit carryforwards of $434 available to offset future income taxes, of which $240 are available to carryforward indefinitely while the remaining $194 will begin to expire, if not utilized, in 2008. We also had net operating loss carryforwards for income tax purposes of $255 that will expire in 2008 through 2024, if not utilized, and $2.7 billion available to offset future taxable income indefinitely.
