9. Income Taxes

As of September 30, 2010, Headwaters' net deferred income tax position was near $0. Beginning in 2011, Headwaters has recorded a full valuation allowance on its net amortizable deferred tax assets and accordingly, did not recognize benefit for tax credit carryforwards, net operating loss (NOL) carryforwards or other deferred tax assets in 2011, 2012 or 2013, except to the extent of 2013 earnings. Headwaters recorded a minimal income tax benefit in 2011 and approximately $0.7 million and $3.9 million of income tax expense in 2012 and 2013, respectively.

The reported income tax rate for 2011 of near 0% and the negative income tax rate of (3)% for 2012 were due to the combination of not recognizing benefit for pre-tax losses and tax credits, but recognizing current state income taxes in certain state jurisdictions where Headwaters generated taxable income. The reported 32% rate for 2013 was also due primarily to the combination of recognizing benefit for deferred tax assets only to the extent of 2013 earnings plus state income taxes in certain state jurisdictions.

A valuation allowance is required when there is significant uncertainty as to the realizability of deferred tax assets. Because the realization of Headwaters' deferred tax assets is dependent upon future income in domestic and foreign jurisdictions that have generated losses, management determined that Headwaters does not meet the "more likely than not" threshold that NOLs, tax credits and other deferred tax assets will be realized. Accordingly, a valuation allowance is required. During 2014, Headwaters may realize a three-year cumulative accounting profit. If this occurs, Headwaters will also consider other positive and negative evidence such as current financial performance, financial and taxable income projections, the market environment and other factors, in evaluating the continued need for a full, or partial, valuation allowance. Any reversal of the valuation allowance will favorably impact Headwaters' results of operations in the period of reversal.

As of September 30, 2013, Headwaters' NOL and capital loss carryforwards totaled approximately $78.1 million (tax effected). The U.S. and state NOLs expire from 2014 to 2033. Substantially all of the non-U.S. NOLs, which are not material, do not expire. In addition, there are approximately $25.6 million of tax credit carryforwards as of September 30, 2013, which expire from 2014 to 2033.

The income tax benefit (provision) consisted of the following for the years ended September 30:

(in thousands)	2011			2012			2013

Current tax benefit (provision):
Federal	$	1,109		$	1,267		$	(1,292	)
State		(968	)		(1,717	)		(1,934	)

Total current tax benefit (provision)		141			(450	)		(3,226	)
Deferred tax benefit (provision):
Federal		30			(211	)		(698	)
State		0			0			0

Total deferred tax benefit (provision)		30			(211	)		(698	)

Total income tax benefit (provision)	$	171		$	(661	)	$	(3,924	)

The benefit (provision) for income taxes differs from the amount computed using the statutory federal income tax rate due to the following:

(in thousands)	2011			2012			2013

Tax benefit (provision) at U.S. statutory rate	$	46,936		$	9,019		$	(4,273	)
State income taxes, net of federal tax effect		(968	)		(1,717	)		(1,934	)
Valuation allowance		(45,310	)		(8,913	)		3,955
Unrecognized tax benefits		1,110			1,268			(1,245	)
Other		(1,597	)		(318	)		(427	)

Income tax benefit (provision)	$	171		$	(661	)	$	(3,924	)

The components of Headwaters' deferred income tax assets and liabilities were as follows as of September 30:

(in thousands)	2012			2013

Deferred tax assets:
NOL and capital loss carryforwards	$	69,252		$	78,095
Tax credit carryforwards		23,779			25,619
Debt repurchase premium		18,221			15,503
Estimated liabilities		15,819			14,165
Stock-based compensation		9,306			8,127
Reserves and allowances		2,409			5,805
Deferred revenue		584			6,792
Convertible note hedge		1,279			47
Other		1,950			2,137
Valuation allowances		(127,795	)		(127,418	)

Total deferred tax assets		14,804			28,872
Deferred tax liabilities:
Property, plant and equipment basis differences		(11,066	)		(26,065	)
Goodwill and intangible asset basis differences		(2,381	)		(2,759	)
Convertible debt discount		(1,357	)		(48	)
Indefinite lived intangible asset basis differences		(2,505	)		(3,204	)

Total deferred tax liabilities		(17,309	)		(32,076	)

Net deferred tax liability	$	(2,505	)	$	(3,204	)

A reconciliation of the change in the amount of gross unrecognized income tax benefits is as follows.

(in thousands)	2011			2012			2013

Gross unrecognized income tax benefits at beginning of year	$	11,843		$	8,312		$	4,872
Changes based on tax positions related to the current year		(872	)		(370	)		0
Increases for tax positions related to prior years		4,915			560			1,214
Reductions for tax positions related to prior years		(5,365	)		(2,073	)		(1,439	)
Settlements		(1,720	)		(65	)		(16	)
Lapse of statute of limitations		(489	)		(1,492	)		(79	)

Gross unrecognized income tax benefits at end of year	$	8,312		$	4,872		$	4,552

During 2011 and 2012, Headwaters released approximately $3.4 million and $0.4 million, respectively, of liabilities for interest and penalties. During 2013, Headwaters accrued approximately $0.3 million of liabilities for interest and penalties and as of September 30, 2013, approximately $2.6 million was accrued for the payment of interest and penalties. Changes to the estimated liability for unrecognized income tax benefits during 2011 were primarily the result of settlement of the IRS audit for the years 2005 through 2008. Changes to the estimated liability for unrecognized income tax benefits during 2012 were primarily the result of an agreement reached with the IRS regarding its audit of 2009 and the expiration of statute of limitation time periods. Changes to the estimated liability for unrecognized income tax benefits during 2013 were primarily the result of additional state income tax reserves and the reversal in discontinued operations of unrecognized income tax benefits related to the completion of the 2009 IRS audit, as noted below. As of September 30, 2013, approximately $4.8 million of unrecognized income tax benefits would affect the 2013 effective tax rate if released into income, due to the impact of the valuation allowance.

The calculation of tax liabilities involves uncertainties in the application of complex tax regulations in multiple tax jurisdictions. Headwaters currently has open tax years subject to examination by the IRS for the years 2010 through 2012 and by other taxing authorities for the years 2009 through 2012. Headwaters recently completed an audit by the IRS for 2009 which did not result in any material impact to earnings from continuing operations. However, the completion of this audit did result in a tax benefit of approximately $2.7 million in discontinued operations related to the reversal of unrecognized tax benefits.

Headwaters recognizes potential liabilities for anticipated tax audit issues in the U.S. and state tax jurisdictions based on estimates of whether, and the extent to which, additional taxes and interest will be due. If events occur (or do not occur) as expected and the payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when it is determined the liabilities are no longer required to be recorded in the consolidated financial statements. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. It is reasonably possible that the amount of Headwaters' unrecognized income tax benefits could change significantly within the next 12 months. These changes could be the result of Headwaters' ongoing tax audits or the settlement of outstanding audit issues. However, due to the issues being examined, at the current time, an estimate of the range of reasonably possible outcomes cannot be made, beyond amounts currently accrued.