10. Income Taxes

Headwaters recorded income tax expense of approximately $3.9 million and $3.6 million in 2013 and 2014, respectively. For both years, Headwaters 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, except to the extent of earnings. The reported 32% and 18% effective tax rates for 2013 and 2014 were due primarily to state income taxes in certain state jurisdictions. In 2013, Headwaters also recognized a tax benefit of approximately $2.7 million in discontinued operations, due primarily to the reversal of unrecognized income tax benefits related to audit periods that closed.

In 2015, Headwaters recorded an income tax benefit of approximately $94.5 million, primarily due to the release of approximately $109.3 million of the valuation allowance established in prior years. A valuation allowance is required when there is significant uncertainty as to the realizability of deferred tax assets. Realization of deferred tax assets is dependent upon Headwaters' ability to generate sufficient taxable income within the carryforward periods provided for in the tax law for each tax jurisdiction. Headwaters considered the following possible sources of taxable income when assessing the realization of its deferred tax assets:


	•	future reversals of existing taxable temporary differences;
	•	future taxable income or loss, exclusive of reversing temporary differences and carryforwards;
	•	tax-planning strategies; and
	•	taxable income in prior carryback years.

Headwaters considered both positive and negative evidence in determining the continued need for a valuation allowance, including the following:


	Positive evidence:
	•	Current forecasts indicate that Headwaters will generate pre-tax income and taxable income in the future.
	•	Headwaters had a three-year cumulative income as of September 30, 2015.
	•	A majority of Headwaters' tax attributes have significant carryover periods of 20 years or more.
	Negative evidence:
	•	Headwaters operates in cyclical industries that are difficult to forecast.

Headwaters placed more weight on objectively verifiable evidence than on other types of evidence and management believes that available positive evidence outweighed the available negative evidence. Management therefore determined that Headwaters met the "more likely than not" threshold that NOLs, tax credits and other deferred tax assets will be realized. Accordingly, a full valuation allowance was no longer deemed to be required as of September 30, 2015. A valuation allowance of approximately $10.1 million was maintained against capital loss carryforwards, certain state NOL carryforwards, and certain tax credit carryforwards as of September 30, 2015.

All of the factors Headwaters considered in evaluating whether and when to release all or a portion of the deferred tax asset valuation allowance involved significant judgment. For example, there are many different interpretations of "cumulative income or losses in recent years" which can be used. Also, significant judgment is involved in making projections of future financial and taxable income, especially because Headwaters' financial results are significantly dependent upon industry trends, including new housing construction, repair and remodeling, and infrastructure construction. Most of the end use categories in which Headwaters sells its products and services are currently in varying states of recovery from the historic downturn experienced in recent years; however, it is not possible to accurately predict whether recovery will continue, and if it does, at what rate and for how long.

As of September 30, 2015, Headwaters' U.S. and state NOL and capital loss carryforwards totaled approximately $67.5 million (tax effected). The NOLs expire from 2016 to 2035. In addition, there are approximately $25.0 million of tax credit carryforwards as of September 30, 2015, which expire from 2028 to 2033.

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

(in thousands)	2013			2014			2015
Current tax benefit (provision):
Federal	$	(1,292	)	$	65		$	8
State		(1,934	)		(1,973	)		(2,027	)

Total current tax provision		(3,226	)		(1,908	)		(2,019	)
Deferred tax benefit (provision):
Federal		(5,473	)		(10,956	)		(14,100	)
State		820			1,296			1,300
Change in valuation allowance		3,955			7,994			109,277

Total deferred tax benefit (provision)		(698	)		(1,666	)		96,477

Total income tax benefit (provision)	$	(3,924	)	$	(3,574	)	$	94,458

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

(in thousands)	2013			2014			2015
Tax provision at U.S. statutory rate	$	(4,273	)	$	(7,016	)	$	(13,185	)
State income taxes, net of federal tax effect		(1,934	)		(1,973	)		(931	)
Valuation allowance		3,955			7,994			109,277
Non-deductible executive compensation		0			(1,242	)		(105	)
Unrecognized tax benefits		(1,245	)		101			706
Other		(427	)		(1,438	)		(1,304	)

Income tax benefit (provision)	$	(3,924	)	$	(3,574	)	$	94,458

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

(in thousands)	2014			2015
Deferred tax assets:
NOL and capital loss carryforwards	$	70,320		$	67,505
Tax credit carryforwards		24,784			24,954
Estimated liabilities		15,925			19,240
Stock-based compensation		6,958			5,903
Debt repurchase premium		12,711			5,154
Reserves and allowances		4,860			2,469
Deferred revenue		5,898			170
Other		1,644			3,006
Valuation allowances		(119,424	)		(10,146	)

Total deferred tax assets		23,676			118,255
Deferred tax liabilities:
Property, plant and equipment basis differences		(20,483	)		(15,797	)
Goodwill and intangible asset basis differences		(8,062	)		(9,606	)

Total deferred tax liabilities		(28,545	)		(25,403	)

Net deferred tax asset (liability)	$	(4,869	)	$	92,852

A reconciliation of the change in the amount of gross unrecognized income tax benefits, not including interest and penalties, is as follows:

(in thousands)	2013			2014			2015
Gross unrecognized income tax benefits at beginning of year	$	4,872		$	4,552		$	4,497
Changes based on tax positions related to the current year		0			0			25
Increases for tax positions related to prior years		1,214			0			1,055
Reductions for tax positions related to prior years		(1,439	)		0			0
Settlements		(16	)		0			0
Lapse of statute of limitations		(79	)		(55	)		(575	)

Gross unrecognized income tax benefits at end of year	$	4,552		$	4,497		$	5,002

During 2013, Headwaters accrued approximately $0.3 million of liabilities for interest and penalties. During 2014, Headwaters accrued approximately $0.1 million of liabilities for interest and penalties. During 2015, Headwaters released approximately $0.2 million of liabilities for interest and penalties and as of September 30, 2015, approximately $2.5 million was accrued for the payment of interest and penalties. Changes to the estimated liability 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 completion of the 2009 IRS audit. Changes to the estimated liability during 2014 were primarily the result of the expiration of statute of limitation time periods. Changes to the estimated liability during 2015 were primarily the result of the expiration of statute of limitation time periods. As of September 30, 2015, approximately $3.9 million of unrecognized income tax benefits would affect the 2015 effective tax rate if released into income.

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 and state tax authorities for the years 2012 through 2014. 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 approximately $5.0 million of Headwaters' unrecognized income tax benefits will be released within the next 12 months. Most of this amount relates to state taxes and is currently expected to be released in the December 2015 quarter due to the expiration of statute of limitation time periods.