9.Income Taxes

Headwaters’ estimated effective income tax rate for continuing operations for the fiscal year ending September 30, 2015, exclusive of discrete items, is currently expected to be approximately 10%. This estimated rate was used to record income taxes for the six months ended March 31, 2015. For the six months ended March 31, 2014, Headwaters used an estimated effective income tax rate for continuing operations of 18%. Headwaters did not recognize any tax expense or benefit for discrete items in 2014, but recognized approximately $0.9 million of tax benefit for discrete items in 2015 that did not affect the calculation of the estimated effective income tax rate for the 2015 fiscal year. The discrete items were due primarily to unrecognized state income tax benefits that were reversed due to audit periods that closed.

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 for any period presented, except to the extent of projected fiscal year earnings. The estimated income tax rates of 18% for fiscal 2014 and 10% for fiscal 2015 resulted primarily from the combination of recognizing benefit for deferred tax assets only to the extent of projected fiscal year earnings, plus current state income taxes in certain state jurisdictions where taxable income is expected to be generated.

A valuation allowance is required when there is significant uncertainty as to the realizability of deferred tax assets. The ability to realize 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 has 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.

A majority of Headwaters’ tax attributes have significant carryover periods of 20 years or more.

Negative evidence:

Headwaters had a three-year cumulative loss as of September 30, 2014, and has not generated significant earnings year to date in fiscal 2015.

Headwaters operates in cyclical industries that are difficult to forecast.

Headwaters places more weight on objectively verifiable evidence than on other types of evidence and management currently believes that available negative evidence outweighs the available positive evidence. Management has therefore 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 fiscal 2015, Headwaters may emerge from a three-year cumulative loss status on a consolidated basis. Headwaters will consider this and the other factors described above in evaluating the continued need for a full, or partial, valuation allowance.

All of the factors Headwaters is considering in evaluating whether and when to release all or a portion of the deferred tax asset valuation allowance involve significant judgment. For example, there are many different interpretations of “cumulative 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. Any reversal of the valuation allowance will favorably impact Headwaters’ results of operations in the period of reversal.

As of March 31, 2015, Headwaters’ NOL and capital loss carryforwards totaled approximately $77.8 million (tax effected). The U.S. and state NOLs expire from 2015 to 2034. In addition, there are approximately $24.8 million of tax credit carryforwards as of March 31, 2015, which expire from 2028 to 2034.

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 2011 through 2013. 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.