9. Income Taxes

Headwaters recorded income tax expense of approximately $3.6 million in 2014. For 2014, 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 18% effective tax rate for 2014 was due primarily to state income taxes in certain state jurisdictions.

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 indicated that Headwaters would 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 believed 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 several years ago; however, it is not possible to accurately predict whether recovery will continue, and if it does, at what rate and for how long.

Headwaters recorded income tax expense of approximately $22.8 million in 2016. The reported 31% effective rate for 2016 is the result of Headwaters being subject to normal statutory rates following the valuation allowance reversal in 2015. The reported effective tax rate is less than the statutory rate primarily due to unrecognized income tax benefits that were reversed due to audit periods that closed and changes to prior year estimated amounts for research and development tax credits.

As of September 30, 2016, Headwaters’ U.S. and state NOL and capital loss carryforwards totaled approximately $43.0 million (tax effected). The NOLs expire from 2017 to 2036. In addition, there are approximately $27.4 million of tax credit carryforwards as of September 30, 2016, which expire from 2025 to 2036. A valuation allowance of approximately $10.4 million was recorded against capital loss carryforwards, certain state NOL carryforwards, and certain tax credit carryforwards as of September 30, 2016.

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


(in thousands)	2014		2015		2016
Current tax benefit (provision):
Federal	$	65	$	8	$	(272)
State		(1,973)		(2,027)		246
Total current tax provision		(1,908)		(2,019)		(26)
Deferred tax benefit (provision):
Federal		(10,956)		(14,100)		(23,332)
State		1,296		1,300		810
Change in valuation allowance		7,994		109,277		(208)
Total deferred tax benefit (provision)		(1,666)		96,477		(22,730)
Total income tax benefit (provision)	$	(3,574)	$	94,458	$	(22,756)

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


(in thousands)	2014		2015		2016
Tax provision at U.S. statutory rate	$	(7,016)	$	(13,185)	$	(25,352)
State income taxes, net of federal tax effect		(1,973)		(931)		(1,349)
Valuation allowance		7,994		109,277		(208)
Non-deductible executive compensation		(1,242)		(105)		—
Tax credits		305		186		1,741
Unrealized gains		—		—		1,558
Unrecognized tax benefits		101		706		3,570
Other		(1,743)		(1,490)		(2,716)
Income tax benefit (provision)	$	(3,574)	$	94,458	$	(22,756)

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


(in thousands)	2015		2016
Deferred tax assets:
NOL and capital loss carryforwards	$	67,505	$	43,038
Tax credit carryforwards		24,954		27,406
Estimated liabilities		19,240		23,439
Stock-based compensation		5,903		5,480
Debt repurchase premium		5,154		5,635
Reserves and allowances		2,469		3,708
Other		3,176		549
Valuation allowances		(10,146)		(10,354)
Total deferred tax assets		118,255		98,901
Deferred tax liabilities:
Property, plant and equipment basis differences		(15,797)		(18,630)
Goodwill and intangible asset basis differences		(9,606)		(12,212)
Total deferred tax liabilities		(25,403)		(30,842)
Net deferred tax asset	$	92,852	$	68,059

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


(in thousands)	2014		2015		2016
Gross unrecognized income tax benefits at beginning of year	$	4,552	$	4,497	$	5,002
Changes based on tax positions related to the current year		—		25		122
Increases for tax positions related to prior years		—		1,055		1,437
Settlements		—		—		(417)
Lapse of statute of limitations		(55)		(575)		(3,082)
Gross unrecognized income tax benefits at end of year	$	4,497	$	5,002	$	3,062

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. During 2016, Headwaters released approximately $1.8 million of liabilities for interest and penalties and as of September 30, 2016, approximately $0.7 million was accrued for the payment of interest and penalties. Changes to the estimated liability during 2014, 2015 and 2016 were primarily the result of the expiration of statute of limitation time periods. As of September 30, 2016, approximately $2.8 million of unrecognized income tax benefits would affect the 2016 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 2013 through 2016. 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, the settlement of outstanding audit issues or the lapse of tax statutes of limitation. 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.