NOTE 15

INCOME TAXES

Income from Continuing Operations Before Income Tax Expense by Category

years ended December 31 (in millions)	2016		2015			2014
United States	$	3,906	$	(738	)	$	(803	)
International		1,048		1,166			1,293
Income from continuing operations before income taxes	$	4,954	$	428		$	490

Income Tax Expense Related to Continuing Operations

years ended December 31 (in millions)	2016			2015			2014
Current
United States
Federal	$	10		$	(251	)	$	(305	)
State and local		(3	)		(6	)		(44	)
International		282			345			398
Current income tax expense		289			88			49
Deferred
United States
Federal		(286	)		(9	)		63
State and local		3			(20	)		7
International		(18	)		(24	)		(86	)
Deferred income tax expense		(301	)		(53	)		(16	)
Income tax (benefit) expense	$	(12	)	$	35		$	33

Deferred Tax Assets and Liabilities

as of December 31 (in millions)	2016			2015
Deferred tax assets
Accrued expenses	$	377		$	389
Retirement benefits		411			352
Tax credits and net operating losses		747			547
Valuation allowances		(150	)		(135	)
Total deferred tax assets		1,385			1,153
Deferred tax liabilities
Subsidiaries’ unremitted earnings		145			147
Asset basis differences		704			847
Total deferred tax liabilities		849			994
Net deferred tax asset	$	536		$	159

At December 31, 2016, the company had U.S. operating loss carryforwards totaling $887 million and tax credit carryforwards totaling $332 million. The U.S. operating loss carryforwards expire between 2018 and 2036 and the tax credits expire between 2017 and 2034. At December 31, 2016, the company had foreign operating loss carryforwards totaling $1.4 billion and foreign tax credit carryforwards totaling $48 million. Of these foreign amounts, $38 million expires in 2017, $18 million expires in 2018, $20 million expires in 2019, $41 million expires in 2020, $28 million expires in 2021, $293 million expires after 2021 and $1 billion has no expiration date. Realization of these operating loss and tax credit carryforwards depends on generating sufficient taxable income in future periods. A valuation allowance of $150 million and $135 million was recorded at December 31, 2016 and 2015, respectively, to reduce the deferred tax assets associated with net operating loss and tax credit carryforwards, because the company does not believe it is more likely than not that these assets will be fully realized prior to expiration. The company will continue to evaluate the need for additional valuation allowances and, as circumstances change, the valuation allowance may change.

Income Tax Expense Related to Continuing Operations Reconciliation

years ended December 31 (in millions)	2016			2015			2014
Income tax expense at U.S. statutory rate	$	1,734		$	150		$	174
Retained shares tax free exchange gains		(1,587	)		—			—
Tax incentives		(126	)		(133	)		(105	)
State and local taxes		1			(13	)		(24	)
Foreign tax expense (benefit)		5			11			(16	)
Valuation allowances		3			5			7
Contingent tax matters		(48	)		9			(18	)
Branded Prescription Drug Fee		1			1			4
Deferred tax charge on intangible intra-group transfers		13			14			14
R&D tax credit		(2	)		(4	)		(1	)
Puerto Rico excise tax credit		(5	)		(9	)		—
Other factors		(1	)		4			(2	)
Income tax (benefit) expense	$	(12	)	$	35		$	33

The company recognized deferred US income tax expense of $35 million during 2016 relating to 2016 earnings outside the United States that are not deemed indefinitely reinvested. The company continues to evaluate whether to indefinitely reinvest earnings in certain foreign jurisdictions as it continues to analyze the company’s global financial structure. Currently, management intends to continue to reinvest past earnings in several jurisdictions outside of the United States indefinitely, and therefore has not recognized U.S. income tax expense on these earnings. U.S. federal and state income taxes, net of applicable credits, on these foreign unremitted earnings from continuing operations of $9.3 billion as of December 31, 2016 would be approximately $2.6 billion. As of December 31, 2015 the foreign unremitted earnings from continuing operations and U.S. federal and state income tax amounts were $8.5 billion and $2.4 billion, respectively.

Effective Income Tax Rate — Continuing Operations

The effective income tax rate for continuing operations was $(0.2%) in 2016, 8.2% in 2015 and 6.7% in 2014. As detailed in the income tax expense reconciliation table above, the company’s effective tax rate differs from the U.S. federal statutory rate each year due to certain operations that are subject to tax incentives, state and local taxes, and foreign taxes that are different than the U.S. federal statutory rate. In addition, the effective tax rate can be impacted each period by discrete factors and events.

Factors impacting the company’s effective tax rate in 2016 included tax-free net realized gains during the first and second quarter associated with the exchanges of Baxalta Retained Shares for the company’s debt and the company’s shares as well as tax-free net realized gains associated with the contribution of Baxalta Retained Shares to the company’s pension plan. Additionally, the income tax rate for 2016 was favorably impacted by tax benefits from partially settling an IRS (2008-2013) income tax audit, settling a German (2008-2011) income tax audit, resolution of uncertain tax positions related to the company’s former Turkish JV and other miscellaneous TP matters including partial settlement of interest expense deductions related to the company’s acquisition of Gambro.

Factors adversely impacting the company’s effective tax rate in 2015 included charges related to contingent tax matters primarily related to transfer pricing and separation of Baxalta as well as the need to record valuation allowances for some loss making entities. Partially offsetting the foregoing adverse factors was a benefit from reaching a settlement of the Puerto Rico excise tax matter as well as the retroactive reinstatement in December 2015 of the US R&D credit resulting from the Protecting Americans from Tax Hikes Act of 2015.

Factors impacting the company’s effective tax rate in 2014 included the favorable settlement of a portion of the company’s contingent tax matter related to operations in Turkey as well as a favorable shift of earnings from high to low tax jurisdictions compared to the prior period. Additionally, the effective tax rate was unfavorably impacted by increases in valuation allowances in respect of the tax benefit from losses that the company does not believe that it is more likely than not to realize and interest expense related to the company’s unrecognized tax benefits.

Unrecognized Tax Benefits

The company classifies interest and penalties associated with income taxes in the income tax expense line in the consolidated statements of income. Net interest and penalties recorded during 2016, 2015 and 2014 were $6 million, $3 million and $12 million, respectively. The liability recorded at December 31, 2016 and 2015 related to interest and penalties was $11 million and $56 million, respectively. The decrease in the liability for interest and penalties was due, in part, to settlement of audits in the United States, Germany and Italy, as described in the Examination of Tax Returns section below. The total amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate is approximately $82 million.

The following table is a reconciliation of the company’s unrecognized tax benefits, including those related to discontinued operations for the years ended December 31, 2016, 2015 and 2014.

as of and for the years ended (in millions)	2016			2015			2014
Balance at beginning of the year	$	191		$	206		$	287
Increase associated with tax positions taken during the current year		7			24			41
Decrease associated with tax positions taken during a prior year		(31	)		(26	)		(27	)
Settlements		(75	)		(3	)		(82	)
Decrease associated with lapses in statutes of limitations		(10	)		(10	)		(13	)
Balance at end of the year	$	82		$	191		$	206

Of the gross unrecognized tax benefits, $74 million and $209 million were recognized as liabilities in the consolidated balance sheets as of December 31, 2016 and 2015, respectively. Baxter has recorded net indemnification receivables from Baxalta in the amount of $28 million and $93 million as of December 31, 2016 and 2015, respectively, related to the unrecognized tax benefits for which Baxter is the primary obligor but economically relate to Baxalta operations. Additionally, in the table above amounts related to 2015 included as a decrease a gross liability transferred to Baxalta in the amount of $10 million for which Baxalta is the primary obligor.

None of the positions included in the liability for uncertain tax positions related to tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility.

Tax Incentives

The company has received tax incentives in Puerto Rico, Switzerland, Dominican Republic, Costa Rica and certain other taxing jurisdictions outside the United States. The financial impact of the reductions as compared to the statutory tax rates is indicated in the income tax expense reconciliation table above. The tax reductions as compared to the local statutory rate favorably impacted earnings from continuing operations per diluted share by $0.23 in 2016, $0.24 in 2015 and $0.20 in 2014. The Puerto Rico grant provides that the company’s manufacturing operations are and will be partially exempt from local taxes until the year 2018.

Examinations of Tax Returns

During 2016, Baxter paid approximately $303 million to partially settle a U.S. federal income tax audit for the period 2008-2013. Additionally, the company settled a German income tax audit for the period 2008-2011 and settled an Italian audit for the period 2010-2012. As a result of these settlements, the company reduced its gross unrecognized tax benefits by $75 million. Pursuant to the tax matters agreement with Baxalta, Baxalta paid the company approximately $37 million related to its tax indemnity obligations in respect of its portion of the settled gross unrecognized tax benefits. See Note 2 for additional details regarding the separation of Baxalta.

As of December 31, 2016, Baxter had ongoing audits in the United States, Austria, Sweden and other jurisdictions. Baxter expects to reduce the amount of its liability for uncertain tax positions within the next 12 months by $10 million due principally to the resolution of transfer pricing disputes in several jurisdictions. While the final outcome of these matters is inherently uncertain, the company believes it has made adequate tax provisions for all years subject to examination.