Note 9. Income Taxes

Pre-tax Income

The domestic and foreign components of income before income taxes were as follows for the three years ended June 27, 2014 (in millions):



	2014		2013		2012
Foreign	$	1,664	$	870	$	1,559
Domestic	88		352		198
Income before income taxes	$	1,752	$	1,222	$	1,757

Income Tax Provision

The components of the provision for income taxes were as follows for the three years ended June 27, 2014 (in millions):



	2014			2013			2012
Current:
Foreign	$	47		$	57		$	12
Domestic-federal	98			149			98
Domestic-state	3			1			1
Deferred:
Foreign	(3		)	(7		)	18
Domestic-federal	(14		)	(46		)	25
Domestic-state	4			88			(9		)
Income tax provision	$	135		$	242		$	145

The Company’s income tax provision for 2013 reflects a tax benefit of $37 million as a result of the retroactive extension of the U.S. Federal research and experimentation tax credit (“R&D credit”) that was signed into law on January 2, 2013 as part of the American Taxpayer Relief Act of 2012. The R&D credit, which had previously expired on December 31, 2011, was extended through December 31, 2013. In addition, the Company recorded an $88 million charge to reduce its previously recognized California deferred tax assets in 2013 as a result of the enactment of California Proposition 39.

Remaining net undistributed earnings from foreign subsidiaries at June 27, 2014 on which no U.S. tax has been provided amounted to $8.2 billion. The net undistributed earnings are intended to finance local operating requirements and capital investments. Accordingly, an additional U.S. tax provision has not been made on these earnings. The tax liability for these earnings would be $2.7 billion if the Company repatriated the $8.2 billion in undistributed earnings from the foreign subsidiaries.

Deferred Taxes

Temporary differences and carryforwards, which give rise to a significant portion of deferred tax assets and liabilities as of June 27, 2014 and June 28, 2013 were as follows (in millions):



	2014			2013
Deferred tax assets:
Sales related reserves and accrued expenses not currently deductible	$	38		$	45
Accrued compensation and benefits not currently deductible	190			182
Domestic net operating loss carryforward	130			103
Business credit carryforward	155			123
Long-lived assets	58			47
Other	65			71
Total deferred tax assets	636			571
Deferred tax liabilities:
Long-lived assets	(152		)	(156		)
Other	(11		)	—
Total deferred tax liabilities	(163		)	(156		)
Valuation allowances	(128		)	(133		)
Deferred tax assets, net	$	345		$	282
Deferred tax assets:
Current portion (included in other current assets)	$	184		$	160
Non-current portion (included in other non-current assets)	452			411
Total deferred tax assets	636			571
Deferred tax liabilities:
Current portion (included in other current assets)	(2		)	—
Non-current portion (included in other non-current assets)	(161		)	(156		)
Total deferred tax liabilities	(163		)	(156		)
Valuation allowances (included in non-current portion of deferred tax assets)	(128		)	(133		)
Deferred tax assets, net	$	345		$	282

The net deferred tax asset valuation allowance was $128 million as of June 27, 2014. The valuation allowance is based on the Company’s assessment that it is more likely than not that certain deferred tax assets will not be realized in the foreseeable future.

In addition to the deferred tax assets presented above, the Company had additional NOL benefits related to stock-based compensation deductions of $11 million and $13 million at June 27, 2014 and June 28, 2013, respectively. During the current year, the Company generated an additional $66 million of benefits related to stock-based compensation deductions, of which $60 million were utilized in the current year and recorded as a credit to shareholder's equity.

Effective Tax Rate

Reconciliation of the U.S. Federal statutory rate to the Company’s effective tax rate is as follows for the three years ended June 27, 2014:



	2014		2013		2012
U.S. Federal statutory rate	35	%	35	%	35	%
Tax rate differential on international income	(28	)	(19	)	(29	)
Tax effect of U.S. permanent differences	2		—		3
State income tax, net of federal tax	—		8		1
Income tax credits	(1	)	(4	)	(2	)
Effective tax rate	8	%	20	%	8	%

Tax Holidays and Carryforwards

A substantial portion of the Company’s manufacturing operations in Malaysia, the Philippines, Singapore and Thailand operate under various tax holidays and tax incentive programs which will expire in whole or in part at various dates from 2015 through 2025. Certain of the holidays may be extended if specific conditions are met. The net impact of these tax holidays and tax incentives was to increase the Company’s net earnings by $905 million ($3.74 per diluted share), $899 million ($3.65 per diluted share), and $729 million ($2.98 per diluted share) in 2014, 2013 and 2012, respectively.

As of June 27, 2014, the Company had federal and state NOL carryforwards of $440 million and $480 million, respectively. In addition, as of June 27, 2014, the Company had various federal and state tax credit carryforwards of $331 million combined. The NOL carryforwards available to offset future federal and state taxable income expire at various dates from 2020 to 2032 and 2017 to 2032, respectively. Approximately $50 million of the credit carryforwards available to offset future taxable income expire at various dates from 2016 to 2033. The remaining amount is available indefinitely. NOLs and credits relating to Komag, Incorporated (“Komag”), which was acquired by the Company on September 5, 2007, HGST, sTec and Virident are subject to limitations under Sections 382 and 383 of the Internal Revenue Code. The Company does not expect these limitations to result in a reduction in the total amount of Komag, sTec or Virident's NOLs and credits ultimately realized. The Company expects the total amount of HGST’s NOLs and credits ultimately realized will be reduced by $39 million and $25 million, respectively. Because the Company expects the amount of HGST’s NOLs and credits ultimately realized will be reduced, the Company has adjusted goodwill accordingly.

Uncertain Tax Positions

The Company recognizes liabilities for uncertain tax positions based on a two-step process. First, the tax position is evaluated for recognition by determining if it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. If the tax position is deemed more-likely-than-not to be sustained, the tax position is then assessed to determine the amount of benefit to be recognized in the financial statements. The amount of the benefit that may be recognized is the largest amount that has a greater than 50% likelihood of being realized upon ultimate settlement. With the exception of certain unrecognized tax benefits that are directly associated with the tax position taken, unrecognized tax benefits are presented gross in the Company’s balance sheet. Interest and penalties related to unrecognized tax benefits are recognized on liabilities recorded for uncertain tax positions and are recorded in the provision for income taxes. As of June 27, 2014, such interest and penalties were not material. As of June 27, 2014, the Company had $300 million of unrecognized tax benefits.

The following is a tabular reconciliation of the total amounts of unrecognized tax benefits for the years ended June 27, 2014, June 28, 2013 and June 29, 2012 (in millions):



	2014			2013			2012
Unrecognized tax benefit at beginning of period	$	240		$	280		$	245
Gross increases related to current year tax positions	27			29			14
Gross increases related to prior year tax positions	26			10			—
Gross decreases related to prior year tax positions	(5		)	(8		)	—
Settlements	—			(64		)	(18		)
Lapse of statute of limitations	—			(7		)	—
Acquisitions	12			—			39
Unrecognized tax benefit at end of period	$	300		$	240		$	280

The Company’s unrecognized tax benefits are primarily included within long-term liabilities in the Company’s consolidated balance sheets. The entire balance of unrecognized tax benefits at June 27, 2014, June 28, 2013 and June 29, 2012, if recognized, would affect the effective tax rate.

The Company files U.S. Federal, U.S. state, and foreign tax returns. For both federal and state tax returns, with few exceptions, the Company is subject to examination for fiscal years 2008 through 2013. In foreign jurisdictions, with few exceptions, the Company is subject to examination for all years subsequent to fiscal 2007. The Company is no longer subject to examination by the IRS for periods prior to 2008, although carry forwards generated prior to those periods may still be adjusted upon examination by the IRS or state taxing authority if they either have been or will be used in a subsequent period.

The IRS previously completed its field examination of the Company’s federal income tax returns for fiscal years 2006 and 2007 and issued Revenue Agent Reports that proposed adjustments to income before income taxes of approximately $970 million primarily related to transfer pricing and intercompany payable balances. The Company disagreed with the proposed adjustments and filed a protest with the IRS Appeals Office. In June 2013, the Company reached an agreement with the IRS to resolve the transfer pricing issue. This agreement resulted in a decrease in the amount of net operating loss and tax credits realized, but did not have an impact to the Company’s consolidated statements of income. The proposed adjustment relating to intercompany payable balances for fiscal years 2006 and 2007 will be addressed in conjunction with the IRS’s examination of the Company’s fiscal years 2008 and 2009, which commenced in January 2012. In addition, in January 2012, the IRS commenced an examination of the 2007 fiscal period ended September 5, 2007 of Komag. In February 2013, the IRS commenced an examination of calendar years 2010 and 2011 of HGST, which was acquired by the Company on March 8, 2012.

The Company believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. As of June 27, 2014, it is not possible to estimate the amount of change, if any, in the unrecognized tax benefits that is reasonably possible within the next twelve months. Any significant change in the amount of the Company’s liability for unrecognized tax benefits would most likely result from additional information or settlements relating to the examination of the Company’s tax returns.