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 28, 2013 (in millions):


	2013		2012		2011
Foreign	$	870	$	1,559	$	660
Domestic		352		198		120

Income before income taxes	$	1,222	$	1,757	$	780

Income Tax Provision

The components of the provision for income taxes were as follows for the three years ended June 28, 2013 (in millions):


	2013			2012			2011
Current:
Foreign	$	57		$	12		$	12
Domestic-federal		149			98			21
Domestic-state		1			1			1
Deferred:
Foreign		(7	)		18			—
Domestic-federal		(46	)		25			30
Domestic-state		88			(9	)		(10	)

Income tax provision	$	242		$	145		$	54

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, on November 6, 2012, California voters approved California Proposition 39, which affects California state income tax apportionment for most multi-state taxpayers for tax years beginning on or after January 1, 2013. This proposition reduces the Company’s future income apportioned to California, making it less likely for the Company to realize certain California deferred tax assets. As a result, the Company recorded an $88 million charge in 2013 to reduce its previously recognized California deferred tax assets as of December 28, 2012.

Remaining net undistributed earnings from foreign subsidiaries at June 28, 2013 on which no U.S. tax has been provided amounted to $6.8 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 $2.3 billion if the Company repatriated the $6.8 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 28, 2013 and June 29, 2012 were as follows (in millions):


	2013			2012
Deferred tax assets:
Sales related reserves and accrued expenses not currently deductible	$	45		$	61
Accrued compensation and benefits not currently deductible		182			166
Domestic net operating loss carryforward		103			112
Business credit carryforward		123			154
Long-lived assets		47			—
Other		71			90

Total deferred tax assets		571			583
Deferred tax liabilities:
Long-lived assets		(156	)		(191	)
Other		—			(18	)

Total deferred tax liabilities		(156	)		(209	)

Valuation allowances		(133	)		(40	)

Deferred tax assets, net	$	282		$	334

Deferred tax assets:
Current portion (included in other current assets)	$	160		$	159
Non-current portion (included in other non-current assets)		411			424

Total deferred tax assets		571			583
Deferred tax liabilities:
Current portion (included in other current assets)		—			(3	)
Non-current portion (included in other non-current assets)		(156	)		(206	)

Total deferred tax liabilities		(156	)		(209	)

Valuation allowances (included in non-current portion of deferred tax assets)		(133	)		(40	)

Deferred tax assets, net	$	282		$	334

The net deferred tax asset valuation allowance was $133 million as of June 28, 2013. This $93 million increase in valuation allowance was due to the passage of Proposition 39, which affects California state income apportionment for most multi-state taxpayers beginning on or after January 1, 2013. This proposition reduces the Company’s future income apportioned to California, making it less likely for the Company to realize certain California deferred tax assets. 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 $13 million and $33 million at June 28, 2013 and June 29, 2012, respectively. During the current year, the Company generated an additional $25 million of benefits related to stock-based compensation deductions. The benefits generated in the current year, along with $20 million of the benefits related to prior years, were utilized in the current year. This $45 million was recorded as a credit to shareholders’ 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 28, 2013:


	2013			2012			2011
U.S. Federal statutory rate		35	%		35	%		35	%
Tax rate differential on international income		(19	)		(29	)		(26	)
Tax effect of U.S. permanent differences		—			3			3
State income tax, net of federal tax		8			1			(1	)
Income tax credits		(4	)		(2	)		(4	)

Effective tax rate		20	%		8	%		7	%

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 2014 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 $899 million ($3.65 per diluted share), $729 million ($2.98 per diluted share), and $362 million ($1.54 per diluted share) in 2013, 2012 and 2011, respectively.

As of June 28, 2013, the Company had federal and state NOL carryforwards of $309 million and $205 million, respectively. In addition, as of June 28, 2013, the Company had various federal and state tax credit carryforwards of $271 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 2031, respectively. Approximately $42 million of the credit carryforwards available to offset future taxable income expire at various dates from 2016 to 2031. The remaining amount is available indefinitely. NOLs and credits relating to Komag, Incorporated (“Komag”), which was acquired by the Company on September 5, 2007, and HGST, which was acquired by the Company on March 8, 2012, are subject to limitations under Section 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’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 $33 million, respectively. Because the Company expects the amount of HGST’s NOLs and credits ultimately realized will be reduced, the Company has adjusted the 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 28, 2013, such interest and penalties were not material. As of June 28, 2013, the Company had $240 million of unrecognized tax benefits.

The following is a tabular reconciliation of the total amounts of unrecognized tax benefits for the years ended June 28, 2013, June 29, 2012 and July 1, 2011 (in millions):


	2013			2012			2011
Unrecognized tax benefit at beginning of period	$	280		$	245		$	230
Gross increases related to current year tax positions		29			14			24
Gross increases related to prior year tax positions		10			—			5
Gross decreases related to prior year tax positions		(8	)		—			(11	)
Settlements		(64	)		(18	)		(2	)
Lapse of statute of limitations		(7	)		—			(1	)
HGST acquisition		—			39			—

Unrecognized tax benefit at end of period	$	240		$	280		$	245

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 28, 2013, June 29, 2012 and July 1, 2011, 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 2012. In foreign jurisdictions, with few exceptions, the Company is subject to examination for all years subsequent to fiscal 2006. 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 had completed its field examination of the Company’s federal income tax returns for fiscal years 2006 and 2007 and issued Revenue Agent Reports (“RARs”) 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, Incorporated (“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 28, 2013, 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.