Note 16. Income taxes

U.S. GAAP requires that the interim period tax provision be determined as follows:

At the end of each quarter, Woodward estimates the tax that will be provided for the current fiscal year stated as a percentage of estimated “ordinary income.” The term ordinary income refers to earnings from continuing operations before income taxes, excluding significant unusual or infrequently occurring items.

The estimated annual effective rate is applied to the year-to-date ordinary income at the end of each quarter to compute the estimated year-to-date tax applicable to ordinary income. The tax expense or benefit related to ordinary income in each quarter is the difference between the most recent year-to-date and the prior quarter year-to-date computations.

The tax effects of significant unusual or infrequently occurring items are recognized as discrete items in the interim period in which the events occur. The impact of changes in tax laws or rates on deferred tax amounts, the effects of changes in judgment about beginning of the year valuation allowances, and changes in tax reserves resulting from the finalization of tax audits or reviews are examples of significant unusual or infrequently occurring items that are recognized as discrete items in the interim period in which the event occurs.

The determination of the annual effective tax rate is based upon a number of significant estimates and judgments, including the estimated annual pretax income of Woodward in each tax jurisdiction in which it operates, and the development of tax planning strategies during the year. In addition, as a global commercial enterprise, Woodward’s tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits and reviews, changes in the estimate of the amount of undistributed foreign earnings that Woodward considers indefinitely reinvested, and other factors that cannot be predicted with certainty. As such, there can be significant volatility in interim tax provisions.

On December 7, 2016, the U.S. Treasury issued regulations under Internal Revenue Code Section 987 (“Section 987 Regulations”) which clarify how companies calculate foreign currency translation gains and losses for income tax purposes for branches whose accounting records are kept in a currency other than the currency of the company. The issuance of these Section 987 Regulations had no significant impact on Woodward’s Condensed Consolidated Financial Statements for the three months ended December 31, 2016.

The following table sets forth the tax expense and the effective tax rate for Woodward’s earnings before income taxes:



	Three-Months Ended
	December 31,
	2016		2015
Earnings before income taxes	$	47,059	$	27,956
Income tax expense		511		2,136
Effective tax rate		1.1%		7.6%

The decrease in the year-over-year effective tax rate for the three-months ended December 31, 2016 is primarily attributable to the impact in the quarter of the repatriation to the U.S. of certain net foreign profits and losses. The U.S. foreign tax credits available as a result of the repatriation of the foreign net earnings is greater than the U.S. taxes payable on these net foreign earnings. The excess U.S. foreign tax credits are expected to be used to offset U.S. taxes on other foreign source income.

The decrease in the year-over-year effective tax rate caused by the repatriated earnings was partially offset by the retroactive benefit of the U.S. research and experimentation credit (“R&E credit”) pursuant to the December 18, 2015 enactment of the Protecting Americans from Tax Hikes (PATH) Act of 2015, which was included in the effective tax rate for the first quarter of fiscal year 2016 but did not repeat in the first quarter of fiscal year 2017.

Gross unrecognized tax benefits were $18,579 as of December 31, 2016, and $23,526 as of September 30, 2016. Included in the balance of unrecognized tax benefits were $11,460 as of December 31, 2016 and $11,426 as of September 30, 2016 of tax benefits that, if recognized, would affect the effective tax rate. At this time, Woodward estimates that it is reasonably possible that the liability for unrecognized tax benefits will decrease by as much as $3,373 in the next twelve months due to the completion of reviews by tax authorities, lapses of statutes, and the settlement of tax positions. Woodward accrues for potential interest and penalties related to unrecognized tax benefits and all other interest and penalties related to tax payments in tax expense. Woodward had accrued gross interest and penalties of $1,460 as of December 31, 2016 and $1,273 as of September 30, 2016.

Woodward’s tax returns are subject to audits by U.S. federal, state, and foreign tax authorities, and these audits are at various stages of completion at any given time. Reviews of tax matters by authorities and lapses of the applicable statutes of limitations may result in changes to tax expense. Fiscal years remaining open to examination in significant foreign jurisdictions include 2008 and thereafter. Woodward’s fiscal years remaining open to examination in the United States include fiscal years 2013 and thereafter. Woodward is currently under examination by the Internal Revenue Service for fiscal year 2014. Woodward has concluded U.S. federal income tax examinations through fiscal year 2012. Woodward is generally subject to U.S. state income tax examinations for fiscal years 2012 and the periods thereafter.