7. INCOME TAXES

In December 2017, the 2017 Tax Act was enacted. The 2017 Tax Act includes a number of changes to previous U.S. tax laws that impact the company, most notably a reduction of the U.S. corporate income tax rate from 35 percent to 21 percent for tax years beginning after December 31, 2017. The 2017 Tax Act also provides for a one-time transition tax on certain foreign earnings and the acceleration of depreciation for certain assets placed into service after September 27, 2017 as well as prospective changes which began in 2018, including repeal of the domestic manufacturing deduction, capitalization of research and development expenditures, additional limitations on executive compensation and limitations on the deductibility of interest.

The company recognized the income tax effects of the 2017 Tax Act in its financial statements in accordance with Staff Accounting Bulletin (SAB) No. 118, which provides SEC staff guidance for the application of ASC Topic 740, Income Taxes. The company finalized its accounting for the income tax effects of the 2017 Tax Act in the third quarter of 2018.

The following tables present the impact of the 2017 Tax Act relating to SAB 118 amounts as an increase (decrease) reflected in the noted line items in the Consolidated Statements of Earnings and Comprehensive Income and Consolidated Statements of Financial Position:



	Year Ended December 31
$ in millions	2018		2017		2018		2017
	Income Tax Expense				Income Tax Rate
Reduction of U.S. Corporate Income Tax Rate	$	—	$	265	—	%	6.3	%
Transition Tax on Foreign Earnings	5		13		0.1		0.3
Acceleration of Depreciation	—		5		—		0.1
Other	—		2		—		0.1
Total	$	5	$	285	0.1	%	6.8	%



	Year Ended December 31
$ in millions	2018			2017			2018		2017
	Deferred Tax Assets						Other Current Liabilities
Reduction of U.S. Corporate Income Tax Rate	$	—		$	(265	)	$	—	$	—
Transition Tax on Foreign Earnings	(5		)	(13		)	—		—
Acceleration of Depreciation	17			(80		)	17		(75		)
Other	—			—			—		2
Total	$	12		$	(358	)	$	17	$	(73	)

Income Tax Expense

Federal and foreign income tax expense consisted of the following:



	Year Ended December 31
$ in millions	2018		2017			2016
Federal income tax expense:
Current	$	292	$	449		$	661
Deferred	213		907			(36		)
Total federal income tax expense	505		1,356			625
Foreign income tax expense:
Current	7		8			14
Deferred	1		(4		)	(1		)
Total foreign income tax expense	8		4			13
Total federal and foreign income tax expense	$	513	$	1,360		$	638

Earnings from foreign operations before income taxes are not material for all periods presented.

Income tax expense differs from the amount computed by multiplying earnings before income taxes by the statutory federal income tax rate due to the following:



	Year Ended December 31
$ in millions	2018					2017					2016
Income tax expense at statutory rate	$	786		21.0	%	$	1,480		35.0	%	$	938		35.0	%
Stock compensation - excess tax benefits	(27		)	(0.7	)	(48		)	(1.1	)	(85		)	(3.2	)
Research credit	(186		)	(5.0	)	(130		)	(3.1	)	(61		)	(2.2	)
Manufacturing deduction	—			—		(97		)	(2.3	)	(58		)	(2.2	)
Settlements with taxing authorities	—			—		(42		)	(1.0	)	(40		)	(1.5	)
Repatriation of non-U.S. earnings	—			—		—			—		(33		)	(1.2	)
Impacts related to the 2017 Tax Act	(84		)	(2.2	)	285			6.8		—			—
MTM benefit tax rate differential⁽¹⁾	—			—		(72		)	(1.7	)	—			—
Other, net	24			0.6		(16		)	(0.4	)	(23		)	(0.9	)
Total federal and foreign income taxes	$	513		13.7	%	$	1,360		32.2	%	$	638		23.8	%


⁽¹⁾	Impact of applying the 2017 Tax Act enacted statutory tax rate of 21% versus 35%.

2018 – The effective tax rate for 2018 was 13.7 percent, as compared with 32.2 percent in 2017, principally due to the reduction of the U.S. corporate income tax rate from 35 percent to 21 percent as a result of the 2017 Tax Act and a $56 million increase in research credits. In addition, the company’s effective tax rate for 2017 includes $285 million of tax expense recorded in connection with the 2017 Tax Act, largely due to the write-down of net deferred tax assets, offset by $97 million of tax benefits associated with manufacturing deductions and a $72 million tax benefit from the impact of applying the 2017 Tax Act enacted statutory tax rate of 21% versus 35% to the 2017 MTM benefit.

2017 – The effective tax rate for 2017 was 32.2 percent, as compared with 23.8 percent in 2016. The higher rate is principally due to $285 million of tax expense recorded in connection with the 2017 Tax Act, largely due to the write-down of net deferred tax assets, partially offset by a $69 million increase in research credits and a $39 million benefit recognized for additional manufacturing deductions principally related to prior years. The effective tax rates for the years ended December 31, 2017 and 2016 each include separate approximately $40 million benefits recognized in connection with the resolution of Internal Revenue Service (IRS) examinations of the company’s prior year tax returns.

Income tax payments, net of refunds received, were $270 million, $517 million and $691 million for the years ended December 31, 2018, 2017 and 2016, respectively.

Uncertain Tax Positions

In connection with the Merger, the company has initially recognized an increase in unrecognized tax benefits of approximately $160 million for matters associated with legacy Orbital ATK, principally related to federal and state research credits. In addition, during 2018, we increased our unrecognized tax benefits related to our methods of accounting associated with the 2017 Tax Act by approximately $100 million and it is reasonably possible that within the next twelve months those unrecognized tax benefits may increase by up to an additional $70 million.

We file income tax returns in the U.S. federal jurisdiction and in various state and foreign jurisdictions. The Northrop Grumman 2014-2015 federal tax returns and refund claims related to its 2007-2016 federal tax returns are currently under IRS examination. In addition, legacy Orbital ATK federal tax returns for the year ended March 31, 2015 and nine-month transition period ended December 31, 2015 are currently under IRS examination.

Tax returns for open tax years related to state and foreign jurisdictions remain subject to examination, but the amounts currently subject to examination are not material.

The change in unrecognized tax benefits during 2018, 2017 and 2016, excluding interest, is as follows:



	December 31
$ in millions	2018			2017			2016
Unrecognized tax benefits at beginning of the year	$	283		$	135		$	223
Additions based on tax positions related to the current year	293			102			35
Additions for tax positions of prior years	207			110			2
Reductions for tax positions of prior years	(23		)	(44		)	(40		)
Settlements with taxing authorities	(7		)	(20		)	(84		)
Other, net	(5		)	—			(1		)
Net change in unrecognized tax benefits	465			148			(88		)
Unrecognized tax benefits at end of the year	$	748		$	283		$	135

These liabilities, along with $24 million of accrued interest and penalties, are included in other current and non-current liabilities in the consolidated statements of financial position. If the income tax benefits from these tax positions are ultimately realized, $430 million of federal and foreign tax benefits would reduce the company’s effective tax rate.

Net interest expense within the company’s federal, foreign and state income tax provisions was not material for all years presented.

Deferred Income Taxes

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and tax purposes. Net deferred tax assets and liabilities are classified as non-current in the consolidated statements of financial position.

The tax effects of significant temporary differences and carryforwards that gave rise to year-end deferred federal, state and foreign tax balances, as presented in the consolidated statements of financial position, are as follows:



	December 31
$ in millions	2018			2017
Deferred Tax Assets
Retiree benefits	$	1,541		$	1,477
Accrued employee compensation	308			263
Provisions for accrued liabilities	139			193
Inventory	650			447
Stock-based compensation	42			46
Tax credits	174			9
Other	59			30
Gross deferred tax assets	2,913			2,465
Less valuation allowance	(142		)	(26		)
Net deferred tax assets	2,771			2,439
Deferred Tax Liabilities
Goodwill	511			508
Purchased intangibles	346			9
Property, plant and equipment, net	518			256
Contract accounting differences	1,381			1,182
Other	29			37
Deferred tax liabilities	2,785			1,992
Total net deferred tax (liabilities) assets	$	(14	)	$	447

Realization of deferred tax assets is primarily dependent on generating sufficient taxable income in future periods. The company believes it is more-likely-than-not our net deferred tax assets will be realized.

At December 31, 2018, the company has available tax credits and unused net operating losses of $255 million and $330 million, respectively, that may be applied against future taxable income. The majority of tax credits and net operating losses expire in 2019 through 2039, however, some may be carried forward indefinitely. Due to the uncertainty of the realization of the tax credits and net operating losses, the company has recorded valuation allowances of $110 million and $27 million as of December 31, 2018, respectively.

Undistributed Foreign Earnings

As of December 31, 2018, the company has accumulated undistributed earnings generated by our foreign subsidiaries and most have been taxed in the U.S. as a result of the 2017 Tax Act. The 2017 Tax Act allows for a dividend received deduction for repatriation of earnings. We intend to indefinitely reinvest these earnings, as well as future earnings from our foreign subsidiaries, to fund our international operations and foreign credit facility. In addition, we expect future U.S. cash generation will be sufficient to meet future U.S. cash needs.