INCOME TAXES

Eaton Corporation plc is domiciled in Ireland. Income (loss) before income taxes and income tax (benefit) expense are summarized below based on the geographic location of the operation to which such earnings and income taxes are attributable. Certain Eaton operations which are located outside the United States are subject to income tax in both the United States as well as the country in which the operations are located. As a result, income before tax by location and the components of income tax expense by taxing jurisdiction are not directly related.



	Income (loss) before income taxes
	2016			2015			2014
Ireland	$	(923	)	$	(608	)	$	(332	)
Foreign	3,050			2,753			2,093
Total income before income taxes	$	2,127		$	2,145		$	1,761



	Income tax expense (benefit)
	2016			2015			2014
Current
Ireland	$	2		$	8		$	(13	)
United States
Federal	95			88			87
State and local	(2		)	22			41
Foreign - other	209			240			239
Total current income tax expense	304			358			354

Deferred
Ireland	2			1			2
United States
Federal	(72		)	(65		)	(224		)
State and local	(2		)	(6		)	(49		)
Foreign - other	(30		)	(124		)	(125		)
Total deferred income tax benefit	(102		)	(194		)	(396		)
Total income tax expense (benefit)	$	202		$	164		$	(42	)

Reconciliations of income taxes from the Ireland national statutory rate of 25% to the consolidated effective income tax rate follow:



	2016		2015		2014
Income taxes at the applicable statutory rate	25.0	%	25.0	%	25.0	%

Ireland operations
Ireland tax on trading income	(0.3	)%	(0.4	)%	(0.1	)%
Nondeductible interest expense	11.5	%	7.9	%	4.8	%

United States operations
United States (loss) income	0.2	%	(0.4	)%	(2.8	)%
Nondeductible goodwill - Aerospace divestitures	—	%	—	%	1.4	%
Credit for research activities	(0.8	)%	(0.8	)%	(1.0	)%
Other - net	2.5	%	5.4	%	1.5	%

Other foreign operations
United States foreign tax credit	0.6	%	(0.8	)%	(1.1	)%
Other foreign operations (earnings taxed at other than the applicable statutory tax rate)	(26.8	)%	(25.1	)%	(24.8	)%
Other foreign operations - other items	0.9	%	(0.5	)%	(1.0	)%

Worldwide operations
Adjustments to tax liabilities	(2.5	)%	(1.4	)%	(1.7	)%
Adjustments to valuation allowances	(0.8	)%	(1.2	)%	(2.6	)%
Effective income tax expense (benefit) rate	9.5	%	7.7	%	(2.4	)%

During 2016, income tax expense of $202 was recognized (an effective tax rate of 9.5%) compared to income tax expense of $164 for 2015 (an effective tax rate of 7.7%) and income tax benefit of $42 for 2014 (an effective tax benefit rate of 2.4%). The 2016 effective tax rate increased from 2015 primarily due to greater levels of income earned in higher tax jurisdictions, partially offset by net decreases in worldwide tax liabilities. In 2014, excluding the net tax benefit of 7.6% for the Meritor and Triumph litigation settlements and related legal costs and the gain on the sale of the Aerospace businesses, the effective tax rate was 5.2%. The 2015 effective tax rate increased from 2014 due to greater levels of income earned in higher tax jurisdictions and net increases in worldwide tax liabilities.

See Note 8 and Note 2 for additional information about litigation settlements and sales of businesses, respectively.

No provision has been made for income taxes on undistributed earnings of foreign subsidiaries of approximately $17.3 billion at December 31, 2016, since it is the Company's intention to indefinitely reinvest undistributed earnings of its foreign subsidiaries. It is not practicable to estimate the additional income taxes and applicable withholding taxes that would be payable on the remittance of such undistributed earnings.

The Company expects to deploy capital to those markets which offer particularly attractive growth opportunities. Given expected population growth and economic growth rates, most of the particularly attractive markets are outside of the United States. The cash that is permanently reinvested is typically used to expand these operations either organically or through acquisitions. In addition, the Company expects that minimal to no Irish tax would apply to dividends paid to the Irish parent due to the impact of the Irish foreign tax credit system. The Company's public dividends and share repurchases are funded primarily from Non-U.S. operations.

Worldwide income tax payments, net of tax refunds, follow:



2016	$	272
2015	302
2014	258

Deferred Income Tax Assets and Liabilities

Components of current and noncurrent deferred income taxes follow:



	2016			2015
	Noncurrent assets and liabilities			Noncurrent assets and liabilities
Accruals and other adjustments
Employee benefits	$	761		$	808
Depreciation and amortization	(1,823		)	(1,824		)
Other accruals and adjustments	796			717
United States federal income tax loss carryforwards	51			20
United States federal income tax credit carryforwards	182			183
United States state and local tax loss carryforwards and tax credit carryforwards	63			63
Other foreign tax loss carryforwards	1,715			2,265
Other foreign income tax credit carryforwards	63			70
Valuation allowance for income tax loss and income tax credit carryforwards	(1,728		)	(2,315		)
Other valuation allowances	(41		)	(15		)
Total deferred income taxes	$	39		$	(28	)

In July 2013, the FASB issued Accounting Standards Update No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Loss, or a Tax Credit Carryforward Exists (ASU 2013-11). ASU 2013-11 requires the netting of unrecognized tax benefits against a deferred tax asset for a loss or other carryforward that would apply in settlement of the uncertain tax positions except where the deferred tax asset or other carryforward are not available for use. The adoption of this standard resulted in a reduction of the Company’s consolidated long term deferred tax assets by $331 in 2016 and $262 in 2015.

At December 31, 2016, certain Irish and non-United States subsidiaries had tax loss carryforwards and income tax credit carryforwards that are available to reduce future taxable income and tax liabilities. These carryforwards and their respective expiration dates are summarized below:



	2017 through 2021		2022 through 2026		2027 through 2031		2032 through 2036		Not subject to expiration		Valuation allowance
Ireland and Non-U.S. income tax loss carryforwards	$	652	$	7,476	$	3	$	—	$	3,685	$	—
Ireland and Non-U.S. deferred income tax assets for income tax loss carryforwards	76		688		1		—		950		(1,607		)
Ireland and Non-U.S. income tax credit carryforwards	10		21		2		—		30		(31		)

At December 31, 2016, United States federal income tax loss carryforwards and income tax credit carryforwards are available to reduce future United States federal taxable income or tax liabilities. These carryforwards and their respective expiration dates are summarized below:



	2017 through 2021		2022 through 2026		2027 through 2031		2032 through 2036		2037 through 2041		Not subject to expiration		Valuation allowance
United States federal income tax loss carryforwards	$	—	$	15	$	20	$	618	$	—	$	—	$	—
United States federal deferred income tax assets for income tax loss carryforwards	—		5		7		172		—		—		(12		)
United States federal deferred income tax assets for income tax loss carryforwards after ASU 2013-11	—		5		7		39		—		—		(12		)
United States federal income tax credit carryforwards	62		36		39		115		—		29		(44		)
United States federal income tax credit carryforwards after ASU 2013-11	62		36		8		76		—		—		(44		)

At December 31, 2016, United States state and local tax loss carryforwards and tax credit carryforwards are also available to reduce future taxable income or tax liabilities. The deferred tax assets for these carryforwards and their respective expiration dates are summarized below:



	2017 through 2021		2022 through 2026		2027 through 2031		2032 through 2036		2037 through 2041		Not subject to expiration		Valuation allowance
United States state and local deferred income tax assets for income tax loss carryforwards - net of federal tax effect	$	8	$	17	$	11	$	8	$	—	$	—	$	(17	)
United States state and local deferred income tax assets for income tax loss carryforwards - net of federal tax effect after ASU 2013-11	—		12		11		8		—		—		(17		)
United States state and local income tax credit carryforwards - net of federal tax effect	11		11		7		4		5		—		(17		)
United States state and local income tax credit carryforwards - net of federal tax effect after ASU 2013-11	8		11		6		2		5		—		(17		)

Recoverability of Deferred Income Tax Assets

Eaton is subject to the income tax laws in the jurisdictions in which it operates. In order to determine its income tax provision for financial statement purposes, Eaton must make significant estimates and judgments about its business operations in these jurisdictions. These estimates and judgments are also used in determining the deferred income tax assets and liabilities that have been recognized for differences between the financial statement and income tax basis of assets and liabilities, and income tax loss carryforwards and income tax credit carryforwards.

Management evaluates the realizability of deferred income tax assets for each of the jurisdictions in which it operates. If the Company experiences cumulative pretax income in a particular jurisdiction in the three-year period including the current and prior two years, management normally concludes that the deferred income tax assets will more likely than not be realizable and no valuation allowance is recognized, unless known or planned operating developments would lead management to conclude otherwise. However, if the Company experiences cumulative pretax losses in a particular jurisdiction in the three-year period including the current and prior two years, management then considers a series of factors in the determination of whether the deferred income tax assets can be realized. These factors include historical operating results, known or planned operating developments, the period of time over which certain temporary differences will reverse, consideration of the utilization of certain deferred income tax liabilities, tax law carryback capability in the particular country, prudent and feasible tax planning strategies, and estimates of future earnings and taxable income using the same assumptions as those used for the Company's goodwill and other impairment testing. After evaluation of these factors, if the deferred income tax assets are expected to be realized within the tax carryforward period allowed for that specific country, management would conclude that no valuation allowance would be required. To the extent that the deferred income tax assets exceed the amount that is expected to be realized within the tax carryforward period for a particular jurisdiction, management would establish a valuation allowance.

Applying the above methodology, valuation allowances have been established for certain deferred income tax assets to the extent they are not expected to be realized within the particular tax carryforward period.

Unrecognized Income Tax Benefits

A summary of gross unrecognized income tax benefits follows:



	2016			2015			2014
Balance at January 1	$	584		$	493		$	479
Increases and decreases as a result of positions taken during prior years
Transfers from valuation allowances	—			—			(3		)
Other increases, including currency translation	21			34			37
Other decreases, including currency translation	(24		)	(34		)	(3		)
Balances related to acquired businesses	—			(1		)	(3		)
Increases as a result of positions taken during the current year	90			109			65
Decreases relating to settlements with tax authorities	(19		)	—			(51		)
Decreases as a result of a lapse of the applicable statute of limitations	(23		)	(17		)	(28		)
Balance at December 31	$	629		$	584		$	493

Eaton's long-term policy has been to enter into tax planning strategies only if it is more likely than not that the benefit would be sustained upon audit. For example, the Company does not enter into any of the United States Internal Revenue Service (IRS) Listed Transactions as set forth in Treasury Regulation 1.6011-4.

If all unrecognized tax benefits were recognized, the net impact on the provision for income tax expense would be $529.

As of December 31, 2016 and 2015, Eaton had accrued approximately $94 and $108, respectively, for the payment of worldwide interest and penalties, which are not included in the table of unrecognized income tax benefits above. Eaton recognizes interest and penalties related to unrecognized income tax benefits in the provision for income tax expense. The Company has accrued penalties in jurisdictions primarily where they are automatically applied to any deficiency, regardless of the merit of the position.

The resolution of the majority of Eaton's unrecognized income tax benefits is dependent upon uncontrollable factors such as the prospect of retroactive regulations; new case law; the willingness of the income tax authority to settle the issue, including the timing thereof; and other factors. Therefore, for the majority of unrecognized income tax benefits, it is not reasonably possible to estimate the increase or decrease in the next 12 months. For each of the unrecognized income tax benefits where it is possible to estimate the increase or decrease in the balance within the next 12 months, the Company does not anticipate any significant change.

Eaton or its subsidiaries file income tax returns in Ireland and many countries around the world. With only few exceptions, Irish and non-United States subsidiaries of Eaton are no longer subject to examinations for years before 2007.

The United States Internal Revenue Service (“IRS”) has completed its examination of Eaton Corporation and Includible Subsidiaries’ United States income tax returns for 2005 through 2010 and has issued Statutory Notices of Deficiency (Notices) as discussed below. The statute of limitations on these tax years remains open until the matters are resolved. The IRS is currently examining tax years 2011 through 2013. The statute of limitations for tax years 2011 through 2013 is open until April 30, 2018. Tax years 2014 and 2015 are still subject to examination by the IRS.

With respect to the BZ Holdings Inc. and Subsidiaries (the former U.S. holding company for Cooper Industries) final return period ended December 21, 2012, the statute of limitations closed on September 15, 2016. On December 22, 2012, BZ Holdings Inc. and Subsidiaries joined the Eaton US Holdings Inc. and Includible Subsidiaries consolidated United States income tax return for 2012.

Eaton is also under examination for the income tax filings in various states and localities of the United States. With only a few exceptions, Eaton Corporation and Includible Subsidiaries are no longer subject to income tax examinations from states and localities within the United States for years before 2012. Income tax returns of states and localities within the United States will be reopened to the extent of United States federal income tax adjustments, if any, going back to 2005 when those audit years are finalized. Some states and localities may not limit their assessment to the United States federal adjustments, and may require the opening of the entire tax year. In addition, with only a few exceptions, BZ Holdings Inc. and Includible Subsidiaries are no longer subject to United States state and local income tax examinations for years before 2012.

In 2011, the IRS issued a Notice for Eaton Corporation and Includible Subsidiaries for the 2005 and 2006 tax years (the 2011 Notice). The 2011 Notice proposed assessments of $75 in additional taxes plus $52 in penalties related primarily to transfer pricing adjustments for products manufactured in the Company's facilities in Puerto Rico and the Dominican Republic and sold to affiliated companies located in the U.S., net of agreed credits and deductions. The Company has set its transfer prices for products sold between these affiliates at the same prices that the Company sells such products to third parties as required by two successive Advance Pricing Agreements (APAs) the Company entered into with the IRS. For the years 2001 through 2004, the IRS had previously accepted the transfer pricing methodology related to these APAs after a comprehensive review conducted in two separate audit cycles. Immediately prior to the 2011 Notice being issued, the IRS sent a letter stating that it was retrospectively canceling the APAs, even though their respective APA terms had already expired.

The Company is contesting the proposed assessments. The Company believes that it was in full compliance with the terms of the two APAs, and that the IRS's cancellation of these two APAs is without merit. On February 29, 2012, the Company filed a Petition with the U.S. Tax Court in which it asserted that the transfer pricing established in the APAs meets the arms-length standard set by the U.S. income tax laws, and accordingly, that the APAs should be enforced in accordance with their terms. The case involves both whether the APAs should be enforced and, if not, the appropriate transfer pricing methodology. The Tax Court’s decision in the case is now pending following a trial in 2015 and the completion of the parties’ briefing in 2016.

In 2014, the Company received a Notice from the IRS for the 2007 through 2010 tax years (the 2014 Notice) proposing assessments of $190 in additional taxes plus $72 in penalties, net of agreed credits and deductions. The proposed assessments pertain primarily to the same transfer pricing issues for which the Tax Court’s decision is pending, as noted above. During 2007 through 2010, the Company set its transfer prices for products sold between its affiliates consistent with the terms of a written APA between it and the IRS that covered the years at issue. To establish the relevant transfer prices, the APA relied on prices at which the Company sells the products to third parties. The Company has continued to apply the arms-length transfer pricing methodology for 2011 through the current reporting period. The 2014 Notice includes a separate proposed assessment involving the recognition of income for several of the Company’s controlled foreign corporations. The Company believes that all proposed assessments are without merit. On November 25, 2014, the Company filed a Petition with the U.S. Tax Court in which it challenged the IRS's adjustments. The Company expects the outcome of the 2014 Notice on the transfer pricing matter to be determined by the judicial decision related to the 2011 Notice. In 2016, litigation activities commenced for the separate issue in the 2014 Notice regarding recognition of income for several of the Company’s controlled foreign corporations.

In 2014 and 2016, the Company resolved uncertain tax positions with a European government. The resolutions had minimal impact on the Company's Consolidated Statements of Income in each respective year.

During 2010, the Company received a tax assessment of $51 (translated at the December 31, 2016 exchange rate), plus interest and penalties, in Brazil for the tax years 2005 through 2008 that relates to the amortization of certain goodwill generated from the acquisition of third-party businesses and corporate reorganizations. The Company is contesting the assessment, which is under review at the second of three administrative appeals levels. During 2013, the Brazilian tax authorities began an audit of tax years 2009 through 2012. During 2014, the Company received a tax assessment of $39 (translated at the December 31, 2016 exchange rate), plus interest and penalties, for the 2009 through 2012 tax years (primarily relating to the same issues concerning the 2005 through 2008 tax years), which the Company is also contesting and is under review in the second of three administrative appeals levels. Multiple outside advisors have stated that Brazilian tax authorities are raising the issue for most clients with similar facts and that the matter is expected to require at least 10 years to resolve. The Company continues to believe that final resolution of the assessments will not have a material impact on its consolidated financial statements.