Tax Matters

A. Taxes on Income

As of the Separation date, we operate under a new standalone legal entity structure. In connection with the Separation, adjustments have been made to the income tax accounts. See Note 2B. The Separation, Adjustments Associated with the Separation, Senior Notes Offering, Initial Public Offering and Exchange Offer— Adjustments Associated with the Separation.

For the periods prior to the Separation presented in the combined financial statements, Zoetis did not generally file separate tax returns since Zoetis was generally included in the tax grouping of other Pfizer entities within the respective entity’s tax jurisdiction. The income tax provision included in these combined financial statements has been calculated using the separate return basis, as if Zoetis filed a separate tax return.

The components of Income before provision for taxes on income follow:



	Year Ended December 31,
(MILLIONS OF DOLLARS)	2013		2012		2011
United States	$	238	$	340	$	(239	)
International	452		370		633
Income before provision for taxes on income^(a)(b)	$	690	$	710	$	394

The components of Provision for taxes on income based on the location of the taxing authorities follow:



	Year Ended December 31,
(MILLIONS OF DOLLARS)	2013		2012			2011
United States:
Current income taxes:
Federal	$	63	$	132		$	(3	)
State and local	12		5			(1		)
Deferred income taxes:
Federal	10		(7		)	(19		)
State and local	2		11			(3		)
Total U.S. tax provision/(benefit)	87		141			(26		)
International:
Current income taxes	89		211			85
Deferred income taxes	11		(78		)	87
Total international tax provision	100		133			172
Provision for taxes on income^(a)(b)(c)	$	187	$	274		$	146


^(a)	In 2013, the Provision for taxes on income reflects the following:


•	U.S. tax expense of approximately $3 million as a result of providing U.S. deferred income taxes on certain current-year income earned outside the United States that will not be indefinitely reinvested overseas (see C. Deferred Taxes);


•	U.S. tax benefit related to U.S. Research and Development Tax Credit which was retroactively extended on January 3, 2013, and the U.S. Domestic Production Activities deduction;


•	Tax expense of approximately $25 million related to the establishment of valuation allowance; and


•	Tax cost related to changes in uncertain tax positions (see D. Tax Contingencies).


^(b)	In 2012, the Provision for taxes on income reflects the following:

•

U.S. tax benefits of approximately $29.3 million, representing tax and interest, resulting from a multi-year settlement with the U.S. Internal Revenue Service with respect to audits for the years 2006 through 2008, and international tax benefits of approximately $2.7 million, representing tax and interest, resulting from the resolution of certain tax positions pertaining to prior years with various foreign tax authorities and from the expiration of certain statutes of limitations;


•	U.S. tax expense of approximately $9 million as a result of providing U.S. deferred income taxes on certain current-year income earned outside the United States that will not be indefinitely reinvested overseas (see C. Deferred Taxes);


•	The expiration of the U.S. Research and Development Tax Credit on December 31, 2011; and


•	Tax cost related to changes in uncertain tax positions (see D. Tax Contingencies).


^(c)	In 2011, the Provision for taxes on income reflects the following:


•	U.S. tax expense of approximately $9 million as a result of providing U.S. deferred income taxes on certain current-year income earned outside of the United States that will not be indefinitely reinvested overseas; and


•	U.S. tax benefits of approximately $9.5 million, representing tax and interest, resulting from the tax benefit recorded in connection with the settlement of certain audits with the U.S. Internal Revenue Service.

Tax Rate Reconciliation

The reconciliation of the U.S. statutory income tax rate to our effective tax rate follows:



	Year Ended December 31,
	2013		2012		2011
U.S. statutory income tax rate	35.0	%	35.0	%	35.0	%
State and local taxes, net of federal benefits	1.0		1.7		(0.2	)
Taxation of non-U.S. operations^(a)(b)(c)	(6.7	)	5.6		2.7
Unrecognized tax benefits and tax settlements and resolution of certain tax positions^(d)	1.1		(4.1	)	(2.4	)
U.S. healthcare legislation^(e)	—		(0.4	)	0.3
U.S. Research and Development Tax Credit and U.S. Domestic Production Activities deduction^(f)	(1.2	)	(0.3	)	(2.3	)
Non-deductible / non-taxable items^(g)	0.5		0.8		2.1
All other—net	(2.6	)	0.3		1.9
Effective tax rate	27.1	%	38.6	%	37.1	%

^(a)

For taxation of non-U.S. operations, this rate impact reflects the income tax rates and relative earnings in the locations where we do business outside of the United States, together with the cost of repatriation decisions, as well as changes in uncertain tax positions not included in the reconciling item called “Unrecognized tax benefits and tax settlements and resolution of certain tax positions”: (i) the jurisdictional mix of earnings is a component of our effective tax rate each year as tax rates outside of the U.S. are generally lower than the U.S. statutory income tax rate. The rate impact of the jurisdictional mix of earnings is influenced by the specific location of non-U.S. earnings and the level of such earnings as compared to our total earnings. This rate impact is then offset or more than offset by the cost of repatriation decisions and other U.S. tax implications of our foreign operations, which may significantly impact the taxation of non-U.S. operations; and (ii) the impact of changes in uncertain tax positions not included in the reconciling item called “Unrecognized tax benefits and tax settlements and resolution of certain tax positions” is a component of our effective tax rate each year that can result in either an increase or decrease to our effective tax rate. The jurisdictional mix of earnings, which includes the impact of the location of earnings as well as repatriation costs, can vary as a result of the repatriation decisions and as a result of operating fluctuations in the normal course of business, the impact of non-deductible items and the extent and location of other income and expense items, such as restructuring charges, asset impairments and gains and losses on asset divestitures.

^(b)

The rate impact of taxation of non-U.S. operations was a decrease to our effective tax rate in 2013 due to (i) the jurisdictional mix of earnings as tax rates outside of the United States are generally lower than the U.S. statutory income tax rate; and (ii) incentive tax rulings in Belgium effective December 1, 2012 and in Singapore effective October 29, 2012. The rate impact of taxation of non-U.S. operations was an increase to our effective tax rate in 2012 and 2011 due to (i) the cost of repatriation decisions and other U.S. tax implications that more than offset the impact of the generally lower tax rates outside of the United States; (ii) the tax impact of non-deductible items in those jurisdictions; and (iii) the tax impact of changes in uncertain tax positions related to our non-U.S. operations.

^(c)

In 2013, the impact to the rate due to increases in uncertain tax positions was more than offset by the jurisdictional mix of earnings and other U.S. tax implications of our foreign operations described in the above footnotes. The increase in the rate in 2012 as compared to 2011 is primarily due to increases in uncertain tax positions (see D. Tax Contingencies, for current and prior period increases to uncertain tax positions), of which a significant portion relates to our non-U.S. operations.


^(d)	For a discussion about unrecognized tax benefits and tax settlements and resolution of certain tax positions, see A. Taxes on Income and D. Tax Contingencies.


^(e)	The decrease in the rate in 2012 primarily relates to the tax benefit recorded in connection with the establishment of deferred income tax assets related to the Medicare Part D subsidy for retiree prescription drug coverage.


^(f)	In 2013, the decrease in the rate was due to the benefit associated with the U.S. Research and Development Tax Credit. In 2012, no benefit from the U.S. Research and Development Tax Credit was reflected as the credit expired on December 31, 2011 and was not extended until January 2013. In all years, we received a benefit from the U.S. Domestic Production Activities deduction.


^(g)	Non-deductible items include meals and entertainment expenses.


B.	Tax Matters Agreement

In connection with the Separation, we entered into a tax matters agreement with Pfizer that governs the parties' respective rights, responsibilities and obligations with respect to tax liabilities and benefits, tax attributes, the preparation and filing of tax returns, the control of audits and other tax proceedings and other matters regarding taxes. For additional information, see below and Note 17B. Transactions and Agreements with Pfizer—Agreements with Pfizer.

In connection with this agreement and the Separation, the activity in our income tax accounts reflects Separation Adjustments, including significant adjustments to the deferred income tax asset and liability accounts and the tax liabilities associated with uncertain tax positions. For additional information, see below and Note 2B. The Separation, Adjustments Associated with the Separation, Senior Notes Offering, Initial Public Offering and Exchange Offer—Adjustments Associated with the Separation.

In general, under the agreement:

•

Pfizer will be responsible for any U.S. federal, state, local or foreign income taxes and any U.S. state or local non-income taxes (and any related interest, penalties or audit adjustments and including those taxes attributable to our business) reportable on a consolidated, combined or unitary return that includes Pfizer or any of its subsidiaries (and us and/or any of our subsidiaries) for any periods or portions thereof ending on or prior to December 31, 2012. We will be responsible for the portion of any such taxes for periods or portions thereof beginning on or after January 1, 2013, as would be applicable to us if we filed the relevant tax returns on a standalone basis.


•	We will be responsible for any U.S. federal, state, local or foreign income taxes and any U.S. state or local non-income taxes (and any related interest, penalties or audit adjustments) that are reportable on returns that include only us and/or any of our subsidiaries, for all tax periods whether before or after the completion of the Separation.


•	Pfizer will be responsible for certain specified foreign taxes directly resulting from certain aspects of the Separation.

We will not generally be entitled to receive payment from Pfizer in respect of any of our tax attributes or tax benefits or any reduction of taxes of Pfizer. Neither party's obligations under the agreement will be limited in amount or subject to any cap. The agreement also assigns responsibilities for administrative matters, such as the filing of returns, payment of taxes due, retention of records and conduct of audits, examinations or similar proceedings. In addition, the agreement provides for cooperation and information sharing with respect to tax matters.

Pfizer will be primarily responsible for preparing and filing any tax return with respect to the Pfizer affiliated group for U.S. federal income tax purposes and with respect to any consolidated, combined, unitary or similar group for U.S. state or local or foreign income tax purposes or U.S. state or local non-income tax purposes that includes Pfizer or any of its subsidiaries, including those that also include us and/or any of our subsidiaries. We will generally be responsible for preparing and filing any tax returns that include only us and/or any of our subsidiaries.

The party responsible for preparing and filing a given tax return will generally have exclusive authority to control tax contests related to any such tax return.

C. Deferred Taxes

Deferred taxes arise as a result of basis differentials between financial statement accounting and tax amounts.

The components of our deferred tax assets and liabilities follow:



	December 31,
	2013			2012
(MILLIONS OF DOLLARS)	Assets (Liabilities)
Prepaid/deferred items	$	59		$	69
Inventories	29			9
Intangibles	(111		)	(187		)
Property, plant and equipment	(92		)	(61		)
Employee benefits	11			54
Restructuring and other charges	4			27
Legal and product liability reserves	13			20
Net operating loss/credit carryforwards	30			219
Unremitted earnings	(3		)	(86		)
All other	(10		)	(3		)
Subtotal	(70		)	61
Valuation allowance	(107		)	(69		)
Net deferred tax liability^(a)(b)	$	(177	)	$	(8	)

^(a)

2013 vs. 2012-The significant increase in the total net deferred tax liability from December 31, 2012 to December 31, 2013 is primarily attributable to the Separation Adjustments, predominantly related to deferred tax assets associated with net operating loss/credit carryforwards and deferred tax liabilities associated with unremitted earnings that were retained by Pfizer, partially offset by an increase in valuation allowances representing the amounts determined to be unrecoverable. See Note 2B. The Separation, Adjustments Associated with the Separation, Senior Notes Offering, Initial Public Offering and Exchange Offer— Adjustments Associated with the Separation.

^(b)

In 2013, included in Current deferred tax assets ($97 million), Noncurrent deferred tax assets ($63 million), Other current liabilities ($15 million) and Noncurrent deferred tax liabilities ($322 million). In 2012, included in Current deferred tax assets ($101 million), Noncurrent deferred tax assets ($216 million), Other current liabilities ($2 million) and Noncurrent deferred tax liabilities ($323 million).

We have carryforwards, primarily related to net operating losses, which are available to reduce future foreign and U.S. state income taxes payable with either an indefinite life or expiring at various times from 2014 to 2033.

Valuation allowances are provided when we believe that our deferred tax assets are not recoverable based on an assessment of estimated future taxable income that incorporates ongoing, prudent and feasible tax planning strategies. On the basis of this evaluation, as of December 31, 2013, a valuation allowance of $107 million has been recorded to record only the portion of the deferred tax asset that is more likely than not to be realized. The amount of the deferred tax asset considered realizable, however, could be adjusted if estimates of future taxable income during the carryforward period are reduced or increased or if objective negative evidence in the form of cumulative losses is no longer present and additional weight may be given to subjective evidence such as projections for growth.

In general, it is our practice and intention to permanently reinvest the majority of the earnings of the company’s non U.S. subsidiaries. As of December 31, 2013, the cumulative amount of such undistributed earnings was $1.2 billion, for which we have not provided U.S. federal income and foreign withholding taxes. As these earnings are intended to be indefinitely reinvested overseas, as of December 31, 2013, we cannot predict the time or manner of such potential repatriation. As such, it is not practicable to estimate the amount of the deferred tax liability associated with these unremitted earnings due to the complexity of its hypothetical calculation.

D. Tax Contingencies

We are subject to income tax in many jurisdictions, and a certain degree of estimation is required in recording the assets and liabilities related to income taxes. All of our tax positions are subject to audit by the local taxing authorities in each tax jurisdiction. These tax audits can involve complex issues, interpretations and judgments and the resolution of matters may span multiple years, particularly if subject to negotiation or litigation. Our assessments are based on estimates and assumptions that have been deemed reasonable by management, but our estimates of unrecognized tax benefits and potential tax benefits may not be representative of actual outcomes, and variation from such estimates could materially affect our financial statements in the period of settlement or when the statute of limitations expire. We treat these events as discrete items in the period of resolution.

For a description of our accounting policies associated with accounting for income tax contingencies, see Note 4. Significant Accounting Policies—Deferred Tax Assets and Liabilities and Income Tax Contingencies. For a description of the risks associated with estimates and assumptions, see Note 4. Significant Accounting Policies—Estimates and Assumptions.

Uncertain Tax Positions

As tax law is complex and often subject to varied interpretations, it is uncertain whether some of our tax positions will be sustained upon audit. As of December 31, 2013 and 2012, we had approximately $44 million and $112 million, respectively, in net liabilities associated with uncertain tax positions, excluding associated interest:

•

Tax assets associated with uncertain tax positions primarily represent our estimate of the potential tax benefits in one tax jurisdiction that could result from the payment of income taxes in another tax jurisdiction. These potential benefits generally result from cooperative efforts among taxing authorities, as required by tax treaties to minimize double taxation, commonly referred to as the competent authority process. The recoverability of these assets, which we believe to be more likely than not, is dependent upon the actual payment of taxes in one tax jurisdiction and, in some cases, the successful petition for recovery in another tax jurisdiction. As of December 31, 2013 and 2012, we had approximately $1 million and $32 million, respectively, in assets associated with uncertain tax positions recorded in Other noncurrent assets.

•

Tax liabilities associated with uncertain tax positions represent unrecognized tax benefits, which arise when the estimated benefit recorded in our financial statements differs from the amounts taken or expected to be taken in a tax return because of the uncertainties described above. These unrecognized tax benefits relate primarily to issues common among multinational corporations. Substantially all of these unrecognized tax benefits, if recognized, would impact our effective income tax rate.

The reconciliation of the beginning and ending amounts of gross unrecognized tax benefits follows:



(MILLIONS OF DOLLARS)	2013			2012			2011
Balance, January 1	$	(144	)	$	(114	)	$	(93	)
Adjustments associated with the Separation^(a)	115			—			—
Acquisitions^(b)	—			—			(19		)
Increases based on tax positions taken during a prior period^(c)	(2		)	(2		)	—
Decreases based on tax positions taken during a prior period^(c)(d)	—			40			1
Decreases based on cash payments for a prior period	1			3			7
Increases based on tax positions taken during the current period^(c)	(16		)	(73		)	(10		)
Decreases based on tax positions taken during the current period	—			—			—
Lapse in statute of limitations	1			2			—
Balance, December 31^(e)	$	(45	)	$	(144	)	$	(114	)

^(a)

The significant decrease in the total gross unrecognized tax benefits from December 31, 2012 to December 31, 2013 is primarily attributable to the elimination of net tax liabilities associated with uncertain tax positions that were retained by Pfizer. See Note 2B. The Separation, Adjustments Associated with the Separation, Senior Notes Offering, Initial Public Offering and Exchange Offer— Adjustments Associated with the Separation.


^(b)	The amount in 2011 primarily relates to the acquisition of KAH.


^(c)	Primarily included in Provision for taxes on income.


^(d)	In all years, the decreases are primarily a result of effectively settling certain issues with the U.S. and non-U.S. tax authorities. See A. Tax Matters—Taxes on Income.


^(e)	In 2013, included in Noncurrent deferred tax assets ($6 million) and Other taxes payable ($39 million). In 2012, included in Noncurrent deferred tax assets ($6 million) and Other taxes payable ($138 million).

•

Interest related to our unrecognized tax benefits is recorded in accordance with the laws of each jurisdiction and is recorded in Provision for taxes on income in our consolidated and combined statements of income. In 2013, we recorded a net interest expense of $3 million; in 2012, we recorded a net interest expense of $1 million; and in 2011, interest expense was de minimis. Gross accrued interest totaled $11 million and $17 million as of December 31, 2013 and 2012, respectively, and were included in Other taxes payable. Accrued penalties are not significant.

Status of Tax Audits and Potential Impact on Accruals for Uncertain Tax Positions

We are subject to taxation in the United States including various states, and foreign jurisdictions. The United States is one of our major tax jurisdictions. The 2013 tax year is our only open audit year for U.S. Federal tax purposes (see B. Tax Matters Agreement for years prior to 2013). With respect to the United States, state tax years 2006-2011 are currently under audit.

In addition to the open audit years in the United States, we have open audit years in other major foreign tax jurisdictions, such as Canada (2009-2013), Asia-Pacific (2008-2013 primarily reflecting Australia, Japan, and Korea), Europe (2009-2013, primarily reflecting the United Kingdom, France, Italy, Spain and Germany) and Latin America (2005-2013, primarily reflecting Brazil and Mexico).

Any settlements or statute of limitations expirations could result in a significant decrease in our uncertain tax positions. We do not expect that within the next twelve months any of our gross unrecognized tax benefits, exclusive of interest, could significantly decrease as a result of settlements with taxing authorities or the expiration of the statutes of limitations. Our assessments are based on estimates and assumptions that have been deemed reasonable by management, but our estimates of unrecognized tax benefits and potential tax benefits may not be representative of actual outcomes, and any variation from such estimates could materially affect our financial statements in the period of settlement or when the statutes of limitations expire, as we treat these events as discrete items in the period of resolution. Finalizing audits with the relevant taxing authorities can include formal administrative and legal proceedings, and, as a result, it is difficult to estimate the timing and range of possible change related to our uncertain tax positions, and such changes could be significant.