INCOME TAXES

Income tax provisions for interim quarterly periods are based on an estimated annual effective income tax rate calculated separately from the effect of significant, infrequent or unusual items related specifically to interim periods. Income tax expense for the three months ended March 31, 2018 was $27 million, an effective tax rate of 28.7%, compared to expense of $38 million, an effective tax rate of 34.9%, for the three months ended March 31, 2017. The decrease in income tax expense and the effective tax rate was primarily driven by the reduction in the corporate federal income tax rate resulting from the enactment of U.S. tax reform legislation in December 2017.

Income tax expense for the six months ended March 31, 2018 was $121 million, an effective tax rate of 68.0% compared to expense of $76 million, an effective tax rate of 34.7%, for the six months ended March 31, 2017. The increase in income tax expense and the effective tax rate was principally driven by the enactment of U.S. tax reform legislation, which resulted in a net increase in income tax expense of approximately $70 million that more than offset benefits related to the reduction in the estimated annual effective tax rate for fiscal 2018.

U.S. tax reform legislation

On December 22, 2017, the President of the United States signed into law tax reform legislation (the “Act”), which generally became effective January 1, 2018. The Act includes a number of provisions, including lowering the federal corporate income tax rate from a maximum of 35% to 21% and changing or limiting certain tax deductions. While the Company expects this rate reduction will ultimately benefit Valvoline, the Act also includes provisions that are expected to offset some of the benefit of the rate reduction, including the repeal of the deduction for domestic production activities and the expansion of the limitation on the deduction of certain executive compensation. In addition, the Act alters the landscape of taxation of non-U.S. operations and provides immediate deductions for certain new investments, among other provisions.

Based on the effective date of the rate reduction in the Act, the Company’s federal corporate statutory income tax rate for fiscal 2018 will be a blended rate of 24.5%, declining to 21% for fiscal 2019 and beyond.

During the six months ended March 31, 2018, enactment of the Act resulted in the following provisional impacts on income tax expense:


•	The remeasurement of net deferred tax assets at the lower enacted corporate tax rate resulted in a net $67 million increase in income tax expense;


•	Income tax expense increased by $4 million related to the deemed repatriation tax on unremitted non-U.S. earnings and profits and $2 million for withholding taxes due to the Company’s change in indefinite reinvestment assertion regarding its undistributed earnings; and


•	The remeasurement of net indemnity liabilities associated with the Tax Matters Agreement increased pre-tax expense by $7 million and generated a $3 million tax benefit primarily related to the higher expected utilization of tax attributes payable to Ashland.

The impacts of the Act recorded during the six months ended March 31, 2018 are provisional, and the Company will continue to assess the impact of the Act and will record adjustments through the income tax provision in the relevant period as amounts are known and reasonably estimable. Accordingly, the impact of the Act may differ from the Company’s provisional estimates due to and among other factors, information currently not available, changes in interpretations and the issuance of additional guidance, as well as changes in assumptions the Company has currently made, including actions the Company may take in future periods as a result of the Act.

There is currently a lack of clarity regarding most state tax implications as a result of the Act, though Valvoline is incorporated in Kentucky, which enacted income tax reform on April 13, 2018 that will be effective for the Company beginning in fiscal 2019. The Company is currently in the process of evaluating the impact of Kentucky income tax reform on its condensed consolidated financial statements and will record the associated estimated impacts in the period of enactment during the third fiscal quarter of 2018, including the remeasurement of net deferred tax assets at the lower tax rate and the related Tax Matters Agreement indemnity implications, which are not expected to be material to net income.

Deferred tax remeasurement

The Company’s net deferred income taxes represent benefits that will be used to reduce corporate taxes expected to be paid as well as differences between the tax bases and carrying amounts of assets and liabilities that will result in taxable or deductible amounts in future years. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in years in which those temporary differences are expected to be recovered or settled. As changes in tax laws or rates occur, deferred tax assets and liabilities are adjusted in the period changes are enacted through income tax expense.

The Company’s net deferred tax assets of $281 million were determined at September 30, 2017 based on the then-current enacted income tax rates prior to the passage of the Act. As a result of the reduction in the federal corporate income tax rate from 35% to 21% under the Act, the Company revalued its net deferred tax assets, which resulted in a reduction in the value of net deferred tax assets of approximately $67 million that was recorded as additional income tax expense in the Company’s Condensed Consolidated Statements of Comprehensive Income for the six months ended March 31, 2018.

Deemed repatriation

The Act implements a new territorial tax system that imposes a one-time transition tax, or deemed repatriation, on unremitted earnings of certain non-U.S. subsidiaries that is based in part on the amount of these earnings held in cash and other specified assets. The mandatory deemed repatriation resulted in a $22 million gross liability, but allows for the realization of $18 million of previously unrecognized foreign tax credits related to taxes previously paid in relevant local jurisdictions. The net result was $4 million of income tax expense which was recognized during the six months ended March 31, 2018.

The Company has historically intended to indefinitely reinvest undistributed earnings of its non-U.S. subsidiaries. As undistributed earnings of the Company’s non-U.S. subsidiaries were subject to the one-time deemed repatriation tax, the Company reevaluated its intentions to indefinitely reinvest its non-U.S. undistributed earnings. As a result, the Company no longer intends to indefinitely reinvest non-U.S. undistributed earnings and accordingly, recorded $2 million for estimated incremental withholding taxes during the six months ended March 31, 2018. The Company is presently not aware of any significant restrictions on the ability to transfer these funds, and additional taxes and other costs that may arise between the deemed and actual distribution dates are not estimated to be material.

Tax Matters Agreement

Total liabilities related to obligations owed to Ashland under the Tax Matters Agreement were $69 million and $62 million at March 31, 2018 and September 30, 2017, respectively. At March 31, 2018 and September 30, 2017, $3 million and $1 million was recorded in Accrued expenses and other liabilities, respectively, and $66 million and $61 million was recorded in Other noncurrent liabilities in the Condensed Consolidated Balance Sheets as of March 31, 2018 and September 30, 2017, respectively.

Under the Tax Matters Agreement, Valvoline has net indemnification obligations for a number of tax matters, including certain taxes that arise upon audit or examination related to the periods prior to Distribution and Valvoline’s utilization of legacy tax attributes contributed as part of the separation from Ashland. During the six months ended March 31, 2018, Valvoline recognized $8 million of expense in Legacy and separation-related expenses, net for the estimated increase in net amounts due. The estimated increase in net amounts due was principally a result of the reduction in the federal tax rate primarily related to the reduced federal benefit of state tax deductions, which drove increases in estimated taxes payable upon audit or examination as well as the expected utilization of tax attributes, which also resulted in an income tax benefit of $3 million during the period.

Uncertainties in income taxes

The Company records reserves related to its uncertain tax positions when it is more likely than not that the tax position may not be sustained on examination by the taxing authorities. As of March 31, 2018, the Condensed Consolidated Balance Sheet includes a $10 million liability for uncertain income tax positions, and during the three months ended March 31, 2018, there were no significant changes in Valvoline’s uncertain tax positions or related reserves. As tax examinations are completed or settled, statutes of limitations expire, or other new information becomes available, the Company will adjust its liabilities for uncertain tax positions in the respective period through payment or through the income tax provision. The Company has provided adequate reserves for its income tax uncertainties in all open tax years based on the recognition and measurement considerations in the relevant accounting principles and any adjustments are not expected to have a material effect on its condensed consolidated financial statements at this time; however, it is reasonably possible that there could be changes to the Company’s reserves related to its uncertain tax positions due to activities of the taxing authorities, resolution of examination issues, or reassessment of existing uncertain tax positions.

Although the timing and nature of the resolution and/or closure of examinations cannot be predicted with certainty, management estimates that it is reasonably possible that reserves related to uncertain tax positions may decrease by as much as $3 million from the resolution of tax examinations in U.S. jurisdictions during the next twelve months.