INCOME TAXES

The following table presents pre-tax income and the principal components of the reconciliation between the effective tax rate and the U.S. federal statutory income tax rate in effect for the years ended September 30:



(In millions)	2018			2017			2016
Income before income taxes
United States	$	282		$	433		$	382
Non-U.S.	50			57			39
Total income before income taxes	$	332		$	490		$	421

U.S. statutory tax rate	24.5		%	35.0		%	35.0		%
Income taxes computed at U.S. statutory tax rate	$	81		$	171		$	147
Increase (decrease) in amount computed resulting from:
Unrecognized tax benefits	—			2			3
State taxes, net of federal benefit	14			17			16
International rate differential	—			(7		)	(5		)
Permanent items	(3		)	(8		)	(11		)
Remeasurement of net deferred taxes	73			—			—
Deemed repatriation	4			—			—
Tax Matters Agreement activity	(2		)	10			—
Other	(1		)	1			(2		)
Income tax expense	$	166		$	186		$	148
Effective tax rate	50.0		%	38.0		%	35.2		%

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 was a blended rate of 24.5% for fiscal 2018, declining to 21% for fiscal 2019 and beyond.

During the year ended September 30, 2018, enactment of the Act resulted in the following provisional impacts:


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


•	Income tax expense increased by $4 million related to the deemed repatriation tax on undistributed 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 reduced federal benefit of state tax deductions, which drove increases in the higher expected utilization of tax attributes payable to Ashland.

The estimated impacts of the Act recorded during the year ended September 30, 2018 are provisional, and management will continue to assess the impact and record adjustments through the income tax provision up to one year from the enactment date 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.

The Company also reclassified $8 million from accumulated other comprehensive income to retained deficit related to the stranded tax effects resulting from the change in the federal corporate tax rate during fiscal 2018 as further detailed in Notes 2 and 17.

Many states have enacted state specific tax reform and legislation in response to the Act. In general, these impacts are not material to the Company’s financial statements. Valvoline is incorporated in Kentucky, which enacted income tax reform on April 13, 2018. The provisions of Kentucky tax reform generally become effective in fiscal 2019 and include a number of provisions, notably lowering the corporate income tax rate from a maximum of 6% to 5%. While the Company expects these changes will ultimately benefit Valvoline, during the year ended September 30, 2018, the enactment of Kentucky tax reform resulted in the following impacts:


•	The remeasurement of net deferred tax assets at the lower enacted Kentucky corporate tax rate resulted in a net $4 million increase in income tax expense; and


•	The remeasurement of the net indemnity liabilities associated with the Tax Matters Agreement increased pre-tax income by $4 million and generated $4 million of income tax expense primarily related to the lower expected utilization of tax attributes payable to Ashland.

The Company will continue to monitor enacted state legislation and make relevant updates to estimates when warranted.

Components of income tax expense

Income tax expense consisted of the following for the years ended September 30:



(In millions)	2018			2017			2016
Current
Federal ^(a)	$	(2	)	$	47		$	99
State	6			8			24
Non-U.S.	17			14			12
	21			69			135
Deferred
Federal	136			106			14
State	9			12			2
Non-U.S.	—			(1		)	(3		)
	145			117			13
Income tax expense	$	166		$	186		$	148


(a)	Benefit from favorable settlement with tax authorities in fiscal 2018.

Deferred income taxes are provided for income and expense items recognized in different years for tax and financial reporting purposes.

Deferred taxes

A summary of the deferred tax assets and liabilities included in the Consolidated Balance Sheets follows as of September 30:



(In millions)	2018			2017
Deferred tax assets
Federal net operating loss carryforwards	$	—		$	96
Non-U.S. net operating loss carryforwards ^(a)	2			1
State net operating loss carryforwards ^(b)	19			28
Employee benefit obligations	86			132
Compensation accruals	21			29
Credit carryforwards^(c)	36			13
Other	9			13
Valuation allowances ^(d)	(7		)	(8		)
Net deferred tax assets	166			304
Deferred tax liabilities
Goodwill and other intangibles	3			3
Property, plant and equipment	23			17
Undistributed earnings	2			3
Total deferred tax liabilities	28			23
Total net deferred tax assets	$	138		$	281


(a)	Gross non-U.S. net operating loss carryforwards of $7 million expire in fiscal years 2020 to 2033, with $5 million that has no expiration.


(b)	Apportioned gross net operating loss carryforwards of $481 million expire in fiscal years 2019 through 2037.


(c)	Credit carryforwards consist primarily of non-U.S. tax credits that generally expire in the fiscal years 2025 through 2037.


(d)	Valuation allowances primarily relate to certain state and non-U.S. net operating loss carryforwards and certain other deferred tax assets that are not expected to be realized or realizable.

As a result of the Act and Kentucky tax reform, the Company revalued its net deferred tax assets, which resulted in a reduction in the value of approximately $71 million primarily related to the reduction in the federal and Kentucky corporate income tax rates that was recorded as additional deferred income tax expense in the Company’s Consolidated Statements of Comprehensive Income for the year ended September 30, 2018 as noted above.

Undistributed earnings

The Act implements a new territorial tax system that imposes a one-time transition tax, or deemed repatriation, on undistributed 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 $23 million gross liability, but allows for the realization of $19 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 year ended September 30, 2018.

Prior to the Act, the Company had not provided for U.S. income taxes on undistributed earnings and other outside basis differences of its non-U.S. subsidiaries as it was the Company’s intention for these tax basis differences to remain indefinitely reinvested based on access to sufficient liquidity within the United States, as well as plans for use and investment outside of the United States. As these tax basis differences were subject to the deemed repatriation tax, the Company reevaluated its assertion and no longer intends to indefinitely reinvest the Company’s non-U.S. current and undistributed earnings. As a result, Valvoline recorded $2 million for estimated incremental withholding taxes during fiscal 2018 and began to account for certain of its non-U.S. subsidiaries as being immediately subject to tax, while certain other outside basis differences restricted by regulations, operational or investing needs for non-U.S. subsidiaries remain indefinitely reinvested. If these earnings were to be repatriated in the future, the Company may be subject to additional income and withholding taxes, which are not practicable to estimate.

Tax Matters Agreement

The Tax Matters Agreement was entered into on September 22, 2016 between Ashland and Valvoline (the “Tax Matters Agreement”) and generally provides that Valvoline is required to indemnify Ashland for the following items:


•	Taxes of Valvoline for all taxable periods that begin on or after the day after the date of the Distribution;


•	Taxes of Valvoline for the period between the IPO and Distribution that are not attributable to Ashland Group Returns (as defined below);


•	Taxes for the pre-IPO period that arise on audit or examination and are directly attributable to the Valvoline business;


•	Certain U.S. federal, state or local taxes for the pre-IPO period of Ashland and/or its subsidiaries for that period that arise on audit or examination and are directly attributable to neither the Valvoline business nor the Ashland chemicals business;


•	Certain tax attributes inherited from Ashland as the result of the Contribution from Ashland; and


•	Transaction Taxes (as defined below) that are allocated to Valvoline under the Tax Matters Agreement.

For taxable periods that begin on or after the day after the date of Distribution, Valvoline has not been included in Ashland’s consolidated U.S. and state income tax returns, nor in income tax returns of certain Ashland international subsidiaries (collectively, the “Ashland Group Returns”). Following the Distribution, Valvoline files tax returns that include only Valvoline and/or its subsidiaries, as appropriate, and accordingly, Valvoline is not required to make tax sharing payments to Ashland for these taxable periods. Valvoline has joint and several liability with Ashland to the U.S. Internal Revenue Service (“IRS”) for the consolidated U.S. federal income taxes of the Ashland consolidated group for the taxable periods in which Valvoline was part of the Ashland Group Returns. Valvoline will have joint control with Ashland, over any audit or examination related to taxes for which Valvoline is required to indemnify Ashland.

For the periods prior to the Distribution, Valvoline was included in the Ashland Group Returns. Under the Tax Matters Agreement, Ashland generally made all necessary tax payments to the relevant tax authorities with respect to Ashland Group Returns, and Valvoline made tax sharing payments to Ashland, inclusive of tax attributes utilized. The amount of the tax sharing payments were generally determined as if Valvoline and each of its relevant subsidiaries included in the Ashland Group Returns filed their own consolidated, combined or separate tax returns for the period from the IPO to the Distribution that include only Valvoline and/or its relevant subsidiaries, as the case may be. During fiscal 2017, Valvoline made $48 million in net tax-sharing payments to Ashland for the period prior to the Distribution.

During fiscal 2018, Valvoline recognized $8 million of pre-tax expense in Legacy and separation-related expenses, net within the Consolidated Statements of Comprehensive Income for the estimated adjustments in net amounts due to Ashland primarily as a result of Ashland’s lower than expected utilization of Valvoline tax attributes in Ashland Group Returns, tax reform legislation that reduced statutory rates, as well as the settlement of fiscal 2012 and 2013 federal examinations that resulted in increases in Valvoline’s expected utilization of tax attributes. Valvoline recognized an income tax benefit of $5 million during fiscal 2018 related to these changes. In fiscal 2017, Valvoline recognized a $16 million pre-tax benefit in Legacy and separation-related expenses, net for a reduction in amounts due to Ashland under the Tax Matters Agreement as a result of Ashland’s estimated utilization of Valvoline tax attributes in the Ashland Group Returns. This pre-tax benefit was offset by income tax expense of $16 million.

Total liabilities related to obligations owed to Ashland under the Tax Matters Agreement are primarily recorded in Other noncurrent liabilities in the Consolidated Balance Sheets and were $66 million and $62 million as of September 30, 2018 and 2017, respectively.

The Tax Matters Agreement also provides that Valvoline indemnify Ashland for any taxes (and reasonable expenses) resulting from the failure of the Distribution to qualify for non-recognition of gain and loss or certain reorganization transactions related to the Contribution or the Distribution to qualify for their intended tax treatment (“Transaction Taxes”), where the taxes result from (1) breaches of covenants (including covenants containing the restrictions described below that are designed to preserve the tax-free nature of the Distribution), (2) the application of certain provisions of U.S. federal income tax law to the Distribution with respect to acquisitions of Valvoline’s common stock, or (3) any other actions that Valvoline knows or reasonably should expect would give rise to such taxes. The Tax Matters Agreement also requires Valvoline to indemnify Ashland for a portion of certain other Transaction Taxes allocated to Valvoline based on Valvoline’s market capitalization relative to the market capitalization of Ashland.

The Tax Matters Agreement imposes certain restrictions on Valvoline and its subsidiaries (including restrictions on share issuances or repurchases, business combinations, sales of assets and similar transactions) that are designed to preserve the tax-free nature of the Distribution. These restrictions apply for the two-year period following the Distribution. Valvoline may be able to engage in an otherwise restricted action if Valvoline obtains an appropriate opinion from counsel or ruling from the IRS.

Unrecognized tax benefits

The aggregate changes in the balance of gross unrecognized tax benefits were as follows for the years ended September 30:



(In millions)	2018			2017		2016
Gross unrecognized tax benefits as of October 1	$	10		$	8	$	5
Increases related to tax positions from prior years	2			—		2
Increases related to tax positions taken during the current year	1			2		1
Settlements with tax authorities	(2		)	—		—
Lapses of statutes of limitation	(1		)	—		—
Gross unrecognized tax benefits as of September 30^(a)	$	10		$	10	$	8


(a)	As of September 30, 2018 and 2017, the Company had accruals of $1 million for interest and penalties related to unrecognized tax benefits.

Unrecognized tax benefits of $10 million as of September 30, 2018 and 2017 would favorably impact the effective income tax rate if recognized.

Together with Ashland, the Company resolved IRS examinations in fiscal 2018 for the 2012 and 2013 tax years, and accordingly, U.S. federal tax years remain open from fiscal 2014 forward. With certain exceptions, years beginning on or after fiscal 2006 remain open to examination by certain U.S. state and non-U.S. taxing authorities.

Because Valvoline is routinely under examination by various taxing authorities, it is reasonably possible that the amount of unrecognized tax benefits will change during the next twelve months. An estimate of the amount or range of such change cannot be made at this time. However, the Company does not expect the change, if any, to have a material effect on the Company’s consolidated financial statements within the next twelve months. Given the indemnification of Ashland and the years remaining open to examination, the majority of the Company’s liability for unrecognized tax benefits as of September 30, 2018 and 2017 is included in the Tax Matters Agreement obligation to Ashland summarized above within Other noncurrent liabilities in the Consolidated Balance Sheets.