Income Taxes

The components of income from operations before income taxes for fiscal 2012, 2011 and 2010 were as follows:



	2012			2011		2010

	(In millions)
U.S.	$	381		$	1,257	$	787
Foreign	(65		)	1,121		600
	$	316		$	2,378	$	1,387

The components of the provision for income taxes for fiscal 2012, 2011 and 2010 were as follows:



	2012			2011			2010

	(In millions)
Current:
U.S.	$	74		$	290		$	463
Foreign	75			206			134
State	8			5			34
	157			501			631
Deferred:
U.S.	52			(95		)	(160		)
Foreign	(4		)	(23		)	4
State	2			69			(26		)
	50			(49		)	(182		)
	$	207		$	452		$	449

A reconciliation between the statutory U.S. federal income tax rate of 35 percent and Applied’s actual effective income tax rate for fiscal 2012, 2011 and 2010 is presented below:



	2012		2011		2010
Tax provision at U.S. statutory rate	35.0	%	35.0	%	35.0	%
Favorable resolutions from audits of prior years’ income tax filings	(6.0	)	(6.9	)	—
Effect of foreign operations taxed at various rates	(8.5	)	(8.1	)	(3.0	)
State income taxes, net of federal benefit	2.0		1.6		0.9
Research and other tax credits	(1.0	)	(1.2	)	(0.3	)
Production benefit	(8.0	)	(0.8	)	(1.2	)
Goodwill impairment	47.0		—		—
Share-based compensation	4.0		0.4		0.6
Other	1.0		(1.0	)	0.4
	65.5	%	19.0	%	32.4	%

The effective income tax rate for fiscal 2012 is significantly higher than the rate for fiscal 2011 due primarily to the recording of goodwill impairment charges in fiscal 2012, which are not deductible for tax purposes.

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The components of deferred income tax assets and liabilities are as follows:



	October 28, 2012			October 30, 2011

	(In millions)
Deferred tax assets:
Inventory reserves and basis difference	$	119		$	214
Installation and warranty reserves	27			31
Foreign tax credits on undistributed foreign earnings	—			112
Accrued liabilities	224			250
Restructuring reserves	23			4
Deferred revenue	36			53
Capital loss carryforward	—			4
Tax credits and net operating losses	111			39
Deferred compensation	41			21
Share-based compensation	51			49
Intangibles	12			10
Gross deferred tax assets	644			787
Valuation allowance	(46		)	(13		)
Total deferred tax assets	598			774
Deferred tax liabilities:
Depreciation	(71		)	(61		)
Purchased technology	(190		)	(86		)
Undistributed foreign earnings	(93		)	—
Other	(25		)	(44		)
Total gross deferred tax liabilities	(379		)	(191		)
Net deferred tax assets	$	219		$	583

The following table presents the breakdown between current and non-current net deferred tax assets and liabilities:



	October 28, 2012			October 30, 2011

	(In millions)
Current deferred tax asset	$	369		$	580
Non-current deferred tax asset	51			78
Current deferred tax liability	(1		)	(1		)
Non-current deferred tax liability	(200		)	(74		)
	$	219		$	583

Current deferred tax liabilities are included in accounts payable and accrued expenses on the Consolidated Balance Sheets and non-current deferred tax liabilities are included in deferred income taxes and income taxes payable on the Consolidated Balance Sheets.

A valuation allowance is recorded to reflect the estimated amount of deferred tax assets that may not be realized. A valuation allowance was established against state research and development credit carryforwards where it is believed that it is not more likely than not that the carryforwards will be realized.

Applied has been granted tax holidays for certain of its subsidiaries in Singapore and Israel. The tax benefit arising from these tax holidays was $54 million for 2012 ($0.04 per diluted share). The tax holidays expire at various times through 2025, excluding potential renewals, and are subject to certain conditions with which the Company expects to comply.

For fiscal 2012, U.S. income taxes have not been provided for approximately $1.6 billion of cumulative undistributed earnings of several non-U.S. subsidiaries. Applied intends to reinvest these earnings indefinitely in operations outside of the U.S. If these earnings were distributed to the United States in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, Applied would be subject to additional U.S. income taxes (subject to an adjustment for foreign tax credits) and foreign withholding taxes. Determination of the amount of unrecognized deferred income tax liability related to these earnings is not practicable.

At October 28, 2012, Applied has state research and development tax credit carryforwards of $51 million which have lives ranging from 15 years to indefinite. Applied has a $40 million federal foreign tax credit carryforward which has a 10 year life. Applied also has net operating loss carryforwards in foreign jurisdictions of $11 million and state jurisdictions of $6 million, which have lives ranging from five years to indefinite. Management believes it is more likely than not that all loss and tax credit carryforwards at October 28, 2012, net of valuation allowance, will be utilized in future periods.

Applied’s income taxes payable have been reduced by the tax benefits associated with employee stock option transactions. These benefits, credited directly to stockholders’ equity with a corresponding reduction to taxes payable, amounted to $2 million for fiscal 2012, $4 million for fiscal 2011, and $2 million for fiscal 2010.

Applied maintains liabilities for uncertain tax positions. These liabilities involve considerable judgment and estimation and are continuously monitored by management based on the best information available. A reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits is as follows:



	2012			2011

	(In millions)
Beginning balance of gross unrecognized tax benefits	$	59		$	328
Uncertainties arising from the acquisition of Varian	76			—
Settlements with tax authorities	(16		)	(314		)
Increases in tax positions for current years	46			45
Increases in tax positions for prior years	53			—
Decreases in tax positions for prior years	(37		)	—
Ending balance of gross unrecognized tax benefits	$	181		$	59

As of October 28, 2012, Applied had unrecognized tax benefits, net of federal deduction for state tax, of $177 million, all of which, if recognized, would result in a reduction of Applied’s effective tax rate.

As of October 28, 2012, the gross liability for unrecognized tax benefits was $174 million, exclusive of interest and penalties. Increases or decreases to interest and penalties on uncertain tax positions are included in provision for income taxes in the Consolidated Statement of Operations. Interest and penalties accrued related to uncertain tax positions were $7 million as of October 28, 2012 and $1 million as of October 30, 2011, which were classified as a long-term liability in the Consolidated Balance Sheets.

In fiscal 2011, Applied received a refund of $276 million, including interest, as a result of settling an Internal Revenue Service (IRS) audit for fiscal years 2006 and 2007. This resulted in the recognition of a tax benefit of $176 million in the Consolidated Statement of Operations for fiscal 2011, which was net of previously recognized tax benefits.

During fiscal 2011, the IRS began an examination of Applied’s federal income tax returns for fiscal years 2009 and 2008. Applied believes it has adequately reserved for any income tax uncertainties that may arise as a result of this examination.

A number of Applied’s tax returns remain subject to examination by taxing authorities. These include U.S. federal returns for fiscal 2008 and later years, California returns for fiscal 2006 and later years, tax returns for certain other states for fiscal 2007 and later years, and tax returns in certain jurisdictions outside of the United States for fiscal 2005 and later years.

The timing of the resolution of income tax examinations, as well as the amounts and timing of various tax payments that may be part of the settlement process, is highly uncertain. This could cause large fluctuations in the balance sheet classification of current assets and non-current assets and liabilities. Applied estimates that unrecognized tax benefits at October 28, 2012 could be reduced by approximately $9 million in the next 12 months.