Income Taxes

The components of income before income taxes for fiscal 2013, 2012 and 2011 were as follows:



	2013		2012			2011

	(In millions)
U.S.	$	194	$	381		$	1,257
Foreign	156		(65		)	1,121
	$	350	$	316		$	2,378

The components of the provision for income taxes for fiscal 2013, 2012 and 2011 were as follows:



	2013			2012			2011

	(In millions)
Current:
U.S.	$	3		$	74		$	290
Foreign	72			75			206
State	2			8			5
	77			157			501
Deferred:
U.S.	34			52			(95		)
Foreign	(19		)	(4		)	(23		)
State	2			2			69
	17			50			(49		)
	$	94		$	207		$	452

A reconciliation between the statutory U.S. federal income tax rate of 35 percent and Applied’s actual effective income tax rate for fiscal 2013, 2012 and 2011 is presented below:



	2013		2012		2011
Tax provision at U.S. statutory rate	35.0	%	35.0	%	35.0	%
Resolutions from prior years’ income tax filings	(4.7	)	(6.0	)	(6.9	)
Effect of foreign operations taxed at various rates	(19.4	)	(8.5	)	(8.1	)
State income taxes, net of federal benefit	0.8		2.0		1.6
Research and other tax credits	(5.4	)	(1.0	)	(1.2	)
Production benefit	(1.0	)	(8.0	)	(0.8	)
Goodwill impairment	22.5		47.0		—
Share-based compensation	2.2		4.0		0.4
Other	(3.1	)	1.0		(1.0	)
	26.9	%	65.5	%	19.0	%

The effective tax rate for fiscal 2013 was significantly lower than the rate for fiscal 2012 due primarily to the geographic composition of Applied's pre-tax income, lower nondeductible goodwill impairment charges, and reinstatement of the U.S. federal research and development tax credit retroactive to its expiration in December 2012. These reductions were partially offset by a lower benefit in fiscal 2013 from the U.S. federal domestic production deduction, which was limited by U.S. federal taxable income. The effective income tax rate for fiscal 2012 was significantly higher than the rate for fiscal 2011 due primarily to the nondeductible goodwill impairment charges in fiscal 2012 and the fiscal 2011 benefit from the December 2010 reinstatement of the U.S. R&D tax credit retroactive to its expiration in December 2009.

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 27, 2013			October 28, 2012

	(In millions)
Deferred tax assets:
Inventory reserves and basis difference	$	134		$	124
Installation and warranty reserves	14			27
Accrued liabilities	201			211
Restructuring reserves	5			23
Deferred revenue	27			36
Tax credits and net operating losses	182			111
Deferred compensation	33			41
Share-based compensation	60			51
Gross deferred tax assets	656			624
Valuation allowance	(116		)	(46		)
Total deferred tax assets	540			578
Deferred tax liabilities:
Fixed assets	(54		)	(71		)
Intangible assets	(94		)	(178		)
Undistributed foreign earnings	(75		)	(92		)
Other	(14		)	(18		)
Total gross deferred tax liabilities	(237		)	(359		)
Net deferred tax assets	$	303		$	219

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



	October 27, 2013			October 28, 2012

	(In millions)
Current deferred tax asset	$	323		$	369
Non-current deferred tax asset	53			51
Current deferred tax liability	(2		)	(1		)
Non-current deferred tax liability	(71		)	(200		)
	$	303		$	219

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 other liabilities 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 and non-U.S. net operating loss 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, China and Israel. The tax benefit arising from these tax holidays was $15 million for 2013 ($0.08 per diluted share). The tax holidays expire at various times through 2026, excluding potential renewals, and are subject to certain conditions with which the Company expects to comply.

For fiscal 2013, U.S. income taxes have not been provided for approximately $2.2 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 27, 2013, Applied has state research and development tax credit carryforwards of $109 million, including $89 million of credits that are carried over until exhausted and $19 million which are carried over for 15 years and begin to expire in fiscal 2021. Applied has a $51 million federal foreign tax credit carryforward which may be carried over 10 years and expires in fiscal 2022. Applied has a $19 million federal research and development tax credit carryover which may be carried over for 20 years and begins to expire in fiscal 2032. Applied has a net operating loss carryover in state jurisdictions of $65 million which begin to expire in fiscal 2018. Management believes it is more likely than not that all loss and tax credit carryovers at October 27, 2013, 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 $11 million for fiscal 2013, $2 million for fiscal 2012, and $4 million for fiscal 2011.

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:



	2013			2012

	(In millions)
Beginning balance of gross unrecognized tax benefits	$	174		$	59
Uncertainties arising from the acquisition of Varian	—			70
Settlements with tax authorities	(15		)	(15		)
Lapses of statutes of limitation	(15		)	—
Increases in tax positions for current years	48			42
Increases in tax positions for prior years	2			51
Decreases in tax positions for prior years	—			(33		)
Ending balance of gross unrecognized tax benefits	$	194		$	174

Increases or decreases to interest and penalties on uncertain tax positions were included in the provision for income taxes in the Consolidated Statement of Operations. Interest and penalties related to uncertain tax positions were $7 million as of October 27, 2013 and $7 million as of October 28, 2012 and were classified as a non-current liability in the Consolidated Balance Sheets.

In fiscal 2013, Applied received a refund of $31 million, including interest, as a result of settling an Internal Revenue Service (IRS) audit of fiscal 2008 and fiscal 2009. This resulted in the recognition of a tax benefit of $12 million in the Consolidated Statement of Operations. In fiscal 2013, Applied paid $14 million to the IRS as part of an ongoing audit of the Varian subsidiary for fiscal 2010 through fiscal 2012. No tax expense or benefit was recognized. In fiscal 2011, Applied received a refund of $276 million, including interest, as a result of settling an 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.

A number of Applied’s tax returns remain subject to examination by taxing authorities. These include U.S. federal returns for fiscal 2010 and later years, California returns for fiscal 2009 and later years, tax returns for certain other states for fiscal 2009 and later years, and tax returns in certain jurisdictions outside of the United States for fiscal 2007 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 continues to have ongoing negotiations with various taxing authorities throughout the year. During the next twelve months, it is reasonably possible that audit resolutions and the expiration of statutes of limitation could reduce our unrecognized tax benefits by up to $115 million.