Income Taxes

The components of income before income taxes for fiscal 2014, 2013 and 2012 were as follows:



	2014		2013		2012

	(In millions)
U.S.	$	612	$	194	$	381
Foreign	836		156		(65		)
	$	1,448	$	350	$	316

The components of the provision for income taxes for fiscal 2014, 2013 and 2012 were as follows:



	2014			2013			2012

	(In millions)
Current:
U.S.	$	270		$	3		$	74
Foreign	97			72			75
State	27			2			8
	394			77			157
Deferred:
U.S.	(9		)	34			52
Foreign	(3		)	(19		)	(4		)
State	(6		)	2			2
	(18		)	17			50
	$	376		$	94		$	207

A reconciliation between the statutory U.S. federal income tax rate of 35 percent and Applied’s actual effective income tax rate for fiscal 2014, 2013 and 2012 is presented below:



	2014		2013		2012
Tax provision at U.S. statutory rate	35.0	%	35.0	%	35.0	%
Resolutions from prior years’ income tax filings	2.0		(4.7	)	(6.0	)
Effect of foreign operations taxed at various rates	(10.9	)	(21.1	)	(8.5	)
State income taxes, net of federal benefit	1.0		0.8		2.0
Research and other tax credits	(0.3	)	(5.4	)	(1.0	)
Production benefit	(1.3	)	(1.0	)	(8.0	)
Acquisition costs	0.8		—		—
Goodwill impairment	—		22.5		47.0
Share-based compensation	0.4		2.2		4.0
Other	(0.7	)	(1.4	)	1.0
	26.0	%	26.9	%	65.5	%

The effective tax rate for fiscal 2014 was lower than the rate for fiscal 2013 due primarily to nondeductible goodwill impairment charges in fiscal 2013, offset by resolutions and changes related to prior years and expiration of the U.S. federal research and development tax credit. 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.

In the reconciliation between the statutory U.S. federal income tax rate and the actual effective income tax rate for fiscal 2014, the effect of foreign operations taxed at various rates represents the difference between an income tax provision at the U.S. federal statutory income tax rate and the recorded income tax provision, with the difference expressed as a percentage of worldwide income before income taxes. This effect is substantially related to the tax effect of foreign income before income taxes generated in jurisdictions with lower statutory tax rates. The foreign operations with the most significant effective tax rate impact are Singapore and Israel. The fiscal 2014 statutory tax rates for Singapore and Israel are 17% and 26.5%, respectively. Applied has been granted tax holidays for both jurisdictions that expire in fiscal 2025 and fiscal 2017, respectively, excluding potential renewals and subject to certain conditions with which Applied expects to comply. The tax benefit arising from these tax holidays was $85 million for fiscal 2014 or $0.07 per diluted share.

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 were as follows:



	October 26, 2014			October 27, 2013

	(In millions)
Deferred tax assets:
Allowance for doubtful accounts	$	26		$	27
Inventory reserves and basis difference	128			134
Installation and warranty reserves	18			14
Accrued liabilities	123			138
Deferred revenue	32			27
Tax credits and net operating losses	160			182
Deferred compensation	44			33
Share-based compensation	57			60
Fixed assets	16			(34		)
Other	27			13
Gross deferred tax assets	631			594
Valuation allowance	(173		)	(116		)
Total deferred tax assets	458			478
Deferred tax liabilities:
Intangible assets	(92		)	(82		)
Undistributed foreign earnings	(87		)	(75		)
Foreign exchange	(12		)	(18		)
Total gross deferred tax liabilities	(191		)	(175		)
Net deferred tax assets	$	267		$	303

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



	October 26, 2014			October 27, 2013

	(In millions)
Current deferred tax asset	$	232		$	323
Non-current deferred tax asset	67			53
Current deferred tax liability	—			(2		)
Non-current deferred tax liability	(32		)	(71		)
	$	267		$	303

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. During fiscal 2014, the valuation allowance against current state research and development credit carryforwards increased by $39 million and the valuation allowance against foreign deferred tax assets increased by $18 million.

For fiscal 2014, U.S. income taxes have not been provided for approximately $2.7 billion of cumulative undistributed earnings of several foreign 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 26, 2014, Applied has state research and development tax credit carryforwards of $146 million, including $112 million of credits that are carried over until exhausted and $34 million which are carried over for 15 years and begin to expire in fiscal 2021. Applied has a net operating loss carryover in state jurisdictions of $45 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 26, 2014, 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 $27 million for fiscal 2014, $11 million for fiscal 2013, and $2 million for fiscal 2012.

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:



	2014			2013

	(In millions)
Beginning balance of gross unrecognized tax benefits	$	194		$	174
Settlements with tax authorities	(143		)	(15		)
Lapses of statutes of limitation	(2		)	(15		)
Increases in tax positions for current year	52			48
Increases in tax positions for prior years	42			2
Decreases in tax positions for prior years	(9		)	—
Ending balance of gross unrecognized tax benefits	$	134		$	194

In the provision for income taxes in the Consolidated Statement of Operations, tax expense of $18 million was realized in fiscal 2014 and a tax benefit of $1 million was realized in fiscal 2013 related to interest and penalties on unrecognized tax benefits. The liability for interest and penalties was $25 million as of October 26, 2014 and $7 million as of October 27, 2013 and was classified as a non-current liability in the Consolidated Balance Sheets.

Included in the ending balance of unrecognized tax benefits for fiscal 2014 and fiscal 2013 are $124 million and $183 million, respectively, of tax benefits that, if recognized, would affect the effective tax rate. Also included in the ending balance of unrecognized tax benefits for fiscal 2014 and fiscal 2013 are $9 million and $10 million respectively, of tax benefits that, if recognized, would result in adjustments to other tax accounts, primarily deferred taxes.

In fiscal 2014, Applied received a refund of $18 million, including interest, as a result of settling an audit of fiscal 2008 through fiscal 2012 in Korea, and received a refund of $17 million, including interest, as a result of settling an Internal Revenue Service (IRS) audit of Varian for fiscal 2010. These settlements resulted in the recognition of a tax benefit of $3 million in the Consolidated Statement of Operations. In fiscal 2013, Applied received a refund of $31 million, including interest, as a result of settling an 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 Varian for fiscal 2010 through fiscal 2012. No tax expense or benefit was recognized.

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 2010 and later years, tax returns for certain other states for fiscal 2010 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.