Income Taxes

The components of income before income taxes for each fiscal year were as follows:



	2015		2014		2013

	(In millions)
U.S.	$	629	$	612	$	194
Foreign	969		836		156
	$	1,598	$	1,448	$	350

The components of the provision for income taxes for each fiscal year were as follows:



	2015			2014			2013

	(In millions)
Current:
U.S.	$	134		$	270		$	3
Foreign	199			97			72
State	18			27			2
	351			394			77
Deferred:
U.S.	(194		)	(9		)	34
Foreign	69			(3		)	(19		)
State	(5		)	(6		)	2
	(130		)	(18		)	17
	$	221		$	376		$	94

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



	2015		2014		2013
Tax provision at U.S. statutory rate	35.0	%	35.0	%	35.0	%
Resolutions from prior years’ income tax filings	(4.9	)	2.0		(4.7	)
Effect of foreign operations taxed at various rates	(16.3	)	(10.9	)	(21.1	)
State income taxes, net of federal benefit	0.9		1.0		0.8
Research and other tax credits	(0.2	)	(0.3	)	(5.4	)
U.S. domestic production deduction	(0.6	)	(1.3	)	(1.0	)
Acquisition costs	(1.1	)	0.8		—
Goodwill impairment	—		—		22.5
Share-based compensation	0.8		0.4		2.2
Other	0.2		(0.7	)	(1.4	)
	13.8	%	26.0	%	26.9	%

The effective tax rate for fiscal 2015 was lower than the rate for fiscal 2014 due primarily to acquisition costs that became deductible in the second quarter of fiscal 2015 as a result of the termination of the proposed business combination with TEL, an adjustment in the second quarter of fiscal 2015 to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales, reinstatement of the U.S. federal research and development tax credit during the first quarter of fiscal 2015 which was retroactive to its expiration in December 2013, resolutions and changes related to income tax liabilities for prior years, and changes in the geographical composition of income.

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.

In the reconciliation between the statutory U.S. federal income tax rate and the actual effective income tax rate for fiscal 2015, 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 in jurisdictions with lower statutory tax rates. The foreign operations with the most significant effective tax rate impact are Singapore and Israel. The statutory tax rates for fiscal 2015 for Singapore and Israel are 17% and 26.5%, respectively. Applied has been granted tax holidays for both jurisdictions that expire in fiscal 2026 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 $68 million for fiscal 2015 or $0.06 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 25, 2015			October 26, 2014

	(In millions)
Deferred tax assets:
Allowance for doubtful accounts	$	20		$	26
Inventory reserves and basis difference	155			128
Installation and warranty reserves	11			18
Accrued liabilities	106			123
Deferred revenue	17			32
Tax credits and net operating losses	196			160
Deferred compensation	79			44
Share-based compensation	53			57
Fixed assets	—			16
Other	150			27
Gross deferred tax assets	787			631
Valuation allowance	(207		)	(173		)
Total deferred tax assets	580			458
Deferred tax liabilities:
Fixed assets	(15		)	—
Intangible assets	(91		)	(92		)
Undistributed foreign earnings	(68		)	(87		)
Foreign exchange	(4		)	(12		)
Total gross deferred tax liabilities	(178		)	(191		)
Net deferred tax assets	$	402		$	267

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



	October 25, 2015			October 26, 2014

	(In millions)
Current deferred tax asset	$	403		$	232
Non-current deferred tax asset	55			67
Non-current deferred tax liability	(56		)	(32		)
	$	402		$	267

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 net deferred tax assets that may not be realized. Changes in the valuation allowance in each fiscal year were as follows:



	2015			2014			2013

	(In millions)
Beginning balance	$	173		$	116		$	46
Increases	40			60			70
Decreases	(6		)	(3		)	—
Ending balance	$	207		$	173		$	116

For fiscal 2015, U.S. income taxes have not been provided for approximately $4.1 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 U.S. 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 25, 2015, Applied has state research and development tax credit carryforwards of $179 million, including $143 million of credits that are carried over until exhausted and $36 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 $34 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 25, 2015, 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 $56 million, $27 million and $11 million for fiscal 2015, 2014 and 2013, respectively.

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 in each fiscal year is as follows:



	2015			2014			2013

	(In millions)
Beginning balance of gross unrecognized tax benefits	$	134		$	194		$	174
Settlements with tax authorities	(16		)	(143		)	(15		)
Lapses of statutes of limitation	(1		)	(2		)	(15		)
Increases in tax positions for current year	43			52			48
Increases in tax positions for prior years	21			42			2
Decreases in tax positions for prior years	(4		)	(9		)	—
Ending balance of gross unrecognized tax benefits	$	177		$	134		$	194

In the provision for income taxes in the Consolidated Statements of Operations, a tax benefit of $6 million, a tax expense of $18 million, and a tax benefit of $1 million were realized in fiscal 2015, 2014 and 2013, respectively, related to interest and penalties on unrecognized tax benefits. The liability for interest and penalties for fiscal 2015, 2014 and 2013 was $14 million, $25 million and $7 million, respectively, and was classified as a non-current liability in the Consolidated Balance Sheets.

Included in the ending balance of unrecognized tax benefits for fiscal 2015, 2014 and 2013 are $167 million, $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 2015, 2014 and 2013 are $9 million, $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 2015, Applied paid $19 million, including interest and penalties, as a result of a settlement of fiscal 2009 through fiscal 2011 in Italy and paid $2 million, including interest, as a result of a settlement of fiscal 2013 in Switzerland. These settlements resulted in the recognition of a tax benefit of $10 million in the Consolidated Statements of Operations. In fiscal 2014, Applied received a refund of $18 million, including interest, as a result of a settlement of fiscal 2008 through fiscal 2012 in Korea, and received a refund of $17 million, including interest, as a result of a settlement with the Internal Revenue Service for fiscal 2010 related to Varian. These settlements resulted in the recognition of a tax benefit of $3 million in the Consolidated Statements of Operations. In fiscal 2013, Applied received a refund of $31 million, including interest, as a result of a settlement with the Internal Revenue Service for 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 Internal Revenue Service 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 and state returns for fiscal 2010 and later years, and tax returns in certain jurisdictions outside of the United States for fiscal 2009 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.