Income Taxes

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



	2016		2015		2014

	(In millions)
U.S.	$	199	$	629	$	612
Foreign	1,814		969		836
	$	2,013	$	1,598	$	1,448

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



	2016			2015			2014

	(In millions)
Current:
U.S.	$	(36	)	$	134		$	270
Foreign	351			199			97
State	(2		)	18			27
	313			351			394
Deferred:
U.S.	55			(194		)	(9		)
Foreign	(89		)	69			(3		)
State	13			(5		)	(6		)
	(21		)	(130		)	(18		)
	$	292		$	221		$	376

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:



	2016		2015		2014
Tax provision at U.S. statutory rate	35.0	%	35.0	%	35.0	%
Resolutions of prior years’ income tax filings	3.9		(4.9	)	2.0
Effect of foreign operations taxed at various rates	(24.1	)	(16.3	)	(10.9	)
State income taxes, net of federal benefit	0.6		0.9		1.0
Research and other tax credits	(1.3	)	(0.2	)	(0.3	)
U.S. domestic production deduction	(0.2	)	(0.6	)	(1.3	)
Acquisition costs	—		(1.1	)	0.8
Share-based compensation	0.4		0.8		0.4
Other	0.2		0.2		(0.7	)
	14.5	%	13.8	%	26.0	%

The effective tax rate for fiscal 2016 was higher than fiscal 2015 primarily due to resolutions and changes related to income tax liabilities for uncertain tax positions, partially offset by changes in the geographical composition of income.

The effective tax rate for fiscal 2015 was lower than 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.

In the reconciliation between the statutory U.S. federal income tax rate and the effective income tax rate for fiscal 2016, 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 pre-tax income 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 2016 for Singapore and Israel are 17% and 25%, respectively. Applied has been granted conditional reduced tax rates 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 rates was $254 million for fiscal 2016 or $0.23 per diluted share.

Deferred tax assets and liabilities are recognized for the estimated future tax effects of temporary differences between the book and tax bases of assets and liabilities. Deferred tax assets are also recognized for net operating loss and tax credit carryovers. Deferred tax assets are offset by a valuation allowance to the extent it is more likely than not that they are not expected to be realized. The components of deferred income tax assets and liabilities were as follows:



	October 30, 2016			October 25, 2015

	(In millions)
Deferred tax assets:
Allowance for doubtful accounts	$	20		$	20
Inventory reserves and basis difference	151			155
Installation and warranty reserves	3			11
Accrued liabilities	53			106
Deferred revenue	17			17
Tax credits and net operating losses	210			196
Deferred compensation	45			79
Share-based compensation	55			53
Other	176			150
Gross deferred tax assets	730			787
Valuation allowance	(207		)	(207		)
Total deferred tax assets	523			580
Deferred tax liabilities:
Fixed assets	(29		)	(15		)
Intangible assets	(81		)	(91		)
Undistributed foreign earnings	(42		)	(68		)
Foreign exchange	—			(4		)
Total gross deferred tax liabilities	(152		)	(178		)
Net deferred tax assets	$	371		$	402

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



	October 30, 2016			October 25, 2015

	(In millions)
Current deferred tax asset	$	—		$	403
Non-current deferred tax asset	372			55
Non-current deferred tax liability	(1		)	(56		)
	$	371		$	402

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:



	2016			2015			2014

	(In millions)
Beginning balance	$	207		$	173		$	116
Increases	27			40			60
Decreases	(27		)	(6		)	(3		)
Ending balance	$	207		$	207		$	173

For fiscal 2016, U.S. income taxes have not been provided for approximately $5.3 billion of cumulative undistributed earnings of several foreign subsidiaries. Applied intends to indefinitely reinvest these earnings in foreign operations. 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 30, 2016, Applied has state research and development tax credit carryforwards of $207 million, including $171 million of credits that are carried over until exhausted and $36 million that are carried over for 15 years and begin to expire in fiscal 2021. Applied has net operating loss carryforwards in state jurisdictions of $16 million which begin to expire in fiscal 2018. Management believes it is more likely than not that all net operating loss and tax credit carryforwards at October 30, 2016, net of valuation allowance, will be utilized.

Applied’s income taxes payable have been reduced by the tax benefits associated with share-based compensation. These benefits, credited directly to additional paid-in capital with a corresponding reduction to taxes payable, amounted to $23 million, $56 million and $27 million for fiscal 2016, 2015 and 2014, 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. Gross unrecognized tax benefits are classified as non-current income taxes payable in other liabilities in the Consolidated Balance Sheets. A reconciliation of the beginning and ending balances of gross unrecognized tax benefits in each fiscal year is as follows:



	2016			2015			2014

	(In millions)
Beginning balance of gross unrecognized tax benefits	$	177		$	134		$	194
Settlements with tax authorities	(25		)	(16		)	(143		)
Lapses of statutes of limitation	(2		)	(1		)	(2		)
Increases in tax positions for current year	62			43			52
Increases in tax positions for prior years	109			21			42
Decreases in tax positions for prior years	(1		)	(4		)	(9		)
Ending balance of gross unrecognized tax benefits	$	320		$	177		$	134

In the provision for income taxes in the Consolidated Statements of Operations, a tax expense of $24 million, a tax benefit of $6 million, and a tax expense of $18 million, were realized in fiscal 2016, 2015 and 2014, respectively, related to interest and penalties on unrecognized tax benefits. The liability for interest and penalties for fiscal 2016, 2015 and 2014 was $33 million, $14 million and $25 million, respectively, and was classified as non-current income taxes payable.

Included in the balance of unrecognized tax benefits for fiscal 2016, 2015 and 2014 are $302 million, $167 million, and $124 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 2016, 2015 and 2014 are $8 million, $9 million, and $9 million, respectively, of tax benefits that, if recognized, would result in adjustments to other tax accounts, primarily non-current deferred tax assets.

In fiscal 2016, Applied accrued $25 million, including interest and penalties, as a result of a settlement of fiscal 2011 through fiscal 2015 in Switzerland. This settlement resulted in the recognition of a tax expense of $19 million. 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 related to Varian. These settlements resulted in the recognition of a tax benefit of $10 million. 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.

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 foreign tax returns 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 fluctuations in Applied’s financial condition and results of operations. Applied continues to have ongoing negotiations with various taxing authorities throughout the year.