INCOME TAXES

Deferred Income Taxes

Deferred income taxes reflect the impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and such amounts for tax purposes. Primarily due to differences in depreciation rates for federal income tax purposes and for financial reporting purposes, the Company has generated a net deferred tax liability.

Deferred tax (assets) and liabilities comprise the following (in millions):



	2016			2015
Excess of tax over book depreciation	$	1,282		$	1,110
Intangibles	39			—
Other—net	26			23
Gross deferred tax liabilities	1,347			1,133

Mileage Plan™	(310		)	(208		)
Inventory obsolescence	(23		)	(22		)
Deferred gains	(8		)	(8		)
Employee benefits	(196		)	(167		)
Fuel hedge contracts	—			(5		)
Acquired net operating losses	(289		)	—
Other—net	(62		)	(41		)
Gross deferred tax assets	(888		)	(451		)
Valuation allowance	4			—
Net deferred tax (assets) liabilities	$	463		$	682

Changes in net deferred tax liabilities resulted from 2016 activity and the acquisition of Virgin America.

At December 31, 2016, as a result of the acquisition of Virgin America, discussed in Note 2, Virgin America had federal NOLs of approximately $773 million that expire beginning in 2028 and continuing through 2036, and state NOLs of approximately $344 million that expire beginning in 2027 and continuing through 2035.

Virgin America has experienced multiple “ownership changes” as defined in Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), the most recent being its acquisition by the Company. Section 382 of the Code imposes an annual limitation on the amount of pre-ownership change NOLs of the corporation that experiences an ownership change. The limitation imposed by Section 382 of the Code for any post-ownership change year generally would be determined by multiplying the value of such corporation’s stock immediately before the ownership change by the applicable long-term tax-exempt rate. Any unused annual limitation may, subject to certain limits, be carried over to later years, and the limitation may, under certain circumstances, be increased by built-in gains or reduced by built-in losses in the assets held by such corporation at the time of the ownership change. The combined company’s use of NOLs generated after the date of an ownership change would not be limited unless the combined company were to experience a subsequent ownership change.

The combined company’s ability to use the NOLs will also depend on the amount of taxable income generated in future periods. The NOLs may expire before the combined company can generate sufficient taxable income to utilize the NOLs.

Valuation allowances are provided to reduce the related deferred income tax assets to an amount which will, more likely than not, be realized. The Company has determined it is more likely than not that a portion of the state NOL carryforward will not be realized and, therefore, has provided a valuation allowance of $4 million for that portion. The Company has likewise concluded that it is more likely than not that all of its federal and the remaining state deferred income tax assets will be realized and thus no additional valuation allowance has been recorded. The Company reassesses the need for a valuation allowance each reporting period.

Components of Income Tax Expense

The components of income tax expense were as follows (in millions):



	2016		2015			2014
Current income tax expense:
Federal	$	392	$	397		$	229
State	48		30			27
Total current income tax expense	440		427			256

Deferred income tax expense:
Federal	77		60			103
State	14		(23		)	11
Total deferred income tax expense	91		37			114
Income tax expense	$	531	$	464		$	370

Income Tax Rate Reconciliation

Income tax expense reconciles to the amount computed by applying the U.S. federal rate of 35% to income before income tax and accounting changes as follows (in millions):



	2016			2015			2014
Income before income tax	$	1,345		$	1,312		$	975

Expected tax expense	471			459			341
Nondeductible expenses	20			4			4
State income taxes	28			19			25
State income sourcing	13			(15		)	—
Other—net	(1		)	(3		)	—
Actual tax expense	$	531		$	464		$	370

Effective tax rate	39.5		%	35.4		%	37.9		%

In 2016, the Company incurred $39 million of acquisition-related costs that are not deductible under U.S. federal tax law. These expenses are included in Special items—merger-related costs and other on the Company’s consolidated statement of operations for the year ended December 31, 2016 and are reflected as a permanent unfavorable adjustment for the year ended December 31, 2016, in the table above.

In the fourth quarter of 2015, the Company filed amended state tax returns for the years 2010 through 2013 to change the Company’s position on income sourcing in various states. These positions were also taken on 2014 and future filings, unless guidance or rules changed. In 2016, adjustments were made to the Company's position on income sourcing in various states due to updated guidance from state taxing authorities. The impact of this guidance is reflected as an unfavorable adjustment of approximately $17 million for the year ended December 31, 2016.

Uncertain Tax Positions

The Company has identified its federal tax return and its state tax returns in Alaska, Oregon and California as “major” tax jurisdictions. A summary of the Company's jurisdictions and the periods that are subject to examination are as follows:



Jurisdiction	Period
Federal	2006 to 2015^(a)(b)
Alaska	2012 to 2015
California	2006 to 2015^(a)
Oregon	2003 to 2015^(a)

(a)

The 2003, 2004, 2008-2010 and 2011 Oregon tax returns are subject to examination only to the extent of net operating loss carryforwards from those years that were utilized in 2010 and later years. The 2006-2012 Federal and California Virgin America tax returns are subject to examination only to the extent of net operating loss carryforwards from those years that were utilized in 2012 and later years.


(b)	Income tax years 2012 and 2013 are currently under exam by the Internal Revenue Service.

Changes in the liability for unrecognized tax benefits during 2016, 2015 and 2014 are as follows (in millions):



	2016		2015		2014
Balance at January 1,	$	22	$	3	$	2
Additions based on tax positions and settlements related to the current year	3		19		1
Additions from acquisitions	8		—		—
Balance at December 31,	$	33	$	22	$	3

At December 31, 2016, the total amount of unrecognized tax benefits is recorded as a liability and some have reduced the NOL carryover from the Virgin America acquisition. The Company added $3 million of reserves for uncertain tax positions in 2016, primarily due to changes in income sourcing for state income taxes and added $8 million related to the acquisition of Virgin America. These uncertain tax positions could change as a result of the Company's ongoing audits, settlement of issues, new audits and status of other taxpayer court cases. The Company cannot predict the timing of these actions. Due to the positions being taken in various jurisdictions, the amounts currently accrued are the Company's best estimate as of December 31, 2016.