Income Taxes

Our income (loss) before income taxes consisted of the following:



	Year ended September 30,
	2012			2011			2010
	(in thousands)
Domestic	$	(11,422	)	$	(23,984	)	$	(31,837	)
Foreign	132,158			128,532			113,973
Total income before income taxes	$	120,736		$	104,548		$	82,136

Our provision for income taxes consisted of the following:



	Year ended September 30,
	2012			2011			2010
	(in thousands)
Current:
Federal	$	8,534		$	22,849		$	5,755
State	1,733			(192		)	(177		)
Foreign	41,101			31,530			30,192
	51,368			54,187			35,770
Deferred:
Federal	106,041			(31,303		)	30,570
State	7,706			(2,176		)	733
Foreign	(8,981		)	(1,584		)	(9,305		)
	104,766			(35,063		)	21,998
Total provision for income taxes	$	156,134		$	19,124		$	57,768

The reconciliation between the statutory federal income tax rate and our effective income tax rate is shown below:



	Year ended September 30,
	2012		2011		2010
Statutory federal income tax rate	35	%	35	%	35	%
Change in valuation allowance	103	%	3	%	4	%
State income taxes, net of federal tax benefit	—	%	(2	)%	1	%
Federal and state research and development credits	(1	)%	(5	)%	(1	)%
Tax audit and examination settlements	1	%	—	%	1	%
Foreign rate differences	(16	)%	(15	)%	(26	)%
Subsidiary reorganization	3	%	1	%	53	%
Other, net	4	%	1	%	3	%
Effective income tax rate	129	%	18	%	70	%

In 2012, our effective tax rate was higher than the 35% statutory federal income tax rate due primarily to the recording of a $124.5 million charge to the income tax provision related to the establishment of a valuation allowance on U.S. net deferred tax assets. This increase was offset in part as a result of our corporate structure in which our foreign taxes are at a net effective tax rate lower than the U.S. rate. Our 2012 provision included $4.2 million related to the restructuring of our Canadian operations that resulted in a change in the tax status of the foreign legal entity and a discrete non-cash charge of $1.4 million related to the impact of a Japanese legislative change on our Japan entities' deferred tax assets. Additionally, our 2012 tax provision reflects a $7.8 million provision related to a research and development cost sharing prepayment by a foreign subsidiary to the U.S. We made a comparable prepayment in 2011. Foreign rate differences in our effective tax rate reconciliation above include the effect of the current year deferred charges associated with intercompany transactions.

In 2011, our effective tax rate was lower than the 35% statutory federal income tax rate due primarily to our corporate structure in which our foreign taxes are at a net effective tax rate lower than the U.S. rate and a $2.3 million tax benefit related to research and development (R&D) triggered by a retroactive extension of the R&D tax credit enacted in the first quarter of 2011. Our 2011 tax provision reflects a $7.5 million provision related to a research and development cost sharing prepayment by a foreign subsidiary to the U.S. A similar prepayment was made in 2010 resulting in a $6.0 million provision in that year. As a result, the net increase to the 2011 provision was $1.5 million. This impact is included in foreign rate differences in our effective tax rate reconciliation above. Also included in foreign rate differences is the effect of permanent items in foreign jurisdictions and the current year deferred charge associated with intercompany transactions.

In 2011, we continued the reorganization of our legal entity structure which began in 2010 to support our tax and cash planning. The 2011 reorganization resulted in a $46.4 million taxable gain in the U.S. The tax on this gain was offset in part by the reversal of a deferred tax liability for unremitted earnings of a foreign subsidiary of $6.5 million (established in 2010 in contemplation of this transaction), the recognition of foreign tax credits previously not benefitted, and foreign tax credits generated as a result of this transaction.

During the fourth quarter of 2010, we undertook a reorganization of our legal entity structure to support our tax and cash planning. The objective of this reorganization was to enable significant re-deployment and repatriation of cash between our international and domestic operations. This reorganization resulted in $446 million of foreign source taxable gain in the U.S., which was offset by foreign tax credits, primarily generated as a result of this transaction, and carry forward credits available. A significant amount of these carry forward credits were previously unrecognized due to the uncertainty of generating foreign source income in the U.S. The net tax effect of this reorganization was a $43.4 million tax provision in the U.S. While this reorganization drove a one-time increase in our 2010 effective income tax rate of 53%, it had no material effect on cash taxes paid. Our 2010 tax provision reflected a $6.0 million provision related to a research and development (R&D) cost sharing prepayment by a foreign subsidiary to the U.S. This prepayment had no impact on our 2010 tax rate as the same prepayment was made in 2009. Additionally, we established a full valuation allowance on foreign tax credits not expected to be realized.

In the first quarter of 2009, we completed a realignment of our European business which, in part, resulted in a one-time taxable gain in the U.S. This taxable gain enabled us to recognize current year and previously unrecognized tax credits. The resulting tax impact of this one-time gain was deferred over the useful life of the property being transferred. and as of September 30, 2012 and 2011, the accompanying consolidated balance sheet included deferred charges of $7.7 million ($3.6 million in other current assets and $4.1 million in other assets) and $11.4 million ($3.6 million in other current assets and $7.8 million in other assets), respectively.

At September 30, 2012 and 2011, income taxes payable and income tax accruals recorded in accrued income taxes, other current liabilities, and other liabilities on the accompanying consolidated balance sheets were $16.4 million ($0.8 million in accrued income taxes, $4.4 million in other current liabilities and $11.2 million in other liabilities) and $27.5 million ($11.9 million in accrued income taxes, $5.4 million in other current liabilities and $10.2 million in other liabilities), respectively. At September 30, 2012 and 2011, prepaid taxes recorded in prepaid expenses on the accompanying consolidated balance sheets were $0.7 million and $0.0 million, respectively. We made net income tax payments of $53.0 million, $28.1 million and $34.3 million in 2012, 2011 and 2010, respectively.

The significant temporary differences that created deferred tax assets and liabilities are shown below:



	September 30,
	2012			2011
	(in thousands)
Deferred tax assets:
Net operating loss carryforwards	$	23,879		$	29,785
Foreign tax credits	—			5,403
Capitalized research and development expense	59,562			66,957
Pension benefits	29,651			25,431
Deferred maintenance revenue	34,618			13,786
Stock-based compensation	17,137			15,723
Accrual for litigation	16,310			17,893
Other reserves not currently deductible	18,083			15,728
Amortization of intangible assets	10,658			7,552
Other tax credits	23,899			20,432
Depreciation	5,582			4,816
Other	8,464			6,859
Gross deferred tax assets	247,843			230,365
Valuation allowance	(170,404		)	(38,600		)
Total deferred tax assets	77,439			191,765
Deferred tax liabilities:
Acquired intangible assets not deductible	(53,030		)	(58,303		)
Pension prepayments	(12,475		)	(10,957		)
Other	(651		)	(649		)
Total deferred tax liabilities	(66,156		)	(69,909		)
Net deferred tax assets	$	11,283		$	121,856

The change in the net deferred tax asset to $11.3 million in 2012 from $121.9 million in 2011 includes the establishment of a valuation allowance on U.S. net deferred tax assets. In the fourth quarter of 2012, we recorded a $124.5 million non-cash charge to the income tax provision to establish a valuation allowance against all of our U.S. deferred tax assets, which were net of approximately $28 million of U.S. deferred tax liabilities. There were $6.1 million of U.S. deferred tax liabilities related to indefinite-lived intangible assets that were not available to be offset against deferred tax assets. The accounting guidance for income taxes requires that deferred tax assets be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets, including carryforwards and deductible temporary differences, depends on the existence of sufficient taxable income of the same character during the carryback or carryforward period. We considered all sources of taxable income available to realize the deferred tax assets, including the future reversal of existing temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards, taxable income in prior carryback years and tax-planning strategies.

In making a determination whether to record a valuation allowance, we weighed all available evidence, both positive and negative, including our cumulative profitability on a pre-tax basis for the last three years and our estimate of future pre-tax results. On a pre-tax basis (adjusted for permanent differences) for the three years ended September 30, 2012, we have cumulative U.S. profits, including the tax effect of legal entity reorganizations in 2010 and 2011 described above. However, based on our fiscal 2013 plan completed in the fourth quarter of 2012, we now estimate that the U.S. will generate a taxable loss in 2013 sufficient to result in cumulative three year losses by the end of 2013. Our 2012 results and our forecast for 2013 have not shown the improvement to U.S. earnings previously forecast. Although we anticipate continued improvement in U.S. core earnings, the turnaround to operating profitability is not anticipated in the near term. We had also anticipated that we would execute a legal entity reorganization of a foreign subsidiary that would generate sufficient U.S. taxable income to result in cumulative U.S. profits through at least 2013. We have now determined that this tax planning strategy is not feasible. As a result, we do not expect to generate sufficient U.S. taxable income in the near future to realize our U.S. net deferred tax assets.

In the first quarter of 2013, our acquisition of Servigistics, Inc. will be accounted for as a business combination. Assets acquired, including the fair values of acquired intangible assets, and liabilities assumed will be recorded in purchase accounting. In conjunction with recording the finite-lived acquired intangible assets, we anticipate that we will be recording deferred tax liabilities equal to the tax effect of the acquired intangible assets that are not deductible for income tax purposes. We anticipate that, in purchase accounting, Servigistics will be in a U.S. net deferred tax liability position, which will result in an adjustment to decrease our valuation allowance on U.S. net deferred tax assets. As this decrease in the valuation allowance is not part of the purchase accounting for Servigistics (the fair value of the assets acquired and liabilities assumed) it will be recorded as an income tax benefit. We expect our tax provision in the first quarter of 2013 to be an income tax benefit, net, due to the release of a significant portion of the valuation allowance on U.S. net deferred tax assets as a result of purchase accounting for Servigistics.

For U.S. tax return purposes, net operating loss carryforwards (NOL) and tax credits are generally available to be carried forward to future years, subject to certain limitations. At September 30, 2012, we had U.S. federal NOL carryforwards of $2.9 million from acquisitions, consisting of $1.0 million from MKS which expire beginning in 2020 through 2030, $1.1 million from CoCreate which expire beginning in 2019 through 2027, and $0.7 million from 4CS which expire in 2030. The utilization of these NOL carryforwards is limited as a result of the change in ownership rules under Internal Revenue Code Section 382. As of September 30, 2012, we had Massachusetts research and development credit carryforwards of $18.3 million, which expire beginning in 2016 and ending in 2027. A full valuation allowance is recorded against these carryforwards.

We also have loss carryforwards in non-U.S. jurisdictions totaling $110.3 million, the majority of which do not expire. There are limitations imposed on the utilization of such NOLs that could restrict the recognition of any tax benefits.

As of September 30, 2012, we have a valuation allowance of $147.1 million against net deferred tax assets in the U.S. and a remaining valuation allowance of $23.3 million against net deferred tax assets in certain foreign jurisdictions. The valuation allowance recorded against net deferred tax assets of certain foreign jurisdictions is established primarily for our net operating loss carryforwards, the majority of which do not expire. There are limitations imposed on the utilization of such net operating losses that could restrict the recognition of any tax benefits.

The changes to the valuation allowance were primarily due to:



	Year ended September 30,
	2012			2011			2010
	(in millions)
Valuation allowance beginning of year	$	38.6		$	40.5		$	46.3
Net release of valuation allowance (1)	—			(2.4		)	(16.8		)
Establish valuation allowance in the U.S.	124.5			—			4.8
Net increase in deferred tax assets for foreign jurisdictions with a full valuation allowance	—			—			2.8
Net decrease in deferred tax assets for foreign jurisdictions with a full valuation allowance	(2.1		)	(0.8		)	(0.3		)
Establish valuation allowance in foreign jurisdictions	0.6			—			—
Adjust deferred tax asset and valuation allowance in the U.S. primarily for tax credits	8.8			1.3			3.7
Valuation allowance end of year	$	170.4		$	38.6		$	40.5

(1)

In 2011 and 2010, this net reduction is primarily attributed to the release of the valuation allowance on foreign tax credits in the U.S. In both 2011 and 2010, this was the result of the subsidiary reorganizations described previously. As such, the current year change is included in subsidiary reorganization in the reconciliation between our statutory income tax rate and our effective income tax rate.

Our policy is to record estimated interest and penalties related to the underpayment of income taxes as a component of our income tax provision. In 2012, 2011 and 2010, we included in our income tax provision $0.3 million, $0.3 million and $0.5 million, respectively, of net interest expense and penalty expense of $0.1 million in 2012 and 2010. In 2011, we had no tax penalty expense in our income tax provision. As of September 30, 2012 and 2011, we had accrued $2.3 million and $2.0 million, respectively, of net estimated interest expense related to income tax accruals. We had $0.1 million of accrued tax penalties as of September 30, 2012.

As of September 30, 2012, we had an unrecognized tax benefit of $19.1 million ($19.1 million net of tax benefits from other jurisdictions). As of September 30, 2011, we had an unrecognized tax benefit of $16.2 million ($15.9 million net of tax benefits from other jurisdictions). If all of our unrecognized tax benefits as of September 30, 2012 were to become recognizable in the future, we would record a benefit to the income tax provision of $18.3 million which would be partially offset by an increase in the U.S. valuation allowance of $5.3 million. Changes in the unrecognized tax benefit were due to:



	Year ended September 30,
	2012				2011			2010
	(in millions)
Unrecognized tax benefit beginning of year	$	16.2			$	15.9		$	16.9
Tax positions related to current year	3.4				1.1			1.2
Tax positions related to prior years	0.9				(0.8		)	(2.2		)
Statute expirations	(1.4		)	—	—			—
Unrecognized tax benefit end of year	$	19.1			$	16.2		$	15.9

Although we believe our tax estimates are appropriate, the final determination of tax audits and any related litigation could result in favorable or unfavorable changes in our estimates. We anticipate the settlement of tax audits may be finalized within the next twelve months and could result in a decrease in our unrecognized tax benefits of up to $6 million.

In the normal course of business, PTC and its subsidiaries are examined by various taxing authorities, including the IRS in the United States. As of September 30, 2012, we remained subject to examination in the following major tax jurisdictions for the tax years indicated:



Major Tax Jurisdiction		Open Years
United States		2009 through 2012
Germany		2007 through 2012
France		2009 through 2012
Japan		2006 through 2012
Ireland		2008 through 2012

We incurred expenses related to stock-based compensation in 2012, 2011 and 2010 of $51.3 million, $45.4 million and $48.9 million, respectively. Accounting for the tax effects of stock-based awards requires that we establish a deferred tax asset as the compensation is recognized for financial reporting prior to recognizing the tax deductions. The tax benefit recognized in the consolidated statement of operations related to stock-based compensation totaled $2.8 million, $13.6 million and $14.8 million in 2012, 2011 and 2010, respectively. Upon the settlement of the stock-based awards (i.e., exercise, vesting, forfeiture or cancellation), the actual tax deduction is compared with the cumulative financial reporting compensation cost and any excess tax deduction is considered a windfall tax benefit, and is tracked in a “windfall tax benefit pool” to offset any future tax deduction shortfalls and will be recorded as increases to additional paid-in capital (APIC) in the period when the tax deduction reduces income taxes payable. In 2012 and 2011, we recorded net windfalls of $1.1 million and $9.4 million to APIC, respectively. In 2010, we recorded a net shortfall of $1.1 million. We follow the with-and-without approach for the direct effects of windfall tax deductions to determine the timing of the recognition of benefits for windfall tax deductions. We follow the direct method for indirect effects. As of September 30, 2012, the tax effect of windfall tax deductions which had not yet reduced taxes payable was $18.0 million.

In the fourth quarter of 2010, in conjunction with the subsidiary reorganization completed in 2010 and a subsequent transfer executed in 2011, we changed our assertion on the undistributed earnings of certain foreign subsidiaries resulting in a tax charge of $43.4 million in 2010 and a benefit of $0.7 million was recorded to foreign currency translation adjustment in accumulated other comprehensive income. With the exception of this continued reorganization, we have not provided for U.S. income taxes or foreign withholding taxes on foreign unrepatriated earnings as it is our current intention to permanently reinvest these earnings outside the U.S. unless it can be done with no significant tax cost. If we decide to change this assertion in the future to repatriate any additional non-U.S. earnings, we may be required to establish a deferred tax liability on such earnings through a charge to our income tax provision. The cumulative amount of undistributed earnings of our subsidiaries for which U.S. income taxes have not been provided totaled approximately $209 million and $99 million as of September 30, 2012 and 2011, respectively. The amount of unrecognized deferred tax liability on the undistributed earnings cannot be practicably determined at this time. However, we do currently have an outstanding loan receivable in the amount of $280.7 million owed to the U.S. from our top tier foreign subsidiary that can be repaid to repatriate foreign generated cash to the U.S. without tax cost.