ANNUAL REPORT 2007

 

 

NOTE 11
INCOME TAXES

 

 

Earnings before income taxes and the provision for U.S. federal, state, and foreign taxes on these earnings were:

 

 

 

The difference between the U.S. federal statutory tax rate and the Company’s effective income tax rate was:

 

As presented in the preceding table, the Company’s 2007 consolidated effective tax rate was approximately 29%, as compared to approximately 32% in 2006 and 31% in 2005. The 2007 effective income tax rate was lower than the two preceding years due principally to the favorable effect of several discrete adjustments. In the first quarter of 2007, management implemented an international restructuring initiative which eliminated a foreign tax liability of approximately $40 million. Accordingly, the reversal was recorded within the Company’s consolidated provision for income taxes. The Company benefited from statutory rate reductions, primarily in the United Kingdom and in Germany which resulted in an $11 million reduction to income tax expense. These rate reductions will first be applicable to income taxed in 2008 and amounted to two percentage points in the United Kingdom and ten percentage points in Germany, partially offset by the effect of other German tax law changes. During 2007, the Company repatriated approximately $327 million of current year foreign earnings, for a gross U.S. tax cost of $35 million. This cost was offset by foreign tax credit related items of $31 million, reducing the net cost of repatriation to $4 million. At December 29, 2007, accumulated foreign subsidiary earnings of approximately $1.3 billion were considered permanently invested in those businesses. Accordingly, U.S. income taxes have not been provided on these earnings.

 

 

In addition to the aforementioned statutory rate reductions enacted in the Company’s fiscal third quarter, the government of Mexico enacted a tax reform package. Beginning in 2008, corporate entities will pay the higher of traditional income tax (generally imposed at a rate of 28%) or a new corporate flat tax, which is phased in at a rate of 16.5% in 2008 to 17.5% by 2010. Under the new flat tax, allowable deductions, such as interest expense, are limited. The Company has evaluated the impact of the Mexican tax law reform on its Latin American operations. A valuation allowance of $3 million has been recorded against certain deferred tax assets. In addition, this tax reform will result in a slight increase to the Company’s consolidated effective income tax rate, beginning in 2008.

 

 

The Company’s 2006 consolidated effective tax rate included two significant, but partially-offsetting, discrete adjustments. The Company reduced its reserves for uncertain tax positions by $25 million, related principally to the closure of several domestic tax audits. In addition, the Company revised its repatriation plan for certain foreign earnings, giving rise to an incremental net tax cost of $18 million.

 

 

Generally, the changes in valuation allowances on deferred tax assets and corresponding impacts on the effective income tax rate result from management’s assessment of the Company’s ability to utilize certain future tax deductions, operating losses and tax credit carryforwards prior to expiration. For 2007, the .5% rate reduction presented in the preceding table primarily reflects the reversal of a valuation allowance against U.S. foreign tax credits which were utilized in conjunction with the aforementioned 2007 foreign earnings repatriation. Total tax benefits of carryforwards at year-end 2007 and 2006 were approximately $17 million and $29 million, respectively, with related valuation allowances at year-end 2007 and 2006 of approximately $17 and $28 million. Of the total carryforwards at year-end 2007, less than $2 million expire in 2008 with the remainder principally expiring after five years.

 

 

The following table provides an analysis of the Company’s deferred tax assets and liabilities as of year-end 2007 and 2006. The significant decline in the “employee benefits” caption of the Company’s noncurrent deferred tax asset during 2007 is principally related to net experience gains associated with employer pension and other postretirement benefit plans that are recorded in other comprehensive income, net of tax.

 

The change in valuation allowance against deferred tax assets was:

 

 

 

Cash paid for income taxes was (in millions): 2007–$560; 2006–$428; 2005–$425. Income tax benefits realized from stock option exercises and deductibility of other equity-based awards are presented in Note 8.

 

Uncertain tax positions

 

The Company adopted Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (FIN No. 48) as of the beginning of its 2007 fiscal year. This interpretation clarifies what criteria must be met prior to recognition of the financial statement benefit, in accordance with SFAS No. 109, “Accounting for Income Taxes,” of a position taken in a tax return.

 

 

Prior to adopting FIN No. 48, the Company’s policy was to establish reserves that reflected the probable outcome of known tax contingencies. Favorable resolution was recognized as a reduction to the effective income tax rate in the period of resolution. As compared to a contingency approach, FIN No. 48 is based on a benefit recognition model. Provided that the tax position is deemed more likely than not of being sustained, FIN No. 48 permits a company to recognize the largest amount of tax benefit that is greater than 50 percent likely of being ultimately realized upon settlement. The tax position must be derecognized when it is no longer more likely than not of being sustained. The initial application of FIN No. 48 resulted in a net decrease to the Company’s consolidated accrued income tax and related interest liabilities of approximately $2 million, with an offsetting increase to retained earnings.

 

 

The Company files income taxes in the U.S. federal jurisdiction, and in various state, local, and foreign jurisdictions. For the past several years, the Company’s annual provision for U.S. federal income taxes has represented approximately 70% of the Company’s consolidated income tax provision. With limited exceptions, the Company is no longer subject to U.S. federal examinations by the Internal Revenue Service (IRS) for years prior to 2004. During the first quarter of 2007, the IRS commenced an examination of the Company’s 2004 and 2005 U.S. federal income tax returns, which is anticipated to be completed during the second half of 2008. The Company is also under examination for income and non-income tax filings in various state and foreign jurisdictions, most notably: 1) a U.S.-Canadian transfer pricing issue pending international arbitration (“Competent Authority”) with a related advanced pricing agreement for years 1997-2008; and 2) an on-going examination of 2002-2004 U.K. income tax filings, with an examination of the 2005 filing, which began in July 2007.

 

 

As of December 29, 2007, the Company has classified approximately $36 million of unrecognized tax benefits as a current liability, representing several individually insignificant income tax positions under examination in various jurisdictions. Management’s estimate of reasonably possible changes in unrecognized tax benefits during the next twelve months is comprised of the aforementioned current liability balance expected to be settled within one year, offset by approximately $29 million of projected additions related primarily to ongoing intercompany transfer pricing activity. Management is currently unaware of any issues under review that could result in significant additional payments, accruals, or other material deviation in this estimate.

 

 

Following is a reconciliation of the Company’s total gross unrecognized tax benefits as of the year ended December 29, 2007. Approximately $147 million of this total represents the amount that, if recognized, would affect the Company’s effective income tax rate in future periods. This amount differs from the gross unrecognized tax benefits presented in the table due to the decrease in U.S. federal income taxes which would occur upon recognition of the state tax benefits included therein.

 

 

 

The current portion of the Company’s unrecognized tax benefits is presented in the balance sheet within accrued income taxes and the amount expected to be settled after one year is recorded in other noncurrent liabilities.

 

 

The Company classifies income tax-related interest and penalties as interest expense and selling, general, and administrative expense, respectively. For the year ended December 29, 2007, the Company recognized $9 million of tax-related interest and penalties and had approximately $31 million accrued at December 29, 2007.