O. Taxes
| ($ in millions) | |||
| For the year ended December 31: | 2007 | 2006 | 2005 |
|---|---|---|---|
| Income from continuing operations before income taxes: | |||
| U.S. operations | $ 7,667 | $ 7,277 | $ 7,450 |
| Non-U.S. operations | 6,822 | 6,040 | 4,776 |
| Total income from continuing operations before income taxes | $ 14,489 | $ 13,317 | $ 12,226 |
The continuing operations provision for income taxes by geographic operations is as follows:
| ($ in millions) | |||
| For the year ended December 31: | 2007 | 2006 | 2005 |
|---|---|---|---|
| U.S. operations | $ 2,280 | $ 2,413 | $ 2,988 |
| Non-U.S. operations | 1,791 | 1,488 | 1,244 |
| Total continuing operations provision for income taxes | $ 4,071 | $ 3,901 | $ 4,232 |
The components of the continuing operations provision for income taxes by taxing jurisdiction are as follows:
| ($ in millions) | |||
| For the year ended December 31: | 2007 | 2006 | 2005 |
|---|---|---|---|
| U.S. federal: | |||
| Current | $ 1,085 | $ 602 | $ 521 |
| Deferred | 683 | 1,326 | 1,811 |
| 1,768 | 1,928 | 2,332 | |
| U.S. state and local: | |||
| Current | 141 | 11 | 80 |
| Deferred | (19) | 198 | 183 |
| 122 | 209 | 263 | |
| Non-U.S: | |||
| Current | 2,105 | 1,564 | 1,446 |
| Deferred | 76 | 200 | 191 |
| 2,181 | 1,764 | 1,637 | |
| Total continuing operations provision for income taxes | 4,071 | 3,901 | 4,232 |
| Provision for social security, real estate, personal property and other taxes | 3,832 | 3,461 | 3,501 |
| Total taxes included in income from continuing operations | $ 7,903 | $ 7,362 | $ 7,733 |
A reconciliation of the statutory U.S. federal tax rate to the company’s continuing operations effective tax rate is as follows:
| For the year ended December 31: | 2007 | 2006 | 2005 |
|---|---|---|---|
|
* American Jobs Creation Act of 2004, which permitted the repatriation of non-U.S. earnings at a reduced tax rate. |
|||
| Statutory rate | 35% | 35% | 35% |
| Foreign tax differential | (6) | (5) | (5) |
| State and local | 1 | 1 | 1 |
| “Act” repatriation* | — | — | 4 |
| Other | (2) | (2) | — |
| Effective rate | 28% | 29% | 35% |
The effect of tax law changes on deferred tax assets and liabilities did not have a material impact on the company’s effective tax rate.
The significant components of deferred tax assets and liabilities that are recorded in the Consolidated Statement of Financial Position were as follows:
Deferred tax assets
| ($ in millions) | ||
| At December 31: | 2007 | 2006 |
|---|---|---|
| Stock-based and other compensation | $ 2,920 | $ 3,147 |
| Retirement-related benefits | 2,505 | 3,002 |
| Capitalized research and development | 1,050 | 1,355 |
| Federal/state tax loss/state credit carryforwards | 772 | 299 |
| Bad debt, inventory and warranty reserves | 647 | 724 |
| Deferred income | 645 | 506 |
| Foreign tax loss/credit carryforwards | 498 | 390 |
| Capital loss carryforwards | 9 | 131 |
| Other | 1,962 | 1,802 |
| Gross deferred tax assets | 11,008 | 11,356 |
| Less: valuation allowance | 772 | 510 |
| Net deferred tax assets | $ 10,236 | $ 10,846 |
Deferred tax liabilities
| ($ in millions) | ||
| At December 31: | 2007 | 2006 |
|---|---|---|
| Retirement-related benefits | $ 4,964 | $ 2,906 |
| Leases | 1,635 | 1,385 |
| Software development costs | 462 | 505 |
| Other | 1,334 | 1,340 |
| Gross deferred tax liabilities | $ 8,395 | $ 6,136 |
For income tax return purposes, the company has available foreign, domestic and capital loss carryforwards, the tax effect of which is $799 million, as well as state tax credit carryforwards of approximately $480 million. Substantially all of these carryforwards are available for at least two years or are available for 10 years or more.
The company has certain foreign tax loss carryforwards that have not been reflected in the gross deferred tax asset balance. These losses, the potential tax benefit of which is approximately $1.1 billion, have not been recorded in the Consolidated Statement of Financial Position as the company has not determined if it will claim these losses. The company is currently evaluating whether to claim these losses and expects to make a decision within the next 12 months.
The valuation allowance at December 31, 2007, principally applies to certain foreign and state loss carryforwards, and state credit carryforwards, that, in the opinion of management, are more likely than not to expire unutilized. However, to the extent that tax benefits related to these carryforwards are realized in the future, the reduction in the valuation allowance will reduce income tax expense. The year-to-year increase of $262 million was primarily driven by an additional allowance related to the recognition of certain state tax credit carryforwards not previously recorded as deferred tax assets.
The company adopted the provisions of FIN 48 on January 1, 2007. The cumulative effect of adopting FIN 48 was a decrease in tax reserves and an increase of $117 million to the January 1, 2007 Retained earnings balance. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
| ($ in millions) | ||
| Balance at January 1, 2007 | $ 2,414 | |
|---|---|---|
| Additions based on tax positions related to the current year | 745 | |
| Additions for tax positions of prior years | 195 | |
| Reductions for tax positions of prior years (including impacts due to a lapse in statute) | (144) | |
| Settlements | (116) | |
| Balance at December 31, 2007 | $ 3,094 | |
The liability at December 31, 2007 of $3,094 can be reduced by $496 million of offsetting tax benefits associated with the correlative effects of potential transfer pricing adjustments, state income taxes and timing adjustments. The net amount of $2,598, if recognized, would favorably affect the company’s effective tax rate.
Interest and penalties related to income tax liabilities are included in income tax expense. During the year ended December 31, 2007, the company recognized $85 million in interest and penalties. The company has $195 million for the payment of interest and penalties accrued at December 31, 2007 and had $126 million accrued on January 1, 2007 upon adoption of FIN 48.
During the first quarter of 2007, the U.S. Internal Revenue Service (IRS) commenced its audit of the company’s U.S. income tax returns for 2004 and 2005. The company anticipates that this audit will be completed by the end of 2008.
Within the next 12 months, the company believes it is reasonably possible that the total amount of unrecognized tax benefits associated with certain positions may be significantly reduced. The potential decrease in the amount of unrecognized tax benefits is primarily associated with the possible resolution of the company’s U.S. income tax audit for 2004 and 2005. Specific positions that may be resolved, and that may significantly reduce the related amount of unrecognized tax benefits, include various transfer pricing matters and claims for tax incentives, as well as various other foreign tax matters. The company estimates that the unrecognized tax benefits at December 31, 2007 could be reduced by approximately $800 million.
In December 2006, the company and the IRS reached resolution of the company’s U.S. income tax audit for 2001 through 2003. The settlement of this audit resulted in a decrease in the 2006 effective tax rate of 3 points due to the release of previously recorded tax reserves.
In the fourth quarter of 2006, as a continuation of its global strategy, the company aligned, through an intercompany transfer, certain non-U.S. intellectual property rights with existing non-U.S. rights currently owned by one of the company’s non-U.S. manufacturing subsidiaries. This transfer resulted in a one-time increase in the 2006 effective tax rate of 4 points.
With limited exception, the company is no longer subject to U.S. federal, state and local or non-U.S. income tax audits by taxing authorities for years through 2001. The years subsequent to 2001 contain matters that could be subject to differing interpretations of applicable tax laws and regulations as it relates to the amount and/or timing of income, deductions and tax credits. Although the outcome of tax audits is always uncertain, the company believes that adequate amounts of tax and interest have been provided for any adjustments that are expected to result for these years.
The company has not provided deferred taxes on $18.8 billion of undistributed earnings of non-U.S. subsidiaries at December 31, 2007, as it is the company’s policy to indefinitely reinvest these earnings in non-U.S. operations. However, the company periodically repatriates a portion of these earnings to the extent that it does not incur an additional U.S. tax liability. Quantification of the deferred tax liability, if any, associated with indefinitely reinvested earnings is not practicable.
For additional information on the company’s effective tax rate, as well as the cash tax rate, refer to the “Looking Forward” section of the Management Discussion.
