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Notes to consolidated financial statements (audited)
International Business Machines Corporation and Subsidiary Companies

P. Taxes

($ in millions)
For the year ended December 31: 2008 2007 2006
Income from continuing operations before income taxes:      
U.S. operations $8,424 $7,667 $7,277
Non-U.S. operations 8,291 6,822 6,040
Total income from continuing operations before income taxes $16,715 $14,489 $13,317

The continuing operations provision for income taxes by geographic operations is as follows:

($ in millions)
For the year ended December 31: 2008 2007 2006
U.S. operations $2,348 $2,280 $2,413
Non-U.S. operations 2,033 1,791 1,488
Total continuing operations provision
for income taxes
$4,381 $4,071 $3,901

The components of the continuing operations provision for income taxes by taxing jurisdiction are as follows:

($ in millions)
For the year ended December 31: 2008 2007 2006
U.S. federal:      
Current $338 $1,085 $602
Deferred 1,263 683 1,326
1,601 1,768 1,928
U.S. state and local:      
Current 216 141 11
Deferred 205 (19) 198
421 122 209
Non-U.S.:      
Current 1,927 2,105 1,564
Deferred 432 76 200
2,359 2,181 1,764
Total continuing operations provision for income taxes 4,381 4,071 3,901
Provision for social security, real estate, personal property and other taxes 4,076 3,832 3,461
Total taxes included in income from continuing operations $8,457 $7,903 $7,362

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: 2008 2007 2006
Statutory rate 35% 35% 35%
Foreign tax differential (8) (6) (5)
State and local 1 1 1
Other (2) (2) (2)
Effective rate 26% 28% 29%

During the second quarter of 2008, the company reached agreement with the Internal Revenue Service (IRS) regarding claims for certain tax incentives. The resolution of this matter resulted in a net tax benefit of $281 million. Also, during the second quarter, the company completed its analysis with respect to certain issues associated with newly published U.S. tax regulations. The review resulted in a tax benefit of $200 million. The above benefits were predominately offset by the second-quarter 2008 tax cost associated with the intercompany transfer of certain intellectual property during the quarter.

During the fourth quarter of 2008, the IRS concluded its examination of the company’s income tax returns for 2004 and 2005 and issued a final Revenue Agent’s Report (RAR). The company has agreed with all of the adjustments contained in the RAR, with the exception of a proposed adjustment, with a pre-tax amount in excess of $2 billion, relating to valuation matters associated with the intercompany transfer of certain intellectual property in 2005 and computational issues related to certain tax credits. The company disagrees with the IRS on these specific matters and intends to contest the proposed adjustments through the IRS appeals process and the courts, if necessary. The company has redetermined its unrecognized tax benefits, including all similar items during open tax years, based on the agreed and disputed adjustments contained in the RAR and associated information and analysis. As a result, the company has recorded a net increase in tax reserves and an associated charge to the provision for income taxes of $85 million.

In addition, in 2008, the company’s effective tax rate also benefited from a net increase in the utilization of foreign tax credits.

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: 2008 2007*

* Reclassified to conform with 2008 presentation.

Retirement-related benefits $5,215 $2,505
Stock-based and other compensation 2,579 2,920
Federal/State tax loss/state credit carryforwards 862 781
Capitalized research and development 795 1,050
Foreign tax loss/credit carryforwards 642 498
Deferred income 739 645
Bad debt, inventory and warranty reserves 561 647
Other 2,061 1,962
Gross deferred tax assets 13,454 11,008
Less: valuation allowance 720 772
Net deferred tax assets $12,734 $10,236

Deferred tax liabilities

($ in millions)
At December 31: 2008 2007*

* Reclassified to conform with 2008 presentation.

Leases $1,913 $1,635
Depreciation 941 478
Software development costs 449 462
Retirement-related benefits 104 4,964
Other 1,059 856
Gross deferred tax liabilities $4,466 $8,395

For income tax return purposes, the company has foreign and domestic loss carryforwards, the tax effect of which is $989 million as well as state tax credit carryforwards of $515 million. Substantially all of these carryforwards are available for at least two years or are available for ten 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 $1.3 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 six months.

The valuation allowance at December 31, 2008, principally applies to certain foreign, state and local loss 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 change in the allowance balance was a decrease of $52 million.

The amount of unrecognized tax benefits at December 31, 2008 determined in accordance with the provisions of FIN 48 increased by $804 million in 2008 to $3,898 million. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:

($ in millions) 2008 2007
Balance at January 1 $3,094 $2,414
Additions based on tax positions related to the current year 1,481 745
Additions for tax positions of prior years 747 195
Reductions for tax positions of prior years (including impacts due to a lapse in statute) (1,209) (144)
Settlements (215) (116)
Balance at December 31 $3,898 $3,094

The additions to the unrecognized tax benefits related to the current and prior years are primarily attributable to various transfer pricing and related valuation matters, certain tax incentives and credits, acquisition-related matters and other non-U.S. and state matters.

The settlements and reductions to the unrecognized tax benefits for tax positions of prior years are primarily attributable to the conclusion of the company’s various U.S. and non-U.S. income tax examinations, the agreement reached with the IRS regarding claims for certain tax incentives, the company’s analysis with respect to certain issues associated with newly published U.S. tax regulations and various non-U.S. matters including impacts due to lapses in statutes of limitation.

The liability at December 31, 2008 of $3,898 million can be reduced by $532 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 $3,366 million, 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, 2008, the company recognized $96 million in interest and penalties; in 2007, the company recognized $85 million in interest and penalties. The company has $286 million for the payment of interest and penalties accrued at December 31, 2008 and had $195 million accrued at December 31, 2007.

It is not anticipated that the amount of unrecognized tax benefits reflected as of December 31, 2008 will materially change in the next 12 months; any changes are not expected to have a significant impact on the results of operations, cash flows or the financial position of the company.

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 2002. The years subsequent to 2002 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.

It is expected that the audit of the company’s 2006 and 2007 U.S. income tax returns will commence in the first quarter of 2009.

The company has not provided deferred taxes on $21.9 billion of undistributed earnings of non-U.S. subsidiaries at December 31, 2008, 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 refer to the “Looking Forward” section of the Management Discussion.

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