10. Income Taxes

Headwaters recorded income tax expense of approximately $0.7 million, $3.9 million and $3.6 million in 2012, 2013 and 2014, respectively. For all years presented, Headwaters recorded a full valuation allowance on its net amortizable deferred tax assets and accordingly, did not recognize benefit for tax credit carryforwards, net operating loss (NOL) carryforwards or other deferred tax assets, except to the extent of earnings in 2013 and 2014. The reported income tax rate of (3)% for 2012 was due to the combination of not recognizing benefit for pre-tax losses and tax credits, but recognizing current state income taxes in certain state jurisdictions where Headwaters generated taxable income. The reported 32% and 18% rates for 2013 and 2014 were also due primarily to state income taxes in certain state jurisdictions. In 2013, Headwaters recognized a tax benefit of approximately $2.7 million in discontinued operations, due primarily to the reversal of unrecognized income tax benefits related to audit periods that closed.

A valuation allowance is required when there is significant uncertainty as to the realizability of deferred tax assets. The ability to realize deferred tax assets is dependent upon Headwaters' ability to generate sufficient taxable income within the carryforward periods provided for in the tax law for each tax jurisdiction. Headwaters has considered the following possible sources of taxable income when assessing the realization of its deferred tax assets:

•	future reversals of existing taxable temporary differences;
•	future taxable income or loss, exclusive of reversing temporary differences and carryforwards;
•	tax-planning strategies; and
•	taxable income in prior carryback years.

Headwaters considered both positive and negative evidence in determining the continued need for a valuation allowance, including the following:

Positive evidence:

•	Current forecasts indicate that Headwaters' will generate pre-tax income and taxable income in the future.
•	A majority of Headwaters' tax attributes have significant carryover periods of 20 years or more.

Negative evidence:

•	Headwaters has a three-year cumulative loss as of September 30, 2014.
•	Headwaters operates in cyclical industries that are difficult to forecast.

Headwaters places more weight on objectively verifiable evidence than on other types of evidence and management currently believes that available negative evidence outweighs the available positive evidence. Management has therefore determined that Headwaters does not meet the "more likely than not" threshold that NOLs, tax credits and other deferred tax assets will be realized. Accordingly, a valuation allowance is required. During 2015, Headwaters may realize a three-year cumulative profit on a consolidated basis. If this occurs, Headwaters will also consider the other factors described above in evaluating the continued need for a full, or partial, valuation allowance.

All of the factors Headwaters is considering in evaluating whether and when to release all or a portion of the deferred tax asset valuation allowance involve significant judgment. For example, there are many different interpretations of "cumulative losses in recent years" which can be used. Also, significant judgment is involved in making projections of future financial and taxable income, especially because Headwaters' financial results are significantly dependent upon industry trends, including the new residential, repair and remodel, and infrastructure construction markets. Most of the markets in which Headwaters participates are currently in varying states of recovery from the historic downturn experienced in recent years; however, it is not possible to accurately predict whether recovery will continue, and if it does, at what rate and for how long. Any reversal of the valuation allowance will favorably impact Headwaters' results of operations in the period of reversal.

As of September 30, 2014, Headwaters' NOL and capital loss carryforwards totaled approximately $70.3 million (tax effected). The U.S. and state NOLs expire from 2015 to 2034. In addition, there are approximately $24.8 million of tax credit carryforwards as of September 30, 2014, which expire from 2028 to 2034.

The income tax provision consisted of the following for the years ended September 30:

(in thousands)	2012			2013			2014
Current tax benefit (provision):
Federal	$	1,267		$	(1,292	)	$	65
State		(1,717	)		(1,934	)		(1,973	)

Total current tax provision		(450	)		(3,226	)		(1,908	)
Deferred tax provision:
Federal		(211	)		(698	)		(1,666	)
State		0			0			0

Total deferred tax provision		(211	)		(698	)		(1,666	)

Total income tax provision	$	(661	)	$	(3,924	)	$	(3,574	)

The provision for income taxes differs from the amount computed using the statutory federal income tax rate due to the following:

(in thousands)	2012			2013			2014
Tax benefit (provision) at U.S. statutory rate	$	9,019		$	(4,273	)	$	(7,016	)
State income taxes, net of federal tax effect		(1,717	)		(1,934	)		(1,973	)
Valuation allowance		(8,913	)		3,955			7,994
Non-deductible executive compensation		0			0			(1,242	)
Unrecognized tax benefits		1,268			(1,245	)		101
Other		(318	)		(427	)		(1,438	)

Income tax provision	$	(661	)	$	(3,924	)	$	(3,574	)

The components of Headwaters' deferred income tax assets and liabilities were as follows as of September 30:

(in thousands)	2013			2014
Deferred tax assets:
NOL and capital loss carryforwards	$	78,095		$	70,320
Tax credit carryforwards		25,619			24,784
Estimated liabilities		14,165			15,925
Debt repurchase premium		15,503			12,711
Stock-based compensation		8,127			6,958
Deferred revenue		6,792			5,898
Reserves and allowances		5,805			4,860
Other		2,136			1,644
Valuation allowances		(127,418	)		(119,424	)

Total deferred tax assets		28,824			23,676
Deferred tax liabilities:
Property, plant and equipment basis differences		(26,065	)		(20,483	)
Goodwill and intangible asset basis differences		(2,759	)		(3,193	)
Indefinite lived intangible asset basis differences		(3,204	)		(4,869	)

Total deferred tax liabilities		(32,028	)		(28,545	)

Net deferred tax liability	$	(3,204	)	$	(4,869	)

A reconciliation of the change in the amount of gross unrecognized income tax benefits is as follows.

(in thousands)	2012			2013			2014
Gross unrecognized income tax benefits at beginning of year	$	8,312		$	4,872		$	4,552
Changes based on tax positions related to the current year		(370	)		0			0
Increases for tax positions related to prior years		560			1,214			0
Reductions for tax positions related to prior years		(2,073	)		(1,439	)		0
Settlements		(65	)		(16	)		0
Lapse of statute of limitations		(1,492	)		(79	)		(55	)

Gross unrecognized income tax benefits at end of year	$	4,872		$	4,552		$	4,497

During 2012, Headwaters released approximately $0.4 million of liabilities for interest and penalties. During 2013, Headwaters accrued approximately $0.3 million of liabilities for interest and penalties. During 2014, Headwaters accrued approximately $0.1 million of liabilities for interest and penalties and as of September 30, 2014, approximately $2.7 million was accrued for the payment of interest and penalties. Changes to the estimated liability for unrecognized income tax benefits during 2012 were primarily the result of an agreement reached with the IRS regarding its audit of 2009 and the expiration of statute of limitation time periods. Changes to the estimated liability during 2013 were primarily the result of additional state income tax reserves and the reversal in discontinued operations of unrecognized income tax benefits related to the completion of the 2009 IRS audit, as noted previously. Changes to the estimated liability during 2014 were primarily the result of the expiration of statute of limitation time periods. As of September 30, 2014, approximately $4.6 million of unrecognized income tax benefits would affect the 2014 effective tax rate if released into income, due to the impact of the valuation allowance.

The calculation of tax liabilities involves uncertainties in the application of complex tax regulations in multiple tax jurisdictions. Headwaters currently has open tax years subject to examination by the IRS and state tax authorities for the years 2011 through 2013. Headwaters recognizes potential liabilities for anticipated tax audit issues in the U.S. and state tax jurisdictions based on estimates of whether, and the extent to which, additional taxes and interest will be due. If events occur (or do not occur) as expected and the payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when it is determined the liabilities are no longer required to be recorded in the consolidated financial statements. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. It is reasonably possible that approximately $1.0 million of Headwaters' unrecognized income tax benefits, primarily related to state taxes, will be released within the next 12 months, due to the expiration of statute of limitation time periods.