9.Income Taxes

Headwaters’ estimated effective income tax rate for continuing operations for the fiscal year ending September 30, 2014 is currently expected to be approximately 22%, and this estimated rate was used to record income taxes for the June 2014 quarter and the nine months ended June 30, 2014. For the nine months ended June 30, 2013, Headwaters used an estimated effective income tax rate for continuing operations of 18%. Headwaters did not recognize any tax expense for discrete items in the 2014 periods, but recognized approximately $1.3 million of tax expense for discrete items in continuing operations in the fiscal 2013 periods that did not affect the calculation of the estimated effective income tax rate for the 2013 fiscal year. A majority of the expense recognized for discrete items was for adjustments related to unrecognized income tax benefits, most of which were for additional state income taxes. In addition, 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.

Beginning in 2011, Headwaters has 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 in any of the 2013 or 2014 periods, except to the extent of projected fiscal year earnings. The estimated income tax rates of 18% for fiscal 2013 and 22% for fiscal 2014 resulted primarily from the combination of recognizing benefit for deferred tax assets only to the extent of projected fiscal year earnings, plus state income taxes in certain state jurisdictions.

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.

Because Headwaters’ operations in domestic and foreign jurisdictions have generated losses in recent years, management has 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 fiscal 2015, Headwaters may realize a three-year cumulative accounting profit on a consolidated basis. If this occurs, Headwaters will also consider other factors in evaluating the continued need for a full, or partial, valuation allowance. These factors include:

current financial performance;

our ability to meet short-term and long-term financial and taxable income projections;

the overall market environment; and

the volatility and trend of the industries in which Headwaters operates.

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.

During fiscal 2014, Headwaters may realize a three-year cumulative accounting profit in certain state jurisdictions. If this occurs, Headwaters will consider the factors above in determining the continued need for a valuation allowance on the deferred tax assets related to those state jurisdictions.

As of June 30, 2014, Headwaters’ NOL and capital loss carryforwards totaled approximately $77.3 million (tax effected). The U.S. and state NOLs expire from 2014 to 2033. Substantially all of the non-U.S. NOLs, which are not material, do not expire. In addition, there are approximately $25.7 million of tax credit carryforwards as of June 30, 2014, which also expire from 2014 to 2033.

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.