Note 9. Income Taxes

Pre-tax Income

The domestic and foreign components of income before income taxes were as follows for the three years ended July 3, 2015 (in millions):



	2015		2014		2013
Foreign	$	1,501	$	1,664	$	870
Domestic	76		88		352
Income before income taxes	$	1,577	$	1,752	$	1,222

Income Tax Provision

The components of the provision for income taxes were as follows for the three years ended July 3, 2015 (in millions):



	2015			2014			2013
Current:
Foreign	$	54		$	47		$	57
Domestic-federal	43			98			149
Domestic-state	(13		)	3			1
Deferred:
Foreign	12			(3		)	(7		)
Domestic-federal	11			(14		)	(46		)
Domestic-state	5			4			88
Income tax provision	$	112		$	135		$	242

The Company’s income tax provision for 2015 and 2013 reflects tax benefits of $27 million and $37 million, respectively, as a result of the retroactive extensions of the U.S. Federal research and development tax credit that were signed into law on December 19, 2014 and January 2, 2013. In addition, the Company recorded an $88 million charge to reduce its previously recognized California deferred tax assets in 2013 as a result of the enactment of California Proposition 39.

Remaining net undistributed earnings from foreign subsidiaries at July 3, 2015 on which no U.S. tax has been provided amounted to $9.4 billion. The net undistributed earnings are intended to finance local operating requirements and capital investments. Accordingly, an additional U.S. tax provision has not been made on these earnings. The tax liability for these earnings would be $3.1 billion if the Company repatriated the $9.4 billion in undistributed earnings from the foreign subsidiaries.

Deferred Taxes

Temporary differences and carryforwards, which give rise to a significant portion of deferred tax assets and liabilities as of July 3, 2015 and June 27, 2014 were as follows (in millions):



	2015			2014
Deferred tax assets:
Sales related reserves and accrued expenses not currently deductible	$	50		$	38
Accrued compensation and benefits not currently deductible	138			190
Domestic net operating loss carryforward	137			130
Business credit carryforward	167			155
Long-lived assets	49			58
Other	65			65
Total deferred tax assets	606			636
Deferred tax liabilities:
Long-lived assets	(126		)	(152		)
Other	(10		)	(11		)
Total deferred tax liabilities	(136		)	(163		)
Valuation allowances	(166		)	(128		)
Deferred tax assets, net	$	304		$	345
Deferred tax assets:
Current portion (included in other current assets)	$	167		$	184
Non-current portion (included in other non-current assets)	273			324
Total deferred tax assets	440			508
Deferred tax liabilities:
Current portion (included in other current assets)	(1		)	(2		)
Non-current portion (included in other non-current assets)	(135		)	(161		)
Total deferred tax liabilities	(136		)	(163		)
Deferred tax assets, net	$	304		$	345

The net deferred tax asset valuation allowance increased by $38 million in 2015 and decreased by $5 million in 2014. The valuation allowance is based on the Company’s assessment that it is more likely than not that certain deferred tax assets will not be realized in the foreseeable future.

In addition to the deferred tax assets presented above, the Company had additional NOL benefits related to stock-based compensation deductions of $90 million and $11 million at July 3, 2015 and June 27, 2014, respectively. During 2015, the Company generated an additional $97 million of benefits related to stock-based compensation deductions, of which $19 million were utilized in 2015 and recorded to shareholders' equity.

Effective Tax Rate

Reconciliation of the U.S. Federal statutory rate to the Company’s effective tax rate is as follows for the three years ended July 3, 2015:



	2015		2014		2013
U.S. Federal statutory rate	35	%	35	%	35	%
Tax rate differential on international income	(29	)	(28	)	(19	)
Tax effect of U.S. permanent differences	1		2		—
State income tax, net of federal tax	—		—		8
Income tax credits	(2	)	(1	)	(4	)
Other	2		—		—
Effective tax rate	7	%	8	%	20	%

Tax Holidays and Carryforwards

A substantial portion of the Company’s manufacturing operations in Malaysia, the Philippines, Singapore and Thailand operate under various tax holidays and tax incentive programs which will expire in whole or in part at various dates from 2016 through 2025. Certain of the holidays may be extended if specific conditions are met. The net impact of these tax holidays and tax incentives was to increase the Company’s net earnings by $641 million ($2.70 per diluted share), $905 million ($3.74 per diluted share), and $899 million ($3.65 per diluted share) in 2015, 2014 and 2013, respectively.

As of July 3, 2015, the Company had federal and state NOL carryforwards of $515 million and $422 million, respectively. In addition, as of July 3, 2015, the Company had various federal and state tax credit carryforwards of $417 million combined. The NOL carryforwards available to offset future federal and state taxable income expire at various dates from 2021 to 2035 and 2020 to 2035, respectively. Approximately $100 million of the credit carryforwards available to offset future taxable income expire at various dates from 2017 to 2035. The remaining amount is available indefinitely. NOLs and credits relating to Komag, Incorporated (“Komag”), HGST, sTec, Virident and Amplidata are subject to limitations under Sections 382 and 383 of the Internal Revenue Code. The Company does not expect these limitations to result in a reduction in the total amount of Komag, sTec, Virident or Amplidata's NOLs and credits ultimately realized. The Company expects the total amount of HGST’s NOLs and credits ultimately realized will be reduced by $39 million and $25 million, respectively.

Uncertain Tax Positions

With the exception of certain unrecognized tax benefits that are directly associated with the tax position taken, unrecognized tax benefits are presented gross in the Company’s balance sheet. Interest and penalties related to unrecognized tax benefits are recognized in liabilities recorded for uncertain tax positions and are recorded in the provision for income taxes. As of July 3, 2015, such interest and penalties were not material. As of July 3, 2015, the Company had $350 million of unrecognized tax benefits.

The following is a tabular reconciliation of the total amounts of unrecognized tax benefits for the years ended July 3, 2015, June 27, 2014 and June 28, 2013 (in millions):



	2015			2014			2013
Unrecognized tax benefit at beginning of period	$	300		$	240		$	280
Gross increases related to current year tax positions	44			27			29
Gross increases related to prior year tax positions	6			26			10
Gross decreases related to prior year tax positions	—			(5		)	(8		)
Settlements	—			—			(64		)
Lapse of statute of limitations	(3		)	—			(7		)
Acquisitions	3			12			—
Unrecognized tax benefit at end of period	$	350		$	300		$	240

The Company’s unrecognized tax benefits are primarily included within long-term liabilities in the Company’s consolidated balance sheets. The entire balance of unrecognized tax benefits at July 3, 2015, June 27, 2014 and June 28, 2013, if recognized, would affect the effective tax rate, subject to certain future valuation allowance reversals.

The Company files U.S. Federal, U.S. state, and foreign tax returns. For both federal and state tax returns, with few exceptions, the Company is subject to examination for fiscal years 2008 through 2014. In foreign jurisdictions, with few exceptions, the Company is subject to examination for all years subsequent to fiscal 2008. The Company is no longer subject to examination by the IRS for periods prior to 2008, although carry forwards generated prior to those periods may still be adjusted upon examination by the IRS or state taxing authority if they either have been or will be used in a subsequent period.

The IRS previously completed its field examination of the Company's federal income tax returns for fiscal years 2006 and 2007, and the Company and the IRS reached agreement with respect to all matters except on the proposed adjustments to income before income taxes relating to intercompany payable balances. The proposed adjustments relating to intercompany payable balances for fiscal years 2006 and 2007 are addressed in conjunction with the IRS’s examination of the Company's fiscal years 2008 and 2009, which commenced in January 2012. The Company received a Notice of Proposed Adjustment ("NOPA") from the IRS for fiscal year 2009 relating to intercompany payable balances and two NOPAs from the IRS for fiscal years 2008 and 2009 relating to transfer pricing with the Company's foreign subsidiaries. The NOPAs relating to intercompany payable balances and transfer pricing with the Company's foreign subsidiaries propose to increase the Company's U.S. taxable income which would result in additional federal tax expense of approximately $72 million and $723 million, respectively, subject to interest. The Company disagrees with the proposed adjustments, believes that the tax positions are properly supported and will vigorously contest the position taken by the IRS. In January 2012, the IRS commenced an examination of the 2007 fiscal period ended September 5, 2007 of Komag, which the Company acquired on September 5, 2007. The IRS examined calendar years 2010 and 2011 of HGST, which was acquired by the Company on March 8, 2012, and completed the examination with no material adjustments.

The Company believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax examinations cannot be predicted with certainty. If any issues addressed in the Company’s tax examinations are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. As of July 3, 2015, it is not possible to estimate the amount of change, if any, in the unrecognized tax benefits that is reasonably possible within the next twelve months. Any significant change in the amount of the Company’s liability for unrecognized tax benefits would most likely result from additional information or settlements relating to the examination of the Company’s tax returns.