Note 17. Income taxes

U.S. GAAP requires that the interim period tax provision be determined as follows:

At the end of each quarter, Woodward estimates the tax that will be provided for the current fiscal year stated as a percentage of estimated “ordinary income.” The term ordinary income refers to earnings from continuing operations before income taxes, excluding significant unusual or infrequently occurring items.

The estimated annual effective rate is applied to the year-to-date ordinary income at the end of each quarter to compute the estimated year-to-date tax applicable to ordinary income. The tax expense or benefit related to ordinary income in each quarter is the difference between the most recent year-to-date and the prior quarter year-to-date computations.

The tax effects of significant unusual or infrequently occurring items are recognized as discrete items in the interim period in which the events occur. The impact of changes in tax laws or rates on deferred tax amounts, the effects of changes in judgment about beginning of the year valuation allowances, and changes in tax reserves resulting from the finalization of tax audits or reviews are examples of significant unusual or infrequently occurring items that are recognized as discrete items in the interim period in which the event occurs.

The determination of the annual effective tax rate is based upon a number of significant estimates and judgments, including the estimated annual pretax income of Woodward in each tax jurisdiction in which it operates, and the development of tax planning strategies during the year. In addition, as a global commercial enterprise, Woodward’s tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits and reviews, changes in the estimate of the amount of undistributed foreign earnings that Woodward considers indefinitely reinvested, as well as other factors that cannot be predicted with certainty. As such, there can be significant volatility in interim tax provisions.

The following table sets forth the tax expense and the effective tax rate for Woodward’s income from operations:



	Three-Months Ended				Nine-Months Ended
	June 30,				June 30,
	2014		2013		2014		2013
Earnings before income taxes	$	62,468	$	35,497	$	152,168	$	124,370
Income tax expense		16,467		11,834		37,986		30,893
Effective tax rate		26.4%		33.3%		25.0%		24.8%

The decrease in the year-over-year effective tax rate for the three-months ended June 30, 2014 is attributable to higher earnings in jurisdictions with lower tax rates, reduced taxes on current and anticipated future distributions of foreign earnings to the U.S, and the favorable impact of reviews by tax authorities. This overall year-over-year decrease was partially offset by the lack of a U.S. research and experimentation credit in the three months ended June 30, 2014, as discussed below.

On January 2, 2013, the American Taxpayer Relief Act of 2012 (the “Taxpayer Relief Act”) was enacted, which retroactively extended the U.S. research and experimentation tax credit through December 31, 2013. As a result, income taxes for the nine-months ended June 30, 2013 included a net expense reduction of $6,558 related to the retroactive impact of the U.S. research and experimentation tax credit pursuant to the Taxpayer Relief Act. The slight increase in effective tax rate for the nine-months ended June 30, 2014 is due to the lack of the retroactive benefit of the research and experimentation credit, offset by larger net favorable resolutions and reviews of tax matters and lapses of applicable statutes of limitations, higher earnings in jurisdictions with lower tax rates, and reduced taxes on current and anticipated future distributions of foreign earnings to the U.S in the current year.

Gross unrecognized tax benefits as of June 30, 2014 and September 30, 2013 were $14,582 and $22,694, respectively. Included in the balance of unrecognized tax benefits as of June 30, 2014 and September 30, 2013 are $11,628 and $17,838, respectively, of tax benefits that, if recognized, would affect the effective tax rate. At this time, Woodward estimates that it is reasonably possible that the liability for unrecognized tax benefits will decrease by as much as $113 in the next twelve months due to the completion of reviews by tax authorities and the expiration of certain statutes of limitations. Woodward accrues for potential interest and penalties related to unrecognized tax benefits in tax expense. Woodward had accrued interest and penalties of $1,473 as of June 30, 2014 and $2,066 as of September 30, 2013.

Woodward’s tax returns are audited by U.S., state, and foreign tax authorities, and these audits are at various stages of completion at any given time. Reviews of tax matters by authorities and lapses of the applicable statutes of limitations may result in changes to tax expense. During the three-month period ended June 30, 2014, such reviews of tax matters resulted in a net favorable amount of $1,986. With a few exceptions, Woodward’s fiscal years remaining open to examination in the United States include fiscal years 2011 and thereafter, and fiscal years remaining open to examination in significant foreign jurisdictions include 2005 and thereafter.