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, and 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 earnings before income taxes:



	Three-Months Ended				Nine-Months Ended
	June 30,				June 30,
	2016		2015		2016		2015
Earnings before income taxes	$	63,408	$	57,559	$	145,730	$	172,222
Income tax expense		12,361		13,806		28,039		40,830
Effective tax rate		19.5%		24.0%		19.2%		23.7%

The decrease in the year-over-year effective tax rate for the three and nine-months ended June 30, 2016 is primarily attributable to the recognition through earnings of a net excess income tax benefit from stock compensation due to the adoption of ASU 2016-09 and the permanent extension of the U.S. research and experimentation credit (“R&E Credit”), both occurring in fiscal year 2016. These impacts were partially offset by a smaller favorable release of a foreign valuation allowance in the current fiscal year as compared to the prior fiscal year and a favorable increase in the net value of deferred tax assets recorded in the third quarter of fiscal year 2015 that did not repeat in the third quarter of fiscal year 2016. The retroactive portion of the R&E Credit related to the year ended September 30, 2015 was $6,500, including an adjustment of $1,303 recorded in the third quarter of fiscal year 2016.

Gross unrecognized tax benefits were $21,804 as of June 30, 2016, and $21,469 as of September 30, 2015. Included in the balance of unrecognized tax benefits were $10,988 as of June 30, 2016 and $10,494 as of September 30, 2015, 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 $6,702 in the next twelve months due to the completion of reviews by tax authorities and the settlement of tax positions. Woodward accrues for potential interest and penalties related to unrecognized tax benefits and all other interest and penalties related to tax payments in tax expense. Woodward had accrued gross interest and penalties of $1,017 as of June 30, 2016 and $859 as of September 30, 2015.

Woodward’s tax returns are subject to audits by U.S. federal, 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. Fiscal years remaining open to examination in significant foreign jurisdictions include 2008 and forward. Woodward has concluded U.S. federal income tax examinations through fiscal year 2012. Woodward is generally subject to U.S. state income tax examinations for fiscal years 2012 and forward.