Note 17. Income taxes

On December 22, 2017, the United States (“U.S.”) enacted significant changes to the U.S. tax law following the passage and signing of the Tax Act. The Tax Act included significant changes to existing tax law, including a permanent reduction to the U.S. federal corporate income tax rate from 35% to 21%, a one-time repatriation tax on deferred foreign income (“Transition Tax”), deductions, credits and business-related exclusions.

Also on December 22, 2017, the SEC issued SAB 118. SAB 118 expresses views of the SEC regarding ASC 740 in the reporting period that includes the enactment date of the Tax Act. Subsequent to the issuance of SAB 118, in March 2018, the FASB issued ASU 2018-05, which formally amended ASC 740 for the guidance previously provided by SAB 118. The SEC staff issuing SAB 118 (the “Staff”) recognized that a registrant’s review of certain income tax effects of the Tax Act may be incomplete at the time financial statements are issued for the reporting period that includes the enactment date, including interim periods therein. The Staff’s view of the enactment of the Tax Act has been developed considering the principles of ASC 805 which addresses the accounting for certain items in a business combination for which the accounting is incomplete upon issuance of the financial statements that include the reporting period in which the business combination occurs. Specifically, the Staff provides that the accounting guidance in ASC Topic 805 may be analogized to the accounting for impacts of the Tax Act. If a company does not have the necessary information available, prepared or analyzed for certain income tax effects of the Tax Act, SAB 118 allows a company to report provisional numbers and adjust those amounts during the measurement period not to extend beyond one year. For the fiscal year ended September 30, 2018, Woodward has recorded all known and estimable impacts of the Tax Act that are effective for fiscal year 2018. Future adjustments to the provisional numbers will be recorded to income tax expense in the period in which those adjustments become estimable and/or are finalized. The Company will finalize its assessment of the income tax effects of the Tax Act in the first quarter of fiscal year 2019.

Accordingly, Woodward’s income tax for the fiscal year ended September 30, 2018 reflects a net current year provisional discrete income tax expense resulting from the enactment of the Tax Act as follows:



	Year Ended
	September 30, 2018
Transition Tax (provisional)	$	13,580
Net impact on U.S. deferred tax assets and liabilities (provisional)		(16,038)
Net changes in deferred tax liability associated with anticipated repatriation taxes (provisional)		8,121
Total provisional impact of the enactment of the Tax Act		5,663
Impact on the U.S. net deferred tax assets from IRS audit changes and tax return adjustments		5,197
Net impact of the enactment of the Tax Act	$	10,860

In the first quarter of fiscal year 2018, Woodward recorded a provisional tax impact in the amount of $14,778 related to the Tax Act. During the third quarter of fiscal year 2018, Woodward increased the tax impact from the Tax Act by an amount of $3,671 (an increase of 1.7% in the fiscal year 2018 effective tax rate) related to the tax rate change effect on an increased deferred tax asset resulting from a U.S. Internal Revenue Service (“IRS”) audit. During the fourth quarter of fiscal year 2018, Woodward made the following provisional tax impacts related to the Tax Act: (i) the Transition Tax was reduced by an amount of $12,420 (a decrease of 5.7% in the fiscal year 2018 effective tax rate) as a result of increased technical consensus in the interpretation of the Tax Act and comments by the IRS, (ii) the net benefit related to the change in tax rates on U.S. deferred tax assets and liabilities was decreased by an amount of $222 (an increase of 0.1% in the fiscal year 2018 effective tax rate) as a result of adjustments made to the first quarter estimate, (iii) Woodward recorded an amount of $3,083 (an increase of 1.4% in the fiscal year 2018 effective tax rate) of additional anticipated repatriation taxes related to the future repatriation of earning to the U.S., and (iv) Woodard recorded an additional amount of $1,526 (an increase of 0.7% in the fiscal year 2018 effective tax rate) related to adjustments to prior period items.

Consistent with provisions allowed under the Tax Act, the $13,580 estimated Transition Tax liability will be paid over an eight year period beginning in fiscal year 2019. As of September 30, 2018, the current portion of the estimated Transition Tax liability in the amount of $1,086 has been included in “Income taxes receivable, net,” and the noncurrent portion in the amount of $12,494 has been included in “Other liabilities” in the Consolidated Balance Sheets.

Income taxes consisted of the following:



		Year Ended September 30,
		2018		2017		2016
Current:
	Federal	$	39,979	$	17,872	$	81,127
	State		3,697		1,379		6,067
	Foreign		25,968		15,118		9,689
Deferred:
	Federal		(10,519)		16,907		(40,801)
	State		(3,784)		(2,561)		(9,054)
	Foreign		(16,141)		3,525		(1,380)
		$	39,200	$	52,240	$	45,648

Earnings before income taxes by geographical area consisted of the following:



	Year Ended September 30,
	2018		2017		2016
United States	$	181,671	$	192,220	$	175,146
Other countries		37,907		60,527		51,340
	$	219,578	$	252,747	$	226,486

Significant components of deferred income taxes presented in the Consolidated Balance Sheets are related to the following:



		At September 30,
		2018		2017
Deferred tax assets:
	Defined benefit plans, other postretirement	$	6,844	$	11,947
	Foreign net operating loss carryforwards		6,071		4,707
	Inventory		23,549		29,444
	Stock-based and other compensation		39,903		37,693
	Defined benefit plans, pension		2,187		1,148
	Deferred revenue		60,177		92,426
	Other reserves		10,154		10,850
	Tax credits and incentives		12,512		9,769
	Other		9,887		7,700
	Valuation allowance		(4,522)		(3,714)
	Total deferred tax assets, net of valuation allowance		166,762		201,970
Deferred tax liabilities:
	Goodwill and intangibles - net		(231,223)		(103,781)
	Property, plant and equipment		(85,459)		(109,229)
	Other		(4,425)		(2,418)
	Total deferred tax liabilities		(321,107)		(215,428)
Net deferred tax liabilities		$	(154,345)	$	(13,458)

Woodward has recorded a net operating loss (“NOL”) deferred tax asset of $6,071 as of September 30, 2018 and $4,707 as of September 30, 2017. A portion of these NOL carryforwards will start to expire in 2019 and is currently offset by a valuation allowance. Woodward has placed valuation allowances against all other NOL carryforwards that are less than 50 percent likely to be realized.

Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Both positive and negative evidence are considered in forming Woodward’s judgment as to whether a valuation allowance is appropriate, and more weight is given to evidence that can be objectively verified. Valuation allowances are reassessed whenever there are changes in circumstances that may cause a change in judgment. The change in the valuation allowance was primarily the result of new valuation allowances placed on two wholly owned subsidiaries with net operating losses and a reassessment of another valuation allowance based on a change in estimate of future earnings.

As a result of foreign earnings being taxed in the current fiscal year under the Transition Tax, Woodward has reassessed its indefinite investment assertions on certain of those previously taxed foreign earnings. At September 30, 2018, Woodward has not provided for taxes on undistributed foreign earnings of $199,845 that it considered indefinitely reinvested. These earnings could become subject to income taxes if they are remitted as dividends, are loaned to Woodward or any of Woodward’s subsidiaries located in the United States, or if Woodward sells its stock in the foreign subsidiaries. Any additional U.S. taxes could be offset, in part or in whole, by foreign tax credits. The amount of such taxes and application of tax credits would be dependent on the income tax laws and other circumstances at the time these amounts are repatriated. Based on these variables, it is impractical to determine the income tax liability that might be incurred if these funds were to be repatriated.

The permanent reduction to the U.S. federal corporate income tax rate from 35% to 21% was effective January 1, 2018 (the “Effective Date”). When a U.S. federal tax rate change occurs during a taxpayer’s fiscal year, taxpayers are required to compute a weighted daily average rate for the fiscal year of enactment. As a result of the Tax Act, Woodward has calculated a U.S. federal statutory corporate income tax rate of 24.5% for the fiscal year ending September 30, 2018 and applied this rate in computing the income tax provision for the fiscal year ended September 30, 2018. The U.S. federal statutory corporate income tax rate of 24.5% is the weighted daily average rate between the pre-enactment U.S. federal statutory tax rate of 35% applicable to Woodward’s 2018 fiscal year prior to the Effective Date and the post-enactment U.S. federal statutory tax rate of 21% applicable to the 2018 fiscal year after the Effective Date. Woodward expects the U.S. federal statutory rate to be 21% for fiscal years beginning after September 30, 2018.

The following is a reconciliation of the U.S. Federal statutory tax 24.5% in the fiscal year ended September 30, 2018 and 35% in both the fiscal year ended September 30, 2017 and 2016 to Woodward’s effective income tax rate:



	Year Ending September 30,
	2018		2017		2016
Percent of pretax earnings
Statutory tax rate	24.5	%	35.0	%	35.0	%
State income taxes, net of federal tax benefit	(0.5)		(0.3)		0.4
Taxes on international activities	(1.8)		(7.6)		(2.2)
Research credit	(4.8)		(3.2)		(3.6)
Net excess income tax benefit from stock-based compensation	(1.4)		(1.4)		(2.6)
Domestic production activities deduction	(1.6)		(1.5)		(2.1)
Adjustments of prior period tax items	(5.0)		(0.9)		(0.2)
Effect of U.S. federal corporate rate reduction on net beginning U.S. deferred tax liability	(5.0)		-		-
Transition Tax	6.2		-		-
Increased deferred tax liability associated with anticipated repatriation taxes	3.7		-		-
Effect of U.S. federal corporate rate reduction on net current year U.S. deferred tax activity	2.0		-		-
Retroactive extension of research credit	-		-		(3.2)
Other items, net	1.6		0.6		(1.3)
Effective tax rate	17.9	%	20.7	%	20.2	%

In determining the tax amounts in Woodward’s financial statements, estimates are sometimes used that are subsequently adjusted in the actual filing of tax returns or by updated calculations. In addition, Woodward occasionally has resolutions of tax items with tax authorities related to prior years due to the conclusion of audits and the lapse of applicable statutes of limitations. Such adjustments are included in the “Adjustments of prior period tax items” line in the above table. The majority of these adjustments are related to the conclusion of audits, effective settlement, and lapse of applicable statutes of limitations in various tax jurisdictions. During fiscal year 2018, Woodward adjusted gross tax reserves by $6,677 related to prior year tax positions as a result of concluding IRS and other foreign audits.

The decrease in the effective tax rate for fiscal year 2018 compared to the fiscal year 2017 is primarily attributable to the current year impact of the U.S. federal corporate tax rate reduction in connection with the enactment of the Tax Act, which was partially offset by a net unfavorable impact of $10,860 from the Tax Act in fiscal year 2018. Also contributing to the decrease in the effective tax rate was the fiscal year 2018 research and experimentation credit, which was higher than the fiscal year 2017, as well as larger favorable resolutions of tax matters in the fiscal year 2018 compared to fiscal year 2017. The overall decrease in the effective tax rate was partially offset by the fiscal year 2017 benefit from the repatriation to the U.S. of certain net foreign profits and losses, which did not repeat in fiscal year 2018.

On December 18, 2015, the Protecting Americans from Tax Hikes (“PATH”) Act of 2015 was enacted, which permanently extended the Research and Experimentation (“R&E”) Tax Credit. As a result, income taxes for the year ended September 30, 2016 included a net benefit related to the retroactive impact from the last three quarters of fiscal year 2015 of the R&E Credit pursuant to the PATH Act. In addition, income taxes for the year ended September 30, 2016 included a net benefit related to the full year impact of fiscal year 2016 of the R&E Credit.

Woodward adopted ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting,” in its second quarter of fiscal year 2016 resulting in the recognition through earnings of a net excess income tax benefit from stock-based compensation.

Woodward continues to review the anticipated impacts of the global intangible low taxed income (“GILTI”) and base erosion anti-abuse tax (“BEAT”) on Woodward, which are not effective until fiscal year 2019. Woodward has not recorded any impact associated with either GILTI or BEAT in the fiscal year 2018 tax rate.

A reconciliation of the beginning and ending amounts of gross unrecognized tax benefits follows:



	Year Ending September 30,
	2018		2017		2016
Beginning balance	$	20,132	$	23,526	$	21,469
Additions to current year tax positions		2,675		2,560		3,588
Reductions to prior year tax positions		(14,458)		(5,753)		(2,292)
Additions to prior year tax positions		15		3,501		761
Lapse of applicable statute of limitations		-		(3,702)		-
Ending balance	$	8,364	$	20,132	$	23,526

Included in the balance of unrecognized tax benefits were $3,288 as of September 30, 2018 and $9,677 as of September 30, 2017 of tax benefits that, if recognized, would affect the effective tax rate. At this time, Woodward does not estimate it is reasonably possible that the liability for unrecognized tax benefits will decrease in the next twelve months. 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 $279 as of September 30, 2018 and $1,273 as of September 30, 2017.

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. Woodward’s fiscal years remaining open to examination for U.S. Federal income taxes include fiscal years 2017 and thereafter. In fiscal year 2018, Woodward concluded its U.S. federal income tax examinations through fiscal year 2016. Woodward’s fiscal years remaining open to examination for significant U.S. state income tax jurisdictions include fiscal years 2014 and thereafter. Fiscal years remaining open to examination in significant foreign jurisdictions include 2008 and thereafter.