Income Taxes

The components of earnings before income taxes were:



Years ended December 31,	2012		2011		2010
U.S.		$5,647		$5,083		$4,310
Non-U.S.	263		310		197
Total		$5,910		$5,393		$4,507

Income tax expense/(benefit) consisted of the following:



Years ended December 31,	2012			2011			2010
Current tax expense
U.S. federal		$657			($605	)		$13
Non-U.S.	52			93			80
U.S. state	19			(22		)	(137		)
Total current	728			(534		)	(44		)
Deferred tax expense
U.S. federal	1,209			1,856			969
Non-U.S.	(13		)	(8		)	(13		)
U.S. state	83			68			284
Total deferred	1,279			1,916			1,240
Total income tax expense		$2,007			$1,382			$1,196

Net income tax payments were $410, $57, and $360 in 2012, 2011 and 2010, respectively.

Our effective income tax rates were 34.0%, 25.6% and 26.5% for the years ended December 31, 2012, 2011 and 2010, respectively. Our 2012 effective tax rate was higher than prior years, primarily due to tax benefits of $397 and $371 recorded in 2011 and 2010 as a result of federal income tax audit settlements. The absence of research and development tax credits also contributed to the higher tax rate in 2012. Our 2011 effective tax rate was lower than 2010, primarily due to an income tax charge of $150 recorded during the first quarter of 2010 as a result of the Patient Protection and Affordable Care Act, as modified by the Health Care and Education Reconciliation Act of 2010.

The research and development credit expired on December 31, 2011. On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012 that retroactively renews the research and development credit for 2012 and extends the credit through December 31, 2013. As tax law changes are recognized in the period in which new legislation is enacted, the 2012 R&D credit of approximately $150 will be reflected as a discrete item in our income tax rate for the first quarter of 2013.

The following is a reconciliation of the U.S. federal statutory tax rate of 35% to our effective income tax rate:



Years ended December 31,	2012		2011		2010
U.S. federal statutory tax	35.0	%	35.0	%	35.0	%
Research and development credits	0.8		(2.7	)	(3.5	)
Tax on international activities	(1.2	)	(0.6	)	(1.2	)
Tax deductible dividends	(0.7	)	(0.8	)	(0.9	)
State income tax provision, net of effect on U.S. federal tax	0.8		0.7		1.8
Medicare Part D law change					3.3
Federal audit settlement			(7.4	)	(8.2	)
Other provision adjustments	(0.7	)	1.4		0.2
Effective income tax rate	34.0	%	25.6	%	26.5	%

Federal income tax audits have been settled for all years prior to 2007. During the first quarter of 2012 we filed an appeal with the IRS for the 2007-2008 tax years. The 2009-2010 IRS audit began in the second quarter of 2012. We are also subject to examination in major state and international jurisdictions for the 2001-2012 tax years. We believe appropriate provisions for all outstanding tax issues have been made for all jurisdictions and all open years.

Significant components of our deferred tax assets, net of deferred tax liabilities, at December 31 were as follows:



	2012			2011
Retiree health care accruals		$2,867			$2,820
Inventory and long-term contract methods of income recognition, fixed assets and other (net of valuation allowance of $27 and $27)	(7,151		)	(5,189		)
Partnerships and joint ventures	(162		)	(228		)
Other employee benefits accruals	1,427			1,352
In-process research and development related to acquisitions	37			51
Net operating loss, credit and capital loss carryovers (net of valuation allowance of $94 and $74)	307			488
Pension asset	6,232			5,315
Customer and commercial financing	(1,078		)	(1,471		)
Unremitted earnings of non-U.S. subsidiaries	(49		)	(66		)
Other net unrealized losses	(17		)	69
Net deferred tax assets⁽¹⁾		$2,413			$3,141


⁽¹⁾	Of the deferred tax asset for net operating loss and credit carryovers, $201 expires in years ending from December 31, 2013 through December 31, 2032 and $106 may be carried over indefinitely.

Net deferred tax assets at December 31 were as follows:



	2012			2011
Deferred tax assets		$16,580			$16,181
Deferred tax liabilities	(14,046		)	(12,939		)
Valuation allowance	(121		)	(101		)
Net deferred tax assets		$2,413			$3,141

The measurement of deferred tax assets is reduced by a valuation allowance if, based upon available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Included in the net deferred tax assets at December 31, 2012 and 2011 are deferred tax assets in the amounts of $10,210 and $9,743 related to Accumulated other comprehensive loss.

We have provided for U.S. deferred income taxes and foreign withholding tax in the amount of $49 on undistributed earnings not considered permanently reinvested in our non-U.S. subsidiaries. We have not provided for U.S. deferred income taxes or foreign withholding tax on the remainder of undistributed earnings from our non-U.S. subsidiaries because such earnings are considered to be permanently reinvested and it is not practicable to estimate the amount of tax that may be payable upon distribution.

As of December 31, 2012 and 2011, the amounts accrued for the payment of income tax-related interest and penalties included in the Consolidated Statements of Financial Position were as follows: interest of $11 and $48 and penalties of $11 and $10. The amounts of interest benefit were $43, $94, and $105 for the years ended December 31, 2012, 2011 and 2010, respectively. The interest benefit recorded during 2012 was primarily related to the settlement of non-US audits. The interest benefits recorded during 2011 and 2010 were primarily related to the 2004-2006 and 1998-2003 federal audit settlements, respectively.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:



	2012			2011			2010
Unrecognized tax benefits – January 1		$939			$1,198			$1,787
Gross increases – tax positions in prior periods	55			154			95
Gross decreases – tax positions in prior periods	(20		)	(383		)	(465		)
Gross increases – current-period tax positions	83			28			76
Gross decreases – current-period tax positions	(1		)	(15		)	(40		)
Settlements	(1		)	(42		)	(254		)
Lapse of statute of limitations				(1		)	(1		)
Unrecognized tax benefits – December 31		$1,055			$939			$1,198

As of December 31, 2012, 2011 and 2010, the total amount of unrecognized tax benefits was $1,055, $939, and $1,198 of which $945, $838, and $1,074 would affect the effective tax rate, if recognized. As of December 31, 2011, these amounts are primarily associated with U.S. federal tax issues such as the amount of research and development tax credits claimed, the domestic production activities deductions claimed, and U.S. taxation of foreign earnings. Also included in these amounts are accruals for domestic state tax issues such as the allocation of income among various state tax jurisdictions and the amount of state tax credits claimed.