INCOME TAXES

The provision for (benefit from) income taxes on income (loss) from continuing operations before income taxes consists of the following (in thousands):



	Fiscal
	2018			2017			2016
Currently payable:
Federal	$	1,163		$	5,617		$	(3,069	)
State	114			1,022			89
Foreign	107,487			116,022			48,039
	108,764			122,661			45,059
Deferred and other:
Federal	26,334			1,413			(8,131		)
State	(489		)	(153		)	(439		)
Foreign	(20,414		)	(30,510		)	(1,095		)
	5,431			(29,250		)	(9,665		)
Provision for income taxes	$	114,195		$	93,411		$	35,394

The components of income (loss) from continuing operations before income taxes consist of (in thousands):



	Fiscal
	2018		2017		2016
United States	$	65,272	$	25,540	$	(44,029	)
Foreign	296,283		276,515		166,925
Income from continuing operations before income taxes	$	361,555	$	302,055	$	122,896

The reconciliation of the income tax expense at the U.S. Federal statutory rate (24.5% in fiscal 2018 and 35.0% in each of fiscal 2017 and fiscal 2016) to actual income tax expense is as follows (in thousands):



	Fiscal
	2018			2017			2016
Federal statutory tax expense	$	88,684		$	105,719		$	43,015
Valuation allowance	4,263			4,454			1,441
Foreign taxes at rates greater (less) than U.S. rates, net	8,417			(12,346		)	(5,642		)
Stock-based compensation	(8,536		)	3,969			2,161
State income taxes, net of federal income tax benefit	(373		)	398			(198		)
Research and development credit	(6,972		)	(7,884		)	(4,408		)
Deferred compensation	(560		)	(1,022		)	(428		)
Release of foreign unrecognized tax benefits	(352		)	(538		)	(4,961		)
Release of interest accrued for unrecognized tax benefits	(156		)	(78		)	(1,508		)
Reversal of Competent Authority	—			—			4,328
U.S. tax reform impact	26,653			—			—
Other	3,127			739			1,594
Provision for income taxes	$	114,195		$	93,411		$	35,394
Effective tax rate	31.6		%	30.9		%	28.8		%

On December 22, 2017, the Tax Act was enacted. The Tax Act contains significant changes to U.S. tax law, including lowering the U.S. corporate income tax rate to 21.0% and implementing a territorial tax system. Since we have a September year-end, the lower U.S. corporate income tax rate is phased in. Our U.S. federal blended tax rate is approximately 24.5% for fiscal 2018 and 21.0% for subsequent fiscal years.

The reduction of the U.S. corporate income tax rate adjusts our U.S. deferred tax assets and liabilities to the lower U.S. federal tax rate of 21.0%. There are also certain transitional impacts of the Tax Act. As part of the transition to the new territorial tax system, the Tax Act imposes a one-time deemed repatriation tax on our foreign subsidiaries’ historical earnings. These transitional impacts resulted in a provisional net charge of $26.7 million for fiscal 2018. This is comprised of an estimated deemed repatriation tax charge of $17.8 million less a previously recorded deferred tax liability of $20.3 million for anticipated repatriation of our investment in a foreign subsidiary, plus an estimated deferred tax remeasurement charge of $15.5 million and an accrual for withholding taxes and state income taxes of $13.7 million on certain foreign earnings not considered permanently reinvested.

The Tax Act changes are broad and complex. The final calculation of the Tax Act impact may materially differ from the above provisional estimates. Among other things, this may be due to changes in interpretations of the Tax Act, any legislative action to address questions that arise because of the Tax Act, any changes in accounting standards for income taxes or related interpretations in response to the Tax Act, or any updates or changes to estimates we have utilized to calculate the transitional impacts. The Securities Exchange Commission has issued guidance under Staff Accounting Bulletin No. 118 directing taxpayers to record impacts of the Tax Act as “provisional” when it does not have the necessary information available, prepared or analyzed (including computations) in reasonable detail to complete the accounting under ASC 740. The guidance allows for a measurement period of up to one year after the enactment date of the Tax Act to finalize the recording of the related tax impacts. Most of that activity has provisionally been recorded in our Consolidated Financial Statements in the period ended September 29, 2018, as Treasury has not issued final regulations with respect to the new law. The final regulation may change the provisional estimates. We recorded what we believe to be a reasonable estimate.

The Tax Act also includes provisions for Global Intangible Low-Taxed Income (“GILTI”) wherein taxes on foreign income are imposed in excess of a deemed return on tangible assets of foreign corporations. In general, this income will effectively be taxed at a 10.5% tax rate reduced by any available current year foreign tax credits. This provision is effective for taxable years beginning after December 31, 2017, which is our fiscal 2019. Because of the complexity of the new GILTI tax rules, we continue to evaluate this provision of the Tax Act including the associated forecast of GILTI and the application of ASC 740, Income Taxes. Under U.S. GAAP, we are allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into our measurement of our deferred taxes (the “deferred method”). Our selection of an accounting policy with respect to the new GILTI tax rules will depend, in part, on analyzing our global income to determine whether we expect to have future U.S. inclusions in taxable income related to GILTI and, if so, what the impact is expected to be. Whether we expect to have future U.S. inclusions in taxable income related to GILTI depends on not only our current structure and estimated future results of global operations, but also our intent and ability to modify our structure. We are currently in the process of analyzing our structure and, as a result, are not yet able to reasonably estimate the effect of this provision of the Tax Act. Therefore, we have not made any adjustments related to potential GILTI tax in our financial statements and have not made a policy decision regarding whether to record deferred tax on GILTI. We will make the accounting policy election after completion of the GILTI analysis in the first quarter of fiscal 2019.

The effective tax rate on income from continuing operations before income taxes for fiscal 2018 of 31.6% was higher than the effective U.S. federal blended rate of 24.5%. This was primarily due to the Tax Act's one-time mandatory deemed repatriation transition tax, the impact of income subject to foreign tax rates that are higher than the U.S. tax rates, the remeasurement of deferred tax assets and liabilities based on the newly enacted U.S. federal tax rate of 21.0%, an accrual for foreign withholding taxes and state income taxes on certain foreign earnings not considered permanently reinvested, stock-based compensation not deductible for tax purposes and limitations on the deductibility of compensation under Internal Revenue Code ("IRC") Section 162(m). These amounts are partially offset by the excess tax benefits from stock award exercises and restricted stock unit vesting, the benefit of foreign tax credits, the benefit of federal research and development tax credits, the benefit of a domestic manufacturing deduction under IRC Section 199 and the Singapore tax exemption.

In October 2016, Coherent Singapore received an amended Pioneer Status tax exemption from the Singapore authorities effective from fiscal 2012 through fiscal 2021. The tax holiday continues to be conditional upon our meeting certain revenue, business spending and employment thresholds. The impact of this tax exemption decreased Singapore income taxes by approximately $2.5 million, $1.1 million and $0.7 million in fiscal 2018, fiscal 2017 and fiscal 2016, respectively.

The significant components of deferred tax assets and liabilities were (in thousands):



	Fiscal year-end
	2018			2017
Deferred tax assets:
Reserves and accruals not currently deductible	$	36,467		$	52,803
Operating loss carryforwards and tax credits	67,068			61,371
Deferred service revenue	2,682			2,987
Inventory capitalization	2,450			7,116
Stock-based compensation	5,267			7,839
Competent authority offset to transfer pricing tax reserves	10,585			12,948
Accumulated translation adjustment	432			—
Other	351			4,567
Total gross deferred tax assets	125,302			149,631
Valuation allowance	(33,731		)	(28,745		)
Total net deferred tax assets	91,571			120,886
Deferred tax liabilities:
Gain on issuance of stock by subsidiary	—			22,378
Depreciation and amortization	39,358			60,956
U.S. tax reform impacts	13,694			—
Accumulated translation adjustment	—			234
Total gross deferred tax liabilities	53,052			83,568
Net deferred tax assets	$	38,519		$	37,318

In determining our fiscal 2018 and 2017 tax provisions under ASC Subtopic 740, we calculated the deferred tax assets and liabilities for each separate tax entity. We then considered a number of factors including the positive and negative evidence regarding the realization of our deferred tax assets to determine whether a valuation allowance should be recognized with respect to our deferred tax assets. We determined that a valuation allowance was appropriate for a portion of the deferred tax assets of our California and certain state research and development tax credits, foreign tax attributes and foreign net operating losses at fiscal 2018 and 2017 year-ends.

During fiscal 2018, we increased our valuation allowance on deferred tax assets by $5.0 million to $33.7 million, primarily due to the increase in California research and development tax credits and net operating losses generated from Rofin China, which are not expected to be recognized. The Company had U.S. federal deferred tax assets related to research and development credits, foreign tax credits and other tax attributes that can be used to offset federal taxable income in future periods. These credit carryforwards will expire if they are not used within certain time periods. As of September 29, 2018, management determined that there is sufficient positive evidence to conclude that it is more likely than not that sufficient taxable income will exist in the future allowing us to recognize these deferred tax assets.

The net deferred tax asset is classified on the consolidated balance sheets as follows (in thousands):



	Fiscal year-end
	2018			2017
Non-current deferred income tax assets	$	64,858		$	82,691
Non-current deferred income tax liabilities	(26,339		)	(45,373		)
Net deferred tax assets	$	38,519		$	37,318

We have various tax attribute carryforwards which include the following:

•

Foreign federal and local gross net operating loss carryforwards are $48.7 million, of which $37.4 million have no expiration date and $11.3 million have various expiration dates beginning in fiscal 2019. Among the total of $48.7 million foreign net operating loss carryforwards, a valuation allowance of $9.9 million has been provided for certain jurisdictions since the recovery of the carryforwards are uncertain. U.S. federal and certain state gross net operating loss carryforwards are $8.3 million and $30.8 million, respectively, which were acquired from our Rofin acquisition. A full valuation allowance against certain other state net operating losses of $30.8 million has been recorded. California gross net operating loss carryforwards are $7.4 million and are scheduled to expire beginning in fiscal 2032.

•

U.S. federal R&D credit carryforwards of $33.5 million are scheduled to expire beginning in fiscal 2025. California R&D credit carryforwards of $30.3 million have no expiration date. A total of $25.4 million valuation allowance, before U.S. federal benefit, has been recorded against California R&D credit carryforwards of $30.3 million since the recovery of the carryforwards is uncertain. Other states R&D credit carryforwards of $3.4 million are scheduled to expire beginning in fiscal 2019. A valuation allowance totaling $2.8 million, before U.S. federal benefit, has been recorded against certain state R&D credit carryforwards of $3.4 million since the recovery of the carryforwards is uncertain.


•	U.S. federal foreign tax credit carryforwards of $13.0 million are scheduled to expire beginning in fiscal 2019.

We adopted ASU No. 2016-09 in the first quarter of fiscal 2018. As a result of adopting the new standard, excess tax benefits from equity-based compensation are now reflected in the consolidated statements of operations as a component of the provision for income taxes. The adoption of ASU No. 2016-09 resulted in a decrease in our provision for income taxes of $12.8 million for fiscal 2018 due to the recognition of excess tax benefits for options exercised and the vesting of equity awards.

We are subject to taxation and file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions. Our most significant tax jurisdictions are the U.S. and Germany. For U.S. federal and German income tax purposes, all years prior to fiscal 2015 and 2010, respectively, are closed to examination. In our other major foreign jurisdictions and our major state jurisdictions, the years prior to fiscal 2012 and 2014, respectively, are closed. Earlier years in our various jurisdictions may remain open for adjustment to the extent that we have tax attribute carryforwards from those years.

In the U.S., a legacy Rofin entity is under audit for fiscal 2016. In Germany, various Coherent and legacy Rofin entities are under audit for the years 2010 through 2016. The timing and the resolution of income tax examinations is highly uncertain, and the amounts ultimately paid, if any, upon resolution of the issues raised by the taxing authorities may differ materially from the amounts accrued for each year. Management believes that it has adequately provided for any adjustments that may result from tax examinations. We regularly engage in discussions and negotiations with tax authorities regarding tax matters in various jurisdictions. Although the timing of resolution, settlement and closure of audits is not certain, we do not believe it is reasonably possible that our unrecognized tax benefits will materially change in the next 12 months.

A reconciliation of the change in gross unrecognized tax benefits, excluding interest and penalties, is as follows (in thousands):



	Fiscal year-end
	2018			2017			2016
Balance as of the beginning of the year	$	47,566		$	20,442		$	22,538
Increase related to acquisitions	—			25,151			—
Tax positions related to current year:
Additions	19,033			1,326			2,468
Reductions	—			—			—
Tax positions related to prior year:
Additions	117			4,951			424
Reductions	—			(65		)	(3,239		)
Settlements	—			—			(1,655		)
Lapses in statutes of limitations	(700		)	(610		)	(94		)
Decrease in unrecognized tax benefits based on audit results	—			(5,217		)	—
Foreign currency revaluation adjustment	(134		)	1,588			—
Balance as of end of year	$	65,882		$	47,566		$	20,442

As of September 29, 2018, the total amount of gross unrecognized tax benefits including gross interest and penalties was $70.3 million, of which $50.4 million, if recognized, would affect our effective tax rate. Our total gross unrecognized tax benefit was classified as a long-term taxes payable in the consolidated balance sheets after reduction by certain deferred tax assets. We include interest and penalties related to unrecognized tax benefits within the provision for income taxes. As of September 29, 2018, the total amount of gross interest and penalties accrued was $4.4 million and it is classified as long-term taxes payable in the consolidated balance sheets. As of September 30, 2017, we had accrued $2.8 million for the gross interest and penalties and it is classified as long-term taxes payable in the consolidated balance sheets.

A summary of the fiscal tax years that remain subject to examination, as of September 29, 2018, for our major tax jurisdictions is:



United States—Federal	2015—forward
United States—Various States	2014—forward
Netherlands	2012—forward
Germany	2010—forward
Japan	2013—forward
South Korea	2013—forward
United Kingdom	2016—forward