INCOME TAXES

Income before income taxes and income tax expense are summarized below based on the geographic location of the operation to which such earnings and income taxes are attributable. Certain foreign operations are branches of Eaton and are subject to United States as well as foreign income tax regulations. As a result, income before tax by location and the components of income tax expense by taxing jurisdiction are not directly related. For purposes of this note, non-United States operations include Puerto Rico.



	Income (loss) before income taxes
	2011		2010		2009
United States	$	375	$	114	$	(298	)
Non-United States	1,178		922		601
Total income before income taxes	$	1,553	$	1,036	$	303



	Income tax expense (benefit)
	2011			2010			2009
Current
United States
Federal	$	85		$	(2	)	$	40
State and local	2			1			5
Non-United States	186			107			69
Total current income tax expense	273			106			114

Deferred
United States
Federal	(2		)	95			(174		)
State and local	8			(15		)	(4		)
Non-United States	(78		)	(87		)	(18		)
Total deferred income tax benefit	(72		)	(7		)	(196		)
Total income tax expense (benefit)	$	201		$	99		$	(82	)

Reconciliations of income taxes from the United States federal statutory rate of 35% to the consolidated effective income tax rate follow:



	2011		2010		2009
Income taxes at the United States federal statutory rate	35.0	%	35.0	%	35.0	%

United States operations
State and local income taxes	0.2	%	(0.1	)%	0.4	%
Deductible dividends	(0.5	)%	(0.6	)%	(2.1	)%
Deductible interest	(0.5	)%	(0.8	)%	(2.3	)%
Credit for research activities	(1.0	)%	(1.4	)%	(3.9	)%
Impact of Health Care Reform and Education Reconciliation Act and pre-funding on taxation associated with Medicare Part D	(0.9	)%	2.2	%	0.0	%
Other-net	0.5	%	1.4	%	5.0	%

Non-United States operations
Foreign tax credit	(2.3	)%	(6.4	)%	(2.5	)%
Non-United States operations (earnings taxed at other than the United States tax rate)	(15.5	)%	(13.9	)%	(52.6	)%

Worldwide operations
Adjustments to tax liabilities	(0.8	)%	(1.2	)%	(11.9	)%
Adjustments to valuation allowances	(1.3	)%	(4.7	)%	7.7	%
Effective income tax expense (benefit) rate	12.9	%	9.5	%	(27.2	)%

During 2011, income tax expense of $201 was recognized (an effective tax rate of 12.9%) compared to $99 for 2010 (an effective tax rate of 9.5%). The higher effective tax rate in 2011 was primarily attributable to greater levels of income in high tax jurisdictions, particularly in the United States and Brazil, due to continued improvement in market conditions. Earnings taxed at other than the United States tax rate includes the impact of tax holidays in certain jurisdictions.

With limited exceptions, no provision has been made for income taxes on undistributed earnings of non-United States subsidiaries of $6.4 billion at December 31, 2011, since it is the Company's intention to indefinitely reinvest undistributed earnings of its foreign subsidiaries. It is not practicable to estimate the additional income taxes and applicable foreign withholding taxes that would be payable on the remittance of such undistributed earnings.

The Company's largest growth areas that require capital are in developing foreign markets, such as India, Brazil, the Middle East, Africa, Southeast Asia and China. The cash that is permanently reinvested is typically used to expand operations either organically or through acquisitions in such developing markets as well as other mature foreign markets where the Company targets increased market share. The Company's United States operations normally generate cash flow sufficient to satisfy United States operating requirements. Dividends paid during 2011 from foreign affiliates to the United States parent were not significant.

Worldwide income tax payments follow:



2011	$	191
2010	141
2009	124

Deferred Income Tax Assets and Liabilities

Components of current and long-term deferred income taxes follow:



	2011						2010
	Current assets			Long-term assets and liabilities			Current assets			Long-term assets and liabilities
Accruals and other adjustments
Employee benefits	$	114		$	778		$	94		$	681
Depreciation and amortization	(2		)	(498		)	(1		)	(567		)
Other accruals and adjustments	293			77			224			90
Other items	—			(4		)	—			(6		)
United States federal income tax loss carryforwards	—			7			—			5
United States federal income tax credit carryforwards	—			251			—			253
United States state and local tax loss carryforwards and tax credit carryforwards	—			65			—			74
Non-United States tax loss carryforwards	—			417			—			360
Non-United States income tax credit carryforwards	—			95			—			72
Valuation allowance for income tax loss and income tax credit carryforwards	—			(441		)	—			(421		)
Other valuation allowances	(7		)	(55		)	(14		)	(27		)
Total deferred income taxes	$	398		$	692		$	303		$	514

At the end of 2011, United States federal income tax loss carryforwards and income tax credit carryforwards were available to reduce future federal income tax liabilities. These carryforwards and their expiration dates are summarized below:



	2012 through 2016		2017 through 2021		2022 through 2026		2027 through 2031		Not subject to expiration		Valuation allowance
United States federal income tax loss carryforwards	$	3	$	—	$	14	$	3	$	—	$	—
United States federal deferred income tax assets for income tax loss carryforwards	1		—		5		1		—		(6		)
United States federal income tax credit carryforwards	—		93		20		86		52		(17		)

United States state and local tax loss carryforwards and tax credit carryforwards with a future tax benefit are also available at the end of 2011. These carryforwards and their expiration dates are summarized below:



	2012 through 2016		2017 through 2021		2022 through 2026		2027 through 2031		Not subject to expiration		Valuation allowance
United States state and local income tax loss carryforwards - net of federal tax effect	$	6	$	4	$	11	$	8	$	—	$	(8	)
United States state and local income tax credit carryforwards - net of federal tax effect	11		9		5		5		6		(15		)

At December 31, 2011, certain non-United States subsidiaries had tax loss carryforwards and income tax credit carryforwards that are available to offset future taxable income. These carryforwards and their expiration dates are summarized below:



	2012 through 2016		2017 through 2021		2022 through 2026		2027 through 2031		Not subject to expiration		Valuation allowance
Non-United States income tax loss carryforwards	$	188	$	140	$	10	$	48	$	1,143	$	—
Non-United States deferred income tax assets for income tax loss carryforwards	49		36		3		13		316		(367		)
Non-United States income tax credit carryforwards	46		33		—		9		7		(8		)

Recoverability of Deferred Income Tax Assets

Eaton is subject to the income tax laws in the jurisdictions in which it operates. In order to determine its income tax provision for financial statement purposes, Eaton must make significant estimates and judgments about its business operations in these jurisdictions. These estimates and judgments are also used in determining the deferred income tax assets and liabilities that have been recognized for differences between the financial statement and income tax basis of assets and liabilities, and income tax loss carryforwards and income tax credit carryforwards.

Management evaluates the realizability of deferred income tax assets for each of the jurisdictions in which it operates. If the Company experiences cumulative pretax income in a particular jurisdiction in the three-year period including the current and prior two years, management normally concludes that the deferred income tax assets will more likely than not be realizable and no valuation allowance is recognized, unless known or planned operating developments would lead management to conclude otherwise. However, if the Company experiences cumulative pretax losses in a particular jurisdiction in the three-year period including the current and prior two years, management then considers a series of factors in the determination of whether the deferred income tax assets can be realized. These factors include historical operating results, known or planned operating developments, the period of time over which certain temporary differences will reverse, consideration of the utilization of certain deferred income tax liabilities, tax law carryback capability in the particular country, prudent and feasible tax planning strategies, and estimates of future earnings and taxable income using the same assumptions as the Company's goodwill and other impairment testing. After evaluation of these factors, if the deferred income tax assets are expected to be realized within the tax carryforward period allowed for that specific country, management would conclude that no valuation allowance would be required. To the extent that the deferred income tax assets exceed the amount that is expected to be realized within the tax carryforward period for a particular jurisdiction, management would establish a valuation allowance.

As of December 31, 2011, United States federal deferred income tax assets were $1.6 billion. The largest component of the deferred income tax assets is due to timing differences between revenue and expense recognition for income tax versus financial statement purposes. In addition, the Company possesses certain income tax credit carryforwards that comprise the remainder of the balance. Over the 20 year carryforward period available for net operating losses and general business credits, taxable income of approximately $4.6 billion would need to be realized to utilize all deferred income tax assets. As of December 31, 2011, management believes that, with a couple of very limited exceptions totaling $23, it is more likely than not that the entire United States federal deferred income tax assets will be realized.

Applying the above methodology, valuation allowances have been established for certain United States federal, state and local income, as well as certain non-United States, deferred income tax assets to the extent they are not expected to be realized within the particular tax carryforward period.

Unrecognized Income Tax Benefits

Eaton's historical policy has been to enter into tax planning strategies only if it is more likely than not that the benefit would be sustained upon audit. For example, the Company does not enter into any of the Internal Revenue Service (IRS) Listed Transactions as set forth in Treasury Regulation 1.6011-4.

A summary of gross unrecognized income tax benefits follows:



	2011			2010			2009
Balance at January 1	$	224		$	197		$	139
Increases and decreases as a result of positions taken during prior years
Transfers to valuation allowances	—			(2		)	(1		)
Other increases	3			7			37
Other decreases, including foreign currency translation	(14		)	(31		)	(4		)
Balances related to acquired businesses	2			34			5
Increases as a result of positions taken during the current year	31			23			28
Decreases relating to settlements with tax authorities	(2		)	—			(4		)
Decreases as a result of a lapse of the applicable statute of limitations	(8		)	(4		)	(3		)
Balance at December 31	$	236		$	224		$	197

If all unrecognized tax benefits were recognized, the net impact on the provision for income tax expense would be $184.

As of December 31, 2011 and 2010, Eaton had accrued approximately $29 and $36, respectively, for the payment of worldwide interest and penalties. Eaton recognizes interest and penalties related to unrecognized income tax benefits in the provision for income tax expense. The Company has accrued penalties in jurisdictions where they are automatically applied to any deficiency, regardless of the merit of the position.

The resolution of the majority of Eaton's unrecognized income tax benefits is dependent upon uncontrollable factors such as law changes; the prospect of retroactive regulations; new case law; the willingness of the income tax authority to settle the issue, including the timing thereof; and other factors. Therefore, for the majority of unrecognized income tax benefits, it is not reasonably possible to estimate the increase or decrease in the next 12 months. For each of the unrecognized income tax benefits where it is possible to estimate the increase or decrease in the balance within the next 12 months, the Company does not anticipate any significant change.

Eaton or its subsidiaries file income tax returns in the United States and foreign jurisdictions. The IRS has completed their examination of the Company's United States income tax returns for 2005 and 2006 and has issued a Statutory Notice of Deficiency (Notice) as discussed below. The statute of limitations on these tax years remains open to the extent of the tax assessment until the matter is resolved. Although the formal examination has not begun, the Company recently agreed to extend the statute of limitations for the IRS to examine its United States income tax returns for 2007, 2008 and 2009 until December 31, 2013. Eaton is also under examination for the income tax filings in various state and foreign jurisdictions. With only a few exceptions, the Company is no longer subject to state and local income tax examinations for years before 2008, or foreign examinations for years before 2006.

At the end of the fourth quarter of 2011, the IRS issued a Notice for Eaton's 2005 and 2006 tax years. The Notice proposes assessments of $75 in additional taxes plus $52 in penalties related primarily to transfer pricing adjustments for products manufactured in the Company's facilities in Puerto Rico and the Dominican Republic and sold to affiliated companies located in the U.S., net of agreed credits and deductions. The Company has set its transfer prices for products sold between these affiliates at the same prices that the Company sells such products to third parties. The Notice was issued despite the IRS having previously recognized the validity of the Company's transfer pricing methodology by entering into two successive binding Advance Pricing Agreements (APAs) that approved and, in fact, required the application of the Company's transfer pricing methodology for the ten year period of 2001 through 2010. For the years 2001 through 2004, the IRS had previously accepted the transfer pricing methodology related to these APAs after a comprehensive review conducted in two separate audit cycles. On December 16, 2011, immediately prior to the Notice being issued, the IRS sent a letter stating that it was canceling the APAs.

The Company firmly believes that the proposed assessments are without merit. The Company also believes that it was in full compliance with the terms of the two APAs and that the IRS's unilateral attempt to retroactively cancel these two binding contracts is also without merit and represents a breach of the two contracts. The Company intends to file a Petition with the U.S. Tax Court in which it will assert that the transfer pricing established in the two APA contracts meets the arms-length standard set by the U.S. income tax law, that the transfer pricing the Company has used is in full compliance with U.S. income tax laws, and accordingly, that the two APA contracts should be enforced in accordance with their terms. The Company believes that the ultimate resolution of this matter will not have a material impact on its consolidated financial statements.

During 2010, Eaton received a significant tax assessment in Brazil for the tax years 2005 through 2008 that relates to the amortization of certain goodwill generated from the acquisition of third party businesses and corporate reorganizations. In this jurisdiction, the Company had previously filed and received a favorable tax ruling on the key aspects of the transaction not specifically covered by the plain meaning of the local tax statutes. The ruling request fully disclosed all steps of the transaction. The tax assessment is pending review at the second of three administrative appeals levels. The first administrative appeal level made a 50% reduction in assessed penalties. The Company disagrees with the assessment and intends to litigate the matter if it is not resolved at the administrative appeals levels. Multiple outside advisors have stated that Brazilian tax authorities are raising the issue for most clients with similar facts and that the matter is expected to require at least 10 years to resolve. At this time, management believes that final resolution of the assessment will not have a material impact on the consolidated financial statements.