NOTE 9. INCOME TAXES

Earnings before income taxes consisted of the following:


(DOLLARS IN THOUSANDS)	2011			2010			2009
U.S. loss before taxes	$	(5,854	)	$	(82,112	)	$	(80,345	)
Foreign income before taxes		379,400			441,705			356,894

Total income before taxes	$	373,546		$	359,593		$	276,549

The income tax provision consisted of the following:


(DOLLARS IN THOUSANDS)	2011		2010			2009
Current
Federal	$	2,386	$	5,379		$	3,829
State and local		15		507			413
Foreign		78,922		103,451			94,135

		81,323		109,337			98,377

Deferred
Federal		11,088		(22,423	)		(14,181	)
State and local		5,996		2,868			7,209
Foreign		8,273		6,254			(10,382	)

		25,357		(13,301	)		(17,354	)

Total income taxes	$	106,680	$	96,036		$	81,023

A reconciliation between the U.S. federal statutory income tax rate to our actual effective tax rate is as follows:


	2011			2010			2009
Statutory tax rate		35.0	%		35.0	%		35.0	%
Difference in effective tax rate on foreign earnings and remittances		(10.0	)		(9.5	)		(11.6	)
Unrecognized tax benefit, net of reversals		1.8			1.4			3.2
State and local taxes		1.5			0.8			2.2
Other, net		0.3			(1.0	)		0.5	⁽¹⁾

Effective tax rate		28.6	%		26.7	%		29.3	%

(1)	The 2009 results include $6 million of tax expense due to the recognition of out-of-period tax adjustments arising from periods 2006 and prior.

Our effective tax rate reflects the benefit from having significant operations outside the U.S. that are taxed at rates that are lower than the U.S. federal rate of 35%. The 2011 and 2010 effective tax rates were also favorably impacted by the reversals of liabilities for uncertain tax positions of $5 million and $6 million, respectively, principally due to statutory expiry and effective settlement.

The deferred tax assets consist of the following amounts:


	December 31,
(DOLLARS IN THOUSANDS)	2011			2010
ASSETS
Employee and retiree benefits	$	132,210		$	126,009
Credit and net operating loss carryforwards		210,886			190,690
Property, plant and equipment, net		5,015			4,152
Trademarks and other		87,911			96,373
Amortizable R&D expenses		23,571			22,278
Other, net		18,729			27,690

Gross deferred tax assets		478,322			467,192
Valuation allowance		(290,879	)		(288,182	)

Total net deferred tax assets	$	187,443		$	179,010

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


(DOLLARS IN THOUSANDS)	2011			2010			2009
Balance of unrecognized tax benefits at beginning of year	$	63,928		$	64,673		$	57,616
Gross amount of increases in unrecognized tax benefits as a result of positions taken during a prior year		118			2			—
Gross amount of decreases in unrecognized tax benefits as a result of positions taken during a prior year		(50	)		—			(26	)
Gross amount of increases in unrecognized tax benefits as a result of positions taken during the current year		8,300			4,706			8,827
The amounts of decreases in unrecognized benefits relating to settlements with taxing authorities		(2,960	)		(4,945	)		(509	)
Reduction in unrecognized tax benefits due to the lapse of applicable statute of limitation		(1,721	)		(508	)		(1,235	)

Balance of unrecognized tax benefits at end of year	$	67,615		$	63,928		$	64,673

At December 31, 2011, 2010 and 2009, there are $65.9 million, $63.9 million, and $62.5 million, respectively, of unrecognized tax benefits recorded to Other liabilities and $1.7 million and $2.2 million in 2011 and 2009, respectively, recorded to Other current liabilities. If these unrecognized tax benefits were recognized, the annual effective tax rate would be affected.

For the years ended December 31, 2011, 2010 and 2009 the Company recognized $2.0 million, $1.0 million and $2.0 million, respectively, in interest and penalties. At December 31, 2011, 2010 and 2009, we had accrued $12.8 million, $11.0 million and $10.0 million, respectively, of interest and penalties classified as Other liabilities.

Net operating loss carryforwards were $175 million and $168 million at December 31, 2011 and 2010, respectively. If unused, $6 million will expire between 2012 and 2031. The remainder, totaling $169 million, may be carried forward indefinitely. Tax credit carryforwards were $36 million and $23 million at December 31, 2011 and December 31, 2010, respectively. If unused, the credit carryforwards will expire between 2012 and 2031.

The U.S. consolidated group has historically generated taxable income after the inclusion of foreign dividends. As such, the Company is not in a federal net operating loss position. This tax posture allows IFF and its U.S. subsidiaries to realize tax benefits from the reversal of temporary differences and the utilization of its federal tax credits before the expiration of the applicable carryforward periods.

The majority of states in the U.S. where IFF and its subsidiaries file income tax returns allow a 100% foreign dividend exclusion, effectively converting the domestic companies' reversing temporary differences into net operating losses. As there is significant doubt with respect to realizability of these net operating losses, we have established a full valuation allowance against these deferred tax assets.

The Company has not factored any future trends, other than inflation, in its U.S. taxable income projections. The corresponding U.S. federal taxable income is sufficient to realize $182.6 million in deferred tax assets as of December 31, 2011.

Of the $211 million deferred tax asset for net operating loss carryforwards and credits at December 31, 2011, we consider it unlikely that a portion of the tax benefit will be realized. Accordingly, a valuation allowance of $169 million of net operating loss carryforwards and $7 million of tax credits has been established against these deferred tax assets, respectively. In addition, due to realizability concerns, we established a valuation allowance against certain other net deferred tax assets of $115 million.

Tax benefits credited to Shareholders' equity totaled $2 million and $3 million for 2011 and 2010, respectively, associated with stock option exercises and PRS dividends.

U.S. income taxes and foreign withholding taxes associated with the repatriation of earnings of its foreign subsidiaries were not provided on a cumulative total of $924 million of undistributed earnings of foreign subsidiaries. We intend to, and have plans to, reinvest these earnings indefinitely in our foreign subsidiaries to fund local operations and/or capital projects. It is not practicable to estimate the unrecognized deferred tax liability on these undistributed earnings.

The Company has ongoing income tax audits and legal proceedings which are at various stages of administrative or judicial review, of which the material items are discussed below. In addition, the Company has other ongoing tax audits and legal proceedings that relate to direct and indirect taxes, such as transfer pricing, value-added taxes, sales and use and property taxes, which are discussed in Note 16.

The most significant income tax disputes in which it is currently involved relate to ongoing tax assessments and uncertain tax positions within its European operations. More specifically, the Company is disputing various income tax assessments imposed by the Spanish tax authorities against the Company's Spanish subsidiaries and the judicial process may take a number of years. As a result of a tax audit for the 2002-2003 fiscal years, the Spanish tax authorities challenged certain tax positions taken in the Spanish subsidiaries' tax returns and imposed an assessment of Euro 23.1 million ($29.9 million), which the Company has appealed with the National Appellate Court. During the fourth quarter of 2011, as a result of a tax audit for the 2004-2006 fiscal years, the Spanish tax authorities issued a tax assessment of Euro 61.6 million ($79.6 million). This assessment challenged the same tax positions identified in the prior assessment. The Company has filed an appeal with respect to this subsequent assessment. In order to proceed with these appeals, as of December 31, 2011, the Company is required to and has posted bank guarantees of Euro 30.9 million ($39.9 million) and, in January 2012, posted another bank guarantee of Euro 61.6 million ($79.6 million).

In January 2012, the Spanish tax authorities notified the Company of their intent to audit the 2007-2010 income tax returns of our Spanish subsidiaries. The tax positions that have previously been challenged by the Spanish tax authorities were consistently taken in our Spanish subsidiaries' tax returns from 2002 through the end of 2011. Consequently, the Company anticipates that it will receive an assessment for matters similar to those under appeal, for the fiscal years 2007-2011. It is difficult to anticipate the amount of any future assessment as changes in the Spanish tax legislation permit companies to assert additional defenses for fiscal years commencing in 2007. The Company continues to dispute the pending tax assessments and intends to dispute any future tax assessment that challenges these same tax positions. However, in accordance with ASC 740 "Income Taxes," as of December 31, 2011, the Company has recorded a provision for uncertain tax positions of $49.6 million associated with the Spanish income tax cases.

In addition to the above, the Company is also a party to four dividend withholding tax controversies in Spain which are at different stages of administrative and judicial review, spanning fiscal years 1995-2001, in the aggregate amount of Euro 18.1 million ($23.4 million). In order to proceed with these appeals, as of December 31, 2011, the Company is required to and has posted bank guarantees of Euro 17.0 million ($21.9 million). The Company expects that two of these cases aggregating Euro 12.3 million ($15.9 million) will be decided during the first half of 2012. If the aforementioned tax assessments are ultimately resolved against the Company, the resulting increase in its liability for uncertain tax positions could have a material impact on the Company's results of operations and cash flows in a particular period.

The Company's aggregate provisions for uncertain tax positions with interest and penalties, including those relating to the challenged tax positions in Spain, is $80.4 million. Future events or changes in facts or circumstances could require it to further adjust its liability for unrecognized tax positions and additional interest and penalties which could significantly increase the total amount that would be due if the Company does not ultimately prevail. If the Spanish tax assessments, or any other tax assessments, are ultimately resolved against the Company, the resulting increase in its provision for uncertain tax positions could have a material impact on its results of operations and cash flows in a particular period.

In addition, we have several other tax audits in process and have open tax years with various taxing jurisdictions that range primarily from 2002 to 2010. Based on currently available information, we do not believe the ultimate outcome of these tax audits and other tax positions related to open tax years, when finalized, will have a material impact on our financial position, reported results or liquidity.