NOTE 9. INCOME TAXES

Earnings before income taxes consisted of the following:


	December 31,
(DOLLARS IN THOUSANDS)	2012			2011			2010
U.S. loss before taxes	$	(21,308	)	$	(5,854	)	$	(82,112	)
Foreign income before taxes		464,723			379,400			441,705

Total income before taxes	$	443,415		$	373,546		$	359,593

The income tax provision consisted of the following:


	December 31,
(DOLLARS IN THOUSANDS)	2012			2011		2010
Current
Federal	$	8,280		$	2,386	$	5,379
State and local		(456	)		15		507
Foreign⁽¹⁾		197,335			78,922		103,451

		205,159			81,323		109,337

Deferred
Federal		(4,650	)		11,088		(22,423	)
State and local		(74	)		5,996		2,868
Foreign⁽¹⁾		(11,154	)		8,273		6,254

		(15,878	)		25,357		(13,301	)

Total income taxes	$	189,281		$	106,680	$	96,036

(1)

For year ended December 31, 2012, the foreign current income tax provision includes $72 million of Spanish tax charges and $12 million of charges related to the Spanish dividend withholding cases. The foreign deferred income tax provision includes a $11 million tax benefit from the corporate restructuring of certain foreign subsidiaries.

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


	December 31,
	2012			2011			2010
Statutory tax rate		35.0	%		35.0	%		35.0	%
Difference in effective tax rate on foreign earnings and remittances		(10.6	)		(10.0	)		(9.5	)
Unrecognized tax benefit, net of reversals		0.9			1.8			1.4
Corporate restructuring of certain foreign subsidiaries		(2.4	)		—			—
Spanish tax charges		16.3			—			—
Spanish dividend withholdings		2.6			—			—
State and local taxes		(0.1	)		1.5			0.8
Other, net		1.0			0.3			(1.0	)

Effective tax rate		42.7	%		28.6	%		26.7	%

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%. Included in the 2012 effective tax rate is $72.4 million of tax charges pursuant to the Spanish tax settlement. The 2012, 2011 and 2010 effective tax rates were also favorably impacted by the reversals of liabilities for uncertain tax positions of $1 million, $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)	2012			2011
ASSETS
Employee and retiree benefits	$	156,399		$	132,210
Credit and net operating loss carryforwards⁽¹⁾		308,900			210,886
Property, plant and equipment, net		2,643			5,015
Trademarks and other⁽¹⁾		141,248			87,911
Amortizable R&D expenses		30,590			23,571
Other, net		25,148			18,729

Gross deferred tax assets		664,928			478,322
Valuation allowance⁽¹⁾		(450,733	)		(290,879	)

Total net deferred tax assets	$	214,195		$	187,443

(1)

During 2012, the Company increased its deferred tax assets by $129 million. The 2012 amount includes a revision to the 2011 foreign net operating loss carryforwards in the amount of $74 million and a $55 million increase related to current year internally generated intangible assets. The revision is not considered material to the previously issued financial statements. This entire increase of $129 million was offset by a corresponding increase in valuation allowances.

Net operating loss carryforwards were $273 million and $175 million at December 31, 2012 and 2011, respectively. If unused, $6 million will expire between 2013 and 2032. The remainder, totaling $267 million, may be carried forward indefinitely. Tax credit carryforwards were $36 million at December 31, 2012 and 2011. If unused, the credit carryforwards will expire between 2013 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 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 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 $187.2 million in deferred tax assets as of December 31, 2012.

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.

Of the $309 million deferred tax asset for net operating loss carryforwards and credits at December 31, 2012, we consider it unlikely that a portion of the tax benefit will be realized. Accordingly, a valuation allowance of $268 million of net operating loss carryforwards and $9 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 $174 million.

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


	December 31,
(DOLLARS IN THOUSANDS)	2012			2011			2010
Balance of unrecognized tax benefits at beginning of year	$	67,615		$	63,928		$	64,673
Gross amount of increases in unrecognized tax benefits as a result of positions taken during a prior year		22,031			118			2
Gross amount of decreases in unrecognized tax benefits as a result of positions taken during a prior year		(1,853	)		(50	)		—
Gross amount of increases in unrecognized tax benefits as a result of positions taken during the current year		3,854			8,300			4,706
The amounts of decreases in unrecognized benefits relating to settlements with taxing authorities		(48,355	)		(2,960	)		(4,945	)
Reduction in unrecognized tax benefits due to the lapse of applicable statute of limitation		(2,139	)		(1,721	)		(508	)

Balance of unrecognized tax benefits at end of year	$	41,153		$	67,615		$	63,928

At December 31, 2012, 2011 and 2010, there are $36.4 million, $65.9 million, and $63.9 million, respectively, of unrecognized tax benefits recorded to Other liabilities and $4.8 million and $1.7 million in 2012 and 2011, respectively, recorded to Other current liabilities. If these unrecognized tax benefits were recognized, all the benefits and related interest would be recorded as a benefit to income tax expense.

For the year ended December 31, 2012, the Company reduced its liabilities for interest and penalties by $5.3 million, net, principally due to payments made pursuant to the Spanish tax settlement, as discussed below. For the years ended December 31, 2011 and 2010 the Company recognized $2.0 million and $1.0 million, respectively, in interest and penalties. At December 31, 2012, 2011 and 2010, we had accrued $7.4 million, $12.8 million and $11.0 million, respectively, of interest and penalties classified as Other liabilities and $0.1 million in 2012 recorded to Other current liabilities.

Tax benefits credited to Shareholders’ equity totaled $0.4 million, $2.0 million and $3.0 million for 2012, 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 $1,146 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 indirect taxes, such as value-added taxes, capital tax, sales and use and property taxes, which are discussed in Note 16.

As of December 31, 2012, the most significant income tax disputes in which the Company was involved related to certain tax positions taken by the Company’s Spanish subsidiaries for the 2002-2003 fiscal years which positions have been challenged by the Spanish tax authorities. As a result of the audits of 2002-2003 fiscal years, the Spanish tax authorities imposed assessments aggregating Euro 22.2 million ($29.3 million), including aggregate estimated interest through December 31, 2012. In order to proceed with its appeals of the tax assessments for the 2002-2003 fiscal years, the Company was required to post bank guarantees. As of December 31, 2012, the Company had posted bank guarantees of Euro 21.6 million ($28.5 million) associated with the 2002-2003 appeals. The Company appealed these assessments with the Appellate Court. On February 7, 2013, the Appellate Court upheld the lower court’s ruling with respect to the 2003 tax assessment and the related tax avoidance claims. We have filed a notice of intent to appeal this ruling. The Appellate Court has not yet ruled on our appeal of the 2002 tax assessment and related claims. We recorded an additional tax provision in the first quarter of 2013 of $6 million after-tax associated with the 2002-2003 cases. The Company’s Spanish subsidiaries have not yet received an assessment with respect to the 2011 fiscal year.

During the third quarter of 2012 the Company and the Spanish tax authorities entered into an overall settlement with respect to assessments imposed in connection with audits for the 2004-2010 fiscal years. In connection with this settlement, the Company paid Euro 84.0 million ($105.5 million based on exchange rates at the respective payment dates) during 2012 and will pay the remainder of Euro 1.5 million ($1.9 million) in the first quarter of 2013. This settlement did not address either the 2002-2003 fiscal years or the 2011 fiscal year. In connection with the overall settlement, the Company recorded after-tax charges of $72.4 million during the third quarter 2012, which included $56.0 million related to the tax settlement of the 2004-2010 period and the increased liabilities for uncertain tax positions of $16.4 million for years not settled. During the fourth quarter the Company and the Spanish tax authorities also finalized a multi-year agreement that established the tax basis for the Company’s activities in Spain for 2012 through 2014 consistent with the key principles preliminarily agreed upon as part of the overall settlement.

In addition to the above, the Company has also been a party to four dividend withholding tax controversies in Spain in which the Spanish tax authorities alleged that the Company’s Spanish subsidiaries underpaid withholding taxes during the 1995-2001 fiscal years. The Company had previously appealed each of these controversies. During 2012, the Company received unfavorable decisions on the first three cases. As a result of these rulings, the Company (i) recorded charges (including estimated interest) of approximately $12 million after-tax during 2012, and (ii) made payments of Euro 9.8 million ($12.8 million based on exchange rates at the respective payment date) during 2012. At December 31, 2012, the Company had Euro 4.3 million ($5.7 million) reflected in income taxes payable in connection with these three cases. The fourth and final remaining appeal has not yet been heard by the Spanish Supreme Court. At December 31, 2012, the aggregate amount of the remaining dividend withholding controversy was Euro 8.2 million ($10.8 million), including estimated interest. As of December 31, 2012, the Company had posted bank guarantees of Euro 7.9 million ($10.5 million) in order to proceed with the appeal in this controversy.

As of December 31, 2012, the Company’s aggregate provisions for uncertain tax positions, including interest and penalties, was $48.7 million, which includes $25.9 million associated with the tax positions taken by our Spanish subsidiaries for the 2002-2003 and the 2011 fiscal years, $3.7 million associated with our Spanish dividend withholding tax controversies and the remainder associated with various other tax positions asserted in foreign jurisdictions, none of which is individually material.

In addition, the Company has several other tax audits in process and has open tax years with various taxing jurisdictions that range primarily from 2002 to 2011. Based on currently available information, we do not believe the ultimate outcome of any of these tax audits and other tax positions related to open tax years, when finalized, will have a material impact on our financial position.