Income Taxes

9 Months Ended

Sep. 30, 2012

Income Taxes

Income Taxes

NOTE 5. Income Taxes

The Company files income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2003.

The IRS completed its field examination of the Company's U.S. federal income tax returns for the years 2005 through 2007 in the fourth quarter of 2009. The Company protested certain IRS positions within these tax years and entered into the administrative appeals process with the IRS during the first quarter of 2010. During the first quarter of 2010, the IRS completed its field examination of the Company's U.S. federal income tax return for the 2008 year. The Company protested certain IRS positions for 2008 and entered into the administrative appeals process with the IRS during the second quarter of 2010. During the first quarter of 2011, the IRS completed its field examination of the Company's U.S. federal income tax return for the 2009 year. The Company protested certain IRS positions for 2009 and entered into the administrative appeals process with the IRS during the second quarter of 2011. During the first quarter of 2012, the IRS completed its field examination of the Company's U.S. federal income tax return for the 2010 year. The Company protested certain IRS positions for 2010 and entered into the administrative appeals process with the IRS during the second quarter of 2012.

Currently, the Company is under examination by the IRS for its U.S. federal income tax returns for the years 2011 and 2012. It is anticipated that the IRS will complete its examination of the Company for 2011 by the end of the first quarter of 2013, and for 2012 by the end of the first quarter of 2014. As of September 30, 2012, the IRS has not proposed any significant adjustments to the Company's tax positions for which the Company is not adequately reserved.

During the first quarter of 2010, the Company paid the agreed upon assessments for the 2005 tax year. During the second quarter of 2010, the Company paid the agreed upon assessments for the 2008 tax year. During the second quarter of 2011, the Company received a refund from the IRS for the 2004 tax year. During the first quarter of 2012, the Company paid the agreed upon assessments for the 2010 tax year. Payments relating to other proposed assessments arising from the 2005 through 2012 examinations may not be made until a final agreement is reached between the Company and the IRS on such assessments or upon a final resolution resulting from the administrative appeals process or judicial action. In addition to the U.S. federal examination, there is also limited audit activity in several U.S. state and foreign jurisdictions.

3M anticipates changes to the Company's uncertain tax positions due to the closing of various audit years mentioned above. Currently, the Company is not able to reasonably estimate the amount by which the liability for unrecognized tax benefits will increase or decrease during the next 12 months as a result of the ongoing income tax authority examinations. The total amounts of unrecognized tax benefits that, if recognized, would affect the effective tax rate are $210 million and $295 million as of September 30, 2012 and December 31, 2011, respectively.

The Company recognizes interest and penalties accrued related to unrecognized tax benefits in tax expense. The Company recognized in the consolidated statement of income on a gross basis approximately $3 million of benefit for both the three months ended September 30, 2012 and September 30, 2011, and approximately $8 million of benefit and an immaterial impact for the nine months ended September 30, 2012 and September 30, 2011, respectively. At September 30, 2012 and December 31, 2011, accrued interest and penalties in the consolidated balance sheet on a gross basis were $48 million and$56 million, respectively. Included in these interest and penalty amounts are interest and penalties related to tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate but would accelerate the payment of cash to the taxing authority to an earlier period.

The effective tax rate for the third quarter of 2012 was 28.2 percent, compared to 28.6 percent in the third quarter of 2011, a decrease of 0.4 percentage points. The effective tax rate for the first nine months of 2012 was 29.0 percent, compared to 28.1 percent in the first nine months of 2011, an increase of 0.9 percentage points. Various factors increased or decreased the effective tax rate when compared to the same periods last year. The primary factors which increased the Company's effective tax rate year-on-year included international taxes, specifically with respect to the corporate reorganization of a wholly owned international subsidiary (which benefited 2011), and the lapse of the U.S. research and development credit. These and other factors, when compared to the same periods last year, increased the effective tax rate in the third quarter and first nine months of 2012 by 2.5 and 1.6 percentage points, respectively. Factors which decreased the Company's effective tax rate year-on-year included international taxes as a result of changes to the geographic mix of income before taxes, benefits from certain realized credits, and adjustments to its income tax reserves. These factors, when compared to the same periods last year, decreased the effective tax rate in the third quarter and first nine months of 2012 by 2.9 and 0.7 percentage points, respectively.

The provision for income taxes is determined using the asset and liability approach. Under this approach, deferred income taxes represent the expected future tax consequences of temporary differences between the carrying amounts and tax basis of assets and liabilities. The Company records a valuation allowance to reduce its deferred tax assets when uncertainty regarding their realizability exits. As of September 30, 2012 and December 31, 2011, the Company had valuation allowances of $31 million and $82 million on its deferred tax assets, respectively. The valuation allowance was reduced in the first quarter of 2012 due to the closure of audits with certain taxing authorities.