Income Taxes

Domestic and foreign income (loss) before income taxes and details of the income tax expense (benefit) are as follows (amounts in millions):



	For the Years Ended December 31,
	2016			2015			2014
Income before income tax expense:
Domestic	$	228		$	355		$	325
Foreign	878			766			656
	$	1,106		$	1,121		$	981
Income tax expense (benefit):
Current:
Federal	$	(15	)	$	169		$	146
State	16			31			12
Foreign	150			40			38
Total current	151			240			196
Deferred:
Federal	40			1			26
State	(13		)	(21		)	(18		)
Foreign	(38		)	9			(58		)
Total deferred	(11		)	(11		)	(50		)

Income tax expense	$	140		$	229		$	146

For the year ended December 31, 2016, 2015, and 2014, income tax benefits attributable to equity-based compensation transactions exceeded the amounts recorded based on grant date fair value. During the third quarter of 2016, we early adopted an accounting standard which simplifies the accounting for share-based payments. The standard, among other things, requires all excess tax benefits and tax deficiencies be recorded as an income tax expense or benefit in the statement of operations (see Note 22). As a result, $81 million was recognized as a reduction to income tax expense in 2016. Conversely, in 2015 and 2014, $65 million and $30 million, respectively, were credited to shareholders' equity.

The items accounting for the difference between income taxes computed at the U.S. federal statutory income tax rate and the income tax expense (benefit) at the effective tax rate for each of the years are as follows (amounts in millions):



	For the Years Ended December 31,
	2016					2015					2014
Federal income tax provision at statutory rate	$	387		35	%	$	392		35	%	$	343		35	%
State taxes, net of federal benefit	9			1		5			—		5			—
Research and development credits	(36		)	(3	)	(26		)	(2	)	(24		)	(2	)
Foreign rate differential	(239		)	(22	)	(228		)	(20	)	(245		)	(25	)
Change in tax reserves	210			19		136			12		128			13
Net operating loss tax attribute assumed from the Purchase Transaction	(114		)	(10	)	(63		)	(6	)	(52		)	(5	)
Excess tax benefit related to share-based payments	(81		)	(7	)	—			—		—			—
Other	4			—		13			1		(9		)	(1	)
Income tax expense	$	140		13	%	$	229		20	%	$	146		15	%

The Company's tax rate is affected by the tax rates in the jurisdictions in which the Company operates, the relative amount of income earned by jurisdiction, and the jurisdictions with a statutory tax rate less than the U.S. rate of 35%.

In 2013, in connection with the Purchase Transaction, we assumed certain tax attributes, generally consisting of net operating loss (“NOL”) carryforwards of approximately $760 million, which represent a potential tax benefit of approximately $266 million. The utilization of such NOL carryforwards will be subject to certain annual limitations and will begin to expire in 2021. The Company also obtained indemnification from Vivendi against losses attributable to the disallowance of claimed utilization of such NOL carryforwards of up to $200 million in unrealized tax benefits in the aggregate, limited to taxable years ending on or prior to December 31, 2016. No benefit for these tax attributes or indemnification was recorded upon the close of the Purchase Transaction. As of December 31, 2016, we had utilized approximately $657 million of the original NOL and had recorded an indemnification asset of $200 million in "Other assets." Correspondingly, the same amount was recorded as a reduction to the consideration paid for the shares repurchased in "Treasury stock." In each of the years ended December 31, 2016 and 2015, we utilized $326 million and $180 million of the NOL and recognized a corresponding reserve of $114 million and $63 million in each of those years ended, respectively.

Deferred income taxes reflect the net tax effects of temporary differences between the amounts of assets and liabilities for accounting purposes and the amounts used for income tax purposes. The components of the net deferred tax assets (liabilities) are as follows (amounts in millions):



	As of December 31,
	2016			2015
Deferred tax assets:
Allowance for sales returns and price protection	$	66		$	66
Inventory reserve	9			11
Accrued expenses	26			40
Deferred revenue	238			288
Tax credit carryforwards	71			58
Net operating loss carryforwards	10			10
Share-based compensation	63			54
Acquired intangibles	115			—
Other	29			28
Deferred tax assets	627			555
Valuation allowance	—			—
Deferred tax assets, net of valuation allowance	627			555
Deferred tax liabilities:
Acquired intangibles	(226		)	(166		)
Prepaid royalties	(62		)	(30		)
Capitalized software development expenses	(94		)	(81		)
State taxes	(1		)	(7		)
Other	(5		)	(6		)
Deferred tax liabilities	(388		)	(290		)
Net deferred tax assets	$	239		$	265

As of December 31, 2016, we had gross tax credit carryforwards of $240 million and $137 million for federal and state purposes, respectively, which begin to expire in fiscal 2025. The tax credit carryforwards are presented in "Deferred tax assets" net of unrealized tax benefits that would apply upon the realization of uncertain tax positions. In addition, we had state NOL carryforwards of $9 million which begin to expire in fiscal 2027. Through our foreign operations, we had approximately $6 million in NOL carryforwards at December 31, 2016, attributed mainly to losses in France which can be carried forward indefinitely.

We evaluate our deferred tax assets, including net operating losses and tax credits, to determine if a valuation allowance is required. We assess whether a valuation allowance should be established or released based on the consideration of all available evidence using a "more-likely-than-not" standard. Realization of the U.S. deferred tax assets is dependent upon the continued generation of sufficient taxable income. In making such judgments, significant weight is given to evidence that can be objectively verified. Although realization is not assured, management believes it is more likely than not that the net carrying value of the U.S. deferred tax assets will be realized. At December 31, 2016 and 2015, there are no valuation allowances on deferred tax assets.

Cumulative undistributed earnings of foreign subsidiaries for which no deferred taxes have been provided approximated $5,127 million at December 31, 2016. Deferred income taxes on these earnings have not been provided as these amounts are considered to be permanent in duration. Determination of the unrecognized deferred tax liability on unremitted foreign earnings is not practicable because of the complexity of the hypothetical calculation. In the event of a distribution of these earnings to the U.S. in the form of a dividend, we may be subject to both foreign withholding taxes and U.S. income taxes net of allowable foreign tax credits.

Activision Blizzard's tax years 2009 through 2015 remain open to examination by the major taxing jurisdictions to which we are subject. The IRS is currently examining the Company's federal tax returns for the 2009 through 2011 tax years. During the second quarter of 2015, the Company transitioned the review of its transfer pricing methodology from the advanced pricing agreement review process to the IRS examination team. Their review could result in a different allocation of profits and losses under the Company’s transfer pricing agreements. Such allocation could have a positive or negative impact on our provision for the period in which such a determination is reached and the relevant periods thereafter. The Company also has several state and non-U.S. audits pending. In addition, as part of purchase price accounting for the King Acquisition, the Company assumed $74 million of uncertain tax positions primarily related to the transfer pricing on King tax years occurring prior to the King Acquisition. The Company is currently in negotiations with the relevant jurisdictions and taxing authorities with respect to King's transfer pricing, which could result in a different allocation of profits and losses between the relevant jurisdictions.

Vivendi Games' results for the period from January 1, 2008 through July 9, 2008 are included in the consolidated federal and certain foreign, state and local income tax returns filed by Vivendi or its affiliates, while Vivendi Games' results for the period from July 10, 2008 through December 31, 2008 are included in the consolidated federal and certain foreign, state and local income tax returns filed by Activision Blizzard. IRS Appeals proceedings concerning Vivendi Games’ tax return for the 2008 tax year were concluded during July 2016 but that year remains open to examination by other major taxing authorities. The resolution of the 2008 IRS Appeals process did not have a material impact on the Company’s consolidated financial statements.

Certain of our subsidiaries are under examination or investigation or may be subject to examination or investigation by tax authorities in various jurisdictions, including France. These proceedings may lead to adjustments or proposed adjustments to our taxes or provisions for uncertain tax positions. Such proceedings may have a material adverse effect on the Company’s consolidated financial position, liquidity or results of operations in the period or periods in which the matters are resolved or in which appropriate tax provisions are taken into account in our financial statements. If we were to receive a materially adverse assessment from a taxing jurisdiction, we would plan to vigorously contest it and consider all of our options, including the pursuit of judicial remedies.

As of December 31, 2016, we had approximately $846 million of gross unrecognized tax benefits, of which $812 million would affect our effective tax rate, if recognized. A reconciliation of total gross unrecognized tax benefits for the years ended December 31, 2016, 2015, and 2014 is as follows (amounts in millions):



	For the Years Ended December 31,
	2016			2015			2014
Unrecognized tax benefits balance at January 1	$	552		$	419		$	294
Gross increase for tax positions of prior-years	89			8			2
Gross decrease for tax positions of prior-years	(17		)	(11		)	—
Gross increase for tax positions of current year	240			136			125
Settlement with taxing authorities	(18		)	—			(2		)
Lapse of statute of limitations	—			—			—
Unrecognized tax benefits balance at December 31	$	846		$	552		$	419

We recognize interest and penalties related to uncertain tax positions in "Income tax expense". As of December 31, 2016 and 2015, we had approximately $71 million and $41 million, respectively, of accrued interest and penalties related to uncertain tax positions. For the year ended December 31, 2016, 2015, and 2014, we recorded $17 million, $10 million, and $5 million, respectively, of interest expense related to uncertain tax positions.

The final resolution of the Company’s global tax disputes is uncertain. There is significant judgment required in the analysis of disputes, including the probability determination and estimation of the potential exposure. Based on current information, in the opinion of the Company’s management, the ultimate resolution of these matters is not expected to have a material adverse effect on the Company’s consolidated financial position, liquidity or results of operations, except as noted above.