NOTE I – INCOME TAXES

Our income (loss) before income taxes consisted of the following:



	Year Ended December 31,
(in millions)	2017			2016			2015
Domestic	$	(408	)	$	(1,019	)	$	(1,623	)
Foreign	1,341			1,196			973
	$	933		$	177		$	(650	)

The related benefit for income taxes consisted of the following:



	Year Ended December 31,
(in millions)	2017			2016			2015
Current
Federal	$	320		$	31		$	59
State	9			6			3
Foreign	255			136			132
	584			173			194

Deferred
Federal	272			(337		)	(545		)
State	1			(14		)	(41		)
Foreign	(28		)	8			(19		)
	244			(343		)	(605		)
	$	828		$	(170	)	$	(411	)

The reconciliation of income taxes at the federal statutory rate to the actual benefit for income taxes is as follows:



	Year Ended December 31,
	2017		2016		2015
U.S. federal statutory income tax rate	35.0	%	35.0	%	(35.0	)%
State income taxes, net of federal benefit	(0.9	)%	(1.7	)%	(4.8	)%
Effect of foreign taxes	(29.2	)%	(99.1	)%	(34.4	)%
Acquisition-related	(2.1	)%	9.4	%	6.0	%
Research credit	(2.5	)%	(15.0	)%	(4.4	)%
Valuation allowance	(4.1	)%	(42.2	)%	2.3	%
Compensation-related	(2.5	)%	6.4	%	1.6	%
Non-deductible expenses	2.7	%	9.3	%	2.4	%
Uncertain domestic tax positions	1.1	%	5.5	%	2.7	%
TCJA net impact	91.4	%	—	%	—	%
Other, net	(0.2	)%	(3.5	)%	0.4	%
	88.8	%	(95.9	)%	(63.2	)%

We had net deferred tax liabilities of $103 million as of December 31, 2017 and net deferred tax assets of $62 million as of December 31, 2016. Gross deferred tax liabilities of $1.066 billion as of December 31, 2017 and $1.760 billion as of December 31, 2016 relate primarily to goodwill and intangible assets acquired in connection with our prior acquisitions. Gross deferred tax assets of $963 million as of December 31, 2017 and $1.822 billion as of December 31, 2016 relate primarily to the establishment of inventory and product-related reserves, litigation, product liability and other reserves and accruals, compensation related accruals, net operating loss carryforwards and tax credit carryforwards and the federal benefit of uncertain tax positions.

Significant components of our deferred tax assets and liabilities are as follows:



	As of December 31,
(in millions)	2017			2016
Deferred Tax Assets:
Inventory costs and related reserves	$	29		$	37
Tax benefit of net operating loss and credits	478			798
Reserves and accruals	179			228
Restructuring-related charges	12			14
Litigation and product liability reserves	383			752
Investment write-down	32			17
Compensation related	104			142
Federal benefit of uncertain tax positions	163			238
Other	48			42
	1,428			2,268
Less: valuation allowance	(465		)	(446		)
	963			1,822
Deferred Tax Liabilities:
Property, plant and equipment	33			42
Unrealized gains and losses on derivative financial instruments	5			67
Intangible assets	1,028			1,651
	1,066			1,760
Net Deferred Tax Assets / (Liabilities)	(103		)	62
Prepaid on intercompany profit	66			75
Net Deferred Tax Assets / (Liabilities) and Prepaid on Intercompany Profit	$	(37	)	$	137

Our deferred tax assets, deferred tax liabilities and prepaid on intercompany profit, are included in the following locations within our accompanying consolidated balance sheets:



(in millions)	Location in Consolidated Balance Sheets	As of December 31,
Component	Location in Consolidated Balance Sheets	2017			2016
Prepaid on intercompany profit	Prepaid income taxes	$	66		$	75
Non-current deferred tax asset	Other long-term assets	88			80
Deferred Tax Assets and Prepaid on Intercompany Profit		154			155

Non-current deferred tax liability	Deferred income taxes	191			18
Deferred Tax Liabilities		191			18

Net Deferred Tax Assets / (Liabilities) and Prepaid on Intercompany Profit		$	(37	)	$	137

As of December 31, 2017, we had U.S. federal and state tax net operating loss carryforwards and tax credits, the tax effect of which was $338 million. As of December 31, 2016, we had U.S. federal and state tax net operating loss carryforwards and tax credits, the tax effect of which was $724 million. In addition, we had foreign tax net operating loss carryforwards and tax credits, the tax effect of which was $149 million as of December 31, 2017, as compared to $172 million as of December 31, 2016. These tax attributes will expire periodically beginning in 2018.

In 2017, we recorded a discrete tax benefit related to share-based payment awards due to application of ASC Update No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, the majority of this benefit was recorded in the first quarter of 2017. Refer to Note P - New Accounting Pronouncements to our consolidated financial statements contained in this Item 8. Financial Statements and Supplementary Data for additional information.

After consideration of all positive and negative evidence, we believe that it is more likely than not that a portion of our deferred tax assets will not be realized. As a result, we established a valuation allowance of $465 million as of December 31, 2017 and $446 million as of December 31, 2016, representing an increase of $19 million. The increase in the valuation allowance as of December 31, 2017, as compared to December 31, 2016, is primarily attributable to the establishment of a valuation allowance against certain deferred tax assets and as a result of re-measuring certain state valuation allowances due to the TCJA. The increase was offset by a release of a valuation allowance related to tax net operating losses and credits due to expiration. The income tax impact of the unrealized gain or loss component of other comprehensive income and stockholders' equity was a benefit of $63 million in 2017, a charge of $9 million in 2016 and a charge of $25 million in 2015.

We obtain tax incentives through Free Trade Zone Regime offered in Costa Rica which allows 100% exemption from income tax in the first eight years of operations and 50% exemption in the following four years. This tax incentive resulted in income tax savings of $127 million for 2017, $123 million for 2016 and $7 million for 2015. The tax incentive for 100% exemption from income tax is expected to expire in 2023. The impact on per share earnings was $0.09 for both 2017 and 2016 and was immaterial for 2015. Additionally, we benefit from tax incentives in Puerto Rico. The income tax savings from Puerto Rico were immaterial for 2017, 2016 and 2015.

As of December 31, 2017, we had $1.238 billion of gross unrecognized tax benefits, of which a net $1.150 billion, if recognized, would affect our effective tax rate. As of December 31, 2016, we had $1.095 billion of gross unrecognized tax benefits, of which a net $1.006 billion, if recognized, would affect our effective tax rate. As of December 31, 2015, we had $1.056 billion of gross unrecognized tax benefits, of which a net $900 million, if recognized, would affect our effective tax rate. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:



	Year Ended December 31,
(in millions)	2017			2016			2015
Beginning Balance	$	1,095		$	1,056		$	1,047
Additions based on positions related to the current year	134			47			32
Additions based on positions related to prior years	16			14			38
Reductions for tax positions of prior years	(3		)	(17		)	(36		)
Settlements with taxing authorities	(2		)	(3		)	(18		)
Statute of limitation expirations	(2		)	(2		)	(7		)
Ending Balance	$	1,238		$	1,095		$	1,056

We are subject to U.S. Federal income tax as well as income tax of multiple state and foreign jurisdictions. We have concluded all U.S. federal income tax matters through 2000, all foreign income tax matters through 2002 and substantially all material state and local income tax matters through 2005.

We have received Notices of Deficiency from the Internal Revenue Service (IRS) reflecting proposed audit adjustments for Guidant Corporation for its 2001 through 2006 tax years and Boston Scientific Corporation for its 2006 and 2007 tax years. The total incremental tax liability asserted by the IRS for the applicable periods is $1.162 billion plus interest. The primary issue in dispute for all years is the transfer pricing associated with the technology license agreements between domestic and foreign subsidiaries of Guidant. In addition, the IRS has proposed adjustments in connection with the financial terms of our Transaction Agreement with Abbott Laboratories pertaining to the sale of Guidant's vascular intervention business to Abbott Laboratories in April 2006. During 2014, we received a Revenue Agent Report from the IRS reflecting significant proposed audit adjustments to our 2008, 2009 and 2010 tax years based upon the same transfer pricing methodologies that the IRS applied to our 2001 through 2007 tax years.

We do not agree with the transfer pricing methodologies applied by the IRS or its resulting assessment. We have filed petitions with the U.S. Tax Court contesting the Notices of Deficiency for the 2001 through 2007 tax years in challenge and submitted a letter to the IRS Office of Appeals protesting the Revenue Agent Report for the 2008 through 2010 tax years and requesting an administrative appeal hearing. The issues in dispute were scheduled to be heard in U.S. Tax Court in July 2016. On July 19, 2016, we entered into a Stipulation of Settled Issues with the IRS intended to resolve all of the aforementioned transfer pricing issues, as well as the issues related to our transaction with Abbott Laboratories, for the 2001 through 2007 tax years. The Stipulation of Settled Issues is contingent upon the IRS Office of Appeals applying the same basis of settlement to all transfer pricing issues for the Company’s 2008, 2009 and 2010 tax years as well as review by the United States Congress Joint Committee on Taxation. In October 2016, we reached an agreement in principle with IRS Office of Appeals as to the resolution of transfer pricing issues in 2008, 2009 and 2010 tax years, subject to additional calculations of tax as well as documentation to memorialize our agreement.

In the event that the conditions in the Stipulation of Settled Items are satisfied, we expect to make net tax payments of approximately $275 million, plus interest through the date of payment with respect to the settled issues. If finalized, payments related to the resolution are expected in the next six months. We believe that our income tax reserves associated with these matters are adequate as of December 31, 2017 and we do not expect to recognize any additional charges related to resolution of this controversy. However, the final resolution of these issues is contingent and if the Stipulation of Settled Issues is not finalized, it could have a material impact on our financial condition, results of operations, or cash flows.

We recognize interest and penalties related to income taxes as a component of income tax expense. We had $655 million accrued for gross interest and penalties as of December 31, 2017 and $572 million as of December 31, 2016. The increase in gross interest and penalties of $83 million was recognized in our consolidated statements of operations. We recognized net tax expense related to interest and penalties of $154 million in 2017, $46 million in 2016 and $37 million in 2015. The increase in our net tax expense related to interest and penalties as of December 31, 2017, as compared to December 31, 2016, is primarily attributable to re-measuring the future tax benefit of our accrued interest as a result of the TCJA.

It is reasonably possible that within the next 12 months we will resolve multiple issues including transfer pricing and transactional- related issues with foreign, federal and state taxing authorities, in which case we could record a reduction in our balance of unrecognized tax benefits of up to approximately $757 million.

There are a number of key provisions under the TCJA, which was enacted on December 22, 2017, that impact us and we continue to monitor and analyze the ramification of the new law as the implementation is executed. The final impact of the TCJA may differ from the estimates reported due to, among other things, changes in interpretations and assumptions made by us, additional guidance that may be issued by the U.S. Department of the Treasury and actions that we may take as a result. Due to insufficient guidance, as well as the availability of information to accurately analyze the impact of the TCJA, we have made a reasonable estimate of the effects, as described below, and in other cases we have not been able to make a reasonable estimate and continue to account for those items based on our existing accounting under FASB ASC Topic 740, Income Taxes and the provisions of the tax laws that were in effect immediately prior to enactment. The key changes from the TCJA that are reasonably estimated and reported as of December 31, 2017 are the impact due to the reduced U.S. Federal corporate tax rate from 35.0 percent to 21.0 percent and a one-time transition tax on certain foreign earnings on which U.S. income tax is deferred. For the items for which we were able to determine a reasonable estimate, we recognized net income tax expense of $861 million. In all cases, we will continue to refine our calculations as additional analysis is completed. In addition, our estimates may also be affected as we gain a more thorough understanding of the TCJA.

We are required to record deferred tax assets and liabilities based on the enacted tax rates at which they are expected to reverse in the future. Therefore, any U.S. related deferred taxes were re-measured from 35.0 percent down to 21.0 percent based on the recorded balances. The analysis included a preliminary assessment on the deductibility of certain amounts for which deferred tax assets may have been recorded. However, we are still analyzing certain aspects of the TCJA and refining our calculations based on the available information, which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. The provisional amount recorded related to the re-measurement of our deferred tax balances was a benefit of approximately $99 million.

We are required to calculate a one-time transition tax based on our total post-1986 foreign earnings and profits (E&P) that we previously deferred from U.S. income taxes. We recorded a provisional amount for our one-time transition tax of approximately $1.044 billion. We anticipate offsetting this liability against existing tax attributes reducing the required payment to approximately $463 million which will be remitted over an eight year period. We have not yet completed our calculation of the total post-1986 E&P for these foreign subsidiaries. Further, the transition tax is based in part on the amount of those earnings held in cash and other specified assets. This amount may change when we finalize the calculation of post-1986 foreign E&P previously deferred from U.S. federal taxation and finalize the amounts held in cash or other specified assets. Additionally, no income taxes have been provided for any remaining undistributed foreign earnings that are not subject to the transition tax, or any additional outside basis difference inherent in these entities, as we expect these amounts will remain indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in these entities is not practicable.