NOTE I – INCOME TAXES

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



	Year Ended December 31,
(in millions)	2018		2017			2016
Domestic	$	35	$	(408	)	$	(1,019	)
Foreign	1,387		1,341			1,196
	$	1,422	$	933		$	177

The related benefit for income taxes consisted of the following:



	Year Ended December 31,
(in millions)	2018			2017			2016
Current
Federal	$	(221	)	$	320		$	31
State	(27		)	9			6
Foreign	160			255			136
	(87		)	584			173

Deferred
Federal	(124		)	272			(337		)
State	4			1			(14		)
Foreign	(42		)	(28		)	8
	(162		)	244			(343		)
	$	(249	)	$	828		$	(170	)

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



	Year Ended December 31,
	2018		2017		2016
			(reclassified)⁽¹⁾		(reclassified)⁽¹⁾
U.S. federal statutory income tax rate	21.0	%	35.0	%	35.0	%
State income taxes, net of federal benefit	0.4	%	(1.0	)%	(2.1	)%
Domestic taxes on foreign earnings	0.5	%	0.4	%	0.5	%
Effect of foreign taxes	(8.3	)%	(38.9	)%	(142.1	)%
Acquisition-related	2.1	%	(1.7	)%	11.3	%
Research credit	(2.6	)%	(2.6	)%	(15.5	)%
Valuation allowance	(5.2	)%	(4.1	)%	(42.2	)%
Compensation-related	(1.0	)%	(2.5	)%	6.4	%
Non-deductible expenses	0.3	%	2.2	%	6.6	%
Uncertain tax positions	(22.0	)%	10.7	%	49.5	%
TCJA net impact	(4.7	)%	91.4	%	—	%
Other, net	1.8	%	(0.2	)%	(3.5	)%
	(17.5	)%	88.8	%	(95.9	)%


(1)	Due to the inclusion of new tax provisions in 2018 created by the TJCA, we have reclassified select items in prior years to align with the new categories established in 2018, domestic taxes on foreign earnings and uncertain tax positions.

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



	As of December 31,
(in millions)	2018			2017
Deferred Tax Assets:
Inventory costs and related reserves	$	18		$	29
Tax benefit of net operating loss and credits	450			478
Reserves and accruals	258			179
Restructuring-related charges	12			12
Litigation and product liability reserves	221			383
Investment write-down	28			32
Compensation related	106			104
Federal benefit of uncertain tax positions	10			163
Other	37			48
	1,140			1,428
Less: valuation allowance	(344		)	(465		)
	796			963
Deferred Tax Liabilities:
Property, plant and equipment	25			33
Unrealized gains and losses on derivative financial instruments	44			5
Intangible assets	968			1,028
	1,037			1,066
Net Deferred Tax Assets / (Liabilities)	(241		)	(103		)
Prepaid on intercompany profit	161			66
Net Deferred Tax Assets / (Liabilities) and Prepaid on Intercompany Profit	$	(80	)	$	(37	)

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 on Consolidated Balance Sheets	As of December 31,
Component	Location on Consolidated Balance Sheets	2018			2017
Prepaid on intercompany profit	Prepaid income taxes	$	161		$	66
Non-current deferred tax asset	Other long-term assets	87			88
Deferred Tax Assets and Prepaid on Intercompany Profit		249			154

Non-current deferred tax liability	Deferred income taxes	328			191
Deferred Tax Liabilities		328			191

Net Deferred Tax Assets (Liabilities) and Prepaid on Intercompany Profit		$	(80	)	$	(37	)

As of December 31, 2018, we had U.S. federal and state tax net operating loss carryforwards and tax credits, the tax effect of which was $416 million. 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. In addition, we had foreign tax net operating loss carryforwards and tax credits, the tax effect of which was $42 million as of December 31, 2018, as compared to $149 million as of December 31, 2017. These tax attributes will expire periodically beginning in 2019.

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 $344 million as of December 31, 2018 and $465 million as of December 31, 2017, representing a decrease of $121 million. The decrease in the valuation allowance as of December 31, 2018, as compared to December 31, 2017, is primarily attributable to the release of valuation allowances against expiring net operation losses and utilization of deferred tax assets. The income tax impact of the unrealized gain or loss component of other comprehensive income and stockholders' equity was a charge of $37 million in 2018, a benefit of $63 million in 2017 and a charge of $9 million in 2016.

We obtain tax incentives through Free Trade Zone Regime offered in Costa Rica which allows 100.0 percent exemption from income tax in the first eight years of operations and 50.0 percent exemption in the following four years. This tax incentive resulted in income tax savings of $146 million for 2018, $127 million for 2017 and $123 million for 2016. The tax incentive for 100.0 percent exemption from income tax is expected to expire in 2023. The impact on per share earnings was $0.10 for 2018 and $0.09 for both 2017 and 2016. Additionally, we benefit from tax incentives in Puerto Rico. The income tax savings from Puerto Rico were immaterial for 2018, 2017 and 2016.

As of December 31, 2018, we had $427 million of gross unrecognized tax benefits, of which a net $332 million, if recognized, would affect our effective tax rate. 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. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:



	Year Ended December 31,
(in millions)	2018			2017			2016
Beginning Balance	$	1,238		$	1,095		$	1,056
Additions based on positions related to the current year	79			134			47
Additions based on positions related to prior years	4			16			14
Reductions for tax positions of prior years	(433		)	(3		)	(17		)
Settlements with taxing authorities	(459		)	(2		)	(3		)
Statute of limitation expirations	(3		)	(2		)	(2		)
Ending Balance	$	427		$	1,238		$	1,095

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 2013, with the exception of select issues in 2011 and substantially all material state and local income tax matters through 2010. We have concluded all foreign income tax matters through 2013, with the exception of issues for Italy, which have concluded through 2002.

During 2010 and 2011, we received Notices of Deficiency from the Internal Revenue Service (IRS) reflecting proposed audit adjustments for Guidant Corporation (Guidant) for its 2001 through 2006 tax years and our 2006 and 2007 tax years. The total incremental tax liability asserted by the IRS for the applicable periods was $1.162 billion plus interest. The primary issue in dispute for all years was the transfer pricing associated with the technology license agreements between domestic and foreign subsidiaries of Guidant. In addition, the IRS 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 (RAR) 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 contested in U.S. Tax Court the proposed adjustments from the IRS for Guidant for its 2001 through 2006 tax years and our 2006 and 2007 tax years related to its audit of our transfer pricing methodologies. During 2016, we entered a Stipulation of Settled Issues with the IRS intended to resolve all of the aforementioned transfer pricing issues, as well as issues related to our 2006 transaction with Abbott Laboratories. This stipulation was contingent upon the IRS Office of Appeals applying the same basis of settlement to all transfer pricing issues for the 2008 through 2010 tax years.

In the second quarter of 2018, a decision was entered by the U.S. Tax Court resolving all disputes related to the transfer pricing issues for Guidant for its 2001 through 2006 tax years and our 2006 and 2007 tax years as well as the tax issues related to our 2006 transaction with Abbott Laboratories. Additionally, we resolved all issues with the IRS Office of Appeals for our 2008 through 2010 tax years, including the transfer pricing issue and other unrelated issues. The final settlement calculation included certain elections made in these relevant years and resulted in a final net tax payment of $303 million plus $307 million of estimated interest, which was remitted in the second quarter of 2018. Due to the final settlement of these disputes, we recorded a net tax benefit of $250 million in 2018.

In the fourth quarter of 2018, we received a RAR from the IRS for our 2011 through 2013 tax years. The RAR reflected transfer pricing adjustments consistent with the basis of settlement for all transfer pricing issues agreed to in the Stipulation of Settled Issues. We remitted $93 million to the IRS in the fourth quarter of 2018 reflecting the net balance of tax and interest due for these years after consideration of amounts owed to us by the IRS. Due to the resolution of these tax years, we recorded a net tax benefit of $90 million.

We recognize interest and penalties related to income taxes as a component of income tax expense. We had $11 million accrued for gross interest and penalties as of December 31, 2018 and $655 million as of December 31, 2017. The decrease in gross interest and penalties of $643 million was recognized in our consolidated statements of operations and is primarily related to reaching settlements with the taxing authorities. We recognized net tax benefit related to interest and penalties of $498 million in 2018, as compared to a net tax expense of $154 million in 2017 and $46 million in 2016. The decrease in our net tax expense related to interest and penalties as of December 31, 2018, as compared to December 31, 2017, is related to reaching settlements with the taxing authorities.

It is reasonably possible that within the next 12 months we will resolve transactional- related issues with foreign and state taxing authorities, in which case we could record a reduction in our balance of unrecognized tax benefits of up to approximately $11 million.

There are a number of key provisions under the TCJA, which was enacted on December 22, 2017, that impact us. The final impact of the TCJA, as described below, differs from the estimates reported at December 31, 2017 due to, among other things, additional guidance issued by the U.S. Department of the Treasury, changes in interpretations and assumptions made by us, and actions that we may take as a result. The key changes from the TCJA that are reported as of December 31, 2018 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. As a result of finalizing the impact of the TCJA, we recognized a tax benefit of $67 million in 2018. We recognized a total TCJA related tax expense of $793 million as of December 31, 2018 as compared to the provisional estimate of $861 million recognized as of December 31, 2017.

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 an assessment on the deductibility of certain amounts for which deferred tax assets may have been recorded. As of December 31, 2017, we recorded an estimate related to the re-measurement of our deferred tax balances, which was a benefit of approximately $99 million. In 2018, we finalized our calculations and did not adjust our estimate as recorded.

We are required to calculate a one-time transition tax based on our total post-1986 foreign subsidiaries' earnings and profits (E&P) that we previously deferred from U.S. income taxes. As a result of settling our various tax audits, the revised amount of transition tax is approximately $856 million as of December 31, 2018 as compared to the preliminary amount recorded of approximately $1.044 billion as of December 31, 2017. We anticipate offsetting this liability against existing tax attributes reducing the required payment to approximately $499 million, which will be remitted over an eight-year period. We remitted the first estimated installment payment in the second quarter of 2018, with the balance remaining of $429 million as of December 31, 2018. In addition, we have provided for tax expense of $18 million on U.S. state income taxes on all U.S. dollar-denominated E&P accumulated through December 31, 2017, which constitutes the preponderance of our foreign subsidiaries' accumulated E&P through December 31, 2017. We intend to indefinitely reinvest any remaining foreign earnings as of December 31, 2017 as well as current earnings in foreign operations for which income taxes have not already been provided at December 31, 2018. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings and additional outside basis difference in these entities is not practicable.

We are subject to a territorial tax system under the TCJA, in which we are required to provide for tax on Global Intangible Low Taxed Income (GILTI) earned by certain foreign subsidiaries. We have established an accounting policy election to provide for the tax expense related to GILTI in the year the tax is incurred as a period expense.