Note 8 – Income Taxes

Our provision for federal and foreign income tax expense for continuing operations consisted of the following components:


(In millions)	*2011*		2010			2009
Federal income taxes:
Current	$	912	$	600		$	677
Deferred		9		561			557
Total federal income taxes		921		1,161			1,234
Foreign income taxes:
Current		38		8			(4	)
Deferred		5		(5	)		(15	)
Total foreign income taxes		43		3			(19	)
Income tax expense	$	964	$	1,164		$	1,215

State income taxes are included in our operations as general and administrative costs and, under U.S. Government regulations, are allowable in establishing prices for the products and services we sell to the U.S. Government. Therefore, a substantial portion of state income taxes is included in our net sales and cost of sales. As a result, the impact of certain transactions on our operating profit and of other matters disclosed in these financial statements is disclosed net of state income taxes. Our total net state income tax expense was $149 million for 2011, $168 million for 2010 (including state income taxes related to the sale of EIG), and $144 million for 2009.

The amount of net interest and penalties recognized as a component of income tax expense during 2011, 2010, and 2009, as well as the amount of interest and penalties accrued at December 31, 2011 and 2010, was not material.

Our reconciliation of the 35% U.S. federal statutory income tax rate to actual income tax expense for continuing operations is as follows:


(In millions)	*2011*			2010			2009
Income tax expense at the U.S. federal statutory tax rate	$	1,271		$	1,322		$	1,465
Increase (decrease) in tax expense:
U.S. manufacturing activity benefit		(106	)		(110	)		(39	)
Tax deductible dividends		(62	)		(56	)		(49	)
Research and development tax credit		(35	)		(43	)		(43	)
IRS appeals and audit resolution		(89	)		(10	)		(69	)
Medicare Part D law change		—			96			—
Other, net		(15	)		(35	)		(50	)
Income tax expense	$	964		$	1,164		$	1,215

Our U.S. manufacturing activity benefit is based on income derived from qualified production activity (QPA) in the U.S. The deduction rate, which was 9% for both 2011 and 2010, and 6% for 2009, is applied against QPA income to arrive at the deduction. The increased benefit in 2011 and 2010 was due to an increase in QPA income, as well as the higher deduction rate in 2011 and 2010 compared to 2009.

We receive a tax deduction for dividends paid on shares of our common stock held by certain of our defined contribution plans with an employee stock ownership plan (ESOP) feature. The amount of the tax deduction has increased as we increased our dividend over the last three years.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, signed by the President on December 17, 2010, retroactively extended the research and development tax credit from January 1, 2010 through December 31, 2011. We recognized tax benefits of $35 million in 2011, $43 million in 2010, and $43 million in 2009 related to the impact of the research and development tax credit.

In April 2011, the U.S. Congressional Joint Committee on Taxation (JCT) completed its review of the IRS Appeals Division's resolution of certain adjustments related to our tax years 2003-2008. As a result, we recognized additional tax benefits and reduced our income tax expense for 2011 by $89 million ($.26 per share). This reduction in income tax expense reduced our effective income tax rate for 2011 by 2.5%.

We participate in the IRS Compliance Assurance Process program. The IRS examinations of the years 2010 and 2009 were completed in the fourth quarter of 2011 and 2010. Except for certain issues in our 2009 return that are pending in the IRS Appeals Division, resolution of the examinations did not have a material impact on our effective income tax rates. In 2009, the IRS examinations of our U.S. Federal Income Tax Returns for the years 2005-2007 and 2008 were resolved and settled, except for certain issues that were subsequently resolved in April 2011, following a decision by the IRS Appeals Division as discussed above. As a result, we recognized additional tax benefits and reduced our income tax expense for 2009 by $69 million ($.18 per share), including related interest.

In March 2010, the President signed into law the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010. Beginning January 1, 2013, these laws change the tax treatment for retiree prescription drug expenses by eliminating the tax deduction available to the extent that those expenses are reimbursed under Medicare Part D. Because the tax benefits associated with these future deductions were reflected as deferred tax assets as of December 31, 2009, the elimination of the tax deductions resulted in a reduction in deferred tax assets and an increase in income tax expense of $96 million ($.26 per share) in 2010.

The primary components of our federal and foreign deferred income tax assets and liabilities at December 31 were as follows:


(In millions)	*2011*			2010
Deferred tax assets related to:
Accrued compensation and benefits	$	843		$	877
Pensions		4,578			3,642
Other postretirement benefit obligations		487			459
Contract accounting methods		806			531
Sale of discontinued operations		69			179
Foreign company operating losses and credits		31			31
Other		305			202
Valuation allowance ^(a)		(14	)		(17	)
Deferred tax assets, net		7,105			5,904
Deferred tax liabilities related to:
Goodwill and purchased intangibles		369			336
Property, plant and equipment		638			558
Exchanged debt securities and other ^(b)		379			391
Deferred tax liabilities		1,386			1,285
Net deferred tax assets ^(c)	$	5,719		$	4,619

^(a)	A valuation allowance has been provided against certain foreign company deferred tax assets arising from carryforwards of unused tax benefits.

^(b)	Includes deferred tax liabilities associated with the exchange of debt securities in 2010 (see Note 9) and 2006.

^(c)	Includes net foreign current deferred tax liabilities, which are included on the Balance Sheets in other current liabilities.

We had recorded liabilities for unrecognized tax benefits related to permanent and temporary tax adjustments, exclusive of interest, that totaled $160 million at December 31, 2010, primarily recorded in other current liabilities on the Balance Sheet. In 2011, we eliminated most of these liabilities due to the completion of the JCT's review of the IRS Appeals Division's resolution of certain adjustments related to our tax years 2003-2008 as mentioned above. The remaining balance of our unrecognized tax benefits as of December 31, 2011 is not material.

We and our subsidiaries file income tax returns in the U.S. federal jurisdiction and various foreign jurisdictions. With few exceptions, the statute of limitations is no longer open for U.S. federal or non-U.S. income tax examinations for the years before 2008, other than with respect to refunds.

U.S. income taxes and foreign withholding taxes have not been provided on earnings of $193 million, $108 million, and $123 million that have not been distributed by our non-U.S. companies as of December 31, 2011, 2010, and 2009. Our intention is to permanently reinvest these earnings, thereby indefinitely postponing their remittance to the U.S. If these earnings were remitted, we estimate that the additional income taxes after foreign tax credits would have been approximately $41 million in 2011, $17 million in 2010, and $29 million in 2009.

Our federal and foreign income tax payments, net of refunds received, were $722 million in 2011, $806 million in 2010, and $986 million in 2009. A $250 million refund received in 2011 from the IRS related to estimated taxes paid for 2010 is reflected in 2011 payments. A payment of $260 million associated with the divestiture of EIG, a $325 million refund received in 2010 from the IRS related to estimated taxes paid for 2009, and an $85 million advance payment related to matters pending with IRS Appeals are reflected in 2010 payments.