Note 7 – Income Taxes

Our provision for federal and foreign income tax expense for continuing operations consisted of the following (in millions):


	2012			2011			2010
Federal income taxes:
Current		$	387		$	912		$	600
Deferred			925			9			561
Total federal income taxes			1,312			921			1,161
Foreign income taxes:
Current			14			38			8
Deferred			1			5			(5	)
Total foreign income taxes			15			43			3
Income tax expense		$	1,327		$	964		$	1,164

State income taxes are included in our operations as general and administrative costs and, under U.S. Government regulations, are allowable costs 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 presented in these financial statements is disclosed net of state income taxes. Our total net state income tax expense was $183 million for 2012, $149 million for 2011, and $168 million for 2010 (including state income taxes related to the sale of Enterprise Integration Group (EIG) (Note 14)).

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):


	2012				2011				2010
Income tax expense at the U.S. federal statutory tax rate		$	1,425			$	1,271			$	1,322
Increase (decrease) in tax expense:
U.S. manufacturing activity benefit			(29	)			(106	)			(110	)
Tax deductible dividends			(73	)			(62	)			(56	)
Research and development tax credit			—				(35	)			(43	)
IRS appeals and audit resolution			—				(89	)			(10	)
Medicare Part D law change			—				—				96
Other, net			4				(15	)			(35	)
Income tax expense		$	1,327			$	964			$	1,164

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 2012, 2011, and 2010, is applied against QPA income to arrive at the deduction. Our tax-deductible pension contributions were significantly higher in 2012 than in prior years and, accordingly, our U.S. manufacturing deduction for 2012 was significantly reduced.

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.

We recognized tax benefits of $35 million in 2011 and $43 million in 2010 related to the impact of the research and development (R&D) tax credit. On January 2, 2013, the President signed into law the American Taxpayer Relief Act of 2012, which retroactively reinstates the R&D tax credit for two years, from January 1, 2012 through December 31, 2013. The financial impacts of tax law changes are recognized in the period in which new legislation is enacted, and accordingly we will recognize the benefit of the R&D tax credit for both 2012 and 2013 in 2013.

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).

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.

We participate in the IRS Compliance Assurance Process program. The IRS examinations of the years 2011, 2010, and 2009 were completed in the fourth quarter of 2012, 2011, and 2010. We also resolved certain issues in our 2009 tax return with the IRS Appeals Division in 2012. The resolution of these examinations and issues did not have a material impact on our effective tax rates.

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


	2012		2011
Deferred tax assets related to:
Accrued compensation and benefits	$	909	$	843
Pensions		5,117		4,578
Other postretirement benefit obligations		433		487
Contract accounting methods		853		806
Sale of discontinued operations		—		69
Foreign company operating losses and credits		34		31
Other		284		305
Valuation allowance ^(a)		(8)		(14)
Deferred tax assets, net		7,622		7,105
Deferred tax liabilities related to:
Goodwill and purchased intangibles		402		369
Property, plant, and equipment		604		638
Exchanged debt securities and other ^(b)		544		379
Deferred tax liabilities		1,550		1,386
Net deferred tax assets ^(c)	$	6,072	$	5,719

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

^(b)	Includes deferred taxes associated with the exchange of debt securities in 2012 (Note 8) and prior years.

^(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 January 1, 2011. 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. Our unrecognized tax benefits as of December 31, 2012 and 2011 are 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 2009, other than with respect to refunds.

U.S. income taxes and foreign withholding taxes have not been provided on earnings of $211 million, $193 million, and $108 million that have not been distributed by our non-U.S. companies as of December 31, 2012, 2011, and 2010. 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 $45 million in 2012, $41 million in 2011, and $17 million in 2010.

Our federal and foreign income tax payments, net of refunds received, were $890 million in 2012, $722 million in 2011, and $806 million in 2010. Our 2012 net payments reflect a $153 million refund received from the IRS in 2012 related to a 2011 capital loss carryback claim; our 2011 net payments reflect a $250 million refund received from the IRS in 2011 related to estimated taxes paid for 2010; and our 2010 net payments reflect a $325 million refund received from the IRS in 2010 related to estimated taxes paid for 2009, a payment of $260 million associated with the divestiture of EIG, and an $85 million advance payment related to matters subsequently resolved with the IRS Appeals Division. As of December 31, 2012, we had federal and foreign taxes receivable of $662 million recorded within other current assets on our Balance Sheet, primarily attributable to our tax-deductible pension contributions and debt exchange transaction in the fourth quarter of 2012.