Income Taxes

12 Months Ended

Dec. 31, 2012

Income Taxes

13. Income Taxes

Our income tax expense is a function of the mix between our domestic and international pre-tax earnings or losses, as well as the mix of international tax jurisdictions in which we operate. Certain of our international rigs are owned and operated, directly or indirectly, by Diamond Offshore International Limited, or DOIL, a Cayman Islands subsidiary which we wholly own. It is our intention to indefinitely reinvest future earnings of DOIL and its foreign subsidiaries to finance foreign activities. Accordingly, we have not made a provision for U.S. income taxes on approximately $2.0 billion of undistributed foreign earnings and profits. Although we do not intend to repatriate the earnings of DOIL, and have not provided U.S. income taxes for such earnings, except to the extent that such earnings were immediately subject to U.S. income taxes, these earnings could become subject to U.S. income tax if remitted, or if deemed remitted as a dividend; however, it is not practical to estimate this potential liability.

In 2010, we provided $15.0 million for U.S. taxes attributable to undistributed earnings of Diamond East Asia Limited, or DEAL, a wholly owned subsidiary of DOIL, as it had been our intention to repatriate its earnings to the U.S. However, a tax law provision that expired at the end of 2009, but was subsequently signed back into law in late 2010, in conjunction with our decisions at that time to build three new drillships overseas, caused us to reassess our intent to repatriate the earnings of DEAL to the U.S. We now intend to indefinitely reinvest the earnings of DEAL internationally through another of our foreign subsidiaries, and, consequently, we are no longer providing U.S. income taxes on its earnings. During 2011, we reversed the $15.0 million of U.S. income taxes that had been provided in 2010 for the earnings of DEAL.

The components of income tax expense (benefit) are as follows:

	Year Ended December 31,
	2012			2011			2010
	(In thousands)
Federal – current	$	173,061		$	109,684		$	183,825
State – current		267			264			191
Foreign – current		75,748			104,640			203,459
Total current		249,076			214,588			387,475
Federal – deferred		(51,852	)		(1,023	)		8,287
Foreign – deferred		380			3,164			(15,203)
Total deferred		(51,472	)		2,141			(6,916)
Total	$	197,604		$	216,729		$	380,559

The difference between actual income tax expense and the tax provision computed by applying the statutory federal income tax rate to income before taxes is attributable to the following:

	Year Ended December 31,
	2012			2011			2010
	(In thousands)
Income before income tax expense:
U.S.	$	512,733		$	486,393		$	755,982
Foreign		405,348			692,878			580,034
Worldwide	$	918,081		$	1,179,271		$	1,336,016
Expected income tax expense at federal statutory rate	$	321,328		$	412,745		$	467,606
Foreign earnings of foreign subsidiaries (not taxed at the statutory federal income tax rate) net of related foreign taxes		(166,251	)		(189,051	)		(191,789)
Foreign earnings of foreign subsidiaries for which U.S. federal income taxes have been provided		28,252			(14,681	)		29,736
Foreign taxes of domestic and foreign subsidiaries for which U.S. federal income taxes have also been provided		35,722			65,521			119,009
Foreign tax credits		(45,824	)		(67,232	)		(89,809)
Interest capitalized by foreign subsidiaries		(11,764	)		(3,924	)		--
Reduction of deferred tax liability related to a goodwill deduction resulting from a prior period stock acquisition		--			(2,950	)		(8,850)
Uncertain tax positions		6,325			(7,733	)		30,950
Amortization of deferred charges associated with intercompany rig sales to other tax jurisdictions		31,276			29,556			30,442
Net expense (benefit) in connection with resolutions of tax issues and adjustments relating to prior years		(2,152	)		(6,085	)		(7,346)
Other		692			563			610
Income tax expense	$	197,604		$	216,729		$	380,559

Deferred Income Taxes. Significant components of our deferred income tax assets and liabilities are as follows:

	December 31,
	2012			2011
	(In thousands)
Deferred tax assets:
Net operating loss carryforwards, or NOLs	$	24,067		$	27,212
Worker’s compensation and other current accruals (1)		16,929			15,487
Disputed receivables reserved		956			6
Deferred compensation		9,051			4,504
Foreign contribution taxes		6,780			5,615
Mobilization		4,736			--
Nonqualified stock options and SARs		8,698			7,538
Other		1,640			2,212
Total deferred tax assets		72,857			62,574
Valuation allowance for NOLs		(22,876	)		(26,353)
Net deferred tax assets		49,981			36,221
Deferred tax liabilities:
Depreciation		(526,606	)		(558,915)
Unbilled revenue		(5,649	)		(3,216)
Mobilization		--			(3,939)
Undistributed earnings of foreign subsidiaries		(24	)		(24)
Other		(29	)		(141)
Total deferred tax liabilities		(532,308	)		(566,235)
Net deferred tax liability	$	(482,327	)	$	(530,014)

(1) $8.6 million and $6.8 million reflected in “Prepaid expenses and other current assets” in our Consolidated Balance Sheets at December 31, 2012 and 2011, respectively. See Note 2.

We record a valuation allowance to derecognize a portion of our deferred tax assets, which we do not expect to be ultimately realized. A summary of changes in the valuation allowance is as follows:

	For the Year Ended December 31,
	2012			2011			2010
	(In thousands)
Valuation allowance as of January 1	$	26,353		$	32,102		$	30,975
Establishment of valuation allowances:
Foreign tax credits		--			(186	)		79
Net operating losses		946			1,844			13,381
Releases of valuation allowances in various jurisdictions		(4,423	)		(7,407	)		(12,333)
Valuation allowance as of December 31	$	22,876		$	26,353		$	32,102

Net Operating Loss Carryforwards – As of December 31, 2012, we had recorded a deferred tax asset of $24.1 million for the benefit of NOL carryforwards related to our international operations. Approximately $7.5 million of this deferred tax asset relates to NOL carryforwards that have an indefinite life. The remaining $16.6 million relates to NOL carryforwards of our Mexican entities. Unless utilized, the tax benefits of these Mexican NOL carryforwards will expire between 2013 and 2021 as follows:

Year Expiring	Tax Benefit of NOL Carryforwards (In millions)
2013	$	0.1
2014		3.9
2015		4.3
2016		4.6
2017		3.2
2018		--
2019		--
2020		--
2021		0.5
Total	$	16.6

As of December 31, 2012, a valuation allowance of $22.9 million has been recorded for our NOLs as only $1.2 million of the deferred tax asset is more likely than not to be realized.

Unrecognized Tax Benefits. Our income tax returns are subject to review and examination in the various jurisdictions in which we operate and we are currently contesting various tax assessments. We accrue for income tax contingencies, or uncertain tax positions, that we believe are more likely than not exposures. A reconciliation of the beginning and ending amount of unrecognized tax benefits, excluding interest and penalties, is as follows:

	For the Year Ended December 31,
	2012			2011			2010
	(In thousands)
Balance, beginning of period	$	(41,241	)	$	(45,936	)	$	(27,008)
Additions for current year tax positions		(6,790	)		(900	)		(3,164)
Additions for prior year tax positions		(2,610	)		--			(15,764)
Reductions for prior year tax positions		2,288			1,851			--
Reductions related to statute of limitation expirations		--			3,744			--
Balance, end of period	$	(48,353	)	$	(41,241	)	$	(45,936)

At December 31, 2012, $7.0 million and $55.4 million of the net liability for uncertain tax positions were reflected in “Other assets” and “Other liabilities,” respectively. At December 31, 2011, $7.2 million and $48.4 million of the net liability for uncertain tax positions were reflected in “Other assets” and “Other liabilities,” respectively. Of the net unrecognized tax benefits at December 31, 2012, 2011 and 2010, all $48.4 million, $41.2 million and $45.9 million, respectively, would affect the effective tax rates if recognized.

The following table presents the amount of accrued interest and penalties at December 31, 2012 and 2011 related to uncertain tax positions:

	December 31,
	2012			2011
	(In thousands)
Uncertain tax positions, excluding interest and penalties	$	(48,353	)	$	(41,241)
Accrued interest on uncertain tax positions		(7,029	)		(8,931)
Accrued penalties on uncertain tax positions		(21,662	)		(22,449)
Uncertain tax positions, including interest and penalties	$	(77,044	)	$	(72,621)

We record interest related to accrued uncertain tax positions in interest expense and recognize penalties associated with uncertain tax positions in tax expense. Interest expense and penalties recognized during the three years ended December 31, 2012 related to uncertain tax positions are as follows:

	For the Year Ended December 31,
	2012			2011			2010
	(In thousands)
Net increase (decrease) in interest expense related to unrecognized tax positions	$	(1,902	)	$	245		$	4,751
Net increase (decrease) in penalties related to unrecognized tax positions		(787	)		(3,039	)		12,022

In several of the international locations in which we operate, certain of our wholly-owned subsidiaries enter into agreements with other of our wholly-owned subsidiaries to provide specialized services and equipment in support of our foreign operations. We apply a transfer pricing methodology to determine the amount to be charged for providing the services and equipment. In most cases, there are alternative transfer pricing methodologies that could be applied to these transactions and, if applied, could result in different chargeable amounts. Taxing authorities in the various foreign locations in which we operate could apply one of the alternative transfer pricing methodologies which could result in an increase to our income tax liabilities with respect to tax returns that remain subject to examination.

Tax Returns and Examinations. We file income tax returns in the U.S. federal jurisdiction, various state jurisdictions and various foreign jurisdictions. Tax years that remain subject to examination by these jurisdictions include years 2003 to 2011. We are currently under audit in several of these jurisdictions. We do not anticipate that any adjustments resulting from the tax audit of any of these years will have a material impact on our consolidated results of operations, financial condition and cash flows.

U.S. Tax Jurisdiction. We are currently under audit by the Internal Revenue Service, or IRS, for the tax year 2010. In addition, during 2011, the IRS completed their audit of the tax year 2008 without any adjustment proposed by the auditors.

Brazil Tax Jurisdiction. The Brazilian tax authorities have audited our income tax returns for the years 2000, 2004, 2005 and 2007. In February 2012, the tax authorities concluded their audit of our income tax return for the 2007 tax year for which we received an assessment of R$35.1 million (approximately equal to USD $17 million at December 31, 2012) for income tax, including interest and penalties. We contested the assessment and, in the third quarter of 2012, a court in Brazil ruled to cancel the assessment. However, the Brazilian tax authorities have appealed the ruling. We have not accrued any tax expense related to this assessment.

In December 2009, we received an assessment of approximately $26.0 million for the years 2004 and 2005, including interest and penalty. We contested the tax assessment in January 2010 and are awaiting the outcome of the appeal. As required by GAAP, only the portion of the tax benefit that has a greater than 50% likelihood of being realized upon settlement is to be recognized. Consequently, we have accrued approximately $12.9 million of expense attributable to the portion of the tax assessment we determined to be an uncertain tax position, of which approximately $3.6 million is interest related and approximately $3.2 million is penalty related.

In addition, the tax auditors have issued an assessment for tax year 2000 of approximately $1.5 million, including interest and penalty. We have appealed the tax assessment and are awaiting the outcome of the appeal.

During 2011, unrecognized tax benefits were reduced by approximately $6.8 million due to the lapse in the applicable statute of limitations for the 2006 tax year, of which $1.1 million was interest and $2.0 million was penalty.

Mexico Tax Jurisdiction. The Mexican tax authorities have audited our income tax returns for the years 2004 and 2006. The tax auditors have issued assessments for tax year 2004 of approximately $22.9 million, including interest and penalties, which we appealed. In August 2012, the Mexican tax authorities dismissed a claim against one of our Mexican subsidiaries and the 2004 tax year for that subsidiary is now closed. Consequently, during the third quarter of 2012, we reversed our $4.4 million accrual for this uncertain tax position, which included $0.2 million of penalty and $2.6 million of interest.

In January 2012, we received tax assessments for the tax year 2006 of approximately $24.4 million including interest and penalties. We have appealed the assessments.

Egypt Tax Jurisdiction. We are currently under audit by the Egyptian tax authorities for the tax years 2006 through 2010.

American Taxpayer Relief Act of 2012. The American Taxpayer Relief Act of 2012, or the Act, was signed into law on January 2, 2013. The Act extends through 2013 several expired or expiring temporary business provisions, commonly referred to as “extenders,” which are retroactively extended to the beginning of 2012. As required by GAAP, the effects of new legislation are recognized when signed into law. Consequently, we expect to reduce our first quarter 2013 tax expense by approximately $28 million as a result of recognizing the 2012 effect of the extenders.