Income taxes

On December 22, 2017, the United States enacted major tax reform legislation, Public Law No. 115-97, commonly referred to as the Tax Cuts and Jobs Act (2017 Tax Act). The 2017 Tax Act imposes a repatriation tax on accumulated earnings of foreign subsidiaries, imposes a current tax on certain foreign earnings and lowers the general corporate income tax rate to 21%. In December 2017, the SEC staff issued Staff Accounting Bulletin No. 118, which allows us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. We have completed our accounting for the tax effects of the 2017 Tax Act, including the repatriation tax, the net deferred tax remeasurement and the impact on our UTBs. None of the adjustments we made to our provisional amounts were material to our consolidated financial statements.

Income before income taxes included the following (in millions):



	Years ended December 31,
	2018		2017		2016
Domestic	$	4,856	$	4,436	$	4,478
Foreign	4,689		5,161		4,685
Total income before income taxes	$	9,545	$	9,597	$	9,163

The provision for income taxes included the following (in millions):



	Years ended December 31,
	2018			2017			2016
Current provision:
Federal	$	1,270		$	8,615		$	984
State	17			5			65
Foreign	227			275			176
Total current provision	1,514			8,895			1,225
Deferred (benefit) provision:
Federal	(317		)	(1,120		)	372
State	(7		)	—			(69		)
Foreign	(39		)	(157		)	(87		)
Total deferred (benefit) provision	(363		)	(1,277		)	216
Total provision for income taxes	$	1,151		$	7,618		$	1,441

Deferred income taxes reflect the tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, tax credit carryforwards and the tax effects of net operating loss (NOL) carryforwards. Significant components of our deferred tax assets and liabilities were as follows (in millions):



	December 31,
	2018			2017
Deferred income tax assets:
NOL and credit carryforwards	$	810		$	812
Accrued expenses	428			362
Expenses capitalized for tax	185			155
Stock-based compensation	95			99
Other	174			154
Total deferred income tax assets	1,692			1,582
Valuation allowance	(509		)	(497		)
Net deferred income tax assets	1,183			1,085

Deferred income tax liabilities:
Acquired intangible assets	(1,509		)	(1,748		)
Debt	(184		)	(184		)
Other	(267		)	(240		)
Total deferred income tax liabilities	(1,960		)	(2,172		)
Total deferred income taxes, net	$	(777	)	$	(1,087	)

Valuation allowances are provided to reduce the amounts of our deferred tax assets to an amount that is more likely than not to be realized based on an assessment of positive and negative evidence, including estimates of future taxable income necessary to realize future deductible amounts.

The valuation allowance increased in 2018 due primarily to the Company’s expectation that some state R&D credits will not be utilized.

As of December 31, 2018, we had $20 million of federal tax credit carryforwards available to reduce future federal income taxes and have provided no valuation allowance for those federal tax credit carryforwards. The federal tax credit carryforwards expire between 2026 and 2035. We had $556 million of state tax credit carryforwards available to reduce future state income taxes and have provided a valuation allowance for $444 million of those state tax credit carryforwards. A portion of the state credits for which no valuation allowance has been provided will expire between 2022 and 2024.

As of December 31, 2018, we had $145 million of federal NOL carryforwards available to reduce future federal income taxes and have provided a valuation allowance for $6 million of those federal NOL carryforwards. The federal NOL carryforwards, for which no valuation allowance has been provided, expire between 2020 and 2035. We had $287 million of state NOL carryforwards available to reduce future state income taxes and have provided a valuation allowance for $263 million of those state NOL carryforwards. The state NOLs for which no valuation allowance has been provided expire between 2019 and 2032. We had $1.8 billion of foreign NOL carryforwards available to reduce future foreign income taxes and have provided a valuation allowance for $485 million of those foreign NOL carryforwards. For the foreign NOLs with no valuation allowance provided, $620 million has no expiry; and the remainder will expire between 2019 and 2024.

The reconciliations of the total gross amounts of UTBs (excluding interest, penalties, foreign tax credits and the federal tax benefit of state taxes related to UTBs) were as follows (in millions):



	Years ended December 31,
	2018			2017			2016
Beginning balance	$	2,953		$	2,543		$	2,114
Additions based on tax positions related to the current year	173			447			425
Additions based on tax positions related to prior years	13			1			18
Reductions for tax positions of prior years	(17		)	(5		)	(7		)
Reductions for expiration of statute of limitations	—			(5		)	—
Settlements	(61		)	(28		)	(7		)
Ending balance	$	3,061		$	2,953		$	2,543

Substantially all of the UTBs as of December 31, 2018, if recognized, would affect our effective tax rate. During the year ended December 31, 2018, we effectively settled various examinations with state tax authorities for prior tax years. As a result of these developments, we remeasured our UTBs accordingly.

Interest and penalties related to UTBs are included in our provision for income taxes. During the years ended December 31, 2018, 2017 and 2016, we recognized $137 million, $56 million and $125 million, respectively, of interest and penalties through the income tax provision in the Consolidated Statements of Income. As of December 31, 2018 and 2017, accrued interest and penalties associated with UTBs were $469 million and $332 million, respectively.

The reconciliations between the federal statutory tax rate applied to income before income taxes and our effective tax rate were as follows:



	Years ended December 31,
	2018		2017		2016
Federal statutory tax rate	21.0	%	35.0	%	35.0	%
2017 Tax Act, net repatriation tax	—	%	70.7	%	—	%
Foreign earnings	(4.3	)%	(15.8	)%	(15.5	)%
2017 Tax Act, net deferred tax remeasurement	—	%	(6.9	)%	—	%
Credits, Puerto Rico Excise Tax	(2.5	)%	(2.2	)%	(2.3	)%
2017 Tax Act, net impact on intercompany sales	(1.8	)%	—	%	—	%
Interest on uncertain tax positions	1.2	%	0.6	%	0.5	%
Credits, primarily federal R&D	(0.8	)%	(0.6	)%	(0.7	)%
Share-based payments	(0.2	)%	(0.7	)%	(1.3	)%
Other, net	(0.5	)%	(0.7	)%	—	%
Effective tax rate	12.1	%	79.4	%	15.7	%

The effective tax rate for the year ended December 31, 2018 differs from the federal statutory rate due primarily to impacts of the jurisdictional mix of income and expenses. The effective tax rate for 2017 differs from the federal statutory rate primarily as a result of the 2017 Tax Act. The effective tax rate for 2016 differs from the federal statutory rate primarily as a result of indefinitely invested earnings of our foreign operations. Substantially all of the benefit to our effective tax rate from foreign earnings results from the Company’s operations conducted in Puerto Rico, a territory of the United States that is treated as a foreign jurisdiction for U.S. tax purposes and is subject to tax incentive grants through 2035; these earnings are also subject to U.S. tax at a reduced 10.5% rate.

The U.S. territory of Puerto Rico imposes an excise tax on the gross intercompany purchase price of goods and services from our manufacturer in Puerto Rico. The rate of 4% is effective through December 31, 2027. We account for the excise tax as a manufacturing cost that is capitalized in inventory and expensed in cost of sales when the related products are sold. For U.S. income tax purposes, the excise tax results in foreign tax credits that are generally recognized in our provision for income taxes when the excise tax is incurred.

Income taxes paid during the years ended December 31, 2018, 2017 and 2016, were $1.9 billion, $1.5 billion and $1.1 billion, respectively.

One or more of our legal entities file income tax returns in the U.S. federal jurisdiction, various U.S. state jurisdictions and certain foreign jurisdictions. Our income tax returns are routinely examined by the tax authorities in those jurisdictions. Significant disputes may arise with authorities involving issues of the timing and amount of deductions, the use of tax credits and allocations of income and expenses among various tax jurisdictions because of differing interpretations of tax laws, regulations and the interpretation of the relevant facts. As previously disclosed, we received a Revenue Agent Report (RAR) from the Internal Revenue Service (IRS) for the years 2010, 2011 and 2012. The RAR proposes to make significant adjustments that relate primarily to the allocation of profits between certain of our entities in the United States and the U.S. territory of Puerto Rico. In November 2017, we received a modified RAR that revised the IRS’s calculation but continued to propose substantial adjustments. We disagree with the proposed adjustments and are pursuing resolution with the IRS administrative appeals office, which currently has jurisdiction over the matter. If we deem necessary, we will vigorously contest the proposed adjustments through the judicial process. Final resolution of this complex matter is not likely within the next 12 months and could have a material impact on our consolidated financial statements. We believe our accrual for income tax liabilities is appropriate based on past experience, interpretations of tax law, and judgments about potential actions by tax authorities; however, due to the complexity of the provision for income taxes, the ultimate resolution of any tax matters may result in payments greater or less than amounts accrued. We are no longer subject to U.S. federal income tax examinations for years ended on or before December 31, 2009. In addition, we are currently under examination by a number of other state and foreign tax jurisdictions.