15. Income Taxes

Effective Income Tax Rate

We recorded income tax expense of $1.1 million, or 38.6% of income before income tax expense, for the three month period ended July 31, 2011, compared to income tax expense of $531,000, or 12.4% of income before income tax expense, for the three month period ended August 1, 2010. Our effective income tax rates for the three month periods ended July 31, 2011 and August 1, 2010 were based upon the estimated effective income tax rate applicable for the full year after giving effect to any significant items related specifically to interim periods. The effective income tax rate can be affected over the fiscal year by the mix and timing of actual earnings from our U.S. operations and foreign sources versus annual projections and changes in foreign currencies in relation to the U.S. dollar.

The income tax expense for the three month period ended July 31, 2011 is different from the amount obtained by applying our statutory rate of 34% to income before income taxes for the following reasons:

●	The income tax rate increased 11% for an increase in unrecognized tax benefits.

●	The income tax rate was reduced by 7% for taxable income subject to lower statutory income tax rates in foreign jurisdictions (Canada and China) compared with the statutory income tax rate of 34% for the United States.

●	The income tax rate was increased by 0.6% for stock-based compensation and other miscellaneous items.

The income tax expense for the three month period ended August 1, 2010 is different from the amount obtained by applying our statutory rate of 34% to income before income taxes for the following reasons:

●	The income tax rate was reduced by 18% for a reduction in the valuation allowance recorded against substantially all of our net deferred tax assets. This reduction in the valuation allowance was primarily due to U.S. taxable income that we expected in fiscal 2011.

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The income tax rate was reduced by 7% for adjustments made to our Canadian deferred tax liabilities and associated with our election to file our Canadian income tax returns in U.S. dollars commencing with our fiscal 2011 tax year. Our Canadian income tax returns were filed in Canadian dollars for fiscal years prior to fiscal 2011. This adjustment totaled $315,000 and represented a discrete event in which the full tax effects were recorded in the first quarter of fiscal 2011.

●	The income tax rate was reduced by 6% for taxable income subject to lower statutory income tax rates in foreign jurisdictions (Canada and China) compared with the statutory income tax rate of 34% for the United States.

●	The income tax rate increased 9% for an increase in unrecognized tax benefits.

●	The income tax rate was increased by 0.4% for stock-based compensation and other miscellaneous items.

Deferred Income Taxes

Summary

In accordance with ASC Topic 740, we evaluate our deferred income taxes to determine if a valuation allowance is required. ASC Topic 740 requires that companies assess whether a valuation allowance should be established based on the consideration of all available evidence using a “more likely than not” standard, with significant weight being given to evidence that can be objectively verified. Since the company operates in multiple jurisdictions, we assess the need for a valuation allowance on a jurisdiction-by-jurisdiction basis, taking into account the effects of local tax law. Based on our assessments at July 31, 2011 and May 1, 2011, we recorded a partial valuation allowance of $16.4 million against our net deferred tax assets associated with our U.S. operations. No valuation allowance has been recorded against our net deferred tax assets associated with our operations located in China, Canada, and Europe.

United States

Our net deferred tax asset regarding our U.S. operations primarily pertains to incurring significant U.S. pre-tax losses over prior fiscal years, with U.S. loss carryforwards totaling $60.0 million at May 1, 2011. Due to the favorable results of our multi-year restructuring process in our upholstery fabric operations and key acquisitions and capital investments made for our mattress fabric segment, on a cumulative three-year basis ending May 1, 2011 (the end of our fiscal 2011), our U.S. operations earned a pre-tax income of $4.2 million. In addition, our U.S. operations reported a pre-tax income over fiscal years 2011 and 2010 totaling $8.2 million. We believe that fiscal years 2011 and 2010 are a more indicative measure of future pre-tax income as these fiscal years reflect operating performance after the cost savings of recent profit-improvement and restructuring plans were realized, as well as the full operational effects of the acquisitions associated with the company’s mattress fabric operations located in the U.S. This improvement continued in the first quarter of fiscal 2012, as our U.S. operations earned a cumulative pretax income over the first quarter of fiscal 2012 and fiscal years 2011 and 2010 totaling $8.9 million. Although our U.S. operations have reported pre-tax income on a cumulative three-year basis, the significant uncertainty in current and expected demand for furniture and mattresses, and the prevailing uncertainty in the overall economic climate, have made it very difficult to forecast medium and long-term financial results associated with our U.S. operations. Based on the current economic conditions, we believe it is too uncertain to project pre-tax income associated with our U.S. operations after fiscal 2012. Based on this significant positive and negative evidence, we maintained our position as of May 1, 2011, and recorded a partial valuation allowance of $16.4 million at July 31, 2011, against the net deferred tax assets associated with our U.S. operations that are expected to reverse beyond fiscal 2012.

Overall

The recorded valuation allowance of $16.4 million has no effect on our operations, loan covenant compliance, or the possible realization of the U.S. income tax loss carryforwards in the future. If it is determined that it is more-likely-than-not that we will realize any of these U.S. income tax loss carryforwards, an income tax benefit would be recognized at that time.

At July 31, 2011, the current deferred tax asset of $1.2 million represents $927,000 and $310,000 from our operations located in the U.S. and China, respectively. At May 1, 2011, the current deferred tax asset of $293,000 pertains to our operations located in China. At July 31, 2011 and May 1, 2011, the current deferred tax liability of $82,000 pertains to our operations located in Canada. At July 31, 2011, the non-current deferred tax asset of $2.2 million represents $1.2 million and $1.0 million from our operations located in China and the U.S., respectively. At May 1, 2011, the non-current deferred tax asset of $3.6 million represents $2.3 million and $1.3 million from our operations located in the U.S. and China, respectively. At July 31, 2011 and May 1, 2011, the non-current deferred tax liability of $596,000 pertains to our operations located in Canada.

Uncertainty In Income Taxes

At July 31, 2011, we had $12.1 million of total gross unrecognized tax benefits, of which $4.2 million represents the amount of gross unrecognized tax benefits that, if recognized would favorably affect the income tax rate in future periods. Of the $12.1 million in gross unrecognized tax benefits as of July 31, 2011, $7.9 million were classified as net non-current deferred income taxes and $4.2 million were classified as income taxes payable –long-term in the accompanying consolidated balance sheets.

We estimate that the amount of gross unrecognized tax benefits will increase by approximately $1.4 million for fiscal 2012. This increase primarily relates to double taxation under applicable tax treaties with foreign tax jurisdictions.