13. Income Taxes

Effective Income Tax Rate

We recorded income tax expense of $1.8 million, or 34.4% of income before income tax expense, for the three month period ended July 29, 2012, compared to 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. Our effective income tax rates for the three month periods ended July 29, 2012 and July 31, 2011 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 29, 2012 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 5% for an increase in unrecognized tax benefits.

The income tax rate was reduced by 5% 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 0.4% for stock-based compensation and other miscellaneous items.

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.

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 29, 2012 and April 29, 2012, we recorded a partial valuation allowance of $12.8 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 Poland.

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 $59.9 million at April 29, 2012. Due to the favorable results of our multi-year restructuring process and profit improvements made in our upholstery fabric operations and key acquisitions and capital investments made for our mattress fabric segment, on a cumulative three-year basis ending April 29, 2012 (the end of our fiscal 2012), our U.S. operations earned a pre-tax income of $11.9 million. This trend continued into the first quarter of fiscal 2013, as our U.S. operations earned a pretax income of $1.2 million.

Although our U.S. operations have reported pre-tax income on a cumulative three-year basis and financial results continue to improve, the significant uncertainty in the overall economic climate has also continued. As a result, to forecast medium and long-term financial results has remained difficult. Since it will take a significant period of time for our U.S. operations to realize its U.S. net deferred income tax assets based on earned and forecasted U.S. pre-tax income levels, we believe it is too uncertain to project U.S. pre-tax income levels associated with our U.S. operations after fiscal 2014 that support a “more likely than not” assertion at the end of our first quarter of fiscal 2013.

Based on this significant positive and negative evidence, we maintained our position as of April 29, 2012, and recorded a partial valuation allowance of $12.8 million at July 29, 2012, against the net deferred tax assets associated with our U.S. operations that are expected to reverse beyond fiscal 2014.

Overall

The recorded valuation allowance of $12.8 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 29, 2012, the current deferred tax asset of $2.3 million represents $1.9 million and $387,000 from our operations located in the U.S. and China, respectively. At April 29, 2012, the current deferred tax asset of $2.5 million represents $2.1 million and $405,000 from our operations located in the U.S. and China, respectively. At July 29, 2012, the non-current deferred tax asset of $2.7 million represents $1.6 million, $929,000, and $169,000 from our operations located in the U.S., China, and Poland, respectively. At April 29, 2012, the non-current deferred tax asset of $3.2 million represents $2.1 million, $1.0 million, and $115,000 from our operations located in the U.S., China, and Poland, respectively. At July 29, 2012 and April 29, 2012, the non-current deferred tax liability of $705,000 pertains to our operations located in Canada.

Uncertainty In Income Taxes

At July 29, 2012, we had $12.6 million of total gross unrecognized tax benefits, of which $4.1 million represents the amount of gross unrecognized tax benefits that, if recognized would favorably affect the income tax rate in future periods. Of the $12.6 million in gross unrecognized tax benefits as of July 29, 2012, $8.5 million were classified as net non-current deferred income taxes and $4.1 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 $819,000 for fiscal 2013. This increase primarily relates to double taxation under applicable tax treaties with foreign tax jurisdictions.