Income taxes

The provision for income taxes includes the following for the years ended December 31, 2012, 2011 and 2010 (in millions):



	2012			2011			2010
Current provision:
Federal	$	438		$	551		$	620
State	47			54			52
Foreign	158			148			153
Total current provision	643			753			825
Deferred provision (benefit):
Federal	83			(273		)	(180		)
State	(43		)	(12		)	43
Foreign	(19		)	(1		)	2
Total deferred provision (benefit)	21			(286		)	(135		)
Total provision	$	664		$	467		$	690

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.

In 2012, we reclassified the prepaid taxes associated with intercompany profit in ending inventory from current deferred income tax assets to current prepaid tax. This change resulted in a reclassification of approximately $71 million and $16 million for 2011 and 2010, respectively, from the deferred provision to the current provision.

Significant components of our deferred tax assets and liabilities are as follows as of December 31, 2012 and 2011 (in millions):



	2012			2011
Deferred income tax assets ⁽¹⁾:
Expense accruals	$	805		$	751
NOL and credit carryforwards	427			206
Expenses capitalized for tax	195			193
Stock-based compensation	115			241
Deferred revenue	40			133
Other	83			70
Total deferred income tax assets	1,665			1,594
Valuation allowance	(273		)	(126		)
Net deferred income tax assets	1,392			1,468

Deferred income tax liabilities:
Acquired intangibles	(1,249		)	(832		)
Fixed assets	(117		)	(219		)
Unremitted foreign earnings	(106		)	(61		)
Other	(145		)	(110		)
Total deferred income tax liabilities	(1,617		)	(1,222		)
Total deferred income taxes, net	$	(225	)	$	246

⁽¹⁾

In 2012, we reclassified certain prior period amounts to conform with current period reporting, primarily in connection with reclassifying prepaid taxes associated with intercompany profit in ending inventory from current deferred tax assets to prepaid taxes. Prepaid taxes are not included in the net deferred income tax table above; therefore, amounts related to these prepaid taxes which totaled $349 million for 2011 have been removed from the above table.

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 for deferred tax assets increased by $147 million and $46 million in 2012 and 2011, respectively, due primarily to valuation allowances established as part of acquisitions and the Company’s expectation that some state R&D credits will not be utilized, offset partially by the release of valuation allowance related to state investment credits.

At December 31, 2012, we had $242 million of tax credit carryforwards available to reduce future state income taxes and have provided a valuation allowance for $110 million of those state tax credit carryforwards. The majority of the state tax credit carryforwards have no expiry; the remainder expires between 2013 and 2019.

At December 31, 2012, we had $233 million of NOL carryforwards available to reduce future federal income taxes and have provided a valuation allowance for $75 million of those federal NOL carryforwards. The federal NOL carryforwards for which no valuation allowance has been provided expire between 2023 and 2032. We had $301 million of NOL carryforwards available to reduce future state income taxes and have provided a valuation allowance for $48 million of those state NOL carryforwards. The state NOLs for which no valuation allowance has been provided expire between 2014 and 2018. We had $383 million of NOL carryforwards available to reduce future foreign income taxes for which a full valuation allowance has been provided. The majority of the foreign NOLs have no expiry; the remainder of the foreign NOLs expire between 2017 and 2022.

The reconciliation of the total gross amounts of UTBs (excluding interest, penalties, foreign tax credits and the federal tax benefit of state taxes related to UTBs) for the years ended December 31, 2012, 2011 and 2010 is as follows (in millions):



	2012			2011			2010
Balance at beginning of year	$	975		$	920		$	1,140
Additions based on tax positions related to the current year	300			283			305
Reductions for tax positions of prior years	(45		)	(7		)	(110		)
Settlements	(30		)	(221		)	(415		)
Balance at end of year	$	1,200		$	975		$	920

Substantially all of the UTBs as of December 31, 2012, if recognized, would affect our effective tax rate.

During the year ended December 31, 2012, we settled examinations with various state and foreign tax authorities for prior tax years. As a result of these developments, we remeasured our UTBs accordingly.

During the year ended December 31, 2011, we settled our examination with the Internal Revenue Service (IRS) related to certain transfer pricing tax positions for the years ended December 31, 2007, 2008 and 2009. As a result of these developments, we remeasured our UTBs accordingly.

During the year ended December 31, 2010, we settled our examination with the IRS related to certain transfer pricing tax positions for the years ended December 31, 2007 and 2008. In addition, we also settled issues under appeal with the IRS for the years ended December 31, 2005 and 2006, primarily related to the impact of transfer pricing adjustments on the repatriation of funds. During the year ended December 31, 2010, the IRS also agreed to Competent Authority relief for certain transfer pricing tax positions for the years ended December 31, 2002, through December 31, 2006. As a result of these developments, we remeasured our UTBs accordingly.

As of December 31, 2012, we believe it is reasonably possible that our gross liabilities for UTBs may decrease by approximately $280 million within the succeeding twelve months due to the resolution of federal and state audits, including a decrease related to the IRS settlement described below.

Interest and penalties related to UTBs are included in our provision for income taxes. During 2012, 2011 and 2010, we accrued approximately $30 million, $23 million and $41 million, respectively, of interest and penalties through the income tax provision in the Consolidated Statements of Income. At December 31, 2012 and 2011, accrued interest and penalties associated with UTBs totaled approximately $102 million and $105 million, respectively.

The reconciliation between the federal statutory tax rate applied to income before income taxes and our effective tax rate for the years ended December 31, 2012, 2011 and 2010, is as follows:



	2012		2011		2010
Federal statutory tax rate	35.0	%	35.0	%	35.0	%
Foreign earnings, including earnings invested indefinitely	(17.8	)%	(19.4	)%	(19.1	)%
State taxes	0.6	%	0.7	%	1.6	%
Credits, Puerto Rico Excise Tax	(5.2	)%	(6.5	)%	0.0	%
Credits, primarily federal R&D	0.0	%	(1.5	)%	(0.9	)%
Legal settlements	(0.2	)%	2.2	%	0.0	%
Audit settlements (federal, state, foreign)	0.3	%	0.0	%	(3.1	)%
Other, net	0.6	%	0.8	%	(0.5	)%
Effective tax rate	13.3	%	11.3	%	13.0	%

Because the American Taxpayer Relief Act of 2012 was not enacted until 2013, certain provisions of the Act benefiting the Company's 2012 federal taxes, including the retroactive extension of the R&D tax credit for 2012, cannot be recognized in the Company's 2012 financial results and instead will be reflected in the Company's 2013 financial results for the first quarter. The tax benefit of the retroactive extension of the 2012 R&D tax credit that will be recognized in the first quarter of 2013 is approximately $65 million.

The effective tax rates for the years ended December 31, 2012, 2011 and 2010, are different from the federal statutory rates primarily as a result of indefinitely invested earnings of our foreign operations. We do not provide for U.S. income taxes on undistributed earnings of our foreign operations that are intended to be invested indefinitely outside the United States. Substantially all of the benefit from foreign earnings on our effective tax rate results from foreign income associated with the Company’s operation conducted in Puerto Rico that is subject to a tax incentive grant that expires in 2020. At December 31, 2012, the cumulative amount of these earnings was approximately $22.2 billion. If these earnings were repatriated to the United States, we would be required to accrue and pay approximately $7.9 billion of additional income taxes based on the current tax rates in effect.

Our total foreign income before income taxes was approximately $3.3 billion, $3.0 billion and $3.5 billion for the years ended December 31, 2012, 2011 and 2010, respectively.

Commencing January 1, 2011, Puerto Rico imposes a temporary excise tax on the purchase of goods and services from a related manufacturer in Puerto Rico. The excise tax is imposed on the gross intercompany purchase price of the goods and services and is effective for a six-year period beginning in 2011, with the excise tax rate declining in each year (4% in 2011, 3.75% in 2012, 2.75% in 2013, 2.5% in 2014, 2.25% in 2015 and 1% in 2016). In February 2013, the Puerto Rico government proposed an amendment to the excise tax legislation which, if approved, would increase the excise tax rate to 4% effective July 1, 2013 through 2017. 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, 2012, 2011 and 2010, totaled $502 million, $595 million and $1,344 million, 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 audited by the tax authorities in those jurisdictions. Significant disputes may arise with these tax authorities involving issues of the timing and amount of deductions, the use of tax credits and allocations of income among various tax jurisdictions because of differing interpretations of tax laws and regulations. We are no longer subject to U.S. federal income tax examinations for tax years ending on or before December 31, 2009, or to California state income tax examinations for tax years ending on or before December 31, 2005.

Subsequent to December 31, 2012, we settled the examination of our U.S. tax returns with the IRS relating to years ended December 31, 2007, 2008, and 2009. We will remeasure our UTBs and recognize the tax impact of this settlement in the first quarter of 2013. We expect the settlement to result in a tax benefit of approximately $185 million.