Income tax provisions for interim quarterly periods are based on an estimated annual effective income tax rate calculated separately from the effect of significant, infrequent or unusual items related specifically to interim periods. Income tax expense for the three months ended June 30, 2018 was $33 million, an effective tax rate of 34.0%, compared to expense of $38 million, an effective tax rate of 40.4%, for the three months ended June 30, 2017. The decrease in income tax expense and the effective tax rate was primarily driven by the reduction in the corporate federal income tax rate resulting from the enactment of U.S. tax reform legislation in December 2017, which was more than offset by an increase in income tax expense of approximately $7 million resulting from the enactment of Kentucky tax reform legislation in April 2018.
Income tax expense for the nine months ended June 30, 2018 was $154 million, an effective tax rate of 56.0%, compared to expense of $114 million, an effective tax rate of 36.4%, for the nine months ended June 30, 2017. The increase in income tax expense and the effective tax rate was principally driven by the enactment of U.S. and Kentucky tax reform legislation, which resulted in a net increase in income tax expense of approximately $76 million that more than offset benefits related to the reduction in the estimated annual effective tax rate for fiscal 2018.
Tax reform legislation
On December 22, 2017, the President of the United States signed into law tax reform legislation (the “Act”), which generally became effective January 1, 2018. The Act includes a number of provisions, including lowering the federal corporate income tax rate from a maximum of 35% to 21% and changing or limiting certain tax deductions. While the Company expects this rate reduction will ultimately benefit Valvoline, the Act also includes provisions that are expected to offset some of the benefit of the rate reduction, including the repeal of the deduction for domestic production activities and the expansion of the limitation on the deduction of certain executive compensation. In addition, the Act alters the landscape of taxation of non-U.S. operations and provides immediate deductions for certain new investments, among other provisions.
Based on the effective date of the rate reduction in the Act, the Company’s federal corporate statutory income tax rate will be a blended rate of 24.5% for fiscal 2018, declining to 21% for fiscal 2019 and beyond.
During the nine months ended June 30, 2018, enactment of the Act resulted in the following provisional impacts on income tax expense:
The remeasurement of net deferred tax assets at the lower enacted corporate tax rate resulted in a net $66 million increase in income tax expense;
Income tax expense increased by $4 million related to the deemed repatriation tax on unremitted non-U.S. earnings and profits and $2 million for withholding taxes due to the Company’s change in indefinite reinvestment assertion regarding its undistributed earnings; and
The remeasurement of net indemnity liabilities associated with the Tax Matters Agreement increased pre-tax expense by $7 million and generated a $3 million tax benefit primarily related to the higher expected utilization of tax attributes payable to Ashland.
The impacts of the Act recorded during the nine months ended June 30, 2018 are provisional, and the Company will continue to assess the impact of the Act and will record adjustments through the income tax provision in the relevant period as amounts are known and reasonably estimable. Accordingly, the impact of the Act may differ from the Company’s provisional estimates due to and among other factors, information currently not available, changes in interpretations and the issuance of additional guidance, as well as changes in assumptions the Company has currently made, including actions the Company may take in future periods as a result of the Act.
Many states have enacted state specific tax reform and legislation in response to the Act. In general, these impacts are not material to the Company’s financial statements. Valvoline is incorporated in Kentucky, which enacted income tax reform on April 13, 2018. The provisions of Kentucky tax reform generally become effective in fiscal 2019 and include a number of provisions, notably lowering the corporate income tax rate from a maximum of 6% to 5%. While the Company expects this rate reduction will ultimately benefit Valvoline, during the three and nine months ended June 30, 2018, the enactment of Kentucky tax reform resulted in the following impacts on income tax expense:
The remeasurement of net deferred tax assets at the lower enacted Kentucky corporate tax rate resulted in a net $3 million increase in income tax expense; and
The remeasurement of the net indemnity liabilities associated with the Tax Matters Agreement increased pre-tax income by $4 million and generated $4 million of income tax expense primarily related to the lower expected utilization of tax attributes payable to Ashland.
The Company will continue to monitor enacted state legislation and make relevant updates to estimates when warranted.
Deferred tax remeasurement
The Company’s net deferred income taxes represent benefits that will be used to reduce corporate taxes expected to be paid as well as differences between the tax bases and carrying amounts of assets and liabilities that will result in taxable or deductible amounts in future years. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in years in which those temporary differences are expected to be recovered or settled. As changes in tax laws or rates occur, deferred tax assets and liabilities are adjusted in the period changes are enacted through income tax expense.
The Company’s net deferred tax assets of $281 million were determined at September 30, 2017 based on the then-current enacted income tax rates prior to the passage of the Act. As a result of the reduction in the federal corporate income tax rate from 35% to 21% under the Act and the reduction of the Kentucky corporate income tax rate from 6% to 5% under Kentucky tax reform, the Company revalued its net deferred tax assets, which resulted in a reduction in the value of net deferred tax assets of approximately $69 million that was recorded as additional income tax expense in the Company’s Condensed Consolidated Statements of Comprehensive Income for the nine months ended June 30, 2018 as noted above.
The Act implements a new territorial tax system that imposes a one-time transition tax, or deemed repatriation, on unremitted earnings of certain non-U.S. subsidiaries that is based in part on the amount of these earnings held in cash and other specified assets. The mandatory deemed repatriation resulted in a $23 million gross liability, but allows for the realization of $19 million of previously unrecognized foreign tax credits related to taxes previously paid in relevant local jurisdictions. The net result was $4 million of income tax expense which was recognized during the nine months ended June 30, 2018.
The Company has historically intended to indefinitely reinvest undistributed earnings of its non-U.S. subsidiaries. As undistributed earnings of the Company’s non-U.S. subsidiaries were subject to the one-time deemed repatriation tax, the Company reevaluated its intentions to indefinitely reinvest its non-U.S. undistributed earnings. As a result, the Company no longer intends to indefinitely reinvest non-U.S. undistributed earnings and accordingly, recorded $2 million for estimated incremental withholding taxes during the nine months ended June 30, 2018. The Company is presently not aware of any significant restrictions on the ability to transfer these funds, and additional taxes and other costs that may arise between the deemed and actual distribution dates are not estimated to be material.
Tax Matters Agreement
Total liabilities related to obligations owed to Ashland under the Tax Matters Agreement were $65 million and $62 million at June 30, 2018 and September 30, 2017, respectively. At June 30, 2018 and September 30, 2017, $3 million and $1 million was recorded in Accrued expenses and other liabilities, respectively, with the remainder recorded in Other noncurrent liabilities in the Condensed Consolidated Balance Sheets at each balance sheet date.
Under the Tax Matters Agreement, Valvoline has net indemnification obligations for a number of tax matters, including certain taxes that arise upon audit or examination related to the periods prior to the Distribution and Valvoline’s utilization of legacy tax attributes contributed as part of the separation from Ashland. During the three and nine months ended June 30, 2018, Valvoline recognized a $3 million benefit and $5 million of expense, respectively, in Legacy and separation-related expenses, net for the estimated adjustments in net amounts due and a $2 million benefit during the three and nine months ended June 30, 2017. During the nine months ended June 30, 2018, expense was recognized due to the increase in estimated net amounts due to Ashland principally as a result of the reduction of the federal tax rate and the reduced federal benefit of state tax deductions, which drove increases in the expected utilization of tax attributes. These impacts were partially offset by the benefit recognized in the three months ended June 30, 2018 for the decline in estimated net amounts due to Ashland primarily related to the rate reduction and associated decrease in certain state tax deductions as a result of Kentucky tax reform. In connection with these impacts recorded in Legacy and separation-related expenses, net, Valvoline recognized income tax expense of $4 million and $1 million during the three and nine months ended June 30, 2018, respectively, related to these changes.
Uncertainties in income taxes
The Company records reserves related to its uncertain tax positions when it is more likely than not that the tax position may not be sustained on examination by the taxing authorities. As of June 30, 2018, the Condensed Consolidated Balance Sheet includes an $11 million liability for uncertain income tax positions which is primarily recorded within the obligations owed to Ashland under the Tax Matters Agreement described above. During the nine months ended June 30, 2018, there were no significant changes in Valvoline’s uncertain tax positions or related reserves. As tax examinations are completed or settled, statutes of limitations expire, or other new information becomes available, the Company will adjust its liabilities for uncertain tax positions in the respective period through payment or through the income tax provision. The Company has provided adequate reserves for its income tax uncertainties in all open tax years based on the recognition and measurement considerations in the relevant accounting principles and any adjustments are not expected to have a material effect on its condensed consolidated financial statements at this time; however, it is reasonably possible that there could be changes to the Company’s reserves related to its uncertain tax positions due to activities of the taxing authorities, resolution of examination issues, or reassessment of existing uncertain tax positions.
Although the timing and nature of the resolution and/or closure of examinations cannot be predicted with certainty, management estimates that it is reasonably possible that reserves related to uncertain tax positions may decrease by as much as $3 million from the resolution of tax examinations in U.S. jurisdictions during the quarter ended September 30, 2018.