12. Income Taxes
Income Tax Expense
The earnings from continuing operations before income taxes and the components of income tax expense (benefit) for the years 2007, 2006 and 2005 were as follows:
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2005 | |||||||
| (In millions) | |||||||||
| Earnings from continuing operations before income taxes: U.S. |
$ | 2,642 | 2,435 | 3,254 | |||||
| Canada | 685 | 751 | 899 | ||||||
| International | 897 | 384 | 225 | ||||||
| Total | $ | 4,224 | 3,570 | 4,378 | |||||
| Current income tax expense: U.S. federal |
$ | 83 | 292 | 811 | |||||
| Various states | 16 | 7 | 26 | ||||||
| Canada and various provinces | 136 | 143 | 106 | ||||||
| International | 265 | 86 | 90 | ||||||
| Total current tax expense | 500 | 528 | 1,033 | ||||||
| Deferred income tax expense (benefit): U.S. federal |
745 | 456 | 271 | ||||||
| Various states | 28 | 77 | (18 | ) | |||||
| Canada and various provinces | (166 | ) | (105 | ) | 217 | ||||
| International | (29 | ) | (20 | ) | (22 | ) | |||
| Total deferred tax expense | 578 | 408 | 448 | ||||||
| Total income tax expense | $ | 1,078 | 936 | 1,481 | |||||
The taxes on the results of discontinued operations presented in the accompanying statements of operations were all related to international operations.
Total income tax expense differed from the amounts computed by applying the U.S. federal income tax rate to earnings from continuing operations before income taxes as a result of the following:
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2005 | |||||||
| (In millions) | |||||||||
| Expected income tax expense based on U.S. statutory tax rate of 35% | $ | 1,478 | 1,249 | 1,532 | |||||
| Effect of Canadian tax rate reductions | (261 | ) | (243 | ) | (14 | ) | |||
| State income taxes | 30 | 55 | 6 | ||||||
| Repatriation of earnings | — | — | 28 | ||||||
| Taxation on foreign operations | (165 | ) | (120 | ) | (50 | ) | |||
| Other | (4 | ) | (5 | ) | (21 | ) | |||
| Total income tax expense | $ | 1,078 | 936 | 1,481 | |||||
In 2007, 2006 and 2005, deferred income taxes were reduced $261 million, $243 million and $14 million, respectively, due to successive Canadian statutory rate reductions that were enacted in each such year.
In 2006, deferred income taxes increased $39 million due to the effect of a new income-based tax enacted by the state of Texas that replaced a previous franchise tax. The new tax was effective January 1, 2007. The $39 million increase is included in 2006 state income taxes in the above table.
In 2005, Devon recognized $28 million of taxes related to its repatriation of $545 million to the United States. The cash was repatriated to take advantage of U.S. tax legislation, which allowed qualifying companies to repatriate cash from foreign operations at a reduced income tax rate. Substantially all of the cash repatriated by Devon in 2005 related to prior earnings of its Canadian subsidiary.
Deferred Tax Assets and Liabilities
At December 31, 2007, Devon had the following net operating loss carryforwards, which are available to reduce future taxable income in the jurisdiction where the net operating loss was incurred. These carryforwards will result in a future tax reduction based upon the future tax rate applicable to the taxable income that is ultimately offset by the net operating loss carryforward. For financial purposes, the tax effects of these carryforwards, net of any valuation allowances, have been recognized as reductions to the net deferred tax liability at December 31, 2007.
| Jurisdiction | Years of Expiration | Carryforward Amounts | ||
|---|---|---|---|---|
| (In millions) | ||||
| Various U.S. states | 2008 — 2026 | $ | 494 | |
| Canada | 2010 — 2027 | $ | 15 | |
| Brazil | Indefinite | $ | 188 | |
The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and liabilities at December 31, 2007 and 2006 are presented below:
| December 31, | ||||||
|---|---|---|---|---|---|---|
| 2007 | 2006 | |||||
| (In millions) | ||||||
| Deferred tax assets: Net operating loss carryforwards |
$ | 92 | 57 | |||
| Fair value of financial instruments | 167 | 97 | ||||
| Asset retirement obligations | 387 | 265 | ||||
| Pension benefit obligations | 93 | 81 | ||||
| Insurance proceeds | 21 | 113 | ||||
| Other | 102 | 103 | ||||
| Total deferred tax assets | 862 | 716 | ||||
| Valuation allowance | (50 | ) | (22 | ) | ||
| Net deferred tax assets | 812 | 694 | ||||
| Deferred tax liabilities: Property and equipment, principally due to nontaxable business combinations, differences in depreciation, and the expensing of intangible drilling costs for tax purposes |
(6,152 | ) | (5,374 | ) | ||
| Chevron Corporation common stock | (431 | ) | (326 | ) | ||
| Long-term debt | (216 | ) | (148 | ) | ||
| Other | (11 | ) | (34 | ) | ||
| Total deferred tax liabilities | (6,810 | ) | (5,882 | ) | ||
| Net deferred tax liability | $ | (5,998 | ) | (5,188 | ) | |
As shown in the above table, Devon has recognized $812 million of deferred tax assets as of December 31, 2007, net of a $50 million valuation allowance. Included in total deferred tax assets is $92 million related to various carryforwards available to offset future income taxes. The carryforwards include state net operating loss carryforwards, which expire primarily between 2008 and 2026, Canadian net operating loss carryforwards, which expire primarily between 2010 and 2027, and Brazilian net operating loss carryforwards, which have no expiration. The tax benefits of carryforwards are recorded as an asset to the extent that management assesses the utilization of such carryforwards to be "more likely than not." When the future utilization of some portion of the carryforwards is determined not to be "more likely than not," a valuation allowance is provided to reduce the recorded tax benefits from such assets.
Devon expects the tax benefits from the state and Canadian net operating loss carryforwards to be utilized between 2008 and 2012. Such expectation is based upon current estimates of taxable income during this period, considering limitations on the annual utilization of these benefits as set forth by tax regulations. Significant changes in such estimates caused by variables such as future oil and gas prices or capital expenditures could alter the timing of the eventual utilization of such carryforwards. There can be no assurance that Devon will generate any specific level of continuing taxable earnings. However, management believes that Devon's future taxable income will more likely than not be sufficient to utilize substantially all its state and Canadian tax carryforwards prior to their expiration.
Included in deferred tax assets for net operating loss carryforwards as of December 31, 2007 and 2006 is $64 million and $36 million, respectively, related to the Brazil carryforward. Although this carryforward has no expiration, management is uncertain whether Devon's future taxable income will be sufficient to utilize a substantial portion of its Brazil carryforward. This uncertainty is based upon annual limitations on the amount of net operating loss carryforwards available to reduce taxable income, Devon's lack of historical taxable income in Brazil and the exploratory nature of several of Devon's current projects in Brazil. Therefore, as of December 31, 2007 and 2006, Devon had a valuation allowance of $50 million and $22 million, respectively, related to this carryforward.
Unrecognized Tax Benefits
The following table presents changes in Devon's unrecognized tax benefits for the year ended December 31, 2007 (in millions).
| Balance as of January 1, 2007 | $ | 122 | |
| Increases due to: Tax positions taken in current year |
4 | ||
| Tax positions taken in prior years | 10 | ||
| Accrual of interest related to tax positions taken | 3 | ||
| Decreases due to: Tax positions taken in prior years |
(5 | ) | |
| Lapse of statute of limitations | (20 | ) | |
| Settlements | (9 | ) | |
| Foreign currency translation adjustment | 6 | ||
| Balance as of December 31, 2007 | $ | 111 |
Devon's unrecognized tax benefit balance at January 1, 2007 included $114 million of unrecognized tax benefits before interest and penalties, and $8 million of interest and penalties. Included in Devon's unrecognized tax benefits of $111 million as of December 31, 2007 was $74 million that, if recognized, would affect Devon's effective income tax rate.
Included below is a summary of the tax years, by jurisdiction, that remain subject to examination by taxing authorities.
| Jurisdiction | Tax Years Open |
|---|---|
| U.S. federal | 2002-2007 |
| Various U.S. states | 2001-2007 |
| Canada federal | 2001-2007 |
| Various Canadian provinces | 2001-2007 |
| Various other foreign jurisdictions | 2003-2007 |
Certain statute of limitation expirations are scheduled to occur in the next twelve months. However, Devon is currently in the final stages of the administrative review process for certain open tax years. In addition, Devon is currently subject to various income tax audits that have not reached the administrative review process. As a result, Devon cannot reasonably anticipate the extent that the liabilities for unrecognized tax benefits will increase or decrease within the next twelve months.