CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. INCOME TAXES

   The provision (benefit) for income taxes consists of the following:

   A reconciliation of the income tax provision at the U.S. federal income tax rate of 35 percent to the actual effective tax rate is as follows:

   Except for the U.K. group, we provide for the additional taxes that would be due upon the dividend distribution of the earnings of our foreign subsidiaries and joint ventures assuming the full utilization of foreign tax credits. The unremitted earnings of the U.K. group are considered to be permanently reinvested and the determination of the deferred tax liability, if any, that might be due should those earnings be distributed is not practicable. Earnings before income taxes include equity earnings of foreign joint ventures of $118 million, $78 million and $75 million for the years ended December 31, 2007, 2006, and 2005, respectively. These equity earnings are recorded net of foreign taxes. Additional U.S. income taxes of $18 million, $13 million and $7 million for the years ended December 31, 2007, 2006 and 2005, respectively, were provided for the additional U.S. taxes that will ultimately be due upon the distribution of the foreign joint venture equity earnings. The American Jobs Creation Act of 2004 (Jobs Act) included a special one-year 85-percent dividend deduction for qualifying dividends repatriated from foreign operations in 2005. The application of these rules to foreign joint venture dividend repatriations of $71 million reduced our 2005 income tax provision by $16 million (2.0 percent).

   The Jobs Act also repealed the U.S. export tax benefits beginning in 2007 and phased the benefits down to 80 percent of their value in 2005 and 60 percent in 2006. The export benefits are partially replaced with a new U.S. manufacturer’s tax deduction which phases in one-third in 2005-2006, two-thirds in 2007-2009 and 100 percent after 2009. The U.S. manufacturer’s tax benefits were $2 million, $3 million and $2 million for the years ended December 31, 2007, 2006, and 2005, respectively.

   Our 2006 income tax provision includes a $28 million (2.6 percent) reduction in the second quarter due to the favorable resolution of tax uncertainties related to prior years, and a $12 million (1.1 percent) increase in the first quarter for the effect of new Indiana tax legislation.

   Our 2005 income tax provision includes an $8 million (1.0 percent) reduction due to the favorable resolution in the fourth quarter of 2005 of prior year tax positions which had been in dispute.

   Carryforward tax benefits and the tax effect of temporary differences between financial and tax reporting that give rise to net deferred tax assets are as follows:

   A valuation allowance is recorded to reduce the gross deferred tax assets to an amount we believe is more likely than not to be realized. The valuation allowance decreased in 2007 by a net $2 million and in 2006 by a net $5 million. The valuation allowance is primarily attributable to the uncertainty regarding the realization of a portion of the U.S. state and foreign net operating loss and tax credit carryforward benefits.

   The deferred income tax balances are classified in the Consolidated Balance Sheets as follows:

   On January 1, 2007, we adopted FASB Interpretation (FIN) No. 48, ‘‘Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.’’ FIN 48 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition rules. The adoption of FIN 48 resulted in an increase to our beginning balance retained earnings of $0.8 million and did not have any impact on our results of operations. As of the adoption date, we had gross unrecognized tax benefits of $49 million. Of this total, $37 million, if recognized, would favorably affect the effective tax rate in future periods. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:

   Included in the December 31, 2007, balance is $35 million related to tax positions that, if recognized, would favorably affect the effective tax rate in future periods. Also, we had accrued interest expense related to the unrecognized tax benefits of $11 million as of December 31, 2007 ($9 million as of the January 1, 2007, adoption of FIN 48). We recognize potential accrued interest and penalties related to unrecognized tax benefits in income tax expense. During the year ending December 31, 2007, we recognized approximately $2 million in interest expense.

   As a result of our global operations, we file income tax returns in various jurisdictions including U.S. federal, U.S. state, and foreign jurisdictions. We are routinely subject to examination by taxing authorities throughout the world, including Australia, Belgium, Brazil, Canada, China, France, India, Mexico, the United Kingdom and the U.S. Our U.S. federal income tax returns have been examined through 2004. With few exceptions, major U.S. state and foreign jurisdictions are no longer subject to income tax examinations for years before 2002. Various U.S. state and foreign tax audits are currently underway; however, we do not expect any significant change to our unrecognized tax benefits within the next year.

The accompanying notes are an integral part of the Consolidated Financial Statements.