SecProbe.io

CORRESP
1
filename1.htm

corresp

Ms. Nili Shah

Branch Chief

Securities and Exchange Commission

Washington, D.C. 20549-0510

August 3, 2005

    Re:

    Johnson Controls, Inc.

    Comment letter dated July 29, 2005

    Commission File No. 1-5097

Dear Ms. Shah:

In response to the comment letter dated July 29, 2005 relating to Form 10-Q for the period ended
March 31, 2005 the following is our response. Based on discussions with the Commission, we
understand and agree with comment (2) and will make the suggested disclosures. We have provided an
example of the revised disclosure which will be included in our Third Quarter Form 10-Q and our
amended Form 10-K to address this comment. Regarding comment (1), please find our discussion
below.

    1.

    The Commission’s comment was as follows:

    It does not appear that the $11.5 million and $69 million tax benefits recognized in the
12/31/04 and 3/31/05 quarters, respectively, are changes in tax status as contemplated by
paragraphs 28 and 112 of SFAS 109. Instead, it appears that these benefits have arisen from
tax planning strategies and not from changes in tax laws or tax rates. If this understanding
is not correct then please clarify the issue in a letter of supplemental information.
Otherwise, the description of these tax benefits should be clarified in your filings.

    Tax planning strategies are specifically addressed in paragraphs 22 and 23 of SFAS 109 as a
factor to consider when determining the amount of deferred tax asset valuation allowances
required. It appears that you may use German and French NOL’s as ordinary tax deductions for
US income tax purposes. Therefore, it is not clear why a full valuation allowance is recorded
against these tax assets at 3/31/05. In this regard, we note the consistent history of
substantial taxable income and the Registrant’s positive forecasts of future sales and
earnings. Please clarify this issue in a letter of supplemental information. This apparent
inconsistency should be clarified in the critical accounting policy section of your filings.

We supplementally provide the following background information on the Company’s “check-the-box”
elections and the related authoritative guidance supporting the Company’s accounting treatment.

Ms. Nili Shah

August 3, 2005

Page 2 of 6

Background

The US parent owns via a German holding company, Erste JCI Holding GmbH (Erste), a group of German
subsidiaries. Several of these German subsidiaries were acquired in previous years through third
party share purchase transactions in which purchase price premiums were paid. The capital loss tax
benefit recorded in the second quarter of fiscal 2005 relates to the decrease in value of the
original tax basis of these investments from the time of the respective acquisitions to March 31,
2005 – the date of the “check-the-box” tax election. The election generated a capital loss at the
level of the US parent company. This loss can be used to offset US capital gains. It should be
noted that this election in no way changes the tax attributes of the historic operating losses of
the related German operating subsidiaries for which full valuation allowances have been provided
against the NOL tax assets given the uncertainty as to their future utilization in Germany.

As a matter of further clarification, for US federal income tax purposes, tax basis is generally
equal to the purchase price plus subsequent monies invested, subject to certain adjustments. For
US federal income tax purposes, the fair market value of an asset is determined as of a specific
point in time, which in this case is March 31, 2005 – the date of the “check-the-box” election. As
of that date, the German holding company was deemed liquidated for US tax purposes, and, pursuant
to the deemed liquidation tax rules, the US parent of Erste was required to determine the fair
value of the German holding company. The US parent engaged an independent third party appraiser to
determine fair value and that fair value was used by the Company in determining the capital loss
(fair value less tax basis) from this deemed liquidation as of March 31, 2005.

It should also be noted that the German holding company and its subsidiaries remain in legal
existence and continue business operations as they had before the “check-the-box” tax election.
Nothing has changed from a business or operational standpoint as a result of filing the above
mentioned tax election other than the fact that the election produced a deemed liquidation of Erste
for US federal income tax purposes and the resultant capital loss which is claimable by the
shareholder, a US corporation.

As discussed in our prior response to the Staff dated July 18, 2005, the French subsidiary
“check-the-box” election in the first quarter of fiscal 2005 resulted in similar income tax
accounting and financial reporting considerations.

Finally, for income tax purposes, it is important to note that a company may freely decide those
companies for which it chooses to file a “check-the-box” election. It is not required that the
taxpayer make the election for all companies within a certain business group or jurisdiction and
the tax implications of such an election are limited specifically to the elected entities. It is
important to note that the “check-the-box” election does not affect the tax attributes of any of
the underlying subsidiary entities.

Ms. Nili Shah

August 3, 2005

Page 3 of 6

Authoritative Guidance

The “check-the-box” election changes the tax status of Erste and the respective French entity from
controlled foreign corporations (i.e., taxable entities) to branches (i.e., flow through entities
similar to a partnership) for US federal income tax purposes. The Company does not believe that
the “check-the-box” election is a tax planning strategy as outlined in paragraph 246 of SFAS No.
109. In accordance with the provisions of paragraph 28 of SFAS No. 109, the US capital loss tax
benefits are appropriately accounted for as being the result of a change in tax status and thereby
reported as discrete period items in the Company’s first and second quarter of fiscal 2005 in the
amounts of $11.5 million and $69.0 million, respectively.

Paragraph 112 of SFAS No. 109 states that “a change in tax law or rate or change in tax
status is an event that has economic consequences for an enterprise in the year that change
occurs, that is, in the year that a change in tax law or rate is enacted or a change in tax
status is approved.” The tax status of the respective German and French entities have changed
as a result of the “check-the-box” elections and, as such, paragraph 28 of SFAS No. 109 indicates
that “the effect of an election for a voluntary change in tax status is recognized on the approval
date or on the filing date if approval is not necessary.” As our elections did not require
approval, discrete period accounting recognition of the tax benefits resulting from these elections
is appropriate.

The tax benefits recognized as a result of these elections represent a portion of the excess tax
basis over book investment in the German and French entities, the asset for which was not
previously recorded in accordance with paragraph 34 of SFAS No. 109. However, as a result of the
deemed liquidations of these entities for US federal income tax purposes from the “check-the-box”
elections, discrete period tax benefits were appropriately recorded relating to the resulting
partial reversal of excess tax basis over book investment in these entities.

We will expand the description of the tax benefits in our Amended Form 10-Q’s for the first and
second quarters of fiscal 2005.

With respect to the Staff’s comment regarding the use of German and French NOLs as ordinary
deductions for US income tax purposes, we provide the following supplemental information:

Germany: As discussed above, the “check-the-box” election resulted in the generation of a
capital loss at the level of the US parent which could be used only to offset capital gains
generated by the US parent’s tax group. However, it is important to understand that the cumulative
German NOLs do not flow-through to the US as a result of this election. Therefore, since these
NOLs can only be used to offset future taxable income of the respective German subsidiaries, we
continue to believe that valuation allowances against these tax assets are required at March 31,
2005 in accordance with paragraphs 20-25 of SFAS No. 109.

Ms. Nili Shah

August 3, 2005

Page 4 of 6

France: As discussed in our prior response to the Staff dated July 18, 2005, the
“check-the-box” election for a French subsidiary resulted in an ordinary tax deduction at the level
of the US parent related to the decrease in value of the original tax basis. The Company has no
NOLs in France related to this entity.

Although the Company’s historical operating results and its future forecasts indicate substantial
taxable income on a consolidated basis, the Company’s tax accounting for the “check-the-box”
elections and tax NOLs require detailed analysis at the individual subsidiary level by
jurisdiction, thereby resulting in the need for valuation allowances for selected subsidiaries in
various countries. We will provide additional disclosure regarding this fact in our Critical
Accounting Policy section of Amended Form 10-K for fiscal 2004.

    2.

    The Commission’s comment was as follows:

    Please ensure that the revised disclosures specifically address the negative trend in
consolidated gross margin over the past 8 fiscal quarters. Disclose whether this trend is
expected to continue and the specific competitive and business factors that constrain
management’s ability to reverse this trend. Relevant factors could also include: the remaining
duration of material long term pricing agreements; the strategies being used to manage your
exposure to the rising raw material prices; and whether you are able to secure long-term raw
materials pricing arrangements to match your obligation under the long term pricing agreements
with your customers.

    It is our understanding that the decrease in gross margin you are experiencing is the result of
a decline in sales price and an increase in raw materials prices. Note that Item 303 (a) (3)
(ii) and (iii) of Regulation S-K requires you to disclose the extent to which sales variances
were impacted by price changes. This impact should be quantified in MD&A given your assertion
that the impact has been material. This is also necessary to a reader’s understanding of
whether the material decline in gross margin is primarily attributable to the price changes or
to the increases in raw materials costs.

By way of an example, we provide the proposed disclosures the Company will use to address the above
comment in its Third Quarter Form 10-Q in the Operating Income section of MD&A for the Seating and
Interiors-North America segment (similar disclosure will be provided for other reportable segments
in the amended 10-K and 10-Q’s, as appropriate) as well as the Consolidated Fiscal Year 2005
Operating Income Outlook from the amended Form 10-K.

Seating & Interiors – North America

Seating & Interiors – North America operating income was $276 million (excluding $12
million of restructuring costs), compared to the prior period operating income of
$434 million (excluding $5 million of restructuring costs). The decrease of $158
million was due to selling price reductions in excess of cost savings and the
deconsolidation of a joint venture, partially offset by lower SG&A.

Lower sales mix of mature vehicle programs and sales price reductions under long
term agreements with the Company’s customers exceeded cost reductions

Ms. Nili Shah

August 3, 2005

Page 5 of 6

and
operational efficiencies by $128 million in the period. The lower sales mix of
mature vehicle programs negatively impacted results as these sales typically deliver
more favorable margins due to operational efficiencies and cost reductions that are
implemented throughout the vehicle life cycle. In contrast, new vehicle programs
require significant engineering and start up costs thereby reducing margins at the
onset of the program. Annual price reduction renewal negotiations during the period
yielded terms consistent with prior agreements. It should be noted that price
reduction commitments are often made in the context of broader customer negotiations
on several factors, including volume.

The segment experienced commodity cost increases, primarily steel, of approximately
$97 million compared to the prior year. The Company continues to address the rising
commodity costs in the region through negotiations with both its customers and
suppliers. In order to address future increases, the Company intends to modify the
duration and terms of its direct material buy contracts. The Company expects these
commodity cost pressures on gross profit to continue in the fourth quarter of fiscal
2005, with increased pressure from Tier 2 and Tier 3 suppliers partially offset by
the Company’s direct purchase initiatives.

SG&A expenses decreased $67 million in the period primarily due to lower net
engineering expenses.

Fiscal 2005 Operating Income Outlook

In fiscal 2005, the Company anticipates that growth by both the Automotive Group (which
includes Seating & Interiors and the Battery Group) and the Controls Group, together with
improvements in operational quality and cost, will lead to a 10 to 12 percent increase in
operating income.

The Automotive Group operating margin percentage for fiscal 2005 is expected to increase
slightly compared to fiscal 2004. Management anticipates that the benefits of operational
efficiencies, restructuring, and lower launch costs will be partially offset by lower
pricing, higher commodity costs, and increased employee benefit costs. The Automotive
Group has supply agreements with certain of its customers that provide for annual price
reductions and, in some instances, for the recovery of material cost increases. The group
expects to continue its historical trend of being able to significantly offset any sales
price changes with cost reductions from design changes and productivity improvements and
through similar programs with its own suppliers.

The Controls Group operating margin percentage for fiscal 2005 is expected to decline
moderately compared to the fiscal 2004 level. This reflects competitive pricing in the new
construction market, a higher proportion of facility management sales with inherently lower
margins and rising employee benefit costs. These factors are expected to be partially
offset by strong technical services growth and improved operational efficiencies in North
America.

Ms. Nili Shah

August 3, 2005

Page 6 of 6

We have appreciated the opportunity to discuss the questions raised in your prior correspondence
and look forward to a resolution of these issues. If there are any further comments or questions,
please do not hesitate to contact me at (414) 524-3422.

    Very truly yours,

JOHNSON CONTROLS, INC.

    /s/ R. Bruce McDonald

    R. Bruce McDonald

    Vice President and
Chief Financial Officer