Gap (GPS)

Note 9. Income Taxes

The Company conducts business globally and, as a result, files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. In the normal course of business we are subject to examination by taxing authorities throughout the world, including such major jurisdictions as Canada, France, Hong Kong, Japan, the United Kingdom, and the United States. With few exceptions, we are no longer subject to U.S. federal, state, local, or non-U.S. income tax examinations for fiscal years before 1998.

It is reasonably possible that the Company will recognize a decrease in unrecognized tax benefits within the next 12 months of up to $14 million as a result of filing amended returns and the closing of open tax years. However, we do not expect the change to have a material impact on the Condensed Consolidated Statements of Earnings.

During the thirteen weeks ended May 3, 2008, we recognized a reversal of $15 million of interest expense from the reduction of interest expense accruals resulting primarily from foreign tax audit events occurring in the period.

Income Taxes

We currently expect the fiscal 2009 effective tax rate to be about 39 percent. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Income Taxes

The increase in the effective tax rate in fiscal 2008 from fiscal 2007 was primarily driven by the impact of changes in 2007 in state tax laws and a change in the mix of earnings, with a higher relative percentage of fiscal 2008 earnings occurring in jurisdictions that impose the highest relative tax rates.

The decrease in the effective tax rate in fiscal 2007 from fiscal 2006 was primarily driven by the impact of changes in state tax laws.

We currently expect the fiscal 2009 effective tax rate to be about 39 percent. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Loss from Discontinued Operation, Net of Income Tax Benefit

Loss from discontinued operation relates to the Forth & Towne brand, whose stores were closed by the end of June 2007. Loss from the discontinued operation of Forth & Towne, net of income tax benefit, was $34 million and $31 million for fiscal 2007 and fiscal 2006, respectively.

Income Taxes

We record a valuation allowance against our deferred tax assets arising from certain net operating losses when it is more likely than not that some portion or all of such net operating losses will not be realized. In determining the need for a valuation allowance, management is required to make assumptions and to apply judgment, including forecasting future earnings, taxable income, and the mix of earnings in the jurisdictions in which we operate. Our effective tax rate in a given financial statement period may also be materially impacted by changes in the mix and level of earnings, changes in the expected outcome of audits or changes in the deferred tax valuation allowance.

At any point in time, many tax years are subject to or in the process of audit by various taxing authorities. To the extent that our estimates of settlements change or the final tax outcome of these matters is different from the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions, in accordance with FIN 48. Determining the income tax expense for these potential assessments requires management to make assumptions that are subject to factors such as proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolution of tax audits.

Income Taxes

Income taxes are accounted for in accordance with SFAS 109, “Accounting for Income Taxes.” Deferred income taxes are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated Financial Statements. A valuation allowance is established against deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions in accordance with FIN 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB No. 109.” At any point in time, many tax years are subject to or in the process of audit by various taxing authorities. To the extent that our estimates of settlements change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made.

On February 4, 2007, the Company adopted FIN 48 which 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 issues. The cumulative effects of applying this interpretation have been recorded as a decrease of $4 million to opening retained earnings, an increase of $85 million to short-term and long-term income tax assets and an increase of $89 million to short-term and long-term income tax liabilities as of February 4, 2007. The Company recognizes

46      GAP INC. FORM 10-K

Table of Contents

interest related to unrecognized tax benefits in interest expense and penalties related to unrecognized tax benefits in operating expenses in the Consolidated Statements of Earnings.

Income Taxes

Income taxes
are accounted for in accordance with SFAS 109, “Accounting for Income Taxes.” Deferred income taxes are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated
Financial Statements. A valuation allowance is established against deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Income Taxes

The decrease in the effective tax rate for the thirteen weeks ended November 1, 2008 over the prior year comparable period was primarily driven by favorable adjustments resulting from tax audit resolutions and the closing of an open tax year within the quarter.

We currently expect the fiscal 2008 effective tax rate to be about 39 percent, although the respective quarterly effective tax rates may vary. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Loss from Discontinued Operation, Net of Income Tax Benefit

Loss from discontinued operation relates to the Forth & Towne brand, whose stores were closed by the end of June 2007. Loss from the discontinued operation of Forth & Towne, net of income tax benefit, was $1 million and $34 million for the thirteen and thirty-nine weeks ended November 3, 2007, respectively.

Income Taxes

The increase in the effective tax rate for the second quarter and first half of fiscal 2008 over the prior year comparable periods was primarily driven by the absence of certain favorable adjustments recognized in the first half of fiscal 2007, including adjustments pertaining to a change in state tax legislation and the impact of our determination with respect to utilization of a portion of undistributed earnings from Canadian subsidiaries.

We currently expect the fiscal 2008 effective tax rate to be about 39 percent, although the respective quarterly effective tax rates may vary. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Discontinued Operation

Loss from discontinued operation relates to the Forth & Towne brand, whose stores were closed by the end of June 2007. Loss from the discontinued operation of Forth & Towne, net of income tax benefit, was $6 million and $32 million for the second quarter of fiscal 2007 and first half of fiscal 2007, respectively. Loss from the discontinued operation on a pre-tax basis for the second quarter of fiscal 2007 included $5 million of net sublease losses and $2 million of other lease-related charges. Loss from the discontinued operation on a pre-tax basis for the first half of fiscal 2007 included $29 million related to the impairment of long-lived assets, $5 million of net sublease losses, $4 million of employee severance, $3 million of administrative and other costs, and $2 million of other-lease related charges.

17

Table of Contents

Income Taxes

The increase in the effective tax rate for the first quarter of fiscal 2008 over the prior year comparable period was primarily driven by the absence of certain favorable adjustments recognized in the first quarter of fiscal 2007, including adjustments pertaining to a change in state tax legislation and the impact of our determination with respect to utilization of a portion of undistributed earnings from Canadian subsidiaries.

We currently expect the fiscal 2008 effective tax rate to be about 39 percent, although the respective quarterly effective tax rates may vary. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Discontinued Operation

Loss from discontinued operation relates to the Forth & Towne brand, whose stores were closed by the end of June 2007. Loss from the discontinued operation of Forth & Towne, net of income tax benefit was $27 million for the first quarter of fiscal 2007. Loss from the discontinued operation on a pre-tax basis for the first quarter of fiscal 2007 included $29 million related to the impairment of long-lived assets, $4 million of employee severance, and $3 million of administrative and other costs.

Income Taxes

Income taxes are accounted for using the asset and liability method in accordance with SFAS 109, “Accounting for Income Taxes.” Under this method, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated Financial Statements. A valuation allowance is established against deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

We record reserves for estimates of settlements of foreign and domestic tax audits. At any point in time, many tax years are subject to or in the process of audit by various taxing authorities. To the extent that our estimates of settlements change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made.

On February 4, 2007, the Company adopted FIN 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 issues. The cumulative effects of applying this interpretation have been recorded as a decrease of $4 million to opening retained earnings, an increase of $85 million to short-term and long-term income tax assets and an increase of $89 million to short-term and long-term income tax liabilities as of February 4, 2007. At the beginning of fiscal year 2007, the Company had approximately $135 million of total gross unrecognized tax benefits. Of this total, $50 million (net of the federal benefit on state issues) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. Also, as of the adoption date, the Company had accrued interest expense related to the unrecognized tax benefits of $27 million. The Company recognizes interest related to unrecognized tax benefits in interest expense.

Income Taxes

Income taxes are accounted for using the asset and
liability method in accordance with SFAS 109, “Accounting for Income Taxes.” Under this method, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the
Consolidated Financial Statements. A valuation allowance is established against deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Income Taxes

On February 4, 2007, we adopted FIN 48. 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 issues. To the extent that our estimates change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. We also record a valuation allowance against our deferred tax assets arising from certain net operating losses when it is more likely than not that some portion or all of such net operating losses will not be realized. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings, changes in the expected outcome of audits or changes in the deferred tax valuation allowance.

Income Taxes

On February 4, 2007, we adopted FIN 48. 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 issues. To the extent that our estimates change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. We also record a valuation allowance against our deferred tax assets arising from certain net operating losses when it is more likely than not that some portion or all of such net operating losses will not be realized. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings, changes in the expected outcome of audits or changes in the deferred tax valuation allowance.

Income Taxes

On February 4, 2007, we adopted FIN 48. 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,

18

Table of Contents

classification, interest and penalties, accounting in interim periods, disclosure and transition issues. To the extent that our estimates change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. We also record a valuation allowance against our deferred tax assets arising from certain net operating losses when it is more likely than not that some portion or all of such net operating losses will not be realized. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings, changes in the expected outcome of audits or changes in the deferred tax valuation allowance.

Income Taxes

Income taxes are accounted for using the asset and liability method in accordance with SFAS 109, “Accounting for Income Taxes.” Under this method, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated Financial Statements. A valuation allowance is established against deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

We record reserves for estimates of probable settlements of foreign and domestic tax audits. At any point in time, many tax years are subject to or in the process of audit by various taxing authorities. To the extent that our estimates of probable settlements change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made.

Income Taxes

20

Table of Contents

The decrease in the effective tax rate during the third quarter of fiscal 2006 compared to the third quarter of fiscal 2005 primarily reflects an adjustment related to a favorable tax treaty resolution that was originally recorded in January of fiscal 2005.

We currently expect the fiscal 2006 effective tax rate to be about 39 percent, although the respective quarterly effective tax rates may vary. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Income Taxes

20

Table of Contents

The decrease in the effective tax rate during the second quarter of fiscal 2006 compared to the second quarter of fiscal 2005 primarily reflects the reassessment of foreign tax exposures and the effect of a favorable audit settlement.

We currently expect the fiscal 2006 effective tax rate to be about 39 percent, although the respective quarterly effective tax rates may vary. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Income Taxes

The increase in the effective tax rate for the thirteen weeks ended April 29, 2006, as compared to the thirteen weeks ended April 30, 2005, is primarily due to two factors. The first is the effect of the difference in financial statement and tax treatment of compensation expense relating to the Employee Stock Purchase Plan pursuant to SFAS 123(R), which the company adopted in the first quarter of fiscal 2006. The second results from the effects of certain adjustments made during the first quarter of fiscal 2005 resulting from the favorable resolution of several state audits (net of the effect on federal income tax) and the reassessment of other tax exposures. Similar adjustments did not occur in the first quarter of fiscal 2006.

18

Table of Contents

We currently expect the fiscal 2006 effective tax rate to be about 39 percent, although the respective quarterly effective tax rates may vary. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Income Taxes

We record reserves for estimates of probable settlements of foreign and domestic tax audits. At any point in time, many tax years are subject to or in the process of audit by various taxing authorities. To the extent that our estimates of probable settlements change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. We also record a valuation allowance against our deferred tax assets arising from certain net operating losses when it is more likely than not that some portion or all of such net operating losses will not be realized. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings, changes in the expected outcome of audits or changes in the deferred tax valuation allowance.

Income Taxes

Income taxes are accounted for using the asset and liability method in accordance with SFAS 109 “Accounting for Income Taxes.” Under this method, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated Financial Statements. A valuation allowance is established against deferred tax assets when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

F-13

We record reserves for estimates of probable settlements of foreign and domestic tax audits. At any point in time, many tax years are subject to or in the process of audit by various taxing authorities. To the extent that our estimates of probable settlements change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made.

Income Taxes

The increase in the effective tax rate for the thirteen weeks ended October 29, 2005, as compared to the same period ended October 30, 2004, is primarily due to an adjustment during the quarter of the valuation allowance with respect to state net operating losses. This adjustment was due to the anticipated impact of the enactment by the State of Ohio of Am. Sub. H.B. No. 66, which included a comprehensive restructuring of Ohio’s tax regime.

The decrease in the effective rate for the thirty-nine weeks ended October 29, 2005, as compared to the same period ended October 30, 2004, is primarily due to the favorable resolution of several state tax audits (net of the effect on federal income tax) and reassessment of other tax exposures.

We currently expect the fiscal 2005 effective tax rate to be in a range of 38.0 percent to 39.0 percent, although the respective quarterly effective tax rates could be outside of this range. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

20

Table of Contents

Income Taxes

The decrease in the effective tax rate during the second quarter of fiscal 2005 compared to the second quarter of fiscal 2004 primarily reflects the favorable resolution of several state audits (net of the effect on federal income tax) and reassessment of other tax exposures.

We currently expect the fiscal 2005 effective tax rate to be in a range of 38.0 percent to 39.0 percent, although the respective quarterly effective tax rates could be outside of this range. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

Income Taxes

The decrease in the effective tax rate during the first quarter of fiscal 2005 compared to the first quarter of fiscal 2004 primarily reflects the favorable resolution of several state audits (net of the effect on federal income tax) and reassessment of other tax exposures.

We currently expect the fiscal 2005 effective tax rate to be in a range of 38.0 percent to 39.0 percent, although the respective quarterly effective tax rates could be outside of this range. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

19

Table of Contents