PDL BIOPHARMA, INC.

17. Income Taxes

For financial reporting purposes, income before income taxes includes the following components:



	Years Ended December 31,
(in thousands)	2017			2016		2015
United States	$	195,865		$	103,656	$	530,138
Foreign	(11,338		)	5,714		—
Total	$	184,527		$	109,370	$	530,138

The provision for income taxes for the years ended December 31, 2017, 2016 and 2015 consisted of the following:



	Year Ended December 31,
(in thousands)	2017			2016			2015
Current income tax expense
Federal	$	31,338		$	49,582		$	168,164
State	2,843			3,103			12,112
Foreign	529			2,455			—
Total current	34,710			55,140			180,276
Deferred income tax expense (benefit)
Federal	36,911			(8,476		)	16,910
State	2,591			147			157
Foreign	(386		)	(1,100		)	—
Total deferred	39,116			(9,429		)	17,067
Total provision	$	73,826		$	45,711		$	197,343

A reconciliation of the income tax provision computed using the U.S. statutory federal income tax rate compared to the income tax provision for income included in the Consolidated Statements of Income is as follows:



	Year Ended December 31,
(in thousands)	2017			2016			2015
Tax at U.S. statutory rate on income before income taxes	$	64,589		$	38,279		$	185,548
Change in valuation allowance	1,807			(744		)	2,286
State taxes	1,496			74			1
Change in uncertain tax positions	681			2,184			8,717
Foreign income	3,231			5,668			—
Foreign rate differential	1,356			(1,445		)	—
Change in tax rate reform	716			—			—
Other	(50		)	1,695			791
Total	$	73,826		$	45,711		$	197,343

Deferred tax assets and liabilities are determined based on the differences between financial reporting and income tax bases of assets and liabilities, as well as net operating loss carryforwards and are measured using the enacted tax rates and laws in effect when the differences are expected to reverse. The significant components of the Company’s net deferred tax assets and liabilities are as follows:



	December 31,
(in thousands)	2017			2016
Deferred tax assets:
Net operating loss carryforwards	$	6,276		$	4,197
Research and other tax credits	1,414			1,833
Intangible assets	1,453			494
Stock-based compensation	547			835
Accruals	4,667			1,966
Capital loss carryforward	2,027			1,543
Other	5,878			13,020
Total deferred tax assets	22,262			23,888
Valuation allowance	(2,046		)	(1,543		)
Total deferred tax assets, net of valuation allowance	20,216			22,345
Deferred tax liabilities:
Deferred gain on repurchase of convertible notes	(117		)	(382		)
Debt modifications	(1,197		)	(122		)
Intangible assets	(16,932		)	(2,584		)
Other	(427		)	—
Unrealized gain on foreign currency hedge contracts and investments	(320		)	—
Total deferred tax liabilities	(18,993		)	(3,088		)
Net deferred tax assets	$	1,223		$	19,257

As of December 31, 2017 and 2016, the Company had federal net operating loss carryforwards of $117.3 million and $34.0 million, respectively. As of December 31, 2017 and 2016, the Company also had state net operating loss carryforwards of $299.9 million and $215.5 million, respectively. The federal net operating loss carryforwards will begin expiring in the year 2023 and the California net operating loss carryforwards will begin expiring by 2018, if not utilized. Other states net operating losses will begin expiring by 2023 if not utilized. As of December 31, 2017 and 2016, the Company had $19.3 million and $19.3 million, respectively, of state tax credit carryforwards that do not expire.

Utilization of the federal and state net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code of 1986. The annual limitation may result in the expiration of net operating losses and credits before utilization. The Company has an annual limitation on the utilization of our federal operating losses of $1.8 million for each of the years ending December 31, 2017 to 2022, and $1.3 million for the year ending December 31, 2023. As of December 31, 2017, the Company estimates that at least $22.0 million of federal net operating loss carryforwards and zero of the $18.7 million state net operating losses will expire unutilized. Furthermore, under the 2017 Tax Act, although the treatment of tax losses generated in taxable years ending before December 31, 2017 has not changed, tax losses generated in taxable years beginning after December 31, 2017 may only be utilized to offset 80% of taxable income annually. This change may require the Company to pay additional federal income taxes in future years.

During 2017, the Company determined that is was more likely than not that certain deferred tax carryforward assets would not be realized in the near future. As a result, $2.0 million valuation allowance against deferred tax assets was established as of December 31, 2017. The net change in total valuation allowance for each of the years ending December 31, 2017 and 2016, was an increase of $0.5 million and $0.7 million, respectively. The valuation allowance at December 31, 2017, is related to capital losses that have limited carryback and carryforward utilization. The Company does not have an expectation of future capital gains against which such losses could be utilized and as such determined that it was more likely than not that such deferred tax assets would not be realized.

As a result of the 2017 Tax Act, the Company recorded income tax benefit of $0.4 million due to the re-measurement of its net deferred tax assets at a U.S. federal statutory rate that was reduced from a top rate of 35% to a flat rate of 21%. Based on information available, the Company estimated the cumulative undistributed foreign earnings to be immaterial. For the GILTI provisions of the 2017 Tax Act, a provisional estimate could not be made as the Company has not yet completed its assessment or elected an accounting policy to either recognize deferred taxes for basis differences expected to reverse as GILTI or to record GILTI as period costs if and when incurred. In accordance with SEC guidance, provisional amounts may be refined as a result of additional guidance from, and interpretations by, U.S. regulatory and standard-setting bodies, and changes in assumptions. In the subsequent period, provisional amounts will be adjusted for the effects, if any, of interpretative guidance issued after December 31, 2017, by the U.S. Department of the Treasury. The effects of the 2017 Tax Act may be subject to changes for items that were previously reported as provisional amounts, as well as any element of the 2017 Tax Act that a provisional estimate could not be made, such as for executive compensation, GILTI and BEAT impact.

A reconciliation of the Company’s unrecognized tax benefits, excluding accrued interest and penalties, for 2017, 2016 and 2015 is as follows:



	December 31,
(in thousands)	2017		2016		2015
Balance at the beginning of the year	$	59,429	$	57,125	$	47,146
Increases related to tax positions from prior fiscal years	783		436		—
Increases related to tax positions taken during current fiscal year	18,967		1,868		9,979
Expiration of statute of limitations for the assessment of taxes from prior fiscal years	—		—		—
Balance at the end of the year	$	79,179	$	59,429	$	57,125

The future impact of the unrecognized tax benefit of $79.2 million, if recognized, is as follows: $23.7 million would affect the effective tax rate and $55.5 million would result in adjustments to deferred tax assets. The Company periodically evaluates its exposures associated with our tax filing positions. As noted below, the Company is currently under audit by the California Franchise Tax Board. The timing of the audit resolution and the amount to be ultimately paid (if any) is uncertain. The outcome of these audits could result in the payment of tax amounts that differ from the amounts the Company has reserved for uncertain tax positions for the periods under audit resulting in incremental expense or a reversal of our reserves in a future period. The outcome of these audits could result in the payment of tax amounts that differ from the amounts we have reserved for uncertain tax positions for the periods under audit resulting in incremental expense or a reversal of the Company’s reserves in a future period. At this time, the Company does not anticipate a material change in the unrecognized tax benefits related to the California audit that would affect the effective tax rate or deferred tax assets over the next 12 months.

Estimated interest and penalties associated with unrecognized tax benefits increased income tax expense in the Consolidated Statements of Income by $1.0 million, $1.0 million and $2.3 million during the years ended December 31, 2017, 2016 and 2015, respectively. In general, our income tax returns are subject to examination by U.S. federal, state and local tax authorities for tax years 1996 forward. Interest and penalties associated with unrecognized tax benefits accrued on the balance sheet were $7.0 million and $6.0 million as of December 31, 2017 and 2016, respectively. In May 2012, the Company received a “no-change” letter from the IRS upon completion of an examination of the Company’s 2008 federal tax return. The Company is currently under income tax examination in the state of California for the tax years 2009 through 2015.