Income Taxes
For the year ended December 31, 2017, the income tax provision of $30.1 million was based on book income from operations before income taxes of $44.1 million. For the year ended December 31, 2016, the income tax provision of $12.2 million was based on book income from operations before income taxes of $41.4 million. For the year ended December 31, 2015, the income tax provision of $28.8 million was based on a book income from operations before income taxes of $43.1 million. Deferred tax assets and liabilities are determined based on the difference between financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse.
On December 22, 2017, the federal government passed the federal Tax Cuts and Jobs Act (the "Tax Act"). The Tax Act made broad and complex changes to the U.S. tax code including but not limited to reducing the federal statutory tax rate from 35% to 21%, effective January 1, 2018. Accounting Standards Codification ("ASC") 740, "Income Taxes" ("ASC 740"), requires companies to recognize the effect of tax law changes in the period of enactment. During the quarter ended December 31, 2017, we adjusted the statutory federal and state income tax rates to our deferred tax assets and liabilities. As a result of the statutory rate decrease, we had a reduction in our net deferred tax asset balance of $8.8 million. We recorded $8.7 million of the $8.8 million reduction in our net deferred tax asset balance to our provision for income taxes in our consolidated statement of income and $0.1 million to our consolidated statements of comprehensive income.
The income tax provision consists of the following (in thousands):
|
| | | | | | | | | | | |
| For the Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Current taxes: | | | | | |
Federal | $ | (209 | ) | | $ | 34 |
| | $ | (26,111 | ) |
State and local | (230 | ) | | (170 | ) | | (6,021 | ) |
Foreign | (1,070 | ) | | (856 | ) | | (200 | ) |
Deferred taxes, net | |
| | |
| | |
|
Federal | (26,693 | ) | | (8,858 | ) | | 2,673 |
|
State and local | (2,099 | ) | | (2,478 | ) | | 627 |
|
Foreign | 226 |
| | 150 |
| | 207 |
|
Income tax provision | $ | (30,075 | ) | | $ | (12,178 | ) | | $ | (28,825 | ) |
The income tax provision is different from that which would be obtained by applying the statutory federal income tax rate of 35% to income from continuing operations before income taxes as a result of the following (in thousands):
|
| | | | | | | | | | | |
| For the Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Income tax provision at statutory federal tax rate | $ | (15,446 | ) | | $ | (14,490 | ) | | $ | (15,079 | ) |
State and local income taxes, net of the federal benefit | (1,514 | ) | | (1,720 | ) | | (3,506 | ) |
Non-deductible expenses | (26,196 | ) | | (20,715 | ) | | (13,673 | ) |
Change in tax rates | 374 |
| | 216 |
| | 117 |
|
Recognition of excess tax benefit | 18,415 |
| | 20,966 |
| | — |
|
Research credit, federal benefit | 4,688 |
| | 3,727 |
| | 3,239 |
|
Enactment of Tax Cuts and Jobs Act | (9,750 | ) | | — |
| | — |
|
Other, net | (646 | ) | | (162 | ) | | 77 |
|
Income tax provision | $ | (30,075 | ) | | $ | (12,178 | ) | | $ | (28,825 | ) |
Deferred tax assets and liabilities reflect the net effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. One of the significant provisions of the Tax Act, passed December 22, 2017, is the reduction of the federal corporate tax rate to 21% effective January 1, 2018. In accordance with ASC 740, a company must remeasure its deferred tax assets and liabilities to reflect the enacted rates as of that date. The balances of the deferred tax assets and liabilities were remeasured and an $8.8 million reduction to deferred tax assets was recorded in this period. Significant components of our deferred tax assets and liabilities at December 31, 2017 and 2016 were as follows (in thousands):
|
| | | | | | | |
| As of December 31, |
| 2017 | | 2016 |
Deferred tax assets: | | | |
Net operating losses | $ | 34,771 |
| | $ | 60,026 |
|
Tax credit carryforwards | 1,807 |
| | 911 |
|
Research credit | 27,559 |
| | 22,768 |
|
Deferred revenue | 497 |
| | 918 |
|
Accruals not currently deductible | 1,137 |
| | 1,012 |
|
Allowance for doubtful accounts | 238 |
| | 338 |
|
Charitable contributions | 1,729 |
| | 1,777 |
|
Stock-based compensation | 9,851 |
| | 20,261 |
|
Deferred rent adjustment | 2,128 |
| | 3,081 |
|
Deferred tax assets | $ | 79,717 |
| | $ | 111,092 |
|
Deferred tax liabilities: | | |
|
Property and equipment | $ | (47,022 | ) | | $ | (49,745 | ) |
Foreign, primarily acquired intangible assets | (250 | ) | | (519 | ) |
Gross deferred tax liabilities | (47,272 | ) | | (50,264 | ) |
Net deferred tax assets | $ | 32,445 |
| | $ | 60,828 |
|
Ultimate considers all available evidence, both positive and negative, including historical levels of pre-tax book income, expiration of net operating loss carryforwards, expectations and risks associated with estimates of future taxable income, ongoing prudent and feasible tax planning strategies and reversal of deferred tax liabilities in assessing the need for the valuation allowance. If it is not more likely than not that we will recover our deferred tax assets, we will increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable.
The available positive evidence at December 31, 2017 included, among other factors, three years of cumulative historical pre-tax book income and a projection of future pre-tax book income and taxable income. As a result of our analysis of all available evidence, both positive and negative, we believe that it is more likely than not that the results of future operations will generate sufficient taxable income to realize all of the deferred tax assets as of December 31, 2017. As such, there was no valuation allowance for the years ended December 31, 2017 and 2016.
During the fourth quarter of 2017, as part of the evaluation of net deferred tax assets for implementing the Tax Act, immaterial errors were discovered in the reporting of the GAAP deferred income tax expense and related deferred tax assets, associated with the stock-based compensation expense for certain of our named executive officers for prior periods through September 30, 2017. Since the amount of the error in any prior period was not material, we have retrospectively revised our financial statements to reflect this immaterial correction for these prior periods. See Note 17 in our Notes to Consolidated Financial Statements for further discussion.
One of the provisions of the Tax Act was to transition to a territorial tax system, and to enable this, required a one-time deemed repatriation of post-1986 earnings and profits of certain foreign corporations, and would subject those amounts to reduced federal tax rates depending on whether the earnings and profits relate to cash and cash equivalents or other assets. The effective preferential rates on repatriated earnings are 15.5% for cash and cash equivalents and 8% for other amounts. The bill would require this income inclusion in our tax year ending December 31, 2017 but would allow offset of the deemed repatriated earnings and profits with net operating losses and foreign tax credits. We have more than sufficient foreign tax credits to offset our estimate of the deemed earnings and any transition tax liability. The foreign tax credits rather than the net operating losses would be used, as we are invoking Internal Revenue Code 965(n), which is an election to not use the net operating losses.
For the current and subsequent tax years, we will continue to assert the position of indefinite re-investment of earnings in Canada and Singapore. We will apply the exception to the comprehensive recognition of deferred income taxes to the undistributed earnings of our foreign subsidiaries, the Ultimate Software Group of Canada, Inc. and the Ultimate Software Group of Asia, PTE. LTD. The indefinite reinvestment criteria applicable includes state taxes and withholding taxes that arise from repatriation under IRC Section 965(n).
We recorded deferred tax assets as a result of research and development credit studies of $4.4 million and $4.0 million during the years ended December 31, 2017 and 2016, respectively.
At December 31, 2017, we had approximately $135.0 million of net operating loss carryforwards for federal income tax reporting purposes available to offset future taxable income. Prior to January 1, 2016, the tax benefit of net operating loss carryforwards attributable to deductions from the exercise of non-qualified employee, and non-employee director, stock options and the vesting of restricted stock units and restricted stock awards, were credited to paid-in-capital and deferred tax asset only to the extent realized through a reduction of income taxes payable. As a result, prior to January 1, 2016, the excess tax benefits associated with stock-based compensation were included in net operating loss carryforwards but not reflected in deferred tax assets. Upon adoption of ASU 2016-09, the excess tax benefits associated with stock based compensation were reflected in deferred tax assets. These excess tax benefits combined with the associated financial statement expense (previously included in the stock-based compensation line of this footnote) are currently reflected in the net operating loss line. During 2015, we realized a tax benefit of $42.0 million comprised of a $31.9 million and a $10.1 million credit to paid-in-capital and deferred tax asset, respectively. The carryforwards expire from 2018 through 2034 and from 2017 through 2034, for Federal and state income tax reporting purposes, respectively.
In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-09, "Improvements to Employee Share-Based Payment Accounting" ("ASU 2016-09"). The standard amended the accounting for share-based payments to employees effective for annual periods beginning after December 15, 2016, with early adoption permitted. The standard required transition for specific objectives of the standard. Amendments related to the timing of when excess tax benefits are recognized, minimum statutory withholding requirements, forfeitures, and intrinsic value should be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. We elected to early adopt ASU 2016-09 in the third quarter of fiscal year 2016 which required us to reflect any adjustments as of January 1, 2016. The primary impact of adoption was the recognition of excess tax benefits in our provision for income taxes rather than paid-in capital for all periods in fiscal year 2016. ASU 2016-09 requires entities to recognize all income tax effects of stock-based compensation in the income statement when the restricted stock units and awards vest and when the stock options are exercised. Prior to the adoption of ASU 2016-09, companies could not recognize excess tax benefits (the amount by which the tax deduction exceeds the financial statement expense previously recorded) when a restricted stock unit or award vested or an option was exercised if the related tax deduction increased a net operating loss carryforward rather than a reduction in income taxes payable. Consequently, the excess tax benefits were credited to paid-in-capital and a deferred tax asset only to the extent realized through a reduction of income taxes payable when realized, which resulted in the excess tax benefits being included in Ultimate’s net operating loss carryforwards, while being excluded from deferred tax assets on the consolidated balance sheet. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. Adoption of the new standard resulted in a $39.7 million cumulative-effect adjustment as of January 1, 2016 to record a deferred tax asset with the offset to retained earnings in the consolidated balance sheet representing the amount of our net operating loss carryforward attributable to excess tax benefits. We recognized $23.7 million of excess tax benefits in our provision for income taxes for the twelve months ended December 31, 2016.
Utilization of such net operating loss carryforwards, as well as tax credit carryforwards, may be limited as a result of cumulative ownership changes in Ultimate’s equity instruments due to ownership change provisions of Internal Revenue Code Section 382 and similar state provisions. The Internal Revenue Service examination of our U.S. federal income tax return for the year ended December 31, 2010 was completed in 2013 with no change to the taxable income or income tax liability as reported.
ASC 740, “Income Taxes,” ("ASC 740") requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not (i.e., a likelihood of more than fifty percent) that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. During 2013, the Internal Revenue Service completed their examination of our U.S. Federal income tax return for the year ended December 31, 2010, which resulted in the recognition of previously unrecognized tax benefits of approximately $1.9 million, which decreased our provision for income taxes and our effective tax rate. As of December 31, 2017, we had $5.0 million of gross unrecognized tax benefits resulting from a research and development credit attributable to the 1998-2014 years as a result of the completion of the research and development activities study that if recognized would affect the annual effective tax rate. During 2015 we increased the unrecognized tax benefits by $0.1 million related to the completion of the research credit study for 2014 and increased the unrecognized tax benefits by $0.9 million related to the research credit study estimate for 2015, totaling $6.0 million at December 31, 2015. During 2016, we increased the unrecognized tax benefits by $0.2 million related to the completion of the research credit study for 2015 and increased the unrecognized tax benefits by $1.1 million related to the research credit study estimate for 2016, totaling $7.2 million at December 31, 2016. During 2017, we increased the unrecognized tax benefits by $0.2 million related to the completion of the research credit study for 2016 and increased the unrecognized tax benefits by $1.5 million related to the research credit study estimate for 2017, totaling $8.9 million at December 31, 2017. While it is often difficult to predict the final outcome of any particular uncertain tax position, management does not believe that it is reasonably possible that the estimates of unrecognized tax benefits will change significantly in the next twelve months.
Tax years 1998 to 2017 remain subject to future examination by the tax jurisdictions in which we are subject to tax.
We recognize interest and penalties accrued related to unrecognized tax benefits as components of our income tax provision. Due to our net operating loss carryover position, we did not have any interest and penalties accrued upon the adoption of ASC 740, and, as of December 31, 2017 and 2016, we did not have any interest and penalties accrued related to unrecognized tax benefits.
A reconciliation of the beginning and ending amount of unrecognized tax benefits for the years ended December 31, 2017, 2016 and 2015 is as follows (in thousands):
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| | | | | | | | | | | |
| As of December 31, |
| 2017 | | 2016 | | 2015 |
Balance at January 1, | $ | 7,241 |
| | $ | 5,957 |
| | $ | 4,950 |
|
Tax positions taken in prior period | |
| | |
| | |
|
Gross increases | 187 |
| | 205 |
| | 133 |
|
Gross decreases | — |
| | — |
| | — |
|
Tax positions taken in current period | |
| | |
| | |
|
Gross increases | 1,474 |
| | 1,079 |
| | 874 |
|
Settlements | — |
| | — |
| | — |
|
Statute expiration | — |
| | — |
| | — |
|
Balance at December 31, | $ | 8,902 |
| | $ | 7,241 |
| | $ | 5,957 |
|