OSI SYSTEMS INC

9. INCOME TAXES

The following is a geographical breakdown of income before the provision for income taxes (in thousands):

	2015			2016			2017
Pre-tax income (loss):
United States	$	(16,428	)	$	(34,732	)	$	(39,686	)
Foreign		105,281			70,227			65,437

Total pre-tax income	$	88,853		$	35,495		$	25,751

Our provision (benefit) for income taxes consists of the following (in thousands):

	2015			2016			2017
Current:
Federal	$	2,502		$	(488	)	$	788
State		1,276			108			493
Foreign		25,880			22,942			27,616

Total current provision		29,658			22,562			28,897
Deferred:
Federal	$	(7,910	)	$	(11,865	)	$	(16,314	)
State		(1,180	)		473			(484	)
Foreign		3,134			(1,832	)		(7,424	)

Total deferred benefit		(5,956	)		(13,224	)		(24,222	)

Total provision	$	23,702		$	9,338		$	4,675

As of June 30, 2016 and 2017, our liability for uncertain tax positions was $4.9 million and $6.0 million, respectively. The $6.0 million represents the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate.

We recognize potential interest and penalties related to income tax matters in income tax expense. As of June 30, 2017, we had accrued $0.8 million for interest and penalties. Our uncertain tax positions are related to tax years that remain subject to examination by the relevant tax authorities. These include fiscal years after 2012 for federal purposes, fiscal years after 2011 for state purposes and fiscal years after 2006 for various foreign jurisdictions. Facts and circumstances could arise that could cause us to reduce the liability for unrecognized tax benefits, including, but not limited to, settlement of income tax positions or expiration of statutes of limitation. Since the ultimate resolution of uncertain tax positions depends on many factors and assumptions, we are not able to estimate the range of potential changes in the liability for unrecognized tax benefits or the timing of such changes.

A summary of activity of unrecognized tax benefits for fiscal 2015, 2016 and 2017 is as follows (in thousands).

Balance as July 1, 2015	$	11,049
Additions on tax positions for the current year		350
Additions on tax positions from prior years		533
Reduction in tax position from prior year		(2,178	)

Balance at June 30, 2016	$	9,754
Additions on tax positions for the current year		594
Additions on tax positions from prior years		1,445
Reduction in tax position from prior year		(598	)

Balance at June 30, 2017	$	11,195

We do not provide for U.S. income taxes on the undistributed earnings of our foreign subsidiaries as it is our intention to utilize those earnings in the foreign operations for an indefinite period of time. At June 30, 2017, undistributed earnings of the foreign subsidiaries amounted to approximately $628 million. The amount of unrecognized deferred tax liability related to these temporary differences is estimated to be approximately $220 million. The amount of tax payable could be significantly impacted by the source location and amount of the distribution, the underlying tax rate already paid on the earnings, foreign withholding taxes and the opportunity to use foreign tax credits.

Deferred income tax assets (liabilities) consisted of the following (in thousands):

	June 30,
	2016			2017
Deferred income tax assets:
Tax credit carryforwards	$	16,003		$	19,005
Net operating loss carryforwards		17,468			34,318
Customer advances		14,284			4,028
Allowance for doubtful accounts		3,757			5,839
Inventory reserve		10,700			15,933
Inventory capitalization		4,637			7,348
Accrued liabilities		5,912			11,511
Stock & deferred compensation		20,699			24,211
Other assets		3,641			3,001

Total deferred income tax assets		97,101			125,194
Valuation allowance		(14,458	)		(19,997	)

Net deferred income tax assets		82,643			105,197

Deferred income tax liabilities:
Depreciation		(41,415	)		(21,228	)
State income taxes		(1,629	)		(655	)
Amortization of intangible assets		(21,408	)		(48,966	)
Convertible Debt		—			(17,019	)
Prepaid expenses		(3,813	)		(2,983	)
Other liabilities		(63	)		(130	)

Total deferred income tax liabilities		(68,328	)		(90,981	)

Net deferred tax asset	$	14,315		$	14,216

The components of the net deferred income tax asset are classified in the consolidated balance sheets as follows (in thousands):

	2016			2017
Long term deferred income tax asset, included in other assets		43,475			34,897
Long term deferred income tax liability		(29,160	)		(20,681	)

Net deferred income tax asset	$	14,315		$	14,216

The components of current taxes receivable and payable and prepaid taxes are classified in the consolidated balance sheets as follows (in thousands):

	2016			2017
Current taxes receivable and prepaid taxes, included in prepaid expenses and other current assets	$	12,495		$	12,100
Current taxes payable		(8,032	)		(6,454	)

Net tax receivable		4,463			5,646

As of June 30, 2017, we had federal, state, and foreign net operating loss carryforwards of approximately $81.4 million, $61.4 million and $21.5 million, respectively. As of June 30, 2017, we had federal and state research and development tax credit carryforwards of approximately $10.6 million and $5.4 million, respectively. As of June 30, 2017, we had foreign tax credit carryforwards of $7.8 million. Our credit carryforwards will begin to expire in the tax year ending June 30, 2019.

We have established valuation allowances that relate to the net operating loss of certain subsidiaries and R&D credits. During the year ended June 30, 2017, we recorded a net aggregated increase of $5.5 million to these valuation allowances. We review the adequacy of individual valuation allowances and release such allowances when it is determined that it is more likely than not that the related benefits will be realized.

In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, which simplifies the accounting for income taxes, among other changes, related to stock-based compensation. We adopted this ASU effective April 1, 2017. We recognized all excess tax benefits and tax deficiencies as income tax expense or benefit in the current year. An income tax benefit of approximately $2.4 million was recognized in fiscal 2017 as a result of the adoption of ASU 2016-09. In addition, we recognized $3.8 million of deferred tax assets and, accordingly, increased retained earnings by this same amount.

The consolidated effective income tax rate differs from the federal statutory income tax rate due primarily to the following:

	June 30,
	2015			2016			2017
Provision for income taxes at federal statutory rate		35.0	%		35.0	%		35.0	%
UK Patent Box benefit		(2.1	)		—			—
Research and development tax credits		(0.9	)		(1.8	)		(2.5	)
Foreign income subject to tax at other than federal statutory rate		(9.4	)		(8.9	)		(20.0	)
Stock compensations excess tax benefit		—			—			(9.5	)
Change in valuation allowance		(1.1	)		5.8			10.4
Unrecognized tax benefit		4.1			(5.0	)		(1.4	)
Meals and entertainment		0.4			0.9			1.8
Tax on foreign currency gains and losses		—			2.3			9.1
Transaction costs		—			2.3			1.5
State tax expense		(0.6	)		(0.3	)		(1.5	)
U.S. tax on foreign earnings		4.9			4.5			0.4
Fringe benefits		0.5			0.9			1.5
Non-taxable gain from sale of business		—			—			(3.6	)
Non-taxable earnings from acquisitions		(2.3	)		(7.9	)		(1.8	)
Mexico imputed income or expense		(0.7	)		(0.4	)		(2.0	)
Other		(1.1	)		(1.1	)		0.7

Effective income tax rate		26.7	%		26.3	%		18.1	%

The provision for income taxes consists of provisions for federal, state, and foreign income taxes. We operate in an international environment with significant operations in various locations outside the U.S. Accordingly, the consolidated income tax rate is a composite rate reflecting the earnings in the various locations and the applicable rates.