Note 14. Income Taxes
The Company recorded a deferred tax liability of $5.9 million and $10.9 million as of December 31, 2016 and 2015, respectively, related to the purchase of the AmiKet IPR&D. This deferred tax liability was recorded to account for the book vs. tax basis difference related to the IPR&D intangible asset, which was recorded in connection with the Merger. This deferred tax liability was excluded from sources of future taxable income, as the timing of its reversal cannot be predicted due to the indefinite life of this IPR&D. As such, this deferred tax liability cannot be used to offset the valuation allowance. During the year ended December 31, 2016, the AmiKet IPR&D was written down to $15.0 million resulting in a reduction of the deferred tax liability by $4.9 million (see Note 3).
Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company’s deferred tax assets relate primarily to its net operating loss carryforwards and other balance sheet basis differences. In accordance with ASC 740, “Income Taxes,” the Company recorded a valuation allowance to fully offset the gross deferred tax asset, because it is not more likely than not that the Company will realize future benefits associated with these deferred tax assets at December 31, 2016 and 2015.
At December 31 2016 and 2015, the Company had deferred tax assets of $31.1 million and $22.5 million, respectively, against which a full valuation allowance of $31.1 million and $22.5 million, respectively, had been recorded. The determination of this valuation allowance did not take into account the Company’s deferred tax liability for IPR&D assigned an indefinite life for book purposes, also known as a “naked credit” in the amount of $5.9 million and $10.9 million at December 31, 2016 and 2015, respectively. The change in the valuation allowance for the year ended December 31, 2016 was an increase of $8.6 million. The increase in the valuation allowance for the year ended December 31, 2016 was mainly attributable to an increase in net operating losses and accrued liabilities, which resulted in an increase in the deferred tax assets with a corresponding valuation allowance. Significant components of the Company’s deferred tax assets at December 31, 2016 and 2015 are as follows ($ in thousands):
| | | December 31, | |
| | | 2016 | | 2015 | |
| Deferred tax assets: | | | | | | | |
| Property, plant & equipment | | $ | 5 | | $ | 1 | |
| Accrued liabilities | | | 3,894 | | | 503 | |
| Other | | | 45 | | | 45 | |
| Net operating loss carryforwards – U.S. | | | 13,420 | | | 11,511 | |
| Net operating loss carryforwards – Israel | | | 6,766 | | | 5,757 | |
| Stock-based compensation | | | 5,435 | | | 4,659 | |
| Gross deferred tax assets | | | 29,564 | | | 22,476 | |
| Valuation allowance | | | (29,564) | | | (22,476) | |
| Gross deferred tax assets after valuation allowance | | | - | | | - | |
| Deferred tax liability – AmiKet IPR&D assets | | | (5,933) | | | (10,870) | |
| Net deferred tax liability | | $ | (5,933) | | $ | (10,870) | |
A reconciliation of the federal statutory tax rate and the effective tax rates for the years ended December 31, 2016 and 2015 is as follows:
| | | For the Year Ended | |
| | | December 31, | |
| | | 2016 | | | 2015 | |
| U.S. federal statutory tax rate | | | 34.0 | % | | | 34.0 | % |
| State income taxes, net of federal benefit | | | 4.9 | | | | 4.0 | |
| U.S. vs. foreign tax rate differential | | | (1.0) | | | | (2.4) | |
| Other | | | (2.1) | | | | (0.1) | |
| Change in valuation allowance | | | (22.9) | | | | (35.5) | |
| Effective tax rate | | | 12.9 | % | | | - | % |
The Company had approximately $95.0 million and $81.2 million of available gross net operating loss (“NOL”) carryforwards (federal, state and Israel) as of December 31, 2016 and 2015, respectively. Sections 382 and 383 of the Internal Revenue Code, and similar state regulations, contain provisions that may limit the NOL carryforwards available to be used to offset income in any given year upon the occurrence of certain events, including changes in the ownership interests of significant stockholders. In the event of a cumulative change in ownership in excess of 50% over a three-year period, the amount of the NOL carryforwards that the Company may utilize in any one year may be limited. The Company reduced its tax attributes (NOLs and tax credits) as a result of the Company’s ownership changes in 2007, 2009, 2013, 2015, and 2016 and the limitation placed on the utilization of its tax attributes, as a substantial portion of the NOLs and tax credits generated prior to the ownership changes will likely expire unused. The most significant reduction in tax attributes occurred in 2013 as a result of the Merger with Epicept. The Company does not have any material foreign earnings, due to a history of losses in its foreign subsidiary.
A reconciliation of the Company’s NOLs for the years ended December 31, 2016 and 2015 is as follows ($ in thousands):
| | | December 31, | |
| | | 2016 | | 2015 | |
| U.S. Federal NOLs | | $ | 33,953 | | $ | 29,100 | |
| U.S. State NOLs | | | 33,940 | | | 29,100 | |
| Israel NOLs | | | 27,066 | | | 23,000 | |
| Total NOLs | | $ | 94,959 | | $ | 81,200 | |
The Company’s federal and state NOLs of approximately $34.0 million each begin to expire from 2030 through 2033. The Company’s Israel NOL of $27.1 million does not expire.
The Company has adopted guidance on accounting for uncertainty in income taxes which clarified the accounting for income taxes by prescribing the minimum threshold a tax position is required to meet before being recognized in the financial statements as well as guidance on de-recognition, measurement, classification and disclosure of tax positions. The Company has gross liabilities recorded of $60,000 and $50,000 for the years ended December 31, 2016 and 2015, respectively, to account for potential state income tax exposure. The Company is obligated to file income tax returns in the U.S. federal jurisdiction and Israel and various states. Since the Company had losses in the past, all prior years that generated NOLs are open and subject to audit examination in relation to the NOL generated from those years. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows ($ in thousands):
| | | 2016 | | 2015 | |
| Balance at January 1, | | $ | 50 | | $ | 50 | |
| Additions related to tax positions | | | 10 | | | - | |
| Reductions related to tax positions | | | - | | | - | |
| Balance at December 31, | | $ | 60 | | $ | 50 | |
During 2015, the Company received notices from New York State relating to audits of the 2011 to 2013 tax years. In June 2016, the Company paid $9,000 in full settlement of taxes and interest owed to New York State relating to the audits of the 2011 to 2013 tax years. In addition, during 2015, the Company received tax notices from the Israeli Tax Authority relating to the 2010 to 2014 tax years. During 2016, the Company paid $70,000 in full settlement of taxes and interest owed to the Israeli Tax Authority relating to the audits of the 2010 to 2014 tax years.