7. INCOME TAXES
The income tax provision is based on loss before income taxes of $(8,658,120) in the U.S. and $(2,112,082) in China. The Company has net operating loss (NOL) carryforwards for income tax purposes of approximately $368,134,000 at December 31, 2017 that expire in years 2018 through 2038. The Company also has research and development (“R&D”) tax credit carryforwards of approximately $9,593,000 as of December 31, 2017 that expire in years 2018 through 2038. Under the provisions of the Internal Revenue Code, the NOL and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service and state tax authorities. NOL and tax credit carryforwards may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant shareholders over a three-year period in excess of 50%, as defined under Sections 382 and 383 of the Internal Revenue Code of 1986, respectively, as well as similar state tax provisions. This could limit the amount of tax attributes that the Company can utilize annually to offset future taxable income or tax liabilities. The amount of the annual limitation, if any, will be determined based on the value of the Company immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years. For financial reporting purposes, a valuation allowance has been recognized to reduce the net deferred tax assets to zero due to uncertainties with respect to the Company’s ability to generate taxable income in the future sufficient to realize the benefit of deferred income tax assets.
For financial reporting purposes, loss before taxes includes the following components:
| | | 2017 | | 2016 | |
| United States | | $ | (8,658,120) | | $ | (7,375,974) | |
| Foreign | | | (2,112,082) | | | (2,077,514) | |
| Total | | $ | (10,770,202) | | $ | (9,453,488) | |
Deferred income taxes 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. Significant components of the Company’s deferred income tax assets and liabilities as of December 31, 2017 and 2016 are as follows:
| | | DECEMBER 31, | |
| | | 2017 | | 2016 | |
| Deferred income tax assets: | | | | | | | |
| Net operating loss carryforwards | | $ | 96,786,000 | | $ | 140,468,000 | |
| Research and development credit carryforward | | | 9,592,000 | | | 9,399,000 | |
| Intangible assets | | | 4,184,000 | | | 6,913,000 | |
| Equity-based compensation | | | 3,812,000 | | | 5,578,000 | |
| Other | | | 164,000 | | | 297,000 | |
| Valuation allowance for deferred income tax assets | | | (114,538,000) | | | (162,655,000) | |
| Net deferred income tax assets | | $ | - | | $ | - | |
On December 22, 2017, H.R.1, known as the “Tax Act,” was signed into law and makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate to a flat rate of 21% for periods after December 31, 2017 and (2) requiring a one-time transition tax on certain un-repatriated earnings of foreign subsidiaries that is payable over eight years. As a result of the reduction of the corporate tax rate to 21%, U.S. generally accepted accounting principles require companies to re-value their deferred tax assets and liabilities as of the date of enactment, with resulting tax effects accounted for in the reporting period of enactment. As a result of this revaluation, the Company has reduced its pre-valuation allowance deferred tax asset by $52,258,000 in the year ended December 31, 2017, with a corresponding decrease in the valuation allowance on its net deferred tax assets. The Company has no unrepatriated earnings in any of its foreign subsidiaries as they incurred losses since inception.
A reconciliation of the provision for income taxes to the federal statutory rate is as follows:
| | | 2017 | | 2016 | |
| Tax benefit at statutory rate | | $ | (3,662,000) | | $ | (3,214,000) | |
| Effect of tax law change | | | 52,258,000 | | | - | |
| State taxes | | | (290,000) | | | (232,000) | |
| Net R&D credit adjustment | | | (185,000) | | | (105,000) | |
| Attribute expiration | | | 50,000 | | | - | |
| Nondeductible expenses | | | 6,000 | | | 4,000 | |
| Change in valuation allowance | | | (48,117,000) | | | 3,461,000 | |
| Other | | | 125,000 | | | 177,000 | |
| Changes in applicable tax rates | | | (185,000) | | | (91,000) | |
| | | $ | - | | $ | - | |
The Company had $3,133,000 of unrecognized tax benefits as of December 31, 2016 related to net R&D tax credit carryforwards. The Company had a full valuation allowance on the net deferred tax asset recognized in the consolidated financial statements. For the year ended December 31, 2017, there were net additional unrecognized tax benefits of $65,000 related to R&D tax credits. The Company has a full valuation allowance at December 31, 2017 and 2016 against the full amount of its net deferred tax assets and, therefore, there was no impact on the Company’s financial position.
A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows:
| | | 2017 | | 2016 | |
| Unrecognized tax benefits balance at January 1 | | $ | 3,133,000 | | $ | 3,097,000 | |
| Additions for Tax Positions of Prior Periods | | | 3,000 | | | 1,000 | |
| Additions for Tax Positions of Current Period | | | 62,000 | | | 35,000 | |
| | | | | | | | |
| Unrecognized tax benefits balance at December 31 | | $ | 3,198,000 | | $ | 3,133,000 | |
The Company recognizes interest and penalties related to uncertain tax positions as a component of income tax expense. As of December 31, 2017 and 2016, the Company had no accrued interest or penalties related to uncertain tax positions.
The tax returns for all years in the Company’s major tax jurisdictions are not settled as of December 31, 2017. Due to the existence of tax attribute carryforwards (which are currently offset by a full valuation allowance), the Company treats all years’ tax positions as unsettled due to the taxing authorities’ ability to modify these attributes.
The Company believes that the total unrecognized tax benefit, if recognized, would impact the effective rate, however, such reversal may be offset by a corresponding adjustment to the valuation allowance.