PEGASYSTEMS INC

15. INCOME TAXES

Effective income tax rate

The components of income before provision for income taxes are as follows:


(in thousands)	2017		2016			2015
Domestic	$	18,605	$	37,329		$	63,124
Foreign		18,495		(2,127	)		(2,619	)

Income before provision for income taxes	$	37,100	$	35,202		$	60,505

The components of the provision for income taxes are as follows:


(in thousands)	2017			2016			2015
Current:
Federal	$	(18,205	)	$	6,741		$	17,864
State		97			2,963			4,565
Foreign		8,479			4,322			3,853

Total current (benefits)/provision		(9,629	)		14,026			26,282

Deferred:
Federal		19,683			(1,120	)		2,075
State		(2,158	)		(480	)		(466	)
Foreign		(3,730	)		(4,210	)		(3,708	)

Total deferred provision/(benefit)		13,795			(5,810	)		(2,099	)

Provision for income taxes	$	4,166		$	8,216		$	24,183

The effective income tax rate differed from the statutory federal income tax rate due to the following:


	2017			2016			2015
Statutory federal income tax rate		35.0	%		35.0	%		35.0	%
Valuation allowance		1.2			0.3			0.7
Transaction costs		—			1.1			—
State income taxes, net of federal benefit and tax credits		(4.5	)		3.7			4.6
Permanent differences		2.7			2.2			1.1
Domestic production activities		—			(3.2	)		(3.1	)
Federal research and experimentation credits		(9.1	)		(2.3	)		(1.2	)
Tax effects of foreign activities		(1.1	)		5.2			2.0
Tax-exempt income		(0.3	)		(0.3	)		(0.1	)
Provision to return adjustments		(5.2	)		0.3			0.3
Non-deductible compensation		5.0			6.2			3.3
Provision for uncertain tax positions		0.7			(2.3	)		(2.6	)
Excess tax benefits related to share-based compensation		(66.0	)		(20.1	)		—
Net deferred tax assets re-measurement ⁽¹⁾		51.8			—			—
Other		1.0			(2.5	)		—

Effective income tax rate		11.2	%		23.3	%		40.0	%

⁽¹⁾	Due to the impact of the Tax Reform Act.

On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act (the “Tax Reform Act”). The Tax Reform Act makes significant changes in the U.S. tax code including the following:

•

reduction of the corporate federal income tax rate from 35% to 21%;

•

repeal of the domestic manufacturing deduction;

•

repeal of the corporate alternative minimum tax;

•

a one-time transition tax on accumulated foreign earnings (if any);

•

a move to a territorial tax system; and

•

acceleration of business asset expensing.

In December 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for income tax effects of the Tax Reform Act. The Company has recognized the provisional tax impacts in 2017, including $20.4 million in additional income tax expense in the fourth quarter of 2017 to re-measure its deferred tax assets to the 21% enacted rate. The final amounts may differ from these provisional amounts, possibly materially, due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued, and actions the Company may take as a result of the Tax Reform Act.

The Tax Reform Act provided for a one-time deemed mandatory repatriation of post-1986 undistributed foreign subsidiary earnings and profits through December 31, 2017. Based on the Company’s provisional analysis performed to date, the Company does not expect to be subject to the one-time transition tax due to our foreign subsidiaries being in a net accumulated deficit position.

While the Tax Reform Act provides for a territorial tax system, beginning in 2018, it includes the following new anti-abuse provisions:

•

The global intangible low-taxed income (“GILTI”) provisions require the Company to include in its U.S. income tax base foreign subsidiary earnings in excess of an allowable return on the foreign subsidiary’s tangible assets. The Company expects that it will be subject to incremental U.S. tax resulting from GILTI inclusions beginning in 2018. However, our analysis and accounting for the effects of the GILTI provision is incomplete and an accounting policy on whether we will account for impact of GILTI inclusions in the period in which it is incurred or record deferred taxes for anticipated GILTI inclusions has not been made.

•

The base-erosion and anti-abuse tax (“BEAT”) provisions in the Tax Reform Act impose an alternative minimum tax on taxpayers with substantial base-erosion payments. Our preliminary assessment is that the company will not be subject to the BEAT; however, our analysis is incomplete and we will continue to analyze the impact of the BEAT provisions to determine if these would be material to the company’s effective tax rate.

Deferred income taxes

Significant components of net deferred tax assets and liabilities are as follows:


	December 31,
(in thousands)	2017			2016
Deferred tax assets:
Net operating loss carryforwards	$	52,311		$	69,307
Accruals and reserves		22,984			34,021
Software revenue		2,686			6,559
Depreciation		2,558			3,593
Tax credit carryforwards		13,056			8,094
Other		52			19

Total deferred tax assets		93,647			121,593
Less valuation allowances		(27,993	)		(34,054	)

Total net deferred tax assets		65,654			87,539

Deferred tax liabilities:
Intangibles		(8,527	)		(17,641	)

Total deferred tax liabilities		(8,527	)		(17,641	)

Deferred income taxes	$	57,127		$	69,898

Due to the Tax Reform Act U.S. deferred tax assets and liabilities were re-measured from 35% to 21% resulting in an additional $20.4 million income tax expense in the fourth quarter of 2017.

The Company regularly assesses the need for a valuation allowance against its deferred tax assets. In making that assessment, the Company considers both positive and negative evidence related to the likelihood of realization of the deferred tax assets to determine, based on the weight of available evidence, whether it is more-likely-than-not that some or all of the deferred tax assets will not be realized. This determination requires significant judgment, including assumptions about future taxable income that are based on historical and projected information. The $6.1 million net change in the valuation allowance during the period primarily relates to a $7.4 million decrease due to the re-measurement our deferred income taxes to the new U.S. statutory tax rate offset by $0.8 million increase for movements in foreign exchange rates and $0.5 million valuation allowance recorded against certain state R&D credits generated in the period.

At December 31, 2017, the Company had $99.2 million and $3.3 million in federal and state net operating losses, respectively, and $3.4 million and $1.8 million in federal and state credit carryforwards, respectively. These amounts include $99.2 million and $1 million in federal and state net operating losses carryforwards, respectively, from acquisitions and $0.6 million and $0.3 million in federal and state credit carryforwards, respectively, from acquisitions. The carryforward losses and credits expire between 2018 and 2037, except for $0.6 million in state credits that have unlimited carryforward periods. The federal and state net operating losses exclude $60.2 million and $0.8 million, respectively, in net operating losses that the Company expects will expire unutilized, and the federal and state tax credits exclude $0.1 million and $6.7 million, respectively, in tax credits that the Company expects will expire unutilized.

As of December 31, 2017, the Company had available $33.5 million of foreign NOLS which have an unlimited carryover period.

The Company’s India subsidiary is a development center in an area designated as a Special Economic Zone (“SEZ”) and is entitled to a tax holiday in India. The tax holiday reduces or eliminates income tax in that country and is scheduled to expire in 2022. For 2017, 2016 and 2015, the effect of the income tax holiday was to reduce the Company’s provision for income taxes by approximately $1.3 million, $1 million, and $0.9 million, respectively. The benefit of the tax holiday on net income per share (diluted) was $0.02 for 2017 and $0.01 for 2016 and 2015.

The Company adopted ASU 2016-09 in 2016, which required, among other things, excess tax benefits to be recorded as a reduction of the provision for income taxes, whereas they were previously recognized in equity. The Company was required to reflect any adoption adjustments as of January 1, 2016, the beginning of the annual period that included the period of adoption. Upon adoption the Company recorded a $0.3 million increase to retained earnings as of January 1, 2016, with an offsetting increase to long-term deferred income tax assets.

Uncertain tax benefits and other considerations

A reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits is as follows:


(in thousands)	2017			2016			2015
Balance as of January 1,	$	22,671		$	23,972		$	43,396
Additions based on tax positions related to the current year		452			80			817
Additions for tax positions of prior years		238			110			183
Additions for acquired uncertain tax benefits		—			387			—
Reductions for change in US federal tax rate		(2,424	)		—			—
Reductions for tax positions of prior years		(1,500	)		(1,541	)		(19,855	)
Reductions for a lapse of the applicable statute of limitations		(287	)		(337	)		(569	)

Balance as of December 31,	$	19,150		$	22,671		$	23,972

As of December 31, 2017, the Company had approximately $19.2 million of total unrecognized tax benefits, which would decrease the Company’s effective tax rate if recognized. The $2.4 million reduction for change in U.S. federal tax rate relates to a decrease in the uncertain tax benefits recorded against deferred tax items (e.g., net operating losses) corresponding with the re-measurement of the associated deferred tax assets to the new U.S. statutory tax rate. The $1.5 million reduction for tax positions of prior years primarily relates the lapse in the applicable statute of limitations, change in estimates, and the impact of foreign currency exchange rates. The Company expects that the changes in the unrecognized benefits within the next twelve months will be approximately $0.5 million due to a lapse of applicable statute of limitations.

The Company recognizes interest accrued and penalties related to unrecognized tax benefits in the income tax provision. For 2017 the Company did not recognize any significant change in net interest expense. For the 2016 and 2015, the Company recognized a decrease of approximately $0.6 million and an increase of $0.3 million, respectively, of interest expense. As of December 31, 2017, 2016 and 2015, the company did not recognize any significant penalties. As of December 31, 2017, 2016 and 2015, the Company had accrued approximately $1.5 million, $1.2 million, and $1.2 million, respectively, for interest and penalties.

The Company files income tax returns in the U.S. and in foreign jurisdictions. We have no tax returns under examination by the Internal Revenue Service or state taxing authorities as of December 31, 2017. However, certain foreign jurisdictions are auditing our income tax returns for periods ranging from 2010 through 2014. The Company does not expect the results of these audits to have a material effect on our financial condition, results of operations, or cash flows. With few exceptions, the statute of limitations remains open in all jurisdictions for the tax years 2014 to the present.