11. Income Taxes
New Tax Legislation
On December 22, 2017, the Tax Cuts and Jobs Act (“The Act”) was signed into law. This legislation includes significant changes in U.S. tax law, including a reduction in the corporate tax rates and the creation of a territorial tax system with a one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. The legislation reduced the U.S. corporate tax rate from the current rate of 35% to 21% for tax years beginning after December 31, 2017. As a result of the enacted law, the Company was required to revalue deferred tax assets and liabilities existing as of December 31, 2017 from the 35% federal rate in effect through the end of 2017, to the new 21% rate. Accordingly, the Company recorded a current period tax benefit of $16.8 million and a corresponding reduction in the deferred tax liability. In addition, as a result of changes made by The Act related to taxation of foreign source income and the utilization of foreign tax credits, the Company recorded a valuation allowance on foreign tax credit carryforwards of $5.6 million. The new legislation will require the Company to pay tax on the unremitted earnings of its foreign subsidiaries through December 31, 2017. Because of the complexities involved in determining the previously unremitted earnings and profits of all our foreign subsidiaries, the Company is still in the process of obtaining, preparing, and analyzing the required information, as permitted in accordance with Staff Accounting Bulletin No. 118. The Company has recorded an initial estimate of the tax on unremitted earnings of approximately $0.2 million, however, this amount is offset by available foreign tax credits, and as a result the net estimated amount payable related to the deemed repatriation of foreign earnings is zero. This amount has been further offset by available foreign tax credits, and as a result the net estimated amount payable related to the deemed repatriation of foreign earnings is zero.
Income Taxes
The components of domestic and foreign income (loss) before the provision (benefit) for income taxes are as follows (in thousands):
| 2017 | 2016 | 2015 | ||||||||||
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U.S. |
$ | (13,124 | ) | $ | 142 | $ | 18,787 | |||||
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Foreign |
19,293 | 25,057 | 21,688 | |||||||||
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Total income before provision for income taxes |
$ | 6,169 | $ | 25,199 | $ | 40,475 | ||||||
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The components of the provision for income taxes are as follows (in thousands):
| 2017 | 2016 | 2015 | ||||||||||
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Current |
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U.S. Federal |
$ | 793 | $ | (152 | ) | $ | 2,873 | |||||
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State and local |
224 | 279 | 550 | |||||||||
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Foreign jurisdictions |
7,049 | 8,173 | 5,153 | |||||||||
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| 8,066 | 8,300 | 8,576 | ||||||||||
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Deferred |
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U.S. Federal |
(12,433 | ) | 1,403 | 6,267 | ||||||||
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State and local |
43 | 976 | 81 | |||||||||
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Foreign jurisdictions |
(1,067 | ) | (366 | ) | (646 | ) | ||||||
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| (13,457 | ) | 2,013 | 5,702 | |||||||||
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Total (benefit) provision |
$ | (5,391 | ) | $ | 10,313 | $ | 14,278 | |||||
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A reconciliation of income taxes computed at federal statutory rates to income tax expense is as follows (dollar amounts in thousands):
| 2017 | 2016 | 2015 | ||||||||||||||||||||||
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Provision for income taxes at statutory rate |
$ | 2,159 | 35.0 | % | $ | 8,820 | 35.0 | % | $ | 14,167 | 35.0 | % | ||||||||||||
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State and local income taxes, net of federal tax benefit |
174 | 2.8 | % | 816 | 3.2 | % | 410 | 1.0 | % | |||||||||||||||
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Foreign rate differential |
(138 | ) | (2.2 | )% | (278 | ) | (1.1 | )% | (229 | ) | (0.5 | )% | ||||||||||||
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Stock based compensation |
1,011 | 16.4 | % | 130 | 0.5 | % | 100 | 0.3 | % | |||||||||||||||
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Research credits |
(117 | ) | (1.9 | )% | (485 | ) | (1.9 | )% | (371 | ) | (0.9 | )% | ||||||||||||
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Reversal of reserve for income taxes |
(64 | ) | (1.0 | )% | (47 | ) | (0.2 | )% | (1,305 | ) | (3.2 | )% | ||||||||||||
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Federal and foreign rate changes |
(16,799 | ) | (272.3 | )% | — | — | — | — | ||||||||||||||||
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Foreign tax credit valuation allowance |
5,587 | 90.5 | % | — | — | — | — | |||||||||||||||||
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Permanent non-deductible acquisition-related expense |
1,969 | 31.9 | % | 1,748 | 7.0 | % | 1,209 | 3.0 | % | |||||||||||||||
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Permanent non-deductible executive compensation expense |
591 | 9.6 | % | 34 | 0.1 | % | 249 | 0.6 | % | |||||||||||||||
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Other, net |
236 | 3.8 | % | (425 | ) | (1.7 | )% | 48 | — | |||||||||||||||
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Reported income tax (benefit) provision |
$ | (5,391 | ) | (87.4 | )% | $ | 10,313 | 40.9 | % | $ | 14,278 | 35.3 | % | |||||||||||
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For the year ended December 31, 2017, our effective tax rate was a benefit of 87.4%. The 2017 effective tax rate included a benefit of 272.3% for tax rate changes due to The Act. Our effective tax rate included a charge of 90.5% for valuation allowances provided on foreign tax credit carryforwards in 2017, in connection with The Act. Non-deductible acquisition-related expenses, primarily from the Olapic and Swyft acquisitions, contributed a charge of 31.9% to the 2017 effective tax rate. The 2017 effective tax rate included a charge of 16.4% for stock based compensation, primarily related to the change in accounting as a result of the adoption of ASU 2016-09, which requires that all tax effects of stock compensation be reflected as part of current period tax expense. See Note 2 for further discussion.
For the year ended December 31, 2016, our effective tax rate was 40.9%. The 2016 effective tax rate included a charge of 7.1% for non-deductible acquisition-related expenses primarily from the Olapic and Swyft acquisitions that are contingent on the continued employment of key employees. For financial reporting purposes, these amounts are treated as compensation expense recognized ratably over the minimum required employment periods, which range from January 2018 to August 2019. Since these transactions were accounted for as stock acquisitions, such amounts are not deductible for tax purposes.
For the year ended December 31, 2015, our effective rate was 35.3%. The 2015 effective tax rate included a charge of 3.6% for non-deductible expenses recognized due to the acceleration of the contingent payments associated with the Swyft Media acquisition. The 2015 effective tax rate also included a benefit of 3.2% for the reversal of reserves in connection with a settlement of tax audits of our subsidiary in Japan and of our 2012 U.S. federal tax return, as well as the expiration of the statute of limitations on reserves related to the Company’s 2011 tax returns. The 2015 effective tax rate included a charge of 1.0% for state and local income taxes, net of federal benefit. The foreign rate differential was a benefit of 0.5% in 2015.
In the year ended December 31, 2017, the provision for income taxes included a charge of $3.7 million that was debited directly to stockholders’ equity, rather than to the provision for income taxes related to amounts recorded directly to accumulated other comprehensive income, and a benefit of $0.3 million that was credited directly to stockholders’ equity, rather than to the provision for income taxes, for the cumulative effect adjustment related to our accounting policy election change for forfeitures, in connection with our adoption of ASU 2016-09 on January 1, 2017. The provision for income taxes includes an expense of $1.4 million for the year ended December 31, 2016 that was debited directly to stockholders’ equity, rather than to the provision for income taxes for the tax adjustment associated with the exercise of non-qualified stock options by employees and vesting of restricted stock. The provision for income taxes includes $1.9 million for the years ended December 31, 2015 that was credited directly to stockholders’ equity, rather than to the provision for income taxes for the tax benefit associated with the exercise of non-qualified stock options by employees and vesting of restricted stock. In addition, the 2016 and 2015 provision does not include benefits of $1.1 million and $1.9 million, respectively, related to other amounts recorded directly to accumulated other comprehensive income.
Significant components of the Company’s deferred tax assets and liabilities consisted of the following (in thousands):
| December 31, | ||||||||
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Deferred tax assets: |
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Compensation related deductions |
$ | 7,593 | $ | 9,392 | ||||
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Tax credit carryforwards |
8,053 | 1,927 | ||||||
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Federal, foreign and state net operating losses |
6,963 | 10,135 | ||||||
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Cumulative translation and foreign items |
1,064 | 5,479 | ||||||
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Accrued expenses and deferred revenue |
977 | 2,159 | ||||||
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Subtotal deferred tax assets |
24,650 | 29,092 | ||||||
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Valuation allowance |
(6,921 | ) | (1,617 | ) | ||||
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Total deferred income tax assets |
$ | 17,729 | $ | 27,475 | ||||
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Deferred tax liabilities: |
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Fixed assets |
$ | 1,817 | $ | 2,447 | ||||
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Intangible assets |
16,424 | 17,644 | ||||||
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Goodwill and indefinite-lived intangibles |
25,599 | 44,419 | ||||||
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Unrealized gain |
708 | — | ||||||
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Total deferred tax liabilities |
$ | 44,548 | $ | 64,510 | ||||
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Net deferred tax liabilities |
$ | 26,819 | $ | 37,035 | ||||
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Deferred tax assets and liabilities as classified in the consolidated balance sheets, based on the tax jurisdiction in which they reside as follows: |
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Net deferred income tax assets—long-term (1) |
$ | 1,185 | $ | 745 | ||||
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Net deferred income tax liabilities—long-term |
(28,004 | ) | (37,780 | ) | ||||
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Net deferred income tax liabilities |
$ | (26,819 | ) | $ | (37,035 | ) | ||
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| (1) | Included in other assets in the accompanying consolidated balance sheets. |
In assessing the realizability of the deferred tax assets within each jurisdiction, the primary evidence we considered included the cumulative pre-tax income for financial reporting purposes over the past three years, and the estimated future taxable income based on historical, as well as subsequent interim period operating results. After giving consideration to these factors, we concluded that it was more likely than not that the deferred tax assets would be fully realized, and as a result, no valuation allowance against the domestic deferred tax assets was deemed necessary at December 31, 2017 and 2016, except as described below.
A valuation allowance has been established for U.S. foreign tax credit carryforwards and potential future foreign tax credit carryforwards that may primarily be generated by Monotype Germany’s deferred tax liability related to temporary differences. As of December 31, 2017 and 2016, the valuation allowance against these credits was $6.9 million and $1.4 million, respectively. As a result of the changes in U.S. tax law related to taxation of foreign earnings, the Company has concluded that utilization of existing foreign tax credit carryforwards will be significantly limited. Factors attributing to this conclusion include the significant reduction in U.S. tax rates, along with the fact that branch earnings are subject to a separate limitation, which will significantly limit the sources of future foreign source income. Monotype Germany is a branch for U.S. tax purposes, and therefore we are eligible to claim a foreign tax credit for taxes paid to Germany. However, under The Act, foreign tax credits related to Germany may only offset income related to Monotype Germany, thus limiting the amount of foreign tax credits that may be realized. As a result of the complexity of the U.S. foreign tax credit computation, and the uncertainty related to whether we will be entitled to a foreign tax credit when the related deferred taxes are paid or accrued, we have established a valuation allowance against these credits.
In accordance with ASC 740, the Company has recorded approximately $7.1 million as a reserve for unrecognized tax benefits at December 31, 2017. The following is a reconciliation of the Company’s gross unrecognized tax benefits at December 31, 2016 and 2017 (in thousands):
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December 31, 2015 |
$ | 5,516 | ||
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Increases related to: |
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Positions taken in prior years |
147 | |||
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Positions taken and acquired in the current year |
930 | |||
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December 31, 2016 |
$ | 6,593 | ||
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Increases related to: |
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Positions taken in prior years |
34 | |||
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Positions taken in the current year |
553 | |||
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Decreases related to: |
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Expiration of statute of limitations |
(65 | ) | ||
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December 31, 2017 |
$ | 7,115 | ||
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Of this amount of unrecognized tax benefits, approximately $5.0 million, $5.1 million and $4.5 million, if recognized, would result in a reduction of the Company’s effective tax rate at December 31, 2017, 2016 and 2015, respectively. The Company recognizes interest and penalties as a component of income tax expense. As of December 31, 2017, 2016 and 2015, the Company has accrued approximately $0.2 million, $0.2 million and $0.1 million, respectively, related to interest and penalties. The tax provision for the years ended December 31, 2017, 2016 and 2015 includes a tax expense of $0.1 million, expense of $0.1 million and a benefit of $0.1 million, respectively, for interest. The Company does not anticipate a significant change in the balance of uncertain tax positions over the next twelve months.
As a result of the enactment of The Act, the Company has included in U.S. taxable income the total amount of its undistributed earnings, and provided the incremental U.S. tax on this amount. As a result, the Company does not have any untaxed, undistributed earnings. However, the Company is indefinitely invested in its foreign subsidiaries, excluding its foreign branch in Germany, and has not provided deferred taxes for any other basis differences in its foreign subsidiaries.
The Act creates a new requirement that certain income earned by a foreign subsidiary must be included in the income of the foreign subsidiary U.S. shareholder. This income (called Global Intangible Low-Taxed Income, or GILTI) is defined as the excess of foreign subsidiaries income over a nominal return on fixed assets. The Company expects to be subject to this inclusion in future years. Under U.S. GAAP, the Company is allowed to make an accounting policy choice of either accounting for the effects of the GILTI inclusion as a current period expense, when incurred, or factoring such amounts into the Company’s measurement of its deferred taxes. The Company has elected to treat the effects of this provision as a period cost, and therefore, has not considered the impacts of GILTI on its deferred tax liabilities at December 31, 2017.
As a result of the Olapic acquisition, the Company has federal net operating loss carryforwards of $21.1 million at December 31, 2017. The net operating losses are subject to limitations under federal Internal Revenue Code Section 382. The Company also has state net operating loss carryforwards with a state tax effect of $2.2 million. These losses are also subject to limitation in certain states.
As of December 31, 2017, the Company has foreign net operating losses with a tax effect of $0.8 million.
The Company is currently subject to audit by the Internal Revenue Service and foreign jurisdictions for the years 2014 through 2017 and the Company and its subsidiaries state income tax returns are subject to audit for the years 2013 through 2017.