ALTAIR ENGINEERING INC.

13. Income taxes

The components of (loss) income before income taxes are as follows (in thousands):


	Year ended December 31,
	2017			2016			2015
U.S.	$	(49,761	)	$	(2,225	)	$	(6,861	)
Non-U.S.		13,350			15,927			18,610

	$(36,411)			$13,702			$11,749

The significant components of the income tax expense are as follows (in thousands):


	Year ended December 31,
	2017			2016			2015
Current
U.S. Federal	$	—		$	—		$	—
Non-U.S.		10,290			9,413			9,893
U.S. State and Local		135			202			56

Total current		10,425			9,615			9,949

Deferred
U.S. Federal		54,130			(5,358	)		(8,445	)
Non-U.S.		(1,306	)		(610	)		(587	)
U.S. State and Local		(253	)		(108	)		(99	)

Total deferred		52,571			(6,076	)		(9,131	)

Income tax expense	$	62,996		$	3,539		$	818

The reconciliation of income taxes calculated at the U.S. Federal statutory income tax rate of 35% to income tax expense is as follows (in thousands):


	Year ended December 31,
	2017			2016			2015
Income taxes at U.S. federal statutory rate	$	(12,744	)	$	4,796		$	4,117
Foreign income taxes at rates other than the federal statutory rate		373			(584	)		(10	)
U.S. state and local income taxes, net of U.S. federal tax benefit		(155	)		94			(47	)
U.S. Tax Cut and Jobs Act: transition tax, net of foreign tax credits		4,187			—			—
Change in valuation allowance		47,429			—			—
Foreign withholding taxes		4,181			4,235			3,790
Foreign dividends		—			5,077			4,152
U.S. foreign tax credit		(4,154	)		(8,786	)		(9,808	)
Research and development tax credit		(2,999	)		(2,696	)		(1,608	)
Domestic production activities deduction		—			(840	)		(833	)
Non-deductible stock-based compensation		10,871			2,064			234
Meals & entertainment		358			235			258
Other		(163	)		(91	)		125
Deferred tax on investment in subsidiary		—			(264	)		(214	)
Uncertain tax position		446			299			662
Tax law changes		15,366			—			—

Income tax expense	$	62,996		$	3,539		$	818

The effective tax rate for the year ended December 31, 2017, as compared to December 31, 2016, was impacted by increased tax expense of approximately $15.4 million due to the enactment of the Tax Cuts and Jobs Act (the “Tax Act”) in the United States on December 22, 2017, entirely offset by a valuation allowance. The Tax Act significantly revises the U.S. corporate income tax by, among other things, lowering corporate income tax rates and imposing a one-time transition tax on deemed repatriated earnings of foreign subsidiaries. The impact was primarily the result of increased tax expense due to the one-time transition tax with an offset of foreign tax credits amounting to $4.2 million, and a valuation allowance in the amount of $47.0 million recorded against the net deferred tax assets in the U.S.

The enactment of the Tax Cuts and Jobs Act (the “Tax Act”) in the United States on December 22, 2017, significantly revises the U.S. corporate income tax by, among other things, lowering corporate income tax rates from 35% to 21% and imposing a one-time transition tax on deemed repatriated earnings of foreign subsidiaries. Pursuant to the guidance within SEC Staff Accounting Bulletin No. 118 (“SAB 118”), as of December 31, 2017, the Company recognized the provisional effects of the enactment of the Tax Act for which measurement could be reasonably estimated. Although the Company continues to analyze certain aspects of the Tax Act and refine its assessment, the ultimate impact of the Tax Act may differ from these estimates due to the Company’s continued analysis, or further regulatory guidance that may be issued as a result of the Tax Act. Pursuant to SAB 118, adjustments to the provisional amounts recorded by the Company as of December 31, 2017, that are identified within a subsequent measurement period of up to one year from the enactment date, will be included as an adjustment to tax expense from continuing operations in the period the amounts are determined.

The Company remeasured certain U.S. deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21%. However, the Company is still analyzing certain aspects of the Tax Act and refining its calculations, which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. The provisional amount recorded related to the remeasurement of net deferred tax assets and deferred tax liabilities was a net tax charge of $15.4 million, which was fully offset by an adjustment to the valuation allowance. Additionally, the Company recorded a deferred tax benefit of $1.3 million for the reduction of a deferred tax liability related to an indefinite-lived intangible asset. The Tax Act did not change the Company’s judgment regarding the realizability of these net deferred tax assets.

The one-time transition tax is based on the Company’s total post-1986 earnings and profits (“E&P”) that were previously deferred from U.S. income taxes and for which no deferred taxes were recorded since the Company previously claimed the indefinite reinvestment assertion exception on these earnings. In December 2017, the Company recorded a provisional amount for its one-time transition tax liability of $4.2 million, net of foreign tax credits. The Company has not yet completed its calculation of the total post-1986 E&P and associated foreign tax credits for these foreign subsidiaries. Further, the transition tax is based in part on the amount of those earnings held in cash and other specified assets. This amount may change when the Company finalizes the calculation of post-1986 foreign E&P previously deferred from U.S. federal taxation, and finalizes the amounts held in cash or other specified assets. The Company anticipates that additional guidance and clarification regarding the implementation of the transition tax will be issued by federal and state taxing authorities and the Company’s estimate is, therefore, subject to future refinement.

Deferred income tax assets and liabilities result from differences in the basis of assets and liabilities for tax and financial statements purposes. The approximate tax effect of each type of temporary difference, and operating losses and tax credit carryforwards that give rise to a significant portion of the deferred tax assets and liabilities are as follows (in thousands):


	December 31,
	2017			2016
Deferred tax assets:
Deferred revenue	$	19,569		$	16,966
Net operating loss carryforwards		7,601			3,550
Tax credit carryforwards		22,191			17,839
Stock-based compensation		8,922			15,825
Capitalized research and development		8,798			12,492
Accrued expenses		648			1,775
Employee benefits		3,931			3,995
Other		1,905			2,527

Total gross deferred tax assets		73,565			74,969
Less: valuation allowances		(54,331	)		(4,153	)

Net deferred tax assets⁽¹⁾		19,234			70,816
Deferred tax liabilities:
Prepaid royalties		6,925			5,821
Property and equipment and intangibles		4,567			2,394
Deferred tax on investment in subsidiary		272			272
Other		739			812

Total deferred tax liabilities		12,503			9,299

Total net deferred tax assets	$	6,731		$	61,517

₍₁₎	Reflects gross amount before jurisdictional netting of deferred tax assets and liabilities.

The Company’s accounting for the indefinite reinvestment assertion is incomplete. However, a reasonable estimate of book and tax basis was calculated, and the Company made a provisional assertion. In general, it is the practice and intention of the Company to repatriate previously taxed earnings and to reinvest all other earnings of its non-U.S. subsidiaries. As part of the Tax Act, the Company incurred U.S. tax on substantially all of the earnings of its non-U.S. subsidiaries as part of the one-time transition tax. This tax increased the Company’s previously taxed earnings and will allow for the repatriation of the majority of its foreign earnings without any residual U.S. federal tax. This assertion is subject to change as additional information is gathered to precisely compute the book and tax basis of the Company’s non-U.S. subsidiaries.

The following table summarizes the changes to the valuation allowance balance at December 31, 2017, 2016 and 2015 (in thousands):


	December 31,
	2017		2016			2015
Beginning balance	$	4,153	$	2,452		$	2,858
Additions charged to expense		47,429		177			—
Deductions		—		(207	)		(270	)
Other		2,749		1,731			(136	)

Ending balance	$	54,331	$	4,153		$	2,452

Additions charged to expense for 2017 of $47.4 million are primarily related to the recording of a valuation allowance against the Company’s U.S. deferred tax assets. In evaluating the need for a valuation allowance, Altair considered the large U.S. federal tax deduction that resulted when non-qualified stock options were exercised in connection with the Company’s IPO in November 2017, and expected NSO exercises and determined that it was not more likely than not that the U.S. deferred tax assets would be realized.

The following table summarizes the amount and expiration dates of operating loss and tax credit carryforwards at December 31, 2017 (in thousands):


	Expiration dates		Amounts
U.S. general business credits and loss carryforwards		2018-2037	$	24,564
Foreign loss carryforwards		indefinite		2,879
U.S. foreign tax credits		2027		2,349

Total operating loss and tax credit carryforwards			$	29,792

A reconciliation of the beginning and ending amounts of unrecognized tax benefits is as follows (in thousands):


	Year ended December 31,
	2017			2016		2015
Unrecognized tax benefits—January 1	$	5,604		$	5,305	$	4,712
Increase in unrecognized tax benefits as a result of:
Additions for tax positions of current period		634			299		826
Reductions for tax positions of prior periods		(81	)		—		(233	)

Unrecognized tax benefits—December 31	$	6,157		$	5,604	$	5,305

At December 31, 2017, the Company had $6.2 million of gross unrecognized tax benefits that if recognized would affect the effective tax rate and adjustments to other tax accounts, primarily deferred taxes. It is reasonably possible that a change in the Company’s gross unrecognized tax benefits may occur in the next twelve months; however, it is not possible to reasonably estimate the effect this may have upon the gross unrecognized tax benefits.

The Company operates globally but considers its more significant tax jurisdictions to include the United States, India, Germany, Japan, and China. India has tax years open for examination from 2005 through 2016. All other significant jurisdictions have open tax years from 2013 through 2016.

The Company records interest and penalties with respect to unrecognized tax benefits as a component of the provision for income taxes. For the years ended December 31, 2017 and 2016, accrued interest and penalties related to unrecognized tax benefits were insignificant. For the year ended December 31, 2015, accrued interest and penalties related to unrecognized tax benefits were $0.1 million.