INCOME TAXES
Income before income taxes consisted of the following (in thousands):
|
| | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Domestic | $ | (40,709 | ) | | $ | (49,707 | ) | | $ | (37,437 | ) |
Foreign | 164,703 |
| | 92,855 |
| | 54,442 |
|
Total income before income taxes | $ | 123,994 |
| | $ | 43,148 |
| | $ | 17,005 |
|
The provision for income taxes consisted of the following (in thousands):
|
| | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Current: | | | | | |
Federal | $ | 34,739 |
| | $ | 7,904 |
| | $ | 9,864 |
|
State | 816 |
| | 803 |
| | (136 | ) |
Foreign | 27,688 |
| | 17,829 |
| | 13,683 |
|
Total current | $ | 63,243 |
| | $ | 26,536 |
| | $ | 23,411 |
|
Deferred: | | | | | |
Federal | $ | 39,103 |
| | $ | (10,037 | ) | | $ | (9,383 | ) |
State | (9,333 | ) | | (4,861 | ) | | (2,988 | ) |
Foreign | (418 | ) | | (677 | ) | | (2,022 | ) |
Total deferred | 29,352 |
| | (15,575 | ) | | (14,393 | ) |
Provision for income taxes | $ | 92,595 |
| | $ | 10,961 |
| | $ | 9,018 |
|
The provision for income taxes differs from the amount computed by applying the statutory federal income tax rate as follows (in thousands):
|
| | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Tax at federal statutory tax rate | $ | 43,398 |
| | $ | 15,096 |
| | $ | 5,951 |
|
Foreign income taxed at different rates | (19,536 | ) | | (13,681 | ) | | (11,225 | ) |
Foreign withholding taxes | 17,445 |
| | 14,998 |
| | 10,962 |
|
Stock-based compensation expense | 9,502 |
| | 10,010 |
| | 6,369 |
|
Foreign tax credit | (12,795 | ) | | (34,992 | ) | | (6,901 | ) |
State taxes—net of federal benefit | (3,505 | ) | | (4,252 | ) | | (2,454 | ) |
Research and development credit | (4,009 | ) | | (2,713 | ) | | (3,529 | ) |
Dividend distribution | — |
| | 27,295 |
| | 9,647 |
|
Impact of the 2017 Tax Act: | | | | | |
Deferred tax asset remeasurement due to reduction in the federal corporate income tax rate | 47,878 |
| | — |
| | — |
|
One-time transition tax | 15,222 |
| | — |
| | — |
|
Other | (1,005 | ) | | (800 | ) | | 198 |
|
Total provision for income taxes | $ | 92,595 |
| | $ | 10,961 |
| | $ | 9,018 |
|
Significant permanent differences arise from the portion of stock-based compensation expense that is not expected to generate a tax deduction, such as stock-based compensation expense on stock option grants to certain foreign employees, offset by the actual tax benefits in the current periods from disqualifying dispositions of shares held by our U.S. employees. For stock options exercised by our U.S. employees, we receive an income tax benefit calculated as the difference between the fair market value of the stock issued at the time of the exercise and the option price, tax effected. In 2017, the excess tax benefits of $13.5 million were recognized in income tax provision due to the adoption of ASU 2016-09. In 2016, the excess tax benefits of $10.8 million were recognized in income tax provision. For 2015, income tax payable was reduced by excess tax benefits from the exercise or vesting of stock-based awards of $1.3 million.
In December 2017, the U.S. federal government enacted the Tax Cuts and Jobs Act (the “2017 Tax Act”). The 2017 Tax Act reduced the U.S. federal corporate income tax rate from 35% to 21% effective January 1, 2018 and created a territorial tax system with a one-time mandatory tax on foreign earnings of U.S. subsidiaries not previously subject to U.S. income tax. Under GAAP, changes in tax rates and tax law are accounted for in the period of enactment and deferred tax assets and liabilities are measured at the enacted tax rate.
The Securities and Exchange Commission (“SEC”) staff issued Staff Accounting Bulletin No. 118 (“SAB 118”), which provides guidance on accounting for the tax effects of the 2017 Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the 2017 Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the 2017 Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the 2017 Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the 2017 Tax Act.
Consistent with the guidance issued by the SEC, which provides for a measurement period of one year from the enactment date to finalize the accounting for effects of the 2017 Tax Act, we provisionally recorded a $47.9 million expense on the remeasurement of deferred tax assets due to the reduction of federal corporate income tax rate, and a $15.2 million expense for the one-time transition tax on deemed repatriation. We are able to make a reasonable estimate of the transition tax. However, we are continuing to gather additional information to more precisely compute the amount of the transition tax.
The 2017 Tax Act creates a new requirement that global intangible low-taxed income (“GILTI”) earned by controlled foreign corporations (“CFCs”) must be included currently in the gross income of the CFCs’ U.S. shareholder. Because of the complexity of the new GILTI tax rules, we are continuing to evaluate this provision of the 2017 Tax Act and the application of ASC 740. Under GAAP, we are allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into a company’s measurement of its deferred taxes (the “deferred method”). Our selection of an accounting policy with respect to the new GILTI tax rules will depend, in part, on analyzing our global income to determine whether we expect to have future U.S. inclusions in taxable income related to GILTI and, if so, what the impact is expected to be. We have not yet made any adjustments related to potential GILTI tax in our financial statements and have not made a policy decision regarding whether to record deferred taxes on GILTI.
During 2016, we repatriated $55.0 million of foreign earnings and profits. A decision was made to bring this cash back to the United States as it carried a foreign tax credit of $22.3 million. Our 2015 income tax provision reflected a $1.2 million tax benefit due to a recent U.S. Tax Court opinion involving an independent third party filed on July 27, 2015. Based on the findings of the U.S. Tax Court, we recognized the tax benefit for excluding the share-based compensation from intercompany charges in prior periods. During 2015, we completed a corporate reorganization to convert our Canadian company to a branch of our U.S. company resulting on a $27.6 million deemed dividend distribution. The tax impact of the Canadian deemed dividend distribution of $9.6 million was partially offset by an additional tax benefit of $6.4 million due to the deferred tax benefit of the Canadian stock based compensation expense.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets as of the years ended are presented below (in thousands):
|
| | | | | | | |
| December 31,
2017 | | December 31,
2016 |
Deferred tax assets: | | | |
General business credit carryforward | $ | 49,854 |
| | $ | 62,705 |
|
Deferred revenue | 37,432 |
| | 41,877 |
|
Nondeductible reserves and accruals | 22,966 |
| | 27,029 |
|
Net operating loss carryforward | 15,670 |
| | 24,348 |
|
Stock-based compensation expense | 12,265 |
| | 20,943 |
|
Depreciation and amortization | 8,753 |
| | 5,776 |
|
Other | (8 | ) | | 67 |
|
Total deferred tax assets | $ | 146,932 |
| | $ | 182,745 |
|
In assessing the realizability of deferred tax assets, we considered whether it is more likely than not that some portion or all of our deferred tax assets will be realized. This realization is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We concluded that it is more likely than not that we would be able to realize the benefits of our deferred tax assets in the future.
As of December 31, 2017, we had $42.4 million in federal net operating loss carryforwards to offset future income, which is limited by Section 382 of the Internal Revenue Code (“Section 382”) due to the acquisition of Meru and AccelOps. With the acquisition of Meru, we had $22.6 million in federal net operating loss carryforwards which is limited by Section 382 available from year 2020. With the acquisition of AccelOps, we had $19.9 million in federal net operating loss carryforwards which is limited by Section 382 available from year 2016. We had $25.6 million federal tax credits to offset future federal taxes. As of December 31, 2017, we had $36.7 million in California net operating loss carryforwards. With the acquisition of Meru and AccelOps, we also had $22.1 million and $14.6 million in California net operating loss carryforwards, respectively, which is subject to Section 382 limitation. We had state tax credit carryforwards of $21.7 million available to offset our future state taxes. The state credits carry forward indefinitely.
We have analyzed our global working capital and cash requirements and the potential tax liabilities attributable to a repatriation, and have determined that we will be repatriating certain unremitted foreign earnings which was previously deemed indefinitely reinvested. For those investments from which we were able to make a reasonable estimate of the tax effects of such repatriation, we have recorded a provisional estimate for withholding and state taxes. For those investments from which we were not able to make a reasonable estimate, we have not recorded any deferred taxes. We will record the tax effects of any change in our prior assertion with respect to these investments, and disclose any unrecognized deferred tax liability for temporary differences related to our foreign investments, if practicable, in the period that we are first able to make a reasonable estimate, no later than December 2018.
We operate under a tax incentive agreement in Singapore, which is effective through December 31, 2021, and may be extended if certain additional requirements are satisfied. The tax incentive agreement is conditional upon our meeting certain employment and investment thresholds.
As of December 31, 2017, we had $72.5 million of unrecognized tax benefits, of which, if recognized, $70.8 million would favorably affect our effective tax rate. Our policy is to include accrued interest and penalties related to uncertain tax benefits in income tax expense. As of December 31, 2017, 2016 and 2015, accrued interest and penalties were $13.5 million, $9.5 million and $5.5 million, respectively.
The aggregate changes in the balance of unrecognized tax benefits are as follows (in thousands):
|
| | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | 2016 | | 2015 |
Unrecognized tax benefits, beginning of year | $ | 65,534 |
| | $ | 59,672 |
| | $ | 44,151 |
|
Gross increases for tax positions related to the current year | 13,166 |
| | 4,837 |
| | 17,478 |
|
Gross decreases for tax positions related to the current year | (10,747 | ) | | — |
| | — |
|
Gross increases for tax positions related to the prior year | 7,049 |
| | 1,762 |
| | 8,319 |
|
Gross decreases for tax positions related to prior year | (874 | ) | | (737 | ) | | (9,207 | ) |
Gross decreases for tax positions related to expiration of statute of limitations | (1,584 | ) | | — |
| | (1,069 | ) |
Unrecognized tax benefits, end of year | $ | 72,544 |
| | $ | 65,534 |
| | $ | 59,672 |
|
As of December 31, 2017, 2016 and 2015, $90.2 million, $68.6 million and $60.6 million, respectively, of the amounts reflected above were recorded as Income tax liabilities—non-current in our consolidated balance sheet.
It is reasonably possible that our gross unrecognized tax benefits will decrease by up to $12.0 million in the next 12 months, primarily due to the lapse of the statute of limitations and audit settlement. These adjustments, if recognized, would positively impact our effective tax rate, and would be recognized as additional tax benefits.
We file income tax returns in the U.S. federal jurisdiction and in various U.S. state and foreign jurisdictions. Generally, we are no longer subject to U.S. state and non-U.S. income tax examinations by tax authorities for tax years prior to 2009. We are no longer subject to examination by U.S federal income tax authorities for tax years prior to 2012. We have closed the Internal Revenue Service audit for tax years 2012, 2013 and 2014 at the field level. This audit included a refund claim for $6.5 million, which was approved in the audit process. This refund claim was sent to the Joint Committee in Washington for the final review on January 18, 2018, and was approved on January 31, 2018 and will result in a benefit to the tax provision in 2018 by approximately $3.0 million. In addition, the tax authorities in France are examining the intercompany relationship between Fortinet, Inc., Fortinet France and Fortinet Singapore. In May 2017, we received a notice from the French tax authorities that an audit was officially opened for tax years from 2007 to 2015.