Compass Diversified Holdings

Income Taxes

Compass Diversified Holdings and Compass Group Diversified Holdings LLC are classified as partnerships for U.S. Federal income tax purposes and are not subject to income taxes. Each of the Company’s majority owned subsidiaries are subject to Federal and state income taxes.

Components of the Company's pretax income (loss) before taxes are as follows (in thousands):



	Year ended December 31,
	2017			2016			2015
Domestic (including U.S. exports)	$	(13,276	)	$	63,782		$	29,432
Foreign subsidiaries	5,869			(564		)	(5,440		)
	$	(7,407	)	$	63,218		$	23,992

Components of the Company’s income tax provision (benefit) are as follows (in thousands):



	Year ended December 31,
	2017			2016			2015
Current taxes
Federal	$	10,293		$	12,994		$	16,079
State	2,221			2,486			2,567
Foreign	6,236			3,857			688
Total current taxes	18,750			19,337			19,334
Deferred taxes:
Federal	(55,299		)	(5,816		)	(764		)
State	(1,712		)	(1,357		)	70
Foreign	(2,418		)	(2,695		)	(3,639		)
Total deferred taxes	(59,429		)	(9,868		)	(4,333		)
Total tax provision	$	(40,679	)	$	9,469		$	15,001

The tax effects of temporary differences that have resulted in the creation of deferred tax assets and deferred tax liabilities at December 31, 2017 and 2016 are as follows (in thousands):



	December 31,
	2017			2016
Deferred tax assets:
Tax credits	$	5,035		$	11,485
Accounts receivable and allowances	1,134			1,032
Net operating loss carryforwards	27,631			28,896
Accrued expenses	5,789			7,324
Other	5,174			3,966
Total deferred tax assets	$	44,763		$	52,703
Valuation allowance ⁽¹⁾	(5,912		)	(7,256		)
Net deferred tax assets	$	38,851		$	45,447
Deferred tax liabilities:
Intangible assets	$	(102,581	)	$	(120,645	)
Property and equipment	(17,060		)	(19,810		)
Repatriation of foreign earnings	(68		)	(8,973		)
Prepaid and other expenses	(191		)	(6,857		)
Total deferred tax liabilities	$	(119,900	)	$	(156,285	)
Total net deferred tax liability	$	(81,049	)	$	(110,838	)


⁽¹⁾	Primarily relates to the 5.11 and Arnold operating segments.

For the years ending December 31, 2017 and 2016, the Company recognized approximately $119.9 million and $156.3 million, respectively in deferred tax liabilities. A significant portion of the balance in deferred tax liabilities reflects temporary differences in the basis of property and equipment and intangible assets related to the Company’s purchase accounting adjustments in connection with the acquisition of certain of its businesses. For financial accounting purposes the Company has recognized a significant increase in the fair values of the intangible assets and property and equipment in certain of the businesses it acquired. For income tax purposes the existing, pre-acquisition tax basis of the intangible assets and property and equipment is utilized. In order to reflect the increase in the financial accounting basis over the existing tax basis, a deferred tax liability was recorded. This liability will decrease in future periods as these temporary differences reverse but may be replaced by deferred tax liabilities generated as a result of future acquisitions.

A valuation allowance relating to the realization of foreign tax credits and net operating losses of $5.9 million was provided at December 31, 2017 and $7.3 million was provided at December 31, 2016. A valuation allowance is provided whenever it is more likely than not that some or all of deferred assets recorded may not be realized.

The reconciliation between the Federal Statutory Rate and the effective income tax rate for 2017, 2016 and 2015 are as follows:



	Year ended December 31,
	2017		2016		2015
United States Federal Statutory Rate	(35.0	)%	35.0	%	35.0	%
State income taxes (net of Federal benefits)	(6.5	)	0.6		6.5
Foreign income taxes	(18.4	)	1.5		1.2
Expenses of Compass Group Diversified Holdings, LLC representing a pass through to shareholders ⁽¹⁾	(3.3	)	3.6		29.1
Effect of (gain) loss on equity method investment	26.6		(41.2	)	(6.6	)
Impact of subsidiary employee stock options	9.9		1.3		1.3
Domestic production activities deduction	(8.4	)	(0.9	)	(3.2	)
Non-deductible acquisition costs	4.6		1.9		—
Impairment expense	69.4		—		—
Effect of undistributed foreign earnings	(18.7	)	4.2		—
Non-recognition of NOL carryforwards at subsidiaries	(18.1	)	3.6		(6.1	)
Adjustments to uncertain tax positions ⁽²⁾	(124.0	)	—		—
Utilization of tax credits	(40.1	)	(0.7	)	(1.1	)
Effect of Tax Act - remeasurement of deferred tax assets and liabilities ⁽³⁾	(468.0	)	—		—
Effect of Tax Act - transition tax on non-U.S. subsidiaries' earnings⁽³⁾	65.6		—		—
Other	15.2		6.1		6.4
Effective income tax rate	(549.2	)%	15.0	%	62.5	%


⁽¹⁾	The effective income tax rate for each of the years presented includes losses at the Company’s parent, which is taxed as a partnership.


⁽²⁾	Represents the effect of the reversal of an uncertain tax position at our 5.11 business that existed as of the acquisition date and was settled during the fourth quarter of 2017, resulting in a tax benefit of $9.2 million in our 2017 tax provision.

⁽³⁾

The effect of the enactment of the Tax Act on our tax provision for the year ended December 31, 2017 was a benefit of $34.7 million related to the reduction in the U.S. federal corporate income tax rate from 35% to 21%, and tax expense of $4.9 million related to the one-time transition tax liability of our foreign subsidiaries. Our loss before income taxes for 2017 was $7.4 million, and as a result, the effect from the Tax Act on the reconciliation in the table above was significant.

A reconciliation of the amount of unrecognized tax benefits for 2017, 2016 and 2015 are as follows (in thousands):



Balance at January 1, 2015	$	433
Additions for current years’ tax positions	73
Additions for prior years’ tax positions	—
Reductions for prior years’ tax positions	(15		)
Reductions for settlements	—
Reductions for expiration of statute of limitations	(102		)
Balance at December 31, 2015	$	389
Additions for current years’ tax positions	64
Additions for prior years’ tax positions ⁽¹⁾	10,150
Reductions for prior years’ tax positions	(16		)
Reductions for settlements	—
Reductions for expiration of statute of limitations	(87		)
Balance at December 31, 2016	$	10,500



Additions for current years’ tax positions	96
Additions for prior years’ tax positions	23
Reductions for prior years’ tax positions ⁽¹⁾	(9,397		)
Reductions for settlements	—
Reductions for expiration of statute of limitations	(87		)
Balance at December 31, 2017	$	1,135

⁽¹⁾ The increase in prior year tax positions during the year ended December 31, 2016 related to an unrecognized tax benefit at the Company's 5.11 business, which was acquired in August 2016. The uncertainty was resolved in the fourth quarter of 2017 and the amount was reversed.

Included in the unrecognized tax benefits at December 31, 2017 and 2016 is $1.0 million and $10.4 million, respectively, of tax benefits that, if recognized, would affect the Company’s effective tax rate. The Company accrues interest and penalties related to uncertain tax positions. The amounts accrued at December 31, 2017, 2016 and 2015 are not material to the Company. Such amounts are included in the provision (benefit) for income taxes in the accompanying consolidated statements of operations. The change in the unrecognized tax benefit during 2017 and 2016 resulted from the acquisition of 5.11. The change in the unrecognized tax benefit during 2015 was not material. It is expected that the amount of unrecognized tax benefits will change in the next twelve months. However, we do not expect the change to have a significant impact on the consolidated results of operations or financial position.

Each of the Company’s businesses file U.S. Federal, state and foreign income tax returns in multiple jurisdictions with varying statutes of limitations. The 2013 through 2017 tax years generally remain subject to examinations by the taxing authorities.