ROSETTA STONE INC

INCOME TAXES

New tax legislation, commonly referred to as the Tax Cuts and Jobs Act ("Tax Reform"), was enacted on December 22, 2017. ASC 740, Accounting for Income Taxes, requires companies to recognize the effect of tax law changes in the period of enactment even though the effective date for most provisions is for tax years beginning after December 31, 2017, or in the case of certain other provisions, January 1, 2018.

Given the significance of the Tax Reform, the SEC staff issued Staff Accounting Bulletin No. 118 (SAB 118), which allows registrants to record provisional amounts during a one year “measurement period” similar to that used when accounting for business combinations. However, the measurement period is deemed to have ended earlier when the registrant has obtained, prepared and analyzed the information necessary to finalize its accounting. During the measurement period, impacts of the Tax Reform law are expected to be recorded at the time a reasonable estimate for all or a portion of the effects can be made, and provisional amounts can be recognized and adjusted as information becomes available, prepared or analyzed.

SAB 118 summarizes the process to be applied at each reporting period to account for and qualitatively disclose: (1) the effects of the change in tax law for which accounting is complete; (2) provisional amounts (or adjustments to provisional amounts) for the effects of the tax law where accounting is not complete, but that a reasonable estimate has been determined; and (3) a reasonable estimate cannot yet be made and therefore taxes are reflected in accordance with law prior to the enactment of the Tax Reform.

Amounts recorded in the period ended December 31,2017, principally relate to the reduction in the U.S. corporate income tax rate from 35% to 21%, which resulted in the Company reporting an income tax benefit of $2.4 million to remeasure deferred tax liabilities associated with indefinite-lived intangible assets that will reverse at the new 21% rate. Absent this deferred tax liability, the Company is in a net deferred tax asset position that is offset by a full valuation allowance. Though the impact of the rate change has a net tax effect of zero, the accounting to determine the gross change in the deferred tax position and the offsetting valuation resulted in a $26.3 million reduction in both.

Under the Tax Reform, deferred tax assets scheduled to reverse in subsequent years will result in net operating losses with an unlimited carryforward. The change in the carryforward period to post-2017 net operating losses allowed the Company to release valuation allowance associated with the reversing deferred tax assets to offset 80% of the deferred tax liability associated with indefinitely lived intangible asset. The release of valuation allowance resulted in the Company reporting an income tax benefit of $3.1 million.

The Tax Reform includes a one-time mandatory repatriation transition tax on the net accumulated earnings and profits of a U.S. taxpayer’s foreign subsidiaries.

The final impact of Tax Reform may differ from these estimates, due to, among other things, changes in interpretations, additional guidance that may be issued by the Internal Revenue Service or state and local authorities, and any updates or changes to estimates the Company has utilized to calculate the transition impact. Therefore, the Company's accounting for the elements of Tax Reform is incomplete. However, the Company was able to make reasonable estimates of the effects of Tax Reform. The Company will complete the accounting for these items during 2018, after completion of the 2017 U.S. income tax return.

Other significant Tax Reform provisions that are not yet effective but may impact income taxes in future years include: an exemption from U.S. tax on dividends of future foreign earnings, a limitation of net operating losses generated after 2017 to 80% of taxable income, the inclusion of commissions and performance based compensation in determining the excess compensation limitation, and a minimum tax on certain foreign earnings in excess of 10% of the foreign subsidiaries tangible assets (i.e., global intangible low-taxed income or GILTI). The Company is still evaluating its policy election to treat the GILTI tax as a period expense or to provide U.S. deferred taxes on foreign temporary differences that are expected to generate GILTI income when they reverse in future years.

The following table summarizes the significant components of the Company's deferred tax assets and liabilities as of December 31, 2017 and 2016 (in thousands):



	As of December 31,
	2017			2016
Deferred tax assets:
Inventory	$	847		$	735
Net operating and capital loss carryforwards	46,683			61,174
Deferred revenue	11,534			10,862
Accrued liabilities	4,064			6,975
Stock-based compensation	3,790			4,440
Amortization and depreciation	773			1,056
Bad debt reserve	90			389
Foreign and other tax credits	2,047			1,881
Gross deferred tax assets	69,828			87,512
Valuation allowance	(60,302		)	(78,363		)
Net deferred tax assets	9,526			9,149
Deferred tax liabilities:
Goodwill and indefinite lived intangibles	(5,033		)	(6,098		)
Deferred sales commissions	(4,996		)	(7,060		)
Prepaid expenses	(619		)	(656		)
Foreign currency translation	(846		)	(1,508		)
Gross deferred tax liabilities	(11,494		)	(15,322		)
Net deferred tax liabilities	$	(1,968	)	$	(6,173	)

For the year ended December 31, 2017, the Company recorded an income tax benefit of $2.5 million. The tax benefit primarily related to the reduction in the corporate tax rate from 35% to 21% which resulted in a tax benefit of $5.5 million, offset by current year profits of operations in Canada, Germany, and the U.K. Additionally, the tax expense relates to the tax impact of the amortization of U.S. indefinite-lived intangible assets and the inability to recognize tax benefits associated with current year losses of operations in certain foreign jurisdictions and in the U.S.

For the year ending December 31, 2016, the Company recorded income tax expense of $2.5 million. The tax expense was primarily related to current year profits in of operations in Germany and the U.K. Additionally, the tax expense relates to the tax impact of the amortization of U.S. indefinite-lived intangible assets and the inability to recognize tax benefits associated with current year losses of operations in all other foreign jurisdictions and in the U.S. due to the valuation allowance recorded against the deferred tax asset balances of these entities.

As of December 31, 2017, a full valuation allowance was provided for domestic and certain foreign deferred tax assets in those jurisdictions where the Company has determined the deferred tax assets will more likely than not be realized. If future events change the outcome of the Company's projected return to profitability, a valuation allowance may not be required to reduce the deferred tax assets. The Company will continue to assess the need for a valuation allowance.

As of December 31, 2017, the Company had federal, state and foreign tax NOL carryforward amounts and expiration periods as follows (in thousands):



Year of Expiration	U.S. Federal		State		Brazil		France		Spain		Mexico		Total
2018-2022	$	—	$	409	$	—	$	—	$	—	$	—	$	409
2023-2027	—		5,458		—		—		—		377		5,835
2028-2032	471		17,784		—		—		—		—		18,255
2033-2037	125,759		108,086		—		—		4		—		233,849
2038-2042	3,234		2,702		—		—		—		—		5,936
Indefinite	—		—		4,160		7,673		697		—		12,530
Totals	$	129,464	$	134,439	$	4,160	$	7,673	$	701	$	377	$	276,814

As of December 31, 2017, the Company had federal and state capital loss carryforward amounts and expiration periods as follows (in thousands):



Year of Tax Capital Loss Expiration	U.S. Federal		State
2018-2022	$	6,837	$	2,351
2023-2027	15,135		14,990
2028-2032	—		164
2033-2037	—		362
2038-2042	—		—
Indefinite	—		—
Totals	$	21,972	$	17,867

As of December 31, 2017, the Company had federal tax credit carryforward amounts and expiration periods as follows (in thousands):



Year of Tax Credit Expiration	U.S. Federal
2018-2022	$	—
2023-2027	1,638
2028-2032	166
2033-2037	218
2038-2042	—
Indefinite	26
Totals	$	2,048

The components of loss before income taxes and the provision for taxes on income consist of the following (in thousands):



	Years Ended December 31,
	2017			2016			2015
United States	$	(12,648	)	$	(24,963	)	$	(41,458	)
Foreign	8,603			(84		)	(4,179		)
Loss before income taxes	$	(4,045	)	$	(25,047	)	$	(45,637	)
The provision for taxes on income consists of the following (in thousands):
Federal	$	—		$	—		$	(157	)
State	(21		)	78			96
Foreign	1,701			1,250			444
Total current	$	1,680		$	1,328		$	383
Deferred:
Federal	$	(4,541	)	$	1,147		$	1,148
State	335			169			169
Foreign	27			(141		)	(541		)
Total deferred	(4,179		)	1,175			776
(Benefit) provision for income taxes	$	(2,499	)	$	2,503		$	1,159

Reconciliation of income tax (benefit) provision computed at the U.S. federal statutory rate to income tax (benefit) expense is as follows (in thousands):



	Years Ended December 31,
	2017			2016			2015
Income tax benefit at statutory federal rate	$	(1,416	)	$	(8,766	)	$	(15,973	)
Remeasurement of deferred tax liability related to indefinite-lived intangible due to U.S. rate reduction, effective January 1, 2018	(2,586		)	—			—
Release of valuation allowance due to change in U.S. net operating loss carry forward period	(3,103		)	—			—
Shortfall in tax benefit - stock compensation	233			—			—
State income tax expense, net of federal income tax effect	314			219			231
Tax capital loss in excess of book loss on sale of Japan subsidiary	(5,297		)	—			—
Nondeductible goodwill impairment	—			604			1,961
Other nondeductible expenses	398			384			88
Tax rate differential on foreign operations	(816		)	(474		)	(1,019		)
Increase in valuation allowance	9,446			10,404			15,713
Tax audit settlements	—			—			(96		)
Change in prior year estimates	150			—			225
Other tax credits	173			129			29
Other	5			3			—
Income tax (benefit) expense	$	(2,499	)	$	2,503		$	1,159

The Company accounts for uncertainty in income taxes under ASC topic 740-10-25, Income Taxes: Overall: Recognition, ("ASC 740-10-25"). ASC 740-10-25 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

The Company recognizes interest and penalties related to unrecognized tax benefits as a component of income tax expense (benefit). As of December 31, 2017 and 2016, the Company had no unrecognized tax benefits or interest and penalties.

The Company is subject to taxation in the U.S. and various states and foreign jurisdictions. The Company's tax years 2011 and forward are subject to examination by the tax authorities.

Prior to the fourth quarter of 2017, the Company asserted that the unremitted earnings of its foreign subsidiaries with unremitted earnings were deemed indefinitely reinvested. As the Company is in an aggregate net foreign deficit position for U.S. tax purposes, the Company is not liable for the transition tax enacted as part of the Tax Reform. As such, all prior earnings of the foreign subsidiaries with unremitted earnings are deemed to be previously taxed income for U.S. tax purposes as of December 31, 2017. The Company's assessment is provisional and we continue to assess the impact of the transition tax on unremitted earnings and its impact to the Company's outside basis.

The Company made income tax payments of $2.2 million, $0.8 million, and $1.4 million, in 2017, 2016 and 2015, respectively.