ANAPTYSBIO INC

Income Taxes

The components of income/(loss) before income tax provision (benefit) consist of the following:



	Year Ended December 31,
(in thousands)	2017			2016			2015
U.S.	$	(27,494	)	$	(632	)	$	1,719
Foreign	(2,576		)	(3,627		)	(6,985		)
Balance at the end of the year	$	(30,070	)	$	(4,259	)	$	(5,266	)

Significant components of our deferred tax assets and liabilities are as follows:



	December 31,
(in thousands)	2017			2016
Deferred Tax Assets:
Net operating loss carryforwards	$	17,408		$	15,300
Research and development credits	4,773			3,086
Other, net	1,686			1,017
Total deferred tax assets	23,867			19,403
Deferred Tax Liabilities:
Fixed assets	(57		)	(108		)
Total deferred tax liabilities	(57		)	(108		)
Net deferred tax assets	23,810			19,295
Less: valuation allowance	(23,810		)	(19,295		)
Deferred tax assets, net of valuation allowance	$	—		$	—

We have recorded a full valuation allowance against our net deferred tax assets due to the uncertainty surrounding the realization of such assets. Management has determined it more likely than not that the deferred tax assets are not realizable due to our historical loss position.

At December 31, 2017, we had federal and state net operating loss carryforwards, or NOLs, of $60.1 million and $57.2 million, respectively. The federal and state NOLs will both begin to expire in 2028, unless previously utilized. At December 31, 2017 we had federal and California research tax credit carryforwards of $3.0 million and $2.9 million, respectively. The federal research tax credit carryforward will begin to expire in 2026 and the California state credits carryforward indefinitely. We also have foreign tax losses of $2.6 million, which will carry forward indefinitely, subject to a continuity of ownership test.

The above NOL carryforward and the research tax credit carryforwards may be subject to an annual limitation under Section 382 and 383 of the Internal Revenue Code of 1986, as amended (the “Code”), and similar state provisions if we experience one or more ownership changes which would limit the amount of NOL and tax credit carryforwards that can be utilized to offset future taxable income and tax, respectively. In general, an ownership change as defined by Section 382 and 383, results from transactions increasing ownership of certain stockholders or public groups in the stock of the corporation by more than 50 percentage points over a three-year period. In September 2015, we completed a Section 382 analysis through December 31, 2014 and determined that there was an ownership change in 2007 that may limit the utilization of approximately $5.3 million and $5.4 million in federal and state NOLs, respectively, and $0.2 million in both federal and state research tax credits. We extended the analysis period of the study through December 31, 2016, noting no ownership changes during fiscal 2015 or 2016. We intend to extend the analysis period through December 31, 2017 in the current year, and are expecting an ownership change as a result of our IPO that may limit the utilization of Federal and State NOLs. Our use of federal NOL carryforwards could be limited further by the provisions of Section 382 of the Code depending upon the timing and amount of additional equity securities that we have issued or will issue. State NOL carryforwards may be similarly limited. If eliminated, the related asset would be removed from the deferred tax asset schedule with a corresponding reduction in the valuation allowance. Due to the existence of the valuation allowance, limitations created by future ownership changes, if any, will not impact our effective tax rate.

The following is a reconciliation of the expected statutory federal income tax provision to our actual income tax provision:



	Year Ended December 31,
(in thousands)	2017			2016			2015
Expected income tax expense (benefit) at federal statutory tax rate	$	(10,223	)	$	(1,448	)	$	(1,790	)
State income taxes, net of federal benefit	(787		)	(174		)	(206		)
Permanent items	13			12			10
Equity compensation⁽¹⁾	(739		)	163			144
Change in fair value of preferred stock warrant liabilities	464			257			434
Research and development expenditure	679			789			—
Return to provision adjustment	11			1,957			2
Rate differential	297			52			279
Federal rate adjustment - tax reform	7,595			—			—
Research credits	(1,554		)	(814		)	13
Change in the valuation allowance	4,244			(794		)	1,253
Income tax expense	$	—		$	—		$	139

⁽¹⁾ Includes non-deductible stock-based compensation and, beginning in 2017, excess tax benefits from stock-based compensation. During fiscal 2017, our tax provision includes $0.4 million of excess tax benefits associated with the exercise of non-qualified stock options and $0.7 million associated with the disqualifying dispositions of incentive stock options.

In December 2017, the Tax Cuts and Jobs Act, or the 2017 Act, was enacted, which includes a number of changes to existing U.S. tax laws that impact us, most notably a reduction of the U.S. corporate income tax rate from 35% to 21% for tax years beginning after December 31, 2017. The 2017 Act also provides for a one-time transition tax on certain foreign earnings and the acceleration of depreciation for certain assets placed in service after September 27, 2017 as well as prospective changes beginning in 2018, including additional limitations on: executive compensation; the deductibility of interest; the usage of NOLs against taxable income; the capitalization of research and development expenditures. While the 2017 Act provides for a territorial tax system, beginning in 2018, it includes two new U.S. tax base erosion provision, the global intangible low-taxed income, or GILTI provisions and the base-erosion and anti-abuse tax, or BEAT, provisions.

We measure deferred tax assets and liabilities using enacted tax rates that will apply in the years in which the temporary differences are expected to be recovered or paid. Accordingly, our deferred tax assets and liabilities were remeasured to reflect the reduction in the U.S. corporate income tax rate from 35% to 21% percent, resulting in a $7.6 million increase in tax expense for the year ended December 31, 2017 and a corresponding $7.6 million decrease in net deferred tax assets for the year ended December 31, 2017. The impact was fully offset by a valuation allowance.

The Act will no longer allow deductions for compensation in excess of $1.0 million for certain employees, even if paid as commissions or performance based compensation. It also subjects the principal executive officer, principal financial officer and three other highest paid officers to the limitation and once the individual becomes a covered person, the individual will remain a covered person for all future years. The tax effects of these provisions requires further analysis which is expected to be completed in the second half of 2018.

The 2017 Act provided for a one-time deemed mandatory repatriation of post-1986 undistributed foreign subsidiary earnings and profits through the year ended December 31, 2017. Our foreign subsidiary had an estimated accumulated deficit as of December 31, 2017. We do not expect we will be subject to this tax and therefore have not included any tax impacts related to the mandatory deemed repatriation in our consolidated financial statements.

The GILTI provisions require us to include in our US income tax return foreign subsidiary earnings in excess of an allowable return on the foreign subsidiary's tangible assets. While a Company may elect to account for GILTI tax in the period in which it is incurred, or recognize deferred taxes when basis differences exist that are expected to affect the amount of the GILTI inclusion upon reversal, we do not expect we will be subject to this tax and have not made a policy election as of December 31, 2017.

The BEAT provisions in the 2017 Act eliminates the deduction of certain base-erosion payments made to foreign corporations, and imposes a minimum tax if greater than regular tax. We do not expect it will be subject to this tax and do not anticipate any tax impacts of BEAT.

On December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed, including computations, in reasonable detail to complete the accounting for certain income tax effects of the 2017 Act. We have recognized provisional tax impacts related to the revaluation of deferred tax assets and liabilities and included these amounts in our consolidated financial statements for the year ended December 31, 2017. The ultimate impact may differ from these provisional amounts due to additional analysis, changes in interpretations and assumptions we have made, additional regulatory guidance that may be issued, and actions we may take as a result of the 2017 Act. The accounting is expected to be complete when the 2017 U.S. corporate income tax return is filed in fiscal 2018.

We recognize a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Income tax positions must meet a more likely than not recognition at the effective date to be recognized. At December 31, 2017 and 2016, we had no unrecognized tax benefits that if recognized and realized, would affect the effective tax rate due to the valuation allowance against deferred tax assets. The following table summarizes the activity related to our unrecognized tax benefits:



	Year Ended December 31,
(in thousands)	2017		2016
Balance at the beginning of the year	$	409	$	252
Decrease related to prior year tax positions	—		97
Increase related to current year tax positions	182		60
Balance at the end of the year	$	591	$	409

If recognized, these amounts would not affect our effective tax rate, since they would be offset by an equal corresponding adjustment in the deferred tax asset valuation allowance. We do not anticipate there will be a significant change in unrecognized tax benefits within the next 12 months.

Our policy is to recognize interest and penalties related to income tax matters in the provision for income taxes. At December 31, 2017, 2016 and 2015, there were no interest or penalties on uncertain tax benefits.

We file income tax returns in the United States, California and Australia. Due to our losses incurred, we are essentially subject to income tax examination by tax authorities from inception to date.