NOVABAY PHARMACEUTICALS, INC.

NOTE

15.

INCOME TAXES

The federal and state income tax provision is summarized as follows (in thousands):

	Year Ending December 31
(in thousands)	2017		2016		2015
Current
Federal	$	-	$	-	$	-
State		3		2		2
Other		—		—		—
Total Current tax expense		3		2		2

Deferred		—		—		—
Federal		—		—		—
State		—		—		—
Other		—		—		—
Total deferred tax expense		—		—		—

Income tax provision	$	3	$	2	$	2

Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (b) operating losses and tax credit carryforwards.

The tax effects of significant items comprising the Company's deferred taxes as

December 31,

are as follows:

	December 31
(in thousands)	2017			2016
Deferred tax assets:
Net operating losses	$	25,564		$	34,902
Accruals		225			287
Deferred revenue		508			829
Stock options		1,556			1,894
Other deferred tax assets		727			765
Total deferred tax assets		28,580			38,677


Deferred tax liabilities:
Property and equipment		(35	)		(32	)
Total deferred tax liabilities		(35	)		(32	)

Valuation allowance		(28,545	)		(38,645	)
Net deferred taxes	$	—		$	—

December 22, 2017,

the Tax Cuts and Jobs Act of

2017

(the “Act”) was signed into law resulting in significant changes to the Internal Revenue Code. The Act, among other things, reduced the federal corporate income tax rate from

35%

21%

effective for tax years beginning after

December 31, 2017.

Consequently, the Company's net deferred tax assets as of

December 31, 2017

were significantly reduced to reflect the estimated impact of the Tax Act. Due to the Company's lack of earnings history and uncertainties surrounding the ability to generate future taxable income, the net deferred tax assets have been fully offset by a valuation allowance as mentioned above. The significant reduction in the deferred tax assets are fully offset by a reduction in the valuation allowance, resulting in

impact to income tax expense.

March 2016,

the FASB issued ASU

No.

2016

09,

Improvements to Employee Share-Based Payment Accounting (ASU

2016

), which is intended to simplify several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU

2016

is effective for annual periods beginning after

December 15, 2016,

and interim periods within those annual periods. We adopted ASU

2016

in the

first

quarter of

2017.

The impact of adopting ASU

2016

resulted in the following:

• Classification of excess income tax benefits from stock-based compensation arrangement as a discrete item within income tax expense, rather than recognizing such excess income tax benefits in additional paid-in capital. The adoption of this guidance resulted in an increase of approximately

$1.1

million of net operating losses, which has an impact of

$0.4

million on our deferred tax assets before our full valuation allowance established against the related deferred tax assets.

The Company records

the tax benefit of net operating loss carryforwards and temporary differences as an asset to the extent that management assesses that realization is "more likely than

not."

Realization of the future tax benefits is dependent on the Company's ability to generate sufficient taxable income within the carryforward period. Because of the Company's recent history of operating losses, management believes that recognition of the deferred tax assets is currently

not

likely to be realized and, accordingly, has provided a valuation allowance.

The valuation allowance

(decreased)/increased by the following amounts (in thousands):

2017			2016			2015
	$(10,100)			$3,642			$8,101

Net operating loss

and tax credit carryforwards as of

December 31, 2017,

are as follows (in thousands):

			Expiration
	Amount		Years
Net operating losses, federal	$	94,830	2024	-	2037
Net operating losses, state	$	78,533	2028	-	2037
Tax credits, federal	$	1,316	2026	-	2035
Tax credits, state	$	282	do not expire

Under U.S. federal tax law, the amount and availability of tax benefits are subject to a variety of interpretations and restrictive tests. Utilization of the net operating loss (NOL) carryforwards

may

be subject to a substantial annual limitation due to ownership changes that have occurred previously or that could occur in the future, as provided by Section

382

of the Internal Revenue Code of

1986,

and similar state provisions. Ownership changes

may

limit the amount of NOL carryforwards that can be utilized annually to offset future taxable income and tax, respectively. In general, an ownership change, as defined by Section

382,

results from transactions increasing the ownership of certain shareholders or public groups in the stock of a corporation by more than

percentage points over a

three

-year period. Since the Company

’s formation, the Company has raised capital through the issuance of capital stock on

two

occasions which, combined with the purchasing shareholders’ subsequent disposition of those shares,

may

have resulted in

one

or more changes of control, as defined by Section

382.

The Company has

not

currently completed a study to assess whether any change of control has occurred, or whether there have been multiple changes of control since the Company’s formation, due to the significant complexity and cost associated with the study. If the Company has experienced a change of control at any time since its formation, its NOL carryforwards and tax credits

may

not

be available, or their utilization could be subject to an annual limitation under Section

382.

A full valuation allowance has been provided against the Company’s NOL carryforwards, and if an adjustment is required, this adjustment would be offset by an adjustment to the valuation allowance. Accordingly, there would be

impact on the consolidated balance sheet or statement of operations if an adjustment is required.

The effective tax rate of the Company's provision (benefit) for income taxes differs from the federal statutory rate as follows:

	Year Ending December 31
(in thousands)	2017			2016			2015
Income tax provision (benefit) at federal statutory rate	$	(2,516	)	$	(4,471	)	$	(6,439	)
State tax		(12	)		(157	)		(1,060	)
ISO-related expense for GAAP		154			52			164
Change in valuation allowance		(10,484	)		3,641			8,101
Revaluation of warrant liability		34			806			(731	)
Tax credits		—			(31	)		(123	)
Other		(49	)		162			90
Section 162(m) disallowance		336			—			—
Tax Reform - Tax Rate Change		12,540			—			—
Total	$	3		$	2		$	2

Uncertain Income Tax Positions

The Company

adopted the provisions of ASC

740

10,

Accounting for Uncertainty in Income Taxes

, on

January 1, 2007.

There was

impact on our consolidated financial position, results of operations and cash flows as a result of adoption. A reconciliation of the beginning and ending balances of the unrecognized tax benefits during the years ended

December 31, 2017

and

2016

is as follows:

	Year ended December 31,
(in thousands)	2017			2016
Unrecognized benefit - beginning of period	$	974		$	957
Gross increases/ (decreases) - prior/current period tax positions		(43	)		17
Unrecognized benefit - end of period	$	931		$	974

Our policy will be to recognize interest and penalties related to income taxes as a component of income tax expense. We are subject to income tax examinations for U.S. incomes taxes and state income taxes

from

2004

and

2006

forward respectively. We do

not

anticipate that total unrecognized tax benefits will significantly change in the next

months.