Guidewire Software, Inc.

Income Taxes

The Company’s income before provision for income taxes for the years ended July 31, 2017, 2016 and 2015 is as follows:



	Fiscal years ended July 31,
	2017		2016		2015
	(in thousands)
Domestic	$	26,474	$	11,209	$	11,348
International	6,803		9,573		5,392
Income before provision for income taxes	$	33,277	$	20,782	$	16,740

The provision for income taxes consisted of the following:



	Fiscal years ended July 31,
	2017			2016			2015
	(in thousands)
Current:
U.S. federal	$	7,793		$	4,936		$	2,509
State	1,974			1,006			300
Foreign	3,595			4,350			3,910
Total current	13,362			10,292			6,719
Deferred:
U.S. federal	(686		)	(4,867		)	983
State	(429		)	631			169
Foreign	(194		)	(250		)	(1,016		)
Total deferred	(1,309		)	(4,486		)	136
Total provision for income taxes	$	12,053		$	5,806		$	6,855

Differences between income taxes calculated using the statutory federal income tax rate of 35% and the provision for income taxes are as follows:



	Fiscal years ended July 31,
	2017			2016			2015
	(in thousands)
Statutory federal income tax	$	11,647		$	7,274		$	5,858
Nondeductible items and other	2,703			2,289			1,575
State income taxes, net of federal benefit	1,022			191			388
Impact of state rate changes	—			1,132			—
Foreign income taxed at different rates	1,513			945			816
Tax credits	(4,709		)	(5,963		)	(1,697		)
Change in valuation allowance	(123		)	(62		)	(85		)
Total provision for income taxes	$	12,053		$	5,806		$	6,855

The tax effects of temporary differences that gave rise to significant portions of deferred tax assets and liabilities are as follows:



	As of July 31,
	2017		2016
	(in thousands)
Accruals and reserves	$	11,612	$	11,618
Stock-based compensation	8,519		6,874
Deferred revenues	3,848		1,513
Property and equipment	1,189		1,815
Net operating loss carryforwards	16,720		10,333
Tax credits	11,919		12,145
Total deferred tax assets	53,807		44,298
Less valuation allowance	12,583		10,505
Net deferred tax assets	41,224		33,793
Less deferred tax liabilities:
Intangible assets	3,794		2,429
Total net deferred tax assets	$	37,430	$	31,364

During the years ended July 31, 2017, 2016 and 2015, the Company was able to consider positive evidence in determining the realizability of its deferred tax assets, including projections for future growth, and determined a valuation allowance was not required for a significant portion of its deferred tax assets. A valuation allowance of $12.6 million and $10.5 million remained as of July 31, 2017 and 2016, respectively, primarily for California research and development credits and net operating loss carryforwards that were not more likely than not realizable.

As of July 31, 2017, the Company had U. S. federal, California and other states net operating loss (“NOL”) carryforwards of $220.0 million, $68.0 million, and $96.2 million, respectively. The U. S. federal and California NOL carryforwards will start to expire in 2022 and 2018, respectively.

The Company had research and development tax credit (“R&D credit”) carryforwards of the following:



	As of July 31, 2017
	(in thousands)
U.S. federal	$	21,600
California	22,200
Total R&D credit carryforwards	$	43,800

The U.S. federal R&D credit will start to expire in 2023. California R&D tax credits have no expiration.

The excess tax benefits associated with stock option exercises are recorded directly to stockholders’ equity only when realized through reduction to income tax payable on the tax returns. As a result, the pre-tax excess tax benefits included in federal and California net operating loss carryforwards on the tax returns but not reflected in deferred tax assets for fiscal year 2017 are $176.1 million and $50.6 million, respectively.

Federal and California laws impose restrictions on the utilization of net operating loss carryforwards and R&D credit carryforwards in the event of a change in ownership of the Company, which constitutes an “ownership change” as defined by Internal Revenue Code Sections 382 and 383. The Company experienced an ownership change in the past that does not materially impact the availability of its net operating losses and tax credits. Nevertheless, should there be an ownership change in the future, the Company’s ability to utilize existing carryforwards could be substantially restricted.

The Company provides U.S. income taxes on the earnings of foreign subsidiaries, unless the subsidiaries’ earnings are considered indefinitely reinvested outside the United States. As of July 31, 2017, U.S. income taxes were not provided for on the cumulative total of $35.6 million in undistributed earnings from profitable foreign subsidiaries. As of July 31, 2017, the unrecognized deferred tax liability for these earnings was approximately $10.8 million.

Unrecognized Tax Benefits

The following table summarizes the activity related to unrecognized tax benefits:



	Fiscal years ended July 31,
	2017			2016			2015
	(in thousands)
Unrecognized tax benefit - beginning of period	$	7,687		$	6,109		$	7,976
Gross increases - prior period tax positions	712			177			1
Gross decreases - prior period tax positions	(691		)	(216		)	(2,896		)
Gross increases - current period tax positions	1,638			1,617			1,028
Unrecognized tax benefit - end of period	$	9,346		$	7,687		$	6,109

During the year ended July 31, 2017, the Company’s unrecognized tax benefits increased by $1.7 million, primarily associated with the Company’s U.S. federal and California R&D tax credits. As of July 31, 2017, the Company had unrecognized tax benefits of $4.0 million that, if recognized, would affect the Company’s effective tax rate.

The Company or one of its subsidiaries files income taxes in the U.S. federal jurisdiction and various states and foreign jurisdictions. If the Company utilizes net operating losses or tax credits in future years, the U.S. federal, state and local, and non-U.S. tax authorities may examine the tax returns covering the period in which the net operating losses and tax credits arose. As a result, the Company’s tax returns in the U.S. and California remain open to examination from fiscal years 2002 through 2017. As of July 31, 2017, the Company has no tax audits in progress in the U.S. and in foreign jurisdictions.