10. Income Taxes

 

The following table presents the components of income (loss) before the provision for (benefit from) income taxes during the years ended December 31, 2015, 2016, and 2017 (in thousands):

 

 

Provisions for income taxes for the years ended December 31, 2015, 2016 and 2017 are as follows (in thousands):

 

 

The following table presents a reconciliation of income tax expense (benefit) at the statutory federal income tax rate to the effective income tax rate as reflected in the consolidated financial statements:

 

 

The Company’s effective rate for the year ended December 31, 2017 compared to the year ended December 31, 2016 decreased primarily as a result of China withholding taxes on the up-front license payment received from Zai Lab during the year ended December 31, 2016, offset by increases as a result of subsidiary operations in foreign tax jurisdictions during the year ended December 31, 2017.

 

The Company accounts for income taxes in accordance with ASC Topic 740.  Deferred income tax assets and liabilities are determined based upon temporary differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.  The following table presents the principal components of the Company’s deferred tax assets and liabilities (in thousands):

 

 

Effective January 1, 2017, the Company adopted ASC Topic 606, using the full retrospective transition method.  Under this method, the Company has revised its consolidated financial statements for the years ended December 31, 2015 and 2016, and applicable interim periods within those years, as if Topic 606 had been effective for those periods.  The adoption of this guidance did not have a significant impact on the Company’s related tax disclosures.

 

On December 22, 2017, the Tax Cuts and Jobs Act of 2017, or the Tax Act, was signed into law, resulting in significant changes to the U.S. corporate income tax system.  These changes include a reduction of the federal statutory rate from 35% to 21%, reduction of certain tax credits, limitations on deductibility of interest expense and executive compensation, and limitations on the use of net operating loss, or NOL, carryforwards.  The Tax Act also transitions U.S. international taxation from a worldwide system to a territorial system and includes provisions to prevent base erosion on foreign earnings, which has the effect of subjecting certain earnings of the Company’s foreign subsidiaries to current U.S. taxation.  These changes are generally effective beginning in 2018.

 

The Tax Act also includes a one-time mandatory deemed repatriation tax on accumulated foreign subsidiaries’ previously untaxed foreign earnings, or the Transition Toll Tax.  The Transition Toll Tax can be paid over an eight-year period, starting in 2018 and will not be subject to interest.

 

The Company has recognized the provisional tax impacts related to the Transition Toll Tax and the revaluation of deferred tax assets and liabilities in its consolidated financial statements for the year ended December 31, 2017.  The Tax Act did not have a significant impact on the Company’s consolidated financial statements for the year ended December 31, 2017 because the Company maintains a full valuation allowance on its net operating losses and other deferred tax assets.  In addition, the Company has an accumulated deficit from its foreign operations and does not have an associated liability from the Transition Toll Tax.

 

The Tax Act subjects a U.S. stockholder to tax on global intangible low-taxed income, or GILTI, earned by certain foreign subsidiaries.  Companies can make an accounting policy election to either recognize deferred taxes for temporary basis differences expected to reverse as GILTI in future years, or provide for the tax expense related to GILTI in the year the tax is incurred.  Given the complexity of the GILTI provisions, the Company is still evaluating the effects of GILTI provisions and has not yet determined its accounting policy.

 

In accordance with SEC Staff Accounting Bulletin No. 118, the Company’s preliminary estimate of the impact of the Tax Act is subject to the finalization of management's analysis related to certain matters, such as developing interpretations of the provisions of the Tax Act, changes to certain estimates and amounts related to the earnings and profits of certain subsidiaries and the filing of the Company’s tax returns.  U.S. Treasury regulations, administrative interpretations or court decisions interpreting the Tax Act may require further adjustments and changes in the Company’s estimates, which could have a material adverse effect on the Company’s business, results of operations or financial condition.  The Company’s final determination of the impact of the Tax Act will be completed as additional information becomes available, but no later than one year from its enactment.

 

ASC Topic 740 requires a valuation allowance to reduce the deferred tax assets reported if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized.  After consideration of all the evidence, both positive and negative, the Company has recorded full valuation allowances against its domestic and foreign deferred tax assets at December 31, 2017, because management has determined that is it more likely than not that these assets will not be realized.  The valuation allowance increased by $50.0 million from December 31, 2016 to December 31, 2017, primarily due to increases in operating losses and tax credits, partially offset by decreases reflecting the change in the U.S. corporate income tax rate from 35% to 21% resulting from the Tax Act.

 

As of December 31, 2017, the Company had cumulative federal, state and foreign NOL carryforwards of $963.9 million and $449.5 million and $14.2, million respectively.  The federal, state and foreign NOL carryforwards will expire at various dates through 2037, if not utilized, and are fully offset by a valuation allowance.

 

As of December 31, 2017, the Company had federal general business and state research and development tax credit carryforwards of approximately $102.1 million and $7.4 million, respectively, available to reduce future tax liabilities.  The federal general business and state research and development tax credits will expire at various dates through 2037.  The federal and state tax credit carryforwards are fully offset by a valuation allowance. 

 

Under the provisions of the Internal Revenue Code, the NOL and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service and state tax authorities.  NOL and tax credit carryforwards may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant stockholders over a three-year period in excess of 50 percent, as defined under Sections 382 and 383 of the Internal Revenue Code, respectively, as well as similar state provisions.  This could limit the amount of tax attributes that can be utilized annually to offset future taxable income or tax liabilities.  The amount of the annual limitation is determined based on the value of the Company immediately prior to the ownership change.  Subsequent ownership changes may further affect the limitation in future years.  The Company has completed several financings since its inception that it believes may have resulted in a change in control as defined by Sections 382 and 383 of the Internal Revenue Code.

 

The Company and its subsidiaries file income tax returns in the United States, as well as various state and foreign jurisdictions.  Generally, the tax years 2014 through 2016 remain open to examination by the major taxing jurisdictions to which the Company is subject.  To the extent the Company has tax attribute carryforwards, the tax years in which the attribute was generated may still be adjusted upon examination by the Internal Revenue Service, or state or foreign tax authorities, to the extent utilized in a future period.

 

A reconciliation of the beginning and ending balances of unrecognized tax benefits is as follows (in thousands):

 

 

During the year ended December 31, 2017, the Company established gross reserves of $4.0 million and $9.9 million related to research and development tax credits and the allocation of taxable income to the various jurisdictions where the Company is subject to tax, respectively.    

 

The Company’s policy is to record estimated interest and penalties related to the underpayment of income taxes as a component of its income tax provision.  As of December 31, 2016 and 2017, the Company had no accrued interest or penalties related to uncertain tax positions and no amounts have been recognized in the Company’s consolidated statement of operations.