Evolent Health, Inc.

Income Taxes

On December 22, 2017, the U.S. government enacted the Tax Act. The Tax Act establishes new U.S. tax laws impacting the Company which include a reduction of the U.S. corporate income tax rate from 35% to 21% effective for tax years beginning after December 31, 2017, an indefinite carryforward period and 80% taxable income limitation on NOLs arising after December 31, 2017, and the repeal of the corporate alternative minimum tax (“AMT”).

In accordance with SEC Staff Accounting Bulletin No. 118, which provides SEC staff guidance for the application of ASC Topic 740, Income Taxes, in the reporting period in which the Tax Act was signed into law, the Company recorded provisional amounts representing reasonable estimates of effects of the Tax Act in its 2017 financial statements. The Company did not identify items for which the income tax effects of the Tax Act have not been completed and a reasonable estimate could not be determined as of December 31, 2017. The Company may adjust provisional estimates, which may impact our current income tax expense in the period in which the adjustments are made. The Company will continue to evaluate any adjustments necessary to our initial provisional estimates throughout 2018.

The Company believes the revaluation of our deferred tax assets and liabilities as a result of the Tax Act will have the most significant impact on the Company’s income tax expense. The Company measures 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 settled. The Company recorded provisional expense of $27.5 million related to the decrease in net deferred tax assets, and a corresponding $30.2 million provisional benefit from the decrease in valuation allowance to reflect the reduction of the statutory corporate income tax rate. The Company also recorded a $2.8 million provisional benefit for release of valuation allowance related to indefinite-lived intangible deferred tax liabilities now considered a source of income as support for the realization of future indefinite-lived NOL deferred tax assets, and a $0.3 million provisional benefit for the refundability of existing AMT credit carryforward.

The Company incurs U.S. federal, state and local income taxes on the Company’s allocable share of taxable income of Evolent Health LLC. Our income before income tax is derived exclusively from U.S. sources.

Components of income tax expense (benefit) (in thousands) consist of the following:



	For the Years Ended December 31,
	2017			2016			2015
Current
Federal	$	368		$	—		$	15
State and local	266			—			—
Total current tax expense	634			—			15
Deferred
Federal	3,202			(9,708		)	7,092
State and local	(3,102		)	(1,138		)	1,166
Total deferred tax expense	100			(10,846		)	8,258
Change in valuation allowance	(7,371		)	91			15,202
Total tax expense (benefit)	$	(6,637	)	$	(10,755	)	$	23,475

A reconciliation of the U.S. statutory tax rate to our effective tax rate is presented below:



	For the Years Ended December 31,
	2017		2016		2015
U.S. statutory tax rate	35.0	%	35.0	%	35.0	%
U.S. state income taxes, net of U.S. federal tax benefit	3.3	%	4.0	%	4.9	%
Change in valuation allowance	(34.0	)%	(0.1	)%	4.4	%
Change in valuation allowance, tax reform	43.7	%	—	%	—	%
Impact of tax reform	(36.0	)%	—	%	—	%
Remeasurement gain	—	%	—	%	(40.1	)%
Non-deductible stock-based compensation expense	—	%	—	%	1.0	%
Goodwill impairment	—	%	(18.7	)%	—	%
Gain on contribution	—	%	(5.0	)%	—	%
Non-controlling interest	(4.6	)%	(11.0	)%	1.4	%
Stock-based compensation excess tax benefits	3.1	%	0.1	%	—	%
Other, net	(1.8	)%	0.2	%	0.2	%
Effective rate	8.7	%	4.5	%	6.8	%

Deferred tax balances reflect the impact of temporary differences between the carrying amount of assets and liabilities and their tax basis and are stated at the tax rates in effect when the temporary differences are expected to be recovered or settled.

Significant components of the Company’s deferred tax assets and liabilities (in thousands) were as follows:



	As of December 31,
	2017			2016
Deferred Tax Assets
Start-up and organizational costs	$	185		$	321
Internally developed software costs	3,974			7,137
Net operating loss carryforwards	51,197			60,076
Other	(69		)	509
Subtotal	55,287			68,043
Valuation allowance	(53,201		)	(26,376		)
Total deferred tax assets	2,086			41,667

Deferred Tax Liabilities
Equity-method investment	4,523			62,513
Total deferred tax liabilities	4,523			62,513
Net deferred tax assets (liabilities)	$	(2,437	)	$	(20,846	)

Changes in our valuation allowance (in thousands) were as follows:



	For the Years Ended December 31,
	2017			2016		2015
Balance at beginning-of-year	$	26,376		$	19,974	$	6,914
Charged to costs and expenses	(7,371		)	91		15,202
Charged to other accounts ⁽¹⁾	34,196			6,311		(2,142		)
Balance at end-of-year	$	53,201		$	26,376	$	19,974


⁽¹⁾	Amounts charged to other accounts includes an increase of $34.2 million, $6.3 million and a decrease of $2.1 million charged to additional paid-in-capital for the years ended December 31, 2017, 2016 and 2015, respectively.

The Company continues to record a valuation allowance against the net deferred tax assets that are not more likely than not to be realized. This assessment is made without considering potentially offsetting deferred tax liabilities established with respect to certain indefinite lived components, or components of the deferred tax liability expected to reverse outside of the net operating loss carryover period, as these were appropriately not considered a source of future taxable income for realizing the deferred tax assets, with the exception of up to 80% of future indefinite-lived NOL deferred tax assets.

For the year ended December 31, 2017, the effective tax rate was 8.7%, due to the impact of the valuation allowance recorded against the Company’s net deferred tax assets, with the exception of indefinite lived components and those expected to reverse outside of the net operating loss carryover period as part of the outside basis difference in our partnership interest in Evolent Health LLC. The benefit recorded during the year primarily relates to the effects of the Tax Act, largely due to the revaluation of our deferred tax assets and liabilities for the new statutory income tax rate, and release of valuation allowance related to indefinite-lived intangible deferred tax liabilities now considered a source of income as support for the realization of future indefinite-lived NOL deferred tax assets.

For the year ended December 31, 2016, the effective tax rate was 4.5%, due to the impact of the valuation allowance recorded against the Company’s net deferred tax assets, with the exception of indefinite lived components and those expected to reverse outside of the net operating loss carryover period as part of the outside basis difference in our partnership interest in Evolent Health LLC. The benefit recorded during the year primarily relates to release of this valuation allowance as a result of the Valence Health acquisition and movement in the indefinite lived book-over-tax basis difference not considered a source of future taxable income to support realizability of the deferred tax assets.

For the year ended December 31, 2015, the effective tax rate was 6.8%, due to the impact of the valuation allowance recorded against the Company’s net deferred tax assets, with the exception of indefinite lived components and those expected to reverse outside of the net operating loss carryover period as part of the outside basis difference in our partnership interest in Evolent Health LLC. Pursuant to the Offering Reorganization, the Company recorded $23.5 million in income tax provision, due to an increase in these components of the deferred tax liability related to the book basis as compared to the tax basis in Evolent Health LLC.

As of December 31, 2017, the Company had NOLs of approximately $207.6 million available to offset future taxable income that begin to expire in 2031 through 2038. However, as realization of such tax benefit is not more likely than not, based on our evaluation, we have established a valuation allowance. Internal Revenue Code Section 382 imposes limitations on the utilization of NOLs in the event of certain changes in ownership of the Company, which may have occurred or could occur in the future. This could impose an annual limit on the Company’s ability to utilize NOLs and could cause U.S. federal income taxes to be paid earlier than otherwise would be paid if such limitations were not in effect.

Changes in our unrecognized tax benefits (in thousands) were as follows:



	For the Years Ended December 31,
	2017			2016		2015
Balance at beginning-of-year	$	—		$	—	$	—
Gross increases - tax positions in prior period	1,108			—		—
Gross increases - tax positions in current period	74			—		—
Change in tax rate	(420		)	—		—
Balance at end-of-year	$	762		$	—	$	—

Included in the balance of unrecognized tax benefits as of December 31, 2017, are $0.8 million of tax benefits that, if recognized, would not affect the effective tax rate. The Company has not recognized interest and penalties related to uncertain tax positions due to the current NOL position. The Company had not recognized any uncertain tax positions, penalties or interest as of December 31, 2016 and 2015, as we concluded that no such positions existed. The Company is not currently subject to income tax audits in any U.S. or state jurisdictions for any tax year.

Tax Receivables Agreement

Pursuant to the Offering Reorganization, Class B Exchanges are expected to increase our tax basis in our share of Evolent Health LLC’s tangible and intangible assets. These increases in tax basis are expected to increase our depreciation and amortization deductions and create other tax benefits and, therefore, may reduce the amount of tax that we would otherwise be required to pay in the future. In addition, certain NOLs of Evolent Health Holdings (and of an affiliate of TPG) are available to us as a result of the Offering Reorganization.

In connection with the Offering Reorganization, we entered into the TRA with the holders of Class B common units. The agreement requires us to pay to such holders 85% of the cash savings, if any, in U.S. federal, state and local and foreign income tax (as applicable) we realize as a result of any deductions attributable to future increases in tax basis following the Class B Exchanges (calculated assuming that any post-offering transfer of Class B common units had not occurred) or deductions attributable to imputed interest or future increases in tax basis following payments made under the TRA. We are accounting for these payments as contingent liabilities and will recognize them in our Consolidated Statements of Operations when their realization is probable. Additionally, pursuant to the same agreement we will pay the former stockholders of Evolent Health Holdings 85% of the amount of the cash savings, if any, in U.S. federal, state and local and foreign income tax that we realize as a result of the utilization of the NOLs of Evolent Health Holdings (and the affiliate of TPG) attributable to periods prior to the Offering Reorganization, approximately $79.3 million, as well as deductions attributable to imputed interest on any payments made under the agreement.

We will benefit from the remaining 15% of any realized cash savings. The TRA was effective upon the completion of the Offering Reorganization and will remain in effect until all such tax benefits have been used or expired, or until the agreement is terminated. See Note 9 for additional discussion of the implications of the TRA.