Note 9—Income Taxes

The components of (loss) income from continuing operations before income taxes are as follows:


Year ended July 31 (in thousands)	2012			2011			2010
Domestic	$	14,435		$	28,417		$	11,354
Foreign		(21,421	)		(18,475	)		(13,456	)
(LOSS) INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES	$	(6,986	)	$	9,942		$	(2,102	)

Significant components of the Company’s deferred income tax assets and deferred income tax liabilities consist of the following:


July 31 (in thousands)	2012			2011
Deferred income tax assets:
Bad debt reserve	$	2,751		$	3,893
Accrued expenses		17,666			15,478
Exercise of stock options and lapsing of restrictions on restricted stock		1,342			1,814
Charitable contributions		7,266			12,397
Impairment		25,671			27,552
Depreciation		409			3,900
Unrealized gain		1,102			—
Net operating loss		183,061			142,376
Credits		2,595			2,300
Total deferred income tax assets		241,863			209,710
Deferred income tax liabilities:
Unrealized loss		—			(3,041	)
Valuation allowance		(204,977	)		(206,669	)
DEFERRED INCOME TAX ASSETS, NET	$	36,886		$	—

The benefit from income taxes consists of the following:


Year ended July 31 (in thousands)	2012			2011		2010
Current:
Federal	$	1,632		$	4,073	$	10,059
State and local		2,497			2,413		(716	)
Foreign		1,741			3,184		(669	)
		5,870			9,670		8,674
Deferred:
Federal		36,166			2,137		—
State and local		764			677		—
Foreign		(44	)		—		—
		36,886			2,814		—
BENEFIT FROM INCOME TAXES	$	42,756		$	12,484	$	8,674

The benefit from income taxes in fiscal 2012 was primarily due to the $36.9 million reversal of a portion of the Company’s valuation allowance. In fiscal 2012, the Company determined that it was more likely than not that a portion of its deferred income tax assets would be realized, therefore the valuation allowance related to those assets was reversed. The Company based its determination on a projection of future U.S. income and took into consideration the historical U.S. performance and decided a partial release of the U.S. valuation that relates to the core businesses was warranted in the current period. Assumptions regarding future taxable income require significant analysis and judgment. This analysis includes financial forecasts based on historical performance of the core business and continuance of doing business in a jurisdiction in which losses are incurred. Based on its projections, the Company expects that it will generate future taxable income over the next five years in the U.S. jurisdiction and will begin utilizing its net operating loss carryover through this period. Accordingly, the Company concluded that a portion of its U.S. jurisdiction core business assets do not require a full valuation allowance.

The Company did not release any of the valuation allowances that relate to its IDT Spectrum business since it is not part of the main tax consolidated group and the portion of the Net2Phone acquired net operating loss that is subject to Internal Revenue Code Section 382 limitations (see below). The Company did not release any of the valuation allowances related to its foreign operations as it is not more likely than not that the assets will be utilized based upon the earnings history and the current profitability projections.

In February 2011, the Company liquidated its Puerto Rico legal entity. The final Puerto Rico tax return was filed in April 2011 claiming a refund of $4.8 million. The Company expects to receive the refund shortly after the completion of the audits of the liquidated entity’s Puerto Rico tax returns for fiscal years 2009 and 2010. The Company reversed $3.5 million of income tax expense in April 2011 as a result of this expected income tax refund. In addition, in the first quarter of fiscal 2011, the Company reversed $2.0 million of income tax expense related to an IRS audit that was completed in August 2010.

The differences between income taxes expected at the U.S. federal statutory income tax rate and income taxes provided are as follows:


Year ended July 31 (in thousands)	2012			2011			2010
U.S. federal income tax at statutory rate	$	2,445		$	(3,480	)	$	736
Valuation allowance		43,637			17,328			14,411
Foreign tax rate differential		(5,800	)		(3,282	)		(5,379	)
Nondeductible expenses		(26	)		(40	)		(44	)
Other		—			49			(399	)
Prior year tax benefit		2,500			2,000			(400	)
State and local income tax, net of federal benefit		—			(91	)		(251	)
BENEFIT FROM INCOME TAXES	$	42,756		$	12,484		$	8,674

At July 31, 2012, the Company had federal and state net operating loss carryforwards of approximately $183 million. This carry-forward loss is available to offset future U.S. federal and state taxable income. The net operating loss carryforwards will start to expire in fiscal 2013, with fiscal 2009’s loss expiring in fiscal 2030. The Company has foreign net operating losses of approximately $140 million, which are available to offset future taxable income in the countries in which the losses were incurred. The Company’s subsidiary, Net2Phone, which provides VoIP communications services, has additional net operating losses of approximately $98 million which will expire through fiscal 2027. With the reacquisition of Net2Phone by the Company in March 2006, its losses were limited under Internal Revenue Code Section 382 to approximately $7 million per year. The Company also has $124 million of net operating losses in IDT Spectrum which is not consolidated for tax purposes and files separate returns.

In fiscal 2010, the Company wrote-off its deferred tax liability for the gain on sales of subsidiary stock that was primarily related to Net2Phone’s initial public offering of its common stock in August 1999 and Net2Phone’s follow-on offering in December 1999 after the Company completed the integration of Net2Phone’s operations with IDT Telecom. As a result, in fiscal 2010, the Company increased its valuation allowance for deferred tax assets.

The Company has not recorded U.S. income tax expense for foreign earnings, as such earnings are permanently reinvested outside the United States. The cumulative undistributed foreign earnings are included in accumulated deficit in the Company’s consolidated balance sheets, and consisted of approximately $355 million at July 31, 2012. Upon distribution of these foreign earnings to the Company’s domestic entities, the Company may be subject to U.S. income taxes and withholding of foreign taxes, however, it is not practicable to determine the amount, if any, which would be paid.

The change in the valuation allowance is as follows:


Year ended July 31 (in thousands)	Balance at beginning of year		Additions charged to costs and expenses		Deductions			Balance at end of year
2012
Reserves deducted from deferred income taxes, net:
Valuation allowance	$	206,669	$	41,925	$	(43,617	)	$	204,977
2011
Reserves deducted from deferred income taxes, net:
Valuation allowance	$	248,345	$	—	$	(41,676	)	$	206,669
2010
Reserves deducted from deferred income taxes, net:
Valuation allowance	$	192,729	$	55,616	$	—		$	248,345

The table below summarizes the change in the balance of unrecognized income tax benefits:


Year ended July 31 (in thousands)	2012			2011		2010
Balance at beginning of year	$	3,754		$	1,754	$	1,754
Additions based on tax positions related to the current year		—			—		—
Additions for tax positions of prior years		—			2,000		—
Reductions for tax positions of prior years		—			—		—
Settlements		(3,754	)		—		—
Lapses of statutes of limitations		—			—		—
Balance at end of year	$	—		$	3,754	$	1,754

All of the unrecognized income tax benefits at July 31, 2011 would have affected the Company’s effective income tax rate if recognized. Settlements of $3.8 million in fiscal 2012 were primarily due to an agreement on certain state tax positions and the related payment of the taxes due, as well as the settlement of a foreign audit.

In fiscal 2012, fiscal 2011 and fiscal 2010, the Company recorded interest on income taxes of nil, $0.1 million and $0.1 million, respectively. As of July 31, 2012 and 2011, accrued interest included in current income taxes payable was nil and $0.2 million, respectively.

The Company currently remains subject to examinations of its tax returns as follows: U.S. federal tax returns for fiscal 2009 to fiscal 2012, state and local tax returns generally for fiscal 2008 to fiscal 2012 and foreign tax returns generally for fiscal 2008 to fiscal 2012.