7. Income Tax

Pretax earnings (loss) were generated by both domestic and foreign operations as follows (in thousands):

	Years Ended December 31,
	2017			2016			2015
United States	$	(47,712	)	$	(57,096	)	$	(47,490	)
Foreign		(495	)		(808	)		(483	)
	$	(48,207	)	$	(57,904	)	$	(47,973	)

A reconciliation of the expected statutory federal income tax provision to the actual income tax provision is summarized as follows (in thousands):

	Years Ended December 31,
	2017			2016			2015
Expected income taxes benefit at federal statutory rate	$	(16,390	)	$	(19,687	)	$	(16,311	)
State income taxes, net of federal benefit		(13	)		—			—
Permanent items and other		1,311			675			865
Research credits		(2,286	)		(6,800	)		(2,674	)
Unrecognized tax benefits		914			2,720			1,070
Foreign rate differential		87			141			84
Change in tax rate		(25	)		—			3,551
Tax cuts and Jobs Act		27,933			—			—
Change in valuation allowance		(11,531	)		22,902			13,415
Income tax (benefit) expense	$	—		$	(49	)	$	—

Deferred income taxes are provided for temporary differences in recognizing certain income and expense items for financial and tax reporting purposes. The deferred tax assets consisted primarily of the income tax benefits from net operating loss (NOL) carryforwards, research and development credits and capitalized research and development expenses, along with other accruals and reserves. Valuation allowances of $59.7 million and $71.1 million as of December 31, 2017 and 2016, respectively, have been recorded to offset deferred tax assets as realization of such assets does not meet the more-likely-than-not threshold under ASC 740, Accounting for Income Taxes.

Significant components of our deferred tax assets are summarized as follows (in thousands):

	December 31,
	2017			2016
Net operating loss carryforwards	$	27,226		$	33,713
Capitalized research and development expenses		16,218			21,624
Research credits and other state credits		11,229			9,227
Intangible assets		2,210			3,874
Reserve and accruals		2,843			2,711
Valuation allowance		(59,726	)		(71,149	)
Net deferred tax assets	$	—		$	—

As of December 31, 2017, we had approximately $112.5 million, $119.2 million, and $7.0 million of net operating loss carryforwards for federal, state, and foreign purposes, respectively, net of Section 382 limitations, available to offset future taxable income. The federal and state net operating loss carryforwards begin to expire in 2025 and 2021, respectively. The foreign net operating losses carry over indefinitely. As of December 31, 2017, we had federal and state research and development credit carryforwards of approximately $3.6 million and $3.2 million, respectively, net of Section 382 limitations, which begin to expire in 2026 for federal purposes and carry over indefinitely for state purposes. We had $12.5 million of federal Orphan Drug Credits as of December 31, 2017, which will begin to expire in 2035.

Utilization of the domestic NOL and research and development credit carryforwards may be subject to a substantial annual limitation due to ownership change limitations that may have occurred or that could occur in the future, as required by Section 382 and 383 of the Internal Revenue Code of 1986, as amended (the Code), as well as similar state and foreign provisions. These ownership changes may limit the amount of NOL and research and development credit carryforwards that can be utilized annually to offset future taxable income and tax, respectively. In general, an “ownership change” as defined by Section 382 of the Code results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50 percentage points of the outstanding stock of a company by certain stockholders. Since the Company’s formation, we raised capital through the issuance of capital stock on several occasions which on its own or combined with the purchasing stockholders’ subsequent disposition of those shares, has resulted in such an ownership change, and could result in an ownership change in the future.

Upon the occurrence of an ownership change under Section 382 as outlined above, utilization of the NOL and research and development credit carryforwards become subject to an annual limitation under Section 382 of the Code, which is determined by first multiplying the value of our stock at the time of the ownership change by the applicable long-term, tax-exempt rate, which could be subject to additional adjustments. Any limitation may result in expiration of a portion of the NOL or research and development credit carryforwards before utilization. We completed an analyses through December 31, 2017, and are in the process of analyzing the impact to our NOL and research and development tax credit carryforwards. Due to the existence of the valuation allowance, any impact to the NOL and R&D tax credit carryforwards from Section 382 analysis will be offset by a corresponding adjustment to valuation allowance, resulting no tax provision impact. Ownership changes that may have occurred subsequent to December 31, 2017, and future ownership changes, including any ownership change resulting from this offering, may further limit our ability to utilize its remaining tax attributes.

We recognize a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Income tax positions must meet a more-likely-than-not recognition threshold to be recognized.

Our practice is to recognize interest and penalties related to income tax matters in income tax expense. We had no accrual for interest and penalties on our balance sheet and had not recognized interest or penalties in the consolidated statements of operations for the years ended December 31, 2017, 2016 and 2015.

Due to the existence of the valuation allowance, future changes in unrecognized tax benefits will not impact our effective tax rate.

Uncertain tax positions are evaluated based upon the facts and circumstances that exist at each reporting period. Subsequent changes in judgment based upon new information may lead to changes in recognition, derecognition, and measurement. Adjustments may result, for example, upon resolution of an issue with the taxing authorities, or expiration of a statute of limitations barring an assessment for an issue.

The activity related to our unrecognized tax benefits is summarized as follows (in thousands):

	December 31,
	2017			2016		2015
Balance as of beginning of year	$	13,000		$	5,033	$	1,106
Increase (decrease) related to prior year tax positions		(189	)		1,890		2,404
Increase related to current year tax positions		3,747			6,077		1,523
Balance as of end of year	$	16,558		$	13,000	$	5,033

We do not anticipate that the amount of unrecognized tax benefits as of December 31, 2017 will change within the next twelve months.

We are subject to taxation in the United States, Hong Kong and state jurisdictions. Our tax years from inception are subject to examination by the United States, Hong Kong and California authorities due to the carry forward of unutilized NOLs and research and development credits.

The Tax Cuts and Jobs Act (the Act) was enacted on December 22, 2017. Among other changes, the Act reduces the U.S. federal corporate tax rate from 34 percent to 21 percent. In accordance with Staff Accounting Bulletin 118, as of December 31, 2017, we have not completed our accounting for the tax effects of enactment of the Act; however, in certain cases, as described below, we have made a reasonable estimate of the effects on our existing deferred tax balances. In all cases, we will continue to make and refine our calculations as additional analysis is completed. In addition, our estimate may also be effected as we gain a more thorough understanding of the tax law.

We remeasured certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21 percent. However, we are still analyzing certain aspects of the Act and refining our calculations, which could potentially affect the measurement of these balances or give rise to new deferred tax amounts. The provisional amount recorded related to the remeasurement of our deferred tax balance was $27.9 million, which was fully offset by a decrease in our valuation allowance.

Due to uncertainties which currently exist in the interpretation of the provisions of the Act regarding Internal Revenue Code (IRC) Section 162(m), the Company is continuing to evaluate the potential impacts of IRC Section 162(m) as amended by the Act in its financial statements.