Income Taxes

The Company only recognizes tax benefits if it is more-likely-than-not to be sustained upon audit by the relevant taxing authority based upon its technical merits. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. The balance of unrecognized tax benefits at December 31, 2015 of $1,132,000 are tax benefits that, if the Company recognizes them, would not impact the Company's effective tax rate as long as they remain subject to a full valuation allowance.

The following table summarizes the activity related to the Company’s unrecognized tax benefits (in thousands):



	December 31,
	2015		2014		2013
Beginning balance of unrecognized tax benefits	$	1,019	$	899	$	714
Gross increases based on tax positions related to current year	113		120		185
Gross increases based on tax positions related to prior year	—		—		—
Settlements with taxing authorities	—		—		—
Expiration of statute of limitations	—		—		—
Ending balance of unrecognized tax benefits	$	1,132	$	1,019	$	899

The Company’s policy is to recognize interest and/or penalties related to income tax matters in income tax expense. The Company had no accrued interest or penalties on the consolidated balance sheets at December 31, 2015 and 2014 and has recognized no interest and/or penalties in the consolidated statements of operations through the year ended December 31, 2015.

The Company is subject to taxation in U.S. federal, state, and foreign jurisdictions. The Company’s tax years for 2008 and forward can be subject to examination by the United States and state tax authorities due to the carryforward of net operating losses.

At December 31, 2015, the Company had available federal, California, and foreign income tax net operating loss carryforwards of approximately $177,427,000, $181,580,000 and $20,697,000, respectively. The federal tax loss carryforwards will begin expiring in 2026 unless previously utilized, and the state tax loss carryforwards will begin expiring in 2015 unless previously utilized. In addition, the Company has federal and California research and development income tax credit carryforwards of $2,966,000 and $3,368,000, respectively. The federal research and development income tax credit carryforwards will begin to expire in 2026 unless previously utilized. The California research and development income tax credit carryforwards will carry forward indefinitely until utilized.

The Company has elected the “with and without method – direct effects only”, prescribed in accordance with authoritative guidance, with respect to recognition of stock option windfall tax benefits within additional paid in capital and will utilize general net operating losses to offset taxable income before utilization of net operating losses attributable to windfall tax benefits.

The Company has completed an analysis under Internal Revenue Service Code (IRC) Sections 382 and 383 to determine if the Company’s net operating loss carryforwards and research and development credits are limited due to a change in ownership. The Company has determined that as of December 31, 2015 the Company had three ownership changes. The first ownership change occurred in August 2006 upon the issuance of the Series A-1 convertible preferred. As a result of this ownership change, the Company has reduced its net operating loss carryforwards by $1,900,000 and research and development income tax credits by $8,000. The Company had a second ownership change as defined by IRC Sections 382 and 383, which occurred in September 2011 upon the issuance of common stock in its follow-on offering. As a result of the second ownership change, the Company has reduced its federal net operating loss carryforwards as of December 31, 2011 by $121,100,000 and research and development income tax credits as of December 31, 2011 by $3,017,000. The Company also reduced its California net operating loss carryforwards as of December 31, 2011 by $53,329,000 as a result of the second ownership change. The Company had a third ownership change as defined by IRC Sections 382 and 383, which occurred in January 2014. There was no forfeiture in federal and California net operating loss carryforwards or research and development income tax credits as a result of the third ownership change. Pursuant to IRC Section 382 and 383, use of the Company’s net operating loss and research and development income tax credit carryforwards may be limited in the event of a future cumulative change in ownership of more than 50% within a three-year period.

During November 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes, which simplifies the presentation of deferred income taxes. This ASU requires that deferred tax assets and liabilities be classified as non-current in a statement of financial position. We early adopted ASU 2015-17 effective December 31, 2015 on a prospective basis. Adoption of this ASU resulted in a reclassification of our net current deferred tax asset to the net non-current deferred tax asset as of December 31, 2015 balance sheet. No prior periods were retrospectively adjusted.

The reconciliation of income tax from continuing operations computed at the Federal statutory tax rate to the (benefit)expense for income taxes is as follows (in thousands):



	December 31,
	2015			2014			2013
Tax at statutory rate	$	(19,586	)	$	20,934		$	(24,684	)
State taxes, net of federal benefit	(691		)	1,499			(1,552		)
Change in valuation allowance	(14,042		)	(12,968		)	19,526
Valuation allowance adjustment for continuing operations	15,498			—			—
Permanent interest disallowed	375			(8,608		)	7,197
Foreign rate change	(1,993		)	—			—
Other permanent differences	114			1,226			1,279
Research and development tax credits	(1,060		)	(1,387		)	(744		)
State tax rate benefit	2,181			(503		)	(822		)
Foreign rate differential	2,550			—			—
Other	753			(109		)	(200		)
Tax (benefit) expense	$	(15,901	)	$	84		$	—

ASC 740-20 requires total income tax expense or benefit to be allocated among continuing operations, discontinued operations, extraordinary items, other comprehensive income and items charged directly to shareholders’ equity. This allocation is referred to as intra-period tax allocation. Since the sale of the Company’s Zohydro ER business to Pernix was a discrete event in April of 2015, ASC 740-270-30-12 requires us to record the total amount of our income tax expense for discontinued operations and a benefit to continuing operations. The amount of income tax expense recorded as part of discontinued operations is limited to the tax benefit from income from continuing operations. Accordingly, the Company has recorded a tax expense of $14,060,000 in 2015 in discontinued operations and a corresponding benefit to income tax expense from continuing operations. The remaining tax benefit to continuing operations principally relates to tax rate reductions enacted in the United Kingdom in November 2015 which resulted in a decrease in our deferred tax liability.

Significant components of the Company’s deferred tax assets as of December 31, 2015 and 2014 are listed below. A valuation allowance of $96,298,000 and $110,338,000 for the years ended December 31, 2015 and 2014, respectively, has been established to offset the deferred tax assets as realization of such assets is uncertain. The components of the deferred tax assets are as follows (in thousands):



	December 31,
	2015			2014
Deferred tax assets:
Net operating losses	$	72,402		$	82,054
Capitalized research and development	5,768			7,176
Accrued expenses	1,266			2,030
Research and development credits	4,451			3,395
Accrued product returns	324			1,772
Inventory reserve and UNICAP	1,063			2,956
Amortization	1,998			2,556
Deferred revenue	3,494			4,446
Other, net	6,432			5,128
Total deferred tax assets	97,198			111,513
Less valuation allowance	(96,298		)	(110,338		)
Net deferred tax assets	900			1,175

Deferred tax liabilities:
Depreciation	(900		)	(1,175		)
IPR&D	(18,450		)	(20,500		)
Total deferred tax liabilities	(19,350		)	(21,675		)
Net deferred tax liability	$	(18,450	)	$	(20,500	)

On December 31, 2015, the California Supreme Court overturned the California Appellate court decision on The Gillette Company et al. v. California Franchise Tax Board. The court held that the taxpayers couldn’t elect an evenly weighted, three-factor apportionment formula pursuant to the Multistate Tax Compact, or MTC. The Company had elected the three-factor apportionment formula pursuant to the MTC for 2013 and 2014. As a result of the California Supreme Court decision, the Company is reducing its deferred tax assets and offsetting valuation allowance related to the California NOL calculated in 2013 and 2014 pursuant to the MTC election.

The Company incurred $45,000 and $84,000 in income tax expense for the years ended December 31, 2015 and 2014, respectively, related to taxable income generated by its wholly-owned subsidiary Zogenix Europe.