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, 2016 of $1.2 million 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,
	2016		2015		2014
Beginning balance of unrecognized tax benefits	$	1,132	$	1,019	$	899
Gross increases based on tax positions related to current year	116		113		120
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	$	1,248	$	1,132	$	1,019

The Company’s accounting policy for interest and penalties related to income tax matters are classified as income tax expense and was zero for all periods presented.

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

For financial reporting purposes, (loss) income from continuing operations before income taxes includes the following components (in thousands):



	December 31,
	2016			2015			2014
United States	(24,285		)	(40,845		)	62,479
Foreign	(45,349		)	(16,760		)	(908		)
Total	$	(69,634	)	$	(57,605	)	$	61,571

At December 31, 2016, the Company’s U.S. federal, state, and foreign income tax net operating loss carryforwards were approximately $208.9 million, $191.3 million and $63.5 million, respectively, which may be subject to limitations as described below. If not utilized, the federal tax loss carryforwards will begin to expire in 2026 and the state tax loss carryforwards will begin to expire in 2016. In addition, the Company has federal and California research and development income tax credit carryforwards of $3.0 million and $3.6 million, respectively. If not utilized, the federal research and development income tax credit carryforwards will begin to expire in 2026. The California research and development income tax credit carryforwards do not expire and can be carried forward indefinitely.

The Company has elected the “with and without method – direct effects only”, under the applicable accounting guidance for income taxes, 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 utilizing 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, 2016 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 $1.9 million 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 $121.1 million and research and development income tax credits as of December 31, 2011 by $3.0 million. The Company also reduced its California net operating loss carryforwards as of December 31, 2011 by $53.3 million 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.

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



	December 31,
	2016			2015			2014
Tax at statutory rate	$	(23,675	)	$	(19,586	)	$	20,934
State taxes, net of federal benefit	(65		)	(691		)	1,499
Change in valuation allowance	16,024			(14,042		)	(12,968		)
Valuation allowance adjustment for continuing operations	—			15,498			—
Permanent interest disallowed	(1,832		)	375			(8,608		)
Foreign rate change - Impact on Deferred Taxes	521			(1,993		)	—
Other permanent differences	1,307			114			1,226
Research and development tax credits	(145		)	(1,060		)	(1,387		)
State tax rate benefit	578			2,181			(503		)
Foreign rate differential	6,122			2,550			—
Credits and other	217			753			(109		)
Tax (benefit) expense	$	(948	)	$	(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. As a result of the gain recognized in discontinued operations from the sale of the Company’s Zohydro ER business to Pernix in 2015, ASC 740-20-45-7 required us to allocate a tax expense to discontinued operations and a tax 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 $14.1 million in 2015 in discontinued operations and a corresponding income tax benefit from continuing operations. The remaining tax benefit to continuing operations primarily relates to tax rate reductions enacted in the U.K. in November 2015 which resulted in a decrease to deferred tax liability.

Significant components of the Company’s deferred tax assets are presented below. A valuation allowance of $112.3 million and $96.3 million as of December 31, 2016 and 2015, respectively, has been established against the deferred tax assets for which it is more likely than not that the tax benefit will not be realized.



	December 31,
	2016			2015
Deferred tax assets:
Net operating losses	$	90,543		$	72,402
Capitalized research and development	4,504			5,768
Accrued expenses	1,240			1,266
Research and development credits	4,596			4,451
Accrued product returns	34			324
Inventory reserve and UNICAP	175			1,063
Amortization	1,680			1,998
Depreciation	1,533			—
Deferred revenue	475			3,494
Other, net	7,542			6,432
Total deferred tax assets	112,322			97,198
Less valuation allowance	(112,322		)	(96,298		)
Net deferred tax assets	—			900

Deferred tax liabilities:
Depreciation	—			(900		)
IPR&D	(17,425		)	(18,450		)
Total deferred tax liabilities	(17,425		)	(19,350		)
Net deferred tax liability	$	(17,425	)	$	(18,450	)

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 previously 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 has reduced 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 recorded income tax expense of $52,000, $45,000 and $84,000 in 2016, 2015 and 2014, respectively, related to the taxable income generated by its wholly-owned subsidiary, Zogenix Europe Limited. In addition, the Company recorded income tax benefit of $1.0 million, $2.1 million and zero in 2016, 2015 and 2014, respectively, related to the operations of its other wholly-owned subsidiary, Zogenix International Limited. The tax benefits were due to income tax rate reductions enacted in the United Kingdom in 2016 and 2015, which resulted in a decrease in the Company’s deferred tax liabilities.