Income Taxes

The Company recognizes liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. There were no unrecognized tax benefits included in the balance sheet at December 31, 2017 and 2016, that would, if recognized, affect the tax rate.

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



	December 31,
	2017		2016		2015
Beginning balance of unrecognized tax benefits	$	1,248	$	1,132	$	1,019
Gross increases based on tax positions related to current year	633		116		113
Gross increases based on tax positions related to prior year	149		—		—
Settlements with taxing authorities	—		—		—
Expiration of statute of limitations	—		—		—
Ending balance of unrecognized tax benefits	$	2,030	$	1,248	$	1,132

If the unrecognized tax benefits as of December 31, 2017 were reversed, there would be no effect on the Company’s effective tax rate as the tax benefit would increase a deferred tax asset, which is currently offset with a full valuation allowance.

The Company recognizes interest and, if applicable, penalties related to income tax matters as income tax expense. No interest or penalties have been recorded for all periods presented. The Company does not expect any significant increases or decreases to its unrecognized tax benefits in the next twelve months.

For financial reporting purposes, the components of loss from continuing operations before income taxes were as follows (in thousands):



	December 31,
	2017			2016			2015
United States	$	(32,112	)	$	(24,285	)	$	(40,845	)
Foreign	(93,910		)	(45,349		)	(16,760		)
Total	$	(126,022	)	$	(69,634	)	$	(57,605	)

At December 31, 2017, the Company’s federal, state, and foreign income tax net operating loss carryforwards were approximately $254.4 million, $192.6 million and $135.7 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. Under the newly enacted federal income tax law, federal net operating losses incurred in 2018 and in future years may be carried forward indefinitely, but the deductibility of such federal net operating losses is limited. It is uncertain if and to what extent various states will conform to the newly enacted federal income tax law. In addition, the Company has federal and California research and development income tax credit carryforwards of $3.3 million and $4.0 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. Due to the net operating loss carryforwards, all years remain open for income tax examination by tax authorities in the United States, various states and foreign tax jurisdictions in which the Company files tax returns.

The Company is in the process of completing 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. As of December 31, 2017, the Company has experienced at least 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 of federal and California net operating loss carryforwards or research and development income tax credits as a result of the third ownership change. The Company may have experienced an ownership change during 2017 and believes that any such ownership change is not expected to further reduce its federal net operating loss or research and development credit carryforwards. 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.

A reconciliation of the Company’s income tax benefit from continuing operations compared to the income tax benefit computed at the Federal statutory tax is was as follows (in thousands):



	December 31,
	2017			2016			2015
Income tax at 34% federal statutory rate	$	(42,846	)	$	(23,675	)	$	(19,586	)
State taxes, net of federal benefit	(19		)	(65		)	(691		)
Change in valuation allowance	(11,208		)	16,024			(14,042		)
U.S. statutory tax rate change	36,085			—			—
Valuation allowance adjustment for continuing operations	—			—			15,498
Permanent interest disallowed	(150		)	(1,832		)	375
Foreign rate change - Impact on Deferred Taxes	1,619			521			(1,993		)
Other permanent differences	5,774			1,307			114
Research and development tax credits	(274		)	(145		)	(1,060		)
State tax rate benefit	56			578			2,181
Foreign rate differential	10,636			6,122			2,550
Credits and other	327			217			753
Income tax benefit	$	—		$	(948	)	$	(15,901	)

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.

On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted into legislation, which includes a broad range of provisions affecting businesses. The Tax Act contains, among other things, significant changes to corporate taxation, including reduction of the corporate tax rate from a top marginal rate of 35% to a flat rate of 21% for tax years beginning after December 31, 2017, limitation of the deduction for net operating losses to 80% of current year taxable income and elimination of net operating loss carrybacks, implementing a territorial tax system, and requiring a mandatory one-time tax on U.S. owned undistributed foreign earnings and profits known as the transition tax.

Pursuant to SAB 118, an entity may select between one of three scenarios to determine a reasonable estimate arising from the Tax Act. The scenarios are (i) a final estimate which effectively closes the measurement window; (ii) a reasonable estimate leaving the measurement window open for future revisions; and (iii) no estimate as the law is still being analyzed. The Company was able to provide a reasonable estimate for the revaluation of deferred taxes and the effects of the transition tax on undistributed foreign earnings and profits. As such, the Company has recorded a $36.1 million reduction in deferred tax assets for the revaluation of deferred taxes which was offset by a corresponding decrease to the Company’s full valuation allowance. The reduction in deferred tax assets included provisional amounts to account for changes to IRC Section 162(m) and the impacts of the transition tax on the Company’s net operating losses. Additional work is necessary for a more detailed analysis of the impacts of the Tax Act. Any subsequent adjustment to these amounts will be recorded to current tax expense in the quarter of 2018 when the analysis is complete.

Significant components of the Company’s deferred tax assets are presented below. A valuation allowance of $101.1 million and $112.3 million as of December 31, 2017 and 2016, 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,
	2017			2016
Deferred tax assets:
Net operating losses	$	87,142		$	90,543
Capitalized research and development	2,155			4,504
Accrued expenses	1,310			1,240
Research and development credits	5,282			4,596
Accrued product returns	—			34
Inventory reserve and UNICAP	—			175
Amortization	630			1,680
Depreciation	163			1,533
Deferred revenue	—			475
Other, net	4,432			7,542
Total deferred tax assets	101,114			112,322
Less valuation allowance	(101,114		)	(112,322		)
Net deferred tax assets	—			—

Deferred tax liabilities:
IPR&D	(17,425		)	(17,425		)
Total deferred tax liabilities	(17,425		)	(17,425		)
Net deferred tax liability	$	(17,425	)	$	(17,425	)

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 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’s income tax expense related to taxable income generated by its wholly-owned subsidiary, Zogenix Europe Limited were not material for all years presented. In addition, the Company recorded income tax benefit of zero, $1.0 million and $2.1 million in 2017, 2016 and 2015, respectively, related to the operations of its other wholly-owned subsidiary, Zogenix International Limited.

The Company carries out extensive research and development activities that may benefit from the UK’s small and medium-sized enterprise (“SME”) research and development tax credit regime, whereby the Company may either receive an enhanced UK tax deduction on its research and development activities or a refundable cash credit. Where an entity is in a net operating loss position under the SME regime, it can surrender a portion of the losses that arise from its research and development activities in return for a refundable cash credit. These refundable cash credits, which may be received without regard to actual tax liability, are not subject to accounting for income taxes and will be recorded as a component of other income if realized. As of December 31, 2017, the Company had filed a claim for a refundable cash credit for its 2015 tax year of up to $3.1 million. The Company has not recorded a receivable for this refundable cash credit at December 31, 2017 as collectability was deemed not probable or reasonably assured.