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



	December 31,
	2012		2011
Beginning balance of unrecognized tax benefits	$	678	$	562
Gross increases based on tax positions related to current year	36		116
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	$	714	$	678

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, 2012 and 2011 and has recognized no interest and/or penalties in the consolidated statements of operations and comprehensive loss through the year ended December 31, 2012.

The Company is subject to taxation in the U.S. and state jurisdictions. The Company’s tax years for 2006 and forward can be subject to examination by the United States and state tax authorities due to the carry forward of net operating losses.

At December 31, 2012, the Company had available federal and state income tax net operating loss carryforwards of approximately $158,282,000 and $164,122,000, 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 $311,000 and $1,970,000, 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.

In January 2013, the American Taxpayer Relief Act of 2012 (the “Act”) was signed into law. The Act retroactively restored several expired business tax provisions, including the research and experimentation credit. The impact to the Company of the reinstated credits was not recognized in 2012 as a change in tax law is accounted for in the period of enactment. The additional credits that will be reported within the 2013 consolidated financial statements will have no impact on operations due to the existence of a full valuation allowance on all deferred tax assets.

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, 2011 the Company had two 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, 2010 by $83,503,000 and research and development income tax credits as of December 31, 2010 by $2,203,000. The Company also reduced its California net operating loss carryforwards as of December 31, 2010 by $46,243,000 as a result of the second 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 Company is currently in the process of completing a Section 382 and 383 study to determine the impact that ownership changes during the year ended December 31, 2012 have had on its carryforwards and expects to complete the analysis within the next three months. As a result of this analysis, the Company may have an adjustment in the net operating losses that are recorded at December 31, 2012.

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



	December 31,
	2012			2011			2010
Tax at statutory rate	$	(16,109	)	$	(28,530	)	$	(25,008	)
State taxes, net of federal benefit	(1,580		)	(2,780		)	(2,953		)
Change in valuation allowance	21,990			(16,807		)	27,968
Section 382 limitation	—			45,728			—
Permanent Interest Disallowed	(4,466		)	(70		)	526
Credits and other	170			2,450			(523		)
	$	5		$	(9	)	$	10

Significant components of the Company’s deferred tax assets as of December 31, 2012 and 2011 are listed below. A valuation allowance of $80,347,000 and $58,359,000 for the years ended December 31, 2012 and 2011, 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,
	2012			2011
Deferred tax assets:
Net operating losses	$	61,739		$	38,357
Capitalized research and development	8,903			7,901
Accrued expenses	3,707			3,728
Research and development credits	1,237			1,078
Accrued product returns	1,087			916
Inventory reserve and UNICAP	688			983
Depreciation and amortization	645			824
Deferred revenue	—			3,169
Other, net	2,341			1,403
Total deferred tax assets	80,347			58,359
Less valuation allowance	(80,347		)	(58,359		)
Net deferred tax assets	$	—		$	—

The Company incurred $5,000 in income tax expense for the year ended December 31, 2012 and received a benefit of $9,000 in income tax expense for the year ended December 31, 2011 related to taxable income generated by its wholly-owned subsidiary Zogenix Europe Limited.