11.

INCOME TAXES

Income before income tax expense consists of the following:


	Years ended December 31,
	2014		2013		2012
Domestic	$	12,877	$	14,842	$	8,310
Foreign		24,645		14,020		22,632


Income before income taxes	$	37,522	$	28,862	$	30,942

The components of the income tax expense (benefit) for income taxes are as follows:


	Years ended December 31,
	2014			2013			2012
Current:
Federal	$	3,780		$	4,859		$	4,418
State		367			472			429
Foreign		4,433			3,751			5,537

Current income tax expense		8,580			9,082			10,384
Deferred:
Federal		306			(1,105	)		(1,871	)
State		30			(108	)		(183	)
Foreign		(5,043	)		(516	)		(386	)

Deferred income tax benefit		(4,707	)		(1,729	)		(2,440	)

Income tax expense	$	3,873		$	7,353		$	7,944

Income tax expense (benefit) for the years ended December 31, 2014, 2013 and 2012 differ from the amount computed by applying the federal statutory corporate rate to income before income taxes. The differences are recorded as follows:


	Years ended December 31,
	2014			2013			2012
Tax expense (benefit) at statutory rate of 34%	$	12,757		$	9,813		$	10,521
State income taxes, net of federal benefit		425			490			274
Foreign tax rate difference		(2,917	)		(1,345	)		(2,549	)
Research and development credit		(583	)		(957	)		—
Change in valuation allowance		(5,392	)		(187	)		3
Equity based compensation		880			(212	)		(225	)
Manufacturing credit		(721	)		(249	)		(139	)
Other		(576	)		—			59

Total income tax expense	$	3,873		$	7,353		$	7,944

The components of the Company’s net deferred income tax asset and liabilities are as follows:


	As of December 31,
	2014			2013
Net deferred income tax asset - Current
Warranty cost	$	404		$	348
Bad debt reserve		30			73
Inventory reserve		512			253
Unearned service revenue		3,474			2,992
Other, net		1,516			935

Net deferred income tax asset - Current	$	5,936		$	4,601


Net deferred income tax asset - Non-current
Depreciation	$	(3,059	)	$	(1,559	)
Goodwill amortization		(2,007	)		(1,841	)
Product design costs		(136	)		(259	)
Employee stock options		2,756			3,021
Unearned service revenue		1,649			1,654
Loss carryforwards		9,240			10,252

Deferred income tax asset - Non-current		8,443			11,268

Valuation Allowance		(1,819	)		(6,845	)

Net deferred income tax asset - Non-current	$	6,624		$	4,423


Net deferred income tax liability - Non-current

Intangible assets	$	—		$	(1,171	)

The effective income tax rate for 2014, 2013, and 2012 includes a reduction in the statutory corporate tax rates for the Company’s operations in Switzerland. The favorable tax rate ruling requires the Company to maintain a certain level of manufacturing operations in Switzerland. The aggregate dollar effect of this favorable tax rate was approximately $1.9 million, or $0.11 per share, in the year ended December 31, 2014, $1.5 million, or $0.09 per share, in the year ended December 31, 2013, and $0.9 million, or $0.05 per share, in the year ended December 31, 2012.

At December 31, 2014 and 2013, the Company’s domestic entities had deferred income tax assets in the amount of $5.2 million and $5.5 million, respectively. At December 31, 2014 and 2013, the Company’s foreign subsidiaries had deferred tax assets primarily relating to net operating losses, some of which expire in the next 5 to 15 years and others which can be carried forward indefinitely, of $9.2 million and $10.3 million, respectively. The valuation allowance for deferred tax assets as of December 31, 2014 and 2013 was $1.8 million and $6.8 million, respectively. The net change in the total valuation allowance for each of years ended December 31, 2014, 2013 and 2012, was a decrease of $5.0 million, a decrease of $0.2 million and an increase of $3.0 thousand, respectively. During the year ended December 31, 2014, the Company identified certain immaterial errors related to deferred tax assets and the related valuation allowance. As a result, the Company decreased deferred tax assets and the related valuation allowance by $4.7 million each to correct the gross-up error. The above table has been adjusted to reflect this adjustment. The Company believes this error is not material to the consolidated financial statements of any prior interim or annual periods and that the correction of the error was not material to the Company’s 2014 consolidated financial statements.

The valuation allowance as of December 31, 2014 and 2013 was primarily related to foreign net operating loss carryforwards that, in the judgment of management, were not more likely than not to be realized. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on the generation of future taxable income during the periods in which those temporary differences are deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected taxable income, and tax-planning strategies in making this assessment. In 2014, certain foreign subsidiaries which had previously generated losses, established a pattern of profitability which resulted in the Company concluding that the valuation allowance should be reversed based on the assessment previously described. As a result, the Company recorded a $4.5 million discrete tax adjustment during the third quarter of 2014. The remaining changes impacting the valuation allowance for the year ended December 31, 2014 related to changes in foreign currency.

The Company has not recognized any U.S. tax expense on undistributed international earnings, as it intends to reinvest the earnings outside the U.S. for the foreseeable future. The Company’s net undistributed international earnings were approximately $106.2 million and $78.2 million at December 31, 2014 and 2013, respectively.

Significant judgment is required in determining the Company’s worldwide provision for income taxes. In the ordinary course of a global business, there are many transactions for which the ultimate tax outcome is uncertain. The Company reviews its tax contingencies on a regular basis and makes appropriate accruals as necessary.

As of December 31, 2014 and 2013, the Company’s gross unrecognized tax benefits totaled $0.3 million, which includes approximately $0.03 million of interest and penalties. The Company estimates that the unrecognized tax benefits will not change significantly within the next year.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:


	Years ended December 31,
	2014		2013		2012

Balance at January 1,	$	265	$	265	$	265
Additions based on tax positions related to the current year		—		—		—
Additions for tax positions of prior years		—		—		—
Reductions for tax positions of prior years		—		—		—
Settlements		—		—		—

Balance at December 31,	$	265	$	265	$	265

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The table below summarizes the open tax years and ongoing tax examinations in major jurisdictions as of December 31, 2014:


Jurisdiction	Open Years		Examination in Process

United States - Federal Income Tax		2010-2014	N/A
United States - various states		2010-2014	N/A
Germany		2009-2014	2010-2011
Switzerland		2013	N/A
Singapore		2010-2014	N/A

The Company recognizes accrued interest and penalties related to unrecognized tax benefits in tax expense. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate is $0.3 million. FARO does not currently anticipate that the total amount of unrecognized tax benefits will result in material changes to its financial position. The Company is subject to income taxes at the federal, state and foreign country level. The Company’s tax returns are subject to examination at the U.S. federal level from 2010 forward and at the state level subject to a three to four year statute of limitations. In September 2013, the U.S. Internal Revenue Service issued new regulations for capitalizing and deducting costs incurred to acquire, produce, or improve tangible property. The Company adopted these new regulations as of January 1, 2014, and it did not have a material effect on its consolidated financial statements.