10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

  For the Fiscal Year ended December 31, 2007 or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

  For the Transition Period from             to             

Commission File Number: 000-23265

Salix Pharmaceuticals, Ltd.

(Exact name of Registrant as specified in its charter)

Delaware	94-3267443
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

1700 Perimeter Park Drive

Morrisville, North Carolina 27560

(Address of principal executive offices, including zip code)

(919) 862-1000

(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act:

Title of Each Class	Name of Exchange on which Registered
Common Stock, $0.001 Par Value Preferred Share Purchase Rights	Nasdaq Global Market Nasdaq Global Market

Securities Registered Pursuant to Section 12(g) of the Act: None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    YES  ¨    NO  x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    YES  ¨    NO  x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Act (Check one):

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨    Smaller reporting company  ¨

Indicate by check mark whether registrant is a shell company (as defined) in Rule 12b-2 of the Exchange Act.    YES  ¨    NO  x

The aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant on June 30, 2007 (based on the closing sale price of U.S. $12.30 of the Registrant’s common stock, as reported on The Nasdaq Global Market on such date) was approximately U.S. $344,628,042. Common stock held by each officer and director and by each person known to the Company who owned 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares of the Registrant’s common stock outstanding at March 10, 2008 was 47,729,085.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement to be filed for its 2008 Annual Meeting of Stockholders currently scheduled to be held June 12, 2008 are incorporated by reference into Part III of this report.

SALIX PHARMACEUTICALS, LTD.

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

		Page
	PART I
Item 1.	Business	1
Item 1A.	Risk Factors	15
Item 1B.	Unresolved Staff Comments	22
Item 2.	Properties	22
Item 3.	Legal Proceedings	22
Item 4.	Submission of Matters to a Vote of Security Holders	22
	Executive Officers of the Registrant	22
	PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	24
Item 6.	Selected Financial Data	26
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	39
Item 8.	Financial Statements and Supplementary Data	39
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	39
Item 9A.	Controls and Procedures	39
Item 9B.	Other Information	40
	PART III
Item 10.	Directors, Executive Officers and Corporate Governance	41
Item 11.	Executive Compensation	41
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	41
Item 13.	Certain Relationships and Related Transactions, and Director Independence	42
Item 14.	Principal Accountant Fees and Services	42
	PART IV
Item 15.	Exhibits and Financial Statement Schedule	43
SIGNATURES		47

i

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are subject to risks and uncertainties, including those set forth under “Item 1A. Risk Factors” and “Cautionary Statement” included in “Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report, that could cause actual results to differ materially from historical results or anticipated results.

PART I

Item 1. Business

Our website address is www.salix.com. Information on our website is not incorporated herein by reference. We make available free of charge through our website our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.

OVERVIEW

We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Our strategy is to:

• identify and acquire rights to products that we believe have potential for near-term regulatory approval or are already approved;

• apply our regulatory, product development, and sales and marketing expertise to commercialize these products; and

• use our approximately 150-member specialty sales and marketing team focused on high-prescribing U.S. gastroenterologists, who are doctors who specialize in gastrointestinal diseases, to sell our products.

Our current products demonstrate our ability to execute this strategy. As of December 31, 2007, our primary products were:

• XIFAXAN^® (rifaximin) Tablets 200 mg;

• OSMOPREP™ (sodium phosphate monobasic monohydrate, USP and sodium phosphate dibasic anhydrous, USP) Tablets;

• MOVIPREP^® (PEG 3350, Sodium Sulfate, Sodium Chloride, Potassium Chloride, Sodium Ascorbate and Ascorbic Acid for Oral Solution);

• COLAZAL^® (balsalazide disodium) Capsules 750 mg;

• VISICOL^® (sodium phosphate monobasic monohydrate, USP, and sodium phosphate dibasic anhydrous, USP) Tablets;

• AZASAN^® Azathioprine Tablets, USP, 75/100 mg;

• ANUSOL-HC^® 2.5% (Hydrocortisone Cream, USP), ANUSOL-HC^® 25 mg Suppository (Hydrocortisone Acetate);

• PROCTOCORT^® Cream (Hydrocortisone Cream, USP) 1% and PROCTOCORT^® Suppository (Hydrocortisone Acetate Rectal Suppositories) 30 mg;

• PEPCID^® (famotidine) for Oral Suspension; and

• Oral Suspension DIURIL^® (Chlorothiazide).

1

Our primary product candidates currently under development and their status are as follows:

Compound	Indication	Status
Balsalazide disodium tablets	Ulcerative colitis	New Drug Application, or NDA, filed
Granulated mesalamine	Ulcerative colitis	NDA filed
Rifaximin	Travelers’ diarrhea prevention	Phase III
Rifaximin	Irritable bowel syndrome	Phase III
Rifaximin	Hepatic encephalopathy	Phase III
Rifaximin	C. difficile–associated diarrhea	Phase III
Vapreotide acetate	Acute esophageal variceal bleeding	Confirmatory Phase III
Metoclopramide–Zydis®	gastroesphageal reflux and gastroparesis	NDA submitted

We currently market our products, and intend to market future products, if approved by the U.S. Food and Drug Administration, or FDA, to U.S. gastroenterologists through our own direct sales force. We enter into distribution or licensing relationships outside the United States and in certain markets in the U.S. where a larger sales organization is appropriate. Currently, our sales and marketing staff consists of approximately 150 people. We believe our sales force also should position us to sell additional products, if and when acquired and/or approved for U.S. marketing.

PRODUCTS

Xifaxan^® (rifaximin) tablets

Xifaxan is a gastrointestinal-specific oral antibiotic that the FDA approved in May 2004 for the treatment of patients 12 years of age and older with travelers’ diarrhea caused by noninvasive strains of E coli. According to the Centers for Disease Control, each year between 30% and 50% of international travelers, an estimated 20.0 million people, develop diarrhea, with approximately 80% of the cases caused by bacteria. Approximately 6.8 million people sought treatment in the United States for infectious diarrhea in 2006 and approximately 4.1 million of those patients were prescribed a drug.

We believe the advantages of Xifaxan to treat these infections are two-fold: (1) site-targeted antibiotic delivery; and (2) improved tolerability compared to other treatments. Less than 0.5% of the drug is absorbed into the bloodstream when it is taken orally. In addition, the drug might also cause fewer side effects or discomforts such as nausea, headache or dizziness than observed with currently available, more highly-absorbed antibiotics. We believe Xifaxan is also less likely to cause harmful interaction with other drugs a patient may be taking. Furthermore, we believe Xifaxan is unique because there is no other U.S.-approved oral antibiotic with its potential lack of systemic absorption and safety profile.

We launched Xifaxan in the United States in July 2004 using our own direct sales force. We had net product sales of $9.8 million, $30.1 million, $51.6 million and $64.3 million of Xifaxan in the United States in 2004, 2005, 2006 and 2007, respectively. We are exploring potential additional indications, formulations, clinical trials and co-promotion arrangements to capitalize on the potential for Xifaxan, including our development programs in irritable bowel syndrome, hepatic encephalopathy, C. difficile–associated diarrhea, and prevention of travelers’ diarrhea. Based on these potential indications, we believe Xifaxan can potentially compete in an annual U.S. market in excess of approximately $4 billion, comprised of over 12 million patient visits. While the potential market for Xifaxan is large, we expect to capture only a portion of each market due to competition, market acceptance and/or other factors.

The patents for the rifaximin composition of matter (also covering a process of making rifaximin and using rifaximin to treat gastrointestinal infectious diseases) expired in May 2001 in the United States and Canada. In May 2006, a U.S. patent (composition of matter and process patent that covers several physical states of rifaximin) was

2

issued that we believe extends the patent coverage of the current form of rifaximin until May 22, 2024. Alfa Wasserman S.p.a., the patent owner, has licensed rights to rifaximin in the United States to Salix. In July 2006, Salix entered into an agreement with Cedars-Sinai Medical Center for the right to use its patent and patent application relating to methods of diagnosis and treating irritable bowel syndrome and other disorders caused by small intestinal bacterial overgrowth.

Visicol^® and OsmoPrep^® (sodium phosphate monobasic monohydrate, USP, sodium phosphate dibasic anhydrous, USP) tablets

In September 2005, we acquired Visicol with the completion of the acquisition of InKine Pharmaceutical Company, Inc. Visicol tablets are indicated for cleansing of the colon as a preparation for colonoscopy in adults 18 years of age or older. Visicol was the first, and it and OsmoPrep are the only, tablet bowel cleansing products approved by the FDA and marketed in the United States. OsmoPrep is a patented, second-generation tablet bowel cleansing product approved by the FDA in March 2006. OsmoPrep tablets are indicated for cleansing of the colon as a preparation for colonoscopy in adults 18 years of age or older. OsmoPrep offers potential benefits compared to Visicol such as its lack of microcrystalline cellulose, smaller tablet size and possible lower dose administration. The patent for the formulation and use of OsmoPrep expires in 2013. An additional U.S. patent application for OsmoPrep is pending that, if issued, could provide patent protection through 2024.

Approximately 5.2 million prescriptions for bowel cleansing products were written in 2007, representing a market value of $191 million. In terms of prescription dollar sales, the market for bowel cleansing products has been growing at a 28% annual compound rate for the last 5 years. Visicol and OsmoPrep compete with a number of liquid polyethylene glycol-salt (PEG-salt solution) bowel cleansing products and an over-the-counter oral sodium phosphate solution bowel cleansing product. Net product sales for Visicol were $14.4 million, $20.7 million, $19.9 million, $18.0 million and $2.2 million in 2003, 2004, 2005, 2006 and 2007, respectively. Net product sales for OsmoPrep were $22.5 million in 2006 and $25.4 million in 2007.

MoviPrep^® (PEG 3350, sodium sulfate, sodium chloride, potassium chloride, sodium ascorbate and ascorbic acid) oral solution

In December 2005, we acquired exclusive rights to sell MoviPrep in the United States from Norgine B.V. MoviPrep is a patent-protected, liquid PEG bowel cleansing product that was approved by the FDA in August 2006. MoviPrep is differentiated from other currently marketed, liquid PEG bowel cleansing products by the inclusion of ascorbic acid in its formulation. MoviPrep is indicated for bowel cleansing prior to colonoscopy, intestinal surgery and barium enema X-ray examinations. In January 2007 the United States Patent Office issued a patent providing coverage to September 1, 2024. Net product sales for MoviPrep were $5.0 million in 2006 and $20.1 million in 2007.

Colazal^® (balsalazide disodium) capsules

The FDA approved Colazal in 2000 for the treatment of mildly to moderately active uncreative colitis. We launched Colazal to physicians in the United States in January 2001 using our own sales force. In December 2006, the FDA approved Colazal for use in pediatric patients between 5 to 17 years of age with ulcerative colitis. The pediatric use of Colazal has been granted orphan drug designation. On December 28, 2007, the Office of Generic Drugs, or OGD, approved three generic balsalazide capsule products. On December 28, 2007, we announced that we had entered into an agreement with Watson Pharma, Inc. to market and sell an authorized generic of Colazal.

Ulcerative colitis is a chronic form of inflammatory bowel disease characterized by inflammation of the lining of the colon. Symptoms of active ulcerative colitis include rectal bleeding, abdominal pain, increased stool frequency, loss of appetite, fever and weight loss. The cause of ulcerative colitis is unknown and no known cure exists except for the removal of the colon. It is estimated that as many as 500,000 people in the United States have ulcerative colitis. People are most often diagnosed with the disease in their mid-30’s, although the disease can occur at any age.

In clinical trials, Colazal demonstrated at least comparable efficacy and had an improved safety profile as compared to some other oral 5-ASA products. Other 5-ASA products often do not deliver optimal doses of the active

3

therapeutic agent to the colon. However, because Colazal’s proprietary formulation allows approximately 99% of the drug to reach the colon, it can work more quickly and effectively than comparable doses of other 5-ASA products that deliver less drug to the diseased area.

We had net product sales of $55.8 million, $85.4 million, $110.3 million, $103.5 million and $92.4 million of Colazal in the United States in, 2003, 2004, 2005, 2006 and 2007 respectively. Colazal net product revenues for 2007 include a $34.6 million reduction representing our estimate of Colazal previously sold to wholesalers that may be returned to us under our return policy as a result of the generic approvals discussed above.

Azasan^® (azathioprine) tablets

In November 2003, we acquired from aaiPharma LLC the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the brand name Azasan. Azasan is an FDA-approved drug that suppresses immune system responses and is indicated for preventing rejection of kidney transplants and treatment of severe arthritis. In February 2004, we launched the 75 and 100 milligram dosage strengths of Azasan in the United States. Net product sales for Azasan were $2.3 million, $4.4 million, $4.8 million and $3.4 million in 2004, 2005, 2006 and 2007, respectively. The patents and data exclusivity for Azasan have expired.

Anusol-HC^® and Proctocort^® (hydrocortisone) creams and suppositories

In June 2004, we acquired the exclusive right to sell Anusol-HC 2.5% (hydrocortisone USP) cream, Anusol-HC 25 mg (hydrocortisone acetate) rectal suppositories, Proctocort 1% (hydrocortisone USP) cream and Proctocort 30 mg (hydrocortisone acetate) rectal suppositories from King Pharmaceuticals, Inc. The two cream products are topical corticosteroids indicated for relief of the inflammatory and pruritic, or itching, manifestations of corticosteroid-responsive dermatoses. The two suppository products are indicated for use in inflamed hemorrhoids and postirradiation proctitis, as well as an adjunct in the treatment of chronic ulcerative colitis and other inflammatory conditions. Combined net product sales for the Anusol-HC and Proctocort product lines were $4.1 million, $4.8 million, $3.0 million and $2.9 million in 2004, 2005, 2006 and 2007, respectively. The patents and data exclusivity for Anusol-HC and Proctocort have expired.

Pepcid^® (famotidine) for Oral Suspension and Oral Suspension Diuril^® (Chlorothiazide)

In February 2007, we purchased the U.S. prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension from Merck & Co., Inc. Pepcid Oral Suspension is a widely known prescription pharmaceutical product indicated for several gastrointestinal indications, including the treatment of duodenal ulcer, benign gastric ulcer and gastro-esophageal reflux disease. The acquisition reflects the ongoing execution of our strategy to expand and diversify revenue. Pepcid Oral Suspension and Diuril Oral Suspension, both liquid formulations of their solid dosage form counterparts, compete in a combined market of approximately $150 million that is concentrated in pediatric and hospitalized patient populations. Net product sales for Pepcid were $22.2 million in 2007. Net product sales for Diuril for 2007 were $0.2 million. The patents and data exclusivity for Pepcid Oral Suspension and Diuril Oral Suspension have expired.

DEVELOPMENT PROGRAMS

Balsalazide Disodium tablets

We have developed an 1100 mg tablet formulation of balsalazide disodium. We believe the convenience the balsalazide tablet formulation is designed to provide, by means of twice-a-day dosing and a reduced number of pills, demonstrates our ongoing commitment to bring products to market that better serve the needs of gastroenterologists and their patients. On July 17, 2007 we submitted an NDA to the FDA seeking approval to market an 1100 mg tablet formulation of balsalazide disodium. The application was accepted for filing and is currently under review. We anticipate receiving a response from the FDA by May 16, 2008. The patent for balsalazide disodium tablets will expire in 2018.

Granulated Mesalamine

In July 2002 we acquired the exclusive development rights in the United States to a granulated mesalamine product from Dr. Falk Pharma GmbH, one of the most recognized gastroenterology companies worldwide. As part of

4

that transaction, we also received a right of first negotiation with respect to additional Falk products in the United States. The Falk granulated mesalamine product has already been approved in most of the principal markets of Europe. The Falk granulated mesalamine formulation combines an enteric pH-dependent coating, which provides for delayed release, and a polymer matrix core, which provides for extended release. This formulation is designed to provide for the distribution of the active ingredient beginning in the small bowel and continuing throughout the colon. If approved in the United States, the product’s unique prolonged release mechanism might allow us to expand the range of treatment options for ulcerative colitis. On December 31, 2007 the Company submitted an NDA to the FDA seeking approval to market granulated mesalamine, dosed once-a-day, for the maintenance of remission in patients with ulcerative colitis. We anticipate receiving a response from the FDA on our NDA for granulated mesalamine during the fourth quarter of 2008. The patent for the treatment of the intestinal tract with the granulated mesalamine product will expire in 2018.

Xifaxan^® (rifaximin) tablets

We are committed to maximizing the commercial potential of our GI-targeted antibiotic, Xifaxan. We have prioritized our development efforts and have budgeted resources to expedite our late-stage trials in irritable bowel syndrome and hepatic encephalopathy. These studies are generating data that should provide the basis for forthcoming New Drug Applications.

In September 2007 we announced the successful completion and outcome of our Phase IIb trial to assess the efficacy and safety of rifaximin in the treatment of patients with diarrhea-associated irritable bowel syndrome (dIBS). Top-line results of this study demonstrate that the protocol-specified, intent-to-treat, co-primary endpoint comparison of a 14-day course of rifaximin at 550 mg twice-a-day, provides a statistically significant improvement in both adequate relief of dIBS symptoms and adequate relief of bloating, compared to placebo. In December 2007 we met with the FDA to discuss next steps in the development program. We anticipate initiating two Phase III trials in mid-2008.

The Phase III trial of rifaximin in the treatment of patients with hepatic encephalopathy continued during 2007. We currently expect to complete patient enrollment in this study during the first quarter of 2008.

In January 2006 we announced the completion of our first of two Phase III trials to evaluate Xifaxan in the prevention of travelers’ diarrhea. In this study 210 U.S. students in Mexico received either 600 mg of Xifaxan or a placebo daily for 14 days. The results of the study were highly statistically significant (p<0.0001) with 84 percent of Xifaxan-treated travelers remaining free from TD versus 50 percent of placebo-treated travelers. In our second Phase III trial to evaluate rifaximin in the prevention of TD in travelers to Thailand, the incidence rate at which international travelers to southern Thailand acquired bacterial diarrhea was lower than the historical incidence rate. Consequently, due to the low incidence of travelers’ diarrhea, the study was unable to determine the utility of rifaximin in this particular study population. We have a strong database of information from other travelers’ diarrhea prophylaxis trials, and we intend to meet with the FDA to discuss these data and potential next steps. We are assessing the current status of enrollment in our C. difficile-associated diarrhea, or CDAD, trial. At this time, the study remains open and patient enrollment continues. However, during 2008, we will continue to redirect funds previously allocated to patient recruitment in the CDAD trial to fund other initiatives.

Vapreotide acetate

In September 2006 we acquired exclusive marketing rights for vapreotide acetate in the United States from the Debiopharm Group. The product is currently undergoing a confirmatory Phase III trial in the United States as a treatment of acute esophageal variceal bleeding. If approved by the FDA, vapreotide acetate will be the only approved treatment for esophageal variceal bleeding in the United States. Vapreotide acetate has been granted orphan drug designation in the United States, and as a result, if approved, will have seven years of exclusivity from the approval date.

Metoclopramide-Zydis^®

In September 2007 we acquired exclusive, worldwide rights to metoclopramide-Zydis^® from Wilmington Pharmaceuticals. Metoclopramide is indicated for short–term (4–12 weeks) therapy for adults with symptomatic

5

documented gastroesphageal reflux who fail to respond to conventional therapy and for the relief of symptoms associated with acute and recurrent diabetic gastric stasis. The licensed compound is a fast-dissolve formulation that has patent protection until 2022, and additional patent protection pending that, if issued, will provide patent protection until 2025. Wilmington has submitted an NDA seeking approval to market metoclopramide-Zydis to the FDA. Wilmington anticipates receiving a response from the FDA during the fourth quarter of 2008.

COLLABORATIVE AND PRODUCT ACQUISITION AGREEMENTS

We have and will continue to enter into various collaborations and product acquisition agreements with licensors, licensees and others. To date, we have entered into the following agreements:

Product Acquisitions and In-License Agreements

aaiPharma LLC

In November 2003, we acquired from aaiPharma LLC for $2.0 million the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the name Azasan. In addition, the agreement provides that Salix is to pay aaiPharma, on a quarterly basis, a percentage royalty payment based on Salix’s net sales of Azasan in exchange for aaiPharma supplying us with drug product. Because the amount of the royalty payment is based on net sales during a quarter, with no minimum royalty amount, Salix is unable to prospectively disclose the absolute amount of such royalty payments. Royalties are only incurred if there is associated revenue, and then are included in “Cost of products sold” in the Statements of Operations.

Alfa Wassermann S.P.A.

In June 1996, Salix entered into a license agreement with Alfa Wassermann S.p.A, a privately held pharmaceutical company headquartered in Italy, pursuant to which Alfa Wassermann licensed to Salix the exclusive rights to make, use and sell rifaximin (Xifaxan) in the United States and Canada for the treatment of gastrointestinal and respiratory tract diseases. Pursuant to the license agreement, we agreed to pay Alfa Wassermann a net sales-based royalty, as well as milestone payments. Salix made annual milestone payments in varying amounts to Alfa Wassermann until the commercial launch of Xifaxan in July 2004. No more milestone payments remain under this agreement. Our obligation to pay royalties commenced upon the commercial launch of the product and continues until the later of (1) the expiration of the period in which the manufacture, use or sale of the products by an unlicensed third party would constitute an infringement on the patent covering the product or (2) 10 years from commercial launch. Thereafter, the licenses granted to us shall continue as irrevocable royalty-free paid-up licenses. However, we would remain obligated to pay a net sales based royalty for use of the product trademark if we choose to continue using it after the other licenses expired. Because the amount of the royalty payment is based on net sales during a quarter, with no minimum royalty amount, Salix is unable to prospectively disclose the absolute amount of such royalty payments. Royalties are only incurred if there is associated revenue, and then are included in “Cost of products sold” in the Statements of Operations.

Alfa Wassermann has agreed separately to supply us with bulk active ingredient rifaximin at a fixed price. Salix is committed to purchase a percentage of its rolling 12-month forecast that is updated monthly, and these amounts are included in the “Purchase Commitments” line of its contractual commitments table in its Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The license agreement does not have a set term and continues until terminated in accordance with its terms. Either party to the agreement may terminate it following a material breach by the other party and the failure of the breaching party to remedy the breach within 60 days. In addition, Alfa Wassermann has the right to terminate the agreement on three months’ written notice in the event that we fail to sell the product for a period of six consecutive months after commercial launch. In addition, Alfa Wassermann may terminate the agreement if we become involved in bankruptcy, liquidation or similar proceedings. We may terminate the agreement in respect of any indication or any part of the territory covered on 90 days’ notice, at which point our rights with respect to that indication or territory shall cease.

6

ALW Partnership

In connection with Salix’s acquisition of InKine Pharmaceutical Company, Inc. in September 2005, Salix assumed a license agreement with ALW Partnership for the worldwide rights, in perpetuity, to develop, use, market, sell, manufacture, have manufactured and sub-license Visicol and improvements, including OsmoPrep, in the field of colonic purgatives, along with ALW Partnership’s body of proprietary technical information, trade secrets and related know-how. Pursuant to this license agreement, Salix pays to Clinical Development Capital, ALW’s successor, on a quarterly basis, a percentage royalty payment based on Salix’s net sales of these products. Because the amounts of the royalty payments are based on net sales during a quarter Salix is unable to prospectively disclose the amount of such royalty payments. The agreement requires a minimum annual royalty payment of $0.1 million.

Biorex Laboratories Limited

Pursuant to an agreement entered into between us and Biorex in 1992, Biorex granted us the exclusive worldwide right (other than Japan, Taiwan, Korea and the United States) to develop, manufacture and sell balsalazide for all disease indications for a period of 15 years from the date of commercial launch, subject to early termination in certain circumstances, including upon the material breach by either party and, in the case of Biorex, in the event of our bankruptcy or if a sub-licensee of ours terminates or becomes entitled to terminate its sublicense as a result of actions by us. Pursuant to this agreement, Salix must pay to Biorex a percentage of any gross profits realized by Salix, plus a percentage of fees payable to Salix in connection with any sublicense by Salix of the rights under the agreement. Under a separate agreement, Biorex granted us the exclusive right to develop, manufacture and sell balsalazide for all disease indications in the United States for a period of nine years from the date of commercial launch or the term of the applicable patent, whichever is longer. Under these agreements, we paid Biorex fees upon entering into the agreements and are obligated to make additional milestone and royalty payments for the drug. The royalty payments to be made by us pursuant to the agreement governing the United States are based on net sales, subject to minimum royalty payments for the first five years following commercial launch. Under the agreement governing territories other than the United States, we are obligated to pay to Biorex a portion of any gross profit on sales of balsalazide outside the United States. Under these agreements, we undertook to complete preclinical testing, perform clinical trials and obtain regulatory approvals for balsalazide. During 2001, we acquired from Biorex the exclusive right and license to develop, manufacture and sell balsalazide in Japan, Korea and Taiwan. There were no fees paid to Biorex upon entering into this agreement, but we are obligated to pay Biorex a portion of any upfront payments, milestone payments and gross profit on sales of balsalazide in Japan, Korea and Taiwan as well. Because the amount of the royalty payment is based on net sales during a quarter, with no minimum royalty amount, Salix is unable to prospectively disclose the absolute amount of such royalty payments. Royalties are only incurred if there is associated revenue, and then are included in “Cost of products sold” in the Statements of Operations.

Cedars — Sinai Medical Center

On June 28, 2006, Salix entered into a license agreement with Cedars-Sinai Medical Center, or CSMC, for the right to use a patent and a patent application relating to methods of diagnosing and treating irritable bowel syndrome and other disorders caused by small intestinal bacterial overgrowth. Under the agreement, CSMC grants Salix the right to use its patent and patent application relating to methods of diagnosis and treating irritable bowel syndrome and other disorders caused by small intestinal bacterial overgrowth. CSMC also grants Salix a nonexclusive license to use any unpublished research and development information, know-how and technical data of CSMC as necessary to exploit all rights granted to Salix with respect to rifaximin, with a right to sublicense. As of December 31, 2007, all of the aggregate $1.2 million license fee had been paid. A portion of the $1.2 million was considered an up-front, non-refundable and irrevocable licensing fee. The balance was considered a prepaid, non-refundable and irrevocable royalty applicable as credit towards royalty amounts due and payable to CSMC, if any, under the agreement. At such time as the use of rifaximin is approved by the FDA as a treatment for irritable bowel syndrome, Salix will be required to pay CSMC low single digit percentage royalties on net sales of licensed products. An additional term of the license agreement with CSMC provides that Salix will expend a minimum amount per calendar year to seek and obtain regulatory approval and develop and commercialize licensed products. Because the license agreement provides the ability for Salix to terminate the agreement upon giving written notice of not less than 90 days, Salix does not include amounts payable under the license agreement as a purchase obligation in its contractual commitments table in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

7

Debiopharm Group

The Debiopharm Group is a global biopharmaceutical development company headquartered in Lausanne, Switzerland. Debiopharm developed vapreotide acetate for the treatment of acute esophageal variceal bleeding. In September 2006 we acquired the exclusive right to sell, market and distribute vapreotide acetate in the United States. The agreement provides that Salix make milestone payments in an aggregate amount of up to $7.5 million to Debiopharm upon certain events prior to the commercial launch of the product, and quarterly royalty payments thereafter. As of December 31, 2007, $0.5 million of milestone payments had been made. The remaining milestone payment is contingent upon achievement of regulatory approval. Because the milestone payment is conditioned upon events that might never occur, we do not consider the potential milestone payment as a purchase obligation nor a commitment to be reported in our contractual commitments table in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Dr. Falk Pharma GmbH

Pursuant to Salix’s license agreement, as amended, with Dr. Falk Pharma GmbH, Salix acquired the rights to develop and market a granulated formulation of mesalamine. The agreement provides that Salix make milestone payments in an aggregate amount of up to $11.0 million to Dr. Falk upon certain events prior to the commercial launch of the product, and quarterly royalty payments thereafter. As of December 31, 2007, $3.0 million of milestone payments had been made. The majority of the remaining milestone payments are contingent upon filing a new drug application and achievement of regulatory approval. Because these milestone payments are conditioned upon events that might never occur, we do not consider the potential milestone payments as purchase obligations nor a commitment to be reported in our contractual commitments table in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

King Pharmaceuticals, Inc.

In June 2004, we acquired the exclusive right to sell Anusol-HC^® 2.5% (hydrocortisone USP) cream, Anusol-HC^® 25 mg (hydrocortisone acetate) rectal suppositories, Proctocort^® 1% (hydrocortisone USP) cream and Proctocort^® 30 mg (hydrocortisone acetate) rectal suppositories from King Pharmaceuticals, Inc. We paid $13.0 million cash for the four products, and entered into a supply agreement for the suppository products and the Anusol-HC cream product with King Pharmaceuticals; an alternate supply arrangement with a contract manufacturer was put in place for the Proctocort cream product. Once payment amounts under this and other supply agreements are known and are non-cancelable, Salix includes them in its contractual commitments table in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Merck & Co., Inc.

In February 2007, we entered into a Master Purchase and Sale and License Agreement with Merck & Co., Inc., to purchase the U.S. prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension. Pursuant to the Master Purchase and Sale and License Agreement, Salix paid Merck $55.0 million at the closing of the transaction. In addition, Salix will make additional payments to Merck up to an aggregate of $6.0 million upon the achievement of certain annual gross sales targets for the acquired Pepcid Oral Suspension and Diuril Oral Suspension products during any of the five calendar years beginning in 2007 and ending in 2011. Because these payments are conditioned upon events that might never occur, we do not consider these payments as purchase obligations nor a commitment to be reported in our contractual commitments table in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

In return for these payments, Salix obtained (1) all rights to the United States regulatory approvals and related data, open purchase orders, inventory and customer lists related to the acquired oral suspension products, (2) an exclusive license to the Pepcid Oral Suspension and Diuril Oral Suspension trademarks for the use of prescription sale of the acquired oral suspension products in the U.S., and (3) an exclusive license to certain know-how related to the manufacture of the acquired oral suspension products in the U.S. Merck also agreed to manufacture and supply the acquired oral suspension products to Salix through December 31, 2008. In the event that Salix is acquired by another

8

party or if Salix sells all or substantially all of the rights to the acquired oral suspension products, and Merck determines in its reasonable judgment that such transaction will result in material harm to the Pepcid Oral Suspension name or the licensed trademark, Merck has the right to terminate one or more of the above licenses and the supply obligation.

In the event that a prescription or over-the-counter product with the same active ingredient and strength as Pepcid Oral Suspension is first sold by any party other than Salix prior to December 2008, Merck shall pay Salix up to $15.0 million depending on the date of such first sale.

Norgine B.V.

In December 2005, we acquired from Norgine B.V. the exclusive rights to sell NRL944 (now marketed by us under the trade name MoviPrep), a proprietary, liquid PEG bowel cleansing product in the United States. In return we will make upfront and milestone payments to Norgine that could total up to $37.0 million over the term of the agreement. As of December 31, 2007, $17.0 million of milestone payments had been made. The remaining milestone payments are contingent upon reaching sales thresholds. Because these milestone payments are conditioned upon events that might never occur, we do not consider the potential milestone payments as purchase obligations nor a commitment to be reported in our contractual commitments table in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Wilmington Pharmaceuticals, LLC

In September 2007, we acquired the exclusive, worldwide right to sell metoclopramide–Zydis^® from Wilmington Pharmaceuticals, LLC. Under the agreement, we are obligated to make upfront and milestone payments that could total up to $8.0 million over the term of the agreement. As of December 31, 2007, we had paid $500,000 of these milestone payments. The remaining milestone payments are contingent upon filing a new drug application and regulatory approval. Because these milestone payments are conditioned upon events that might never occur, we do not consider the potential milestone payments as purchase obligations nor a commitment to be reported in our contractual commitments table in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Product Out-License Collaborations

Dr. Falk Pharma GmbH

In April 2007, we licensed to Dr. Falk exclusive rights to market DIACOL™ 1500 mg Tablets in 28 territories in Europe. We sell DIACOL, or, sodium phosphate monobasic monohydrate, USP, and sodium phosphate dibasic anhydrous, tablets, USP, in the United States under the trade name OSMOPREP™ Tablets. As part of the agreement, Dr. Falk also has a non–exclusive option to market DIACOL in Italy and France. Under the terms of the agreement, we may receive up to $4 million in milestone payments, as well as royalty payments based on product sales. Dr. Falk made the first milestone payment of $1.5 million upon execution of the agreement. Dr. Falk is obligated to use all reasonable efforts to obtain Marketing Authorization by means of the Mutual Recognition Procedure in the territories and option countries.

This agreement remains in effect until the later of the expiration of the underlying patent and April 2024, unless earlier terminated pursuant to its terms. Falk may terminate at any time with 24 months written notice if it reasonably considers that the continued exploitation of the products in the territory by it is no longer in its commercial interests, provided that Falk shall have discussed such circumstance and consulted fully with Salix and the parties shall have discussed and if appropriate amended the minimum royalty payments. In the event there shall have occurred a material adverse breach of the agreement by a party uncured for up to 120 days, the other party may terminate. In addition, Salix may terminate on four months notice upon a Falk change of control unless Falk makes a non-termination payment to Salix.

Menarini Pharmaceutical Industries S.R.L.

Menarini, headquartered in Italy, is the largest manufacturer and distributor of pharmaceuticals in Southern Europe. Menarini also has extensive experience developing and marketing therapies for gastrointestinal disease in its

9

markets. Under our agreements with Menarini, we granted Menarini certain manufacturing rights and exclusive distribution rights with respect to balsalazide in Italy, Spain, Portugal and Greece. The agreement calls for additional milestone revenues to be paid to us relating to additional European marketing approvals, if any, in the Menarini territories. Under the terms of the agreements, we will sell the bulk active ingredient balsalazide to Menarini for marketing and distribution in its territories at cost plus a sales-based royalty. Menarini did not purchase any bulk active ingredient balsalazide from us during 2003, 2005, 2006, or 2007. During 2004, Menarini paid us approximately $0.1 million related to balsalazide purchases.

Unless terminated sooner in accordance with its terms, the agreement with Menarini continues until the earlier of the expiration of (1) the patents relating to the product or (2) 15 years from the date of the agreement, provided however that in any case the agreement shall continue for a period of 10 years from the date of first launch. Either party may terminate the agreement upon a material breach by the other party and the failure to remedy such breach within 30 days in the case of a payment breach or 90 days in the case of any other material breach or if a party enters liquidation, bankruptcy or similar proceedings.

Mayoly-Spindler S.A.S.

In October 2007, we licensed exclusive rights to market OSMOPREP™ (sodium phosphate monobasic monohydrate, USP and sodium phosphate dibasic anhydrous, USP) Tablets in France to Mayoly–Spindler S.A.S of Chatou, France. Under the terms of the agreement, we may receive up to $1 million in milestone payments, as well as royalty payments based on product sales. Mayoly–Spindler will join the current mutual recognition process being conducted by Dr. Falk Pharma to obtain Marketing Authorization in Europe.

Shire Pharmaceuticals Group plc

In May 2000, we signed an agreement with Shire Pharmaceuticals Group under which Shire purchased from us the exclusive rights to balsalazide, for use as a treatment for ulcerative colitis for Austria, Belgium, Denmark, Finland, France, Germany, Iceland, Republic of Ireland, Luxembourg, Norway, The Netherlands, Switzerland, Sweden and the United Kingdom. Under the agreement, Shire agreed to pay us up to a total of approximately $24.0 million, including approximately $12.1 million in up-front fees and up to $12.0 million upon the achievement of certain milestones. In accordance with our license arrangement with Biorex Laboratories Limited, our licensor, we share a portion of these payments with Biorex. In May 2000, Shire paid us $9.6 million of cash and $2.5 million by way of the issue of 160,546 new Shire ordinary shares which we subsequently sold. In August 2000 Shire paid us $4.4 million in connection with the transfer to Shire of the United Kingdom product license for balsalazide. No such additional payments have been made to us by Shire since August 2000. During 2004, we recognized $3.5 million of revenue from collaborative agreements related to this agreement which had previously been deferred. We do not anticipate any future revenues under this agreement.

Zeria Pharmaceutical Co. Ltd.

In August 2001, InKine Pharmaceutical Company, Inc., which we acquired in September 2005, licensed exclusive commercial rights in Japan to Visiclear^® Tablets for colon cleansing to Zeria Pharmaceutical Co., Ltd. of Tokyo, Japan. Zeria launched Visiclear in June 2007. Visiclear, or sodium phosphate monobasic monohydrate and sodium phosphate dibasic anhydrous, tablets are marketed in the United States under the trade name VISICOL^®.

Co-Promotion Agreement with Eisai Inc.

In September 2007, we entered into a Co-Promotion Agreement with Eisai Inc. for Eisai to act as our exclusive co-promoter of Colazal 750 milligram capsules in the United States and its territories. In February 2008 under the terms of this Agreement, we mutually agreed with Eisai to terminate this agreement as a result of the approval of three generic balsalazide capsule products on December 28, 2007. During 2007 there were no amounts paid to Eisai under this Agreement.

10

Supply and Distribution Agreement with Watson Pharma, Inc.

On December 28, 2007, we announced that we entered into a Supply and Distribution Agreement with Watson Pharma, Inc., pursuant to which Watson will be Salix’s exclusive distributor to market and sell an authorized generic of Colazal (balsalazide disodium) Capsules 750 mg, Salix’s anti-inflammatory drug approved for the treatment of mildly to moderately active ulcerative colitis, in the United States. Watson agrees to use commercially reasonable efforts to sell authorized generic Colazal, and has sole discretion to establish prices and terms. Watson will pay Salix a portion of its profits for sales under the agreement, and Salix will supply Watson with all its requirements for the product. The agreement terminates in October 2011, provided that either party may terminate immediately upon bankruptcy of the other, or for uncured breaches of the other party. Salix may also terminate on 30 days notice if the agreement has become commercially unviable, if it obtains the right to prohibit other generics from being sold or if it ceases distribution of branded Colazal.

MANUFACTURING

We own no manufacturing facilities. We have in the past used and plan to continue to use third-party manufacturers to produce material for use in clinical trials and for commercial product. This manufacturing strategy enables us to direct our financial resources to product in-licensing and acquisition, product development, and sales and marketing efforts, without devoting resources to the time and cost associated with building and maintaining manufacturing facilities.

Currently, under long-term supply agreements, we use balsalazide drug substance (the active pharmaceutical ingredient in Colazal capsules) manufactured by Omnichem s.a., a subsidiary of Ajinomoto in Belgium, and Pharmazell (formerly Noveon Pharma, GmbH) in Raubling, Germany. Also, under long-term supply agreements, balsalazide is encapsulated into Colazal drug product for us by Nexgen Pharma, inc. (formerly Anabolic Laboratories) in Irvine, California. Bulk Colazal capsules are packaged into finished Colazal commercial bottles by Nexgen and Carton Service in Norris, Tennessee.

Under our supply agreement with Alfa Wassermann, Alfa Wassermann is obligated to supply us with bulk rifaximin drug substance (the active pharmaceutical ingredient in Xifaxan tablets) until July 2014 or introduction of a generic product, whichever occurs first. Our supply of rifaximin drug substance is manufactured by ZaCh Systems (formerly Zambon) in Lonigo, Italy, and Aventis in Brindisi, Italy. Under a long-term supply agreement, rifaximin is converted into Xifaxan drug product for us by Patheon, Inc. in Whitby, Ontario. Bulk Xifaxan tablets are packaged into finished Xifaxan commercial bottles by Pathoen and packaged into Xifaxan commercial blister packs by Carton Service in Norris, Tennessee.

Under our long-term supply agreement with aaiPharma, aaiPharma produces our commercial supply of 75 mg and 100 mg Azasan finished product. We are in the process of working with aaiPharma to qualify an additional Azasan drug product manufacturer.

Under our long-term supply agreement with Paddock Laboratories in Minneapolis, Minnesota, Paddock produces our commercial supply of finished product of Anusol-HC Cream, Anusol-HC Suppositories and Proctocort Suppositories. In addition, through prior supply arrangements between King Pharmaceuticals and Crown Laboratories in Johnson City, Tennessee, Crown continues to produce our commercial supply of Proctocort Cream finished product.

Under our long-term supply agreement with WellSpring Pharmaceuticals in Oakville, Ontario, WellSpring produces our commercial supply of OsmoPrep finished product.

Under our long-term supply agreement with Norgine in Hengoed, Wales, Norgine produces our commercial supply of MoviPrep pouches. We then supply Carton Service in Norris, Tennessee with these MoviPrep pouches for secondary packaging into finished commercial MoviPrep kits.

Merck has agreed to manufacture our commercial supply of Pepcid Oral Suspension and Diuril Oral Suspension through December 2008. We are in the process of qualifying an alternate manufacturing site for commercial production of Pepcid OS and Diuril OS finished product.

11

With respect to our products currently under development, namely our encapsulated granulated mesalamine, our 1100 mg balsalazide tablet formulation and our 550 mg rifaximin tablet formulation, we plan to negotiate commercial supply agreements with the same manufacturers who supplied the drug substance and drug product for the supplies of the Phase III clinical trial material.

SALES AND MARKETING

We currently market our products and intend, if approved by the FDA, to market future products to U.S. gastroenterologists through our own direct sales force. We enter into distribution relationships outside the United States and in markets where a larger sales organization is appropriate. Currently, our sales and marketing staff consists of approximately 150 people, which we believe should also position us to sell additional products, if and when acquired and/or approved for U.S. marketing. Because there is a relatively small number of gastroenterologists that write a majority of the prescriptions in our indications, we believe that the size of our sales force, is appropriate to reach our target physicians. Our sales force consists of ninety-six employees who regularly call on approximately 11,000 gastroenterologists. We also have nine national account managers who regularly call on major drug wholesalers, managed care organizations, large retail chains, formularies and related organizations. We believe we have created an attractive incentive program for our sales force that is based upon goals in prescription growth, market share achievement and customer service.

We cultivate relationships of trust and confidence with the high prescribing gastroenterologists in the United States. We use a variety of marketing techniques to promote our products including sampling, journal advertising, promotional materials, specialty publications, coupons, money-back or product replacement guarantees, educational conferences and informational websites.

PATENTS AND PROPRIETARY RIGHTS

General

The patents for the balsalazide composition of matter and method of treating ulcerative colitis with balsalazide expired in July 2001 in the United States; however, we were granted five years of new chemical entity data exclusivity for balsalazide until July 2005 and an extension of such patent under the Waxman-Hatch Act through July 2006. We also obtained patent extensions for the composition of balsalazide in Italy and the United Kingdom until July 2006. We have filed applications for patents relating to additional indications using balsalazide and related chemical substances.

The patents for the rifaximin composition of matter (also covering a process of making rifaximin and using rifaximin to treat gastrointestinal infectious diseases) expired in May 2001 in the United States and Canada. In May 2006, a U.S. patent (composition of matter and process patent that covers several physical states of rifaximin) was issued that extends the patent coverage of the currently marketed form of rifaximin to May 22, 2024. Alfa Wasserman S.p.a., the patent owner, has licensed rights to rifaximin in the United States to Salix. In July 2006, Salix entered into an agreement with Cedars-Sinai Medical Center for the right to use its patent and patent application relating to methods of diagnosis and treating irritable bowel syndrome and other disorders caused by small intestinal bacterial overgrowth.

The patent for the treatment of the intestinal tract with the granulated mesalamine product provides patent coverage to 2018.

The patent for balsalazide 1100 mg tablets provides patent coverage to 2018.

The patent for Visicol provides patent coverage to 2013.

The patent for OsmoPrep provides patent coverage to 2013. Additional patent protection is being sought on OsmoPrep that, if approved, will provide patent coverage to 2024.

The patent for MoviPrep provides patent coverage to 2024. This patent was issued by the USPTO in January 2007 and it contains composition of matter and kit claims.

12

The patent for Sanvar expired in 2006; however, we will be applying for Patent Term Restoration.

Data Exclusivity

Rifaximin is a new chemical entity, therefore, the FDA granted us five year new chemical entity exclusivity when it was approved in May 2004. Therefore, rifaximin has data exclusivity through May 2009.

Although the granulated mesalamine product is not a new chemical entity, it may be entitled to three years of exclusivity from the date of its approval based on the new clinical investigations that have been required during the approval process. Such exclusivity would have the effect of preventing the FDA from approving an NDA for a granulated mesalamine product which relied upon the new clinical investigation in our NDA for three years from the date of approval. The patent for the granulated mesalamine protects the product until 2018.

Sanvar is an orphan drug, therefore, the product will be entitled to orphan exclusivity for seven years beginning from the date of the approval of our NDA.

Azasan and the Anusol-HC and Proctocort product lines are mature products, thus, there are no available patent or exclusivity rights.

GOVERNMENT REGULATION

The research, testing, manufacture, marketing and distribution of drug products are extensively regulated by governmental authorities in the United States and other countries. In the United States, drugs are subject to rigorous regulation by the FDA. The Federal Food, Drug and Cosmetic Act, as amended, and the regulations promulgated thereunder, and other federal and state statutes and regulations, govern, among other things, the research, development, testing, manufacture, storage, record keeping, labeling, promotion and marketing and distribution of pharmaceutical products. Failure to comply with applicable regulatory requirements may subject a company to administrative sanctions or judicially imposed sanctions such as civil penalties, criminal prosecution, injunctions, product seizure or detention, product recalls, and total or partial suspension of product marketing and/or approvals. In addition, non-compliance may result in the FDA’s refusal to approve pending NDAs or supplements to approved NDAs or in the withdrawal of an NDA. Any such sanction could result in adverse publicity, which could have a material adverse effect on our business, financial conditions, and results of operation.

The steps ordinarily required before a new pharmaceutical product containing a new chemical entity may be marketed in the United States include: (1) preclinical laboratory tests, preclinical studies in animals and formulation studies; (2) the submission to the FDA of a notice of claimed investigational exemption for a new drug or antibiotic, which must become effective before clinical testing may commence; (3) adequate and well-controlled clinical human trials to establish the safety and efficacy of the drug for each indication; (4) the submission of an NDA to the FDA; and (5) FDA review and approval of the NDA prior to any commercial sale or shipment of the drug. Preclinical tests include laboratory evaluation of product chemistry and formulation, as well as animal studies to assess the potential safety and efficacy of the product. Preclinical tests must be conducted in compliance with Good Laboratory Practice regulations. The results of preclinical testing are submitted to the FDA as part of an IND. A 30-day waiting period after the filing of each IND is required prior to the commencement of clinical testing in humans. In addition, the FDA may, at any time during this 30-day period or at any time thereafter, impose a clinical hold on proposed or ongoing clinical trials. If the FDA imposes a clinical hold, clinical trials cannot commence or recommence without FDA authorization and then only under terms authorized by the FDA. In some instances, the IND application process can result in substantial delay and expense.

Clinical trials to support NDAs are typically conducted in three sequential phases, but the phases may overlap. In Phase I, the initial introduction of the drug into healthy human subjects or patients, the drug is tested to assess metabolism, pharmacokinetics and pharmacological actions and safety, including side effects associated with increasing doses. Phase II usually involves studies in a limited patient population to (1) assess the efficacy of the drug in specific, targeted indications, (2) assess dosage tolerance and optimal dosage and (3) identify possible adverse effects and safety risks. If a compound is found to be potentially effective and to have an acceptable safety profile in

13

Phase II evaluations, Phase III trials are undertaken to further demonstrate clinical efficacy and to further test for safety within an expanded patient population at geographically dispersed clinical study sites. There can be no assurance that Phase I, Phase II or Phase III testing will be completed successfully within any specified time period, if at all, with respect to any of our products subject to such testing.

After successful completion of the required clinical testing, generally an NDA is submitted. FDA approval of the NDA is required before marketing may begin in the United States. The FDA reviews all NDAs submitted before it accepts them for filing and may request additional information rather than accepting an NDA for filing. In such an event, the NDA must be resubmitted with the additional information and, again, is subject to review before filing. Once the submission is accepted for filing, the FDA begins an in-depth review of the NDA. The FDA generally has 10 months in which to review the NDA and respond to the applicant. The review process is often significantly extended by FDA requests for additional information or clarification regarding information already provided in the submission. The FDA may refer the application to an appropriate advisory committee, typically a panel of clinicians, for review, evaluation and a recommendation as to whether the application should be approved. The FDA is not bound by the recommendation of an advisory committee. If the FDA’s evaluation of the NDA submission or manufacturing facilities is not favorable, the FDA may refuse to approve the NDA or issue a not approvable letter, outlining the deficiencies in the submission and often requiring additional testing or information. If FDA evaluations of the NDA and the manufacturing facilities are favorable, the FDA may issue either an approval letter or an approvable letter, which usually contains a number of conditions that must be met in order to secure final approval of the NDA. When and if those conditions have been met to the FDA’s satisfaction, the FDA will issue an approval letter, authorizing commercial marketing of the drug for certain indications. Furthermore, approval may entail ongoing requirements for post-marketing studies, and marketed products, manufacturers and manufacturing facilities are subject to continual review and periodic inspections. In addition, identification of certain side effects after a drug is on the market or the occurrence of manufacturing problems could cause subsequent withdrawal of approval, reformulation of the drug, additional preclinical testing or clinical trials and changes in labeling of the product.

Under the Orphan Drug Act, the FDA may designate a product as an orphan drug if it is a drug intended to treat a disease or condition that affects populations of fewer than 200,000 individuals in the United States or a disease whose incidence rates number more than 200,000 where the sponsor establishes that it does not realistically anticipate that its product sales will be sufficient to recover its costs. The sponsor that obtains the first marketing approval for a designated orphan drug for a given rare disease is eligible to receive marketing exclusivity for use of that drug for the orphan indication for a period of seven years. Vapreotide acetate, rifaximin for the treatment of hepatic encephalopathy and Colazal for the treatment of mildly to moderately active ulcerative colitis in pediatric patients between 5 to 17 years of age have been granted orphan drug status.

Regulation of Drug Compounds Outside of the United States

Outside the United States, the ability to market a drug is contingent upon receiving marketing authorizations from the appropriate regulatory authorities. The requirements governing the conduct of clinical trials and marketing authorization vary widely from country to country. Currently, foreign marketing authorizations are applied for at a national level, although within the European Union procedures are available to companies wishing to market a product in more than one European Union member state. The foreign regulatory approval process includes all of the risks associated with FDA approval set forth above.

If and when necessary, we will choose the appropriate route of European regulatory filing to accomplish the most rapid regulatory approvals. However, the chosen regulatory strategy might not secure regulatory approvals or approvals of our chosen product indications. Furthermore, we must obtain pricing approval in addition to regulatory approval prior to launching the product in the approving country. Failure to obtain pricing approval in a timely manner or approval of pricing which would support an adequate return on investment or generate a sufficient margin to justify the economic risk might delay or prohibit the commercial launch of the product in those countries.

COMPETITION

Competition in our business is intense and characterized by extensive research efforts and rapid technological progress. Technological developments by competitors, earlier regulatory approval for marketing competitive products,

14

or superior marketing capabilities possessed by competitors could adversely affect the commercial potential of our products and could have a material adverse effect on our revenue and results of operations. We believe that there are numerous pharmaceutical and biotechnology companies, including large well known pharmaceutical companies, as well as academic research groups throughout the world, engaged in research and development efforts with respect to pharmaceutical products targeted at gastrointestinal diseases and conditions addressed by our current and potential products. In particular, we are aware of products in research or development by competitors that address the diseases being targeted by our products. Developments by others might render our current and potential products obsolete or non-competitive. Competitors might be able to complete the development and regulatory approval process sooner and, therefore, market their products earlier than us. Many of our competitors have substantially greater financial, marketing and personnel resources and development capabilities than we do.

For example, many large, well capitalized companies already offer products in the United States and Europe that target the indications for balsalazide, including mesalamine and the granulated mesalamine product (GlaxoSmithKline plc, Giuliani S.p.A., Axcan Pharma, Inc., Solvay S.A., The Procter & Gamble Company and Shire Pharmaceuticals Group plc), sulfasalazine (Pharmacia & Upjohn, Inc.), and olsalazine (Pharmacia & Upjohn, Inc.). Asacol, marketed by Proctor & Gamble, is currently the most prescribed product for the treatment of ulcerative colitis in the United States, and Shire recently introduced once-a-day Lialda. In addition, on December 28, 2007, the Office of Generic Drugs approved three generic balsalazide capsule products.

Several prescription, liquid PEG products compete with Visicol, OsmoPrep and MoviPrep in the bowel cleansing market. These prescription products include Colyte, Golytely, Halflytely, and Nulytely (Braintree) and Trilyte (Schwarz Pharma). Generic prescription, liquid PEG products are also available. An over-the-counter product, Fleets Phospho-Soda, also competes in the bowel cleansing market.

The most frequently prescribed product for treatment of travelers’ diarrhea in the United States currently is ciprofloxacin, commonly known as “Cipro^®” and marketed by Bayer AG. The most frequently prescribed products that compete with Azasan are Imuran^®, marketed by Prometheus Laboratories, Inc., and its various generics and Purinethol^®, marketed by GATE Pharmaceuticals, and it’s various generics. The most frequently prescribed products that compete with Anusol-HC and Proctocort are AnaMantle HC, marketed by Bradley Pharmaceuticals; Analpram HC, marketed by Ferndale Laboratories; Proctofoam-HC and Proctocream-HC, marketed by Schwartz Pharma; Procto-Kit, marketed by Ranbaxy Pharmaceuticals; and various generics.

EMPLOYEES

As of December 31, 2007, we had approximately 270 full-time employees. We believe that our future success will depend in part on our continued ability to attract, hire, and retain qualified personnel, including sales and marketing personnel in particular. Competition for such personnel is intense, and there can be no assurance that we will be able to identify, attract, and retain such personnel in the future. None of our employees are represented by a labor union. We have not experienced any work stoppages and consider our relations with our employees to be good.

Item 1A. Risk Factors

This report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed in this report. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and elsewhere in this report and in any documents incorporated in this report by reference.

If any of the following risks, or other risks not presently known to us or that we currently believe to not be significant, develop into actual events, then our business, financial condition, results of operations or prospects could be materially adversely affected. If that happens, the market price of our common stock could decline, and stockholders may lose all or part of their investment.

Future sales of Colazal will be significantly less than historical sales due to the approval of three generic competitors.

Historically we have derived a majority of our revenue from sales of Colazal. On December 28, 2007, the Office of Generic Drugs, or OGD, approved three generic balsalazide capsule products, and we announced that we had

15

entered into an agreement with Watson Pharma, Inc. to market and sell an authorized generic of Colazal. Watson will pay Salix a portion of its profits for sales under the agreement, and Salix will supply Watson with all its requirements for the product. The price competition among the generic firms has resulted in dramatic price erosion compared to pricing prior to the generic approvals, and we expect that the market share that Watson obtains will be significantly less profitable than Colazal’s previous market share. In addition, we have implemented various programs in 2008 that attempt to reduce the market share lost to the generic products, however these programs will reduce the profitability of Colazal sales in 2008 and thereafter. As a result, we expect the future sales of Colazal to be significantly less than historical sales.

In the fourth quarter of 2007, we recorded a $34.6 million reserve which is our estimate of Colazal previously sold to wholesalers that may be returned to us under our return policy as a result of these generic approvals, based on data currently available to us. Since we have limited experience on the actual effect that the generics will have on Colazal demand, this estimate could be adjusted higher or lower in future periods based on actual returns.

The combined effect of Colazal’s reduction in market share, the price erosion in the 5-ASA market and the limited expected contribution from Watson’s share of the generic market will have a material adverse effect on our business, financial condition and results of operations. In addition, it is possible that additional generics could be approved, further increasing competition and pricing pressure.

We expect to be unprofitable and experience negative cash flow during 2008, and we may need additional capital.

Due to the generic approvals discussed above, we will be unprofitable and have negative cash flow during 2008. We believe that our current cash and cash equivalents together with cash generated from the sale of our products will be sufficient to fund our operations for 2008. Our future capital requirements will depend on many factors, including but not limited to:

• patient and physician demand for our products;

• the status of competitive products, including current and potential generics;

• the results, costs and timing of our research and development activities, regulatory approvals and product launches;

• our ability to reduce our costs in the event product demand is less than expected, or regulatory approvals are delayed or more expensive than expected;

• the number of products we acquire or in-license;

• the actual amount of Colazal returns we receive compared to our current estimates; and

• our ability to maintain our current credit facility.

We believe that we will be able to return to a positive cash flow position without requiring additional capital based on our current projections. However these projections may change due to changes in the factors discussed above, or other factors. If we need additional capital, we might seek additional debt or equity financing or both to fund our operations or acquisitions. If we incur more debt, we might be restricted in our ability to raise additional capital and might be subject to financial and restrictive covenants. If we issued additional equity, our stockholders could suffer dilution. We might also enter into additional collaborative arrangements that could provide us with additional funding in the form of equity, debt, licensing, milestone and/or royalty payments. We might not be able to enter into such arrangements or raise any additional funds on terms favorable to us or at all. Our common stock is likely to decrease in value if the market believes that we will be unable to return to profitability, or that we will be required to raise additional capital.

Our credit facility contains various representations, warranties and affirmative, negative and financial covenants customary for financings of this type. The financial covenants include a leverage test and a fixed charge test. We were in compliance with these covenants at December 31, 2007. However, based on our current projections for 2008, we could fall out of compliance with the financial covenants at some point during 2008, unless we obtain a waiver or amend the facility, which we are discussing with the lender. In the event a waiver or amendment is not obtained, the $15.0 million currently outstanding on the credit facility would be immediately due if one or more of the covenants are violated.

16

Future sales of Xifaxan and our other marketed products might be less than expected.

We currently market and sell nine primary products, with a majority of our historical revenue derived from sales of Colazal. We expect Xifaxan, which was launched in mid-2004, OsmoPrep, which we acquired in connection with our acquisition of InKine in September 2005, and MoviPrep, which we acquired from Norgine in December 2005, to be growing and significant sources of revenue in the future. If sales of our marketed products decline or if we experience product returns significantly in excess of estimated amounts recorded, particularly with respect to Xifaxan, OsmoPrep and MoviPrep, it would have a material adverse effect on our business, financial condition and results of operations.

The degree of market acceptance of our products among physicians, patients, healthcare payors and the medical community will depend upon a number of factors including:

• the timing of regulatory approvals and product launches by us or competitors, such as the launch of Lialda, and including any generic or over-the-counter competitors;

• perceptions by physicians and other members of the healthcare community regarding the safety and efficacy of the products;

• price increases, and the price of our products relative to other drugs or competing treatments;

• patient and physician demand;

• adverse side effects or unfavorable publicity concerning our products or other drugs in our class;

• the results of product development efforts for new indications;

• the scope and timing of additional marketing approvals and favorable reimbursement programs for expanded uses;

• availability of sufficient commercial quantities of the products; and

• our success in getting other companies to distribute our products outside of the U.S. gastroenterology market.

Our ability to increase revenue in the future will depend in part on our success in in-licensing or acquiring additional pharmaceutical products.

We currently intend to in-license or acquire pharmaceutical products, like vapreotide acetate, that have been developed beyond the initial discovery phase and for which late-stage human clinical data is already available, or like Pepcid Oral Suspension, that have already received regulatory approval. These kinds of pharmaceutical products might not be available to us on attractive terms or at all. To the extent we acquire rights to additional products, we might incur significant additional expense in connection with the development and, if approved by the FDA, marketing of these products. In addition, our license agreement with Alfa Wassermann provides that we may not promote, distribute or sell any antibiotic product that competes with Xifaxan in the United States and Canada until mid-2009, thereby limiting our ability to acquire, develop or market other antibiotic products.

Regulatory approval of our product candidates is time-consuming, expensive and uncertain, and could result in unexpectedly high expenses and delay our ability to sell our products.

Development of our products are subject to extensive regulation by governmental authorities in the United States and other countries. This regulation could require us to incur significant unexpected expenses or delay or limit our ability to sell our product candidates, including specifically granulated mesalamine, metoclopramide-Zydis and balsalazide disodium tablets, our product candidates that are farthest along in the regulatory approval process. As an example, FDA approval of MoviPrep was delayed from May until August 2006 to resolve regulatory issues, and in early 2008, the FDA announced that because of its large workload it might not meet its target dates to respond to NDA submissions.

Our clinical studies might be delayed or halted, or additional studies might be required, for various reasons, including:

• the drug is not effective;

• patients experience severe side effects during treatment;

17

• appropriate patients do not enroll in the studies at the rate expected, as has been the case with our Xifaxan Phase III trial in Thailand for the prevention of travelers’ diarrhea;

• drug supplies are not sufficient to treat the patients in the studies; or

• we decide to modify the drug during testing.

If regulatory approval of any product is granted, it will be limited to those indications for which the product has been shown to be safe and effective, as demonstrated to the FDA’s satisfaction through clinical studies. We are developing granulated mesalamine and balsalazide disodium tablets as treatments for ulcerative colitis and vapreotide acetate as a treatment for acute esophageal variceal bleeding, as well as studying Xifaxan for other indications. The FDA may never approve these compounds in these indications, which would mean we cannot market these compounds for use in these indications.

Regulatory approval, even if granted, might entail ongoing requirements or restrictions on marketing that could increase our expenses and limit revenue.

Approval might entail ongoing requirements for post-marketing studies, or limit how or to whom we can sell our products. Even if regulatory approval is obtained, such as with Colazal, Xifaxan Visicol, OsmoPrep, and MoviPrep, labeling and promotional activities are subject to continual scrutiny by the FDA and state regulatory agencies and, in some circumstances, the Federal Trade Commission. FDA enforcement policy prohibits the marketing of approved products for unapproved, or off-label, uses. These regulations and the FDA’s interpretation of them might increase our expenses, impair our ability to effectively market our products, and limit our revenue.

Failure to comply with manufacturing regulation could harm us financially and could hurt our reputation.

We and our third-party manufacturers are also required to comply with the applicable FDA current Good Manufacturing Practices, or cGMP, regulations, which include requirements relating to quality control and quality assurance, as well as the corresponding maintenance of records and documentation. Further, manufacturing facilities must be approved by the FDA before they can be used to manufacture our products, and they are subject to additional FDA inspection. Manufacturing regulations can increase our expenses and delay production, either of which could reduce our margins. In addition, if we fail to comply with any of the FDA’s continuing regulations, we could be subject to reputational harm and sanctions, including:

• delays, warning letters and fines;

• product recalls or seizures and injunctions on sales;

• refusal of the FDA to review pending applications;

• total or partial suspension of production;

• withdrawals of previously approved marketing applications; and

• civil penalties and criminal prosecutions.

In addition, the occurrence of manufacturing problems could cause subsequent withdrawal of approval, reformulation of the drug, additional testing or changes in labeling of the product.

Our intellectual property rights might not afford us with meaningful protection.

The intellectual property rights protecting our products might not afford us with meaningful protection from generic and other competition. In addition, because our strategy is to in-license or acquire pharmaceutical products which typically have been discovered and initially researched by others, future products might have limited or no remaining patent protection due to the time elapsed since their discovery. Competitors could also design around any of our intellectual property or otherwise design competitive products that do not infringe our intellectual property.

Any litigation that we become involved in to enforce intellectual property rights could result in substantial cost to us. In addition, claims by others that we infringe their intellectual property could be costly. Our patent or other

18

proprietary rights related to our products might conflict with the current or future intellectual property rights of others. Litigation or patent interference proceedings, either of which could result in substantial cost to us, might be necessary to defend any patents to which we have rights and our other proprietary rights or to determine the scope and validity of other parties’ proprietary rights. The defense of patent and intellectual property claims is both costly and time-consuming, even if the outcome is favorable. Any adverse outcome could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties, or require us to cease selling one or more of our products. We might not be able to obtain a license to any third-party technology that we require to conduct our business, or, if obtainable, that technology might not be available at a reasonable cost.

Upon patent expiration, our drugs could be subject to generic competition, which could negatively affect our pricing and sales volume. As noted above in “Future sales of Colazal will be significantly less than historical sales due to the approval of three generic competitors,” this has already happened to balsalazide capsules.

Patent applications relating to rifaxamin compositions and related chemical substances were filed together with Alfa Wasserman and issued in May 2006. This patent extends patent coverage to 2024. In January 2007, the United States Patent and Trademark Office issued a patent covering composition of matter and kit claims for MoviPrep. The MoviPrep patent provides coverage to September 2024. The patent for Visicol and OsmoPrep will expire in 2013. Additional patent protection is being sought for OsmoPrep that, if approved, will provide patent coverage to 2024. The patent for the treatment of the intestinal tract with the granulated mesalamine product will provide patent coverage to 2018. The patent for Sanvar expired in 2006; however, we will be applying for patent Term Restoration. There is no assurance that these patents or the patent term restoration will be issued or granted, respectively. Patent expiration dates listed herein, unless otherwise noted, are for U.S. patents and assume there are no patent term adjustments, extensions or other adverse events that could affect the term or scope of a patent.

Rifaximin is a new chemical entity and was granted a five-year new chemical entity exclusivity by the FDA when it was approved in May 2004. Rifaximin, therefore, has data exclusivity to May 2009. Similarly, Sanvar is a new chemical entity and will be entitled to data exclusivity for five years beginning from the date of the approval of our NDA. In June and September 2007 we submitted additional Supplements to our Citizen Petition originally filed in April 2005, requesting the director of the Office of Generic Drugs of the Food and Drug Administration adopt guidance applicable to orally administered, locally-acting gastrointestinal drug products prior to approval of any generic versions of such drugs. The FDA rejected our Citizens Petition and all Supplemental filings in December 2007, allowing the three generic versions of balsalazide capsules to be approved and making additional generic versions of our products easier to approve that we had hoped.

Because Azasan, Anusol-HC and Proctocort are mature products there are no patents or data exclusivity rights available, which subjects us to greater risk of generic competition for those products.

We also rely on trade secrets, proprietary know-how and technological advances, which we seek to protect, in part, through confidentiality agreements with collaborative partners, employees and consultants. These agreements might be breached and we might not have adequate remedies for any such breach. In addition, our trade secrets and proprietary know-how might otherwise become known or be independently developed by others.

We could be exposed to significant product liability claims that could prevent or interfere with our product commercialization efforts.

We might be subjected to product liability claims that arise through the testing, manufacturing, marketing and sale of our products. These claims could expose us to significant liabilities that could prevent or interfere with our product commercialization efforts. Product liability claims could require us to spend significant time and money in litigation or to pay significant damages. Although we currently maintain liability coverage for both clinical trials and the commercialization of our products, it is possible that this coverage will be insufficient to satisfy any liabilities that may arise. In the future, we might not be able to obtain adequate coverage at an acceptable cost or might be unable to obtain adequate coverage at all.

19

Intense competition might render our products noncompetitive or obsolete.

Competition in our business is intense and characterized by extensive research efforts and rapid technological progress. Technological developments by competitors, regulatory approval for marketing competitive products, including potential generic or over-the-counter products, or superior marketing resources possessed by competitors could adversely affect the commercial potential of our products and could have a material adverse effect on our revenue and results of operations. We believe that there are numerous pharmaceutical and biotechnology companies, including large well-known pharmaceutical companies, as well as academic research groups throughout the world, engaged in research and development efforts with respect to pharmaceutical products targeted at gastrointestinal diseases and conditions addressed by our current and potential products. In particular, we are aware of products in research or development by competitors that address the diseases being targeted by our products. Developments by others might render our current and potential products obsolete or noncompetitive. Competitors might be able to complete the development and regulatory approval process sooner and, therefore, market their products earlier than we can.

Many of our competitors have substantially greater financial, marketing and personnel resources and development capabilities than we do. For example, many large, well-capitalized companies already offer products in the United States and Europe that target the indications for:

• Colazal, including Asacol (Proctor & Gamble), sulfasalazine (Pfizer), Dipentum (UCB Pharma Inc.), Pentasa (Shire Pharmaceuticals Group, plc), once-a-day Lialda (Shire), and three generic balsalazide capsule products;

• Xifaxan as approved (travelers’ diarrhea), including ciprofloxacin, commonly known as Cipro (Bayer AG);

• Visicol, OsmoPrep and MoviPrep, including Colyte, Golytely, Halflytely, and Nulytely (Braintree) and Trilyte (Schwarz Pharma) and Fleets Phospho-Soda; and

• Xifaxan under development, including Lotronex^® (Prometheus) and Zelnorm^® (Novartis) for IBS.

In addition, other products are in research or development by competitors that address the diseases and diagnostic procedures being targeted by these and our other products.

If third-party payors do not provide coverage or reimburse patients for our products, our ability to derive revenues will suffer.

Our success will depend in part on the extent to which government and health administration authorities, private health insurers and other third-party payors will pay for our products. Reimbursement for newly approved healthcare products is uncertain. In the United States and elsewhere, third-party payors, such as Medicaid, are increasingly challenging the prices charged for medical products and services. Government and other third-party payors are increasingly attempting to contain healthcare costs by limiting both coverage and the level of reimbursement for new therapeutic products. In the United States, a number of legislative and regulatory proposals aimed at changing the healthcare system have been proposed in recent years. In addition, an increasing emphasis on managed care in the United States has and will continue to increase pressure on pharmaceutical pricing. While we cannot predict whether legislative or regulatory proposals will be adopted or what effect those proposals or managed care efforts, including those relating to Medicaid payments, might have on our business, the announcement and/or adoption of such proposals or efforts could increase costs and reduce or eliminate profit margins. Third-party insurance coverage might not be available to patients for our products. If government and other third-party payors do not provide adequate coverage and reimbursement levels for our products, the market acceptance of these products might be reduced.

We are dependent on third parties to manufacture our products.

We have limited experience and capabilities in manufacturing pharmaceutical products. We do not generally expect to engage directly in the manufacturing of products, but instead contract with others for these services. A limited number of manufacturers exist which are capable of manufacturing our marketed products and our product candidates. We might fail to contract with the necessary manufacturers or might contract with manufacturers on terms that may not be entirely acceptable to us. Our manufacturing strategy presents the following risks:

• the manufacture of products might be difficult to scale up when required and result in delays, inefficiencies and poor or low yields of quality products;

20

• some of our contracts contain purchase commitments that require us to make minimum purchases that might exceed needs or limit the ability to negotiate with other manufacturers, which might increase costs;

• the cost of manufacturing certain products might make them prohibitively expensive;

• delays in scale-up to commercial quantities and any change in manufacturers could delay clinical studies, regulatory submissions and commercialization of our products;

• manufacturers are subject to the FDA’s cGMP regulations and similar foreign standards, and we do not have control over compliance with these regulations by the third-party manufacturers; and

• if we need to change manufacturers, FDA and comparable foreign regulators would require new testing and compliance inspections and the new manufacturers would have to be educated in the processes necessary for the production of our products.

Our results of operations might fluctuate from period to period, and a failure to meet the expectations of investors or the financial community at large could result in a decline in our stock price.

Our results of operations might fluctuate significantly on a quarterly and annual basis due to, among other factors:

• the timing of regulatory approvals and product launches by us or competitors, including potential generic or over-the-counter competitors;

• the level of revenue generated by commercialized products, including potential increased purchases of inventory by wholesalers in anticipation of potential price increases or introductions of new dosages or bottle sizes, and subsequent lower than expected revenue as the inventory is used;

• the timing of any up-front payments that might be required in connection with any future acquisition of product rights;

• the timing of milestone payments that might be required to our current or future licensors;

• fluctuations in our development and other costs in connection with ongoing product development programs;

• the level of marketing and other expenses required in connection with product launches and ongoing product growth;

• the timing of the acquisition and integration of businesses, assets, products and technologies; and

• general and industry-specific business and economic conditions.

Our stock price is volatile.

Our stock price has been extremely volatile and might continue to be, making owning our stock risky. Between January 1, 2005 and March 10, 2008, the price of a share of our common stock varied from a low of $5.53 to a high of $22.79, as adjusted for the 3-for-2 stock split effected in July 2004.

The securities markets have experienced significant price and volume fluctuations unrelated to the performance of particular companies, as a result of the current credit crisis. In addition, the market prices of the common stock of many publicly traded pharmaceutical and biotechnology companies have in the past been and can in the future be expected to be especially volatile. Announcements of prescription trends, technological innovations or new products by us or our competitors, generic approvals, developments or disputes concerning proprietary rights, publicity regarding actual or potential medical results relating to products under development by us or our competitors, regulatory developments in both the United States and other countries, public concern as to the safety of pharmaceutical products, and economic and other external factors, as well as period-to-period fluctuations in financial results, might have a significant impact on the market price of our common stock.

Antitakeover provisions could discourage a takeover that stockholders consider to be in their best interests or prevent the removal of our current directors and management.

We have adopted a number of provisions that could have antitakeover effects or prevent the removal of our current directors and management. We have adopted a stockholder protection rights plan, commonly referred to as a

21

poison pill. The rights plan is intended to deter an attempt to acquire us in a manner or on terms not approved by our board of directors. The rights plan will not prevent an acquisition that is approved by our board of directors. We believe our rights plan assisted in our successful defense against a hostile takeover bid earlier in 2003. Our charter authorizes our board of directors to determine the terms of up to 5,000,000 shares of undesignated preferred stock and issue them without stockholder approval. The issuance of preferred stock could make it more difficult for a third party to acquire, or discourage a third party from acquiring, voting control in order to remove our current directors and management. Our bylaws also eliminate the ability of the stockholders to act by written consent without a meeting or make proposals at stockholder meetings without giving us advance written notice, which could hinder the ability of stockholders to quickly take action that might be opposed by management. These provisions could make more difficult the removal of current directors and management or a takeover of Salix, even if these events could be beneficial to stockholders. These provisions could also limit the price that investors might be willing to pay for our common stock.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

In mid-2005, we moved our corporate headquarters to Morrisville, North Carolina, where we occupy approximately 77,000 square feet of office space under a lease expiring in 2015. We sub-leased our former corporate headquarters located in Raleigh, North Carolina, of approximately 26,000 square feet of office space under a lease expiring in 2011. We also lease a small amount of additional space in Palo Alto, California.

Item 3. Legal Proceedings

From time to time, we are party to various legal proceedings or claims, either asserted or unasserted, which arise in the ordinary course of business. Management has reviewed pending legal matters and believes that the resolution of such matters will not have a significant adverse effect on our financial condition or results of operations.

Item 4. Submission of Matters to a Vote of Security Holders

No matter was submitted to a vote of our stockholders during the fourth quarter of the year ended December 31, 2007.

Executive Officers of the Registrant

The following table sets forth information concerning our executive officers as of March 1, 2008:

Name	Age	Position
Carolyn J. Logan	59	President, Chief Executive Officer, and Director
Adam C. Derbyshire	42	Senior Vice President, Finance and Administration, and Chief Financial Officer
William P. Forbes	46	Vice President, Research and Development and Chief Development Officer

Carolyn J. Logan has served as President and Chief Executive Officer and as a member of the Board of Directors since July 2002. She previously served as Senior Vice President, Sales and Marketing from June 2000 to July 2002. Prior to joining us, Ms. Logan served as Vice President, Sales and Marketing of the Oclassen Dermatologics division of Watson Pharmaceuticals, Inc. from May 1997 to June 2000, and as Vice President, Sales from February 1997 to May 1997. Prior to that date, she served as Director, Sales of Oclassen Pharmaceuticals, Inc. from January 1993 to February 1997. Prior to joining Oclassen, Ms. Logan held various sales and marketing positions with Galderma Laboratories, Ulmer Pharmacal and Westwood Pharmaceuticals. Ms. Logan received a B.S. degree in Biology and Dental Hygiene from the University of North Carolina at Chapel Hill.

22

Adam C. Derbyshire has served as Senior Vice President, Finance and Administration and Chief Financial Officer since June 2000. From June 1999 to June 2000, Mr. Derbyshire was Vice President, Corporate Controller and Secretary of Medco Research, Inc., acquired by King Pharmaceuticals, Inc. in February 2000, Corporate Controller and Secretary of Medco from September 1995 to June 1999 and Assistant Controller of Medco from October 1993 to September 1995. Mr. Derbyshire received his B.S. degree from the University of North Carolina at Wilmington and his MBA from the University of North Carolina at Charlotte.

William P. Forbes joined Salix in January 2005 as Vice President, Research and Development, and Chief Medical Officer. From 2002 through 2004, Dr. Forbes was Vice President, Clinical Development and Regulatory Affairs of Metabasis Therapeutics, Inc. He has also worked for Otsuka America Pharmaceutical, Inc. in a variety of roles of increasing responsibility from 1991 to 2002 and Glaxo, Inc. from 1989 through 1991. He has extensive experience in clinical development, regulatory affairs and project management. Dr. Forbes received his Doctor of Pharmacy degree from Creighton University.

23

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity              Securities

Our common stock is traded on the Nasdaq Global Market under the symbol “SLXP”. The following table sets forth the high and low sales prices of our common stock, as reported on the Nasdaq Global Market for the eight quarters ended December 31, 2007.

	High		Low
Fiscal year ended December 31, 2006
First quarter	$	18.72	$	13.68
Second quarter		16.50		10.92
Third quarter		14.59		9.77
Fourth quarter		15.00		12.06
Fiscal year ended December 31, 2007
First quarter	$	16.38	$	11.63
Second quarter		14.49		12.24
Third quarter		14.26		10.75
Fourth quarter		13.33		7.50

On March 10, 2008 the closing price for the common stock as reported on the Nasdaq Global Market was $5.64. As of March 10, 2008 there were 238 stockholders of record, which excludes stockholders whose shares were held in nominee or street name by brokers.

The securities markets have from time to time experienced significant price and volume fluctuations unrelated to the operating performance of particular companies. Our stock has been particularly volatile, including for example the approximate 21.8% single-day drop on December 28, 2007, when three generic versions of our drug Colazal were approved. The market prices of the common stock of Salix and many publicly traded pharmaceutical and biotechnology companies have in the past and can in the future be expected to be especially volatile. Announcements of technological innovations or new products by us or our competitors, developments or disputes concerning proprietary rights, publicity regarding actual or potential medical results relating to products under development by us or our competitors, regulatory developments in both the United States and other countries, public concern as to the safety of pharmaceutical products and economic and other external factors, as well as period-to-period fluctuations in our financial results, might have a significant impact on the market price of our common stock.

24

Performance Graph

The following graph compares our cumulative total stockholder return from December 31, 2002 with those of the Nasdaq Composite Index and the Nasdaq Biotech Index and that all dividends were reinvested. The graph assumes that U.S. $100 was invested on December 31, 2002 in (1) our common stock, (2) the Nasdaq Composite Index and (3) the Nasdaq Biotech Index. The measurement points utilized in the graph consist of the last trading day in each calendar year, which closely approximates the last day of the respective fiscal year of the Company. The historical stock performance presented below is not intended to and may not be indicative of future stock performance.

	12/31/02		12/31/03		12/31/04		12/31/05		12/31/06		12/31/07
SLXP	$	100	$	324	$	377	$	377	$	261	$	169
Nasdaq Composite Index	$	100	$	150	$	163	$	165	$	181	$	199
Nasdaq Biotech Index	$	100	$	146	$	155	$	159	$	161	$	168

In July 2004, we effected a three-for-two stock split of our common stock. As a result of the stock split, stockholders as of the record date of June 30, 2004 received one additional common share for every two shares held on the record date. The payment date for the additional shares was July 13, 2004.

Dividend Policy

We have never declared or paid cash dividends on our common stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of business and do not anticipate paying any cash dividends in the foreseeable future.

25

Item 6. Selected Financial Data

The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and the Notes thereto included elsewhere in this report.

Consolidated Statements of Operations Data:

	Year Ended December 31,
	2007			2006			2005			2004			2003
	(U.S. dollars, in thousands, except per share data)
Revenues:
Net product revenues	$	232,880		$	208,533		$	154,703		$	101,697		$	55,807
Revenues from collaborative agreements		2,912			—			200			3,799			—
Total revenues		235,792			208,533			154,903			105,496			55,807
Costs and expenses:
Cost of products sold		55,024			41,443			34,222			21,754			13,226
Fees and costs related to license agreements		1,850			1,296			100			1,837			125
Amortization of product rights and intangible assets		8,627			4,907			2,279			762			—
Research and development		71,947			47,917			34,547			20,366			23,654
Selling, general and administrative		86,492			82,636			70,823			54,128			38,635
In-process research and development		—			—			74,000			—			—
Total costs and expenses		223,940			178,199			215,971			98,847			75,640
Income (loss) from operations		11,852			30,334			(61,068	)		6,649			(19,833	)
Interest and other income (expense), net		3,326			2,552			1,222			598			(268	)
Income (loss) before income tax expense		15,178			32,886			(59,846	)		7,247			(20,101	)
Income tax expense		(6,953	)		(1,376	)		(739	)		(408	)		—
Net income (loss)	$	8,225		$	31,510		$	(60,585	)	$	6,839		$	(20,101	)
Net income (loss) per share, basic(1)	$	0.17		$	0.68		$	(1.55	)	$	0.19		$	(0.61	)
Net income (loss) per share, diluted(1)	$	0.17		$	0.65		$	(1.55	)	$	0.18		$	(0.61	)
Shares used in computing net income (loss) per share, basic(1)		47,329			46,634			39,129			36,112			32,793
Shares used in computing net income (loss) per share, diluted(1)		48,678			48,369			39,129			38,930			32,793

Consolidated Balance Sheet Data:

	As of December 31,
	2007			2006			2005			2004			2003
Cash and cash equivalents	$	111,272		$	76,465		$	67,184		$	48,108		$	54,795
Short-term investments		—			—			998			4,000			10,012
Working capital		108,891			126,216			94,520			69,914			69,314
Total assets		397,102			323,123			282,472			107,864			90,852
Borrowings under credit facility		15,000			—			—			—			—
Long term portion of capital lease obligations		612			—			—			—			—
Accumulated deficit		(104,738	)		(112,963	)		(144,473	)		(83,888	)		(90,727	)
Stockholders’ equity		292,570			277,551			239,853			86,687			73,935

(1) See Note 2 of Notes to Consolidated Financial Statements for an explanation of shares used in computing net income (loss) per share.

26

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

OVERVIEW

We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Our strategy is to

• identify and acquire rights to products that we believe have potential for near-term regulatory approval or are already approved;

• apply our regulatory, product development, and sales and marketing expertise to commercialize these products; and

• use our 150-member specialty sales and marketing team focused on high-prescribing U.S. gastroenterologists to sell our products.

Our current products demonstrate our ability to execute this strategy. As of December 31, 2007, our primary products were:

• XIFAXAN^® (rifaximin) Tablets 200 mg;

• OSMOPREP™ (sodium phosphate monobasic monohydrate, USP and sodium phosphate dibasic anhydrous, USP) Tablets;

• MOVIPREP^® (PEG 3350, Sodium Sulfate, Sodium Chloride, Potassium Chloride, Sodium Ascorbate and Ascorbic Acid for Oral Solution);

• COLAZAL^® (balsalazide disodium) Capsules 750 mg;

• VISICOL^® (sodium phosphate monobasic monohydrate, USP, and sodium phosphate dibasic anhydrous, USP) Tablets;

• AZASAN^® Azathioprine Tablets, USP, 75/100 mg;

• ANUSOL-HC^® 2.5% (Hydrocortisone Cream, USP), ANUSOL-HC^® 25 mg Suppository (Hydrocortisone Acetate);

• PROCTOCORT^® Cream (Hydrocortisone Cream, USP) 1% and PROCTOCORT^® Suppository (Hydrocortisone Acetate Rectal Suppositories) 30 mg;

• PEPCID^® (famotidine) for Oral Suspension; and

• Oral Suspension DIURIL^® (Chlorothiazide).

We currently market our products, and intend, if approved by the FDA, to market future products to U.S. gastroenterologists through our own direct sales force. We enter into distribution relationships outside the United States and in certain markets in the U.S. where a larger sales organization is appropriate. Currently, our sales and marketing staff consists of approximately 150 people.

We generate revenue primarily by selling our products, namely prescription drugs, to pharmaceutical wholesalers. These direct customers resell and distribute our products to and through pharmacies to patients who have had our products prescribed by doctors. Because demand for our products originates with doctors, our sales force calls on high-prescribing specialists, primarily gastroenterologists, and we monitor new and total prescriptions for our products as key performance indicators for our business.

Prescriptions result in our products being used by patients, requiring our direct customers to purchase more products to replenish their inventory. However, our revenue might fluctuate from quarter to quarter due to other factors, such as increased buying by wholesalers in anticipation of a price increase or because of the introduction of new products. Revenue could be less than anticipated in subsequent quarters as wholesalers’ increased inventory is used up. For example, wholesalers made initial stocking purchases of OsmoPrep when it was launched in second quarter 2006 and MoviPrep when it was launched in the third quarter of 2006. Also, 2006 Colazal revenue was slightly lower than in the comparable periods in 2005 even though prescriptions increased in 2006.

27

In December 2000, we established our own field sales force to market Colazal in the United States. Currently, this sales force has approximately 100 sales representatives in the field. Although the creation of an independent sales organization involved substantial costs, we believe that the financial returns from our direct product sales have been and will continue to be more favorable to us than those from the indirect sale of products through marketing partners. In addition, we intend to enter into distribution relationships outside the United States and in markets where a larger sales organization is appropriate.

Our primary product candidates under development and their status are as follows:

Compound	Indication	Status
Balsalazide disodium tablets	Ulcerative colitis	NDA filed
Granulated mesalamine	Ulcerative colitis	NDA filed
Rifaximin	Travelers’ diarrhea prevention	Phase III
Rifaximin	Irritable bowel syndrome	Phase III
Rifaximin	Hepatic encephalopathy	Phase III
Rifaximin	C. difficile — associated diarrhea	Phase III
SANVAR® IR (vapreotide acetate)	Acute esophageal variceal bleeding	Confirmatory Phase III
Metoclopramide — Zydis®	gastroesphageal reflux and gastroparesis	NDA submitted

CRITICAL ACCOUNTING POLICIES

General

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to sales of our products, bad debts, inventories, investments, intangible assets and legal issues. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results might differ materially from these estimates under different assumptions or conditions.

Methodologies used and assumptions selected by management in making these estimates, as well as the related disclosures, have been reviewed by and discussed with the Audit Committee of our Board of Directors.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue in accordance with the SEC’s Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” as amended by Staff Accounting Bulletin No. 104 (together, “SAB 101”), and FASB Statement No. 48 “Revenue Recognition When Right of Return Exists” (“SFAS 48”). SAB 101 states that revenue should not be recognized until it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have been rendered; (c) the seller’s price to the buyer is fixed and determinable; and (d) collectibility is reasonably assured.

SFAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if (1) the seller’s price to the buyer is substantially fixed or determinable at the date

28

of sale, (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by the seller, (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated. We recognize revenues for product sales at the time title and risk of loss are transferred to the customer, and the other criteria of SAB 101 and SFAS 48 are satisfied, which is generally at the time products are shipped. Our net product revenue represents our total revenues less allowances for customer credits, including estimated discounts, rebates, chargebacks, and product returns.

We establish allowances for estimated rebates, chargebacks and product returns based on numerous qualitative and quantitative factors, including:

• the number of and specific contractual terms of agreements with customers;

• estimated levels of inventory in the distribution channel;

• historical rebates, chargebacks and returns of products;

• direct communication with customers;

• anticipated introduction of competitive products or generics;

• anticipated pricing strategy changes by Salix and/or its competitors;

• analysis of prescription data gathered by a third-party prescription data provider;

• the impact of changes in state and federal regulations; and

• estimated remaining shelf life of products.

In our analyses, we use prescription data purchased from a third-party data provider to develop estimates of historical inventory channel pull-through. We utilize an internal analysis to compare historical net product shipments to estimated historical prescriptions written. Based on that analysis, we develop an estimate of the quantity of product in the channel which may be subject to various rebate, chargeback and product return exposures. At least quarterly for each product line, we prepare an internal estimate of ending inventory units in the distribution channel by adding estimated inventory in the channel at the beginning of the period, plus net product shipments for the period, less estimated prescriptions written for the period. Based on that analysis, we develop an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. This is done for each product line by applying a rate of historical activity for rebates, chargebacks and product returns, adjusted for relevant quantitative and qualitative factors discussed above, to the potential exposed product estimated to be in the distribution channel. Internal forecasts that are utilized to calculate the estimated number of months in the channel are regularly adjusted based on input from members of our sales, marketing and operations groups. The adjusted forecasts take into account numerous factors including, but not limited to, new product introductions, direct communication with customers and potential product expiry issues.

Consistent with industry practice, we periodically offer promotional discounts to our existing customer base. These discounts are calculated as a percentage of the current published list price and are treated as off-invoice allowances. Accordingly, the discounts are recorded as a reduction of revenue in the period that the program is offered. In addition to promotional discounts, at the time that we implement a price increase, we generally offer our existing customer base an opportunity to purchase a limited quantity of product at the previous list price. Shipments resulting from these programs generally are not in excess of ordinary levels, therefore, we recognize the related revenue upon shipment and include the shipments in estimating our various product related allowances. In the event we determine that these shipments represent purchases of inventory in excess of ordinary levels for a given wholesaler, the potential impact on product returns exposure would be specifically evaluated and reflected as a reduction in revenue at the time of such shipments.

Allowances for estimated rebates and chargebacks were $9.9 million and $8.0 million as of December 31, 2007 and 2006, respectively. These allowances reflect an estimate of our liability for items such as rebates due to various

29

governmental organizations under the Medicare/Medicaid regulations, rebates due to managed care organizations under specific contracts and chargebacks due to various organizations purchasing certain of our products through federal contracts and/or group purchasing agreements. We estimate our liability for rebates and chargebacks at each reporting period based on a methodology of applying the relevant quantitative and qualitative assumptions discussed above. Due to the subjectivity of our accrual estimates for rebates and chargebacks, we prepare various sensitivity analyses to ensure our final estimate is within a reasonable range as well as review prior period activity to ensure that our methodology continues to be appropriate. Had a change in one or more variables in the analyses (utilization rates, contract modifications, etc.) resulted in an additional percentage point change in the trailing average of estimated chargeback and rebate activity in 2007, we would have recorded an adjustment to revenues of approximately $3.1 million, or 1.0%, for the year.

Allowances for product returns were $43.1 million and $6.1 million as of December 31, 2007 and 2006, respectively. These allowances reflect an estimate of our liability for product that may be returned by the original purchaser in accordance with our stated return policy. The balance at December 31, 2007 includes the $34.6 million charge recorded in the fourth quarter of 2007 reflecting our estimate of Colazal that may be returned to us under our return policy as a result of the approval of three generic balsalazide capsule products by the Office of Generic Drugs on December 28, 2007. We estimate our liability for product returns at each reporting period based on historical return rates, the estimated inventory in the channel, and the other factors discussed above. Due to the subjectivity of our accrual estimates for product returns, we prepare various sensitivity analyses to ensure our final estimate is within a reasonable range as well as review prior period activity to ensure that our methodology is still reasonable. A change in assumptions that resulted in a 10% change in forecasted return rates for all products other than Colazal would have resulted in a change in total product returns liability at December 31, 2007 of approximately $4.5 million and a corresponding change in 2007 net product revenue of less than 2.0%.

Colazal, our balsalazide disodium capsule, has historically accounted for a majority of the Company’s revenue. On December 28, 2007, the Office of Generic Drugs, or OGD, approved three generic balsalazide capsule products. As a result of these generic approvals, the Company expects the future sales of Colazal to be significantly less than historical sales of Colazal. In the fourth quarter of 2007, the Company recorded a $34.6 million reserve which is an estimate of the Company’s liability for Colazal that may be returned by the original purchaser in accordance with the Company’s stated return policy as a result of these generic approvals. This estimate was developed based on the following estimates:

• our estimate of the quantity and expiration dates of Colazal inventory in the distribution channel based on historical net product shipments less estimated historical prescriptions written;

• our estimate of future demand for Colazal based on the actual erosion of product demand for several comparable products that were previously genericized, and the most recent demand for Colazal prior to the generic approvals;

• the actual demand for Colazal experienced during 2008 subsequent to the generic approvals;

• our estimate of potential cannibalization of Colazal demand by our 1100mg balsalazide tablet which we expect to launch during 2008 if approved by the FDA;

• our estimate of the generic market that will be obtained by Watson; and

• other factors.

Due to the subjectivity of this estimate, the Company prepares various sensitivity analyses to ensure the Company’s final estimate is within a reasonable range. A change in assumptions that resulted in a 10% change in the quantity of Colazal inventory in the distribution channel would have resulted in a change in the Colazal return reserve of approximately $8.2 million and a corresponding change in 2007 net product revenue of approximately 3.5%. A change in assumptions that resulted in a 10% change in the estimated future demand of Colazal would have resulted in a change in the Colazal return reserve of approximately $2.6 million and a corresponding change in 2007 net product revenue of approximately 1.1%.

For the years ended December 31, 2007 and 2006, our absolute exposure for rebates, chargebacks and product returns has grown primarily as a result of increased sales of our existing products, the approval of new products and the

30

acquisition of products, and also in 2007 as a result of the approval of generic balsalazide capsule products. Accordingly, reductions to revenue and corresponding increases to allowance accounts have likewise increased. The provision for these revenue-reducing items as a percentage of gross product revenue in the year ended December 31, 2007 and 2006 was 9.7% and 8.8% for rebates, chargebacks and discounts and was 3.3% and 3.4% for product returns excluding the Colazal return reserve, respectively. The Colazal return reserve was 11.2% of gross product revenue in 2007.

Inventories

Raw materials, work-in-process and finished goods inventories are stated at the lower of cost (which approximates actual cost on a first-in, first-out cost method) or market. In evaluating whether inventory is stated at the lower of cost or market, management considers such factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell such inventory, remaining shelf life, and current and expected market conditions, including levels of competition, including generic competition. Inventory at December 31, 2007 consisted of $7.5 million of raw materials, $3.6 million of work-in-process, and $6.6 million of finished goods. Inventory at December 31, 2006 consisted of $14.4 million of raw materials, $2.5 million of work in process and $8.2 million of finished goods. As of December 31, 2007, we had recorded inventory reserves totaling $0.8 million, compared to $0.7 million as of December 31, 2006, to reduce inventories to their net realizable value.

Intangible Assets and Goodwill

The Company’s intangible assets consist of license agreements, product rights and other identifiable intangible assets, which result from product and business acquisitions. Goodwill represents the excess purchase price over the fair value of assets acquired and liabilities assumed in a business combination.

When the Company makes product acquisitions that include license agreements, product rights and other identifiable intangible assets, it records the purchase price of such intangibles, along with the value of the product-related liabilities that we assume, as intangible assets. The Company allocates the aggregate purchase price to the fair value of the various tangible and intangible assets in order to determine the appropriate carrying value of the acquired assets and then amortizes the cost of the intangible assets as an expense in the consolidated statements of operations over the estimated economic useful life of the related assets. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long Lived Assets”, the Company assesses the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value might not be recoverable. The Company believes the following factors could trigger an impairment review: significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends.

In assessing the recoverability of its intangible assets, the Company must make assumptions regarding estimated future cash flows and other factors. If the estimated undiscounted future cash flows do not exceed the carrying value of the intangible assets, the Company must determine the fair value of the intangible assets. If the fair value of the intangible assets is less than the carrying value, the Company will recognize an impairment loss equal to the difference. The Company reviews goodwill for impairment on an annual basis, and goodwill and other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

The Company assesses impairment of goodwill on an annual basis in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”.

In November 2003, the Company acquired from aaiPharma LLC for $2.0 million the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the name Azasan. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Azasan does not have any patent protection, the Company believes ten years is an appropriate amortization period based on established product history and management’s experience. At December 31, 2007 and 2006, accumulated amortization for the Azasan intangible was $0.8 million and $0.6 million, respectively.

In June 2004, the Company acquired the exclusive U.S. rights to Anusol-HC 2.5% (hydrocortisone Cream USP), Anusol-HC 25 mg Suppository (Hydrocortisone Acetate), Proctocort Cream (Hydrocortisone Cream USP) 1% and

31

Proctocort Suppositories (Hydrocortisone Acetate Rectal Suppositories, 30 mg) from King Pharmaceuticals, Inc. for $13.0 million. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Anusol-HC and Proctocort do not have any patent protection, the Company believes ten years is an appropriate amortization period based on established product sales history and management’s experience. At December 31, 2007 and 2006, accumulated amortization for the King product intangibles was $4.6 million and $3.3 million, respectively.

In September 2005, the Company acquired InKine Pharmaceutical Company, Inc. for $210.0 million. We allocated $74.0 million of the purchase price to in-process research and development, $9.3 million to net assets acquired and $37.0 million to specifically identifiable product rights and related intangibles with an ongoing economic benefit to us. The Company allocated the remaining $89.7 million to goodwill, which is not being amortized. The InKine product rights and related intangibles are being amortized over an average period of 14 years, which the Company believes is an appropriate amortization period due to the product’s patent protections and the estimated economic lives of the product rights and related intangibles. At December 31, 2007 and 2006, accumulated amortization for the InKine intangibles was $6.8 million and $3.8 million, respectively.

In December 2005, the Company entered into a License and Supply Agreement with Norgine B.V., granting Salix the exclusive right to sell a patent-protected, liquid PEG bowel cleansing product, NRL 944, in the United States. In August 2006, the Company received Food and Drug Administration marketing approval for NRL 944 under the branded name of MoviPrep. In January 2007 the United States Patent Office issued a patent providing coverage to September 1, 2024. In August 2006, pursuant to the terms of the Agreement, Salix made a $15.1 million payment to Norgine. The Company is amortizing the milestone payment over a period of 17.3 years, which the Company believes is an appropriate amortization period due to the product’s patent protection and the estimated economic life of the related intangible. At December 31, 2007 and 2006, accumulated amortization for the MoviPrep intangible was $1.2 million and $0.4 million.

In February 2007, the Company entered into a Master Purchase and Sale and License Agreement with Merck & Co., Inc., to purchase the U.S. prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension from Merck. The Company paid Merck $55.0 million at the closing of the transaction. The purchase price was fully allocated to product rights and related intangibles, and is being amortized over a period of 15 years. Although Pepcid and Diuril do not have any patent protection, the Company believes 15 years is an appropriate amortization period based on established product history and management experience. At December 31, 2007, accumulated amortization for the Merck products was $3.2 million.

Allowance for Uncollectible Accounts

Based on a review of specific customer balances, industry experience and the current economic environment, we currently reserve for specific past due accounts that may represent collection concerns plus a percentage of our outstanding trade accounts receivable balance as an allowance for uncollectible accounts, which at December 31, 2007 and 2006 was approximately $3.1 million and $2.7 million, respectively. Refer to “Schedule II—Valuation and Qualifying Accounts” for a roll-forward of the allowance for uncollectible accounts.

Cash and Cash Equivalents

The Company considers all highly liquid investments with maturities from date of purchase of three months or less to be cash equivalents. The Company maintains its cash and cash equivalents in several different financial instruments with various banks and brokerage houses. This diversification of risk is consistent with Company policy to maintain liquidity and ensure the safety of principal. At December 31, 2007, cash and cash equivalents consisted primarily of demand deposits, overnight investments in Eurodollars, and money market funds. The Company has not experienced any loss of principal or liquidity in any of its cash and cash equivalents subsequent to year-end through March 13, 2008.

Research and Development

In accordance with its policy, the Company expenses research and development costs, both internal and externally contracted, as incurred. The Company estimates certain externally contracted development activities to align the related

32

expense with the level of progress achieved and services rendered during the period. As of December 31, 2007 and 2006, the net asset related to on-going research and development activities was $8.9 million and $2.1 million, respectively.

RESULTS OF OPERATIONS

Years Ended December 31, 2007, 2006 and 2005

Revenues

The following table summarizes net product revenues for the years ended December 31, 2007, 2006 and 2005:

	Year ended December 31,
	2007			2006			2005
Colazal	$	92,401		$	103,478		$	110,250
% of net product revenues		40	%		49	%		71	%
Xifaxan		64,260			51,628			30,051
% of net product revenues		28	%		25	%		20	%
Purgatives—MoviPrep/OsmoPrep/Visicol		47,693			45,502			5,137
% of net product revenues		20	%		22	%		3	%
Other—Anusol/Azasan/Diuril/Pepcid/Proctocort		28,526			7,925			9,265
% of net product revenues		12	%		4	%		6	%
Net product revenues	$	232,880		$	208,533		$	154,703

Revenues totaled $235.8 million, $208.5 million and $154.9 million for 2007, 2006 and 2005, respectively. Revenues for the year ended December 31, 2007 included net product revenues of $232.9 million and revenues from collaborative agreements of $2.9 million. Revenues for the year ended December 31, 2006 consisted solely of net product revenues. Revenues for the year ended December 31, 2005 included net product revenue of $154.7 million and revenues from collaborative agreements of $0.2 million.

Net product revenues for 2007 were $232.9 million, compared to $208.5 million for 2006, and $154.7 million for 2005. The net product revenue increase from 2006 to 2007 was primarily due to:

• price increases on our products;

• increased sales of Xifaxan;

• forty-one weeks of sales for Pepcid, which was acquired during February 2007;

• increased Colazal sales, offset by the Colazal return reserve recorded as a result of the approval of three generic balsalazide capsule products on December 28, 2007;

• $2.2 million in sales to Watson Pharma, Inc. during the fourth quarter of 2007 in connection with their launch of the authorized generic; and

• a full year of sales for OsmoPrep and MoviPrep, which were launched during the second and fourth quarters of 2006, respectively; offset by

• reduced sales of Visicol.

Total estimated prescription growth from 2006 to 2007 was 1% for Colazal, 35% for Xifaxan, and 98% for our purgatives.

On December 28, 2007, the Office of Generic Drugs approved three generic balsalazide capsule products. As a result of these generic approvals, the Company expects the future sales of Colazal to be significantly less than historical sales of Colazal. In the fourth quarter of 2007, the Company recorded a $34.6 million reserve as a reduction of net product revenues. This reserve represents an estimate of the Company’s liability for Colazal that may be

33

returned by the original purchaser in accordance with the Company’s stated return policy as a result of these generic approvals. This estimate was developed based on the following estimates:

• our estimate of the quantity and expiration dates of Colazal inventory in the distribution channel based on historical net product shipments less estimated historical prescriptions written;

• our estimate of future demand for Colazal based on the actual erosion of product demand for several comparable products that were previously genericized, and the most recent demand for Colazal prior to the generic approvals;

• the actual demand for Colazal experienced during 2008 subsequent to the generic approvals;

• our estimate of potential cannibalization of Colazal demand by our 1100mg balsalazide tablet which we expect to launch during 2008 if approved by the FDA;

• our estimate of the generic market that will be obtained by Watson; and

• other factors.

Due to the subjectivity of this estimate, the Company prepares various sensitivity analyses to ensure the Company’s final estimate is within a reasonable range. A change in assumptions that resulted in a 10% change in the quantity of Colazal inventory in the distribution channel would have resulted in a change in the Colazal return reserve of approximately $8.2 million and a corresponding change in 2007 net product revenue of approximately 3.5%. A change in assumptions that resulted in a 10% change in the estimated future demand of Colazal would have resulted in a change in the Colazal return reserve of approximately $2.6 million and a corresponding change in 2007 net product revenue of approximately 1.1%.

The net product revenue increase from 2005 to 2006 was primarily due to:

• price increases on our products;

• increased Colazal prescriptions, offset by a draw-down of wholesaler inventories during 2006; and

• increased sales of Xifaxan; offset by

• increases in revenue-reducing items from 2005 to 2006 due to increases in allowances for managed care agreements as a result of increased product sales and the allowance for product returns associated with Colazal, Visicol, Anusol and Proctocort.

Total estimated prescription growth from 2005 to 2006 was 10% for Colazal, 35% for our purgatives and 118% for Xifaxan.

Revenues from collaborative agreements for 2007 consists of an upfront payment of $1.5 million upon execution of an agreement to license exclusive rights to market OsmoPrep, under the name DIACOL™, in 28 territories in Europe to Dr. Falk Pharma GmbH of Freiberg, Germany; a $1.0 million milestone payment from Zeria Pharmaceutical Co., Ltd. of Tokyo, Japan as a result of their receipt of marketing approval of Visiclear^® Tablets, for colon cleansing in Japan; and $0.4 million upon execution of an agreement to license exclusive rights to market OSMOPREP^™ in France to Mayoly — Spindler S.A.S of Chatou, France. Revenues from collaborative agreements for 2007 include $12,000 in royalty income from sales of Visiclear^® by Zeria. We did not receive any revenues from collaborative agreements during 2006. Revenue from collaborative agreements for 2005 was $0.2 million.

Costs and Expenses

Total costs and expenses were $223.9 million, $178.2 million and $216.0 million for 2007, 2006 and 2005, respectively. Higher operating expenses in absolute terms for 2007 compared to 2006 were due primarily to increased research and development activities; increased cost of products sold related to the corresponding increase in product revenue; increased selling, general and administrative expenses due to the expansion of our infrastructure; costs related to OsmoPrep and MoviPrep, which were launched during the second and fourth quarters of 2006, respectively; and the acquisition of Pepcid during February 2007. Excluding the September 2005 one-time charge of $74.0 million for the write-off of in-process research and development associated with the acquisition of InKine, our higher operating

34

expenses in absolute terms for 2006 compared to 2005 were due primarily to increased research and development activities, increased cost of products sold related to the corresponding increase in product revenues, and increased selling, general and administrative expenses due to the expansion of our sales force in connection with the InKine merger and the launches of OsmoPrep and MoviPrep.

Cost of Products Sold

Cost of products sold were $55.0 million, $41.4 million and $34.2 million for 2007, 2006 and 2005, respectively. Gross margin on total product revenue, excluding $8.6 million, $4.9 million and $2.3 million in amortization of product rights and intangible assets for 2007, 2006 and 2005 was 76%, 80% and 78% in 2007, 2006 and 2005, respectively. The increase in cost of products sold in absolute dollars from 2006 to 2007 was primarily due to increased sales of Colazal and Xifaxan, a full year of sales for OsmoPrep and MoviPrep which were launched during the second and fourth quarters of 2006, respectively, and the acquisition of Pepcid during February 2007. The lower gross margin in 2007 is a result of the return reserve recorded in the fourth quarter of 2007 for Colazal as a result of the approval of three generic balsalazide capsule products, which reduced net product revenues and the gross margin for 2007.

The increase in cost of products sold from 2005 to 2006 was due primarily to increased sales of Xifaxan and Visicol and the additions of OsmoPrep and MoviPrep during the second and third quarters, respectively. The lower gross margin in 2005 was primarily due to a one-time write-off of $2.7 million of obsolete inventories associated with the initial launch of Xifaxan. Cost of products sold does not include amortization of product rights and intangibles. Refer to “Critical Accounting Policies — Intangible Assets and Goodwill” above.

Fees and Costs Related to License Agreements

Fees and costs related to license agreements were $1.9 million, $1.3 million and $0.1 million in 2007, 2006 and 2005, respectively, and relate primarily to payments made to Debiovision, Cedars-Sinai, Biorex and Alfa Wassermann under the terms of their respective license agreements. The amount for 2007 also includes payments of $1.5 million to Clinical Development Capital, the successor licensor of Visicol^® and OsmoPrep, for its share of the German, Japanese and French milestone revenue of $2.9 million recognized during 2007.

Research and Development

Research and development expense was $71.9 million, $47.9 million and $34.5 million for 2007, 2006 and 2005, respectively. The increase in research and development expenses was due primarily to the expansion of our Colazal life cycle management program through initiatives to strengthen and support our 1100mg balsalazide tablet submission completed in July 2007, studies of granulated mesalamine, and ongoing late-stage studies to expand the Xifaxan label.

The increase in research and development expenses from 2005 to 2006 was due primarily to the expansion of our Colazal life cycle management program through initiatives to strengthen and support our 1100mg balsalazide tablet submission, our Colazal pediatric exclusivity filing and the costs associated with ongoing late-stage studies to expand the Xifaxan label. To date, we have incurred research and development expense of approximately $60.3 million for balsalazide, $71.1 million for rifaximin and $27.9 million for granulated mesalamine. Due to the risks and uncertainties of the drug development and regulatory approval process, research and development expenditures are difficult to forecast and subject to unexpected increases. As disclosed in Note 2 in the Notes to Consolidated Financial Statements, due to increased development activities and the way in which many of our long-term development contracts are structured, in 2006 we refined our process of estimating development activities to more closely align expenses with the level of progress achieved. We expect research and development costs to increase in absolute terms as we pursue additional indications and formulations for balsalazide and rifaximin, and continue to develop granulated mesalamine, and if and when we acquire new products.

Selling, General and Administrative

Selling, general and administrative expenses were $86.5 million, $82.6 million and $70.8 million for 2007, 2006 and 2005, respectively. The slight increase in absolute dollars from 2006 to 2007 was primarily due to the expansion of our infrastructure related to OsmoPrep and MoviPrep, which were launched during the second and fourth quarters of 2006, respectively, the acquisition of Pepcid during February 2007, and the write-off of Colazal samples, offset by reduced spending on the launch of OsmoPrep.

35

The increase in absolute dollars from 2005 to 2006 was primarily due to launch and training activities associated with our two new purgative products, OsmoPrep and MoviPrep, and the expansion of our sales force and infrastructure subsequent to the InKine merger.

Interest and Other Income, Net

Interest and other income, net was $3.3 million, $2.6 million and $1.2 million in 2007, 2006 and 2005, respectively. Interest and other income, net for 2007 includes $1.2 million received as final settlement of a legal matter initiated by InKine prior to our acquisition of InKine. This increase in interest and other income, net is offset by a decrease in interest and other income, net primarily due to interest expense of $0.2 million on our credit facility discussed below. The increase from 2005 to 2006 was primarily due to higher average daily cash balances and increased short-term interest rates.

Provision for Income Tax

Income tax expense was $7.0 million, $1.4 million and $0.7 million in 2007, 2006 and 2005, respectively. Our effective tax rate was 45.8%, 4.2% and (1.2%) in 2007, 2006 and 2005, respectively, due to utilization of net operating loss carryforwards. The higher than expected rate in 2007 was due to an increase in the valuation allowance for deferred taxes related to the $34.6 million reserve related to Colazal recorded in the fourth quarter.

At December 31, 2007, 2006 and 2005, we had U.S. federal net operating loss carryforwards of approximately $37.0 million, $111.1 million and $128.7 million, respectively. These carryforwards will expire on various dates beginning in 2020 through 2024 if not utilized. Utilization of the federal net operating loss and credit carryforwards may be subject to a substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code. The annual limitation might result in the expiration of net operating losses and credits before utilization.

Quarterly Results of Operations

See Note 11 of Notes to Consolidated Financial Statements for a presentation of our quarterly results of operations for the years ended December 31, 2007 and 2006.

LIQUIDITY AND CAPITAL RESOURCES

From inception until first achieving profitability in the third quarter of 2004, we financed product development, operations and capital expenditures primarily from public and private sales of equity securities and from funding arrangements with collaborative partners. Since launching Colazal in January 2001, net product revenue has been a growing source of cash. As of December 31, 2007, we had $111.3 million in cash, cash equivalents and short-term investments compared to $76.5 million as of December 31, 2006.

Net cash provided by operating activities was $76.1 million, $17.9 million and $3.0 million in 2007, 2006, and 2005, respectively. Positive operating cash flows in 2007 was primarily attributable to increased earnings before the Colazal return reserve noncash charge, and reduced accounts receivable and inventory balances in 2007. Positive operating cash flows in 2006 was primarily attributable to increased earnings, partially offset by increased accounts receivable balances due to increased sales in December 2006 and decreased accounts payable and accrued liability balances. Positive operating cash flows in 2005 were primarily attributable to increased earnings, excluding the impact of non-cash flow items including in-process research and development and depreciation and amortization, partially offset by increased accounts receivable and other current assets.

Net cash used in investing activities was $59.4 million in 2007 and was primarily attributable to the acquisition of Pepcid for $55.0 million and the purchase of property and equipment. Net cash used in investing activities was $12.8 million in 2006 and was primarily attributable to the acquisition of MoviPrep and the purchase of property and equipment, partially offset by $1.0 million of investments that matured or were called by the issuers. Net cash provided by investing activities was $9.5 million in 2005 and was primarily attributable to proceeds from the maturity of investments and net cash acquired in the InKine acquisition, partially offset by the purchase of property and equipment and product rights.

36

Net cash provided by financing activities of $18.1 million in 2007 was attributable to $15.0 million of borrowings under our credit facility entered into in February 2007, and the exercise of stock options. Net cash provided by financing activities of $4.2 million and $6.5 million in 2006 and 2005, respectively, was attributable to the exercise of stock options.

As of December 31, 2007, we had non-cancelable purchase order commitments for inventory purchases of approximately $9.6 million. We anticipate significant expenditures related to our on-going sales, marketing, product launch and development efforts associated with 1100mg balsalazide tablets, Xifaxan, Visicol, Azasan, Anusol-HC, Proctocort, OsmoPrep, MoviPrep, Pepcid Oral Suspension and granulated mesalamine. To the extent we acquire rights to additional products, we will incur additional expenditures.

Our contractual commitments for non-cancelable purchase commitments of inventory, minimum lease obligations for all non-cancelable operating leases, and minimum capital lease obligations (including interest) as of December 31, 2007 are as follows (in thousands):

	Total		< 1 year		1-3 years		3-5 years		> 5 years
Operating leases	$	12,972	$	2,018	$	4,278	$	3,225	$	3,451
Purchase commitments		9,570		9,570		—		—		—
Capital lease obligations		1,687		1,056		630		1
Total	$	24,229	$	12,644	$	4,908	$	3,226	$	3,451

In February 2007, we entered into a $100.0 million revolving credit facility that matures in February 2012. At December 31, 2007, $15.0 million was outstanding under the credit facility. Virtually all of our assets and those of our subsidiaries secure our obligations under the credit facility. The credit facility may be used for working capital, capital expenditures, acquisitions and other general corporate purposes.

The credit facility bears interest at a rate per annum equal to, at our option, either (a) a base rate equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Bank of America prime rate, or (b) a Eurodollar rate (based on LIBOR), plus, in each case, a percentage rate that fluctuates, based on the ratio of our funded debt to EBITDA (income before income taxes plus interest expense and depreciation and amortization), from 0.00% to 0.75% for base rate borrowings and 1.00% to 1.75% for Eurodollar rate borrowings. The rate as of December 31, 2007 on our outstanding borrowings was 6.00%.

The credit facility contains various representations, warranties and affirmative, negative and financial covenants customary for financings of this type. The financial covenants include a leverage test and a fixed charge test. We were in compliance with these covenants at December 31, 2007. However, based on our current projections for 2008, we could fall out of compliance with the financial covenants at some point during 2008, unless we obtain a waiver or amend the facility, which we are discussing with the lender. In the event a waiver or amendment is not obtained, the $15.0 million currently outstanding on the credit facility would be immediately due if one or more of the covenants are violated.

As of December 31, 2007, we had an accumulated deficit of $104.7 million and cash and cash equivalent balances of $111.3 million. We expect to be unprofitable and experience negative cash flow during 2008, due to the approval of three generic balsalazide capsule products. We believe our cash and cash equivalent balances should be sufficient to satisfy our cash requirements for the foreseeable future. Based on our current projections, we believe that we will be able to return to a positive cash flow position without requiring additional capital. However, our actual cash needs might vary materially from those now planned because of a number of factors, including the status of competitive products, including potential generics, intellectual property risks, our success selling products, the results of research and development activities, FDA and foreign regulatory processes, establishment of and change in collaborative relationships, technological advances by us and other pharmaceutical companies, the actual amount of Colazal returns we receive compared to our current estimates, our ability to maintain our current credit facility, and whether we acquire rights to additional products. We might seek additional debt or equity financing or both to fund our operations or acquisitions. If we incur more debt, we might be restricted in our ability to raise additional capital and might be subject

37

to financial and restrictive covenants. If we issue additional equity, our stockholders could suffer dilution. We might also enter into additional collaborative arrangements that could provide us with additional funding in the form of equity, debt, licensing, milestone and/or royalty payments. We might not be able to enter into such arrangements or raise any additional funds on terms favorable to us or at all.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In December 2007, the FASB issued SFAS No. 141 (revised 2007) “Business Combinations” (SFAS 141R). SFAS 141R is effective for fiscal years beginning on or after December 15, 2008, which means that we will adopt SFAS 141R in our fiscal year 2009. SFAS 141R replaces SFAS 141 “Business Combinations” and requires that the acquisition method of accounting (which SFAS 141 called the purchase method) be used for all business combinations, as well as for an acquirer to be identified for each business combination. SFAS 141R establishes principles and requirements for how the acquirer: (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and (iii) determines what information to disclose to enable users of financial statements to evaluate the nature and financial affects of the business combination. We are currently evaluating the impact of adoption of SFAS 141R on our consolidated financial position, results of operations and cash flows.

In December 2007, the FASB issued SFAS No. 160 “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” (SFAS 160). SFAS 160 is effective for fiscal years beginning on or after December 15, 2008, which means that we will adopt SFAS 160 in our fiscal year 2009. This statement amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 changes accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity in the Consolidated Financial Statements. SFAS 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests. All other requirements of SFAS 160 shall be applied prospectively. We do not believe the adoption of SFAS 160 will have a material impact on our consolidated financial position, results of operations and cash flows.

In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). SFAS 159 permits entities to choose, at specified election dates, to measure eligible items at fair value (the “Fair Value Option”). Unrealized gains and losses on items for which the Fair Value Option has been elected are reported in earnings. The Fair Value Option is applied instrument by instrument (with certain exceptions), is irrevocable (unless a new election date occurs) and is applied only to an entire instrument. The effect of the first remeasurement to fair value is reported as a cumulative-effect adjustment to the opening balance of retained earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We do not expect the adoption of SFAS 159 to have a material impact on our consolidated financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. This Statement applies to other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB released FSP No. FAS 157-2. FSP No. FAS 157-2 defers the effective date of FASB 157 for one year for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. It does not defer recognition and disclosure requirements for financial assets and financial liabilities, or for nonfinancial assets and nonfinancial liabilities that are remeasured at least annually. We do not expect the adoption of SFAS 157 to have a material impact on our consolidated financial position, results of operations or cash flows.

CAUTIONARY STATEMENT

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. The following statement highlights some of these risks. For more detail, see “Item 1A — Risk Factors”.

38

Statements contained in this Form 10-K that are not historical facts are or might constitute forward-looking statements under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Although we believe the expectations reflected in such forward-looking statements are based on reasonable assumptions, our expectations might not be attained. Forward-looking statements involve known and unknown risks that could cause actual results to differ materially from expected results. Factors that could cause actual results to differ materially from our expectations expressed in the report include, among others: our need to return to profitability; intense competition, including from generics; the high cost and uncertainty of the research, clinical trials and other development activities involving pharmaceutical products; the unpredictability of the duration and results of regulatory review of New Drug Applications and Investigational New Drug Applications; the possible impairment of, or inability to obtain intellectual property rights and the costs of obtaining such rights from third parties; our dependence on our first nine pharmaceutical products, particularly Colazal and Xifaxan, and the uncertainty of market acceptance of our products; the uncertainty of obtaining, and our dependence on, third parties to manufacture and sell our products; and results of future litigation and other risk factors detailed from time to time in our other SEC filings.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Our purchases of raw materials are denominated primarily in Euros. Translation into our reporting currency, the U.S. dollar, has not historically had a material impact on our financial position. Additionally, our net assets denominated in currencies other than the U.S. dollar have not historically exposed us to material risk associated with fluctuations in currency rates. Given these facts, we have not considered it necessary to use foreign currency contracts or other derivative instruments to manage changes in currency rates. However, these circumstances might change.

Item 8. Financial Statements and Supplementary Data

The information required by this Item is set forth in the Consolidated Financial Statements and Notes thereto beginning at page F-1 of this Report.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

Item 9A. Control and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) are designed only to provide reasonable assurance that information to be disclosed in our Exchange Act Reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s President and Chief Executive Officer and Senior VP, Finance and Administration and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e). Based upon this evaluation, the Company’s President and Chief Executive Officer and Senior VP, Finance and Administration and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to provide the reasonable assurance discussed above.

Management’s Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements. A control system, no matter how well designed and operated, can only provide reasonable, not absolute, assurance that the objectives of the control system are met and must reflect the fact that there are resource constraints that require management to consider the benefits of internal controls relative to their costs. Because of these inherent limitations, management does not expect that our internal controls over financial

39

reporting will prevent all error and all fraud. Under the supervision and with the participation of our management, including our CEO and our Senior VP, Finance and Administration and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control — Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2007.

The effectiveness of our internal control over financial reporting as of December 31, 2007, has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included on page F-2 herein.

Changes in Internal Control over Financial Reporting

There was no change in our internal controls over financial reporting during the fourth quarter of the period covered by this Annual Report that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

Item 9B. Other Information

Not applicable.

40

PART III

Item 10. Directors, Executive Officers and Corporate Governance

Information required by this Item concerning our directors is incorporated by reference from the section captioned “Proposal One—Election of Directors” contained in our proxy statement related to the 2008 Annual Meeting of Stockholders scheduled to be held on June 12, 2008, which we intend to file with the SEC within 120 days of the end of our fiscal year pursuant to General Instruction G(3) of Form 10-K.

The Board of Directors has determined that the members of the Audit Committee are independent as defined in Rule 4200(a)(15) of the National Association of Securities Dealers’ listing standards. The Board of Directors has also determined that John F. Chappell, Thomas W. D’Alonzo, William Harral III and William P. Keane are “audit committee financial experts” as defined in Item 401(h) of Regulation S-K.

Our Board of Directors adopted a code of conduct that applies to all of our directors and employees. Our Board also adopted a separate code of ethics for our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Controller, or persons performing similar functions. We will provide copies of our code of conduct and code of ethics without charge upon request. To obtain a copy of our code of conduct and code of ethics, please send your written request to Salix Pharmaceuticals, Ltd., 1700 Perimeter Park Drive, Morrisville, NC 27560, Attn: General Counsel. In addition, you can find those codes on our website at www.salix.com/pdf/Salix_Code_Bus_Cond.pdf.

The information required by this Item concerning executive officers of the Registrant is set forth at the end of Part I of this report.

The information required by this Item concerning compliance with Section 16(a) of the United States Securities Exchange Act of 1934, as amended, is incorporated by reference from the section of the proxy statement captioned “Other Information—Section 16(a) Beneficial Ownership Reporting Compliance.”

Item 11. Executive Compensation

The information required by this Item is incorporated by reference to the information under the sections captioned “Other Information —Compensation of Non-Employee Directors,” “—Compensation Discussion and Analysis,” “—Summary Compensation Table,” “—Equity Grants, Exercises and Holdings,” “—Compensation Committee Report,” and “—Compensation Committee Interlocks and Insider Participation” contained in the proxy statement.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The following table sets forth the indicated information as of December 31, 2007 with respect to our equity compensation plans:

Plan Category	(a) Number of Securities to be issued Upon Exercise of Outstanding Options, Warrants and Rights, or Vesting of Restricted Shares	(b) Weighted Average Exercise Price of Outstanding Options, Warrants, Rights and Restricted Shares		(c) Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Related in Column (a))
Equity Compensation Plans Approved by Security Holders	6,337,728	$	13.80	611,253
Equity Compensation Plans Not Approved by Security Holders	—	$	—	—
Total	6,337,728	$	13.80	611,253

The other information required by this Item is incorporated by reference to the information under the section captioned “Other Information—Security Ownership of Management and Certain Beneficial Owners.”

41

Item 13. Certain Relationships and Related Transactions, and Director Independence

The information required by this Item is incorporated by reference to the information under the section captioned “Other Information—Certain Transactions” and “Proposal One—Election of Directors—Corporate Governance Matters” contained in the proxy statement.

Item 14. Principal Accountant Fees and Services

The information required by this Item is incorporated by reference to the information under the section captioned “Other Information—Audit Committee Report” contained in the proxy statement.

42

PART IV

Item 15. Exhibits and Financial Statement Schedules

(a) 1. Financial Statements

The following statements are filed as part of this report:

	Page
Report of Independent Registered Public Accounting Firm	F-2
Report of Independent Registered Public Accounting Firm on Financial Statements	F-3
Report of Independent Registered Public Accounting Firm on Internal Control	F-4
Consolidated Balance Sheets	F-5
Consolidated Statements of Operations	F-6
Consolidated Statements of Stockholders’ Equity	F-7
Consolidated Statements of Cash Flows	F-8
Notes to Consolidated Financial Statements.	F-9

     2. Financial Statement Schedules

Schedule II—Valuation and Qualifying Accounts F-29

Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the financial statements or notes thereto.

     3. Exhibits

Exhibit Number	Description of Document	Registrant’s Form	Dated	Exhibit Number	Filed Herewith
2.1	Agreement and Plan of Merger dated June 23, 2005 among Salix Pharmaceuticals, Ltd., InKine Pharmaceutical Company, Inc. and Metal Acquisition Corp.	8-K	6/24/05	2.1
2.2	Certificate of Domestication.	S-3	02/12/02	2.1
2.3*	Asset Purchase Agreement dated June 30, 2004 between King Pharmaceuticals, Inc., Monarch Pharmaceuticals, Inc., Parkedale Pharmaceuticals, Inc., Salix Pharmaceuticals, Inc. and Salix Pharmaceuticals, Ltd.	10-Q	08/09/04	2.2
3.1	Certificate of Incorporation, as amended.	10-Q	05/10/06	3.1
3.2	Amended and Restated Bylaws.	8-K	09/02/03	3.2
10.3	Form of 1996 Stock Plan for Salix Holdings, Ltd., as amended September 2000 and form of Notice of Stock Option Grant and Stock Option Agreement thereunder, as amended March 12, 2001.	10-Q	08/09/04	10.3
10.4*	Amendment Agreement effective as of September 17, 1992 by and among Glycyx Pharmaceuticals, Ltd., Salix Pharmaceuticals, Inc. and Biorex.	S-1	08/15/97	10.4
10.5*	License Agreement, dated September 17, 1992 between Biorex Laboratories Limited and Glycyx Pharmaceuticals, Ltd. and letter agreement amendments thereto.	S-1	08/15/97	10.5

43

Exhibit Number	Description of Document	Registrant’s Form	Dated	Exhibit Number	Filed Herewith
10.6*	Research and Development Agreement dated September 21, 1992 between Glycyx Pharmaceuticals, Ltd. and AB Astra and letter agreement amendments thereto.	S-1	08/15/97	10.6
10.7*	Distribution Agreement dated September 21, 1992 between Glycyx Pharmaceuticals, Ltd. and AB Astra.	S-1	08/15/97	10.7
10.8*	Amended and Restated License Agreement by and between Salix Pharmaceuticals, Inc. and Biorex Laboratories, Limited, dated April 16, 1993.	S-1	08/15/97	10.8
10.9*	Co-Participation Agreement, dated April 30, 1993 between Salix Pharmaceuticals, Inc. and AB Astra as amended by Amendment No. 1 thereto effective September 30, 1993.	S-1	08/15/97	10.9
10.9.1	Letter Agreement dated October 16, 1998 to Co-Participation Agreement dated April 30, 1993 by and between Salix Pharmaceuticals, Inc. and AB Astra.	10-Q	11/16/98	10.9.1
10.11*	Distribution Agreement, dated September 23, 1994 between Glycyx Pharmaceuticals, Ltd. and Menarini International Operations Luxembourg SA and amendments thereto.	S-1	08/15/97	10.11
10.12*	License Agreement, dated June 24, 1996, between Alfa Wassermann S.p.A. and Salix Pharmaceuticals, Ltd.	S-1	08/15/97	10.12
10.13*	Supply Agreement, dated June 24, 1996, between Alfa Wassermann S.p.A. and Salix Pharmaceuticals, Ltd.	S-1	08/15/97	10.13
10.22	Termination and Settlement Agreement dated as of December 22, 1999, by and between Astra AB and Salix Pharmaceuticals Inc. (a wholly owned subsidiary of Salix Pharmaceuticals, Ltd.).	8-K	12/28/99	10.22
10.23	Agreement dated December 22, 1999, between Glycyx Pharmaceuticals, Ltd. and Astra AB.	8-K	12/28/99	10.23
10.25*	Agreement dated May 17, 2000 between Glycyx Pharmaceuticals, Ltd. and Shire Pharmaceuticals Group plc.	10-Q	08/14/00	10.25
10.26*	Agreement dated May 17, 2000 between Biorex Laboratories Limited and Glycyx Pharmaceuticals, Ltd.	10-Q	08/14/00	10.26
10.29	Lease Agreement dated June 30, 2000 by and between Colonnade Development, LLC and Salix Pharmaceuticals, Inc.	10-Q	08/14/01	10.29
10.30*	License Agreement between Biorex Laboratories Limited and Glycyx Pharmaceuticals, Ltd. dated August 22, 2001.	10-Q	11/14/01	10.30
10.31	Form of Employment Agreement for executive officers.	10-Q	11/14/01	10.31
10.32*	License Agreement by and between Salix Pharmaceuticals, Inc. and Dr. Falk Pharma GmbH dated July 15, 2002.	10-Q	11/14/02	10.32
10.36	Rights Agreement, dated as of January 10, 2003, between Salix Pharmaceuticals, Ltd. and Computershare Investor Services LLC, as Rights Agent.	8-K	01/10/03	10.36
10.37	Common Stock Purchase Agreement dated November 6, 2003 among Salix Pharmaceuticals, Ltd. and the investors listed therein.	8-K	11/10/03	10.37

44

Exhibit Number	Description of Document	Registrant’s Form	Dated	Exhibit Number	Filed Herewith
10.39*	License Agreement dated October 17, 2003, between Glycyx Pharmaceuticals, Ltd (a wholly owned subsidiary of Salix Pharmaceuticals, Ltd.) and Chong Kun Dang Pharmaceutical Corporation.	10-Q	11/14/03	10.39
10.40*	Amendment Agreement dated November 24, 2003 between Salix Pharmaceuticals, Inc. and Dr. Falk Pharma Gmbh.	10-K	03/12/04	10.40
10.41*	License Agreement dated October 31, 2003 between aaiPharma LLC, aaiPharma Inc. and Salix Pharmaceuticals, Ltd.	10-K	03/12/04	10.41
10.44*	Supply Agreement dated June 30, 2004 between King Pharmaceuticals, Inc., Parkedale Pharmaceuticals, Inc., Salix Pharmaceuticals, Inc. and Salix Pharmaceuticals, Ltd. Certificate of Incorporation, as amended.	10-Q	08/09/04	10.44
10.45	License Assignment and Consent Agreement dated June 30, 2004 between Parkedale Pharmaceuticals, Inc., King Pharmaceuticals, Inc., Salix Pharmaceuticals, Inc., Salix Pharmaceuticals, Ltd., Warner-Lambert Company LLC and Parke, Davis & Company LLC.	10-Q	08/09/04	10.45
10.46	Assignment of Trademarks Agreement dated June 30, 2004 between Parkedale Pharmaceuticals, Inc. and Salix Pharmaceuticals, Inc.	10-Q	08/09/04	10.46
10.47	License Agreement dated June 30, 2004 between Monarch Pharmaceuticals, Inc., Parkedale Pharmaceuticals, Inc., King Pharmaceuticals, Inc., Salix Pharmaceuticals, Inc. and Salix Pharmaceuticals, Ltd.	10-Q	08/09/04	10.47
10.48	Office lease dated as of November 24, 2004 between Salix Pharmaceuticals, Ltd. And Duke Realty Limited Partnership	8-K	12/13/04	10.48
10.49	Co-Promotion Agreement dated March 2, 2005 between Salix Pharmaceuticals, Inc. and Altana Pharma US, Inc.	10-Q/A	08/23/05	10.49
10.50	2005 Stock Plan and forms of Notice of Option Grant and Stock Option Agreement.	S-8	06/30/05	10.50
10.51	Termination Agreement dated August 19, 2005 between Salix Pharmaceuticals, Inc. and Altana Pharma US, Inc.	8-K	08/22/05	10.51
10.53	License and Supply Agreement dated as of December 7, 2005 between Salix Pharmaceuticals, Inc. and Norgine B.V.	8-K	12/13/05	10.53
10.54	Form of Restricted Stock Grant to be granted pursuant to the 2005 Stock Plan	10-K	03/16/06	10.54
10.55	License Agreement entered into on June 18, 2006 between Cedars-Sinai Medical Center and Salix Pharmaceuticals, Inc.	8-K	07/05/06	10.55
10.56	Development and License Agreement , dated September 5, 2006 with Debiovision Inc.	10-Q	11/09/06	10.56

45

Exhibit Number	Description of Document	Registrant’s Form	Dated	Exhibit Number	Filed Herewith
10.57	$100.0 million Credit Facility by and among Salix Pharmaceuticals, Ltd., Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, Wachovia Bank, National Association, as Syndication Agent, and RBC Centura Bank, as Documentation Agent, and the Other Lenders Party thereto, and Banc of America Securities LLC, as Sole Lead Arranger and Sole Book Manager, dated February 22, 2007.	8-K	02/28/06	10.57
10.58*	Master Purchase and Sale and License Agreement dated February 22, 2007 between Merck & Co., Inc. and Salix Pharmaceuticals, Ltd.	10-Q	5/10/07	10.58
10.59*	License Agreement dated April 16, 2007 between Salix Pharmaceuticals, Inc. and Dr. Falk Pharma GmbH	10-Q	5/10/07	10.59
10.60*	Co-Promotion Agreement dated September 4, 2007, with Eisai Inc.	10-Q	8/09/07	10.60
10.61**	Supply and Distribution Agreement between Salix Pharmaceuticals, Inc. and Watson Pharma, Inc.				X
21.1	Subsidiaries of the Registrant.				X
23.1	Consent of Independent Registered Public Accounting Firm.				X
23.2	Consent of Independent Registered Public Accounting Firm.				X
31.1	Certification by the Chief Executive Officer pursuant to Section 240.13a-14 or section 240.15d-14 of the Securities and Exchange Act of 1934, as amended.				X
31.2	Certification by the Chief Financial Officer pursuant to Section 240.13a-14 or section 240.15d-14 of the Securities and Exchange Act of 1934, as amended.				X
32.1	Certification by the Chief Executive Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.				X
32.2	Certification by the Chief Financial Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.				X

* The registrant has received confidential treatment with respect to portions of this exhibit. Those portions have been omitted from this exhibit and filed separately with the U.S. Securities and Exchange Commission.

** The registrant has requested confidential treatment with respect to portions of this exhibit. Those portions have been omitted from the exhibit and filed separately with the U.S. Securities and Exchange Commission.

(b) Exhibits

See Item 15(a)(3) above.

(c) Financial Statement Schedules

See Item 15(a)(1) above.

46

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.

SALIX PHARMACEUTICALS, LTD.

/s/    CAROLYN J. LOGAN        

Carolyn J. Logan

President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this Form 10-K has been signed below by the following persons on behalf of the Registrant and on the dates indicated.

Date: March 13, 2008	/s/ CAROLYN J. LOGAN
	Carolyn J. Logan President, Chief Executive Officer (Principal Executive Officer) and Director
Date: March 13, 2008	/s/ ADAM C. DERBYSHIRE
	Adam C. Derbyshire Senior Vice President, Finance & Administration and Chief Financial Officer (Principal Financial and Accounting Officer)
Date: March 13, 2008	/s/ JOHN F. CHAPPELL
	John F. Chappell Chairman of the Board
Date: March 13, 2008	/s/ THOMAS W. D’ALONZO
	Thomas W. D’Alonzo Director
Date: March 13, 2008	/s/ RICHARD A. FRANCO
	Richard A. Franco Director
Date: March 13, 2008	/s/ WILLIAM P. KEANE
	William P. Keane Director
Date: March 13, 2008	/s/ WILLIAM HARRAL III
	William Harral III Director
Date: March 13, 2008	/s/ MARK A. SIRGO
	Mark A. Sirgo Director

47

SALIX PHARMACEUTICALS, LTD.

Index to Consolidated Financial Statements

	PAGE
AUDITED CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm	F-2
Report of Independent Registered Public Accounting Firm on Financial Statements	F-3
Report of Independent Registered Public Accounting Firm on Internal Control	F-4
Consolidated Balance Sheets	F-5
Consolidated Statements of Operations	F-6
Consolidated Statements of Stockholders’ Equity	F-7
Consolidated Statements of Cash Flows	F-8
Notes to Consolidated Financial Statements	F-9
CONSOLIDATED FINANCIAL STATEMENT SCHEDULE
Schedule II—Valuation and Qualifying Accounts	F-29

F-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To Board of Directors and Stockholders of

Salix Pharmaceuticals, Ltd.

In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, stockholders’ equity and cash flows present fairly, in all material respects, the financial position of Salix Pharmaceuticals, Ltd at December 31, 2007, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing in Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule and on the Company’s internal control over financial reporting based on our integrated audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for uncertain tax positions in 2007.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Raleigh, North Carolina

March 13, 2008

F-2

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON FINANCIAL STATEMENTS

The Board of Directors and Stockholders of

Salix Pharmaceuticals, Ltd.

We have audited the accompanying consolidated balance sheet of Salix Pharmaceuticals, Ltd. as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Salix Pharmaceuticals, Ltd. at December 31, 2006, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Salix Pharmaceuticals, Ltd.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2007 expressed an unqualified opinion thereon.

Raleigh, North Carolina

March 9, 2007

F-3

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

ON INTERNAL CONTROL

The Board of Directors and Stockholders of

Salix Pharmaceuticals, Ltd.

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Salix Pharmaceuticals, Ltd. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Salix Pharmaceuticals, Ltd.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Salix Pharmaceuticals, Ltd. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Salix Pharmaceuticals, Ltd. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Salix Pharmaceuticals, Ltd. as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2006 of Salix Pharmaceuticals, Ltd. and our report dated March 9, 2007 expressed an unqualified opinion thereon.

Raleigh, North Carolina

March 9, 2007

F-4

SALIX PHARMACEUTICALS, LTD.

Consolidated Balance Sheets

	December 31,
	2007			2006
	(U.S. dollars, in thousands, except share and per share amounts)
A S S E T S
Current assets:
Cash and cash equivalents	$	111,272		$	76,465
Accounts receivable, net		52,208			61,730
Inventory, net		17,676			25,123
Prepaid and other current assets		14,219			6,807
Total current assets		195,375			170,125
Property and equipment, net		5,877			3,866
Goodwill		86,383			89,688
Product rights and intangibles, net		105,713			59,340
Other assets		3,754			104
Total assets	$	397,102		$	323,123
L I A B I L I T I E S   A N D  S T O C K H O L D E R S’  E Q U  I T Y
Current liabilities:
Accounts payable	$	11,889		$	5,912
Accrued liabilities		30,264			32,956
Product return reserve		43,322			6,112
Current portion of capital lease obligations		1,009			—
Total current liabilities		86,484			44,980
Long-term liabilities:
Borrowings under credit facility		15,000			—
Lease incentive obligation		2,436			592
Long term portion of capital lease obligations		612			—
Total long-term liabilities		18,048			592
Stockholders’ equity:
Preferred stock, $0.001 par value; 5,000,000 shares authorized, issuable in series, none outstanding		—			—
Common stock, $0.001 par value; 80,000,000 shares authorized, 47,708,985 and 47,033,717 shares issued and outstanding at December 31, 2007 and 2006, respectively		47			47
Additional paid-in-capital		397,261			390,467
Accumulated deficit		(104,738	)		(112,963	)
Total stockholders’ equity		292,570			277,551
Total liabilities and stockholders’ equity	$	397,102		$	323,123

The accompanying notes are an integral part of these consolidated financial statements.

F-5

SALIX PHARMACEUTICALS, LTD.

Consolidated Statements of Operations

	Year Ended December 31,
	2007			2006			2005
	(U.S. dollars, in thousands, except per share data)
Revenues:
Net product revenues	$	232,880		$	208,533		$	154,703
Revenues from collaborative agreements		2,912			—			200
Total revenues		235,792			208,533			154,903
Costs and expenses:
Cost of products sold (excluding $8,627, $4,907 and $2,279 in amortization of product rights and intangible assets for the years ended December 31, 2007, 2006 and 2005, respectively)		55,024			41,443			34,222
Fees and costs related to license agreements		1,850			1,296			100
Amortization of product rights and intangible assets		8,627			4,907			2,279
Research and development		71,947			47,917			34,547
Selling, general and administrative		86,492			82,636			70,823
In-process research and development		—			—			74,000
Total costs and expenses		223,940			178,199			215,971
Income (loss) from operations		11,852			30,334			(61,068	)
Interest and other income, net		3,326			2,552			1,222
Income (loss) before income tax expense		15,178			32,886			(59,846	)
Income tax expense		(6,953	)		(1,376	)		(739	)
Net income (loss)	$	8,225		$	31,510		$	(60,585	)
Net income (loss) per share, basic	$	0.17		$	0.68		$	(1.55	)
Net income (loss) per share, diluted	$	0.17		$	0.65		$	(1.55	)
Shares used in computing net income (loss) per share, basic		47,329			46,634			39,129
Shares used in computing net income (loss) per share, diluted		48,678			48,369			39,129

The accompanying notes are an integral part of these consolidated financial statements.

F-6

SALIX PHARMACEUTICALS, LTD.

Consolidated Statements of Stockholders’ Equity

	Common Stock			Additional Paid-in- capital		Accumulated Other Comprehensive Loss			Accumulated Deficit			Total Stockholders’ Equity
	Shares	Amount
	(U.S. dollars, in thousands, except share amounts)
Balance at December 31, 2004	36,514,648	$	37	$	171,214	$	(676	)	$	(83,888	)	$	86,687
Issuance of common stock upon exercise of stock options	835,388		—		6,509		—			—			6,509
Issuance of common stock in connection with InKine acquisition	8,957,358		9		206,609		—			—			206,618
Income tax benefit from non-qualified stock option exercises	—		—		142		—			—			142
Compensation expense related to accelerated vesting of stock options	—		—		485		—			—			485
Other comprehensive loss	—		—		—		(3	)		—			(3	)
Net loss	—		—		—		—			(60,585	)		(60,585	)
Balance at December 31, 2005	46,307,394		46		384,959		(679	)		(144,473	)		239,853
Issuance of common stock upon exercise of stock options	726,323		1		4,213		—			—			4,214
Income tax benefit from non-qualified stock option exercises	—		—		90		—			—			90
Realized loss on foreign currency translation	—		—		—		679			—			679
Compensation expense related to restricted stock awards	—		—		1,205		—			—			1,205
Net income	—		—		—		—			31,510			31,510
Balance at December 31, 2006	47,033,717		47		390,467					(112,963	)		277,551
Issuance of common stock upon exercise of stock options	382,115		—		2,053		—			—			2,053
Income tax benefit from non-qualified stock option exercises	—		—		118		—			—			118
Issuance of common stock upon vesting of restricted stock	204,425		—		—		—			—			—
Issuance of common stock upon exercise of warrants	88,728		—		945		—			—			945
Compensation expense related to restricted stock awards	—		—		3,678		—			—			3,678
Net income	—		—		—		—			8,225			8,225
Balance at December 31, 2007	47,708,985	$	47	$	397,261	$	—		$	(104,738	)	$	292,570

The accompanying notes are an integral part of these consolidated financial statements.

F-7

SALIX PHARMACEUTICALS, LTD.

Consolidated Statements of Cash Flows

	Year Ended December 31,
	2007			2006			2005
	(U.S. dollars, in thousands)
Cash Flows from Operating Activities
Net income (loss)	$	8,225		$	31,510		$	(60,585	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Loss on disposal of property and equipment		3			47			78
Reduction in income taxes payable from stock option exercises		—			90			142
Depreciation and amortization		10,642			6,472			3,410
Acquired in-process research and development		—			—			74,000
Realized loss on foreign currency translation		—			679			—
Stock-based compensation expense		3,678			1,205			485
Changes in assets and liabilities net of effects from InKine acquisition in 2005:
Accounts receivable, inventory, prepaid expenses and other assets		11,266			(25,063	)		(27,000	)
Accounts payable and accrued liabilities		5,129			(1,077	)		10,413
Product return reserve		37,210			4,031			2,081
Net cash provided by operating activities		76,153			17,894			3,024
Cash Flows from Investing Activities
Purchases of property and equipment		(2,368	)		(1,700	)		(2,411	)
Purchase of product rights, intangibles and other assets		(55,000	)		(12,124	)		(3,015	)
Increase in other non-current assets		(2,054	)		—			—
Proceeds from maturity of investments		—			998			9,274
Net cash acquired in InKine acquisition		—			—			5,698
Net cash (used in) provided by investing activities		(59,422	)		(12,826	)		9,546
Cash Flows from Financing Activities
Borrowing under credit facility		15,000			—			—
Principal payments on capital lease obligations		(40	)		—			—
Excess tax benefit from stock-based compensation		118			—			—
Proceeds from issuance of common stock upon exercise of stock options and warrants		2,998			4,213			6,509
Net cash provided by financing activities		18,076			4,213			6,509
Effect of exchange rate changes on cash and cash equivalents		—			—			(3	)
Net increase in cash and cash equivalents		34,807			9,281			19,076
Cash and cash equivalents at beginning of year		76,465			67,184			48,108
Cash and cash equivalents at end of year	$	111,272		$	76,465		$	67,184
Supplemental Disclosure of Cash Flow Information
Cash paid for income taxes	$	3,385		$	1,023		$	541
Cash paid for interest	$	862		$	—		$	—

The accompanying notes are an integral part of these consolidated financial statements.

F-8

SALIX PHARMACEUTICALS, LTD.

Notes to Consolidated Financial Statements

December 31, 2007

(1) ORGANIZATION AND BASIS OF PRESENTATION

Salix Pharmaceuticals, Ltd., a Delaware corporation (“Salix” or the “Company”), is a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract.

These consolidated financial statements are stated in U.S. dollars and are prepared under accounting principles generally accepted in the United States. The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant inter-company balances and transactions have been eliminated in the consolidation.

The accompanying consolidated financial statements include all adjustments that, in the opinion of management, are necessary for a fair presentation of financial position, results of operations, and cash flows.

(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Revenue Recognition

The Company recognizes revenue in accordance with the SEC’s Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” as amended by Staff Accounting Bulletin No. 104 (together, “SAB 101”), and FASB Statement No. 48 “Revenue Recognition When Right of Return Exists” (“SFAS 48”). SAB 101 states that revenue should not be recognized until it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have been rendered; (c) the seller’s price to the buyer is fixed or determinable; and (d) collectibility is reasonably assured.

SFAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if (1) the seller’s price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by the seller, (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated. The Company recognizes revenues for product sales at the time title and risk of loss are transferred to the customer, and the other criteria of SAB 101 and SFAS 48 are satisfied, which is generally at the time products are shipped. The Company’s net product revenue represents the Company’s total revenues less allowances for customer credits, including estimated discounts, rebates, chargebacks, and product returns.

The Company establishes allowances for estimated rebates, chargebacks and product returns based on numerous qualitative and quantitative factors, including:

• the number of and specific contractual terms of agreements with customers;

• estimated levels of inventory in the distribution channel;

• historical rebates, chargebacks and returns of products;

F-9

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

• direct communication with customers;

• anticipated introduction of competitive products or generics;

• anticipated pricing strategy changes by the Company and/or its competitors;

• analysis of prescription data gathered by a third-party prescription data provider;

• the impact of changes in state and federal regulations; and

• estimated remaining shelf life of products.

In its analyses, the Company uses prescription data purchased from a third-party data provider to develop estimates of historical inventory channel pull-through. The Company utilizes an internal analysis to compare historical net product shipments to estimated historical prescriptions written. Based on that analysis, it develops an estimate of the quantity of product in the channel which may be subject to various rebate, chargeback and product return exposures. At least quarterly for each product line, the Company prepares an internal estimate of ending inventory units in the distribution channel by adding estimated inventory in the channel at the beginning of the period, plus net product shipments for the period, less estimated prescriptions written for the period. Based on that analysis, the Company develops an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. This is done for each product line by applying a rate of historical activity for rebates, chargebacks and product returns, adjusted for relevant quantitative and qualitative factors discussed above, to the potential exposed product estimated to be in the distribution channel. Internal forecasts that are utilized to calculate the estimated number of months in the channel are regularly adjusted based on input from members of the Company’s sales, marketing and operations groups. The adjusted forecasts take into account numerous factors including, but not limited to, new product introductions, direct communication with customers and potential product expiry issues.

The Company periodically offers promotional discounts to the Company’s existing customer base. These discounts are calculated as a percentage of the current published list price and are treated as off-invoice allowances. Accordingly, the discounts are recorded as a reduction of revenue in the period that the program is offered. In addition to promotional discounts, at the time that the Company implements a price increase, it generally offers its existing customer base an opportunity to purchase a limited quantity of product at the previous list price. Shipments resulting from these programs generally are not in excess of ordinary levels, therefore, the Company recognizes the related revenue upon shipment and includes the shipments in estimating various product related allowances. In the event the Company determines that these shipments represent purchases of inventory in excess of ordinary levels for a given wholesaler, the potential impact on product returns exposure would be specifically evaluated and reflected as a reduction in revenue at the time of such shipments.

Allowances for estimated rebates and chargebacks were $9.7 million and $8.0 million as of December 31, 2007 and 2006, respectively. These allowances reflect an estimate of the Company’s liability for items such as rebates due to various governmental organizations under the Medicare/Medicaid regulations, rebates due to managed care organizations under specific contracts and chargebacks due to various organizations purchasing our products through federal contracts and/or group purchasing agreements. The Company estimates its liability for rebates and chargebacks at each reporting period based on a methodology of applying quantitative and qualitative assumptions discussed above. Due to the subjectivity of the Company’s accrual estimates for rebates and chargebacks, the Company prepares various sensitivity analyses to ensure the Company’s final estimate is within a reasonable range as well as review prior period activity to ensure that the Company’s methodology continues to be appropriate.

Allowances for product returns were $43.1 million and $6.1 million as of December 31, 2007 and 2006, respectively. These allowances reflect an estimate of the Company’s liability for product that may be returned by the original purchaser in accordance with the Company’s stated return policy. The balance at December 31, 2007 includes the $34.6 million charge recorded in the fourth quarter of 2007 reflecting our estimate of Colazal that may be returned to us under our return policy as a result of the approval of three generic balsalazide capsule products by the Office of

F-10

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

Generic Drugs on December 28, 2007. The Company estimates its liability for product returns at each reporting period based on historical return rates, estimated inventory in the channel and the other factors discussed above. Due to the subjectivity of the Company’s accrual estimates for product returns, the Company prepares various sensitivity analyses to ensure the Company’s final estimate is within a reasonable range and also reviews prior period activity to ensure that the Company’s methodology is still reasonable.

The Company’s provision for revenue-reducing items such as rebates, chargebacks, and product returns as a percentage of gross product revenue in the twelve-month periods ended December 31, 2007 and 2006 was 9.7% and 8.8% for rebates, chargebacks and discounts and was 14.5% and 3.4% for product returns, respectively.

Colazal, the Company’s balsalazide disodium capsule, has historically accounted for a majority of the Company’s revenue. On December 28, 2007, the Office of Generic Drugs, or OGD, approved three generic balsalazide capsule products. As a result of these generic approvals, the Company expects the future sales of Colazal to be significantly less than historical sales of Colazal. In the fourth quarter of 2007, the Company recorded a $34.6 million reserve which is an estimate of the Company’s liability for Colazal that may be returned by the original purchaser in accordance with the Company’s stated return policy as a result of these generic approvals. This estimate is based on an estimate of Colazal inventory in the channel and related expiration dates of this inventory, estimated erosion of Colazal demand based on the generic approvals and the resulting estimated pull-through of Colazal, and other factors. Due to the subjectivity of this estimate, the Company prepares various sensitivity analyses to ensure the Company’s final estimate is within a reasonable range.

Research and Development

In accordance with its policy, the Company expenses research and development costs, both internal and externally contracted, as incurred. Due to increased development activity levels and the way in which many of the Company’s long-term development contracts are structured, the Company conducted a review of its process of estimating research and development expenses during the first quarter of 2006. Based on that review, the Company refined its process of estimating certain externally contracted development activities to more closely align the related expense with the level of progress achieved and services received during the period. In accordance with Statement of Financial Accounting Standard No. 154, “Accounting Changes and Error Corrections”, the refined estimation process was implemented in the first quarter of 2006. As of December 31, 2006, the prepaid amount related to on-going research and development activities was $2.1 million. This prepaid amount, which was charged to expense in 2007 as the related research and development activities were performed under the contracts, resulted in a reduction of research and development expense for the year ended December 31, 2006 and a corresponding increase in income from operations of $2.1 million, and net income of $2.0 million, or $0.04 per diluted share. At December 31, 2007, the net asset related to on-going research and development activities to be charged to expense in future periods was $8.9 million. The refined estimation process will continue to be applied on the same basis in future periods.

Cash and Cash Equivalents

The Company considers all highly liquid investments with maturities from date of purchase of three months or less to be cash equivalents. The Company maintains its cash and cash equivalents in several different financial instruments with various banks and brokerage houses. This diversification of risk is consistent with Company policy to maintain liquidity and ensure the safety of principal. At December 31, 2007, cash and cash equivalents consisted primarily of demand deposits, overnight investments in Eurodollars, and money market funds at reputable financial institutions.

Accounts Receivable

The Company extends credit on an uncollateralized basis primarily to wholesale drug distributors and retail pharmacy chains throughout the United States. The Company is required to estimate the level of accounts receivable

F-11

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

which ultimately will be uncollectible. The Company calculates this estimate based on a review of specific customer balances, industry experience and the current economic environment. Currently, the Company reserves for specific accounts plus a percentage of the Company’s outstanding trade accounts receivable balance as an allowance for uncollectible accounts. Our allowance for uncollectible accounts at December 31, 2007 and 2006 was $3.1 million and $2.7 million, respectively.

Fair Value of Financial Instruments

The carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, capital lease obligations and the Company’s credit facility, approximated their fair values as of December 31, 2007 and 2006 due to the short-term nature of these financial instruments.

Property and Equipment

Property and equipment are stated at cost and depreciated over the estimated useful lives of the assets, generally three to five years, using the straight-line method.

Inventories

Raw materials, work-in-process and finished goods inventories are stated at the lower of cost (which approximates actual cost on a first-in, first-out cost method) or market value. In evaluating whether inventory is stated at the lower of cost or market, management considers such factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell such inventory, remaining shelf life, and current and expected market conditions, including levels of competition, including generic competition. Inventory at December 31, 2007 consisted of $7.5 million of raw materials, $3.6 million of work-in-process, and $7.4 million of finished goods. Inventory at December 31, 2006 consisted of $14.4 million of raw materials, $2.5 million of work-in-process and $8.2 million of finished goods. As of December 31, 2007, inventory reserves totaling $0.8 million, compared to $0.7 million as of December 31, 2006, have been recorded to reduce inventories to their net realizable value.

Intangible Assets and Goodwill

The Company’s intangible assets consist of license agreements, product rights and other identifiable intangible assets, which result from product and business acquisitions. Goodwill represents the excess purchase price over the fair value of assets acquired and liabilities assumed in a business combination.

When the Company makes product acquisitions that include license agreements, product rights and other identifiable intangible assets, it records the purchase price of such intangibles, along with the value of the product related liabilities that it assumes, as intangible assets. The Company allocates the aggregate purchase price to the fair value of the various tangible and intangible assets in order to determine the appropriate carrying value of the acquired assets and then amortizes the cost of the intangible assets as an expense in its consolidated statement of operations over the estimated economic useful life of the related assets. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company assesses the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The Company believes that the following factors could trigger an impairment review: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of the Company’s use of the acquired assets or the strategy for the Company’s overall business; and significant negative industry or economic trends.

In assessing the recoverability of its intangible assets, the Company must make assumptions regarding estimated future cash flows and other factors. If the estimated undiscounted future cash flows do not exceed the carrying value of

F-12

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

the intangible assets, the Company must determine the fair value of the intangible assets. If the fair value of the intangible assets is less than the carrying value, the Company will recognize an impairment loss in an amount equal to the difference. The Company reviews goodwill for impairment on an annual basis, and goodwill and other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

The Company assesses impairment of goodwill on an annual basis in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”.

The following table reflects the components of all specifically identifiable intangible assets as of December 31, 2007 (in thousands):

	Gross Amount		Accumulated Amortization		Net Carrying Amount		Average Life
Product rights and intangibles	$	122,388	$	16,675	$	105,713	13 years

The following table reflects the components of all specifically identifiable intangible assets as of December 31, 2006 (in thousands):

	Gross Amount		Accumulated Amortization		Net Carrying Amount		Average Life
Product rights and intangibles	$	67,388	$	8,048	$	59,340	11 years

Amortization expense is calculated on a straight-line basis over the estimated useful life of the asset. Amortization expense for the years ended December 31, 2007, 2006 and 2005 was $8.6 million, $4.9 million and $2.3 million, respectively. Estimated amortization expense related to intangible assets existing as of December 31, 2007 is $9.1 million annually for each of the succeeding five years.

In November 2003, the Company acquired from aaiPharma LLC for $2.0 million the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the name Azasan. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Azasan does not have any patent protection, the Company believes ten years is an appropriate amortization period based on established product sales history and management’s experience. At December 31, 2007 and 2006, accumulated amortization for the Azasan intangible was $0.8 million and $0.6 million, respectively.

In June 2004, the Company acquired the exclusive U.S. rights to Anusol-HC 2.5% (hydrocortisone Cream USP), Anusol-HC 25 mg Suppository (Hydrocortisone Acetate), Proctocort Cream (Hydrocortisone Cream USP) 1% and Proctocort Suppositories (Hydrocortisone Acetate Rectal Suppositories, 30 mg) from King Pharmaceuticals, Inc. for $13.0 million. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Anusol-HC and Proctocort do not have any patent protection, the Company believes ten years is an appropriate amortization period based on established product sales history and management’s experience. At December 31, 2007 and 2006, accumulated amortization for the King product intangibles was $4.6 million and $3.3 million, respectively.

In September 2005, the Company acquired InKine Pharmaceutical Company, Inc. for $210.0 million. The Company allocated $74.0 million of the purchase price to in-process research and development, $9.3 million to net assets acquired and $37.0 million to specifically identifiable product rights and related intangibles with an ongoing economic benefit to the Company. The Company allocated the remaining $89.7 million to goodwill, which is not being amortized. The decrease in goodwill over the twelve-month period ended December 31, 2007 was a result of the use of net operating income tax loss carryforwards generated by InKine prior to its acquisition by the Company in 2005. The

F-13

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

InKine product rights and related intangibles are being amortized over an average period of 14 years, which the Company believes is an appropriate amortization period due to the product’s patent protection and the estimated economic lives of the product rights and related intangibles. At December 31, 2007 and 2006, accumulated amortization for the InKine intangibles was $6.8 million and $3.8 million, respectively.

In December 2005, the Company entered into a License and Supply Agreement with Norgine B.V., granting Salix the exclusive right to sell a patented-protected, liquid PEG bowel cleansing product, NRL 944, in the United States. Upon execution of the Agreement, the Company made a $2.0 million payment to Norgine. In August 2006, the Company received Food and Drug Administration marketing approval for NRL 944 under the branded name of MoviPrep. In January 2007 the United States Patent Office issued a patent providing coverage to September 1, 2024. In August 2006, pursuant to the terms of the Agreement, Salix made a $15.0 million payment to Norgine. The Company is amortizing the milestone payment over a period of 17.3 years, which the Company believes is an appropriate amortization period due to the product’s patent protection and the estimated economic life of the related intangible. At December 31, 2007 and 2006, accumulated amortization for the MoviPrep intangible was $1.2 and $0.4 million, respectively.

In February 2007, the Company entered into a Master Purchase and Sale and License Agreement with Merck & Co. Inc., to purchase the U.S prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension from Merck. The Company paid Merck $55.0 million at the closing of this transaction. The purchase price was fully allocated to product rights and related intangibles, and is being amortized over a period of 15 years. Although Pepcid and Diuril do not have patent protection, the Company believed 15 years is an appropriate amortization period based on established product history and management experience. At December 31, 2007, accumulated amortization for the Merck products was $3.2 million.

Asset Impairment

The Company reviews the value of its long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable to determine if an impairment has occurred. If this review indicates that the assets will not be recoverable, based on an analysis of undiscounted cash flows over the remaining amortization period, the Company will reduce the carrying value of its long-lived assets accordingly, in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

The approval of three generic balsalazide capsule products on December 28, 2007 was a change in circumstance that caused us to review the carrying amount of our long-lived assets. Based on this review there was no impairment to our long-lived assets and no reduction to their carrying value is required.

Shipping and Handling Costs

The Company does not charge its customers for freight costs. The amounts of such costs are included in selling, general and administrative expenses and are not material.

Advertising Costs

The Company charges advertising costs to expense as incurred. Advertising expenses were approximately $5.7 million, $2.3 million and $3.2 million for the years ended December 31, 2007, 2006 and 2005, respectively.

Segment Reporting

The Company operates in a single industry and segment acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Accordingly, the Company’s business is classified as a single reportable segment.

F-14

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

The following table presents net product revenues by product (in thousands):

	Year Ended December 31,
	2007		2006		2005
Colazal	$	92,401	$	103,478	$	110,250
Xifaxan		64,260		51,628		30,051
Purgatives – Visicol/OsmoPrep/MoviPrep		47,693		45,502		5,137
Pepcid		22,191		—		—
Other		6,335		7,925		9,265
Net product revenues	$	232,880	$	208,533	$	154,703

Colazal net product revenues for 2007 include a $34.6 million reduction representing the Company’s estimate of Colazal previously sold to wholesalers that may be returned to the Company under its return policy as a result of the approval of three generic balsalazide capsule products on December 28, 2007.

Comprehensive Income (Loss)

The Company adopted SFAS No. 130, “Reporting Comprehensive Income” effective January 1, 1998. SFAS 130 requires that the Company display an amount representing comprehensive income (loss) for the year in a financial statement, which is displayed with the same prominence as other financial statements. The Company elected to present this information in the Consolidated Statements of Stockholders’ Equity. Other comprehensive income (loss) consists of foreign currency translation gains and losses, as well as any unrealized gains and losses on investments. For the periods presented, comprehensive income (loss) approximated reported net income (loss).

Stock-Based Compensation

At December 31, 2007, the Company had one active share-based compensation plan, the 2005 Stock Plan, allowing for the issuance of stock options and restricted shares. Awards granted from this plan are granted at the fair market value on the date of grant, and vest over periods ranging from one to four years.

On December 30, 2005, the Board of Directors approved the acceleration of the vesting of all outstanding unvested stock options. The acceleration was effective for all such options outstanding on December 30, 2005, all of which were granted by the Company when the accounting rules permitted use of the intrinsic-value method of accounting for stock options. All of the other terms and conditions applicable to such outstanding stock option grants still apply. Under APB No. 25, the acceleration resulted in recognition of estimated share-based compensation expense of $0.5 million based on the forfeiture assumptions, which may change in future periods. The Board of Directors took the action with the belief that is was in the best interest of the stockholders, as it will reduce the Company’s stock compensation expense in future periods regarding existing options in light of new accounting regulations effective beginning in fiscal year 2006. As a result of the accelerations, options to purchase 3.6 million shares of the Company’s common stock became immediately exerciseable.

Prior to January 1, 2006, the Company accounted for stock-based awards to employees under the intrinsic value method in accordance with Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees” and adopted the disclosure-only alternative of SFAS No. 123, “Accounting for Stock-Based Compensation”.

In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, “Share-Based Payment”, which requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. This requirement represents a significant change because share-based stock option awards, a historically predominant form of stock compensation for the Company, were not recognized as compensation expense under APB 25. SFAS No. 123R requires the cost of the award, as determined on the grant date at fair value, to be recognized over the period during which an employee is required to provide service in exchange for the award, usually the vesting period. The grant-date fair value of the award is estimated using an option-pricing model.

F-15

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

The Company adopted SFAS No. 123R effective January 1, 2006 using the modified-prospective transition method. The modified-prospective transition method of SFAS No. 123R requires the presentation of pro forma information, for periods presented prior to the adoption of SFAS No. 123R, regarding net income and net income per share as if the Company had accounted for its stock plans under the fair value method of SFAS No. 123R. For pro forma purposes, fair value of stock option awards was estimated using the Black-Scholes option valuation model. The fair value of all of the Company’s share-based awards was estimated assuming no expected dividends and estimates of expected life, forfeitures, volatility and risk-free interest rate at the time of grant.

Income Taxes

The Company provides for income taxes under the liability method in accordance with SFAS No. 109, “Accounting for Income Taxes”. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of differences between the tax basis of assets or liabilities and their carrying amounts in the consolidated financial statements. The Company provides a valuation allowance for deferred tax assets if it is more likely than not that these items will either expire before the Company is able to realize their benefit or if future deductibility is uncertain.

In June 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which is an interpretation of SFAS 109 “Accounting for Income Taxes”. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on derecognizing, classification, interest and penalties, accounting in interim periods, disclosure and transition.

On January 1, 2007, the Company adopted the provisions of FIN 48. As a result of applying the provisions of FIN 48, the Company recognized an increase of $2.4 million in the liability for unrecognized tax benefits and a reduction in the valuation allowance as of January 1, 2007 for the same amount. The unrecognized tax benefits as December 31, 2007 relate to federal tax credit carryforwards. The Company does not expect the unrecognized tax benefits to change significantly over the next 12 months.

The Company continues to fully recognize its tax benefits which are offset by a valuation allowance to the extent that it is more likely than not that the deferred tax assets will not be realized. The Company does not expect any significant changes in its unrecognized tax benefits for the next twelve months.

The Company files a consolidated U.S. federal income tax return and consolidated and separate company income tax returns in many U.S. state jurisdictions. Generally, the Company is no longer subject to federal and state income tax examinations by U.S. tax authorities for years prior to 1993. The Internal Revenue Service has commenced an examination of the Company’s U.S. income tax return for 2005. The Company anticipates that any adjustments as a result of this examination would not be material to its financial position.

The Company recognizes any interest accrued related to unrecognized tax benefits in interest expense and penalties in operating expenses. During the twelve-month period ended December 31, 2007 there was no such interest or penalties.

Net Income (Loss) Per Share

The Company computes net income (loss) per share in accordance with SFAS No. 128, “Earnings Per Share” (“SFAS 128”). Under the provisions of SFAS 128, basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares and dilutive common share equivalents then outstanding. Common share equivalents consist of the incremental common shares issuable upon the exercise of stock options and the impact of vested restricted stock grants.

F-16

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

The following table reconciles the numerator and denominator used to calculate diluted net income (loss) per share (in thousands):

	Year ended December 31,
	2007		2006		2005
Numerator:
Net income (loss)	$	8,225	$	31,510	$	(60,585	)
Denominator:
Weighted average common shares, basic		47,329		46,634		39,129
Dilutive effect of stock options and restricted stock awards		1,349		1,735		—
Weighted average common shares, diluted		48,678		48,369		39,129

For the years ended 2007, 2006, and 2005, there were 3,731,150, 4,027,149, and 7,336,606, respectively, potential common shares outstanding that were excluded from the diluted net income (loss) per share calculation because their effect would have been anti-dilutive.

Recently Issued Accounting Pronouncements

In December 2007, the FASB issued SFAS No. 141 (revised 2007) “Business Combinations” (SFAS 141R). SFAS 141R is effective for fiscal years beginning on or after December 15, 2008, which means that we will adopt SFAS 141R in our fiscal year 2009. SFAS 141R replaces SFAS 141 “Business Combinations” and requires that the acquisition method of accounting (which SFAS 141 called the purchase method) be used for all business combinations, as well as for an acquirer to be identified for each business combination. SFAS 141R establishes principles and requirements for how the acquirer: (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and (iii) determines what information to disclose to enable users of financial statements to evaluate the nature and financial affects of the business combination. The Company is currently evaluating the impact of adoption of SFAS 141R on the Company’s consolidated financial position, results of operations and cash flows.

In December 2007, the FASB issued SFAS No. 160 “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” (SFAS 160). SFAS 160 is effective for fiscal years beginning on or after December 15, 2008, which means that we will adopt SFAS 160 in our fiscal year 2009. This statement amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 changes accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity in the Consolidated Financial Statements. SFAS 160 requires retroactive adoption of the presentation and disclosure requirements for existing minority interests. All other requirements of SFAS 160 shall be applied prospectively. The Company does not believe the adoption of SFAS 160 will have a material impact on the Company’s consolidated financial position, results of operations and cash flows.

In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). SFAS 159 permits entities to choose, at specified election dates, to measure eligible items at fair value (the “Fair Value Option”). Unrealized gains and losses on items for which the Fair Value Option has been elected are reported in earnings. The Fair Value Option is applied instrument by instrument (with certain exceptions), is irrevocable (unless a new election date occurs) and is applied only to an entire instrument. The effect of the first remeasurement to fair value is reported as a cumulative-effect adjustment to the opening balance of retained earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company does not expect the adoption of SFAS 159 to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and

F-17

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

expands disclosures about fair value measurements. This Statement applies to other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB released FSP No. FAS 157-2. FSP No. FAS 157-2 defers the effective date of FASB 157 for one year for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. It does not defer recognition and disclosure requirements for financial assets and financial liabilities, or for nonfinancial assets and nonfinancial liabilities that are remeasured at least annually. The Company does not expect the adoption of SFAS 157 to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

(3) PROPERTY AND EQUIPMENT

Property and equipment consisted of the following at December 31 (in thousands):

	2007			2006
Cost:
Furniture and equipment	$	5,383		$	5,059
Computer equipment		4,940			3,042
Assets under capital lease		1,661			—
		11,984			8,101
Accumulated depreciation:
Furniture and equipment		(3,230	)		(2,523	)
Computer equipment		(2,837	)		(1,712	)
Assets under capital lease		(40	)		—
		(6,107	)		(4,235	)
Net property and equipment	$	5,877		$	3,866

Depreciation expense was approximately $2.0 million, $1.6 million and $1.1 million in 2007, 2006 and 2005, respectively.

(4) ACCRUED LIABILITIES

Accrued liabilities consisted of the following at December 31 (in thousands):

	2007		2006
Accrued expenses	$	12,937	$	19,057
Allowance for rebates, chargebacks and coupons		9,676		7,986
Accrued royalties		7,651		5,913
Total accrued liabilities	$	30,264	$	32,956

(5) CREDIT FACILITY

In February 2007, the Company entered into a $100.0 million revolving credit facility that matures in February 2012. At December 31, 2007, $15.0 million was outstanding under the credit facility. Virtually all assets of the Company and its subsidiaries secure the Company’s obligations under the credit facility. Borrowings under the credit facility may be used for working capital, capital expenditures, acquisitions and other general corporate purposes.

F-18

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

The credit facility bears interest at a rate per annum equal to, at the Company’s option, either (a) a base rate equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Bank of America prime rate, or (b) a Eurodollar rate (based on LIBOR), plus, in each case, a percentage rate that fluctuates, based on the ratio of the Company’s funded debt to EBITDA (income before income taxes plus interest expense and depreciation and amortization), from 0.00% to 0.75% for base rate borrowings and 1.00% to 1.75% for Eurodollar rate borrowings.

The credit facility contains various representations, warranties and affirmative, negative and financial covenants customary for financings of this type. The financial covenants include a leverage test and a fixed charge test. The Company was in compliance with these covenants at December 31, 2007. Based on current forecasts, the Company could fall out of compliance with these financial covenants during 2008, unless the Company obtains a waiver or amends the facility.

(6) STOCKHOLDERS’ EQUITY

Preferred Stock

A total of 5,000,000 shares of preferred stock are authorized and issuable. No shares of preferred stock were issued or outstanding as of December 31, 2007.

Common Stock

As of December 31, 2007 the Company was authorized to issue up to 80,000,000 shares of $0.001 par value common stock. As of December 31, 2007 and 2006, there were 47,708,985 and 47,033,717 shares of common stock issued and outstanding, respectively.

Stockholder Rights Plan

On January 9, 2003, the Company’s Board of Directors adopted an updated stockholder rights plan. Consequently, the Board authorized the redemption, effective on January 20, 2003, of rights under its existing stockholder rights plan for $0.0001 per right. Pursuant to the updated plan, stock purchase rights were distributed to stockholders at the rate of one right with respect to each share of common stock held of record as of January 20, 2003. The rights plan is designed to enhance the Board’s ability to prevent an acquirer from depriving stockholders of the long-term value of their investment and to protect stockholders against attempts to acquire the Company by means of unfair or abusive takeover tactics. The rights become exercisable based upon certain limited conditions related to acquisitions of stock, tender offers and business combinations involving the Company.

Stock Plans

The Company’s 1994 Stock Plan (the “1994 Plan”) was adopted by the Board of Directors in March 1994 and approved by the stockholders in March 1995. The Company’s 1996 Stock Plan (the “1996 Plan”) was adopted by the Board of Directors and approved by the Company’s stockholders in February 1996. The Company’s 2005 Stock Plan (the “2005 Plan”) was adopted by the Board of Directors in April 2005 and approved by the stockholders in June 2005. The stock granted under the 1994 Plan, the 1996 Plan and the 2005 Plan may be either stock options or restricted shares. Stock options expire no later than ten years from the date of grant.

Option prices shall be at least 100% of the fair market value on the date of grant for incentive stock options, and no less than 85% of the fair market value for nonqualified stock options. If, at the time the Company grants an option, the optionee directly or by attribution owns stock possessing more than 10% of the total combined voting power of all classes of stock of the Company, the exercise price for an incentive stock option shall be at least 110% of the fair market value and the option shall not be exercisable more than five years after the date of grant. The options generally become exercisable in increments of 1/48th per month over a period of 48 months from the date of grant. Options may be granted with different vesting terms as determined by the board of directors. Since inception of the Company’s 1994 Plan, 1996 Plan and 2005 Plan the Company’s stock option grants were all at fair market value. Starting in 2006, the Company began issuing restricted shares to employees, executives and directors of the Company.

F-19

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

Stock-Based Compensation

At December 31, 2007, the Company had one active share-based compensation plan, the 2005 Stock Plan, allowing for the issuance of stock options and restricted shares. Awards granted from this plan are granted at the fair market value on the date of grant and vest over periods ranging from one to four years.

On December 30, 2005, the Board of Directors approved the acceleration of the vesting of all outstanding unvested stock options. The acceleration was effective for all such options outstanding on December 30, 2005, all of which were granted by the Company when the accounting rules permitted use of the intrinsic-value method of accounting for stock options. All of the other terms and conditions applicable to such outstanding stock option grants still apply. Under APB No. 25, the acceleration resulted in recognition of estimated share-based compensation expense of $0.5 million based on forfeiture assumptions, which may change in future periods. The Board of Directors took the action with the belief that it is in the best interests of stockholders, as it will reduce the Company’s stock compensation expense in future periods regarding existing stock options in light of new accounting regulations effective beginning in fiscal year 2006. As a result of the acceleration, options to purchase 3.6 million shares of the Company’s common stock became immediately exercisable. If these options had not been accelerated, the Company estimates that additional share-based compensation expense totaling $16.8 million would have been recognized in 2006, and the estimated balance of $29.8 million would have been recognized over the remaining vesting period of approximately 3.0 years.

Prior to January 1, 2006, the Company accounted for stock-based awards to employees under the intrinsic value method in accordance with Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees” and adopted the disclosure-only alternative of SFAS No. 123, “Accounting for Stock-Based Compensation”.

In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, “Share-Based Payment”, which requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. This requirement represents a significant change because share-based stock option awards, a historically predominate form of stock compensation for the Company, were not recognized as compensation expense under APB 25. SFAS No. 123R requires the cost of the award, as determined on the date of grant at fair value, to be recognized over the period during which an employee is required to provide service in exchange for the award, usually the vesting period. The grant-date fair value of the award is estimated using an option-pricing model.

The Company adopted SFAS No. 123R effective January 1, 2006 using the modified-prospective transition method. The modified-prospective transition method of SFAS No. 123R requires the presentation of pro forma information, for periods presented prior to the adoption of SFAS No. 123R, regarding net income and net income per share as if the Company had accounted for its stock plans under the fair value method of SFAS No. 123R. For pro forma purposes, fair value of stock option awards was estimated using the Black-Scholes option valuation model. The fair value of all of the Company’s share-based awards was estimated assuming no expected dividends and estimates of expected life, volatility and risk-free interest rate at the time of grant.

The fair value of the Company’s stock option awards granted in 2005 was estimated using the following weighted-average assumptions:

	2005
Expected life (years)	5
Expected volatility	0.96
Risk-free interest rate	3.96	%

F-20

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

Starting in 2006, the Company began issuing restricted shares to employees, executives and directors of the Company. The restrictions on the restricted stock lapse according to one of two schedules. For employees and executives of the Company, restrictions lapse 25% annually over four years. For board members of the company, restrictions lapse 100% after one year. The fair value of the restricted stock was estimated using an assumed forfeiture rate of 8.1% and is being expensed on a straight-line basis over the period during which the restrictions lapse. For the year ended December 31, 2007, the Company recognized $3.7 million in share based compensation expense related to the restricted shares. As of December 31, 2007, the total amount of unrecognized compensation cost related to nonvested restricted stock awards, to be recognized as expense subsequent to December 31, 2007, was approximately $12.2 million, and the related weighted-average period over which it is expected to be recognized is approximately 3.04 years.

Had compensation cost for the Company’s stock-based compensation plans prior to 2006 been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, the Company’s net income (loss) and net income (loss) per share would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data).

	Year ended December 31, 2005
Net loss:
As reported	$	(60,585	)
Stock-based compensation reported in net income (loss)		485
Stock-based compensation expense using fair value method for all stock awards		(13,569	)
Pro forma net loss	$	(73,669	)
Net loss per common share-basic and diluted:
As reported, basic	$	(1.55	)
Stock-based compensation expense using fair value method		(0.35	)
Pro forma net loss per share, basic	$	(1.90	)
As reported, diluted	$	(1.55	)
Stock-based compensation expense using fair value method		(0.35	)
Pro forma net loss per share, diluted	$	(1.90	)

F-21

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

Aggregate stock plan activity is as follows:

	Total Shares Available For Grant		Stock Options				Restricted Shares				Stock Options and Restricted Shares
			Number		Weighted Average Price		Number Subject to Issuance		Weighted Average Price		Number		Weighted Average Price
Balance at December 31, 2004	727,438		5,450,868		$	10.76	—			—	5,450,868		$	10.76
Additional shares authorized	1,000,000		—			—	—			—	—			—
Shares available for grant under InKine option plans assumed by Salix	197,508		—			—	—			—	—			—
Shares assumed in InKine acquisition	—		972,279		$	15.00	—			—	972,279		$	15.00
Granted	(2,112,900	)	2,112,900		$	18.22	—			—	2,112,900		$	18.22
Exercised	—		(835,388	)	$	7.79	—			—	(835,388	)	$	7.79
Canceled	242,879		(364,053	)	$	14.76	—			—	(364,053	)	$	14.76
Balance at December 31, 2005	54,925		7,336,606		$	13.58	—			—	7,336,606		$	13.58
Additional shares authorized	1,500,000		—			—	—			—	—			—
Granted	(711,826	)	—			—	711,826		$	12.13	711,826		$	12.13
Exercised	—		(726,280	)	$	5.81	—			—	(726,280	)	$	5.81
Canceled	143,612		(283,789	)	$	18.75	(29,920	)	$	12.02	(313,709	)	$	18.11
Balance at December 31, 2006	986,711		6,326,537		$	14.24	681,906		$	12.52	7,008,443		$	14.07
Granted	(758,407	)	—			—	758,407		$	12.81	758,407		$	12.81
Exercised	—		(382,115	)	$	5.37	—			—	(382,115	)	$	5.37
Vested	—		—			—	(204,425	)	$	12.45	(204,425	)	$	12.45
Canceled	382,949		(729,893	)	$	20.33	(112,689	)	$	13.06	(842,582	)	$	19.36
Balance at December 31, 2007	611,253		5,214,529		$	14.03	1,123,199		$	12.68	6,337,728		$	13.80

Exercise prices for options outstanding as of December 31, 2007 ranged from $1.13 to $48.58 per share.

	Options Outstanding and Exercisable
Exercise Price	Number Outstanding	Weighted Average Remaining Contractual Life (Yrs)	Weighted Average Exercise Price
$  1.13 –   4.92	1,089,097	3.5870	$	3.3490
$  5.40 – 14.46	1,076,880	5.3269		9.7022
$15.02 – 17.94	1,342,115	6.9372		17.3738
$18.14 – 20.89	1,032,534	6.5962		19.1375
$21.07 – 48.58	673,903	6.6522		23.7579
	5,214,529	5.8006	$	14.0346

At December 31, 2007, there were 5,214,529 exercisable options with a weighted average exercise price of $14.03. At December 31, 2006, there were 6,326,537 exercisable options with a weighted average exercise price of $14.24.

For the year ended December 31, 2007, 0.4 million shares of the Company’s outstanding stock with a market value of $5.1 million were issued upon the exercise of stock options. The Company recognized no share-based

F-22

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

compensation expense related to stock options for the year ended December 31, 2006, nor any income tax benefit. The total intrinsic value of options exercised for the year ended December 31, 2007 was $3.0 million. As of December 31, 2007, there was no unrecognized compensation cost due to the fact that all stock options were fully vested as noted above. For the year ended December 31, 2007, the Company received $2.1 million in cash from stock option exercises.

(7) INCOME TAXES

As of December 31, 2007, the Company had U.S. federal net operating loss carryforwards of $37.0 million. Of this amount, approximately $20.4 million is limited by section 382 of the Internal Revenue Code. The Company’s remaining net operating loss carryforwards of approximately $16.6 million relates to excess stock option benefit which, if and when realized, will credit additional paid-in capital. The Company also has gross North Carolina net operating loss carryforwards in the amount of $27.0 million.

The provision for income taxes in the accompanying consolidated statements of operations for the years ended December 31, 2007, 2006 and 2005 consisted of the following (in thousands):

	2007		2006		2005
Current:
Federal	$	1,424	$	522	$	323
State		2,224		854		416
Total current taxes		3,648		1,376		739
Deferred:
Federal		3,305		—		—
State		—		—		—
Total deferred taxes		3,305		—		—
Total current taxes	$	6,953	$	1,376	$	739

The tax effects of temporary differences that give rise to significant portions of the deferred tax asset at December 31, 2007 and 2006 are as follows (in thousands):

	2007			2006
Net operating loss carryforwards	$	15,270		$	47,084
Capitalized research and development expenses		3,583			5,237
Research and development credits		7,505			6,330
Other credits		1,105			—
Timing differences, including reserves, accruals, and writeoffs		26,949			5,464
Total deferred tax assets		54,412			64,115
Valuation allowance		(42,345	)		(50,842	)
Net deferred tax assets		12,067			13,273
Intangible assets		(11,930	)		(13,126	)
Property, plant and equipment		(2	)		(147	)
Allowance for third parties		(135	)		—
Net deferred tax liabilities		(12,067	)		(13,273	)
Net deferred taxes	$	—		$	—

The Company has provided a valuation allowance for the gross deferred tax asset due to the uncertainty regarding the Company’s ability to realize the entire asset. The valuation allowance has decreased by approximately $8.5 million and $4.8 million during the years ended December 31, 2007 and 2006, respectively.

F-23

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

The deferred tax assets include deferred tax assets and liabilities acquired from InKine which were fully reserved in the amount of $15.6 million. In the current year, $3.3 million of these deferred tax assets were realized, resulting in a reduction to goodwill.

Utilization of the federal net operating loss carryforwards may be subject to a substantial annual limitation due to the change in ownership provisions of the Internal Revenue Code of 1986. If this limitation applies, the ultimate ability for the Company to use existing net operating loss carryovers and tax credit carryovers to offset future income may be limited. The Company’s net operating loss carryforwards begin to expire at the end of the taxable year ending December 31, 2020.

A reconciliation of the statutory income tax rate to the effective income tax rate is as follows:

	2007		2006		2005
Federal statutory income tax rate	35.0	%	35.0	%	35.0	%
State income taxes, net of federal income tax benefit	1.4	%	2.4	%	0.8	%
Change in valuation allowance	55.7	%	(30.7	)%	(4.6	)%
Tax credit, non-deductible expenses and other	(46.3	)%	(2.5	)%	(32.4	)%
	45.8	%	4.2	%	(1.2	)%

In June 2006, FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which is an interpretation of SFAS 109 “Accounting for Income Taxes”. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

On January 1, 2007, the Company adopted the provisions of FIN 48. As a result of applying the provisions of FIN 48, the Company recorded an increase of $2.4 million in its unrecognized tax benefits. The unrecognized tax benefits as of December 31, 2007 relate to federal tax credit carryforwards. The Company does not expect our unrecognized tax benefits to change significantly over the next 12 months.

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

Balance at January 1, 2007	$	2,448
Increases related to current year tax positions		—
Balance at December 31, 2007	$	2,448

If these unrecognized tax benefits of $2.4 million at December 31, 2007 were recognized, they would have decreased the Company’s annual effective tax rate. No expense has been recorded for interest and penalties related to these tax positions.

The 1993 through 2007 tax years remain subject to examination by federal and state taxing authorities. The 2005 tax year is currently under audit by the Internal Revenue Service.

(8) SIGNIFICANT CONCENTRATIONS

The Company operates in a single industry acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. The Company’s

F-24

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

principal financial instruments subject to potential concentration of credit risk are accounts receivable, which are unsecured, and cash equivalents. The Company’s cash equivalents consist primarily of money market funds. The amount of certain bank deposits may at times exceed the FDIC insurance limits.

The Company’s primary customers are wholesale pharmaceutical distributors and retail pharmacy chains in the United States.

Total revenues from customers representing 10% or more of total revenues for the respective years, are summarized as follows:

	Year Ended December 31,
	2007		2006		2005
Customer 1	41	%	42	%	36	%
Customer 2	23	%	22	%	19	%
Customer 3	9	%	9	%	11	%

Additionally, 72% and 79% of the Company’s accounts receivable balances were due from these three customers at December 31, 2007 and 2006, respectively.

Currently, under long-term supply agreements, the Company uses balsalazide drug substance (the active pharmaceutical ingredient in Colazal capsules) manufactured by Omnichem s.a., a subsidiary of Ajinomoto in Belgium, and Pharmazell (formerly Noveon Pharma, GmbH) in Raubling, Germany. Also, under long-term supply agreements, balsalazide is encapsulated into Colazal drug product by Nexgen Pharma, inc. (formerly Anabolic Laboratories) in Irvine, California. Bulk Colazal capsules are packaged into finished Colazal commercial bottles by Nexgen and Carton Service in Norris, Tennessee.

Under the Company’s supply agreement with Alfa Wassermann, Alfa Wassermann is obligated to supply the Company with bulk rifaximin drug substance (the active pharmaceutical ingredient in Xifaxan tablets) until July 2014 or introduction of a generic product, whichever occurs first. The Company’s supply of rifaximin drug substance is manufactured by ZaCh Systems (formerly Zambon) in Lonigo, Italy, and Aventis in Brindisi, Italy. Under a long-term supply agreement, rifaximin is converted into Xifaxan drug product by Patheon, Inc. in Whitby, Ontario. Bulk Xifaxan tablets are packaged into finished Xifaxan commercial bottles by Pathoen and packaged into Xifaxan commercial blister packs by Carton Service in Norris, Tennessee.

Under the Company’s long-term supply agreement with aaiPharma, aaiPharma produces the Company’s commercial supply of 25 mg, 75 mg and 100 mg Azasan finished product. The Company is in the process of working with aaiPharma to qualify an additional Azasan drug product manufacturer.

Under the Company’s long-term supply agreement with Paddock Laboratories in Minneapolis, Minnesota, Paddock produces the Company’s commercial supply of finished product of Anusol-HC Cream, Anusol-HC Suppositories and Proctocort Suppositories. In addition, through prior supply arrangements between King Pharmaceuticals and Crown Laboratories in Johnson City, Tennessee, Crown continues to produce the Company’s commercial supply of Proctocort Cream finished product.

Under the Company’s long-term supply agreement with WellSpring Pharmaceuticals in Oakville, Ontario, WellSpring produces commercial supply of OsmoPrep finished product.

Under the Company’s long-term supply agreement with Norgine in Hengoed, Wales, Norgine produces commercial supply of MoviPrep pouches. The Company then supplies Carton Service in Norris, Tennessee with these MoviPrep pouches for secondary packaging into finished commercial MoviPrep kits.

F-25

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

Merck has agreed to manufacture the Company’s commercial supply of Pepcid Oral Suspension and Diuril Oral Suspension through December 2008. The Company is in the process of qualifying an alternate manufacturing site for commercial production of Pepcid OS and Diuril OS finished product.

With respect to the Company’s products currently under development, namely encapsulated granulated mesalamine, 1100 mg balsalazide tablet formulation and 550 mg rifaximin tablet formulation, the Company plans to negotiate commercial supply agreements with the same manufacturers who supplied the drug substance and drug product for the supplies of the Phase III clinical trial material.

(9) 401(K) PLAN

In 1996, the Company adopted the Salix Pharmaceuticals, Inc. 401(k) Retirement Plan. Eligible participants may elect to defer a percentage of their compensation. From inception through June 2006, the Company matched up to 50% of participant deferrals up to 6% of the participant’s compensation. Effective July 2006, the Company matches up to 75% of participant deferrals up to 6% of the participant’s compensation. The Company’s total matching contributions for all participants were approximately $1.0 million, $0.7 million and $0.5 million in 2007, 2006 and 2005, respectively. Additional discretionary employer contributions may be made on an annual basis.

(10) COMMITMENTS

At December 31, 2007, the Company had binding purchase order commitments for inventory purchases aggregating approximately $9.6 million over the next four months.

Lease Agreements

During 2007, the Company entered into a three-year agreement to lease computer equipment. The equipment was capitalized at $0.2 million, which approximates the present value of the minimum lease payments.

The Company leases fleet vehicles for its domestic sales force under a four-year lease agreement. The vehicles were capitalized at $1.4 million, which approximates the present value of the minimum lease payments.

The Company leases office facilities under various non-cancelable operating leases, the last of which expires on April 30, 2015. Certain of these leases contain future payment obligations that escalate over time. Rent expense was approximately $1.9 million, $1.6 million and $1.2 million for the years ended December 31, 2007, 2006 and 2005, respectively. The Company sub-leased its former corporate headquarters of approximately 26,000 square feet of office space under a lease expiring in 2011, total future minimum sublease payments due under this sublease were $1.6 million as of December 31, 2007.

As of December 31, 2007, future minimum payments for leases were as follows (in thousands):

Years ending December 31,	Operating Leases		Capital Leases
2008	$	2,018	$	1,056
2009		2,116		462
2010		2,162		168
2011		1,735		1
2012		1,490		—
Thereafter		3,451		—
Total future minimum payments required	$	12,972		1,687
Less: Amount representing interest				66
Present value of net minimum lease payments				1,621
Less: Current portion of capital lease obligations				1,009
Long term portion of capital lease obligations			$	612

F-26

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

Potential Milestone Payments

The Company has entered into collaborative agreements with licensors, licensees and others. Pursuant to the terms of these collaborative agreements, the Company is obligated to make one or more payments upon the occurrence of certain milestones. The following is a summary of the material payments that the Company might be required to make under its collaborative agreements if certain milestones are satisfied.

License Agreement with Dr. Falk Pharma GmbH — In July 2002, the Company and Dr. Falk entered into a license agreement which they amended in November 2003 and February 2005. Pursuant to the license agreement, as amended, the Company acquired the rights to develop and market a granulated formulation of mesalamine. The agreement provides that the Company is obligated to make milestone payments up to an aggregate amount of $11.0 million to Dr. Falk. As of December 31, 2007, the Company had paid $3.0 million of milestone payments. The remaining milestone payments are contingent upon filing a new drug application and regulatory approval.

License and Supply Agreement with Norgine B.V. — In December 2005, the Company entered into a license and supply agreement with Norgine for the rights to sell NRL944, a bowel cleansing product the Company now markets in the United States under the trade name MoviPrep. Pursuant to the terms of this agreement, the Company is obligated to make upfront and milestone payments to Norgine that could total up to $37.0 million over the term of the agreement. As of December 31, 2007, the Company had paid $17.0 million of milestone payments. The remaining milestone payments are contingent upon reaching sales thresholds.

License Agreement with Cedars-Sinai Medical Center — In June 2006, the Company entered into a license agreement with Cedars-Sinai for the right to use a patent and a patent application relating to methods of diagnosing and treating irritable bowel syndrome and other disorders caused by small intestinal bacterial overgrowth. Pursuant to the license agreement, the Company is obligated to pay Cedars-Sinai a license fee of $1.2 million over time. As of December 31, 2007, the Company had paid this license fee in full. The Company may terminate the license agreement upon written notice of not less than 90 days.

License and Supply Agreement with the Debiopharm Group — In September 2006, the Company acquired the exclusive right to sell, market and distribute Sanvar in the United States. Pursuant to the terms of this agreement, the Company is obligated to make upfront and milestone payments to Debiopharm that could total up to $7.5 million over the term of the agreement. As of December 31, 2007, the Company had paid $0.5 million of milestone payments. The remaining milestone payment is contingent upon achievement of regulatory approval.

License Agreement with Merck & Co, Inc. — In February 2007, the Company entered into a Master Purchase and Sale and License Agreement with Merck, paying Merck $55.0 million to purchase the U.S. prescription pharmaceutical product rights to Pepcid^® Oral Suspension and Diuril^® Oral Suspension. Pursuant to the license agreement, the Company is obligated to make additional milestone payments to Merck up to an aggregate of $6.0 million contingent upon reaching certain sales thresholds during any of the five calendar years beginning in 2007 and ending in 2011.

License Agreement with Wilmington Pharmaceuticals, LLC — In September 2007, the Company entered into an Exclusive Sublicense Agreement with Wilmington Pharmaceuticals. The agreement provides that the Company is obligated to make upfront and milestone payments up to an aggregate amount of $8.0 million to Wilmington. As of December 31, 2007, the Company had paid $0.5 million of these milestone payments. The remaining milestone payments are contingent upon filing a new drug application and regulatory approval. The Company also loaned Wilmington $2.0 million which is due December 31, 2009, or earlier based on regulatory approval.

F-27

SALIX PHARMACEUTICALS, LTD.

Notes To Consolidated Financial Statements — Continued

(11) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2007 and 2006:

	Mar 31		June 30		Sept 30		Dec 31 (2)
(in thousands, except per share amounts)	(unaudited)
2007
Net product revenue	$	59,785	$	66,678	$	67,355	$	39,062
Cost of products sold, excluding amortization of product rights and intangible assets		12,005		13,041		13,083		16,895
Net income		2,844		10,237		14,173		(19,029	)
Net income per share, basic (1)		0.06		0.22		0.30		(0.40	)
Net income per share, diluted (1)		0.06		0.21		0.29		(0.40	)
2006
Net product revenue	$	41,853	$	52,853	$	51,208	$	62,619
Cost of products sold, excluding amortization of product rights and intangible assets		8,285		9,237		11,672		12,249
Net income (loss)		3,663		6,935		7,027		13,885
Net income (loss) per share, basic (1)		0.08		0.15		0.15		0.30
Net income (loss) per share, diluted (1)		0.08		0.14		0.15		0.29

(1) The sum of per share earnings by quarter may not equal earnings per share for the year due to the changes in average share calculations. This is in accordance with prescribed reporting requirements.

(2) The quarter ended December 31, 2007 includes a $34.6 million charge as a reduction of net product revenues as a result of the approval of three generic balsalazide capsule products on December 28, 2007.

(12) SUBSEQUENT EVENTS

The Company has implemented various programs in 2008 that attempt to reduce the market share lost to the generic balsalazide capsule products. These programs will reduce the profitability of Colazal sales in 2008 and thereafter.

F-28

SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS

Allowance for Rebates, Chargebacks and Coupons

			Additions		Deductions
Year ended December 31,	Beginning Balance		Provision Related to Current Period Sales		Rebates, Chargebacks and Discounts or Credits Related to Current Period Sales		Rebates, Chargebacks and Discounts or Credits Related to Prior Period Sales		Ending Balance
(in thousands)
2007	$	7,986	$	29,369	$	22,241	$	5,438	$	9,676
2006	$	7,301	$	21,577	$	15,104	$	5,788	$	7,986
2005	$	4,531	$	14,595	$	7,628	$	4,197	$	7,301

Allowance for Returns

			Additions		Deductions
Year ended December 31,	Beginning Balance		Provision Related to Current Period Sales		Returns or Credits Related to Prior Period Sales		Ending Balance
(in thousands)
2007	$	6,112	$	46,562	$	9,352	$	43,322
2006	$	2,081	$	8,317	$	4,286	$	6,112
2005	$	2,234	$	1,715	$	1,868	$	2,081

Allowance for Uncollectible Accounts

			Additions		Deductions
Year ended December 31,	Beginning Balance		Charged to Costs and Expenses		Accounts Written Off During Period		Ending Balance
(in thousands)
2007	$	2,683	$	429		—	$	3,112
2006	$	1,988	$	695		—	$	2,683
2005	$	793	$	1,275	$	80	$	1,988

Inventory Allowance

			Additions		Deductions
Year ended December 31,	Beginning Balance		Charged to Costs and Expenses		Amounts Recovered During Period		Ending Balance
(in thousands)
2007	$	684	$	297	$	192	$	789
2006	$	2,841	$	1,152	$	3,309	$	684
2005	$	183	$	2,658		—	$	2,841

Valuation Allowance on Deferred Tax Assets

			Additions		Deductions
Year ended December 31,	Beginning Balance		Provisions for Valuation Allowance		Release of Valuation Allowance/Other		Ending Balance
(in thousands)
2007	$	50,842		—	$	8,497	$	42,345
2006	$	55,651		—	$	4,809	$	50,842
2005	$	37,203	$	18,448		—	$	55,651

F-29

EX-10.61

Exhibit 10.61

Portions of this exhibit marked [*] are omitted and are requested to be treated confidentially.

SUPPLY AND DISTRIBUTION AGREEMENT

This Supply and Distribution Agreement (this “Agreement”), dated as of the 13th day of October, 2006 (the “Effective Date”), is made by and between Salix Pharmaceuticals, Inc., a California corporation (“Salix”), and Watson Pharma, Inc., a Delaware corporation (“Watson”).

WITNESSETH:

WHEREAS, Salix has manufactured and distributes in the Territory (as defined herein) 750 mg capsules of balsalazide disodium under the trademark Colazal^®; and

WHEREAS, Watson desires to purchase from Salix, and distribute and sell to certain purchasers in the Territory under the NDA (as defined herein), 750 mg capsules of balsalazide disodium in generic form, and Salix desires to supply such product and grant such distribution rights, all on the terms and conditions set forth herein.

NOW, THEREFORE, in consideration of the agreements and covenants contained herein, the receipt and sufficiency of which are hereby acknowledged, the parties, intending to be legally bound, hereby agree as follows:

ARTICLE 1. DEFINITIONS

The following terms as used in this Agreement, whether used in the singular or the plural, shall have the meanings set forth in this Article 1. References to “Articles”, “Sections” and “subsections” in this Agreement shall be to Articles, Sections and subsections, respectively, of this Agreement unless otherwise specifically provided.

1.1. “Acquisition Notice” shall have the meaning set forth in Section 11.4(b).

1.2. “Act” shall mean the United States Federal Food, Drug, and Cosmetic Act as in effect from time to time.

1.3. “Affiliate” shall mean, with respect to any Person, any other Person that, directly or indirectly, controls, is controlled by, or is under common control with, such Person; provided that for purposes of this Agreement, a Wholesaler Affiliate shall not constitute an Affiliate of Watson. For the purposes of this definition, Section 1.53 and Section 11.4, the term “control”, as applied to any Person, means the possession, directly or indirectly, of the power to direct or cause the direction of the management of such Person, whether through ownership of voting securities or otherwise.

1.4. “Agency” shall mean any applicable supra-national, federal, national, regional, state, provincial or local regulatory agency, department, bureau, commission, council or other government entity regulating or otherwise exercising authority with respect to the Manufacturing, marketing, sale, or distribution of the Generic Product in the Territory.

1.5. “Agreement” shall have the meaning given such term in the introductory paragraph hereof.

1

1.6. “ANDA” shall mean an abbreviated new drug application under the Act for balsalazide disodium, including any amendments or supplements thereto.

1.7. “Applicable Laws” shall mean all applicable provisions of constitutions, statutes, laws, rules, treaties, regulations, guidelines, guidances and orders of all governmental authorities and all applicable orders, rules and decrees of courts and arbitrators in the Territory.

1.8. “Authorized Purchasers” shall mean all Third Parties except Excluded Purchasers.

1.9. “Average Manufacturer Price” shall have the meaning defined in the Social Security Act, 42 U.S.C. §1396r-8(k).

1.10. “Average Monthly Profit” shall mean (a) the aggregate amount of Profits during the six calendar months immediately preceding the month in which the Acquisition Notice is delivered, divided by (b) six (6).

1.11. “Best Price” shall have the meaning defined in the Social Security Act, 42 U.S.C. §1396r-8(c)(1)(C).

1.12. “Branded Product” shall mean 750 mg capsules of balsalazide disodium in finished, packaged form that is distributed by Salix or its Affiliates in the Territory under the Trademark.

1.13. “Calendar Quarter” shall mean each period of three (3) consecutive months commencing on January 1, April 1, July 1, and October 1.

1.14. “Calendar Year” shall mean each twelve (12) month period commencing on January 1 and ending on December 31 in any given year.

1.15. “cGMP” shall mean current Good Manufacturing Practices, as specified in the United States Code of Federal Regulations (21 CFR Part 210 & Part 211), and any other applicable laws, guidelines and/or regulations.

1.16. “Change of Control” shall mean any of the following events:

(a) Watson ceases to be a wholly owned subsidiary of Parent; or

(b) any Person or group (as such term is defined in the Securities Exchange Act of 1934, as amended) acquires beneficial ownership of securities of Parent representing more than fifty percent (50%) of the voting power of the then outstanding securities of Parent with respect to the election of directors of Parent, or

(c) Parent enters into a merger, consolidation or similar transaction with another Person in which Parent is not the surviving entity in such transaction, or

(d) Parent enters into a merger, consolidation or similar transaction with another Person in which Parent is the surviving entity in such transaction but (i) the members of

2

the Board of Directors of Parent immediately prior to such transaction constitute less than one half of the members of the Board of Directors of Parent following such transaction or (ii) the Persons who beneficially owned the outstanding voting securities of Parent immediately prior to such transaction cease to beneficially own securities of Parent representing at least fifty percent (50%) of the voting power of the then outstanding securities of Parent with respect to the election of directors immediately after such transaction in substantially the same proportions as their ownership of securities of Parent immediately prior to such transaction.

1.17. “Commercially Reasonable Efforts” shall mean, with respect to the efforts to be expended by a party with respect to any objective, reasonable, good faith efforts to accomplish such objective as such party would normally use to accomplish a similar objective under similar circumstances, it being understood and agreed that with respect to the marketing, distribution and sale of the Generic Product, such efforts shall be similar to those efforts and resources commonly used by Watson in the Territory for similar pharmaceutical products at a similar stage in their product life and of similar market potential, taking into account the competitiveness of alternative products sold by Third Parties in the marketplace and the profitability of the products.

1.18. “Confidential Information” shall have the meaning set forth in Section 12.1.

1.19. “Disclosing Party” shall mean the party disclosing Confidential Information.

1.20. “Distribution Period” means the period commencing on the Launch Date and ending on the last day of the Term.

1.21. “Effective Date” shall have the meaning given such term in the introductory paragraph to this Agreement.

1.22. “Equivalent Product” means any product other than Generic Product, which (a) is manufactured and distributed by a Person pursuant to an ANDA which was approved by the FDA or (b) is otherwise an A-Rated generic version of the Branded Product.

1.23. “Excluded Purchasers” shall mean [*].

1.24. “FDA” shall mean the United States Food and Drug Administration or any successor organization in the Territory.

1.25. “Firm Order” shall have the meaning set forth in Section 4.2(c).

1.26. “Firm Forecast” shall have the meaning set forth in Section 4.2(b).

1.27. “For Cause Incident” shall have the meaning set forth in Section 7.8.

1.28. “Force Majeure” shall have the meaning set forth in Section 13.2.

1.29. “Force Majeure Party” shall mean a party prevented or delayed in its performance under this Agreement by an event of Force Majeure.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

3

1.30. “Forecast” shall have the meaning set forth in Section 4.2(b).

1.31. “Generic Product” shall mean 750 mg capsules of balsalazide disodium in finished, packaged form (which packaging shall bear trade dress different from the Branded Product) that is Manufactured under the NDA by Salix, its Affiliate or a Third Party designated by Salix, which capsules may have a capsule image different from that of the Branded Product.

1.32. “Launch Date” shall mean the date of the first commercial sale in the Territory by any Third Party of a generic version of 750 mg capsules of balsalazide disodium under an ANDA approved by the FDA.

1.33. “Losses” shall have the meaning set forth in Section 10.1.

1.34. “Manufacture” and “Manufacturing” shall mean all activities related to the production, manufacture, processing, filling, finishing, packaging, labeling, shipping and holding of any pharmaceutical product or any intermediate thereof, including stability testing, quality assurance and quality control.

1.35. “Materials” shall mean all active pharmaceutical ingredients, raw materials, excipients, packaging and labeling components, and other items used to Manufacture Generic Product.

1.36. “NDA” shall mean Salix’s new drug application Colazal 20-610 under the Act, including any amendments or supplements thereto.

1.37. “NDC Number” shall mean a unique 3-segment number that identifies the labeler/vendor, the product and the trade package size.

1.38. “Net Sales” shall mean, with respect to any period, the actual gross amounts invoiced by Watson or its Affiliates on all sales of the Generic Product in the Territory during such period, less deductions actually allowed for by Watson:

(a) [*]

Net Sales shall be determined on an accrual basis (except for clause (e) above) in accordance with generally accepted accounting principles in the Territory, applied on a basis consistent with Watson’s annual audited financial statements. Net Sales with respect to sales of the Generic Product that are not made on an arm’s length basis or that are made for consideration other than cash shall be calculated based on the average per-unit Net Sales of the Generic Product during the applicable period without regard to such non-arm’s length or non-cash sales. If the Generic Product is sold with other products on a portfolio basis, any discounts or other adjustments with respect to the Generic Product shall be allocated pro rata across all products in such portfolio based on the non-discounted, non-adjusted price for each such product. For purposes of calculating Net Sales, sales between or among Watson and its Affiliates shall be excluded from the computation of Net Sales. Watson will not deduct any marketing, selling, advertising or distribution expenses of any kind to determine Net Sales.

1.39. “Parent” shall mean Watson Pharmaceuticals, Inc.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

4

1.40. “Person” shall mean an individual, sole proprietorship, partnership, limited partnership, limited liability partnership, corporation, limited liability company, business trust, joint stock company, trust, incorporated association, joint venture or similar entity or organization, including a government or political subdivision, department or agency of a government.

1.41. “Profits” shall mean, with respect to any period, Net Sales during such period, less the Purchase Price for the Generic Product sold during such period paid by Watson hereunder.

1.42. “Purchase Price” shall have the meaning set forth in Section 5.1.

1.43. “Receiving Party” shall mean the party receiving Confidential Information.

1.44. “Recipient” shall have the meaning se forth in Section 12.1.

1.45. “Salix Indemnitees” shall have the meaning set forth in Section 10.1.

1.46. “Specifications” shall mean the final release quality specifications for the Generic Product as set forth on Exhibit A, as the same may be amended from time to time in accordance with this Agreement.

1.47. “Term” shall have the meaning set forth in Section 11.1.

1.48. “Territory” shall mean the fifty states of the United States of America, the District of Columbia, the Commonwealth of Puerto Rico, and all other territories, possessions and commonwealths of the United States of America.

1.49. “Third Party” shall mean any Person other than Salix, Watson, or their respective Affiliates.

1.50. “Trademark” shall mean Colazal^®.

1.51. “Watson Indemnitees” shall have the meaning set forth in Section 10.2.

1.52. “Whole Lots” shall have the meaning set forth in Section 4.3.

1.53. “Wholesaler Affiliate” shall mean any Person (a) that, directly or indirectly, controls, is controlled by, or is under common control with, Watson and (b) substantially all of the business of which consists of the wholesale distribution of pharmaceutical products.

ARTICLE 2. DISTRIBUTION RIGHTS AND OBLIGATIONS

2.1. Authorized Distributor. Salix hereby appoints Watson to market, distribute, offer for sale and sell the Generic Product to Authorized Purchasers in the Territory under the NDA during the Distribution Period [*], and Watson hereby accepts such appointment. Watson acknowledges and agrees that until the Launch Date, Watson shall have no right to distribute, market, sell or accept orders for the sale of the Generic Product, except that Watson may engage in pre-booking activities of the type described in Exhibit B.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

5

2.2. Commercially Reasonable Efforts.

(a) Watson shall use Commercially Reasonable Efforts to market, sell, and distribute the Generic Product to Authorized Purchasers in the Territory during the Term. Watson shall not use the Trademark or any other trademark or tradename similar to the Trademark on, or in connection with the marketing, sale, or distribution of, the Generic Product; provided, however, that Watson may use the Trademark in Watson’s advertising and promotional materials in accordance with Section 2.9 solely to identify the Generic Product as comparable to Branded Product and to identify Salix as the owner of the Trademark associated with the Branded Product (e.g., “Balsalazide Disodium Capsules – Compare to Colazal^®. Colazal^® is a registered trademark of Salix Pharmaceuticals, Inc.”).

(b) Salix hereby grants to Watson a non-exclusive, non-sublicensable, royalty-free license to use the Trademark solely for the purposes set forth in Section 2.2(a), which license shall terminate upon the expiration or termination of this Agreement. During the Term and thereafter, Watson shall not in any event register or, in connection with the sale of the Generic Product or any Equivalent Product, use any trademark which, in the reasonable opinion of Salix is confusingly similar to the Trademark. Watson shall not use the Trademark in any manner whatsoever which may jeopardize the significance, distinctiveness or validity thereof, and Watson shall give prompt written notice to Salix of any infringement, by any person, of the rights of Salix in the Trademark which come to Watson’s notice. Watson acknowledges and agrees that all right, title and interest in and to the Trademark shall at all times remain the exclusive property of Salix and all use of the Trademark hereunder shall inure to the benefit of Salix. Watson hereby recognizes the validity of the Trademark and the registrations thereof, and will not, during the Term or thereafter, contest the validity thereof. For the avoidance of doubt, no license is granted hereby to use the Trademark in connection with any Equivalent Product.

2.3. Compliance with Law. Watson shall (a) store, handle and distribute the Generic Product in clean and sanitary conditions as required to maintain the quality and traceability of the Generic Product, (b) not alter the Generic Product in any manner, including the labeling and packaging thereof (c) comply with cGMP and all other Applicable Laws in connection with the storage, handling, distribution, marketing and sale of the Generic Product, including applicable recordkeeping obligations, (d) not market the Generic Product in any manner which is inconsistent with the labeling of the Generic Product or Applicable Laws, or otherwise make any false or misleading representations to customers or others regarding the Generic Product.

2.4. No Sales Outside Territory or to Excluded Purchasers. Watson shall not, and Watson shall cause its Affiliates not to, (a) sell any Generic Product to, or solicit orders for sales of any Generic Product from, any existing or prospective customer outside the Territory or any Excluded Purchaser, (b) deliver or tender (or cause to be delivered or tendered) any Generic Product outside the Territory or to any Excluded Purchaser, or (c) sell any Generic Product to, or solicit any sales from, a customer in the Territory if Watson knows or should know that such customer intends to resell the Generic Product outside the Territory.

6

2.5. Pricing. Watson shall have sole discretion to establish the prices and terms on which Watson sells the Generic Product.

2.6. Reserved Rights. Except as expressly provided in this Agreement, no right, title or interest in, to or under the NDA or any patent, trade secret, trademark or any other intellectual property right of Salix or its Affiliates is granted, whether express or implied, by Salix to Watson. In furtherance of the foregoing and not in limitation thereof, nothing herein shall in any way limit the Manufacturing, marketing, selling or distributing of the Branded Product by Salix or its Affiliates (directly or through a Third Party) anywhere in the world.

2.7. NDC Number. Watson shall submit drug listing information to the FDA with respect to the Generic Product. Watson shall distribute and sell only Generic Product bearing an NDC Number that reflects Watson as the distributor and seller thereof. Within fourteen (14) days after the Effective Date, Watson shall obtain an NDC Number for each packaging configuration of the Generic Product set forth on Exhibit D.

2.8. Rebate Processing.

(a) Watson shall be solely responsible for all federal, state and local government and private purchasing, pricing or reimbursement programs with respect to the Generic Product sold by Watson, including taking all necessary and proper steps to execute agreements and file other appropriate reports and other documents with governmental and private entities. Watson shall be solely responsible for payment and processing of all rebates, whether required by contract or local, state or federal law, for the Generic Product sold by Watson.

(b) Watson agrees to provide all information and data that Salix reasonably requests in order to comply with any state or federal government price reporting requirements for the Branded Product. Watson’s obligation under this Section 2.8(b) may include, but shall not be limited to, providing aggregate sales and rebate transaction data, Average Manufacturer Price and Best Price calculations, other data or information regarding sales or pricing (both on and off-invoice) of the Generic Product by Watson necessary for the government submissions, as determined by Salix in its reasonable discretion. Watson further agrees to provide such information within twenty (20) days of the close of each Calendar Quarter, or such sooner time period as may be necessary to permit Salix to satisfy its obligations in a timely manner. Watson warrants that all information provided to Salix pursuant to this Section 2.8(b) will be complete and accurate in all material respects. Salix may use any information provided pursuant to this Section in Salix’s reporting to the Centers for Medicare and Medicaid Services or other Federal and state authorities. In the event that Watson discovers, through a routine audit, reconciliation, its compliance program or otherwise, that any government price reporting has been miscalculated or other data provided to Salix regarding the sales or pricing of the Generic Product in the Territory are inaccurate, Watson shall notify Salix immediately of such circumstance and shall work with Salix to ensure that proper pricing information is provided to Salix as soon as possible, but in no event later than thirty (30) days after the end of the quarter in which such inaccuracy is discovered. Watson further agrees that it will provide any information reasonably requested by Salix pertaining to its methodologies for calculating government price reporting for the Generic Product. Notwithstanding the foregoing, in no event shall Salix be

7

liable for any mistakes, errors, omissions or other inaccuracies in Watson’s pricing methodologies. The parties agree that any pricing data provided by Watson pursuant to this Section 2.8(b) shall be used for the limited purpose of complying with legal price reporting requirements and shall not in anyway be used for “price fixing” or similar anti-competitive behavior by either party. Watson has and will maintain during the Term an effective compliance program based on the Office of Inspector General Compliance Program Guidance for Manufacturers.

2.9. Promotional Materials. Watson shall not use any promotional materials in connection with the marketing, sale or distribution of the Generic Product without Salix’s prior written approval other than (a) the labeling for the Generic Product approved by Salix in accordance with Section 4.6 and (b) after the Launch Date, introduction announcements to the trade, bill sheets and Watson’s on-line product catalog; provided that any such promotional materials shall not contain any information other than the name of the Generic Product, the available packaging configurations, and pricing and delivery terms. For purposes of this Agreement, “promotional materials” means all labeling and advertising materials as defined in the Act and the regulations of the FDA thereunder.

2.10. Sampling. Watson shall not distribute any samples of Generic Product to any Third Party.

2.11. No Subcontracting or Subdistribution. All obligations and services to be performed by Watson under this Agreement shall be solely performed by Watson (or its Affiliates, in which event Watson shall cause any such Affiliate to comply with all the terms and conditions in this Agreement as if named as a party hereto) and Watson shall not outsource or subcontract any of its obligations hereunder. Watson itself shall directly market, offer for sale, and sell the Generic Product to the trade (including, without limitation, pharmaceutical wholesalers and retailers) in the Territory and Watson shall not market, offer for sale, or sell the Generic Product to the trade (including, without limitation, pharmaceutical wholesalers and retailers) through or by means of any Third Party without the prior written consent of Salix. Watson covenants and warrants that all sales of Generic Product by Watson or its Affiliates to Wholesaler Affiliates shall be made on arm’s length terms and conditions.

2.12. [*]

ARTICLE 3. PROFIT SHARE

3.1. Profit Share.

(a) Watson shall pay to Salix, in accordance with Section 3.2, an amount equal to [*] percent ([*]%) of the positive Profits for each calendar month during the Term and any selloff period under Section 11.9 after the Term. [*]. An example of the calculation of the sharing of Profits pursuant to this Section 3.1, for illustration purposes only, is attached as Exhibit E.

(b) If, during any month during the Term occurring during the first twelve (12) months after the Launch Date (the “First Year”) there are two (2) or more Equivalent Products being distributed under separate ANDAs concurrently, then, to the extent Profits are

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

8

negative in such month in the First Year, Salix shall reimburse Watson for [*] percent ([*]%) of the amount of such negative Profits within sixty (60) days after the end of such calendar month; provided that, at Salix’s option, such amount may be credited against future Profits payable by Watson to Salix hereunder if, and to the extent, there are future positive Profits. If Profits are negative at any time during the Term, the parties shall cooperate in good faith to attempt to minimize potential losses to each party; provided that in no event shall either party be obligated to amend this Agreement.

3.2. Reporting and Payment. Not later than forty-five (45) days after the end of each calendar month through and including the calendar month in which all rebate and chargeback amounts on Generic Product sold during the Term and any applicable selloff period under Section 11.9 are finally reconciled in accordance with Section 1.38, Watson shall:

(a) deliver to Salix a written report substantially in the form attached as Exhibit G that specifies the Net Sales and Profits with respect to such calendar month; and

(b) pay to Salix the amount owed to Salix with respect to such calendar month in accordance with Section 3.1.

3.3. Maintenance of Records; Audit. Watson shall maintain, and shall cause its Affiliates to maintain, at a location in the United States, complete and accurate books and records in such detail as is necessary to accurately calculate the amounts payable to Salix under Section 3.1. Such books and records shall be maintained for a period of at least five (5) years after the end of the Calendar Year in which they were generated, or for such longer period as may be required by Applicable Law. Once per each Calendar Year during the period commencing on the Effective Date and ending twenty-four (24) months after the end of the Calendar Quarter in which all rebate and chargeback amounts on Generic Product sold during the Term and any applicable selloff period under Section 11.9 are finally reconciled in accordance with Section 1.38, Salix shall have the right to have an independent accounting firm reasonably acceptable to Watson audit and examine the relevant books and records as may be reasonably necessary to determine and/or verify the amount of payments due hereunder and Watson’s compliance with its obligations hereunder. Such audit and examination shall be conducted and shall take place, and Watson shall, and shall cause its Affiliates to, make such books and records available, during normal business hours at the facility(ies) where such books and records are maintained. Each such audit and examination shall be limited to pertinent books and records for any Calendar Year ending not more than twenty-four (24) months prior to the date of the audit. Before permitting such independent accounting firm to have access to such books and records, Watson may require such independent accounting firm and its personnel involved in such audit to sign a customary confidentiality agreement in form and substance reasonably acceptable to Watson as to any Confidential Information which is to be provided to such accounting firm or to which such accounting firm will have access while conducting the audit under this Section 3.3. The independent accounting firm will prepare and provide to Salix and Watson a written report stating only whether the reports submitted and amounts paid pursuant to Section 3.2 were correct or incorrect, and the amounts of any discrepancies. Prior to disclosing the results of any such audit, the auditor shall present Watson with a preliminary report of its findings and provide Watson with an opportunity to respond to any questions raised or issues identified. In the event that there was an underpayment or overpayment by Watson hereunder, Watson or Salix, as the

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

9

case may be, shall promptly (but in no event later than thirty (30) days after its receipt of the independent accountant’s report so concluding) make payment to the other of the amount of such underpayment or overpayment. Salix shall bear all costs and expenses of any such audit, except that if any audit discloses an underpayment or overpayment by Watson with respect to any Calendar Year in excess of the lesser of (i) [*] percent ([*]%) of the aggregate amount required to be paid under Section 3.1 and (ii) [*] dollars ($[*]), all costs and expenses of the audit, including the expenses of the independent accounting firm, shall be borne and promptly paid by Watson.

ARTICLE 4. PRODUCT SUPPLY

4.1. [*] Supply. Subject to the terms and conditions of this Agreement, Salix agrees to supply, or cause its Affiliate or a Third Party to supply, to Watson during the Term, and Watson agrees to purchase from Salix, Salix’s Affiliate or such Third Party, as the case may be, [*] of Watson’s requirements of the Generic Product. Salix, in its sole discretion, shall determine whether to Manufacture the Generic Product or to have an Affiliate of Salix or Third Party Manufacture Generic Product.

4.2. Forecasting and Orders.

(a) Watson acknowledges and agrees that all forecasts and Firm Orders shall be subject to the maximum monthly Whole Lot quantities set forth in Exhibit C attached hereto.

(b) At least [*] ([*]) days prior to the first day of each Calendar Quarter during the Term commencing with the Calendar Quarter in which the expected Launch Date occurs, Watson shall deliver to Salix a written good faith forecast estimating the quantities of Generic Product that Watson expects to purchase from Salix during such Calendar Quarter and the following three (3) Calendar Quarters, broken out on a monthly basis (each a “Forecast”). The first Calendar Quarter of each Forecast shall be a “Firm Forecast.” Except as provided in Section 4.2(c), each Forecast shall be non-binding and shall be used by Salix for planning purposes only.

(c) At least [*] ([*]) days prior to the first day of each Calendar Quarter during the Term commencing with the Calendar Quarter in which the expected Launch Date occurs, Watson shall submit to Salix a written purchase order in such form as shall be reasonably acceptable to Salix (a “Firm Order”) for the quantity of Generic Product to be delivered to Watson during each month of such Calendar Quarter, which Purchase Order shall specify the required delivery date for such Generic Product. The quantity of Generic Product specified in any Purchase Order for delivery in any month of a Calendar Quarter shall not be less than [*] percent ([*]%) of, nor more than [*] percent ([*]%) of, the quantities specified in the Firm Forecast applicable to such month. In the event Salix fails to timely deliver Generic Product ordered hereunder, Watson may revise its Forecasts, including any Firm Forecast, to address the shortfall of supply and/or the impact such late delivery may have had on the trade for Generic Product, and Salix shall use Commercially Reasonable Efforts to accommodate such revisions.

(d) If any Generic Product purchased by Watson prior to the Launch Date has less than sixteen (16) months remaining before its expiration date, and the Launch Date has not

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

10

occurred, Watson may return such Generic Product to Salix and Salix shall use Commercially Reasonable Efforts to replace promptly such returned Generic Product with Generic Product with expiration dating greater than twenty (20) months at no additional cost. In the event the Parties determine that it is likely that Watson will have to return Generic Product pursuant to this Section 4.2(d), the Parties will use Commercially Reasonable Efforts to assure that such replacement Generic Product shall be available by the Launch Date.

4.3. Whole Lots. Watson shall order and forecast all quantities of Generic Product only in whole batch size increments of approximately [*] capsules (“Whole Lots”); provided that Watson acknowledges and agrees that unit quantities in Whole Lots may vary from time to time due to discards and yield variances. At the time of delivery, all Generic Product delivered hereunder shall have a minimum of twenty-four (24) months remaining on the expiry schedule for the Generic Product as specified in the NDA.

4.4. Firm Orders. Subject to Article 11, Watson shall be obligated to purchase, and Salix shall be obligated to deliver by the required delivery date set forth therein, such quantities of Generic Product as are set forth in each Purchase Order. In the event that the terms of any Purchase Order are not consistent with or are in addition to the terms of this Agreement, the terms of this Agreement shall prevail.

4.5. Delivery. Salix shall deliver, or arrange for delivery of, all Generic Product purchased by Watson hereunder CIP (as defined in Incoterms 2000) a single distribution facility of Watson in the United States. Title to and risk of loss of all Generic Product sold hereunder shall pass to Watson upon delivery to the carrier. Salix shall include, or cause to be included, the following with each shipment of Generic Product: (a) Watson purchase order number, (b) the batch numbers for the Generic Product included, (c) the quantity of the Generic Product included, (d) a Certificate of Analysis (the content of which will be outlined in the Quality Agreement) and (e) a Certificate of Compliance (the content of which will be outlined in the Quality Agreement).

4.6. Packaging Configuration. Within five (5) days after the Effective Date, Salix shall supply Watson with Salix’s labeling for the Branded Product. Within fourteen (14) days after Watson’s receipt of such labeling, Watson shall provide to Salix proposed camera ready artwork for the labeling and packaging for the Generic Product which shall be consistent with the labeling and packaging of the Branded Product; provided that the labeling and packaging for the Generic Product shall have appropriate references to Watson and the NDC Numbers obtained pursuant to Section 2.7 and no reference to the Trademark. The labeling and packaging for the Generic Product shall be subject to the prior approval of Salix, which approval shall not be unreasonably withheld or delayed. Salix shall only be obligated to supply to Watson Generic Product in the packaging configurations set forth in Exhibit D. Watson shall be solely responsible for the content of all labeling and packaging print copy and Watson shall ensure that all such labeling and packaging print copy complies with all Applicable Laws. Any changes to the packaging and labeling of the Generic Product requested by Watson shall require the prior written consent of Salix, which approval shall not be unreasonably withheld or delayed. If Salix consents to such changes, such changes shall be effected at Watson’s sole cost and expense.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

11

4.7. Supply Discussions. As soon as reasonably practicable after the Effective Date, the parties shall engage in good faith discussions for a period of not less than ninety (90) days to attempt to agree on the terms and conditions on which Watson would Manufacture and supply to Salix Branded Product and Generic Product; it being acknowledged and agreed by Watson and Salix that neither party shall have any obligation to enter into any such manufacturing and supply agreement and that either party may determine not to enter into such an agreement in its sole and absolute discretion.

4.8. Salix Premises. Salix will permit Watson’s independent and qualified representatives acceptable to Salix, which acceptance will not be unreasonably withheld, access, no more than once each calendar year, or more frequently in the event of a For Cause Incident, all at reasonable times and on reasonable notice, to Salix’s Manufacturing facilities for Generic Product to conduct inspections of the premises where the Generic Product is being manufactured, tested and stored. All of Watson’s representatives will be obligated to execute a reasonable confidentiality agreement prior to commencing any such inspection and at all times during any such inspection shall be accompanied by a representative of Salix. Watson will provide Salix with a written report of the results of any inspections of Salix’s Manufacturing facilities for Generic Product by Watson’s independent and qualified representatives within thirty (30) days of any such inspection. If Salix disputes the findings of the inspection, such dispute will be resolved through the resolution procedures set forth in the Quality Agreement. To the extent the Generic Product is Manufactured for Salix by a Third Party, Salix shall use Commercially Reasonable Efforts to obtain the consent of such Third Party to submit to and participate in such inspections as set forth in this Section 4.8. For the avoidance of doubt, any and all observations, information and data resulting from or in connection with any such inspection shall be highly confidential information of Salix, shall not be disclosed by Watson to any Person, and shall be used by Watson solely for purposes of ensuring compliance by Salix with its obligations hereunder.

ARTICLE 5. PRICE; COSTS

5.1. Purchase Price. The price payable by Watson (the “Purchase Price”) for all Generic Product delivered hereunder shall be $[*] per 750 mg capsule.

5.2. Payment. Salix shall invoice Watson for all Generic Product promptly after delivery thereof. Watson shall pay the applicable Purchase Price for each delivery of Generic Product within forty-five (45) days after the date of the applicable invoice. In the event that the terms of any invoice are not consistent with or are in addition to the terms of this Agreement, the terms of this Agreement shall prevail.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

12

ARTICLE 6. PRODUCT WARRANTY AND LIMITATIONS

6.1. Warranty. Salix warrants that all Generic Product supplied by it hereunder, at the time of delivery thereof, (a) will comply with the Specifications, (b) will have been Manufactured in material compliance with cGMP and all other Applicable Laws, (c) will not be adulterated or misbranded within the meaning of the Act, and (d) may be introduced into interstate commerce pursuant to the Act. Salix further warrants and represents that, to its knowledge, the Manufacture, use, offer for sale, sale and importation of the Generic Product in the Territory in accordance with this Agreement does not infringe any issued and enforceable patent of any Third Party.

6.2. Disclaimer of Other Warranties. EXCEPT AS EXPRESSLY SET FORTH IN THIS AGREEMENT, THE PARTIES MAKE NO REPRESENTATIONS AND EXTEND NO WARRANTIES OF ANY KIND, EITHER EXPRESS OR IMPLIED, INCLUDING ANY WARRANTY OF FITNESS FOR A PARTICULAR PURPOSE OR WARRANTY OF MERCHANTABILITY.

6.3. Noncompliant Product.

(a) In the event that Watson determines that any Generic Product delivered to it hereunder does not comply with the warranty set forth in Section 6.1, Watson shall give Salix written notice of such noncompliance and the reasons therefor (including sufficient samples for confirmatory testing, if applicable) (a) within thirty (30) days after delivery, in the case of noncompliance readily discoverable by a customary inspection of such Generic Product upon delivery thereof, or (b) within fifteen (15) days after discovery, in the case of noncompliance not readily discoverable by a customary inspection of such Generic Product upon receipt thereof. Salix shall evaluate, or cause to be evaluated, such Generic Product (including appropriate testing of the samples provided by Watson, if applicable) and notify Watson within fifteen (15) business days after receipt of Watson’s notice whether it has confirmed such noncompliance. If Salix notifies Watson that it has not confirmed such noncompliance and Watson continues to believe such Generic Product is noncompliant, Salix and Watson promptly shall submit the dispute to an independent testing laboratory or other applicable expert of recognized standing in the industry mutually acceptable to Salix and Watson. Each party shall cooperate with the laboratory or other expert in its evaluation. The findings of the laboratory or other expert shall be binding on the parties. The expenses for such laboratory or other expert shall be borne by the party whose analysis was not substantiated by the findings of such laboratory or other expert.

(b) If, pursuant to Section 6.3(a), any Generic Product is determined not to comply with the warranty set forth in Section 6.1, then Salix promptly shall replace such noncompliant Generic Product with compliant Generic Product, and any such noncompliant Generic Product that is in Watson’s control shall be destroyed pursuant to Salix’s reasonable instructions and at Salix’s expense. Salix may, if it so requests, be present at the destruction of such Generic Product. Except as set forth in Sections 7.3 and 10.2, the remedies set forth in this Section 6.3(b) shall constitute Watson’s sole and exclusive remedy for any breach by Salix of the warranty set forth in Section 6.1.

13

ARTICLE 7. QUALITY CONTROL

7.1. Quality and Safety Agreements. Prior to the Launch Date, the parties shall enter into a Quality Agreement relating to quality assurance matters for the Generic Product and a Safety Agreement relating to adverse experience reporting and other safety matters for the Generic Product, in each case on customary and reasonable terms, and each party shall duly and punctually perform all of its obligations under and pursuant to such Quality Agreement and Safety Agreement.

7.2. Information Requests. Salix shall have the exclusive right to respond to all questions or requests for information about the Generic Product made by any medical professionals or any other Person to Watson that are beyond the scope of the labeling for the Generic Product. Watson promptly shall communicate to Salix all such questions or requests.

7.3. Recalls. In the event Salix shall be required or shall voluntarily decide to recall any Generic Product or take any other market withdrawal with respect to any Generic Product, then Watson shall fully cooperate with Salix and comply with Salix’s instructions in the carrying out of such recall and/or market withdrawal. Salix shall be responsible for all recall and/or market withdrawal expenses except to the extent such recall and/or market withdrawal is initiated because of a defect in the Generic Product which is attributable to a breach by Watson of its representations, warranties, covenants or agreements under this Agreement. In such event, Watson shall reimburse Salix for recall and/or market withdrawal expenses incurred by Salix or its Affiliates in connection therewith to the extent attributable to such breach. Prior to determining whether to implement a recall or market action with respect to the Generic Product, Salix shall consult in good faith with Watson; provided that if the parties do not agree whether a recall and/or market action should be implemented, the decision to initiate a recall and/or market action shall be made by Salix. Notwithstanding the foregoing, Watson shall not be restricted from taking any action which Watson believes in good faith after consultation with its legal counsel is required by law or regulation.

7.4. Withdrawal. In the event Salix elects to withdraw the NDA from the Territory, then Watson shall fully cooperate with Salix and comply with Salix’s instructions in the carrying out of such withdrawal if so instructed by Salix. Except as set forth in Section 11.9(g)(iv), all expenses incurred by Watson or its Affiliates in connection with such withdrawal shall be borne by Salix. Watson acknowledges and agrees that Salix shall have the right to withdraw the NDA from the Territory at any time in its sole and absolute discretion.

7.5. Noncompliance. If Salix discovers that any lot of Generic Product previously delivered to Watson by Salix under this Agreement fails to comply with the warranty set forth in Section 6.1, Salix shall promptly notify Watson of such failure and the nature thereof in detail. Salix shall promptly investigate all such failures and provide the findings of such investigation to Watson. Salix shall consult with Watson in an effort to arrive at an acceptable procedure for taking appropriate action in response to such failure.

7.6. Change to Specifications. Salix in its sole discretion shall have the right to change the Specifications and the process of Manufacturing Generic Product from time to time; provided that Salix shall give Watson reasonable (under the circumstances) advance notice of

14

any such change. Salix shall not be required to make any change to the Specifications or the process of Manufacturing Generic Product requested by Watson. The costs associated with all changes to the Specifications or the process of Manufacturing Generic Product shall be borne by Salix unless such change was requested by Watson and approved by Salix, in which event Watson shall bear all of such costs.

7.7. Returns. In the event that Salix receives any returned goods of Generic Product from a Third Party, Salix shall notify Watson of such returned goods and destroy such returned goods at Watson’s sole expense. Watson shall not have the right to return any Generic Product to Salix, other than in accordance with Section 4.2(d) and Article 11.

7.8. Batch Records. Batch records, including information relating to the Manufacturing for each lot of finished Generic Product produced hereunder, will be prepared in accordance with cGMP. Batch records and all other records relating to Manufacturing hereunder shall be retained by Salix for such period of time as is required under applicable rules and regulations of the FDA. In the event (i) Salix receives a regulatory letter or comments from any federal agency in connection with its Manufacture of Generic Product or the facility(ies) where Generic Product is Manufactured requiring a response or action by Salix, or the Third Party manufacturer, including, but not limited to, receipt of a Form 483 (Inspectional Observations) or a “Warning Letter,” or (ii) any batch of Generic Product purchased by Watson pursuant to this Agreement is the subject of a recall or market withdrawal (each of (i) and (ii) a “For Cause Incident”), promptly following Watson’s prior written request therefor, Salix shall make available to Watson, at Salix’s premises during business hours, a complete copy of an executed batch record for each SKU of Generic Product associated with such For Cause Incident. Additionally, Salix shall, upon Watson’s written request in connection with any audit under Section 4.8, and to the extent applicable, make available for review by Watson during the course of such audit, updates to the process validation report and equipment cleaning validation for Generic Product. Any representative of Watson shall be accompanied by a representative of Salix at all times during any such review. All records made available to Watson hereunder shall be considered highly confidential materials of Salix, shall not be disclosed by Watson to any person, and shall be used by Watson solely for purposes of ensuring compliance by Salix with its obligations hereunder.

ARTICLE 8. REGULATORY INTERACTIONS

8.1. Control of NDA. Salix shall have the exclusive responsibility for maintenance of the NDA and the conduct of all regulatory actions with respect to, and communications and filings with and submissions to, the FDA with respect to the NDA and the marketing, distribution and sale of the Generic Product under this Agreement, including making all filings with the FDA required for any Specification or Manufacturing change, as well as reporting of adverse events. Salix, at its expense, shall use Commercially Reasonable Efforts to make such filings with the FDA as are necessary for Salix to perform its obligations under this Agreement.

8.2. Cooperation. Each party, at the expense of the other party, shall provide the other party with all reasonable assistance and take all actions reasonably necessary to enable such other party to comply with all Applicable Laws in connection with such other party’s activities under this Agreement.

15

ARTICLE 9. REPRESENTATIONS AND WARRANTIES

9.1. Warranties. Each party represents, warrants and covenants to the other that:

(a) it, its Affiliates, and its and their employees have not been, and during the Term will not be, debarred under Section 306 of the Act or excluded from participation in any Federal or state healthcare program or Federal or state contract;

(b) it has no and will have no conflict of interest in performing its obligations under this Agreement;

(c) it is not and will not be prohibited from performing under this Agreement as a result of any contract, agreement or other arrangement, whether oral or written; and

(d) it has not been convicted of or pled nolo contendere to any felony or to any Federal or state legal violation relating to prescription drug products.

9.2. Warranties. Salix further represents, warrants and covenants to Watson that:

(a) Salix will perform all stability and other testing sufficient to maintain the Generic Product in conformity with the NDA.

(b) Salix will not sell the Generic Product to any Third Party outside of the Territory if Salix knows, or should have known, that such Third Party intends to resell the Generic Product inside of the Territory.

ARTICLE 10. INDEMNITY

10.1. Watson Indemnity. Watson shall defend, indemnify and hold harmless Salix, its Affiliates and their respective directors, officers, shareholders, employees and agents, and their respective successors and permitted assigns (“Salix Indemnitees”) from any and all claims, actions, causes of action, liabilities, losses, costs, damages or expenses, including reasonable attorneys’ fees (“Losses”), which directly or indirectly arise out of or relate to (a) a breach or failure to perform by Watson of any warranty, representation, covenant or agreement made by Watson in this Agreement, (b) the negligence, recklessness or willful misconduct of Watson in the performance of its obligations under this Agreement, or (c) any Third Party allegations, claims, investigations or demands relating to Watson’s sale of Generic Product using Watson trade dress, in each case except for those Losses for which Salix has an obligation to indemnify the Watson Indemnitees pursuant to Section 10.2, as to which Losses each party shall indemnify the other to the extent of its respective liability.

10.2. Salix Indemnity. Salix shall defend, indemnify and hold harmless Watson, its Affiliates and their respective directors, officers, shareholders, employees and agents, and their respective successors and permitted assigns (the “Watson Indemnitees”), from any and all Losses which directly or indirectly arise out of or relate to (a) a breach or failure to perform by Salix of any warranty, representation, covenant or agreement made by Salix in this Agreement, (b) the negligence, recklessness or willful misconduct of Salix in the performance of its obligations under this Agreement, (c) any death or personal injury arising from the use of the Generic

16

Product, (d) any Third Party allegation that the marketing and sale by Watson of the Generic Product in the Territory in accordance with the terms of this Agreement infringes or violates any patent, trade secret, copyright, trademark or other intellectual property rights of any Third Party, or (e) any Third Party allegations, claims, investigations or demands relating to Watson’s sale of Generic Product bearing Salix trade dress, including, but not limited to any Third Party allegations, claims, investigations or demands arising from the packaging of capsules bearing a capsule image that is the same as the capsule image of the Branded Product in Watson trade dress for subsequent sale as Generic Product in each case except for those Losses for which Watson has an obligation to indemnify the Salix Indemnitees pursuant to Section 10.1, as to which Losses each party shall indemnify the other to the extent of its respective liability.

10.3. Procedures. The indemnified party shall give the indemnifying party (a) prompt written notice of any claims made for which the indemnified party knows or reasonably should know the indemnifying party reasonably may be liable under the foregoing indemnification and (b) the opportunity to defend, negotiate, and settle such claims. The indemnified party shall provide the indemnifying party with all information in its possession, all authority and all assistance necessary to enable the indemnifying party to carry on the defense of such suit; provided, however, that the indemnified party reserves the right to retain its own counsel to defend itself in, but not control the defense of, such suit, at its own expense, unless (i) the interests of the indemnified party and the indemnifying party in the suit conflict in such a manner and to such extent as to require, consistent with applicable standards of professional responsibility, the retention of separate counsel for the indemnified party, in which case, the indemnifying party will pay for one separate counsel chosen by the indemnified party or (ii) the indemnifying party shall not have employed attorneys reasonably satisfactory to the indemnified party to defend any action within a reasonable time after notice of commencement of such action. Neither party shall be responsible to or bound by any settlement made by the other party without its prior written consent, which shall not be unreasonably withheld or delayed.

10.4. Limitation of Liability. EXCEPT FOR THE PARTIES’ INDEMNIFICATION OBLIGATIONS FOR THIRD PARTY CLAIMS UNDER SECTIONS 10.1 AND 10.2, IN NO EVENT WILL EITHER PARTY OR ITS AFFILIATES BE LIABLE FOR ANY PUNITIVE, SPECIAL, INDIRECT, CONSEQUENTIAL OR INCIDENTAL DAMAGES OR LOSSES OF ANY KIND, NATURE OR DESCRIPTION WHATSOEVER, INCLUDING BUT NOT LIMITED TO LOST PROFITS, REGARDLESS OF WHETHER ARISING FROM BREACH OF CONTRACT, WARRANTY, TORT, STRICT LIABILITY OR OTHERWISE, EVEN IF SUCH PARTY IS ADVISED OF THE POSSIBILITY OF SUCH LOSS OR DAMAGE OR IF SUCH LOSS OR DAMAGE COULD HAVE BEEN REASONABLY FORESEEN.

10.5. Insurance. Each party shall maintain comprehensive general liability insurance, including product liability insurance against claims related to the Manufacture and commercialization of the Generic Product under this Agreement, in amounts of not less than $[*] for each claim and $[*] in the aggregate, both during the Term and thereafter for so long as it customarily maintains insurance for itself for similar products and activities.

10.6. Nothing in this Article 10 will act to negate any obligation under common law of either Party to mitigate damages with respect to any Losses for which such Party is seeking indemnification from the other Party hereunder.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

17

ARTICLE 11. TERM AND TERMINATION

11.1. Term. Unless earlier terminated in accordance with the terms hereof, the term of this Agreement (the “Term”) shall commence on the Effective Date and shall continue until the fifth (5th) anniversary of the Effective Date, and shall thereafter automatically renew for additional one-year periods unless either party gives the other party written notice at least six (6) months prior to the expiration of the initial five (5)-year period or the applicable renewal period.

11.2. Termination by Salix. This Agreement may be terminated by Salix:

(a) If Watson shall be in breach of any material obligation hereunder and has not cured such breach within [*] ([*]) days after receipt of a notice from Salix requesting the cure of such breach. Such termination shall be effective upon failure of Watson to cure such breach within such period; or

(b) Upon the filing or institution of any bankruptcy, reorganization, liquidation or receivership proceedings by Watson, or upon the failure by Watson for more than ninety (90) days to discharge any such actions against it. Such termination shall be effective upon receipt of notice from Salix; or

(c) If a Force Majeure event affecting the performance of Watson specified in Section 13.2 shall continue for more than [*] ([*]) consecutive days. Such termination shall be effective upon receipt of notice from Salix; or

(d) Upon written notice given by Salix to Watson at least thirty (30) days prior to the end of any Calendar Quarter, if Salix, in its sole and absolute discretion, determines that this Agreement has become commercially unviable as the result of [*]. Such termination shall be effective at midnight of the last day of the Calendar Quarter immediately following the Calendar Quarter in which notice of termination is given by Salix; or

(e) In the event that at any time during the Term Salix obtains the legal right, through the enforcement of Salix’s intellectual property or other rights, to prohibit the marketing and sale of Equivalent Products in the Territory, Salix may terminate this Agreement upon thirty (30) days’ prior notice to Watson; or

(f) In the event that at any time during the Term Salix ceases distribution of the Branded Product, Salix, after consultation with Watson, may terminate this Agreement upon thirty (30) days’ prior notice to Watson.

11.3. Termination by Watson. This Agreement may be terminated by Watson:

(a) If Salix shall be in breach of any material obligation hereunder (other than failure to deliver Generic Product) and has not cured such breach within [*] ([*]) days after receipt of a notice from Watson requesting the cure of such breach. Such termination shall be effective upon failure of Salix to cure such breach within such period; or

(b) Upon the filing or institution of any bankruptcy, reorganization, liquidation or receivership proceedings by Salix, or upon the failure by Salix for more than ninety (90) days to discharge any such actions against it. Such termination shall be effective upon receipt of notice from Watson; or

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

18

(c) If a Force Majeure event affecting the performance of Salix specified in Section 13.2 shall continue for more than [*] ([*]) consecutive days. Such termination shall be effective upon receipt of notice from Watson; or

(d) If for any reason (other than a Force Majeure event) Generic Product is not supplied by the delivery date set forth in a Firm Order submitted in accordance with Section 4.2 and Salix’s failure to supply remains uncured for a period of [*] ([*]) days beyond the applicable delivery date(s) specified in such Firm Order, Watson shall have the right to terminate this Agreement with 30 days’ prior written notice of such termination to Salix; or

(e) If for any reason [*], Watson will have the right to terminate this Agreement with 30 days’ prior written notice of such termination to Salix.

11.4. Change of Control.

(a) No later than ten (10) days following the earlier of (a) the effective date of a Change of Control and (b) the public announcement by or on behalf of Watson or Parent of the entry by Watson or Parent into a definitive agreement providing for a Change of Control, Watson shall provide written notice to Salix informing Salix of such transaction. If any Person or group that controls (or would control) Watson and/or Parent (or assumes Watson’s rights and obligations hereunder) as a result of such Change of Control is not reasonably acceptable to Salix, Salix may terminate this Agreement (i) in the case of notice provided in accordance with subsection (a) above, effective immediately, upon written notice to Watson and (ii) in the case of notice provided in accordance with subsection (b) above, upon ninety (90) days prior written notice, provided that, if the effective date of the Change of Control occurs prior to the end of such ninety (90) day period, the effective date of such termination shall be the effective date of the Change of Control.

(b) If during the Term Watson or an Affiliate enters into an agreement (an “Acquisition Agreement”) pursuant to which Watson becomes an Affiliate of a Person that (i) develops, manufactures, markets or sells an Equivalent Product and (ii) prior to the date of the Acquisition Agreement was a Third Party, and provided that the primary purpose of such Acquisition Agreement was for something other than acquiring rights to the Equivalent Product, (A) Watson will immediately notify Salix of the entry into such Acquisition Agreement (the “Acquisition Notice”), (B) [*], (C) Watson shall have the right to terminate this Agreement upon one-hundred-eighty (180) days’ prior written notice of such termination to Salix, but such termination shall only be effective upon completion of the transactions contemplated by such Acquisition Agreement (which in no event shall relieve Watson of any obligation under Section 2.12 prior to the effective date of such termination), and (D) Salix shall have the right to terminate this Agreement, effective immediately, upon written notice to Watson. In addition to its obligations under Section 11.9(j) or 11(k), as the case may be, Watson shall pay to Salix, not later than forty-five (45) days after the end of each month during the period commencing on the date of delivery of the Acquisition Notice and ending on the last day of the month in which the effective date of termination occurs, an amount (if any) equal to the positive difference between (1) [*]% of the Average Monthly Profits, less (2) [*]% of the actual Profits for such month.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

19

11.5. Withdrawal of NDA. In the event Salix elects to withdraw the NDA from the Territory, this Agreement automatically shall terminate upon such withdrawal.

11.6. Agency Action. In the event that any governmental entity determines that this Agreement violates any Applicable Law, either Salix or Watson may terminate this Agreement immediately upon written notice to the other party.

11.7. Statutory Rights. Watson acknowledges that it is cognizant of certain state statutes that impose on a wholesaler, distributor or importer specific duties and obligations with regard to the termination of a distribution agreement. Notwithstanding the rights conferred under those statutes to a distributor, Watson hereby waives its rights thereunder with respect to a valid termination by Salix pursuant to a termination right under this Agreement and in consideration of its appointment hereunder covenants not to sue Salix in the event of the termination of this Agreement by Salix pursuant to the terms hereof, except for the purpose of enforcing Watson’s express rights under this Agreement.

11.8. [*].

11.9. Effect of Expiration or Termination.

(a) Upon expiration of the Term of this Agreement, Watson shall be permitted to sell off any inventory of Generic Product in its possession as of the date of expiration.

(b) Upon termination of this Agreement by Salix pursuant to Section 11.2(a) or by Watson pursuant to Section 11.8:

(i) Watson immediately shall cease all sales, marketing and distribution of the Generic Product and Watson shall immediately destroy any inventory of Generic Product under its control, at its expense, and shall either, at Salix’s option, (A) allow a Salix representative to be present during such destruction or (B) provide a certificate of such destruction.

(ii) All then outstanding Firm Orders automatically shall be cancelled.

(iii) Watson promptly shall reimburse Salix for all actual and reasonable costs incurred by Salix to complete activities associated with the termination of this Agreement, including, without limitation (A) the costs of all Materials purchased by Salix up to the effective date of termination which cannot be diverted to Salix’s other uses and which are non-refundable and (B) the Purchase Price for any finished Generic Product and the cost of any work in process which cannot be diverted to Salix’s other uses held by Salix as of the effective date of termination and Manufactured by Salix in accordance with Firm Orders then outstanding.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

20

(iv) To the extent any amount reimbursable by Salix pursuant to Section 3.1(b) has not been reimbursed by Salix or credited against Profits payable by Watson as of the date of termination, Salix shall reimburse such amount to Watson within sixty (60) days after the date of termination.

(c) Upon termination of this Agreement by Salix pursuant to Section 11.2(b) or (c):

(i) Watson shall be permitted to sell off any inventory of Generic Product in its possession as of the date of termination.

(ii) All then outstanding Firm Orders automatically shall be cancelled.

(iii) Watson promptly shall reimburse Salix for all actual and reasonable costs incurred by Salix to complete activities associated with the termination of this Agreement, including, without limitation (A) the costs of all Materials purchased by Salix up to the effective date of termination which cannot be diverted to Salix’s other uses and which are non-refundable and (B) the Purchase Price for any finished Generic Product and the cost of any work in process which cannot be diverted to Salix’s other uses held by Salix as of the effective date of termination and Manufactured by Salix in accordance with Firm Orders then outstanding.

(d) Upon termination of this Agreement by Salix pursuant to Section 11.2(d):

(i) All then outstanding Firm Orders automatically shall be cancelled.

(ii) Watson immediately shall cease all sales, marketing and distribution of the Generic Product and Salix promptly shall repurchase all saleable inventory of the Generic Product held by Watson as of the date of termination at the Purchase Price paid for such Generic Product, and Watson shall deliver such Generic Product to Salix at Salix’s expense.

(e) Upon termination of this Agreement by Watson pursuant to Section 11.3 or by Salix pursuant to Section 11.8:

(i) All then outstanding Firm Orders automatically shall be cancelled.

(ii) Watson shall be permitted to sell off any inventory of Generic Product in its possession as of the date of termination.

21

(iii) To the extent any amount reimbursable by Salix pursuant to Section 3.1(b) has not been reimbursed by Salix or credited against Profits payable by Watson as of the date of termination, Salix shall reimburse such amount to Watson within sixty (60) days after the date of termination.

(f) Upon termination of this Agreement by Salix pursuant to Section 11.2(f) or 11.4(a):

(i) All then outstanding Firm Orders automatically shall be cancelled; provided that, if on the date of termination Watson holds less than [*] months’ of inventory of the Generic Product (determined based on the average monthly amount of Generic Product sold by Watson and its Affiliates during the [*] full month-period prior to the date of termination), then, at Watson’s option, Salix will fulfill, in accordance with the terms of this Agreement and such Firm Orders, that portion of any outstanding Firm Orders necessary to supply Watson a quantity of Generic Product equal to the difference between [*] months’ inventory and the quantity of Generic Product actually held by Watson on the date of termination.

(ii) Watson shall be permitted a sell-off period of [*] days to sell off any inventory of Generic Product in its possession as of the date of termination. Watson immediately shall cease all sales, marketing and distribution of the Generic Product at the end of such selloff period and Salix promptly shall repurchase all saleable inventory of the Generic Product held by Watson as of the end of such selloff period at the Purchase Price paid by Watson for such Generic Product, and Watson shall deliver such Generic Product to Salix at Salix’s expense.

(g) Upon termination of this Agreement by Salix pursuant to Section 11.5:

(i) All then outstanding Firm Orders automatically shall be cancelled.

(ii) Watson immediately shall cease all sales, marketing and distribution of the Generic Product.

(iii) Salix promptly shall repurchase (A) all saleable inventory of the Generic Product held by Watson as of the date of termination and (B) all Generic Product recovered by Watson from customers in accordance with subsection (iv) below, in each case at the Purchase Price paid for such Generic Product, and Watson shall deliver such Generic Product to Salix at Salix’s expense.

(iv) Under the direction of Salix, Watson shall, at Salix’s expense (excluding any refunds to customers, which shall be paid by

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

22

Watson and taken into account in the calculation of Net Sales), use its best efforts to recover all Generic Product which has been delivered to Watson but is no longer within Watson’s control, other than such Generic Product that has been consumed; provided that if any refunds paid to a customer by Watson under this Section 11.8(g)(iv) would reduce the Profits for any period with respect to which a payment of Profits had already been made by Watson to Salix pursuant to Section 3.2, Salix promptly shall pay to Watson the amount necessary such that the proper allocation of Profits for such period pursuant to Section 3.1, taking into account such refunds, shall be achieved.

(h) Upon termination of this Agreement by either party pursuant to Section 11.6:

(i) All then outstanding Firm Orders automatically shall be cancelled.

(ii) Watson immediately shall cease all sales, marketing and distribution of the Generic Product and Watson shall immediately destroy any inventory of Generic Product under its control and shall either, at Salix’s option, (i) allow a Salix representative to be present during such destruction or (ii) provide a certificate of such destruction.

(iii) Salix shall bear [*]% and Watson shall bear [*]% of all actual and reasonable costs incurred by the parties to complete activities associated with the termination of this Agreement, including, without limitation, (A) the costs of all Materials purchased by Salix up to the effective date of termination which cannot be diverted to Salix’s other uses and which are non-refundable, (B) the cost of any Generic Product and any work in process which cannot be diverted to Salix’s other uses held by Salix as of the effective date of termination and Manufactured by Salix in accordance with Firm Orders then outstanding, and (C) the Purchase Price paid by Watson for any Generic Product held by Watson as of the date of termination. Each party shall use Commercially Reasonable Efforts to minimize the costs it incurs to complete activities associated with the termination of this Agreement.

(iv) Each party acknowledges and agrees that the other party shall have no liability of any kind to such first party, other than as provided in this Section 11.9(h), for termination of this Agreement under Section 11.6.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

23

(i) Upon termination of this Agreement by Salix pursuant to Section 11.2(e):

(i) All then outstanding Firm Orders automatically shall be cancelled.

(ii) Watson immediately shall cease all sales, marketing and distribution of the Generic Product and Salix promptly shall repurchase all saleable inventory of the Generic Product held by Watson as of the termination date at the Purchase Price paid by Watson for such Generic Product, and Watson shall deliver such Generic Product to Salix at Salix’s expense.

(iii) Salix shall reimburse Watson for any reasonable and customary supplier penalties that are incurred by Watson for cancellation of customer supply contracts that exist as of the date of the notice for such termination.

(j) Upon termination of this Agreement by Watson pursuant to Section 11.4(b):

(i) Watson immediately shall cease all sales, marketing and distribution of the Generic Product and Watson shall immediately destroy any inventory of Generic Product under its control, at its expense, and shall either, at Salix’s option, (A) allow a Salix representative to be present during such destruction or (B) provide a certificate of such destruction.

(ii) All then outstanding Firm Orders automatically shall be cancelled.

(iii) For a period of twelve (12) months from the effective date of such termination, Watson shall make monthly payments to Salix, not later than forty-five (45) days after the end of each month during such twelve (12) month period, each of which payments shall be equal to [*]% of the Average Monthly Profits.

(k) Upon termination of this Agreement by Salix pursuant to Section 11.4(b):

(i) Watson immediately shall cease all sales, marketing and distribution of the Generic Product and Salix promptly shall repurchase all saleable inventory of the Generic Product held by Watson as of the termination date at the Purchase Price paid by Watson for such Generic Product, and Watson shall deliver such Generic Product to Salix at Salix’s expense.

(ii) All then outstanding Firm Orders automatically shall be cancelled.

(iii) For a period of twelve (12) months from the effective date of such termination, Watson shall make monthly payments to Salix, not later than forty-five (45) days after the end of each month during such twelve (12) month period, each of which payments shall be equal to [*]% of the Average Monthly Profits.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

24

11.10. Sales During Selloff Period. During any selloff period after the expiration or termination of this Agreement permitted under Section 11.9, Watson shall store, handle, market, sell and distribute the Generic Product pursuant to all terms and conditions of this Agreement in effect prior to such expiration or termination.

11.11. Reconciliation. For a period of two (2) years from the date of any termination or expiration of this Agreement, Watson shall, initially no later than sixty (60) days after the six-month anniversary of the end of the Calendar Quarter within which the Agreement expired or was terminated, and quarterly thereafter, prepare and deliver to Salix a reasonably detailed report (each, a “Profits Report”), of the cumulative Profits from the Effective Date through the end of the period covered by the Profits Report which reconciles (i) previously estimated amounts of Profits with (ii) actual experience for the period covered by the Profits Report (the difference, if any, the “Reconciled Amount”). If the Profits Report shows a positive adjustment to Profits, Watson shall pay to Salix [*] percent ([*]%) of the Reconciled Amount within fifteen (15) days of Salix’s receipt of the Profits Report. If the Profits Report shows a negative adjustment to Profits, Salix shall pay to Watson [*] percent ([*]%) of the Reconciled Amount within fifteen (15) days of Salix’s receipt of the Profits Report.

11.12. Accrued Rights. The expiration or termination of this Agreement shall not affect the rights and obligations of the parties arising prior to such expiration or termination.

ARTICLE 12. CONFIDENTIAL INFORMATION

12.1. Confidential Information.

(a) For purposes of this Agreement, “Confidential Information” means any and all information or material, whether oral, visual, in writing or in any other form, that, at any time before or after the date hereof, has been or is provided, communicated or otherwise made known to the Receiving Party by or on behalf of the Disclosing Party pursuant to this Agreement or in connection with the transactions contemplated hereby or any discussions or negotiations with respect thereto; any data, ideas, concepts or techniques contained therein; and any modifications thereof or derivations therefrom.

(b) Except to the extent expressly permitted by this Agreement and subject to the provisions of Sections 12.2 and 12.3, at all times during the Term and for a period of seven (7) years following the expiration or termination thereof, the Receiving Party shall keep completely confidential and shall not publish or otherwise disclose or use, directly or indirectly, for any purpose, any Confidential Information of the Disclosing Party, except to those of the Receiving Party’s employees, Affiliates or consultants who have a need to know such information (collectively, “Recipients”) to perform the Receiving Party’s obligations hereunder (and who shall be advised of the Receiving Party’s obligations hereunder and who are bound by confidentiality obligations with respect to such Confidential Information no less onerous than those set forth in this Agreement). The Receiving Party shall be jointly and severally liable for any breach by any of its Recipients of the restrictions set forth in this Agreement.

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

25

12.2. Exceptions to Confidentiality. The Receiving Party’s obligations set forth in this Agreement shall not extend to any Confidential Information of the Disclosing Party:

(a) that is or hereafter becomes part of the public domain by public use, publication, general knowledge or the like through no wrongful act, fault or negligence on the part of a Receiving Party or its Recipients;

(b) that is received from a Third Party without restriction and without breach of any obligation of confidentiality between such Third Party and the Disclosing Party;

(c) that the Receiving Party can demonstrate by competent evidence was already in its possession without any limitation on use or disclosure prior to its receipt from the Disclosing Party;

(d) that is generally made available by a Third Party or otherwise enters the public domain without restriction on disclosure and through no fault of the Receiving Party in breach of this Agreement; or

(e) that the Receiving Party can demonstrate by competent evidence was independently developed by the Receiving Party.

12.3. Permitted Disclosures. Each party and its Recipients may disclose Confidential Information to the extent that such disclosure is:

(a) made in response to a valid order of a court of competent jurisdiction or other Agency of a country or any political subdivision or regulatory body thereof of competent jurisdiction; provided, however, that the Receiving Party shall first have given notice to the Disclosing Party and given the Disclosing Party a reasonable opportunity to quash such order or to obtain a protective order requiring that the Confidential Information or documents that are the subject of such order be held in confidence by such court or Regulatory Authority or, if disclosed, be used only for the purposes for which the order was issued; and provided further that if a disclosure order is not quashed or a protective order is not obtained, the Confidential Information disclosed in response to such court or governmental order shall be limited to that information which is legally required to be disclosed in such response to such court or governmental order; or

(b) otherwise required by applicable law, in the opinion of legal counsel to the Receiving Party as expressed in an opinion letter in form and substance reasonably satisfactory to the Disclosing Party, and the Receiving Party shall exercise its commercially reasonable efforts to obtain a protective order or other reliable assurance that confidential treatment will be accorded to the Confidential Information so disclosed.

12.4. Notification. The Receiving Party shall notify the Disclosing Party immediately, and cooperate with the Disclosing Party as the Disclosing Party may reasonably request, upon the Receiving Party’s discovery of any loss or compromise of the Disclosing Party’s Confidential Information.

26

12.5. Use of Name and Disclosure of Terms. No press release, public announcement, confirmation or other communication to the public or Third Parties regarding the terms of this Agreement or related matters shall be made by either party without the prior written consent of the other party with respect to the form, content and timing of such press release, public announcement, confirmation or other communication to the public or Third Parties, except that either party may confirm the existence, but not the terms, of this Agreement in response to press inquiries and in trade advertisements and customer communications. Neither party shall mention or otherwise use the name, insignia, symbol, trademark, trade name or logotype of the other party or its Affiliates in any manner without the prior written consent of the other party in each instance. The restrictions imposed by this Section 12.5 shall not prohibit either party from making any disclosure identifying the other party that is required by applicable law, rule or regulation or the requirements of a national securities exchange or another similar regulatory body, provided that any such disclosure shall be governed by this Article 12 and that the other party is given a reasonable opportunity to review and comment on any such press release or public communication in advance thereof.

ARTICLE 13. MISCELLANEOUS

13.1. Governing Law.

(a) The interpretation and construction of this Agreement shall be governed by the laws of the State of New York, excluding any conflicts or choice of law rule or principle that might otherwise refer construction or interpretation of this Agreement to the substantive law of another jurisdiction.

(b) Each party further agrees that service of any process, summons, notice or document by registered mail to its address set forth in Section 13.5 shall be effective service of process for any action, suit or proceeding brought against it under this Agreement in any such court.

13.2. Force Majeure. No liability shall result from delay in performance or non-performance, in whole or in part, by either of the parties to the extent that such delay or non-performance is caused by an event of Force Majeure. “Force Majeure” means an event that is beyond a non-performing party’s reasonable control, including an act of God, act of the other party, strike, lock-out or other industrial/labor dispute, war, acts of war (whether war to be declared or not) riot, civil commotion, terrorist act, malicious damage, epidemic, quarantine, fire, flood, storm, natural disaster or compliance with any law or governmental order, rule, regulation or direction, whether or not it is later held to be invalid. The Force Majeure Party shall within thirty (30) days of the occurrence of the Force Majeure event give written notice to the other party stating the nature of the Force Majeure event, its anticipated duration and any action being taken to avoid or minimize its effect. Any suspension of performance shall be of no greater scope and of no longer duration than is reasonably required.

27

13.3. Waiver and Non-Exclusion of Remedies. A party’s failure to enforce, at any time or for any period of time, any provision of this Agreement, or to exercise any right or remedy shall not constitute a waiver of that provision, right or remedy or prevent such party from enforcing any or all provisions of this Agreement and exercising any rights or remedies. To be effective any waiver must be in writing. The rights and remedies provided herein are cumulative and do not exclude any other right or remedy provided by law or otherwise available except as expressly set forth herein.

13.4. Equitable Relief. The Parties acknowledge and agree that the restrictions set forth in Sections 2.4 and 2.12 and Article 12 are reasonable and necessary to protect the legitimate interests of the parties and that neither party would have entered into this Agreement in the absence of such restrictions, and that any breach or threatened breach of any provision of Sections 2.4 or 2.12 or Article 12 will result in irreparable injury to the other party for which there will be no adequate remedy at law. In the event of a breach or threatened breach of any provision of Sections 2.4 or 2.12 or Article 12 by a party, the other party shall be authorized and entitled to obtain from any court of competent jurisdiction injunctive relief, whether preliminary or permanent, specific performance and an equitable accounting of all earnings, profits and other benefits arising from such breach, which rights shall be cumulative and in addition to any other rights or remedies to which such party may be entitled in law or equity. The breaching party agrees to waive any requirement that the non-breaching party (a) post a bond or other security as a condition for obtaining any such relief and (b) show irreparable harm, balancing of harms, consideration of the public interest or inadequacy of monetary damages as a remedy. Nothing in this Section 13.4 is intended, or shall be construed, to limit the parties’ rights to equitable relief or any other remedy for a breach of any provision of this Agreement.

13.5. Notices.

(a) Any notice, request, demand, waiver, consent, approval or other communication permitted or required under this Agreement shall be in writing, shall refer specifically to this Agreement and shall be deemed given only if delivered by hand or sent by facsimile transmission (with transmission confirmed) or by nationally recognized overnight delivery service that maintains records of delivery, addressed to the parties at their respective addresses specified in Section 13.5(b) or to such other address as the party to whom notice is to be given may have provided to the other party in accordance with this Section 13.5(a). Such notice shall be deemed to have been given as of the date delivered by hand or transmitted by facsimile (with transmission confirmed) or on the second business day (at the place of delivery) after deposit with an internationally recognized overnight delivery service. Any notice delivered by facsimile shall be confirmed by a hard copy delivered as soon as practicable thereafter. This Section is not intended to govern the day-to-day business communications necessary between the Parties in performing their obligations under the terms of this Agreement.

(b) Addresses for Notice.

For :	Salix Pharmaceuticals, Inc.
Address:	1700 Perimeter Park Drive

28

	Morrisville, North Carolina 27560
Facsimile:	919-862-1095
Attention:	General Counsel
For:	Watson Pharmaceuticals, Inc.
Address:	311 Bonnie Circle
	Corona, California 92880
Facsimile:	951-493-5821
Attention:	President – U.S. Generics

13.6. Entire Agreement. This Agreement and the Quality Agreement constitute the entire agreement between the parties with respect to the subject matter hereof and thereof. This Agreement supersedes all prior agreements and understandings, whether written or oral, with respect to the subject matter of the Agreement. Each party confirms that it is not relying on any representations, warranties or covenants of the other party except as specifically set out in this Agreement. Nothing in this Agreement is intended to limit or exclude any liability for fraud. All Exhibits referred to in this Agreement are intended to be and are hereby specifically incorporated into and made a part of this Agreement. In the event of any inconsistency between any such Exhibit and this Agreement, the terms of this Agreement shall govern. In the event of any inconsistency between the Quality Agreement and this Agreement, the terms of the Quality Agreement shall govern.

13.7. Amendment. No amendment, modification, release or discharge of this Agreement shall be binding upon the parties unless in writing and signed by authorized representatives of both parties.

13.8. Assignment. Neither party shall sell, transfer, assign, delegate, pledge or otherwise dispose of its rights or delegate its obligations under this Agreement, whether by operation of law or otherwise, in whole or in part without the prior written consent of the other party, except that (i) Salix shall always have the right, without such consent, to assign its rights and delegate its obligations under this Agreement to any purchaser of or successor in interest to the business to which this Agreement relates and (ii) either party may assign its rights and obligations hereunder to any of its Affiliates, without the consent of the other party, provided that the assigning party shall remain primarily liable for all its obligations and agreements set forth herein. All validly assigned rights of a party shall inure to the benefit of and be enforceable by, and all validly delegated obligations of such party shall be binding on and be enforceable against, the permitted successors and assigns of such party. Any attempted assignment or delegation in violation of this Section shall be void.

29

13.9. No Benefit to Others. The provisions of this Agreement are for the sole benefit of the parties and their successors and permitted assigns, and they shall not be construed as conferring any rights in any other persons except as otherwise expressly provided in Article 10 of this Agreement.

13.10. Counterparts. This Agreement may be executed in any number of counterparts, each of which shall be deemed an original and all of which taken together shall be deemed to constitute one and the same instrument. An executed signature page of this Agreement delivered by facsimile transmission shall be as effective as an original executed signature page.

13.11. Severability. To the fullest extent permitted by applicable law, the parties waive any provision of law that would render any provision in this Agreement invalid, illegal or unenforceable in any respect. If any provision of this Agreement is held to be invalid, illegal or unenforceable, in any respect, then such provision will be given no effect by the parties and shall not form part of this Agreement. Subject to Section 11.6, to the fullest extent permitted by Applicable Law and if the rights or obligations of any party will not be materially and adversely affected, all other provisions of this Agreement shall remain in full force and effect and the parties will use their best efforts to negotiate a provision in replacement of the provision held invalid, illegal or unenforceable that is consistent with applicable law and achieves, as nearly as possible, the original intention of the parties.

13.12. Further Assurance. Each party shall perform all further acts and things and execute and deliver such further documents as may be necessary or as the other party may reasonably require to implement or give effect to this Agreement.

13.13. Relationship of the Parties. The status of a party under this Agreement shall be that of an independent contractor. Nothing contained in this Agreement shall be construed as creating a partnership, joint venture or agency relationship between the parties or, except as otherwise expressly provided in this Agreement, as granting either party the authority to bind or contract any obligation in the name of or on the account of the other party or to make any statements, representations, warranties or commitments on behalf of the other party, except upon the prior written consent of the other party to do so, such consent not to be unreasonably withheld or delayed. All persons employed by a party shall be employees of such party and not of the other party and all costs and obligations incurred by reason of any such employment shall be for the account and expense of such party.

13.14. Payments.

(a) Form. All payments due hereunder shall be made by wire transfer to an account designated by the receiving party in writing from time to time.

(b) Taxes and Withholding.

(i) All payments made by one party to the other under this Agreement shall be made without any deduction or withholding for, or on account of, any tax.

30

(ii) Any and all taxes (excluding income taxes based upon Salix’s income) relating to the supply of Generic Product to Watson under this Agreement, including, without limitation, sales taxes required to be paid by any federal, state or local authority shall be borne by Watson. Official receipts indicating proof of payment of any such taxes shall be secured and made available to Salix upon request as evidence of payment.

(c) Currency. All amounts payable by a party hereunder shall be paid in U.S. dollars.

(d) Interest on Late Payments. If any payment under this Agreement is not made within two (2) business days when due, interest shall accrue on such past due amount from the date such amount was due until the date payment is actually made at a rate equal to the lesser of (a) 1.0% per month, compounded monthly, and (b) the maximum rate permitted by law. Time for any payments hereunder shall be of the essence.

13.15. Headings. The headings of the Articles, Sections and subsections of this Agreement are inserted for convenience only and shall not be deemed to constitute a part of this Agreement or affect the construction hereof.

13.16. Survival. The provisions of Sections 2.6, 2.8, 3.2, 3.3, 7.1, 7.3, 7.7, 11.7, 11.9, 11.10, 11.11, and 11.12 and Articles 1, 9, 10, 12 and 13 shall survive the expiration or termination of this Agreement for any reason.

[The remainder of this page has been intentionally left blank.]

31

IN WITNESS WHEREOF, the undersigned have executed this Agreement as of the Effective Date.

SALIX PHARMACEUTICALS, INC.		WATSON PHARMA, INC.
By:	/s/ Carolyn J. Logan	By:	/s/ Andrew S. Boyer
Name:	Carolyn J. Logan	Name:	Andrew S. Boyer
Title:	President and CEO	Title:	Sr. VP Sales and Marketing

PARENT GUARANTY

Watson Pharmaceuticals, Inc., a Nevada corporation, hereby guaranties the performance by Watson Pharma, Inc. of each and every covenant, agreement and obligation set forth in the Supply and Distribution Agreement to which this guaranty is attached, when and as due in accordance with the terms of such Supply and Distribution Agreement.

WATSON PHARMACEUTICALS, INC.
By:	/s/ Allen Chao
Name:	Allen Chao
Title:	Chairman and CEO

32

EXHIBIT A

SPECIFICATIONS, TESTING AND IMAGE

[*]

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

A-1

EXHIBIT B

DESCRIPTION OF PRE-BOOKING ACTIVITIES

Pre-booking activities consist of the following:

• discussions with potential customers to make them aware of the upcoming availability of the Generic Product as authorized generics from Watson, and

• sales order booking (but not shipping) prior to the Launch Date.

B-1

EXHIBIT C

MAXIMUM MONTHLY WHOLE LOT QUANTITIES

[*] Whole Lots per month

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

C-1

EXHIBIT D

PACKAGING CONFIGURATIONS

280 count bottles

500 count bottles

D-1

EXHIBIT E

EXAMPLE OF PROFIT SHARE CALCULATION

Net Sales for July 2007 are $110 and the Purchase Price paid by Watson for Generic Product sold during July 2007 is $10. Profits are $100 (Net Sales less Purchase Price). Not later than September 15, 2007, Watson shall pay Salix $[*] ([*]% of Profits for July 2007).

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

E-1

EXHIBIT F

PROMOTIONAL ALLOWANCES

Invoice Price Correction Value

Promotion Allowances Value

Slotting Allowance Value

Shelf Stock Adjustments Value

F-1

EXHIBIT G

NET SALES AND PROFITS REPORTS

		Profit Calculation
Sample Figures Only
		MTD
Gross invoice sales	$		[*]
Cash discounts	$		[*]
Chargebacks	$		[*]
Rebate programs	$		[*]
Returns	$		[*]
Medicaid rebates	$		[*]
Other - specific allocations	$		[*]
Net Sales	$		[*]
Material Costs	$		[*]
Gross Profit	$		[*]
Profit Due @ [*]%	$		[*]

[*] Confidential treatment requested; certain information omitted and filed separately with the SEC.

G-1

EX-21.1

Exhibit 21.1

Salix Pharmaceuticals, Ltd. Subsidiaries

Name	Jurisdiction
Salix Pharmaceuticals, Inc.	California
Glycyx Pharmaceuticals, Ltd.	Delaware
InKine Pharmaceutical Company, Inc.	New York
Corbec Pharmaceuticals, Inc.	Delaware
Sangen Pharmaceutical Company	Delaware

EX-23.1

EXHIBIT 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We hereby consent to the incorporation by reference in the Registration Statement on Form S-3 (No. 333-110942) and Form S-8 (Nos. 333-126685, 333-126290, 333-116675, 333-96771, 333-63604, 333-61497, 333-135268 and 333-47586) of Salix Pharmaceuticals, Ltd. of our report dated March 13, 2008 relating to the financial statements, financial statement schedule and the effectiveness of internal control over financial reporting, which appears in this Form 10-K.

/s/ PricewaterhouseCoopers LLP

Raleigh, North Carolina

March 13, 2008

EX-23.2

EXHIBIT 23.2

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in the following Registration Statements:

(1) Registration Statement (Form S-3 No. 333-110942) of Salix Pharmaceuticals, Ltd.,

(2) Registration Statement (Form S-8 No. 333-126685) pertaining to the InKine Pharmaceutical Company, Inc. 1993 Stock Option Plan, the InKine Pharmaceutical Company, Inc. 1997 Consultant Stock Option Plan, the InKine Pharmaceutical Company, Inc. 1999 Equity Compensation Plan, and the InKine Pharmaceutical Company, Inc. 2004 Equity Compensation Plan,

(3) Registration Statements (Form S-8 Nos. 333-126290 and 333-135268) pertaining to the 2005 Stock Plan of Salix Pharmaceuticals, Ltd., and

(4) Registration Statements (Form S-8 Nos. 333-116675, 333-96771, 333-63604, 333-61497, and 333-47586) pertaining to the 1996 Stock Option Plan, as amended;

of our reports dated March 9, 2007, with respect to the consolidated financial statements and schedule of Salix Pharmaceuticals, Ltd., Salix Pharmaceuticals, Ltd. management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting of Salix Pharmaceuticals, Ltd., included in this Annual Report (Form 10-K) of Salix Pharmaceuticals, Ltd.

/s/ Ernst & Young LLP

Raleigh, North Carolina

March 12, 2008

EX-31.1

EXHIBIT 31.1

CERTIFICATION

I, Carolyn J. Logan, certify that:

1. I have reviewed this annual report on Form 10-K of Salix Pharmaceuticals, Ltd.;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b. designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c. evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d. disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of this annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 13, 2008	By:	/s/ Carolyn J. Logan
		Carolyn J. Logan President and Chief Executive Officer

EX-31.2

EXHIBIT 31.2

CERTIFICATION

I, Adam C. Derbyshire, certify that:

1. I have reviewed this annual report on Form 10-K of Salix Pharmaceuticals, Ltd.;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal controls over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a. designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b. designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c. evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d. disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of this annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 13, 2008	By:	/s/ Adam C. Derbyshire
		Adam C. Derbyshire Senior Vice President, Finance & Administration, and Chief Financial Officer

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report on Form 10-K of Salix Pharmaceuticals, Ltd. (the “Company”) for the period ended December 31, 2007 as filed with the Securities and Exchange Commission on or about the date hereof (the “Report”), I, Carolyn J. Logan, President and Chief Executive Officer, hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of, and for, the periods presented in the Report.

/s/ Carolyn J. Logan

Carolyn J. Logan

President and Chief Executive Officer

March 13, 2008

EX-32.2

EXHIBIT 32.2

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report on Form 10-K of Salix Pharmaceuticals, Ltd. (the “Company”) for the period ended December 31, 2007 as filed with the Securities and Exchange Commission on or about the date hereof (the “Report”), I, Adam C. Derbyshire, Senior Vice President, Finance and Administration and Chief Financial Officer, hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of, and for, the periods presented in the Report.

/s/ Adam C. Derbyshire

Adam C. Derbyshire

Senior Vice President, Finance & Administration, and Chief Financial Officer

March 13, 2008