Note 13—Income Taxes

The Company does not file a consolidated return with its foreign subsidiaries. The Company files federal and state returns and its foreign subsidiaries file returns in their respective jurisdictions.

The Company’s income tax expense, which includes federal, state and foreign income taxes, was $86.2 million, or an effective tax rate of (462%) for the year ended 2012. For the years ended 2010 and 2011, the provision for income taxes, which included Federal, state and foreign income taxes, was an expense of $2.7 million and a benefit of $9.0 million, reflecting effective tax provision rates of 5.41% and 1,671%, respectively.

Included in the 2012 tax expense of $86.2 million were discrete tax expenses of $92.5 million comprised of expense of $91.7 million relating to the establishment of a 100% valuation allowance against our U.S. deferred tax assets, $0.4 million benefit related to reduction of uncertain tax positions due to statute expiration, $0.5 million expense related to state tax apportionment changes and $0.7 million expense related to income tax audit settlement.

For the years ended 2010 and 2011, provision for income taxes includes federal, state and foreign income taxes at effective tax rates of 5.41% and 1,671%, respectively. The increase in the effective rate in 2011 was primarily due to a decrease in the Company’s consolidated and United States earnings compared to 2010 and the recognition of certain discrete income tax adjustments. These discrete adjustments include $0.3 million reduction of uncertain tax positions related to foreign depreciation due to statute expiration and $1.7 million benefit related to state tax apportionment changes and an adjustment to record various outstanding state tax refunds. Exclusive of these discrete items, the effective tax rate would be 26.2% in 2010 and 1,288% in 2011. The increase in the effective rate absent discrete items was due to the foreign rate differential between the United States and Hong Kong. The foreign rate differential is impacted by the proportion of Hong Kong earnings to overall earnings and is expected to vary depending upon the level of consolidated earnings.

For the years ended 2011 and 2012, provision for income taxes includes federal, state and foreign income taxes at effective tax rates of 1,671% and (462%), respectively. Exclusive of these discrete items, the effective tax provision rate would be 1,288% in 2011 and 34.2% in 2012. The decrease in the effective rate absent discrete items was due to the foreign rate differential between the United States and Hong Kong. The rate exclusive of discrete items can be materially impacted by the ratio of Hong Kong earnings over consolidated earnings.

For year ended 2012, the Company had net deferred tax liabilities of approximately $3.1 million.

Provision (benefit) for income taxes reflected in the accompanying consolidated statements of operations are comprised of the following (in thousands):

	2010			2011			2012
Federal	$	1,656		$	(12,674	)	$	97
State and local		3,290			(661	)		307
Foreign		7,915			4,590			3,467
Total Current		12,861			(8,745	)		3,871
APIC		(713	)		363			(114	)
Deferred		(9,455	)		(628	)		82,394
Total	$	2,693		$	(9,010	)	$	86,151

The components of deferred tax assets/(liabilities) are as follows (in thousands):

	2011			2012
Net deferred tax assets/(liabilities):
Current:
Reserve for sales allowances and possible losses	$	2,184		$	1,124
Accrued expenses		3,127			3,908
Federal and state net operating loss carryforwards		9,035			―
Prepaid Royalties		18,338			18,155
Accrued Royalties		2,081			2,328
Inventory		5,480			6,591
State income taxes		(6,767	)		(7,429	)
Other		1,027			1,063
Gross current		34,505			25,740
Valuation allowance		―			(18,682	)
Net Current		34,505			7,058
Long Term:
Federal and state net operating loss carry fowards		―			17,305
Property and equipment		3,777			5,380
Original issue discount interest		(20,273	)		(19,095	)
Goodwill and intangibles		61,076			50,765
Share Based Compensation		2,588			2,467
Other		(87	)		6,009
Gross long-term		47,081			62,831
Valuation allowance		―			(73,011	)
Net long-term		―			(10,180	)
Total net deferred tax assets/(liabilities)	$	81,586		$	(3,122	)

Provision (benefit) for income taxes varies from the U.S. federal statutory rate. The following reconciliation shows the significant differences in the tax at statutory and effective rates:

	2010			2011			2012
Federal income tax expense (benefit)		35.0	%		35.0	%		35.0	%
State income tax expense, net of federal tax effect		1.65			415.9			5.6
Effect of differences in U.S. and Foreign statutory rates		(14.55	)		1031.8			20.8
Uncertain tax positions		(10.39	)		54.2			2.1
Refund from IRS Exam		(8.03	)		―			―
State tax refund adjustment		—			180.0			―
Goodwill write-down		—			―			―
Foreign NOLs		—			―			―
Other		1.73			(46.2	)		(6.4	)
Foreign deemed dividend		—			—			(51.8	)
Foreign tax credit		—			—			24.4
Valuation Allowance		—			—			(491.7	)
		5.41	%		1670.7	%		(462.0)	%

Deferred taxes result from temporary differences between tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. The temporary differences result from costs required to be capitalized for tax purposes by the U.S. Internal Revenue Code (“IRC”), and certain items accrued for financial reporting purposes in the year incurred but not deductible for tax purposes until paid. The Company has established a full valuation allowance on net deferred tax assets in the United States since, in the opinion of management, it is not more likely than not that the U.S. net deferred tax assets will be realized.

The components of income (loss) before provision (benefit) for income taxes are as follows (in thousands):

	2010		2011			2012
Domestic	$	20,066	$	(30,577	)	$	(38,674	)
Foreign		29,676		30,039			20,025
	$	49,742	$	(538	)	$	(18,649	)

The Company has approximately $190 million of cumulative undistributed earnings of non-U.S. subsidiaries for which U.S. taxes have not been provided on December 31, 2012. These earnings are intended to be permanently reinvested outside the U.S. If future events necessitate that these earnings should be repatriated to the U.S., an additional tax expense and related liability may be required.

The Company uses a recognition threshold and measurement process for recording in the financial statements uncertain tax positions (“UTP”) taken or expected to be taken in a tax return.

Approximately $0.6 million of new unrecognized tax positions (UTPs) were recognized in 2012. These UTPs are associated with a reserve for equipment depreciation in Hong Kong, withholding tax in Hong Kong and U.S. research and development credits. In addition, approximately $0.2 million of Hong Kong based UTPs and $0.6 million U.S. UTPs became de-recognized during 2012, primarily due to statute expirations. These items were included in the 2012 income tax provision, except for the UTP related to the new acquisition and carryforward credits. During 2011, approximately $1.0 million of the liability for UTP was recognized.

Current interest on uncertain income tax liabilities is recognized as interest expense and penalties are recognized in selling, general and administrative expenses in the consolidated statement of operations. During 2010, the Company de-recognized $1.6 million of current year interest expense relating to UTPs. During 2011, the Company recognized $0.2 million of current year interest expense relating to UTPs. During 2012, the Company recognized $27,000 of current year interest expense relating to UTPs.

The following table provides further information of UTPs that would affect the effective tax rate, if recognized, as of December 31, 2012 (in millions):

Balance, January 1, 2010	$	16.8
Current year additions		1.8
Current year reduction due to lapse of applicable statute of limitations		(13.6	)
Balance, January 1, 2011		5.0
Current year additions		1.0
Current year reduction due to lapse of applicable statute of limitations		(1.0	)
Balance, January 1, 2012		5.0
Current year additions		0.6
Current year reduction due to lapse of applicable statute of limitations		(0.8	)
Balance, December 31, 2012	$	4.8

Tax years 2009 through 2011 remain subject to examination in the United States and tax years 2008 through 2011 are still subject to examination in California. The tax years 2006 through 2011 are still subject to examination in Hong Kong. In the normal course of business, the Company is audited by federal, state, and foreign tax authorities. The U.S. Internal Revenue Service concluded its examination related to the 2009 U.S. federal income tax return in December 2012. The Company was under examination by various state jurisdictions during 2012. The ultimate resolution of the state examinations, including matters that may be resolved within the next twelve months, is not yet determinable.

Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to use the existing deferred tax assets by jurisdiction. A significant piece of objective negative evidence evaluated was the cumulative loss incurred over the three-year period ended December 31, 2012. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future growth. The Company is required to establish a valuation allowance for the U.S. deferred tax assets and record a charge to income if Management determines, based upon available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets may not be realized.

For the three-year period ended December 31, 2012, the Company was in a cumulative pre-tax loss position in the U.S. On the basis of this evaluation, as of December 31, 2012, a valuation allowance of $91.7 million has been recorded against the U.S. deferred tax assets that more likely than not will not be realized. The net deferred tax liabilities of $3.1 million represent the net deferred tax liabilities in the foreign jurisdiction, where the Company is in a cumulative income position. The amount of the deferred tax asset considered realizable, however, could be adjusted if estimates of future taxable income during the carryforward period are reduced or increased, or if objective negative evidence in the form of cumulative losses is no longer present and additional weight may be given to subjective evidence such as our projections for growth.