Income Taxes

Components of income (loss) from continuing operations before taxes are as follows for the years ended December 31, (in thousands):



	2010			2011			2012
Income (loss) from continuing operations before taxes:
U.S.	$	(7,448	)	$	(6,229	)	$	(7,211	)
Foreign	429			(2,106		)	(2,442		)
Total income (loss) from continuing operations before taxes	$	(7,019	)	$	(8,335	)	$	(9,653	)

Components of the income tax provision (benefit) are as follows for the years ended December 31, (in thousands):



	2010		2011		2012
Current:
Federal	$	—	$	—	$	—
State, local and foreign	213		129		749
	213		129		749
Deferred:
Federal	—		—		—
State, local and foreign	—		—		—
	—		—		—
Total income tax provision	$	213	$	129	$	749

The reconciliation of the income tax provision computed using the federal statutory income tax rate to the recognized income tax provision (benefit) is as follows for the years ended December 31, (in thousands):



	2010			2011			2012
Federal statutory rate	$	(2,386	)	$	(2,834	)	$	(3,282	)
State and local income taxes, net of federal benefit	(153		)	(85		)	(16		)
State rate change and other adjustments	737			160			531
Increase in valuation allowance	1,400			1,490			597
Foreign tax differential	70			816			915
Research and development credits	(48		)	(49		)	127
Share based compensation	378			402			518
Uncertain tax positions	(2		)	(46		)	767
Adjustments to deferred tax assets	—			—			525
Other	217			275			67
Income tax provision	$	213		$	129		$	749

The tax effect of temporary differences that give rise to deferred income taxes are as follows as of December 31, (in thousands):



	2011			2012
Deferred tax assets:
Net operating loss and tax credit carry forwards	$	88,675		$	93,547
Inventory reserve and uniform capitalization	1,959			2,016
Stock options and warrants	2,807			2,330
In-process research and development	241			237
Allowance for bad debts	265			232
Vacation accrual	354			386
Deferred rent	283			429
Landlord provided leasehold improvements	—			317
Deferred revenue	—			376
Warranty accrual	494			937
Depreciation and amortization	1,579			695
Other accruals and reserves	4,252			701
Acquired intangibles	1,386			1,336
Total deferred tax assets	102,295			103,539
Deferred tax liabilities:
State taxes	(3,568		)	(3,603		)
Cloverleaf intangibles	(456		)	—
Other	—			(205		)
Total deferred income tax liabilities	(4,024		)	(3,808		)
Valuation allowance	(98,271		)	(99,731		)
Net deferred tax assets	$	—		$	—

As a result of certain realization requirements, the table of deferred tax assets and liabilities shown above does not include deferred tax assets for net operating losses as of December 31, 2012 that arose directly from tax deductions related to equity compensation in excess of compensation recognized for financial reporting. Equity will be increased by $0.3 million if and when such excess tax benefits are recognized through current taxes payable. The Company uses ASC 740 ordering when determining when excess tax benefits or shortfalls have been realized.

U.S. income and withholding taxes have not been recognized on the excess of the amount for financial reporting over the tax basis of investments in foreign subsidiaries that are essentially permanent in duration. This amount becomes taxable upon a repatriation of assets from the subsidiary or a sale or liquidation of the subsidiary. The amount of such temporary differences totals $0.5 million at December 31, 2012. Determination of the amount of any unrecognized deferred tax liability on this temporary difference is not practicable.

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



	2010			2011			2012
Balance, January 1	$	4,842		$	5,111		$	5,025
Increase related to prior period positions	367			—			583
Increase related to current year tax positions	91			124			241
Decrease related to prior period positions	(101		)	(210		)	(123		)
Decrease related to change in prior year estimate	(88		)	—			—
Balance, December 31	$	5,111		$	5,025		$	5,726

At December 31, 2010, 2011, and 2012 we had cumulative unrecognized tax benefits of approximately $5.1 million, $5.0 million, and $5.7 million respectively, of which approximately $0.2 million, $0.2 million, and $0.9 million, respectively, are included in other long term liabilities that, if recognized, would affect the effective tax rate. The remaining $4.9 million, $4.8 million and $4.8 million of unrecognized tax benefits will have no impact on the effective tax rate due to the existence of net operating loss carryforwards and a full valuation allowance. Consistent with previous periods, penalties and tax related interest expense are reported as a component of income tax expense. As of December 31, 2010, and 2011, the total amount of accrued income tax related interest and penalties included in the consolidated balance sheet was less than $0.1 million. As of December 31, 2012, the total amount of accrued income tax related interest and penalties included in the consolidated balance sheet was approximately $0.2 million. We do not expect that our unrecognized tax benefit will change significantly within the next 12 months.

Due to net operating losses and other tax attributes going forward, we are currently open to audit under the statute of limitations by the Internal Revenue Service for the years ending March 31, 1999 through December 31, 2011. With few exceptions, our state income tax returns are open to audit for the years ended December 31, 2008 through 2011.

We periodically evaluate the likelihood of the realization of deferred tax assets, and adjust the carrying amount of the deferred tax assets by the valuation allowance to the extent the future realization of the deferred tax assets is not judged to be more likely than not. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income or loss, the carryforward periods available to us for tax reporting purposes, and other relevant factors.

At December 31, 2012, based on the weight of available evidence, including cumulative losses in recent years and expectations regarding future taxable income, we determined that it was not more likely than not that our deferred tax assets would be realized and have a $99.7 million valuation allowance associated with our deferred tax assets.

As of December 31, 2012, we had federal and state net operating loss carryforwards of approximately $203.1 million and $105.4 million, respectively, which begin to expire in the tax years ending 2017 and 2013, respectively. We had foreign net operating loss carryforwards of $43.7 million, which have no expiration date. In addition, we had federal tax credit carryforwards of $6.6 million, of which approximately $0.5 million can be carried forward indefinitely to offset future tax liability, and the remaining $6.1 million begin to expire in the tax year ending 2018. We also had state tax credit carryforwards of $5.5 million, of which the entire $5.5 million has no expiration date.

As a result of our equity transactions, an ownership change, within the meaning of IRC Section 382, occurred on September 18, 2003. As a result, annual use of our federal net operating loss and credit carry forwards is limited to (i) the aggregate fair market value of Dot Hill immediately before the ownership change multiplied by (ii) the long-term tax-exempt rate (within the meaning of Section 382 (f) of the IRC) in effect at that time. The annual limitation is cumulative and, therefore, if not fully utilized in a year, can be utilized in future years in addition to the IRC Section 382 limitation for those years.

As a result of our acquisition of Chaparral Network Storage, Inc., or Chaparral, a second ownership change, within the meaning of IRC Section 382, occurred on February 23, 2004. As a result, annual use of Chaparral’s federal net operating loss and credit carry forwards may be limited. The annual limitation is cumulative and, therefore, if not fully utilized in a year, can be utilized in future years in addition to the Section 382 limitation for those years.

As a result of our acquisition of Cloverleaf, a third ownership change, within the meaning of IRC Section 382, occurred on January 26, 2010. As a result, annual use of Cloverleaf’s federal net operating loss and credit carry forwards may be limited. The annual limitation is cumulative and, therefore, if not fully utilized in a year, can be utilized in future years in addition to the Section 382 limitation for those years.