11. Income Taxes

We provide for income taxes under FASB ASC 740. Deferred income tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities, which are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.

As of December 31, 2014 and 2015, we had approximately $106.7 million and $116.8 million of federal net operating loss (“NOL”) carryforwards and $101.5 million and $111.5 million of state NOL carryforwards, respectively, available to offset future federal and state taxable income that will expire beginning in the year 2023 and through the year 2035. As of December 31, 2014 and 2015, we had approximately $3.6 million and $5.0 million, respectively, of federal research and development (“R&D”) tax credit carryforwards to offset future federal tax liabilities that will expire beginning in the year 2028 and through the year 2035.

In assessing the realizability of deferred tax assets, we consider whether it is more‑likely‑than‑not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the temporary differences representing net future deductible amounts become deductible. Our deferred tax liability related to the indefinite-lived intangible asset may not be considered a source of future taxable income available to offset our deferred tax assets. After consideration of all the evidence, both positive and negative, we have recorded a full valuation allowance against our net deferred tax assets at December 31, 2014 and 2015, respectively, because our management has determined that is it more likely than not that these assets will not be fully realized. The valuation allowance increased by approximately $4.5 million and $14.0 million during the years ended December 31, 2014 and December 31, 2015, respectively, due primarily to the generation of NOLs during those periods. However, for the year ended December 31, 2014, approximately $2.0 million of the increase was related to purchase accounting for the acquisition of Shape Pharmaceuticals and an approximately $6.6 million tax benefit from reversing the valuation allowance was recorded as an adjustment to APIC attributable to recording the deferred tax liability associated with the issuance of the 8% notes. For the year ended December 31, 2015, approximately $5.2 million of the increase in the valuation allowance was related to capitalized licensing payments and research and development costs generated at our newly formed UK subsidiaries.

The NOL carryforwards, as well as the R&D tax credit carryforwards, are subject to review and possible adjustment by the Internal Revenue Service and state tax authorities. NOL and tax credit carryforwards may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant stockholders over a three‑year period in excess of 50%, as defined under Sections 382 and 383 of the Internal Revenue Code of 1986, as amended, as well as similar state tax provisions. This could limit the amount of NOLs that we can utilize annually to offset future taxable income or tax liabilities. The amount of the annual limitation, if any, will be determined based on the value of our company immediately prior to an ownership change. Subsequent ownership changes may further affect the limitation in future years. Additionally, U.S. tax laws limit the time during which these carry forwards may be applied against future taxes, therefore, we may not be able to take full advantage of these carry forwards for federal income tax purposes. The company performed an analysis during the year ended December 31, 2014 to determine an estimate of the Section 382 limitation on the net operating losses and R&D tax credit carryforwards. Accordingly, we recorded a reduction as of December 31, 2014 of approximately $9.2 million to the federal and state NOL carryforwards and approximately $2.1 million to the R&D credit carryforwards available for future utilization.

For all years through December 31, 2015, we generated research credits but have not conducted a study to document the qualified activities. This study may result in an adjustment to our R&D credit carryforwards; however, until a study is completed and any adjustment is known, no amounts are being presented as an uncertain tax position for these years. A full valuation allowance has been provided against our research and development credits and, if an adjustment is required, this adjustment to the deferred tax asset established for the research and development credit carryforwards would be offset by an adjustment to the valuation allowance.

The components of the net deferred tax asset are as follows:


	December 31,
	2014		2015
Gross deferred tax assets:
Net operating loss carryovers	$	43,399,282	$	47,179,913
Stock compensation		2,222,537		4,455,016
R&D credit		3,598,910		5,004,252
Capitalized costs		—		5,155,127
Other		640,548		201,865
Total gross deferred tax assets		49,861,277		61,996,173
Gross deferred tax liabilities:
Depreciation		(28,069)		—
Conversion option discount		(6,079,535)		(4,217,175)
Indefinite-lived intangible asset		(16,879,659)		(16,879,659)
Total gross deferred tax liabilities		(22,987,263)		(21,096,834)
Net deferred tax assets		26,874,014		40,899,339
Less: valuation allowance		(43,753,673)		(57,778,998)
Net deferred tax liabilities after valuation allowance	$	(16,879,659)	$	(16,879,659)

We did not have unrecognized tax benefits as of December 31, 2014 and December 31, 2015, respectively, and do not expect this to change significantly over the next twelve months. We recognize interest and penalties, if any, accrued on any unrecognized tax benefits as a component of income tax expense. As of December 31, 2014 and December 31, 2015, we have not accrued interest or penalties related to any uncertain tax positions.

For the year ended December 31, 2015, the pretax loss was $49.7 million of which $23.7 million is considered a domestic loss, because the results of the operations of the company’s Australian subsidiary is included in the company’s domestic income tax returns. The remaining loss of $26.0 million is attributable of the company’s newly created UK subsidiaries and is considered a foreign loss. For the year ended December 31, 2014, all of our pretax loss of $36.0 million is considered a domestic loss.

In July 2015, we licensed certain intellectual property rights to our wholly-owned subsidiaries in the United Kingdom. The license of the intellectual property rights did not result in any gain or loss in the condensed consolidated statements of operations. The transaction generated a royalty stream from the subsidiaries in the United Kingdom to the US companies. The income from the royalty stream is expected to be primarily offset by net operating loss carryforwards for Federal and state tax purposes.

A reconciliation of income tax expense (benefit) at the statutory federal income tax rate and income taxes as reflected in the financial statements is as follows:


	Year Ended
	December 31,
	2014		2015
Federal income tax expense at statutory rate	34.0	%	34.0	%
Permanent items	(1.9)		(3.3)
State income tax, net of federal benefit	6.4		5.8
Effect of rates different than statutory	—		(7.6)
Adjustment to NOL and credit carryforwards	(16.3)		—
Tax credits generated	2.0		1.9
Change in valuation allowance	(24.2)		(30.8)
Effective income tax rate	—	%	—	%

We file U.S. federal, state and foreign income tax returns, which are generally subject to tax examinations for the tax years ended December 31, 2012 through December 31, 2015. To the extent we utilize our NOL or tax credit attribute carryforwards, the tax years in which the attribute was generated may still be adjusted upon examination by the Internal Revenue Service or state or foreign tax authorities of the tax return in which the attribute was utilized.