Note 10 — Income Taxes

The income tax provision (benefit) consisted of the following (in thousands):

	Current		Deferred			Total
Year ended December 31, 2013
Federal	$	27,985	$	(3,050	)	$	24,935
State		4,145		2,051			6,196
Foreign		-		(598	)		(598	)
	$	32,130	$	(1,597	)	$	30,533
Year ended December 31, 2012
Federal	$	20,843	$	(504	)	$	20,339
State		4,232		(911	)		3,321
Foreign		-		(1,538	)		(1,538	)
	$	25,075	$	(2,953	)	$	22,122
Year ended December 31, 2011
Federal	$	-	$	(460	)	$	(460	)
State		2,704		(3,951	)		(1,247	)
	$	2,704	$	(4,411	)	$	(1,707	)

Income tax expense differs from the “expected” tax expense (benefit) computed by applying the U.S. Federal corporate income tax rates of 35% to income before income taxes, as follows (in thousands):

	Years Ended December 31,
	2013			2012			2011
Computed “expected” tax expense	$	29,013		$	20,125		$	14,457
Change in income taxes resulting from:
State income taxes, net of federal income tax		4,027			2,159			2,217
Foreign income tax expense (benefit)		622			1,468			-
Deduction for domestic production activities		(1,361	)		(1,277	)		-
R&D tax credits		(1,652	)		(508	)
Other, net		(116	)		155			(876	)
Valuation allowance change		-			-			(17,505	)
Income tax expense (benefit)	$	30,533		$	22,122		$	(1,707	)

The geographical allocation of the Company’s income before income taxes between U.S. and foreign operations was as follows (in thousands):

	2013			2012			2011
Pre-tax income from U.S. operations	$	86,382		$	66,087		$	41,306
Pre-tax loss from foreign operations		(3,487	)		(8,587	)		—
Total pre-tax income	$	82,895		$	57,500		$	41,306

Net deferred income taxes at December 31, 2013 and 2012 include (in thousands):

	December 31, 2013						December 31, 2012
	Current			Noncurrent			Current			Noncurrent
Deferred tax assets:
Net operating loss carry-forward	$	439		$	14,061		$	-		$	4,328
Stock-based compensation		-			6,630			-			4,912
Reserve for product returns		3,189			-			2,787			-
Inventory valuation reserve		2,193			-			3,980			-
Other		3,325			1,751			2,974			1,349
Total deferred tax assets		9,146			22,442			9,741			10,589

Deferred tax liabilities:
Prepaid expenses		(1,120	)		-			(551	)		-
Unamortized discount – convertible notes		-			(4,223	)		-			(5,815	)
Depreciation & amortization – tax over book		-			(16,576	)		-			(5,835	)
Other		(81	)		-			-			-
Total deferred tax liabilities		(1,201	)		(20,799	)		(551	)		(11,650	)

Net deferred income tax asset (liability)	$	7,945		$	1,643		$	9,190		$	(1,061	)

The Company records a valuation allowance to reduce net deferred income tax assets to the amount that is more likely than not to be realized. In performing its analysis of whether a valuation allowance to reduce the deferred income tax asset was necessary, the Company evaluated the data and determined that as of December 31, 2013 and 2012 its deferred income tax assets were more likely than not to be realized. Accordingly, no valuation allowance was in place as of either December 31, 2013 or December 31, 2012. The deferred tax balances have been reflected gross on the balance sheet, and are permitted to be netted only if within the same jurisdiction.

As a result of operating losses in past years, the Company was carrying a 100% valuation allowance against its deferred tax assets until the quarter ended September 30, 2011. At that time, the Company determined that based on earnings in recent periods, and expectations for future taxable income, it would be expected to realize the full net value of its deferred tax assets. Accordingly, the Company reversed its valuation allowances in that quarter. This reversal accounts for the Company’s net income tax benefit recorded for the year 2011.

The Company’s net operating loss (“NOL”) carry-forwards as of December 31, 2013 consist of three component pieces: (i) U.S. Federal NOL carry-forwards valued at $7.9 million, (ii) Illinois NOL carry-forwards valued at $2.2 million, and (iii) foreign (Indian) NOLs of $4.4 million. The U.S. Federal NOL carry-forwards belong to Inspire Pharmaceuticals, Inc. and were obtained through the Merck Acquisition completed in the fourth quarter of 2013. The Illinois NOL carry-forwards relate to the Company’s tax losses in the decade of the 2000s and have not yet been fully utilized due to the State of Illinois’s suspension of the use of NOLs for the years 2011, 2012 and 2013. These NOLs would be due to expire from 2021 to 2025, and are expected to be utilized well before their expiration dates. The foreign NOL carry-forwards relate to operating losses by the Company’s subsidiary in India, which was acquired in 2012. The foreign NOLs can be carried forward indefinitely, and the Company has concluded that they are more likely than not to be utilized and therefore has not established a valuation allowance against them. The Company previously had valued NOL carry-forwards in the State of New Jersey. However, due to a change in the tax law, the Company determined that these NOLs could no longer be utilized and wrote them off during 2013.

In 2013, the Company amended its Federal income tax returns to claim research and experimentation tax credits for the years 2003 through 2010 that were not originally claimed due to operating losses incurred in those years. The net benefit of these claims totaled $0.8 million, and was recorded as a reduction to income tax expense for the year ended December 31, 2013.

On January 2, 2013 President Obama signed the American Taxpayer Relief Act of 2012. The Act included an extension of the research and experimentation tax credit for periods ending in 2012 and 2013. Since this extension was not signed into law until 2013, the Company did not include the benefit of R&D tax credits for the tax year 2012 into its effective rate for 2012. The benefit of 2012 R&D tax credit, which totaled approximately $0.6 million, was reflected in the Company’s tax provision in 2013.

The Company’s U.S. Federal income tax returns filed for years 2010 through 2012 are open for examination by the Internal Revenue Service. The majority of the Company’s state and local income tax returns filed for years 2010 through 2012 remain open for examination as well. In the quarter ended December 31, 2013, the Company received notice from the Illinois Department of Revenue that its Illinois income tax returns for the years ended December 31, 2010 and 2011 would be examined. No other examinations of the Company’s income tax returns have been initiated.

In accordance with ASC 740-10-25, Income Taxes – Recognition, the Company performs reviews of its tax positions to determine whether it is “more likely than not” that its tax positions will be sustained upon examination, and if any tax positions are deemed to fall short of that standard, the Company reserves based on the financial exposure and the likelihood of its tax positions not being sustained. Based on its reviews as of and for the years ended December 31, 2012 and December 31, 2013, the Company determined that it would not recognize tax benefits as follows (in thousands):

Balance at December 31, 2011	$	-
Additions relating to current year		1,265
Additions relating to prior years		220
Balance at December 31, 2012	$	1,485
Additions relating to current year		589
Terminations of exposures relating to prior years		(1,229	)
Balance at December 31, 2013	$	845

If recognized, the entire $0.8 million of the above positions will impact the Company’s effective rate. Due to the uncertainty of both timing and resolution of potential income tax examinations, the Company is unable to determine whether any amounts included in the December 31, 2013 balance of unrecognized tax benefits represent tax positions that could significantly change during the next twelve months. The Company accounts for interest and penalties as income tax expense. There were no uncertain tax positions prior to 2012.