Income Taxes

(Loss) income before income taxes consists of the following components:



	2014			2013			2012
	(In thousands)
United States	$	(37,613	)	$	(27,473	)	$	(60,627	)
International	11,427			21,890			51,125
Total loss before income taxes	$	(26,186	)	$	(5,583	)	$	(9,502	)

A reconciliation of the income tax provision (benefit) with the amount computed by applying the federal statutory tax rate to income before income taxes is as follows:



	2014			2013			2012
	(In thousands)
Expected income tax (benefit) expense at the statutory rate	$	(9,165	)	$	(1,954	)	$	(3,325	)
State income tax (benefit) expense, net of federal tax	116			138			(38		)
Change in valuation allowance	10,753			10,767			12,730
Tax rate differential on foreign earnings	(5,140		)	(6,404		)	(8,554		)
Reversal of uncertain tax position accruals	(889		)	—			—
Research and other credits	(2,664		)	(7,350		)	(2,571		)
Stock-based compensation	2,088			2,150			1,921
Section 199 deduction	—			1,357			—
Tax impact on unrealized foreign currency gains (losses) on monetary assets and liabilities	3,204			(281		)	—
Expiration of capital loss carryforward	1,741			—			—
Non-deductible interest	1,161			—			—
Other	2,141			1,208			1,415
Total income tax expense (benefit)	$	3,346		$	(369	)	$	1,578

During fiscal 2014, the Company recognized a tax expense of $1.2 million related to the nondeductible interest from its issuance of convertible debt and $1.7 million related to the expiration of capital loss carryforwards which had been fully offset by a valuation allowance in previous fiscal years. This increase in tax expense was partially offset by a reduction to our tax expense of approximately $0.9 million related to uncertain tax positions being effectively settled during the fiscal year. In addition, during the fourth quarter of fiscal 2014, the Company identified an impact to the tax provision related to intercompany loans between subsidiaries. In accordance with local jurisdiction tax laws, the Company must recognize as taxable income/loss the unrealized currency exchange gain/loss resulting from outstanding inter-company loans. As a result, the Company recognized total net tax expense for this matter of approximately $3.2 million during the fourth quarter, the liability of which will be settled through the utilization of its net operating losses.

During fiscal 2013, President Obama signed The American Taxpayer Relief Act of 2012 into law which contained a provision extending the federal credit for increasing research activities (Research and Development Tax Credit) retroactively from January 1, 2012 through December 31, 2013. As a result of this legislation, the Company recorded additional Research and Development Tax Credit carryforwards during fiscal 2013 for amounts generated in fiscal 2012 of approximately $2.4 million. This increase in deferred tax assets relating to these research and development tax credit carryforwards was fully offset by a valuation allowance. In addition, as a result of the Company’s fiscal 2013 taxable loss that was carried back to fiscal 2011, the Company recorded tax expense of approximately $1.4 million in fiscal 2013 reflecting Section 199 deductions recognized in fiscal 2011 that were no longer available as a result of the carryback claim.

In fiscal 2012, primarily as a result of its Settlement Agreement with Broadcom, the Company determined that there was insufficient positive evidence to support a more likely than not recovery of its remaining U.S. federal and state deferred tax assets for amounts greater than the amount of taxes previously paid in available carryback periods. As a result, the Company recorded an increase to its valuation allowance of approximately $16.4 million. In addition, the Company was also only able to recognize tax benefits associated with the U.S. federal research credit for the first half of fiscal 2012 due to the expiration of such tax credit at the end of calendar year 2011.

The components of income taxes are as follows:



	2014			2013			2012
	(In thousands)
Current:
Federal	$	(21	)	$	(7,882	)	$	4,514
State	116			(118		)	401
Foreign	1,836			5,745			3,420
Total current	1,931			(2,255		)	8,335
Deferred:
Federal	—			6,261			(7,850		)
State	—			256			(299		)
Foreign	1,415			(4,631		)	1,392
Total deferred	1,415			1,886			(6,757		)
Total income tax expense (benefit)	$	3,346		$	(369	)	$	1,578

The Company’s deferred tax assets and liabilities are comprised of the following major components:



	2014			2013
	(In thousands)
Deferred tax assets:
Reserves and accruals not currently deductible	$	5,455		$	6,810
Share-based compensation	6,495			9,474
Net operating loss carryforwards	27,908			25,070
General business credit carryforwards	43,923			40,383
Capitalized research and development expenditures	2,873			3,366
Capital loss carryforwards	3,392			5,161
Intangible assets	3,852			4,310
Other	2,241			354
Total gross deferred tax assets	96,139			94,928
Valuation allowance	(72,100		)	(60,091		)
Total deferred tax assets, net of valuation allowance	24,039			34,837
Deferred tax liabilities:
Property and equipment	$	2,636		$	4,173
Intangible assets	34,651			43,453
Other	2,079			1,123
Total gross deferred tax liabilities	39,366			48,749
Net deferred tax liabilities	$	(15,327	)	$	(13,912	)

Deferred income taxes reflect the net tax effects of tax carryforwards and temporary differences between the carrying amount of assets and liabilities for tax and financial reporting purposes. As of June 29, 2014, the Company has recorded approximately $15.3 million in deferred tax liabilities related to its foreign operations. Based on available positive and negative evidence including the Company’s historical results of operations, scheduled reversals of temporary differences, and available tax planning strategies, management concluded that it was more likely than not that the Company’s U.S. federal and state deferred tax assets will not be realizable, and accordingly, has recorded a valuation allowance of approximately $72.1 million as of June 29, 2014.

The Company had approximately $9.2 million of capital loss carryforwards available as of June 29, 2014. If unused, these carryforwards will expire in fiscal year 2016.

As of June 29, 2014, the Company had federal, California, and international net operating loss carryforwards of approximately $55.3 million, $52.9 million, and $12.3 million, respectively, available to offset future federal, state, and international taxable income. If unused, the federal net operating loss carryforwards will expire during the fiscal years 2022 through 2034, and the state net operating loss carryforwards will begin to expire in fiscal 2016. Included in the federal net operating loss carryforwards are ServerEngines losses of approximately $28.6 million, Aarohi Communications, Inc. losses of approximately $19.2 million and Sierra Logic, Inc. losses of approximately $0.4 million. The annual utilization of these net operating loss carryforwards is limited due to restrictions imposed under federal law due to a change in ownership.

The Company had federal and state research and experimentation credit carryforwards as of June 29, 2014, of approximately $16.5 million and $27.4 million, respectively, which are available to reduce federal and state income taxes. If unused, the federal carryforwards will expire during fiscal years 2015 through 2034, and certain state carryforwards will begin to expire in fiscal 2029.

The Company has made no provision for U.S. income taxes or foreign withholding taxes on the earnings of its foreign subsidiaries, as these amounts are intended to be indefinitely reinvested in operations outside the United States. As of June 29, 2014, there are no cumulative amounts of undistributed earnings at the Company’s foreign subsidiaries.

The Company files federal, state, and foreign income tax returns in jurisdictions with varying statutes of limitations. The Company’s federal income tax returns for fiscal years 2008 to 2013 and California income tax returns for fiscal years 2008 to 2013 are open as the statutes of limitations have not yet expired or have been extended. The Company’s California income tax return for fiscal years 2008 and 2009 are currently under examination by the California Franchise Tax Board. In addition, the Company is currently under audit by various state and international taxing authorities. In foreign jurisdictions, with few exceptions, the Company is subject to examinations for all years subsequent to fiscal 2010. The Company does not expect any audits for these foreign jurisdictions to have a material effect on the results of operations of financial position.

The Internal Revenue Service (IRS) completed its examination of the Company’s federal income tax returns for fiscal years 2008 and 2009 and the amended return filed for fiscal year 2007 and issued a 30-Day Letter in March 2014. In the 30-Day Letter, the IRS proposed adjustments related to the amount of "buy-in-payments" made by one of the international subsidiaries to the Company in connection with the cost-share agreement entered into by the Company and its international subsidiary in fiscal 2008. The incremental tax liability asserted in the 30-Day Letter is approximately $70.0 million, excluding interest and penalties. Upon the 30th day from the issuance of the 30-Day Letter from the IRS, the Company began accruing additional interest and will continue to do so until resolution. The Company responded to the 30-Day Letter in May 2014, disagreeing with the IRS' proposed adjustments and the basis for its positions, and will administratively appeal to the IRS Appeals Office.

The Company has previously accrued for what it believes are adequate amounts of tax and related interest, if any, that may result from these state and federal examinations. Such accruals are reviewed quarterly and adjusted as events occur that affect potential liabilities for additional taxes, such as lapsing of applicable statutes of limitations, proposed assessments by tax authorities, negotiations with tax authorities, identification of new issues, and issuance of new regulations or case law. If the ultimate resolution of these examinations are substantially different from the Company’s estimate of any potential associated liabilities, the resulting adjustments could have a material adverse effect on Emulex’s tax provision, net income/(loss) and cash flows.

For fiscal years ended June 29, 2014 and June 30, 2013, the Company had total unrecognized tax benefits of approximately $40.2 million and $42.7 million, respectively. If fully recognized, approximately $26.5 million of the $40.2 million would impact the Company’s effective tax rate. Absent any resolution of the on-going audit by the IRS discussed above, the Company does not expect that the liability for unrecognized tax benefits will change significantly within the next 12 months.

A rollforward of the activity in the gross unrecognized tax benefits for fiscal years 2014 and 2013 is as follows:



	2014			2013
	(In thousands)
Balance at beginning of year	$	42,730		$	39,757
Additions based on tax positions related to the current year	1,110			1,917
Additions for tax positions of prior years	—			1,056
Reductions for tax positions of prior years	(616		)	—
Reductions for tax positions due to a lapse in statute	—			—
Reductions for tax positions due to settlements	(2,979		)	—
Balance at end of year	$	40,245		$	42,730

The decrease in unrecognized tax benefits was primarily due to the effective settlement of audits. In addition to the unrecognized tax benefits noted above, the Company had accrued interest and penalties related to unrecognized tax benefits included in other liabilities of approximately $3.7 million and $3.0 million as of June 29, 2014 and June 30, 2013, respectively.