INCOME TAXES

We determine our periodic income tax provision based upon the current period taxable income and our annual estimated tax rate adjusted for any change to prior period estimates. The estimated tax rate is revised, if necessary, as of the end of each successive interim period during the fiscal year to our current annual estimated tax rate.

Since our October 21, 2010 acquisition of Heartland, we have been conducting business operations in India. The Indian operations are conducted through both flow-through entities and foreign controlled corporations. We have included the Indian results from operations conducted through the flow-through entities in our U.S. current and deferred income tax provision calculation. We have undistributed foreign earnings in the foreign corporations, which we intend to permanently reinvest overseas. We also intend to reinvest future foreign earnings overseas. Therefore, no U.S. corporate income taxes have been provided on undistributed foreign earnings of the foreign corporations.

Current provisions for state income taxes of $398,000, $516,000 and $441,000 were recorded in 2011, 2010 and 2009, respectively, for states in which we pay alternative minimum tax or no net operating loss carryforwards were available. Income tax expense (benefit) was as follows:



	2011			2010		2009
Current:
Federal	4,662,000			4,758,000		2,985,000
State	398,000			516,000		441,000
Foreign	604,000			133,000		—
Settlement of uncertain tax position	(6,759,000		)	—		—
Total current	(1,095,000		)	5,407,000		3,426,000

Deferred:
Federal	1,868,000			310,000		636,000
State	347,000			83,000		(18,000		)
Settlement of uncertain tax position	(153,000		)	—		—
Foreign	(14,000		)	22,000		—
Valuation allowance	—			—		(7,000		)
Total deferred	2,048,000			415,000		611,000
Income tax expense	$	953,000		$	5,822,000	$	4,037,000

A reconciliation between the amount determined by applying the federal statutory rate to income before income taxes and income tax expense (benefit) is as follows:



	2011					2010				2009
	Amount			Rate		Amount		Rate		Amount			Rate
Income tax expense at federal statutory rate	$	6,997,000		35.0	%	$	4,881,000	34.0	%	$	3,671,000		34.0	%
State and local tax expense , net of federal benefit	607,000			3.1	%	424,000		3.0	%	262,000			2.4	%
Stock-based compensation and other permanent items	76,000			0.4	%	209,000		1.5	%	120,000			1.1	%
Decrease in valuation allowance	(72,000		)	(0.4	)%	—				(7,000		)	**
Non-deductible transaction costs	124,000			0.6	%	94,000		0.7	%	—
Income from foreign entities	—					68,000		0.5	%	—
Tax effect of foreign operations	252,000			1.3	%	—				—
Settlement of uncertain tax position	(6,912,000		)	(34.6	)%	—				—
Other	(119,000		)	(0.6	)%	146,000		0.9	%	(9,000		)	**
Income tax expense / effective tax rate	$	953,000		4.8	%	$	5,822,000	40.6	%	$	4,037,000		37.4	%
** Less than 0.1%

At December 31, 2011 we had a net deferred tax liability of $297,000 as compared to a net deferred tax asset of $799,000. The December 31, 2010 balances have been adjusted to reflect the following retroactive adjustments related to the 2010 purchase of Heartland, a $153,000 decrease to the deferred tax asset, and a $2,900.000 increase to the deferred tax assets and a corresponding $2,900,000 increase to the valuation allowance. The components of the net deferred tax assets as of December 31, 2011 and 2010 were as follows:



				2011					2010
	Current			Long-Term		Total		Current	Long-Term		Total
Deferred tax assets:
Net operating loss carry forward				5,931,000		5,931,000		113,000	2,325,000		2,438,000
Allowance for bad debts	65,000					65,000		45,000			45,000
Share based compensation				792,000		792,000			238,000		238,000
Compensation accruals	60,000					60,000		149,000			149,000
Foreign tax credits				2,900,000		2,900,000			2,900,000		2,900,000
Foreign tax asset				264,000		264,000			327,000		327,000
Intangibles				311,000		311,000
Deferred rent	57,000			—		57,000			57,000		57,000
Other	38,000			197,000		235,000		22,000	55,000		77,000
Total	220,000			10,395,000		10,615,000		329,000	5,902,000		6,231,000
Deferred tax liabilities:
Intangible assets				(4,064,000	)	(4,064,000	)		(1,913,000	)	(1,913,000	)
Capitalized software				(2,656,000	)	(2,656,000	)
Fixed assets				(562,000	)	(562,000	)		(252,000	)	(252,000	)
Cash to accrual				(235,000	)	(235,000	)
Prepaid expenses	(237,000		)			(237,000	)
Other				(20,000	)	(20,000	)		(57,000	)	(57,000	)
Total	(237,000		)	(7,537,000	)	(7,774,000	)		(2,222,000	)	(2,222,000	)
Total deferred tax asset (liability), net	(17,000		)	2,858,000		2,841,000		329,000	3,680,000		4,009,000
Valuation allowance	—			(3,138,000	)	(3,138,000	)		(3,210,000	)	(3,210,000	)
Net deferred tax asset (liability)	$	(17,000	)	(280,000	)	(297,000	)	329,000	470,000		799,000

A valuation allowance is required to be recorded against deferred tax assets if, based on the available evidence, it is more likely than not that such assets will not be realized. When assessing the need for a valuation allowance, appropriate consideration should be given to all positive and negative evidence related to the realization of the deferred tax assets. This evidence includes, among other things, the existence of current and cumulative losses, forecasts of future profitability, the length of statutory carry-forward periods, our experience with loss carry-forwards expiring unused, and available tax planning strategies. At December 31, 2011 and December 31, 2010, we have recorded a valuation allowance of $3,138,000 and $3,210,000 related to expected future utilization of state net operating loss carry-forwards and foreign tax credits resulting from recent acquisitions. The conclusion to record the valuation allowance is based on the inability to predict, with any degree of certainty, whether we will generate income in the corresponding jurisdictions necessary to utilize these tax attributes.

With the 2010 acquisition of Heartland and the 2011 acquisition of DTS, we acquired net operating loss carry-forwards of approximately $17.3 million for Heartland and $23.4 million for DTS, which relate to losses incurred prior to their acquisition by Transcend. These net operating loss carry-forwards will begin to expire in 2023. As a result of the acquisitions, future utilization of these net operating loss carry-forwards is subject to the provisions of Section 382 of the Internal Revenue Code of 1986, as amended. As a result of the preliminary Section 382 analysis we expect $10.2 million and $14.1 million, for Heartland and DTS respectively, to expire unused. We have not established a deferred tax asset for those net operating loss carry-forwards which are expected to expire unused. Based on historical earnings and expected future taxable income, we have established a deferred tax asset in the amount of $2.4 million for Heartland and $3.5 million for DTS, representing the tax benefits related to the available net operating loss carry-forwards. We believe all of the net operating loss carry-forwards recorded as a deferred tax asset will be fully utilized before expiration, thus no valuation allowance has been recorded with respect to these federal operating loss carry-forwards. During the third quarter, 2011, we finalized the Section 382 analysis for the Heartland acquisition and have recorded an increase of $72,000 to goodwill. We plan to complete the same analysis for the DTS net operating loss carry-forward by the second quarter of 2012. In 2011, 2010 and 2009, we utilized net operating losses of $738,000, $657,000 and $5,163,000, respectively.

With limited exception, we are no longer subject to examination by the U.S. federal or state tax authorities for years prior to 2007. We are currently under examination by the Indian tax authorities for the 2003 through 2011 tax years and by the Internal Revenue Service for 2009. We have accrued for potential additional tax liabilities associated with these examinations and do not believe the ultimate resolution will have a material impact on our operations.

We account for all potentially uncertain tax positions in accordance with the provisions in FASB ASC Topic 740-Income Taxes which prescribes a recognition threshold of more-likely-than-not to be sustained upon examination. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax rules and the potential for future adjustment of our uncertain tax positions by the United States Internal Revenue Service or other taxing jurisdictions.

The initial evaluation of uncertain tax positions resulting from the 2010 acquisition of Heartland was related to intercompany transfer pricing, a liability was established at acquisition and had a balance of $4,681,000 at December 31, 2010, adjusted for a retrospective adjustment of $141,000 and an interest allocation adjustment of $(504,000). In 2011, we received a final transfer pricing decision for three tax periods for a total adjustment of $(471,000) that was deducted from the liability and run through current tax expense. We have been adding to the liability for additional taxes on current operations. At December 31, 2011, the tax liability balance is $3,487,000. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:



Balance December 31, 2009	$	—
Additions based on tax positions related to the current year	89,000
Increase due to business combination (1)	4,269,000
Reductions for tax positions of prior years	—
Balance December 31, 2010 (2)	4,358,000
Additions based on tax positions related to the current year	314,000
Settlement of prior years	(471,000		)
Reductions for tax positions of prior years	—
Impact of rate change	(675,000		)
Balance December 31, 2011 (3)	$	3,526,000
(1) Reflects retrospective adjustment of $141,000 and reallocation of interest of $(504,000) and the reclassification of the liability related to the MDSI acquisitions of $40,000
(2) This amount is offset on the balance sheet by advance tax payments of $2,928,000
(3) This amount is offset on the balance sheet by advance tax payments of $3,027,000

We recognize additional accrued interest and penalties related to gross unrecognized tax benefits in income tax expense. As of December 31, 2011 and 2010, accrued interest and penalties related to unrecognized tax benefits was $1,485,000 and $1,491,000 (adjusted $504,000 for interest reallocation of the total liability), respectively. As of December 31, 2011, we do not expect the unrecognized tax benefits to change significantly over the next 12 months.

During the second quarter of 2011, we identified an uncertain tax position pursuant to ASC 740 that resulted in recording a liability of approximately $5,300,000. Further analysis was done in the third quarter, and the liability was adjusted to $6,759,000. This uncertain tax position related to prior tax returns filed by Heartland prior to the 2010 acquisition with respect to the deduction of certain dual consolidated losses generated from Heartland's India operations. We filed for administrative relief from the Internal Revenue Service in August and were granted the relief in November. Since the relief came outside of the one year period from the October 2011 purchase date of Heartland, the reduction of the uncertain tax position was taken to current tax expense.

As of December 31, 2011 and December 31, 2010, the total amount of unrecognized tax benefits was $3,526,000 and $4,358,000, respectively, all of which would affect the effective tax rate if recognized.

Our effective income tax rate, excluding the tax benefit related to the settlement of uncertain tax positions recognized in 2011, was approximately 39.3% and 40.6% for the years ended December 31, 2011 and 2010, respectively.