12.

INCOME TAXES

Income before income tax expense consists of the following:


	Years ended December 31,
	2013		2012		2011
Domestic	$	14,842	$	8,310	$	14,268
Foreign		14,020		22,632		17,437

Income (loss) before income taxes	$	28,862	$	30,942	$	31,705

The components of the income tax expense (benefit) for income taxes are as follows:


	Years ended December 31,
	2013			2012			2011
Current:
Federal	$	4,859		$	4,418		$	4,356
State		472			429			423
Foreign		3,751			5,537			4,195

Current income tax expense (benefit)		9,082			10,384			8,974

Deferred:
Federal		(1,105	)		(1,871	)		(400	)
State		(108	)		(183	)		(40	)
Foreign		(516	)		(386	)		(206	)

Deferred income tax expense (benefit)		(1,729	)		(2,440	)		(646	)

Income tax expense (benefit)	$	7,353		$	7,944		$	8,328

Income tax expense (benefit) for the years ended December 31, 2013, 2012, and 2011 differ from the amount computed by applying the federal statutory corporate rate to income before income taxes. The differences are recorded as follows:


	Years ended December 31,
	2013			2012			2011
Tax expense (benefit) at statutory rate of 35%	$	10,102		$	10,830		$	11,097
State income taxes, net of federal benefit		490			274			471
Foreign tax rate difference		(1,634	)		(2,858	)		(2,910	)
Research and development credit		(957	)		—			(418	)
Change in valuation allowance		(187	)		3			612
Equity based compensation		(212	)		(225	)		(91	)
Manufacturing credit		(249	)		(139	)		(474	)
Other		—			59			41

Total income tax expense	$	7,353		$	7,944		$	8,328

The components of the Company’s net deferred income tax assets and liabilities are as follows:


	December 31,
	2013			2012
Net deferred income tax asset - Current
Intercompany profit in inventory	$	—		$	2,252
Warranty costs		348			290
Bad debt reserve		73			139
Inventory reserve		253			1,059
Unearned service revenue		2,992			2,741
Other, net		935			735

Net deferred income tax asset - Current	$	4,601		$	7,216


Net deferred income tax asset - Non-current
Depreciation	$	(1,559	)	$	(1,871	)
Goodwill amortization		(1,841	)		(1,675	)
Product design costs		(259	)		(190	)
Employee stock options		3,021			1,548
Unearned service revenue		1,654			1,522
Loss carryforwards		14,983			14,825

Deferred income tax asset - Non-current		15,999			14,159

Valuation Allowance		(11,576	)		(11,763	)

Net deferred income tax asset - Non-current	$	4,423		$	2,396


Net deferred income tax liability - Non-current
Intangible assets	$	(1,171	)	$	(1,149	)

The effective income tax rate for 2013, 2012, and 2011 includes a reduction in the statutory corporate tax rates for the Company’s operations in Switzerland. The favorable tax rate ruling requires the Company to maintain a certain level of manufacturing operations in Switzerland. The aggregate dollar effect of this favorable tax rate was approximately $0.2 million, or $0.01 per share, in the year ended December 31, 2013, $0.9 million, or $0.05 per share, in the year ended December 31, 2012, and $0.9 million, or $0.05 per share, in the year ended December 31, 2011.

In 2005, the Company opened a regional headquarters and began to manufacture its products in Singapore. In the third quarter of 2006, the Company received confirmation of a tax holiday for its operations from the Singapore Economic Development Board for a period of four years commencing January 1, 2006 and an additional six-year extension at a favorable tax rate subject to certain terms and conditions including employment, spending, and capital investment. The Company and the Singapore Economic Development Board mutually agreed to end the program as of December 31, 2011, as the Company has expanded its operations in other locations within Asia to meet market demand. The aggregate dollar effect of this favorable tax rate was approximately $0.3 million, or $0.02 per share, in the year ended December 31, 2011.

At December 31, 2013 and 2012, the Company’s domestic entities had deferred income tax assets in the amount of $5,476 and $4,264, respectively.

At December 31, 2013 and 2012, the Company’s foreign subsidiaries had deferred income tax assets relating to net operating loss carry forwards, some of which expire in 5 to 15 years and others which can be carried forward indefinitely, of $14,983 and $14,825, respectively. For financial reporting purposes, a valuation allowance of $11,576 and $11,763, respectively, has been recognized to offset the deferred tax assets relating to net operating losses. The Company maintains a valuation allowance on net operating losses in jurisdictions for which it does not have a history of earnings over the last three years and where the Company believes that the deferred tax assets are not more-likely-than-not to be realized based upon two-year projections of taxable income. The Company released a valuation allowance of approximately $1.2 million in the year ended December 31, 2010 related to net operating losses of a subsidiary in Germany as a result of being included in a group consolidated tax filing with net taxable earnings.

The Company has not recognized any U.S. tax expense on undistributed international earnings, as it intends to reinvest the earnings outside the U.S. for the foreseeable future. The Company’s net undistributed international earnings were approximately $78.2 million and $67.1 million at December 31, 2013 and 2012, respectively.

Significant judgment is required in determining the Company’s worldwide provision for income taxes. In the ordinary course of a global business, there are many transactions for which the ultimate tax outcome is uncertain. The Company reviews its tax contingencies on a regular basis and makes appropriate accruals as necessary.

As of December 31, 2013 and 2012, the Company’s gross unrecognized tax benefits totaled $0.3 million, which includes approximately $0.03 million of interest and penalties. The Company estimates that the unrecognized tax benefits will not change significantly within the next year.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:


	Years ended December 31,
	2013		2012		2011

Balance at January 1,	$	265	$	265	$	265
Additions based on tax positions related to the current year		—		—		—
Additions for tax positions of prior years		—		—		—
Reductions for tax positions of prior years		—		—		—
Settlements		—		—		—

Balance at December 31,	$	265	$	265	$	265

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The table below summarizes the open tax years and ongoing tax examinations in major jurisdictions as of December 31, 2013:


Jurisdiction	Open Years		Examination in Process

United States - Federal Income Tax		2009 - 2013		N/A
United States - various states		2009 - 2013		N/A
Germany		2008 - 2013		N/A
Switzerland		2013		N/A
Singapore		2009 - 2013		N/A

The Company recognizes accrued interest and penalties related to unrecognized tax benefits in tax expense. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate is $0.3 million. FARO does not currently anticipate that the total amount of unrecognized tax benefits will result in material changes to its financial position. The Company is subject to income taxes at the federal, state and foreign country level. The Company’s tax returns are subject to examination at the U.S. federal level from 2009 forward and at the state level subject to a three to four year statute of limitations. In September 2013, the U.S. Internal Revenue Service issued new regulations for capitalizing and deducting costs incurred to acquire, produce, or improve tangible property. These new regulations are effective for taxable years beginning on or after January 1, 2014; however, they are considered enacted as of the date of issuance. As a result of the new regulations, the Company is in the process of reviewing its existing income tax accounting methods related to tangible property. The Company believes that the new regulations will not have a material effect on the Company’s consolidated financial statements.