r&d tax incentive opportunities for life sciences …...r&d tax opportunities for life...

R&D Tax Incentive Opportunities for Life Sciences Companies - A Point of View

2

Contents

3. Executive Summary

4. General discussion of the R&D tax credit for Life Sciences companies

5. Global expansion / off shoring and outsourcing – R&D tax credit implications

7. Refundable research tax credit available for 2008 and 2009

8. Orphan Drug Tax Credits

10. Alternative Simplified Credit and the benefits to election

11. Conclusion

R&D Tax Opportunities for Life Science Companies 3

Executive Summary

Since 1981, taxpayers have been able to reduce the cost of R&D through the research and development tax credit.1 The credit is by no means a secret or new — considering that more than six billion dollars in R&D credits were claimed in 2005.2 The research credit is nonetheless widely misunderstood by many companies and their executive teams due to the ever changing landscape of interpretive rulings, regulations and documentation standards.

In an era where life sciences companies are rapidly witnessing industry consolidation, global expansion, off-shoring of manufacturing and clinical trials, and increased scrutiny of the R&D process, the research credit is more important than ever. This Point of View will touch broadly upon these issues, address various complexities with the calculation, and provide guidance for companies to consider when trying to effectively document and address the tax credit surrounding their R&D processes.

•WhatTaxopportunitiesareavailabletomeevenifour company is not currently paying tax?

•WhattimesensitiveissuesshouldIconsiderinorderto not miss any tax savings?

•Arethereadditionalopportunitiesbeyondthetraditional R&D tax credit?

•Whatrecentchangesinthecreditmaybebeneficialto a Life Sciences Company?

This article will help to understand several significant, and time sensitive, tax opportunities available to Life Sciences companies.

Additionally,itwilladdressthe:•extensionoftheR&Dtaxcreditthrough2009,•recentlyenactedAlternativeSimplifiedCredit,•additionalaspectsoftheHousingandEconomicRecoveryActof2008providingtheoptiontoclaima refundable research tax credit in lieu of bonus depreciation, and

•taximplicationsoftheOrphanDrugCreditandpotential issues associated with only considering orphan designation from a sales and marketing perspective.

1 PleasenotethatthisarticlefocusesexclusivelyonUSfederalresearchcreditsunderInternalRevenueCode§§41and174.Whilethisarticledoes not consider additional state-and-local and global tax incentives for engaging in research, this is not intended to convey the message that suchbenefitsaretrivial.Forexample,Californiahasoneofthelargestresearchcreditsinthecountryand,unlikethefederalresearchcredit,ispermanent.

2 “TheCreditforIncreasingResearchActivities:StatisticsfromTaxYears2004–2005,”byEurryKim;StatisticsofIncomeBulletin,Summer2008

4

General discussion of the R&D tax credit for Life Sciences companies

Withrespecttothemanycomplexitiesinthecalculationand documentation of the R&D tax credit, it is important to take a moment to discuss the fact that the Internal Revenue Service (IRS) has designated the research credit asa“TierOne”issueunderitsnewStrategicInitiative.ATierOneissueisdescribedbytheIRSas:“anissuedetermined to have the greatest compliance risk and has animpactonmorethanonebroadindustry.”TheTierOnedesignation has placed compliance issues on the forefront ofconsiderations–particularlywhetherthereisacceptabledocumentation to substantiate the credit.

Life sciences companies should consider whether they are capturingallpotentiallyqualifyingactivities–whichmaybe occurring outside of the traditional R&D cost centers. This is particularly important as many biotechnology and pharmaceutical companies shift their R&D investment strategy from one or two blockbuster drugs, to one of a largeranddiversifiedportfolioofproductsinthepipeline.Witheachlaunch,thereareassociatedmanufacturingandR&D costs that may be eligible for tax credits.

Belowareafewexamplesofindustryinitiativesthatillustrate the breadth of activities that may qualify as eligibleR&Dtaxincentives:

•Developingneworimprovedpharmaceuticals,biologicsor medical devices

•Developingproductionprocessesfornewproducts,includingFDAqualification,validation,andclinicaltesting during Phases I-IV clinical trials

•Establishinganewfactoryorproductionlinewherenew technology is employed or new manufacturing techniques are used

•Manufacturingexperimentalqualificationlotsandclinicaltrial lots

•Manufacturingprocessscale-updesignanddevelopmentefforts

•Creatingcross-functionalprocessimprovementteams,including production and maintenance employee activities as well as continuous improvement initiatives

•DevelopingtechnologyforcompliancewithEPArequirements and environmental remediation

•Developingnewproductandprocessassays•Designinganddevelopingcertainhardwareandsoftware

systems for use in research and clinical development, and medical device equipment used for treating various diseases

•Developingproductimprovementstoincreasetheshelflife or stability of an existing product and reformulation to reduce side effects or dosage

•Supportingneworimprovedproductdevelopmentthrough pharmacovigilance data collection activities, biometrics analyses, informatics, quality, etc.


Global expansion / off shoring and outsourcing – R&D tax credit implications

Acurrentindustrytrendinlifesciencesisthemovementof manufacturing facilities and clinical activities offshore. Companies are increasingly moving production facilities to an emerging market for lower production costs, or moving production to other jurisdictions for protection and leniency of intellectual property. Increasingly, life sciences companies are also conducting clinical trials outside the USeitherforcostbenefitsorforaccesstocertainpatientpopulations, such as countries with patients’ naïve to certain treatments. These activities have been occurring with greater frequency in recent years.

However,whenmovingmanufacturingorclinicaltrialsoffshore, companies must realize that qualifying research and development activity must occur in the United States. Forpaymentstooutsourcingcompaniestobequalified,therearespecificrequirementsthatmustbemet.

ThefollowingtableillustratesactivitiesPharmaandBiotechcompanies are considering off-shoring.

Top reasons for choosing offshore location

19%91%

88%

70%

70%

64%

24%

ExpertiseLow cost of laborTalent pool availableQuality of infrastructure

Location of best service providerCultural proximityGovernment incentives

Source: Lewin, A., and Couto, V., Next Generation Offshoring: The Globalization of Innovation, Offshoring Research Network, Duke University Fuqua School of Business and Booz Allen Hamilton, March 2007

Functions being considered for outsourcing by Pharma and Biotech

To a great extent

To some extent

Not at all

20 40 60 80-60 -40 -20 0

Large scale mfg (bio)

API

Discovery

Large scale mfg(small molecules

Formulation

Analyticalservices

Clinical trials 26 42

36

24

24

24

15

12 8

18

12

15

21

18

26

36

41

47

50

48

58

There are two principal areas to consider with respect to global expansion.

1. Manufacturing – Increasingly, life sciences companies are contracting globally or off-shoring manufacturing activities. The costs incurred to develop manufacturing IP in the US may potentially qualify, but may also require that companies examine the purchase of materials used intheresearchefforttosegregateouttheexpense.Whileall qualifying R&D labor must occur in the US, materials used in research can be purchased ex-US. If a company can segregate the cost of the purchase of materials, the cost can be included as Research and Development if the materials are primarily used in the R&D process. Examplesinclude:(i)thepurchaseofActivePharmaceuticalIngredient(API)whichisthenutilizedintheUSforfurthertesting, (ii) the purchase of the drug product that is produced outside the US but intended for use in US clinical trials, or (iii) supplies for use in development of a new or improved manufacturing or development process in the United States.

Source:GearingUpforaGlobalGravityShift–Growth,RiskandLearningintheAsiaPharmaceuticalMarket,PriceWaterhouseCoopers,May2007.

6

2. Clinical Trials –ClinicalTrialsarebeingconductedwith increasing frequency outside the United States. Life Sciences companies need to make certain that data from clinical trials is made available by the Contract Research Organization(CRO)runningtheglobaltrialonbehalfofthe company to enable costs to be segregated between USandex-USactivities.GenerallythisdataisavailableiftheUScompanyhasworkedwiththeCROtomakecertain that appropriate data points are captured. If Life Sciences companies do not take these measures in advancewiththeirCRO,itbecomesacomplicatedandchallenging look-back process to determine what costs will potentially qualify. To provide the necessary accounting whencontractingwithaCROorconductingothermeansof global trials, it is of critical importance that these discussions occur in advance.

Withrespecttoglobalexpansionandclinicaltrials,therearetwonotableandfavorableexceptionstoconsider.First,the R&D activities that are conducted in the US as part of overall global trials will potentially qualify as research expenditures under the US rules. Second, with respect to clinicaltrialspertainingtoanOrphanDrug,R&Dactivitieswill potentially qualify even if they occurred outside the US, if it is deemed necessary because a US patient population is not large enough to sustain trials within the United States.TheOrphanDrugexceptionwillbeaddressedlaterin this document.

Offshore testing on the rise:

Rest of the World

Western Europe

United States

0%

20%

40%

60%

80%

100%

‘97 ’99 ‘01 ’03 ‘05 ’07

Source: Tufts Center for the study of drug development

Offshore testingSince 1997, scientists based outside the United States have represented a growing portion of the medical researchers whoregisterwiththeFoodandDrugAdministrationtoconduct human studies of drugs


Refundable research tax credit available for 2008 and 2009

Generally,theR&Dcreditisanon-refundabletaxcredit,i.e., companies can utilize the credit to reduce their current tax liability, reduce their estimated tax payments for the current year, or carry back the credit one year to generate a refund for income taxes paid in the prior year. Congress recognized, however, that early-stage biotechnology, pharmaceutical, and medical device companies have not been able to utilize the credit because they are not in a taxableposition.TheHousingandEconomicRecoveryActof2008,signedintolawonJuly30,2008,providesa limited exception to this rule, thereby providing an opportunity for cash refunds for companies who cannot otherwise utilize their research credits. This special tax benefit,undersection168(k)(4),allowscorporationstoclaim refundable tax credits in lieu of 50-percent bonus depreciation for certain capital investments made during theperiodofApril1,2008throughDecember31,2009.Themaximumbenefitis$30Mandonly6%oftheircarryforwardcreditsfrompriorto2006canbecashedin.The“price”companies’payforthisbenefitisgivingupaccelerated bonus depreciation. Companies interested in this benefit must move quickly because there are strictly enforced rules regarding the timing of the election that must be made to take advantage of this opportunity, i.e., elections must be made on timely filed original returns in most cases.Moreover,thecalculationofthisbenefitiscomplicated and beyond the scope of this article.

The enactment of the provision has been favorable to taxpayersonboththefinancialandpolicyfronts.First,it serves to provide a cash infusion for companies at a timewhenthereisaseverecapitalcrunchinthefinancialmarkets.Forexample,emergingbiotechnologycompaniesthat made new capital investments during much of 2008 in qualifying laboratory equipment, software, or those gearing up for commercialization, will be able to receive a refundable tax credit (i.e., the amount of the credit will be refunded to the company, even if it is not paying taxes as it is in a "loss" position). Second, the enactment of this

provision is an important policy victory for this industry in that it reflects Congress' growing understanding that manyLifeSciencescompanies,whilenotyetprofitable,areengaged in research that is highly valuable to the growth and well being of our nation.

Since the tax code generally requires a company to use its accumulatedNetOperatingLosses(NOLs)beforeitstaxcredits can be claimed, the ability to use R&D credits is doublybeneficialinthelifesciencesindustry.Asaresult,R&D credits may expire before they can be fully utilized. The provision not only allows companies to accelerate the date when they can claim their R&D credits, it also allows companies to claim credits that might otherwise expire and be permanently lost to the taxpayer.3

Hereisanexampleofanearlystagebiotechnologycompanythattookadvantageofthisnewlaw:Thecompanyhadaccumulatednearly$30millionofunusedR&D credits from 2005 and earlier years that they had been carrying forward since they had not generated taxable income. The company opened a new facility to manufacture clinical trial supplies in 2008, which would have afforded them bonus depreciation. Their carryforward credits could not be utilized in 2008 due to their loss position, and bonus depreciation merely increased their losses, providing no immediate tax relief. This company was nonetheless able to make a timely election to monetize a portion of their carryforward R&D credits in 2008 in lieu of bonus depreciation allowance. This election providedthecompanyanearly$2millioncashrefundbyenabling them to cash-in research credits that could not be utilizedin2008–andmayhaveneverbeenutilizedduetothe limited period for carrying forward research credits.

3 R&D credits post-1998 may be carried forward for 20 years. Those before 1998 expire after 15 years.

8

Orphan Drug Tax Credits

AnOrphanDrugisaclassificationofdrugthathasbeenspecificallydevelopedtotreatauniqueorraremedicalcondition, and is marked by a small class of patients that suffer from a particular disease or ailment. The governmentenactedtheOrphanDrugActof1983toincentivize biotechnology and pharmaceutical companies to work to combat these unique conditions rather than purely focusing on developing larger more widely applicable(andthereforemoreprofitable)drugs.Oftenoverlooked,the‘OrphanDrug’designationismorethanjust a pharmaceutical marketing position. It provides a significanttaxbenefit,aswell.AlthoughOrphandiseasesaffect a much smaller class of patients, the US government isincentivizinglargecompaniestodevelopspecificdrugs to help the limited patient classes through various incentivesincludingtheOrphanDrugCredit(ODC).

TheODCprovidesaverylucrativeincentiveintheformofasignificanttaxcreditavailableforcertainactivitiesrelatedtodevelopingtheorphandrug.Fromatechnicalstandpoint, we are providing a brief description of activities thatmayqualifyundertheODCregime.

Section 45C(a) of the Internal Revenue Code (IRC) provides that taxpayers may claim a credit against income tax equal to50%of“qualifiedclinicaltestingexpenses”paidorincurredduringthetaxableyear.IRCSection45C(b)definestheterm“qualifiedclinicaltestingexpenses”byreferencetosection41(b)–whichdefinesexpensesqualifyingforthesection41researchcredit–exceptthatsection45C expenses must be incurred with respect to “clinical testing”(asdefinedbelow)ofanorphandrugorbiologicalproduct, rather than simply being incurred with respect to thebroadercategoryof“qualifiedresearch”describedinsection41(d).Asaconsequenceofthiscross-referencetosection 41(b), the following expenses incurred with respect to clinical testing of a designated orphan drug are eligible forthesection45Ccredit:

(1) “in-houseresearchexpenses,”meaning(a)wagespaid to employees for directly engaging in, or directly supporting or supervising, clinical testing of an orphan drug, (b) amounts paid for supplies used in the conduct of such clinical testing, and (c) certain amounts paid to another for the right to use computers in the conduct ofsuchclinicaltesting;and

(2) “contractresearchexpenses,”meaningamountspaidto any person (other than an employee) for clinical testing of an orphan drug undertaken on the payor’s behalf.

AnimportantelementoftheODCfocusesonavailabilitytoincludeasqualifiedexpensesthoseexpensesrelatedtoactivitieswhichoccurredoutsideoftheUS.AsOrphandiseases are rare and therefore patients may be scarce, the required testing patient population in the United States

0 20 40 60 80

Transplantation

Respiratory disorders

Other

Neurological disorders

Infectious diseases

Genetic disorders

Cardiovascular diseases

Cancer-related conditions

Cancer, Skin

Cancer, Blood

Cancer

Blood disorders

Autoimmune Disorders 16

3

81

42

19

9

7

26

28

35

37

13

7

Orphan drugs in Development*

*Some medicines are listed in more than one category.Source: Orphan Drugs in Development Report - Presented by America's Biopharmaceutical companies, Genetic Alliance, and National Organization For Rare Diseases; RARE DISEASES 2007; Pharmaceutical Research and Manufacturers of America


maybedifficulttoobtain.Thus,manycompaniesarefindingpatientpoolsonaglobalscale.Asglobalizationofclinicaltrialsincreases,theODCallowsacompanytopotentiallydeductasignificantportionofitsrelatedexpenses that would not have otherwise been available to offset costs of globalized clinical trials. If a company candemonstratethattherearenotasufficientnumberofpatients with the particular condition, disease or ailment intheUnitedStatestoallowforefficientenrolmentofapatient class such that conducting the clinical trials solely in the U.S. would lead to a delay of several years in obtaining the required testing results, it is likely that the exception forforeigntestingundersection45C(d)(2)(A)wouldbeavailable.

IfacompanydoesnotreceiveOrphandesignationbeforeclinical trials begin, then the credit may be lost for certain tax years. This incentive is available once a company receivesorphandesignationandupuntilthedateofFDAapproval for that drug (for any indication). Consequently, itisessentialthatacompanywhoisapplyingforOrphanstatus do so very early in the research process to take advantage of the credit in early years of the development effort.ThisvaluabletaxbenefitshoulddispelthecommonmisunderstandingthattheOrphanDrugActisonlyimportant for product marketing purposes.

10

Alternative Simplified Credit and the benefits to election

Current IRS enforcement policies have forced tax departments and R&D functions to focus on whether they have the documentation needed to determine, as well as to sustain, R&D tax credits. This is due, in part, to the fact that the research credit is an incremental credit computed on the increase of research spending over the amount the company would be expected to spend on research (called the“baseamount”).Determiningthebaseamountforthe traditional credit requires companies to substantiate the amount of research spending during the years from 1984–1988,orfortheinitialyearsofoperation(ifnotinexistenceduring1984-88).TheIRS’sTierOneprogramdirects IRS examiners to focus on whether research credits areadequatelysubstantiated–notonlyforthecurrentyear–butalsoforthebaseperiod.Whatmakesthisissueparticularlydifficulttoaddressisthatthereisnoclearlegalstandarddefining“adequatesubstantiation.”Recognizingthedifficultiestaxpayersfacedinsubstantiatingresearchspendingoccurring10–20yearsago,ledtotheenactmentoftheAlternativeSimplifiedCredit(ASC)–whicheliminatestheneedtosubstantiateresearchspending occurring many years ago. This new credit optionisparticularlybeneficialforlifesciencescompanies,which often lack the time and resources to effectively document the R&D process in real-time and, thus, may not have the records often requested by IRS examiners to substantiate the traditional base amount.

TheASCprovidescompaniestheopportunitytoclaima credit without having to compute the historical base amountbysimplyquantifyingtheirqualifiedR&Dexpenditures for the current tax year and the previous threetaxyears.Thebaseamountis50%oftheaverageprior three years of qualifying R&D expenditures. Taxpayers thengetacreditequalto12%(7.8%aftertheSection280C(c) reduced credit adjustment) of the excess R&D spend over this base amount. This credit amount increases to14%(net9.1%)fortaxyearsendingin2009.Sounlessataxpayer'sR&Dspendisdownsignificantly,theywouldvirtuallybeassuredofgettingacreditundertheASC,butmay not be able to get over the traditional base amount.

Theopportunityisalsosignificantfortaxpayerswhohistoricallyhavenotclaimedacreditandhaveafiscalyearendedin2009becausetheycanclaimthe14%ASCcreditfortheentireyear,whichendsin2009.FiscalyeartaxpayerscanalsotakefinancialstatementbenefitfortheASCbeginninginthequarterendingafterDecember31,2006(thefirstquarterfollowingtheeffectivedateofthenewlawcreatingtheASC).Also,itisveryrelevanttotaxpayerswhohadsignificantincreasesinrevenueinrecent years which resulted in a substantially increased base amount for the traditional credit.

ItisimportanttonotethattheASCisanelectivecreditandmustbeelectedonatimelyfiledtaxreturn.OncetheASCiselectedforthetaxyearitisirrevocable,butonlyforthattaxyear,i.e.,ataxpayercouldnotelecttheASCandthenfileanamendedreturnreportingtheregularcreditforthesametaxyear.TheASCelectiondoesnot,however, bind the taxpayer to that election for subsequent tax years because the regulations allow taxpayers to revoke the election by simply reporting the traditional credit on atimelyfiledoriginalreturn.Consequently,taxpayerscanelectin-and-outofthetraditionalandASCcreditsaslongastheyarereportedontimelyfiledoriginaltaxreturns.

Afewnotableitems:ExamplesofcompaniesthatwillbenefitfromtheASCwouldincludecompanieswhich:• currentlyareusingtheAlternativeIncrementalCredit

or those who have no R&D credit due to base amount considerations;

• currentlyhavelimitedcreditopportunityduetoincreasinggrossreceipts;

• areplanningalargeresearcheffortinthecurrenttaxyear(relativetoresearchspendinginprioryears);

• havedifficultydeterminingtheir”regular”baseamountduetolackofsubstantiationfromthehistoricalperiod;or

• aresmallercompaniesthatcannotjustifythecompliancecost of reconstructing data from the historical base period.

•


Conclusion

TherearesignificanttaxopportunitiesavailableforR&Dactivities being engaged in at Life Sciences companies. However,therehavebeenchangestohistoricalincentivesand new incentives are available that make these tax opportunitiessignificantlyeasiertoclaim,aswellaspotentially more lucrative. Now more than ever, companies are taking a new look at the opportunities available to save valuable tax dollars and to potentially infuse cash into their companies for the current year. Deloitte Tax is well-positioned to team with and help your company with compliance and strategic issues.

For more information about exploring tax opportunities for your organization, please contactMichael GoldbasTax PrincipalDeloitte Tax LLPHartford,CTTel:[email protected]

Steve ArkinTax DirectorDeloitte Tax LLPWashingtonD.C.Tel:[email protected]

Tori BoeghSeniorManagerDeloitte Tax LLPLosAngeles,CATel:[email protected]

r&d tax incentive opportunities for life sciences …...r&d tax opportunities for life...

Documents