According to BDO’s 2021 Life Sciences CFO Outlook Survey, life sciences organizations are doubling down on research and development (R&D), with 69% of life sciences CFOs planning to increase investment in R&D in 2021. At the same time, business and investment decisions are steeped in more risk than ever before, changing the way companies approach R&D spending. As life sciences companies navigate this shifting landscape and prioritize R&D, they must plan to maximize return on investment of R&D spending through diligent tax planning and by capitalizing on the various incentives designed to spur innovation.
The U.S. federal and state governments understand the need to drive innovation within the life sciences industry and to that end have created a litany of incentive programs. Navigating these opportunities—while maximizing benefits, staying in compliance with the law, and reducing strain on internal resources—is a delicate balance, but also a worthwhile endeavor.
This article highlights various programs, guidance and key considerations relating to life sciences tax credit benefits, including:
- R&D Tax Credits
- Payroll Tax Credits
- Orphan Drug Tax Credit
- IRC Section 174
- Collaboration Agreements
- COVID-19 and Recent Legislation
R&D Tax Credits
Life sciences companies may be eligible to claim lucrative federal and state R&D tax credits provided a number of requirements are met. To qualify for such incentives, the company generally must develop or improve functionality, performance, reliability or quality that must evaluate alternatives to eliminate technological uncertainty. Successfully claiming these credits requires diligent documentation of qualifying activities, careful application of certain computational rules and proper exclusion of certain costs (e.g., costs related to activities conducted outside the U.S., costs funded by third parties).
Over the years, the IRS has published considerable guidance for life sciences companies claiming R&D tax credits. While this added guidance increases the complexity of compliance, it also adds clarity that helps companies comply and simplifies the exam process. Life sciences companies should be familiar with the following guidance specifically:
- Pharmaceutical Industry Research Credit Audit Guidelines (ATG)(2004) – The ATG identifies key points and high-risk areas IRS agents are guided to review. Understanding these risk areas can help taxpayers address them, better substantiate the claim and reduce time spent on exams.
- LB&I Directive Regarding Developing New Pharmaceutical Drugs and Therapeutic Biologics (2012) – This directive applies to Large Business and International (LB&I) taxpayers and provides guidance for examiners in determining whether a taxpayer in the pharmaceutical and biotechnology industries has appropriately computed the tax credit for increasing research activities for the development of new pharmaceutical drugs and therapeutic biologics. Specifically, the directive provides that examiners should not challenge a taxpayer’s qualified research expenses (QREs) that are incurred during stages 1 and 2 of the pharmaceutical drug and therapeutic biologics development process and clinical trials as required by the FDA. Stage 1 involves the discovery and pre-clinical stage, while Stage 2 is comprised of all phases of clinical trials. To rely on the IRS Pharmaceutical Directive, a taxpayer’s representative must submit a certification statement confirming that the taxpayer’s QREs are consistent with Section 41 of the Internal Revenue Code.
In addition to this guidance specifically targeting life sciences companies, the IRS has published other helpful guidance, including:
- Research Credit Audit Techniques Guide (2005)
- Research Credit Claims Audit Techniques Guide (RCCATG)(2008)
- LB&I Directive Regarding Taxpayers that Expense Research and Development Costs on their Financial Statements pursuant to ASC 730 (2017) (also known as the 2017 ASC 730 Directive).
2017 ASC 730 Directive
The 2017 ASC 730 Directive is intended to improve the efficiency of the process of resolving exams involving R&D tax credits. It allows LB&I examiners to accept as QREs certain R&D costs currently expensed on a taxpayer’s Certified Audited Financial Statements pursuant to ASC 730. The 2017 Directive applies to original returns timely filed (including extensions) on or after September 11, 2017 for tax periods ending before July 31, 2020.
The 2017 ASC 730 Directive was updated September 10, 2020, with the Revised Directive effective for original returns for tax periods ending on or after July 31, 2020. Developing ideas outlined in the LB&I Concept Unit entitled, “ASC730 Research and Development – How it Relates to IRC 41 and 174” (April 23, 2018), the Revised Directive:
- Updates the taxpayers to whom the Directive applies;
- Clarifies the exam and review process;
- Expands the IRS’s discretion for determining taxpayer eligibility;
- Identifies additional documentation requirements;
- Makes certain software development costs ineligible; and
- Makes certain other costs ineligible.
Payroll Tax Credits
Startup life sciences companies face even greater risk bringing new offerings to the market. Realizing that often these new ventures are critical, but are not always able to take advantage of R&D tax credits as they may not yet have federal tax liability, new legislation has allowed startup life sciences companies to use R&D credits against up to $250,000 of the employer portion of payroll taxes in five separate taxable years—a total of $1,250,000—if they have:
- Gross receipts less than $5 million in the current tax year; and
- No gross receipts for any of the four preceding taxable years.
Determining eligibility for this benefit, documenting the activities and costs qualifying for the credit, and complying with the procedures to obtain the benefit require careful consideration.
Orphan Drug Tax Credit
An “orphan” drug is a therapeutic or treatment for a disease that affects 200,000 or fewer people in the U.S., or for a disease that may affect more than 200,000 people in the U.S. but is unlikely to garner enough sales volume to cover the cost of development. A company developing orphan drugs may be entitled to a tax credit for 25% of expenses relating to clinical trials.
A company seeking orphan designation for a drug must submit a request to the FDA. After the date of designation, expenses related to the clinical phase of the orphan drug’s development are eligible for the credit.
It is important to note that the same expenses may not be taken for both the R&D tax credit and the Orphan Drug Credit.
Section 174 Changes
The Tax Cuts and Jobs Act of 2017 amended IRC Section 174 such that for amounts paid or incurred in a tax year beginning after December 31, 2021, taxpayers will be required to capitalize and amortize Section 174 research and experimental (R&E) expenditures over a five-year period, beginning with the midpoint of the taxable year in which the expenditure is paid or incurred. Costs for research conducted outside of the U.S. will be amortized over a 15-year period. As a result, taxpayers may wish to consider accelerating R&E expenditures or moving development to the U.S.
Current law generally allows taxpayers to deduct Section 174 R&E expenditures as the amounts are paid or incurred during a tax year; alternatively, taxpayers may elect to capitalize and amortize these expenditures over a period of no less than 60 months.
The new provision will impact taxpayers treating R&E costs as deductible expenses by no longer allowing them to recover costs in the year they are incurred. Accordingly, taxpayers currently deducting R&E costs in the year incurred will be required to file an Application for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing such costs for tax years beginning after December 31, 2021.
Life sciences companies frequently collaborate with one another, particularly in drug or therapeutic development efforts. Collaboration can take a variety of forms, including joint ventures, licensing agreement, shared staff or shared intellectual property.
Issues can arise as to which party in a collaboration arrangement is entitled to R&D tax benefits. Recipients of payments under a collaboration agreement should review the agreement terms to determine the appropriate amounts to include in their Section 174 deduction and Section 41 credit calculations. In general, the party entitled to the R&D tax credits must the bear economic risk of the collaboration agreement, but also retain substantial rights to the research results.
COVID-19 and Recent Legislation
Life sciences companies impacted by COVID-19 may be eligible to claim the Employee Retention Credit (ERC), a refundable payroll tax credit for wages paid and health coverage provided by an employer whose operations were either fully or partially suspended due to a COVID-19-related governmental order or that experienced a significant reduction in gross receipts. The ERC may offer a tax credit up to $5,000 per employee for wages paid from March 13 to December 31, 2020. Employers may use ERCs to offset federal payroll tax deposits, including the employee Federal Insurance Contributions Act (FICA) and income tax withholding components of the employer’s federal payroll tax deposits.
The Consolidated Appropriations Act of 2021 (Act), signed into law on December 27, 2020, provides significant enhancements and improvements to the ERC. The Act retroactively provides that employers that received Paycheck Protection Program (PPP) loans may now qualify for the ERC with respect to wages that are not paid with proceeds from a forgiven PPP loan. Further, the Act expands and enhances the ERC for quarters one and two of 2021 by increasing the credit rate from 50% to 70% of qualified wages and the limit on per-employee wages is increased from $10,000 for the year to $10,000 per quarter.
Given the renewed focus on R&D in life sciences, understanding the ins and outs of potential tax credits is more important than ever. As life sciences organizations move forward with their R&D strategies for 2021, they should consider taking the following steps to maximize their return on R&D investment:
- Keep up with the guidance. Life sciences companies should read and understand all tax credit guidance relevant to the particular organization. Any questions should be directed to a tax professional to ensure that the guidance is fully understood.
- Organize all financial documents. Life sciences organizations need to have all pertinent financial information easily accessible and navigable. It’s important to know what information will be needed and to keep it accessible to simplify the tax credit exam process.
- Partner with a professional. When it comes to finances, it’s best to work with a professional who understands tax credits. Life sciences organizations should find a trusted tax partner to help guide them through the tax credit process.
This article originally appeared in BDO USA, LLP’s “Technology & Life Sciences” newsletter (February 2021). Copyright © 2021 BDO USA, LLP. All rights reserved. www.bdo.com