Is your pharma business missing out R&D tax credits?
The now-permanent U.S. R&D tax credit is designed to encourage and reward comprehensive innovation across numerous industries, encompassing many more activities than simply white lab coat functions.
Although the pharma industry has historically lagged in terms of digitizing operational improvements that many other leading industries are utilizing, comprehensive federal and state R&D tax credit programs can help implement the necessary business improvements. In fact, these credits could be utilized as the pharma industry explores important technology-based trends, including digitizing the supply chain, artificial intelligence, 3D Printing for drug development and discovery and virtual reality/augmented reality visualization.
From startups to big pharma and its supply chain, the industry can benefit in multiple ways from R&D tax credits.
A 40+ year tax provision
The U.S. R&D tax credit was enacted in 1981 and became a permanent part of U.S. tax law effective January 1, 2016. The credit was enacted to create jobs through innovation driven by new and improved products, processes and IT and software. In 1981 the U.S. was concerned about Japanese competition. In 2022, the U.S. is primarily concerned about Chinese competition.
While most companies are aware that drug discovery is an eligible R&D activity, what they may not know is that developing the process to manufacture drugs as well as the inventing, designing and developing of equipment to manufacture drugs is equally eligible.
R&D qualified expenses are typically found in the wages paid to R&D employees, time and material allotted to R&D contractors, as well as the cost of supplies consumed in the R&D process.
The advantage of a forty-plus year tax provision — one that includes regulations, notices and court rulings — is that both the government and taxpayers have an established set of rules that they can work with.
Permanency enables taxpayers to incorporate the tax credit benefits into their prospective business growth plans and economic models.
Safe harbor for large drug discovery companies
For companies with more than $10 million in assets, the IRS has created a ‘safe harbor’ for a portion of the drug discovery process — meaning a portion of a drug discovery company’s R&D Tax Credit resides in a safe harbor and cannot be audited by the IRS.
The IRS defines four stages of the pharmaceutical drugs and therapeutic biologics development process:
- Stage 1: Discovery and preclinical
- Stage 2: Clinical trials
- Stage 3: Regualtory review
- Stage 4: Post approval
While eligible R&D activities may occur in any/all of these stages, the safe harbor relates to expenses in stage 1 and stage 2. With a company’s signing of a certification document, R&D expenses in stage 1 and stage 2 are protected from IRS challenge. Eligible R&D expenses in stage 3 and stage 4 are not protected and could be challenged in an IRS audit.
Federal R&D tax credits for startups
Beginning with the 2016 tax year, the U.S. enacted a new startup tax incentive that provides a cash rebate of up to $1,250,000 over five years. Since 2016, a qualifying startup can use the R&D tax credit against up to $250,000 in payroll or income taxes per year. An eligible startup cannot have had gross receipts that equal or exceed $5,000,000 or more in the current tax year and the five-year period begins in the first year of sales. This provision is particularly helpful for startup pharma and life science companies that have engineers, scientists and software developers on payroll but are not yet profitable or currently have no major income tax liability.
State R&D tax credits
Thirty-five states offer R&D tax incentives in addition to the federal incentives. We are going to concentrate on the major pharma industry states.
New Jersey is a unique state in that it is at the intersection of various manufacturing industries. This list includes the pharma industry, med-tech and life sciences. New Jersey is arguably the manufacturing hub of the Northeast. Pharmaceutical manufacturing is one of the largest manufacturing sectors in New Jersey.
Eligible expenses for the New Jersey state credit are defined according to the same federal standards as defined in RC Section 41(D) of the Internal Revenue Code.
The New Jersey Technology Business Tax Certificate Transfer Program allows new or expanding emerging tech/biotech companies in New Jersey with unused amounts of R&D tax credits which cannot be applied for the tax year, to surrender or transfer those tax benefits for use by other corporation business taxpayers in New Jersey, provided that the taxpayer receiving the surrendered tax benefits is not affiliated with the corporation that is surrendering its tax benefits under the program. The maximum lifetime value of surrendered tax benefits that a corporation shall be permitted to surrender pursuant to the program is $15,000,000.
New Jersey pharma-related companies whose primary business involves the provision of a scientific process, product or service are eligible. The tax taxpayer transferring the R&D credits may receive private financial assistance provided by the transferee to assist in funding the costs of the new or expanding biotechnology that the firm selling the R&D credits incurred. The amount of financial assistance must be equal to at least 80% of the amount of the surrendered tax benefit. The unprofitable company must have fewer than 225 U.S. employees use this provision.
The Pennsylvania State Research & Development Tax Credit largely mirrors the federal R&D tax credit previously discussed. Over one thousand companies utilized the Pennsylvania R&D tax credit in 2020 alone.
The State of Pennsylvania is very transparent and annually publishes a detailed report including company name, industry and amount of state R&D tax credit. The Pennsylvania R&D credit is allocated from a pool of funds, so it is crucial to file for the credit by the statutory deadlines.
There is an annual cap that over the years has reduced the amount of the Pennsylvania R&D credit, per company, by approximately 40%. The actual R&D credits awarded totaled $873 million over the timeframe from 1997 (inception) through 2020.
Large businesses have received $727.5 million of the $873 million in R&D tax credits. The current annual cap is $55 million, $11 million of which is set aside for “small” businesses.
It should be mentioned that three of the top five companies that received and utilized the R&D credit in 2020 were big pharma companies such as Janssen, GlaxoSmithKline and Merck. In fact, Janssen was the number one utilizer of the credit, earning about $6.3 million in R&D credits in Pennsylvania.
Even some of the companies that were not profitable benefitted from the credit thanks to the feature of the Pennsylvania state tax credit, similar to New Jersey, that provides the ability to sell unused tax credits to others. This technique is especially beneficial for small businesses that incur research expenses but have no tax liability.
Similar to the federal credit, eligible costs such as wages, supplies, testing expenses and contractor research expenses can be used to calculate the California R&D tax credit. Unused research credits may be carried forward indefinitely, unlike the federal which is limited to 20 years, making it very attractive to early-stage companies with long development cycles.
Qualified research for purposes of the California R&D tax credit must meet the following four criteria:
- The research must have qualified as a business deduction under IRC §174. [IRC §41(d)(1)(A)]
- The research must be undertaken to “discover information which is technological in nature.” [IRC §41(d)(1)(B)(i)]
- The taxpayer must intend to use the information to develop a new or improved business component. [IRC §41(d)(1)(B)(ii)]
- The taxpayer must pursue a “process of experimentation” during substantially all of the research. [IRC §41(d)(1)(C)]
The California R&D credit is very generous in that the credit rate is 15% over the R&D amount, whereas the federal is about 10%. This means that the California R&D credit can often be greater than the federal credit. Combining both can generate large tax savings for California companies.
The state of Maryland is home to the Maryland HealthTech Coalition which is described as a grassroots effort to promote an ecosystem in the Maryland region that fosters health technology innovation, investment and growth through public and private collaboration, mentorship, leadership, and engagement.
The Maryland R&D tax credit awards a refund of 10% of eligible R&D expenses that exceed the firm’s average R&D expenses over the last four years. The goal is to provide an incentive for businesses to increase their R&D spending each year.
To qualify the business must incur qualified R&D expenses, as defined by § 41(b) of the Internal Revenue Code in Maryland. The tax credit remains in effect until June 30, 2027, subject to extension by the General Assembly.
While New York does not offer a traditional state R&D tax credit, it does have a very large startup life science R&D credit. Effective in 2018, the NYS Life Science Credit offers up to a 20% refundable credit on qualified R&D expenses in New York state. The fact that it is a refundable credit indicates that it can be used to offset a tax liability, or it can be received as a cash refund.
Combined with the benefit of the federal R&D credit for life science startups in New York, there is a potential $2,750,000 in cash rebates over a five-year period per eligible company. These credits can be directly applied to quarterly payroll and income taxes. This recent provision is beneficial for startup life science companies, in operation for fewer than five years, whose focus is research, development or commercialization in life sciences. Some of the industries eligible for this NYS Life Science Startup tax credit include: academic medical centers, agricultural biotechnology, biopharmaceuticals, chemical synthesis, medical nanotechnology, medical & neurological clinical trials, natural product pharmaceuticals, regenerative medicine, RNA interference and stem cell research.
Massachusetts R&D took center stage in the summer of 2020 when Cambridge-based Moderna unveiled one of the world’s first COVID-19 vaccines. Moderna is part of a biotech cluster that has grown into one of the nation’s finest.
Massachusetts does have an R&D tax credit for companies in the state. It provides a 10% R&D credit over the base amount of comparable R&D expense. The credit is limited to the first $25,000 of corporate excise tax, plus 75% of any excise tax more than $25,000.
Massachusetts owes the success of its Boston-area biotech cluster to a late-1970s decision by the Cambridge City Council to allow DNA experimentation. That decision opened the door for Biogen, now one of the state’s largest companies, to establish a base within the city. Other biopharmas followed, including Novartis, Amgen, Pfizer, and, more recently, Moderna. These and other firms drew from dense talent pools emanating from top nearby universities (Harvard, MIT, Tufts, and many others), as well as from a nationally reputed hospital system.
In short order, a cluster was born, wherein Massachusetts firms worked hand in glove with leading universities, hospitals, financing arms, and with one another. Moderna is a case in point, having been formed by two Harvard-educated scientists.
Where to apply R&D tax credits
Digitization of supply chain management:
Recent years have brought supply chain management issues to the forefront, particularly in the COVID-era. One example is the rise of novel therapeutics, such as biologics and vaccines, including the current COVID-19 vaccines, which require specialized materials as well as specific temperature conditions for packaging and transport.
In addition, the advent of sophisticated platforms is driving real-time collaboration across customers, suppliers and distributors requiring new levels of efficiencies, quality, and customer experiences throughout the pharma industry. These platforms can connect various technologies across multiple locations providing customers with real-time visibility into their clinical and commercial supply chain to inform faster and more seamless decision-making.
AI expert models are created to facilitate analyses that can then be used for processes such as inspection preparation, tracking and trending inspection observations, and finding observations and citations ‘hiding in plain sight’ within the deficiency descriptions of warning letters.
VR/AR for drug visualization:
With VR/AR, scientists and physicians can leverage 3D models of patients’ anatomical structures to find ways to deliver outstanding patient care. Using VR in pharma research involves implementing research for drug-target interaction studies and predicting the outcomes of a drug’s effects in the human body.
Another revolutionary use of VR is its support in diagnosing various illnesses. VR can be used alongside other diagnostic devices such as MRI and CT scans to help physicians make an accurate diagnosis and identify many diseases. It is being used to help diagnose complicated diseases such as Alzheimer’s, schizophrenia, PTSD, ADHD, brain trauma and eye conditions.
A prime use of VR in pharma research is for drug-target interaction studies and predicting the outcomes of a drug’s effect in the body. Using VR technology to see how molecules interact and mobilize around the body is extremely beneficial for improving drug discovery and preclinical research phases. This is because the research scientists can see these interactions and mechanisms, which go far beyond human imagination alone. This assists scientists to restructure and reengineer molecules and drugs.
3D Printing in drug discovery and development:
3D printing of drugs has the potential to revolutionize the pharma industry. The primary benefit of using 3D printing for drug development is that 3D printing can produce small batches of drugs with specific dosages, shapes, sizes and release properties. 3D printing also enables flavoring to be included in tablets and pills without requiring film coatings. 3D printers can easily be installed in hospitals, pharmacies, and clinics for on-demand production of medications, especially those with poor shelf-life stability and those that have cold chain storage requirements.
Fully understanding and utilizing comprehensive federal and state R&D tax credit programs can help savvy pharma companies large and small implement the necessary technology-based business improvements.