For the biopharmaceutical industry, research and development are paramount to progress. Without a consistent investment in ongoing R&D, it becomes impossible to identify, develop, and manufacture novel treatments for unmet needs, and to continue developing therapeutics for patients who desperately need them.
According to the EY 2022 Biotechnology Report, R&D expenses have increased by 94% from 2016 to 2021, and new drug approvals by the Food and Drug Administration have increased approximately 80% during that same period. But the drug development process remains expensive and arduous, and it often comes with a high risk of failure. It is frequently estimated that the average drug costs nearly $3 billion to develop and can take at least 10 years to get to market.
Despite this increasing and continued investment in US biopharmaceutical innovation, the industry is hindered by tax laws and proposed legislation. These changes have the potential to make the drug development process more expensive and, ultimately, slower to deliver lifesaving treatments to patients:
- The treatment of the R&D tax credit in the proposed implementation of a global minimum tax under OECD Pillar Two;
- The recently enacted foreign tax credit regulations in the US; and
- The required capitalization of global R&D expenses starting in 2022 for US tax purposes.
Pillar Two’s Impact on R&D Tax Credits
US-based multinational companies that benefit from the credit are at risk of increased foreign taxation under Pillar Two. The calculations call for covered taxes to be reduced by certain non-refundable tax credits, including the US R&D credit. This could reduce the effective tax rate calculation below the minimum 15% in the US, which would trigger top-up taxes in foreign jurisdictions if the US doesn’t adopt Pillar Two.
This can be true for USMNCs that are taxed at an ETR above 15% in the US, due to the variety of differences between the requirements in the Pillar Two ETR calculations and the US GAAP ETR calculations. Unless the US Treasury can negotiate with the Organization for Economic Cooperation and Development to change the calculation of covered taxes, or convert the credit to a refundable credit, USMNCs required to pay in this top-up tax to foreign jurisdictions will see the benefit of the US R&D tax credit effectively nullified. Certain refundable credits, such as those R&D credit regimes in the UK and France, don’t reduce covered taxes under Pillar Two.
For USMNCs in the biopharmaceutical industry, recently enacted FTC regulations have targeted the refundable R&D tax credit regimes used by many foreign jurisdictions. Many USMNCs perform R&D in more than one country and benefit from the regimes available in those countries. In countries such as the UK and France, the R&D tax credit is refundable, and thus acceptable under the Pillar Two regime.
Until January 2022, prior FTC regulations (and associated IRS guidance) allowed for USMNCs receiving benefits from refundable tax credits in foreign jurisdictions to claim an FTC for the foreign tax paid in those jurisdictions. The foreign refundable tax credit was instead treated as a cash refund, resulting from the payment of tax to said foreign jurisdiction. Under the new regulations, taxpayers no longer can claim an FTC for foreign taxes that are reduced for a refundable tax credit if the foreign law first requires that credit to reduce the foreign local tax liability before the taxpayer gets a refund.
These regulatory changes put USMNCs at a disadvantage with their foreign-based competitors. Taxpayers now will have fewer FTCs available to offset their global intangible low-taxed income inclusion, resulting in additional US tax. This won’t be the case for foreign-based biopharmaceutical companies, which will benefit from the refundable R&D tax credits without paying additional tax in their home country.
Additionally, the recently enacted FTC regulations are inconsistent with the financial accounting treatment required under US GAAP, which generally don’t treat refundable tax credits as a reduction to the ETR, but instead as grant income. This is also inconsistent with the Pillar Two treatment of refundable tax credits.
Capitalization of R&D Expenses
Many industries, including the biopharmaceutical industry, are already in the second year of required capitalization of Section 174 R&D expenses. The definition of R&D expenses under Section 174 is much broader than the costs allowable under the R&D credit, and thus this capitalization has resulted in significant (albeit temporary) increases to cash taxes.
With regard to the foreign operations of USMNCs, the required capitalization of foreign-incurred R&D expenses also can increase the GILTI inclusion, combined with the reduced ability to utilize FTCs because of the new FTC regulations against refundable tax credits. This will result in a higher ETR and cash taxes for US companies.
USMNCs generating significant R&D expenses are experiencing an impasse on R&D spending and tax credits. The US R&D tax credit historically has benefited from bipartisan support. Yet under US tax law and OECD Pillar Two Model proposals, USMNCs that perform R&D both at home and abroad are being penalized through the forced capitalization of their R&D expenses—and by a loss of foreign tax credits from jurisdictions where refundable tax credits are available, regardless of whether cash taxes are actually paid in those jurisdictions.
It’s possible that those companies paying more in US tax also will pay more tax in foreign jurisdictions as part of a top-up required under Pillar Two until the US enacts legislation in line with Pillar Two. The combination of this additional tax and increased competition from the foreign-based industry may only increase the cost of the drug development process overall.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Bridget Goutopoulos is corporate vice president of corporate tax at Charles River Laboratories. She has nearly 20 years of corporate tax experience, most of which has been spent in the biopharmaceutical industry.
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