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This article examines the key ways the new tax bill will impact the pharmaceutical industry.
Companies in the pharmaceutical industry will see both favorable and unfavorable consequences from the U.S. tax reform effort. But, overall, the changes should be viewed as positive for the industry.
“By lowering America’s corporate tax rate, maintaining the R&D Tax Credit, and moving the U.S. to a territorial tax system, the proposal will make the U.S. more competitive on the world stage and support American jobs and manufacturing,” wrote Kenneth Lisaius, senior vice president of communications at Biotechnology Innovation Organization, in a December 2017 statement supporting the Senate proposal.
Generally, the 2017 tax act (Pub. L. No. 115-97) contains rules that impact the availability of deductions and credits, the treatment of intangible assets, and the taxation of cross-border receipts and payments between related parties. Given that pharmaceutical companies invest heavily in R&D and intangible assets, their outlook will be greatly affected by these changes.
Reduced corporate tax rate, participation exemption, and repeal of corporate AMT
The act taxes corporations at a flat rate of 21%, down from the previous top rate of 35%, repeals the corporate alternative minimum tax, and allows a full deduction of the foreign portion of dividends received by corporate shareholders from foreign subsidiaries (this deduction is what is referred to as the “participation exemption”). Companies in the pharmaceutical industry will likely have extra cash on hand as they benefit from the corporate tax cut while excluding from income foreign dividends they receive from foreign subsidiaries.
Deferred foreign earnings are subject to a repatriation tax upon transition to the participation exemption system. These earnings will be taxed at rates lower than the 21% corporate tax rate-15.5% for liquid assets (like cash and cash equivalents) and 8% for noncash assets. The reduced rates are of great benefit to pharmaceutical companies, given their vast amounts of overseas earnings.
Treatment of intangible assets
Noncapital Asset Treatment. The act treats gain or loss from the disposition of a self-created patent, invention, model or design, or secret formula or process as ordinary in character. Such items no longer qualify as capital assets, subject to certain elections that likely do not apply to companies in the pharmaceutical industry.
Credits, deductions, and depreciation
Orphan Drug Credit. The act limits the orphan drug credit to 25% of qualified clinical testing expenses for the tax year. Taxpayers are permitted, however, to elect a reduced credit in lieu of reducing otherwise allowable deductions (similar to the research credit under §280C). This reduction in the credit will affect pharmaceutical companies but should not be considered overly disadvantageous given that the credit was only reduced, not repealed, and other benefits of the tax act will likely offset the partial loss of this credit. Moreover, amounts excluded from the orphan drug credit may be included in the computation of the research credit under §41, although that section offers a much smaller tax benefit.
Interest Expense Deduction. The act limits the deductibility of net interest expense in excess of the sum of 30% of the business’s adjusted taxable income, business interest income, and floor plan financing interest. In determining adjusted taxable income, certain adjustments apply, including the disallowance of deductions allowable for depreciation, amortization, or depletion for tax years beginning before January 1, 2022. Businesses with average annual gross receipts of $25 million or less, however, are exempt from the limit.
Excessive Compensation Deduction. The act modifies the $1 million yearly limit on the deduction for compensation with respect to a covered employee of a publicly traded corporation. The modification eliminates the exceptions for commissions and performance-based compensation. The act also defines “covered employees” to include, generally, the CEO, CFO, and three highest paid employees.
Increased Expensing. The act extends the first-year additional depreciation for qualified property and increases the first-year additional depreciation percentage to 100%. This allows taxpayers to immediately deduct the full cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. For property placed in service after January 1, 2023, the percent that may be expensed will be phased down. It is anticipated that full expensing will provide additional cash, which may increase merger and acquisition activity in the pharmaceutical industry.
Deductions Relating to Domestic Production Activities. Before the 2017 tax act, a taxpayer was allowed, under §199, a deduction based on the taxpayer's income derived from certain production activities and services performed in the United States. The act repeals the deduction under §199 relating to domestic production activities for tax years beginning after December 31, 2017. Despite the reduced corporate tax rate of 21%, companies in the pharmaceutical industry should review the consequences of this repeal as it has implications for the industry.
Amortization of research and experimental expenditures
Under the act, amounts defined as specified research or experimental expenditures, including software development expenditures, are required to be capitalized and amortized ratably over a five-year period. If the specified research or experimental expenditures are attributable to research conducted outside of the United States, they are required to be capitalized and amortized ratably over a 15-year period. Although the provision is applicable to research or experimental expenditures paid after December 31, 2021, taxpayers should immediately evaluate the impact of this provision and plan accordingly.
Additional international considerations
In addition to the participation exemption and repatriation tax mentioned above, there are additional international tax considerations that companies in the pharmaceutical industry must watch, including:
Subpart F Provisions. The act amends the ownership attribution rules to attribute certain stock of a foreign corporation owned by a foreign person downward to a related U.S. person for purposes of determining whether the foreign corporation is a CFC. The act also eliminates the requirement that a corporation must be controlled for 30 days before subpart F inclusions apply.
Base Erosion Provisions. The act subjects U.S. shareholders of CFCs to current U.S. taxation on 50% of “global intangible low-taxed income” (GILTI) with certain allowable deductions. Additionally, the act denies a deduction for any disqualified related party amount (including interest and royalties) paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. A hybrid entity includes an entity treated as fiscally transparent for federal income tax purposes but not so treated under the tax law of the foreign country of which the entity is resident or is subject to tax. The act also imposes a base erosion minimum tax amount which is defined, generally, as the excess of 10% of the modified taxable income of the taxpayer for the tax year over the taxpayer’s regular tax liability for the tax year reduced by the excess of allowable credits over certain credits allowable under §38.
John Bentil can be reached at firstname.lastname@example.org