Pharma and Life Sciences Tax News - Vol 7, No. 3
For most pharmaceutical and life science companies, the research credit is a very valuable and critical component of their effective tax rate. Without it, the effective tax rates would be several points higher. As such, this news alert draws your attention to the status of it's re-enactment and some of the computational alternatives.
The section 41 research tax credit -- which was originally enacted (as section 44F) in 1981 and extended numerous times over the intervening years with various modifications -- lapsed after December 31, 2007. Although a number of proposed bills include provisions to extend the credit on a retro-active basis, and to modify the credit rates and calculation methodologies, it is unclear whether or when any of the proposed bills will be enacted, a factor taxpayers need to take into account for financial statement and estimated tax purposes.
Thus, unless and until the credit is extended, taxpayers should not book any research tax credit financial statement benefit (e.g., the credit cannot be factored into a taxpayer's estimated annual rate for purposes of APB 28) for any periods after December 31, 2007. In addition, taxpayers should not factor the credit into any estimated tax payments for any periods after December 31, 2007.
It is also important to note that for the period January 1, 2007 through December 31, 2007, there are three methods for calculating the credit: (1) the Regular Research Credit (“RRC”); (2) the Alternative Incremental Research Credit (“AIRC”) and the new (3) Alternative Simplified Credit (“ASC”). Taxpayers must elect which calculation method they wish to use by making an election (by filing under their desired method on the corresponding section of Form 6765: Section A for RRC; Section B for AIRC and Section C for ASC) on their timely filed original return, including extension.
Note: The Section 45C credit for clinical testing for certain drugs for rare diseases or conditions (a/k/a the “Orphan Drug Credit”) was made permanent by the Taxpayer Relief Act of 1997 (P.L. 105-34) and, therefore, the Orphan Drug credit still remains in effect.
New Alternative Simplified Credit
Beginning in 2007, a taxpayer can elect the ASC to calculate its credit based solely on Qualified Research Expenses (“QRE”). Under the ASC, there is no fixed-base percentage calculation as under the RRC, and there is no four-year average gross receipts component as under either the RRC or the AIRC. The new ASC equals 12 percent of the QRE that exceed 50 percent of the average QRE for the three taxable years preceding 2007. If the taxpayer has no QRE in any one of the three preceding tax years, the ASC rate equals six percent of the QRE for the credit determination year. Unlike the RRC, the ASC does not have a minimum base amount.
Note: For fiscal-year taxpayers that are electing the ASC, the credit must be determined for the full fiscal year, and the taxpayer must prorate the credit using either the RRC or AIRC for the period before January 1, 2007 and the ASC for the period after December 31, 2006. Special rules apply for short taxable years or a 52-53 week tax year.
Impact of the new ASC
With the ASC, many taxpayers may benefit from the removal of the research intensity approach (the relation of QREs to gross receipts) used by the RRC and the AIRC calculation methods. This allows ASC taxpayers to measure the credit solely on the calculation of incremental QREs. This new calculation method is particularly important for taxpayers with:
- AIRC elections in effect;
- Incomplete records from the 1984-88 base period;
- Significant growth of gross receipts in recent years;
- A complex history of organizational activity (mergers, acquisitions, and dispositions); or
- Significant amounts of dividends repatriated into the United States pursuant to the temporary dividends received deduction of section 965.
Note: Because the treatment of section 965 dividends as gross receipts for purposes of the research credit is uncertain, section 965 dividends may have a significant impact on the calculation of four-year average annual gross receipts for purposes of both the RRC and AIRC.
Calculating and substantiating the RRC can be burdensome for many taxpayers. Election of the ASC, although binding, can relieve much of this administrative burden by limiting the base measurement to the three prior years. This is a key consideration for taxpayers that have limited records and/or that have been unable to claim the RRC because their current research intensity is lower than during the credit’s 1984-1988 fixed base period.
For some taxpayers, one key benefit in calculating the ASC is the removal of gross receipts from the equation if their facts reflect a rising revenue stream. In addition, manufacturing and high technology companies may benefit from the ASC if the amount of RRC available to them is limited due to a shift in the relationship of QREs to gross receipts from the base period to current years. During 1984-1988, it was common for manufacturing companies, in particular taxpayers in the government contracting industry, to spend significant amounts on company-funded research in relation to sales in those years. As these companies have decreased research expenditures through the development of more efficient, cost-effective processes, and have received increased amounts of government-funded research, the ratio of QREs to gross receipts has been decreasing, effectively limiting the amount of credit available under the RRC.
Proposed extensions of the credit
A number of introduced bills would extend the research credit, in some cases with modifications. For example, a bill introduced last year by Senate Finance member Orrin Hatch (R-UT) and Finance Chairman Max Baucus (D-MT) would gradually increase the ASC rates from 12% for 2007 to 16 % for 2008, to 18% for 2009, and 20% for 2010 and thereafter and also would eliminate the RRC and AIRC methods after 2009. The Hatch/Baucus bill (S. 2209) also would increase the general qualifying percentage for qualifying contract research from 65% to 80% and make changes to the rules for basic research.
Last fall, the House passed H.R. 3996, which included a provision to extend the research credit for one year (through the end of 2008). The Senate did not take action on that bill. In addition, President Bush, in his recent budget proposal for Fiscal 2009, proposed a permanent extension of the research credit for periods after December 31, 2007.
Financial statement treatment
Companies that routinely claim the U.S. federal R&E credit will have to be careful to properly account for the credit during the lapse period (i.e., after December 31, 2007). Companies must account for income taxes in accordance with currently enacted tax law, which would not include the consideration of new R&E credits generated during a lapse period. Therefore, in estimating the annual effective tax rate for periods that cross over or begin after December 31, 2007, it would not be appropriate to assume reinstatement of the credit. For example, for a company with a March 31 fiscal year-end, the estimated annual effective tax rate to be used each quarter during the year-ending March 31, 2008 would take into consideration the effect of the R&E credit only for qualified expenditures incurred during the first nine months of the year. If the credit is renewed or enacted in some other form, the accounting for the effects of the change in tax law would occur within the period the new tax law is enacted.
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