The Orphan Drug and Research Tax Credits: The “Substantially All” Rule

Originally introduced in the Economic Recovery Tax Act of 1981, 1 the Sec. 41 credit for increasing research activities is a Sec. 38 general business tax credit commonly referred to as the research tax credit or research credit. The research credit was enacted because Congress was concerned that the United States' economic performance had fallen behind globally. The research credit was intended to increase economic growth and overall U.S. competitiveness by offsetting the tax liability for those companies that incurred research and development expenses. The research tax credit applies to taxpayers operating in various industries, ranging from heavy industrials and manufacturing, defense and aerospace, pharmaceuticals and biotechnology, to computer engineering and software development. 2

Throughout the history of the research credit, numerous attempts have been made 3—most recently, as part of the American Taxpayer Relief Act of 2012 4—to modify, amend, and extend the law or to repeal certain provisions. Perhaps the most notable modifications to the research credit were the introduction of additional methods for computing the credit by the Small Business Job Protection Act of 1996 5 and the Tax Relief and Health Care Act of 2006, 6 and the provision of enhanced tax benefits to taxpayers that operate in the energy sector by the Energy Policy Act of 2005. 7

To encourage the development of drugs for uncommon diseases and conditions that affect less than 200,000 people in the United States, 8 Congress passed the Orphan Drug Act of 1983 9 and the Rare Diseases Act of 2002. 10 These acts were intended to offer a number of incentives to pharmaceutical companies that develop drugs to treat uncommon diseases and to establish a centralized system to coordinate and facilitate the development of those drugs. 11 Among these incentives is a tax credit equal to 50% of the development costs attributable to qualified clinical testing, which, unlike the research credit, is now a permanent part of the Code. 12 Similar to costs considered qualified under the research tax credit, costs considered qualified under the orphan drug tax credit include wages paid to employees for qualified services, i.e., to conduct, directly supervise, and directly support qualified clinical testing activities.

This article examines the methods for computing qualified wages in situations where a taxpayer conducts qualified research and clinical testing that qualify for both the research tax credit and the orphan drug credit in the same tax year. 13

Conducting Qualified Research and Clinical Testing in the Same Tax Year

Pharmaceutical companies often conduct a wide range of activities involving drug discovery and design that range from identifying and designing new molecular and chemical entities, preclinical work that relates to studies about safety, toxicity, pharmacokinetics, and pharmacodynamics, 14 and clinical testing that encompasses drug safety, dosages, and efficacy. Often, this wide range of activities may be performed by the same individuals within the company.

The expenses the taxpayer incurs in performing preclinical work can be considered qualified expenses for computing the research tax credit if the associated activities meet the qualification requirements outlined in Sec. 41 and Regs. Secs. 1.41-1 through 1.41-8. In contrast, the clinical testing performed for a drug that is designated 15 by the Food and Drug Administration (FDA) as an orphan drug can be considered qualified for computing the orphan drug tax credit only after the date of the designation. While clinical testing performed by the company before the date of designation is not a qualified expense for computing the orphan drug tax credit, 16 it may be for computing the research tax credit.

Similarly, after the FDA approves a designated drug for patient use, the pharmaceutical company may choose to engage in additional clinical testing, post-approval clinical trials, post-­marketing surveillance studies, or any other activities (e.g., formulation research, development or improvement of delivery methods or systems). Although they are related to the orphan drug for which the designation has been obtained, these activities are not eligible clinical testing for the orphan drug tax credit 17 as they occur after the date the FDA approved the drug.

Only clinical testing activities that occur between the orphan drug designation date and the FDA approval date can be considered qualified clinical testing for the orphan drug tax credit. This clinical testing must be related to human clinical testing, which is defined as clinical testing that uses human test subjects (as participants to whom the drug is administered or control subjects, which may be healthy individuals or patients) to determine the effect of the designated drug on humans and is necessary for the drug to be approved for sale. 18 Any activities the taxpayer conducted that are outside of this time interval can be considered qualified for the research tax credit only if these activities meet the general requirements for qualified research under Sec. 41.

When qualified activities the taxpayer conducted are a combination of qualified research and clinical testing, the taxpayer must separate the associated expenses before computing the research tax credit and the orphan drug tax credit if the taxpayer decides to claim both tax credits during the same tax year.

This separation of expenses related to qualified research and clinical testing activities is mandated by Sec. 45C(c)(1), which explicitly prohibits including any of the same expenses used to compute the orphan drug tax credit in the qualified research expenses used to compute the research tax credit.

Research and Clinical Testing Performed Outside of the United States

To correspond with the congressional intent to promote research and development in the United States, for purposes of the research and development credit, any research conducted outside of the United States is not considered qualified research. 19 Generally, a similar rule applies to clinical testing of orphan drugs conducted outside the United States for purposes of the orphan drug credit. 20

Often, when conducting clinical testing of pharmaceutical drug candidates to treat rare diseases and conditions, it becomes difficult—if not impossible—to recruit an adequate number of test subjects solely within the United States. This is particularly true during the later stages of clinical testing when the subject testing population needs to be expanded. The initial phases of the clinical trials to test pharmacodynamics, pharmacokinetics, or even the physiological safety of active pharmaceutical ingredients often can be conducted in the United States because the testing population required to conduct these studies is usually not as expansive compared to the testing populations needed to meet the randomization standards of later stage testing phases. In any case, at any point in the testing process, it can be rather problematic to identify a sufficient number of test recruits solely within the United States.

As a result, current law treats clinical testing expenses incurred outside of the United States as qualified if a sufficient testing population is unavailable in the United States. There is an insufficient testing population in the United States if the taxpayer is unable to gather reliable and reproducible clinical testing data solely from clinical testing conducted in the United States. In situations where qualified clinical testing expenses include those incurred outside of the United States, it is advisable to maintain adequate documentation to demonstrate the taxpayer's inability to identify a sufficient testing population solely within the United States. The taxpayer can make this documentation available at the request of a tax examining authority in the event of an audit.

Computation of Qualified Wages Under the "Substantially All" Rule

Under the research credit regulations, 21 qualified wages (qw i) for an employee (i) are determined as the product of taxable wages (tw i) and the ratio of time (qp i) spent by employees conducting, directly supervising, or directly supporting qualified research activities 22 to the total working time: qw i = tw i × qp i. Nonworking activities, such as vacation, holidays, sick leave, and similar time, are generally not included in total working time to arrive at the total qualified wages. The qualified wages paid to conduct clinical testing for drugs for which orphan drug designation is obtained are computed similarly.

Under the "substantially all" rule, if an employee spends 80% or more of his or her time performing qualified services, then the employee's total taxable wages are considered to be qualified wages. 23 Thus, if qp i ≥ 80%, qw i = tw i; however, if qp i < 80%, qw i = tw i × qp i.

The "substantially all" rule applies to the calculation of the total qualified wages for computing the research tax credit, as well as the orphan drug tax credit. The "substantially all" rule, however, applies only when computing qualified wages, not when computing qualified supply and contract research expenses.

How to Apply the "Substantially All" Rule to Qualified Research and Clinical Testing Wages

Technically, applying the "substantially all" rule may not seem particularly problematic, although computing qualified wages for the research tax credit does sometimes result in the IRS's challenging the taxpayer's treatment of the issue. However, applying the rule correctly presents some challenges when a pharmaceutical company pursues a wide range of activities that qualify for both the research and the orphan drug tax credits and the company decides to claim both credits in the same tax year. An analysis of various potential scenarios is presented in this exhibit.

Consider a pharmaceutical company that performs drug development activities for two pharmaceutical products, only one of which has an orphan drug designation. Further, assume that the company conducts clinical trials both within and outside of the United States. Under Employee Scenario 1 in the exhibit, consider an employee who spends approximately 75% of his or her time conducting clinical trials in the United States for a drug that does not have the orphan drug designation and approximately 5% of his or her time conducting other activities that are qualified for the research tax credit. Provided that 80% of the work activities this employee performs meet the qualification requirements for the research tax credit, the application of the "substantially all" rule to this particular employee results in 100% of the employee's taxable wages being qualified for the research tax credit.

Under Employee Scenario 2 in the exhibit, the employee has spent 65% of his or her time engaged in conducting clinical trials in the United States for a drug with an orphan drug designation. The time spent in conducting these clinical trials qualifies for the orphan drug tax credit. Ten percent of the employee's time would be considered qualified for the purpose of the research tax credit. The "substantially all" rule could not be applied to Employee Scenario 2 since the key 80% threshold is not met for either the research tax credit or the orphan drug tax credit.

Employee Scenario 3 in the exhibit presents further complication. It involves clinical testing for a non—orphan drug conducted equally within and outside of the United States for a total of 70% of the time devoted to clinical testing activities for a non—orphan drug. Since only the research conducted in the United States qualifies for the research tax credit, only 35% of the time dedicated to clinical trials conducted in the United States, in addition to the 15% of the time spent on other qualified research activities, for a total of 50%, qualifies for the credit. The 35% of time spent conducting clinical testing outside of the United States will not qualify for the research tax credit or the orphan drug tax credit.

Employee Scenarios 4A and 4B in the exhibit involve two possibilities where the employee is conducting clinical testing for a designated drug both in the United States and in a foreign country. The company would have to choose whether to allocate the 80% and 20% of the employee's wages between the orphan drug tax credit and the research tax credit, respectively, as shown in Employee Scenario 4A. However, the company would find that it is most beneficial to apply the "substantially all" rule to the qualified wages for the orphan drug tax credit as shown in Employee Scenario 4B, rather than allocating the qualified wages between the research tax credit and the orphan drug tax credit as shown in Scenario 4A. The second scenario is much better because the orphan drug tax credit rate of 50% yields a much higher credit than the research tax credit rate of 20%. (Also, if the Sec. 41 research tax credit has not been renewed, the orphan drug credit would be the only possibility.)

It is important to note that applying the "substantially all" rule to Employee Scenario 4B (considering 80% of the wages to be qualified for the purpose of computing the orphan drug tax credit) might seem to contradict the requirements of Sec. 45C and Regs. Sec. 1.28-1, which explicitly prohibit including the same qualified research wages for both the research credit and the orphan drug tax credit. However, in this scenario, because of the higher rate for the orphan drug tax credit, no qualified research wages have been claimed for the research credit, which avoids the prohibition on using the same expenses for both credits. Therefore, both Employee Scenarios 4A and 4B appear to be proper approaches to calculating the credits. In addition, the research tax credit computation is much more complex than the computation of the orphan drug tax credit. Once the research tax credit has been computed, it may be apparent that it is less beneficial than the orphan drug credit, which even more strongly favors selecting the orphan drug tax credit in most cases when it is available.

Conclusion

It is essential to carefully identify the qualified research and clinical testing of orphan drug activities that a pharmaceutical company conducts. The "substantially all" rule should then be applied to qualified research and clinical testing in a way that maximizes the amount of credit that a taxpayer is eligible for, and at the same time eliminates possibly including in the computation of the research tax credit any clinical testing expenses that were included in computing the orphan drug tax credit in the same tax year.

Footnotes

¹ Economic Recovery Tax Act of 1981, P.L. 97-34.

² As of this writing, the research credit is expired, and recent efforts to extend the credit or make it permanent have stalled. (See, e.g., the American Research and Competitiveness Tax Act of 2014, H.R. 4438, passed by the House of Representatives on May 9, 2014, which would permanently extend and expand the research tax credit. The legislation was passed without offsets for its costs, and President Barack Obama has said he will veto that version if the Senate passes it.) However, due to the credit's long history of being renewed, often retroactively, and its widespread support in Congress, observers expect the credit to be renewed.

³ P.L. 99-514; P.L. 103-66; P.L. 105-34; P.L. 105-277, P.L. 106-170; P.L. 108-311; P.L. 109-432; P.L. 110-343; P.L. 111-312; P.L. 100-647; P.L. 101-239; P.L. 101-508; P.L. 102-227; P.L. 110-289; P.L. 111-5; P.L. 112-240.

⁴ American Taxpayer Relief Act of 2012, P.L. 112-240.

⁵ Small Business Job Protection Act of 1996, P.L. 104-188.

⁶ Since 2007, taxpayers have been permitted to calculate the research credit using the alternative simplified credit method, in addition to the traditional and startup methods. See Section 104(c)(2) of the Tax Relief and Health Care Act of 2006, P.L. 109-432.

⁷ Energy Policy Act of 2005, P.L. 109-58.

⁸ Sec. 45C(d)(1)(A). The credit is also available for the development of drugs that affect more than 200,000 people, if "there is no reasonable expectation that the cost of developing and making available in the United States a drug for such disease or condition will be recovered from sales in the United States of such drug" (Sec. 45C(d)(1)(B)).

⁹ Orphan Drug Act of 1983, P.L. 97-414.

¹⁰ Rare Diseases Act of 2002, P.L. 107-280.

¹¹ Orphan Drug Act, §1; H.R. Rep't 107-543, 107th Cong., 2d Sess. 1 (June 26, 2002). The Rare Diseases Act established the Office of Rare Diseases of the National Institutes of Health.

¹² The Sec. 45C credit was made permanent for amounts paid or incurred after May 31, 1997, by the Taxpayer Relief Act of 1997, P.L. 105-34, §604(a).

¹³ This article assumes that the research credit will be reauthorized retroactively and/or made permanent. The strategies described are also applicable to tax years that remain open under the statute of limitation.

¹⁴ Pharmacokinetics is a fundamental area of science focused on the study of the various processes by which a drug is absorbed, distributed, metabolized, and eliminated from the body. Pharmacodynamics is another fundamental area of science that studies the interactions and effects of a drug on living organisms at the site of action, including the time and intensity of therapeutic and adverse effects.

¹⁵ For the purposes of this discussion, a drug that is designated by the Food and Drug Administration for a rare indication or condition is referred to as a designated drug.

¹⁶ Regs. Sec. 1.28-1(c)(1)(ii).

¹⁷ Regs. Sec. 1.28-1(c)(1)(iii).

¹⁸ Regs. Sec. 1.28-1(c)(2); Federal Food, Drug, and Cosmetic Act, §505(b); Public Health Services Act, §351.

¹⁹ Sec. 41(d)(4)(F) and Regs. Sec. 1.41-4(c)(7).

²⁰ Sec. 45C(d)(2) and Regs. Sec. 1.28-1(d)(3)(i).

²¹ Regs. Sec. 1.41-2(d).

²² Sec. 41(b)(2)(B) and Regs. Sec. 1.41-2(c).

²³ Regs. Sec. 1.41-2(d)(2).

Contributors

Alexander Korniakov is the senior vice president of Research Credit and Other Tax Incentives at Fortisure Consulting LP in San Mateo, Calif. David Pauls is a technical consultant with Fortisure Consulting LP and spent over 22 years with the IRS. He was previously licensed as a CPA. Tom Hopkins is the founder and CEO of Fortisure Consulting LP. For more information about this article, contact Dr. Korniakov at alexander.korniakov@fortisureconsulting.com.