Overlapping expenses affect multiple tax credit calculations

Editor: Mark G. Cook, CPA, CGMA

The Fourth Circuit recently affirmed in United Therapeutics Corp., No. 23-1718 (4th Cir. 1/25/24), the Tax Court’s 2023 holding in the case (United Therapeutics Corp., 160 T.C. No. 12 (2023)).

In the Tax Court proceedings, the court ruled in favor of the IRS, holding that overlapping research expenses (i.e., qualified clinical testing expenses for purposes of the Sec. 45C orphan drug credit that are also qualified research expenses for purposes of the Sec. 41 research credit) used to determine the orphan drug credit for preceding tax years must also be included in determining the average qualified research expenses for the three preceding tax years when calculating the research credit using the alternative simplified method for subsequent tax years. Not only does this case clarify the coordination of one tax credit with another, but it also highlights the importance of compliance with the intermingled nature of tax provisions.

Research credit and orphan drug credit

To incentivize taxpayers to undertake new research and increase economic growth, Congress introduced the credit for increasing research activities, generally known as the research credit, with the Economic Recovery Tax Act of 1981, P.L. 97-34. The research credit rewards taxpayers that incur qualified research expenses, as defined under Sec. 41 and Regs. Secs. 1.41-1 through 1.41-8. Generally, these include wages, supplies, and amounts paid to certain small businesses, universities, and laboratories. These expenses qualify for the research credit only if they are incurred while performing qualified research (i.e., conducting experiments, developing prototypes, or using technical and scientific experts to improve processes).

There have been several amendments and modifications to the research credit over the years. One notable change, arising from the enactment of the Small Business Job Protection Act of 1996, P.L. 104-188, was allowing different methods for computing the research credit. United Therapeutics used the alternative simplified method under Sec. 41(c)(5) (now redesignated as Sec. 41(c)(4)) when calculating its research credit for the 2014 tax year. Under this method, a taxpayer is allowed a credit equal to 14% of its excess qualified research expenses for the tax year that exceed 50% of its average qualified research expenses for the three preceding tax years (the base period research expenses amount).

With the passing of the Orphan Drug Act of 1983, P.L. 97-414, Congress sought to incentivize pharmaceutical companies to develop medical treatments and drugs to address the needs of people suffering from rare diseases. The orphan drug credit was the key tax incentive included in the act. Much like the research credit under Sec. 41, the orphan drug credit under Sec. 45 has been extensively modified over the years. Currently, the orphan drug credit allows taxpayers a credit equal to 25% of its qualified clinical testing expenses under Sec. 45C. In the year at issue in the United Therapeutics case, 2014, the credit equaled 50% of qualified clinical testing expenses incurred for the tax year.

Qualified clinical testing expenses are defined under Secs. 45C(b), (c), and (d), with additional guidance under Regs. Sec. 1.28-1. Generally, “qualified clinical testing expenses” are expenses incurred for human clinical testing trials to the extent that the testing is related to the use of a drug for rare diseases and conditions. Moreover, only the expenses incurred between the drug designation date and the Food and Drug Administration’s approval date are considered qualified clinical testing expenses for the orphan drug credit.

With both credits having similar goals of incentivizing taxpayers for research, expenses that meet criteria for one credit can overlap with the criteria of the other, as noted by the Tax Court:

Congress recognized this potential for overlap and addressed it in section 45C(c), which provides as follows:

Sec. 45C(c). Coordination with credit for increasing research expenditures. —

(1) In general. — Except as provided in paragraph (2), any qualified clinical testing expenses for a taxable year to which an election under this section applies shall not be taken into account for purposes of determining the credit allowable under section 41 for such taxable year.

(2) Expenses included in determining base period research expenses. — Any qualified clinical testing expenses for any taxable year which are qualified research expenses (within the meaning of section 41(b)) shall be taken into account in determining base period research expenses for purposes of applying section 41 to subsequent taxable years.

The court observed that “[w]orking together, the two statutory provisions [Secs. 41(c)(5) and 45C(c)(2)] require taxpayers who have elected the generous orphan drug credit for prior years to account for that prior-year benefit in calculating their research credit for the current year.”

United Therapeutics excludes overlapping research expenses

United Therapeutics is a biotechnology company that develops novel pharmaceutical therapies and technologies to address the needs of patients with chronic and life-threatening illnesses. Under Secs. 41 and 45C, respectively, it claimed the research credit and the orphan drug credit for tax years 2011 through 2014. 

United Therapeutics used the Sec. 41(c)(5) alternative simplified method for calculating its research credit in the years 2011 through 2014. In calculating the research credit, the company excluded overlapping research expenses in calculating the current-year research expenses in each year. However, in 2014, the company, ignoring Sec. 45C(c)(2), also excluded overlapping research expenses in calculating its base period research expenses amount. This made the amount of the company’s base period research expenses amount for 2014 much smaller, which had the practical effect of greatly increasing the amount of the research credit it calculated under the Sec. 41(c) (5) alternative simplified method.

The IRS examined United Therapeutics’ 2014 tax return. The Service determined that, due to the company’s exclusion of the overlapping research expenses from its base period research expenses amount in calculating the research credit, it had overstated its research credit for the year by roughly $1.2 million and issued the company a notice of deficiency.

The company challenged the IRS’s determination in Tax Court. United Therapeutics argued that “because of changes in [Sec. 41] since its original enactment, [Sec.] 45C(c)(2) is a dead letter and has no application here.” The IRS argued that Sec. 45C(c)(2) had not been rendered ineffective and that, by its terms, the overlapping expenses were required to be included in United Therapeutics’ base period research expenses amount in calculating its 2014 research credit.

Tax Court’s analysis

The Tax Court, agreeing with the IRS, held that, based on the text and structure of Secs. 41 and 45C(c)(2) as they existed for 2014, United Therapeutics was required to include the overlapping expenses in its base period research expenses amount in calculating its research credit for 2014.

The Tax Court found that, in statutory interpretation disputes, a court should look to the ordinary meaning and structure of the law. Citing the Supreme Court opinion in Lamie, 540 U.S. 526 (2004), the Tax Court determined the interpretation of a statute should follow its plain meaning so long as it produces a result that is not absurd.

As the Tax Court noted, in the 2014 versions of Secs. 41 and 45C, there was no codified definition for “base period research expenses.” Thus, the court found that it was required to give that term its ordinary meaning. As the parties did not dispute that the expenses in question were qualified research expenses under Sec. 41, the court focused on the term “base period.”

To determine the ordinary meaning of the term “base period,” the Tax Court looked to the term’s definition in Webster’s Encyclopedic Unabridged Dictionary of the English Language (1989). This dictionary in general defined “base period” as “a period of time used as a standard of comparison in measuring changes … at other periods of time.” The court found this definition was consistent with the way Congress has used the term in other statutes, including Sec. 41(e), and, thus, it interpreted the term “base period research expenses” to mean “research expenses that are incurred during the base period — i.e., the period of time section 41 employs as a standard of comparison (or as a baseline or reference point).”

According to the Tax Court, this interpretation was compatible with the structure of Secs. 45C and 41 and produced a nonabsurd result. The result of using the ordinary meaning of “base period research expenses” meant that in calculating the Sec. 41 research credit, under Sec. 45C(c) (1) , the taxpayer that makes the election under Sec. 45C must exclude qualified clinical testing expenses incurred in the year for which the election is made when calculating qualified research expenses for that year.

Under Sec. 45C(c)(2), however, the taxpayer must include qualified clinical testing expenses incurred during a reference period (i.e., a base period) prescribed by Sec. 41 in its calculation of qualified research expenses for that reference period so long as those qualified clinical testing expenses also meet the definition of qualified research expenses in Sec. 45C(c) (2) . In other words, overlapping research expenses for which the Sec. 45C orphan drug is claimed must be included when determining the base period research expenses amount in the calculation of the research credit using the Sec. 41(c)(5) alternative simplified method.

In the Tax Court’s view, this result followed from the text of Secs. 41(c)(5) and 45C(c)(2), and “there is nothing unreasonable or illogical about it.” Together, the court reasoned, the statutory provisions require taxpayers who have elected the “generous” orphan drug credit in prior years to account for the prior-year benefit in calculating their research credit for the current year. The court stated that “[o]ne can conceive of many reasons why Congress might have taken such an approach.”

As noted above, United Therapeutics argued that Sec. 45C(c)(2) was no longer effective due to amendments made to the research credit and the orphan drug credit over the years. The company contended that the coordination rule of Sec. 45C(c)(2) remained in the Code due to an “oversight” by Congress. The Tax Court acknowledged the numerous changes to both the research credit and the orphan drug credit: “Between the 1989 amendments to the research credit that United Therapeutics highlights and the end of 2014, Congress amended the research credit at least 16 times and the orphan drug credit at least 14 times.”

However, the court found that in interpreting a statute, it should not assume that Congress made mistakes and failed to express in the statutory text what it wished to accomplish. Rather, under Supreme Court precedent, it was required to presume that Congress says what it means in a statute. Thus, as United Therapeutics had provided no valid reasons to do otherwise, the court was required to follow “the straightforward and ordinary meaning of the statutory text” of Sec. 45C(c)(2) as it applied in 2014 and give full effect to the coordination provision.

Fourth Circuit affirms

On appeal to the Fourth Circuit, United Therapeutics and the IRS made essentially the same arguments as they did in Tax Court. The Fourth Circuit, stating it had “little to add to [the Tax Court’s] thorough and persuasive reasoning,” affirmed the Tax Court’s judgment.

Implications

United Therapeutics’ position was based on what it thought Congress meant to do rather than on following the current statutory text. The subsequent court rulings against it serve as a stark warning to companies looking to interpret the law.

While this case certainly highlights the plain reading of Secs. 41 and 45C as they apply to companies claiming both the research credit and the orphan drug credit, all taxpayers can learn from this result. Interpretations of the Internal Revenue Code should be based on what is plainly stated in the current existing text. Predecessor statutes and previous congressional intent do not determine what Congress intended with the passage of the current version of the Code.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Cook at mcook@singerlewak.com.

Contributors are members of or associated with SingerLewak LLP.