Navigating Tax Liabilities Ahead

September 2017

With no immediate path forward for healthcare reform, the Trump administration has brought another hot button issue back into the spotlight: tax reform.

For the first time, BDO’s analysis tracked the following tax risks this year: overall tax liabilities, the ability to use net operating loss (NOL) carryforwards to reduce future tax liability, differing tax laws in domestic and foreign jurisdictions, changes to the availability of tax credits or tax holidays, tax reform, repatriation earnings, and state and local tax issues.

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Nearly three-fourths (71 percent) cite tax liabilities as a risk in their latest 10-K filings, including issues related to potential U.S. tax reform, differing tax laws in domestic and foreign jurisdictions, and state and local tax (SALT) issues. Specifically:
  • 51% cite risks around the ability to use NOL carryforwards to reduce future tax liability
  • 47% mention risks around differing tax laws in domestic and foreign jurisdictions
  • 30% say changes to the availability of tax credits or tax holidays are a risk
  • 22% are worried about tax reform
  • 18% cite risks around repatriation earnings
  • 15% mention state and local tax issues as risks 
Though recent political rhetoric has focused on U.S. tax reform, for life sciences companies, a large proportion of which are historically multi-national, the bigger tax concerns might be changing global tax laws and accounting rules. These developments, which include Base Erosion and Profit Sharing (BEPS) guidelines from the Organisation for Economic Co-operation and Development (OECD), could force the modification of current IP holding structures and a new approach to global tax planning.

The BEPS guidelines, issued in late 2015, are a set of 15 actions concerning global tax rules related to transfer pricing, permanent establishments and aggressive tax planning including the use of IP holding structures. Many countries have begun implementing BEPS-compliant tax laws, with the U.S. recently implementing BEPS guidance related to country-by-country reporting. This will require the disclosure of certain critical information that can be accessed by taxing authorities of all OECD member states. At the same time, the European Union (EU) is pushing to get rid of certain tax benefits in its member countries that, under EU state aid law, are considered anti-competitive and unfair.  

While global tax changes are taking shape, under ASC 606, companies will be required to fully recognize current and deferred income taxes from intercompany transfers of all property (except inventory) when transfers occur, even though the intercompany pre-tax profit would still be eliminated and recognized in future periods. The net tax effect is recognized when the asset is transferred, meaning entities will no longer be able to spread the tax consequence from intercompany transfers of IP and other assets over multiple reporting periods. 

At the same time, life sciences companies need to keep abreast of evolving U.S. tax reform proposals, most of which are based on President Trump’s tax framework released in April. The proposed changes include a reduction of the corporate tax rate from 35 percent to 15 percent for businesses. They also include a shift from a worldwide tax system to a territorial tax system, which would tax U.S. businesses only on what they earn within the U.S. rather than on profits earned around the world, as well as a onetime tax holiday (rate unspecified) on overseas profits.

The implications of tax reform on U.S. life sciences companies are not inconsequential. A lowering of the corporate tax rate, for example, may encourage U.S. multinationals to bring back some of their manufacturing operations to America, while a onetime tax holiday could be a boon for those looking to repatriate millions or billions of dollars from overseas.

Pharma companies could be one of the biggest beneficiaries of a tax holiday, say analysts at Bank of America Merrill Lynch. After all, pharma companies reaped the most benefits during the last U.S. tax holiday approved in 2004 when companies could repatriate their foreign earnings at a 5.25 percent corporate tax rate. The pharma and medicine industry made up 32 percent of the total profits repatriated, with Pfizer bringing back the largest share, amounting to $37 billion in foreign earnings from 2005-06.

Every company will use their repatriation earnings differently, and the effect repatriation could have on each company remains to be seen. Ideas about what the excess money could fund include new or revived investments in manufacturing, and research and development (R&D) programs, as well as dividends to shareholders. The extra cash may also boost mergers and acquisitions (M&A) activity, as life sciences companies invest in strategic deals that can help them innovate and outpace the competition.

Until companies are clear on how tax reform could affect asset values in corporate deals—or how the corporate tax rate could affect foreign companies interested in merging with American companies—many are instead choosing to adopt a “wait-andsee” approach. As with any pending policy, the exact implications of these changes will vary depending on where each company’s global supply chain and customers are based.


Growing Focus Around Global, SALT & R&D Tax Issues

While national tax reform is making many life sciences companies uneasy, so are tax issues abroad: Nearly half (47 percent) worry about maintaining compliance with differing tax laws in domestic and foreign jurisdictions. This comes as little surprise since these laws often introduce additional compliance costs, including regular audits under foreign tax authorities. Depending on the jurisdiction, economic and political pressures to increase tax revenue may also make favorably resolving tax disputes more difficult.

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Tax issues at the local level spark concerns as well: 15 percent cite state and local tax (SALT) issues, with nearly one-third (30 percent) expressing concern over changes to the availability of tax credits or holidays offered to help encourage private companies’ R&D efforts.

Many pharma and biotech companies find these R&D credits critical to funding innovative research, and as such, changes in their availability could deter progress. The orphan drug tax credit, while more limited in applicability than traditional R&D credits, is another incentive that has helped bring new products to market in the industry. Created under the Orphan Drug Act of 1983, the credit aims to financially incentivize pharmaceutical companies to develop drugs that treat diseases affecting less than 200,000 patients in the U.S. Makers of such drugs are eligible for a tax credit equal to 50 percent of qualifying costs that are incurred between the date the FDA grants them orphan status and the date the FDA approves their drug for patients.

Under the program, more than 400 drugs have come to market. To mention just one example, in 2012, BioMarin received $32.6 million from a combination of federal and California R&D tax credits, with the orphan drug credit making up most of the deferred tax benefit. In fact, the Treasury Department estimates that, because of the volume of orphan drugs under development, the U.S. could grant almost $50 billion in orphan drug tax credits from 2016-2025.  

Thus, while the current U.S. tax reform proposal seeks to preserve R&D credits, companies are continuing to keep an eye out for any changes proposed at the federal, state and local levels.

As life sciences companies prepare for the future, balancing competing tax codes on the local, state, national and global levels will prove challenging as new tax statues and regulations unfurl. Life sciences companies must keep abreast of both current and future tax developments to ensure they are able to reduce their tax liabilities and maximize tax opportunities when the time comes.
 

“R&D spending has been critical to developing cutting-edge biotechnologies and breakthrough drugs in recent years. As such, drug manufacturers that work to develop or improve biotechnologies must ensure they are taking full advantage of the federal and state R&D tax credits available to them, which can increase cash flow as much as 9.1 percent of qualified spending for the former and up to 40 percent of qualified spending for the latter.”   

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 Chris Bard

 Leader of BDO’s Specialized Tax Services R&D Practice