By Alexis Jordan, Client Development Director, Engineered Tax Services
It’s hard to think of a business sector that’s poised to benefit more from research and development (R&D) tax credits than the pharmaceutical industry. Sometimes it seems like R&D tax credits were devised with pharma in mind.
R&D tax credits are permanent federal and state tax incentives, in the form of tax credits (to be applied against tax debt), designed to stimulate innovation, technical design, and product development and enhancement. They maintain the U.S.’s leadership status in innovation by reimbursing companies that develop new products, processes, or inventions and returning a significant percentage in tax savings to the company for undertaking qualified research activities and qualified research expenses.
With R&D tax credits, pharma companies can obtain tax savings, boost cash flow, and remain competitive in the marketplace. While many activities that qualify for the credit are considered day-to-day operations in pharma, only one-third of all companies are aware they’re eligible for the credit.
Pharma and R&D Tax Credits
According to a source no less than the Congressional Budget Office, the pharmaceutical industry spent $83 billion dollars on R&D in 2019, roughly 10 times what it spent per year in the 1980s, adjusted for inflation.
In 2019, the average pharmaceutical company spent approximately one-quarter of its revenue, net of expenses and buyer rebates, on R&D. That’s almost twice as large a revenue share as they spent in 2000. It’s important to note that pharma’s revenue share outmatches other knowledge-based industries, including semiconductors, technology hardware, and software.
Between 2015 and 2019, pharma’s spending on drugs R&D ballooned by nearly 50 percent. Over approximately the past decade, R&D costs have increased by about 8.5 percent annually. Compared to the previous decade, between 2010 and 2019, there was a 60 percent increase in the number of new drugs approved for sale, with a peak of 59 new drugs approved in 2018.
Interestingly enough, small drug companies with annual revenues of less than $500 million now test over 70 percent of the nearly 3,000 drugs in phase III clinical trials. In recent years, many approved drugs are high-priced specialty drugs for relatively small numbers of potential patients, while the best-selling drugs of the 1990s were lower-cost pharmaceuticals with large patient populations.
How Pharma Targets R&D Dollars
How much money drug companies are willing to invest in R&D is dictated by:
· the amount of revenue they expect to earn from a new drug
· the expected cost of developing that drug and
· policies that influence the supply of and demand for drugs.
How much does it cost to develop a new drug, including capital costs and expenditures on drugs that fail to reach the market? It can range from less than $1 billion to more than $2 billion. An important point to consider: the federal government has an impact on the amount of private spending on R&D in three ways: 1) via programs (such as Medicare) that increase the demand for prescription drugs; 2) via policies (such as spending for basic research and regulations on what must be demonstrated in clinical trials) that shape the supply of new drugs; and 3) via policies (such as recommendations for vaccines) that affect both supply and demand.
Breaking Down R&D Spending in Pharma
R&D spending in the pharmaceutical industry tends to follow this process:
- incremental innovation
- product differentiation
- safety monitoring or clinical trials.
According to the IRS’ Pharmaceutical Industry Research Credit Audit Guidelines – Revised – 4/30/04, the pharmaceutical product development process can be broken down into four stages:
1. Preclinical/Discovery Research – where new compounds are discovered.
2. Clinical Development – conducted in three (3) phases.
Phase I – first trials in humans that test a compound for safety, tolerance and pharmacokinetics. The trials usually employ normal, healthy volunteers.
Phase II – pilot studies to determine efficacy and safety in selected populations of patients with the disease or condition to be treated, diagnosed, or prevented. Dose and dosing regimens are assigned for magnitude and duration of effect during this phase.
Phase III – expanded clinical trials intended to gather additional evidence of effectiveness for specific indications and to better understand safety and drug-related adverse effects.
3. Regulatory Review – the New Drug Application (NDA) is submitted to a regulatory agency, such as the Food and Drug Administration, for marketing and manufacturing approval.
4. Post-Marketing – activities occurring after approval to market has been granted by the appropriate regulatory agency. These activities include Phase IV studies performed to determine the incidence of adverse reactions; to determine the longterm effect of a drug; to study a patient population not previously studied; and for marketing comparisons against other products and other uses.
When deciding whether to award an R&D tax credit claim, the IRS seeks these types of documentation:
· tax workpapers
· qualified wages
· qualified supplies
· qualified contract research
· tour of research facility
· organizational chart and
· job titles, grade levels and position descriptions.
The Four-Part Test
How do you qualify for R&D tax credits? The IRS requires that your R&D activities meet this four-part test:
- Permitted Purpose: The activities must relate to new or improved business components, function, performance, reliability, and quality.
- Technological in Nature: The activity performed must fundamentally rely on principles of physical or biological science, engineering, or computer science.
- Elimination of Uncertainty: The activity must be intended to discover information to eliminate uncertainty concerning the capability, method, or design for developing or improving a product or process.
- Process of Experimentation: The taxpayer must engage in an evaluative process that can identify and evaluate more than one alternative to achieve a result. This may include modeling, simulation, or a systematic trial-and-error methodology.
But R&D tax credits aren’t just for successful projects. You can also use them for efforts that result in failure. In addition, the product or process developed need not be new to your industry; it only needs to be new to your company.
Where To Go for Research & Development Tax Advice
Last year, the IRS made its reporting and record-keeping requirements for R&D tax credits much, much stricter and complex. As a result, it’s to your benefit, if getting a R&D tax credit study, to only rely on a specialized company with both engineering and accounting capabilities, which can undertake a full-fledged technical study to help you with your R&D tax credit application and claims processing, and then back you up with accounting know-how. It could save you millions of dollars.