The orphan drug and research tax credits: the "substantially all" rule.

• Author: Korniakov, Alexander

The research credit under Sec. 41 (when in effect) and the orphan drug credit under Sec. 45C are sometimes available for the same expenses incurred during the development of pharmaceuticals. Understanding how the credits work and how to maximize the benefit from both of them when they are both available can reduce taxes for eligible companies.

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...