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Hui: Breaks and benefits for life sciences investors. |
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When it comes to sustaining needed levels of investment, life sciences companies—medical device, pharmaceutical, and biotech firms alike—face unique challenges. New companies in the life sciences industry often take a decade or longer to deliver new healthcare solutions to patients and providers. During the research and development phase—when the companies often do not have product revenues—the survival of these new companies hinges on capital injected by investors. Because of the lengthy process required to bring a product to market, however, the companies may be deprived of certain tax benefits when they finally become profitable.
The proposed legislation would modernize numerous elements of the federal tax code to help life sciences companies continue to raise the funds needed to bring new therapies to market. In particular, the legislation promotes long-term investment in small life sciences companies, reforms net operating-loss rules, revises the research tax credit and the orphan drug credit, and encourages the development of new biodefense and pandemic flu countermeasures.
The legislation refers to the life sciences companies that could take advantage of the enhanced tax benefits as biomedical research corporations. In order to qualify as a biomedical research corporation, a company must be based in the United States and hold the rights to a drug, biologic, or device that is covered by either a federal investigational new drug application or an investigational device exemption. Companies would have to certify that the drug, biologic, or device was under study pursuant to a federal investigational use exemption.
Benefits for Manufacturers
The proposed legislation would provide the following tax breaks to qualifying biomedical research corporations.
Expansion for Net Operating-Loss Carryforwards. When a company incurs a loss in a given year, federal tax law permits the company to carry the loss forward to reduce the company’s taxable income generated in succeeding years. This concept, known as a carryforward, can go on for 20 years before the loss is fully exhausted. Any amount of the loss that is not utilized in the 20th year will be lost permanently.
Currently, a federal tax provision places limitations on the use of carryforwards when a significant part of a company’s ownership changes hands. The limitation is triggered any time new or current shareholders—whether individually or combined—increase their stake in the company by more than 50% of the company’s total shares in a three-year period. Companies in the life sciences industry are particularly vulnerable to this provision due to the numerous financing rounds often required during their lengthy research and development phases.
In regard to carryforwards, the proposed legislation would disregard a change in ownership at a biomedical research corporation in the case of several common investment scenarios. The first would be a cash investment in a biomedical research corporation for the original issue of stock, so long as the investing party would become a less-than-50% shareholder after the stock acquisition. The second scenario would be an acquisition of stock by or a merger with another biomedical research corporation that was operating at a loss. In addition, because convertible debt is a common vehicle used by biomedical research corporations to raise cash, the bill would permit cash investment in convertible debt and subsequent conversion into stock as a qualifying investment.
Research Credit Expansion. The proposed legislation would amend the tax code to allow biomedical research corporations to claim 100% of contract research expenses. Currently, only 65% of qualified contract research expenditures may be considered.
Orphan Drug Credit Expansion. An orphan drug credit is generally available for companies that have qualified clinical testing expenses after a drug for a rare disease is designated under the Federal Food, Drug, and Cosmetic Act. The bill would extend the qualification period to the date the application for designation was filed.
Credit for Research into Countermeasures. The bill would create a new tax credit for a biomedical research corporation that has research expenditures—including expenses for preclinical research and animal model development—related to the development of a countermeasure drug, biological product, or device for a qualified biomedical threat.
Benefits for Investors
Some of the most significant provisions of the proposed legislation are those that would benefit entities that invest in medical technologies, thus benefiting the manufacturers themselves. The following two tax benefits are intended for investors in a qualified life sciences company.
Capital Gains Rollover. Currently, noncorporate taxpayers may defer certain taxable gains from the sale of qualified small business stock if they invest the proceeds in the stock of another qualified small business stock within 60 days of the date of sale. A qualified small business stock is a domestic corporation that has gross assets not exceeding $50 million at any time between August 1993 and the date of the stock issuance. The company also must use a large majority of its assets for its business.
The proposed legislation would extend this tax benefit to noncorporate taxpayers who would otherwise recognize taxable gains from the sale of a biomedical research corporation’s stock. Under the legislation, biomedical research corporation stock would become qualified if the company meets the requirements for a qualified small business and has average gross assets over the last three years of no more than $250 million.
Incubational Equity Tax Credit. The bill would also create a new tax credit for investors in small start-up qualified life sciences companies. The credit would be 20% of qualified cash investment—limited to $500,000 per year—for the original issue of stock. To qualify for this tax credit, at least half of such investment proceeds would have to be spent on qualified research activities. The company would have to have no more than 25 employees and gross assets of less than $25 million.
However, the proposed law would set a $500 million national annual cap on these available tax credits. The amount of tax credit available to each life sciences company would be determined by the Internal Revenue Service, and the mechanism for such allocation is not stipulated in the proposed legislation. Also, this credit would only be available to investors in each qualified life sciences company for a period of five years. After that, the IRS could allocate the company’s unused credits to other qualified companies.
The proposed legislation has garnered support from industry associations AdvaMed (Washington, DC) and the Biotechnology Industry Organization (Washington, DC), but it still has a long way to go in Congress. The bill has been referred to the House Committee on Ways and Means, and it is still too early to evaluate its likelihood of passage this year.
Gary Hui is a tax senior manager at Burr, Pilger & Mayer LLP (San Francisco).
© 2007 Canon Communications LLC
