November 8, 2017 Life sciences sector significantly affected by House tax reform bill On November 2, 2017, the House Ways and Means Committee released its proposed tax reform bill (H.R. 1, the Tax Cuts and Jobs Act). This Alert includes relevant changes made in the Chairman's Mark, which the House Ways and Means Committee adopted November 6, 2017. The mark-up is ongoing, and further changes are expected to be released later this week with the intent of passing the bill in the House prior to Thanksgiving. During the same time period, the Senate Finance Committee will be working on its version of the tax reform bill, which it hopes to release by the end of the week. President Trump has stated a goal of passing tax reform legislation before Christmas. The topics discussed below highlight the provisions likely to be of greatest interest to life sciences companies. For a more comprehensive discussion of the bill, see Tax Alert 2017-1831. Given the significance of the proposed legislation, life sciences companies should complete detailed TCJA modeling to quantify the tax impact of the provisions. Lower corporate income tax rate Current lawThe top corporate federal income tax rate is currently 35%. ProvisionThe bill would permanently reduce the top corporate federal income tax rate from 35% to 20% for tax years beginning after 2017. With a possible lower corporate tax rate of 20%, deductions would effectively be worth less in the future, and some might disappear altogether. As such, companies may want to evaluate their tax accounting methods and identify opportunities to accelerate deductions and defer income as part of their tax planning. Effective dateWhile the legislative text provides no effective date, the section-by-section summary provides that the rate would be effective for tax years beginning after 2017. ImplicationsThere are certain tax planning actions life sciences companies may consider taking now regarding the timing of their deductions and income recognition. Such planning would cause minimal disruption to the business, but could create permanent tax savings given the possibility of a 20% corporate income tax rate. Specifically, life sciences companies may consider the following accounting method planning ideas related to the timing of deductions: — Accelerate deductions for charge backs paid to third-party wholesalers under the recurring item exception — Accelerate the deduction of Medicaid rebate liability under the recurring item exception, instead of deducting it when paid — File a non-automatic method change to accelerate deductions for product returns when received but not yet paid under the recurring item exception — Deduct certain prepaid assets for tax purposes upon payment rather than amortizing them ratably — Estimate expenses that have been incurred but not reported , such as employee medical and dental services rendered before claims have been filed, which generally can be deducted for tax purposes — Deduct certain software development costs (e.g., enterprise resource planning costs for employee compensation and outside consultants) for tax purposes currently rather than amortizing them ratably over 36 months once placed in service They can also consider the following accounting method planning ideas related to the timing of income recognition: — File a non-automatic method change to defer recognition of revenue of receivables in dispute (e.g., due to incorrect product quantities/goods, invoice pricing errors, etc.) under general revenue recognition principles of Section 451 — File a non-automatic method change to recognize in income the invoice price, less any prompt-pay discounts, when an invoice has been issued, but payment has not yet been received — Use the deferral method of Revenue Procedure 2004-34 to the extent payments are recognized for financial statement purposes for a tax year following the tax year of receipt — File a non-automatic method change to defer revenue recognition of unbilled receivables until the amounts are truly earned or are due/received — Defer recognition for a portion of income that, based on experience, the taxpayer does not expect to collect, under Section 448(d)(5) Changing the timing of deductions would necessitate an application for change in accounting method (i.e., Form 3115).Non-automatic accounting method changes must be filed on or before December 31, 2017 to be effective for the 2017 tax year. Automatic accounting method changes must be filed on or before September 15, 2018 (i.e., the extended due date of the tax return) to be effective for the 2017 calendar tax year. US accounting rules (under ASC 740-10-35-4) require the adjustment of deferred tax assets and liabilities in the period in which tax legislation is enacted, such as the proposed change in the federal income tax rate. The effect of such adjustment must be included in income from continuing operations. In addition, the elimination of certain tax preferences may inhibit a taxpayer's ability to offset taxable income. Accordingly, taxpayers need to act quickly to assess potential benefits as well as any latent pitfalls that could result from a failure to act. Repeal of Section 199 domestic production activities deduction Current lawSection 199 allows taxpayers to claim a deduction equal to 9% (6% for certain oil and gas activities) of the lesser of the taxpayer's qualified production activities income or the taxpayer's taxable income for the tax year. The deduction is limited to 50% of the W-2 wages paid by a taxpayer during the calendar year. Qualified production activities income is derived from certain production activities and services performed (i.e., construction, engineering or architecture) in the United States, and, for tax years beginning before January 1, 2017, in Puerto Rico. ProvisionThe provision would repeal Section 199 for tax years beginning after December 31, 2017. For production activities performed in Puerto Rico, however, the provision would also extend Section 199 to tax years beginning before January 1, 2018. Effective dateThe repeal provision would be effective for tax years beginning after December 31, 2017. ImplicationsAs foreshadowed by the Unified Tax Reform Framework (Framework), the provision would eliminate Section 199 for tax years beginning after December 31, 2017. According to the Framework, Section 199 is no longer necessary because of the across-the-board rate reduction on all business income. Section 199 has been a recent focus of increased IRS examination activity, which has resulted in several cases pending in a variety of federal courts. Because the bill would eliminate Section 199 for tax years beginning after December 31, 2017, it is unclear how the IRS will examine and litigate Section 199 claims for tax years beginning before 2018. Because taxpayers can make amended return claims for Section 199 deductions, taxpayers with production or service activities that are within the scope of Section 199 may want to review the claims they have already made for additional opportunities or consider making an initial claim on an amended return for open tax years beginning before January 1, 2018. Life sciences companies may benefit from an increased focus on Section 199 planning for tax years beginning before January 1, 2018 to ensure they are maximizing the benefit of the deduction before it is possibly repealed. Particular areas of focus could include, but not be limited to: — Life sciences companies are increasingly investing in building out and developing their software and digital capabilities, transforming their organizations, automating and digitizing many facets of their businesses, which may be eligible for Section 199. Section 199 computations need to be updated to reflect the software transformation and digital initiatives. — Rapid speed of innovation in the life sciences sector is creating new products, solutions and services and attracting disproportionate investments. — Recent taxpayer favorable court cases — United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013) and Precision Dose, Inc. v. United States, 2015-2 USTC p. 50,493 (N.D. Ill., Sept. 24, 2015) — Determination of what constitutes manufacturing/production, what production activities are substantial in nature. The Precision Dose case specifically addressed taxpayer facts in the life sciences sector. — Companies have opportunities to review and claim contract manufacturing activities and the commensurate revenue streams as Section 199 eligible. Repeal of orphan drug credit Current lawUnder current law, Section 45C allows a drug manufacturer to claim a credit equal to 50% of qualified clinical testing expenses (the orphan drug credit). ProvisionThe provision would repeal the credit for clinical testing expenses related to certain drugs for rare diseases or conditions under Section 45C. Effective dateThe provision would be effective for tax years beginning after December 31, 2017. ImplicationsTaxpayers that currently claim the orphan drug credit would be negatively affected by its repeal, but would still be able to claim tax benefits for their qualified clinical testing expenses under Sections 41 and 174 in tax years beginning after December 31, 2017. Expenses that qualify for the credit under Section 45C generally also qualify for the research credit under Section 41, and taxpayers could include what would have been treated as qualified clinical testing expenses as qualified research expenses when calculating the research credit. The research credit under Section 41, however, provides a substantially smaller benefit for these expenses than does the orphan drug credit under Section 45C. New category of Subpart F income: foreign high returns amounts ProvisionThe bill would add new Section 951A, which would require a US person that is a US shareholder of any CFC for any tax year to include in gross income 50% of its "foreign high return amount" determined for that tax year. A US shareholder's foreign high return amount is the excess, if any, of the US shareholder's "net CFC tested income" for that tax year over the excess, if any, of: (1) the US shareholder's "applicable percentage" of its aggregate pro rata share of the "qualified business asset investment" of each CFC with respect to which it is a US shareholder in that tax year, over (2) any interest expense taken into account in determining the US shareholder's net CFC tested income for that tax year. Effectively, the bill is identifying an amount of income earned by the US shareholder's CFCs that it considers "excessive." A US shareholder's net CFC tested income is the excess, if any, of its aggregate pro rata share of any tested income of each CFC, over its aggregate pro rata share of any tested loss of each CFC. A CFC's tested income is the excess, if any, of: (1) its gross income (other than ECI, subpart F gross income, amounts excluded from foreign personal holding company income under Section 954(c)(6) that do not reduce a US shareholder's foreign high return amount, active insurance and financing income, amounts excluded from foreign base company income under Section 954(b)(4), commodities income (as defined), and related-party dividends) over (2) deductions (including taxes) properly allocable to such gross income under rules similar to those of Section 954(b)(5). Tested loss is the excess of: (1) properly allocated and apportioned deductions; over (2) gross income taken into account in determining tested income. So for any tax year a CFC would have either tested income or tested loss, but not both. The applicable percentage for any tax year would equal the federal short-term rate (determined under Section 1274(d)) for the month in which or with which such tax year ends, plus seven percentage points. A CFC's qualified business asset investment is the aggregate of its adjusted bases in tangible property that is: (1) used in a trade or business of the CFC, (2) of a type with respect to which a deduction is allowed under Section 168, and (3) used in the production of tested income or tested loss. The bill would amend current Section 960 to treat a US corporation that includes a foreign high return amount in income as paying a portion of any foreign income taxes paid or accrued by its CFCs with respect to gross income taken into account in determining tested income or tested loss. Specifically, under new Section 960(d), the US corporation would be treated as paying foreign income taxes equal to 80% of "foreign high return percentage," multiplied by the aggregate foreign income taxes paid or accrued by its CFCs that are properly attributable to gross income taken into account in determining tested income or tested loss (defined as "tested foreign income taxes"). For any tax year, the US corporation's foreign high return percentage would be the ratio of its foreign high return amount to its aggregate tested income. The bill would create a new Section 904(d) limitation category for foreign high return amounts but any foreign income taxes not claimed as a credit in a tax year could not be carried back or forward. Effective dateNew section 951A would apply to tax years of foreign corporations beginning after December 31, 2017, and to tax years of US shareholders in which or within which such tax years of a foreign corporation end. ImplicationsSignificant to most life sciences companies is the fact that intangible property is not treated as a qualified business asset investment. Most life science companies have significant intangible property outside the United States. In addition, due to outsourcing of manufacturing, the age of existing manufacturing facilities, or other supply chain changes, many do not have tangible assets with significant adjusted basis. Accordingly, it is expected that many companies will be impacted by this provision and have increased Subpart F income. Repeal of Section 956 for domestic corporations Current lawA US shareholder of a CFC must include in income annually its pro rata share of any United States property (as defined in Section 956(c)) held by a CFC for any tax year. The amount included in income by the US shareholder is determined based on the CFC's adjusted basis in the property, the untaxed E&P of the CFC and the length of time the CFC holds the US property during the tax year. ProvisionThe bill would repeal this provision in alignment with new Section 245A. The bill would also authorize the US Treasury Department to issue regulations to address US partnerships with corporate partners. Effective dateThe bill would repeal Section 956 for domestic corporations effective for tax years of foreign corporations beginning after December 31, 2017. ImplicationsLife sciences companies have complex global supply chains. Often, a non-US CFC subsidiary will have title to inventory or other property in the United States, which could result in a Section 956 inclusion. Although current law — Section 956 — has an exception for property held for export, it is often difficult to segregate inventory in a manner that meets this exception. Accordingly, companies often have to modify their supply chains to minimize the application of Section 956. The repeal of Section 956 would allow companies to simplify their supply chains in many instances. Repeal of Section 958(b)(4) downward attribution rules Current lawSection 958(b)(4) generally prevents stock owned by a foreign shareholder from being attributed downward to a domestic subsidiary. For foreign-parented groups, this rule could prevent CFC status for any foreign subsidiaries jointly owned, for example, by the foreign parent corporation and US subsidiary. ProvisionThe bill would repeal current Section 958(b)(4). Effective dateThe bill would repeal Section 958(b)(4) for domestic corporations with tax years of foreign corporations beginning after December 31, 2017. ImplicationsFor foreign-parented groups, the repeal of Section 958(b)(4) would allow downward attribution of a foreign company's ownership in a foreign subsidiary to a US subsidiary that partially owns that foreign subsidiary (so-called "sandwich structures"). This downward attribution would cause a partially owned foreign subsidiary to become a CFC and subject to Subpart F. Because growth in life sciences has in large part been through acquisitions, many groups have sandwich structures. These structures were often created during the integration of a US target's non-US operations with the foreign acquiror's non-US operations. Requiring these partially owned foreign subsidiaries to be treated as CFCs adds significantly to the complexity of these structures. New excise tax on certain payments from a domestic corporation to a foreign affiliate Current lawUnder current law, a foreign corporation is generally subject to US taxation on a net basis on ECI under Section 882, or on a gross basis (30% statutory rate subject to reduction under a US tax treaty) on certain non-ECI income that is fixed or determinable annual or periodical (FDAP) under Section 881. New Section 4491New Section 4491 would impose on each "specified amount" paid or incurred by a domestic corporation to a foreign corporation that is a member of the same international financial reporting group (IFRG) a tax equal to the highest rate of tax imposed under Section 11 for the tax year in which the specified amount is paid. This new "excise tax" would be imposed on the domestic corporation and would not be deductible for US federal tax purpose. For this purpose, a specified amount paid, incurred or received by a partnership that is a member of an IFRG would be treated as paid, incurred or received by its partners, and a specified amount paid, incurred or received by a foreign corporation in connection with a US trade or business would be treated as paid, incurred or received by a domestic corporation. A specified amount for this purpose means any amount that is, with respect to the payor, deductible or includible in cost of goods sold (COGS), inventory or the basis of a depreciable or amortizable asset for the payor. However, a specified amount does not include interest, amounts paid or incurred for the acquisition of certain commodities, FDAP payments subject to withholding tax under Section 881, or service fees not subject to a markup to the extent the payor elects the services cost method for Section 482 purposes. For FDAP amounts, however, the provision would only exclude the portion of such amount in proportion to the actual rate of tax imposed under Section 881(a) to 30%. Thus, for example, it would appear that, if $100 of a FDAP royalty payment were subject to a treaty-reduced withholding tax rate of 10% under Section 881(a), only 1/3 of that amount would be excluded from treatment as a specified amount. An IFRG for this purpose is any group of entities, with respect to any specified amount, if the specified amount is paid or incurred during a reporting year of such group with respect to which it prepares consolidated financial statements (within the meaning of Section 163(n)(4)) and the average annual aggregate payment of specified amounts of such group for the three-reporting-year period ending with such reporting year exceeds $100 million. Election to treat specified amounts as ECIIn lieu of the domestic corporation incurring an excise tax on a specified amount, the foreign corporation that receives the payment would be permitted to elect to take the specified amount into account as if it were engaged in a USTB and had a US permanent establishment (PE) during the tax year in which the amount was received, and as if such amount were ECI and attributable to the US PE (the ECI election). Once made, the ECI election could be revoked only with IRS consent. Importantly, for any underpayment, penalties, additions to tax or additional amounts, the provision would place joint and several liability on each domestic corporation that is a member of the IFRG. If the ECI election were made, the foreign corporation would be allowed a deduction against the specified amount for a "deemed expenses" amount. The deemed expenses with respect to a specified amount received by the foreign corporation during a reporting year is the amount of expenses required so that the foreign corporation's net income ratio (i.e., the ratio of the net income determined without regard to interest income, interest expense, and income taxes, divided by revenues) with respect to the specified amount equals the IFRG's net income ratio with respect to the product line to which the specified amount relates. The amounts required to determine the net income ratio would be determined on the basis of the IFRG's consolidated financial statements and the books and records of the IFRG members used to prepare those statements. Any ECI amount resulting from the ECI election would be treated as such for all purposes of the Code. Thus, as explained in the Joint Committee on Taxation's Explanation, it is subject to the branch profits tax and is not subject to the excise tax under Section 4371. For purposes of Section 245 and new Section 245A, however, these amounts would not be treated as ECI. Thus, a distribution of earnings attributable to the amounts described in this proposal would be eligible for the participation DRD under new Section 245A. No deduction would be allowed for any taxes (including withholding taxes) paid or accrued with respect to any amount to which this proposal applies. The Chairman's Mark amends this proposal (applying only when the effectively connected income election is made) as follows: — Increases the allowable deduction for deemed expenses so that "routine returns" are not taxed — Excludes payments for the acquisition of securities (within the meaning of section 475(c)(2)) from income — Changes the method of determining net income to reflect foreign profit margins rather than global profit margins — Allows a foreign tax credit for a portion of the foreign taxes paid. Effective dateThe provision would apply to amounts paid or accrued after December 31, 2018. ImplicationsLife science companies have complex and global supply chains with many cross-border payments for goods and services. In addition, many life sciences companies have grown through acquisition, often the acquisition of non-US multinationals. If US companies pay royalties to use IP owned abroad, purchase product manufactured abroad by a related party, or pay for services undertaken outside the US, the excise tax will apply absent the ECI election. Because the excise tax is non-deductible and applied on a gross basis, it is likely that the ECI election will lead to a better result. For life science companies with many SKUs, calculating the ECI amount will be complex. With respect to services, many foreign countries may not accept a payment at cost and require a mark-up which would trigger the excise tax. Many companies have already begun to outsource their manufacturing and other operations. Because the excise tax applies only to related party payments, such third party arrangements may become more attractive. Finally, repatriation of the deemed ECI amount is eligible for the 100% DRD (i.e. participation exemption) because the income is not treated as ECI for certain purposes; however, the electing foreign corporation will need to be in a treaty country for the branch profits tax not to apply. Overall state income tax implications Many of the proposed federal tax reform measures, if enacted, would affect the income taxes imposed by state governments. Generally, most state income tax systems use federal taxable income as a starting point for state income tax computations, but do not automatically conform to federal tax rate changes. Thus, state income taxes would rise (immediately or in the near term) as the federal tax base expands, unless states align their tax rates with federal tax rate reductions. States that do not adjust their rates could significantly increase their tax revenues without taking any action. As federal tax reform progresses, life sciences companies should keep the parallel state income tax implications in mind. Consequently, all taxpayers should focus in the coming months on utilizing a state-specific model to quantify the potential impacts of federal tax reform, as well as to identify and implement any applicable mitigation strategies (with particular time-sensitive focus on the transition tax). Corporate taxpayers should also educate their governmental affairs group as to the potential impact of federal tax reform from a state income tax perspective so that the appropriate message can be conveyed to state legislatures. ———————————————
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