November 17, 2017 Life sciences sector notes significant provisions in Senate Finance Committee tax reform plan On November 9, 2017, the Senate Finance Committee issued an extensive tax reform proposal via a description of the Chairman's Mark of the "Tax Cuts and Jobs Act" (Chairman's Mark). The Chairman's Mark, released one week after House Republicans unveiled an initial tax reform bill (House Bill), maintains the same basic reform framework as the House Bill, which the House passed on November 16. (The impact of the House Bill on the Life Sciences sector is discussed in Tax Alert 2017-1879.) While both the Chairman's Mark and the House Bill have substantial similarities, the Chairman's Mark diverges from the House Bill in several key respects that have material implications for the Life Sciences Sector. The purpose of this Alert is to examine the differences between the Chairman's Mark proposed tax reform rules and the tax reform rules adopted in the House Bill, with a view towards analyzing those provisions that are likely to be the most relevant to life sciences companies. For a comprehensive overview of the primary Chairman's Mark provisions, see Tax Alert 2017-1907. International tax provisions The Chairman's Mark includes major proposals for the international tax system, such as: (a) imposing a transition tax on accumulated foreign earnings; (b) modifying Subpart F; and (c) imposing anti-base erosion rules. Transition tax Like the House Bill, the Chairman's Mark would impose a one-time transition on a US 10%-shareholder's pro rata share of the foreign corporation's post-1986 tax-deferred earnings. The Chairman's Mark would tax these earnings at the rate of either 10% (in the case of accumulated earnings held in cash, cash equivalents or certain other short-term assets) or 5% (in the case of accumulated earnings invested in illiquid assets (e.g., property, plant and equipment)). In addition to the rate difference from the House Bill, the Chairman's Mark also has a new anti-inversion provision. The anti-inversion provision would require the US corporation to pay the full 35% rate on the deferred foreign earnings (less the tax it already paid), if the US corporation inverted within 10 years after enactment. No foreign tax credits would be available to offset the tax in this instance. This may be particularly relevant to inbound life science companies considering the number of past inversions in the sector. Modifications to Subpart F The Chairman's Mark would impose a tax on a US shareholder's pro rata share of its CFC's global intangible low-taxed income (GILTI) at a reduced rate equal to 10% (12.5% after 2025). Relevant CFC income, for this purpose, is gross income in excess of a 10% return on depreciable, tangible assets, other than income that is effectively connected income (ECI), subpart F income, certain high taxed income, dividends from related parties, and foreign oil and gas extraction income. This provision has similarities to the House Bill's foreign high-return amounts (FHRA) provisions, although there are also significant differences. In particular, the House Bill would treat as FHRA income in excess of 7% plus the short-term applicable federal rate. In addition, the carve-outs are similar, but not identical to the House Bill. Most notably the carve-outs do not include active financing or insurance income. Only 80% of the foreign taxes paid on the income would be allowed as a foreign tax credit. Similar to the House Bill, all CFCs are aggregated. As noted in the previous Alert on the impact of the House Bill on the Life Sciences sector (discussed in Tax Alert 2017-1879), the fact that intangible property would not be treated as a qualified business asset investment for purposes of the GILTI provisions is significant to life sciences companies. Most life sciences companies have significant intangible property outside the US. 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. Unlike the House Bill, the Chairman's Mark would create incentives for US companies to repatriate their intangible property by allowing both a deduction for foreign-derived intangible income (FDII) and tax-free repatriation of existing IP. Similar provisions were not included in the House bill. This provision, along with the deduction for foreign-derived intangible income (FDII) provision as discussed below, may be of particular interest to companies in the life sciences sector who are looking to align ownership of the US intangible rights with development, enhancement, maintenance, protection, and exploitation ( DEMPE) functions in the US. Lastly, the Chairman's Mark would modify current law that taxes as dividends investments made by certain foreign corporations in US property (Section 956). The Chairman's Mark would provide an exception for domestic corporations that are US shareholders in the CFC directly or through a domestic partnership. The House Bill would repeal the whole section. Life sciences companies often have to modify their supply chains to minimize the application of Section 956. The modification of Section 956 would allow companies to simplify their supply chains in many instances. Anti-base erosion In addition to incentives to repatriate intangible property, the Chairman's Mark would include an incentive for US companies to sell goods and services abroad. Income from the sale of goods and services abroad would be effectively taxed at only 12.5% due to a deduction equal to 37.5% of FDII at 37.5% (21.875% for tax years after 2025). FDII is the "foreign-derived" portion of the excess of certain net items of income, over a deemed return on related tangible property. Generally, foreign-derived income arises from product sales and the provision of services by a US company to non-US persons for use outside of the United States.1 Foreign branch income is excluded. Interestingly, this provision does not appear to apply to royalties received from foreign persons, as would be the case where intangible property is repatriated as discussed above. Additionally, the Chairman's Mark would create a new base erosion minimum tax provision focused on inbound companies, but which may have broader applicability. The provision would apply a minimum tax to corporations (other than RICs, REITs, or S-corporations) that have average annual gross receipts of at least $500 million for the three-year period ending with the preceding tax year and make related party base-eroding payments totaling 4% or more of the corporation's total deductions for the year. A base erosion payment generally would mean (i) any amount paid or accrued by the corporation to a foreign related party and with respect to which a deduction is allowable, including amounts paid or accrued to acquire depreciable or amortizable property (but not including cost of goods sold) and (ii) any amount that constitutes reductions in gross receipts (such as cost of goods sold) of the taxpayer that is paid to or accrued by the taxpayer with respect to either a surrogate foreign corporation related to the taxpayer, or a foreign person that is a member of the same expanded affiliated group as the surrogate foreign corporation. A corporation would be subject to a minimum tax of 10% (for years beginning before January 1, 2026 and 12.5% thereafter) based on its adjusted taxable income for the year, which would add back to taxable income all base-eroding payments made to a foreign affiliate for the year (the modified taxable income). Lastly, differing from the House Bill, the Chairman's Mark would change the definition of intangible property for transfers falling under Section 367(d) after December 31, 2017 to include workforce in place, goodwill and going concern value and "any similar item" the value of which is not attributable to tangible property or the services of an individual. The Chairman's Mark also would confirm the authority to require certain valuation methods. This would impact companies that license or sell intangibles to be used abroad. Life sciences companies have complex and global supply chains with many cross-border payments for goods and services for which these anti-base erosion provisions would be impacted. In addition, many life sciences companies have grown through acquisition, often the acquisition of non-US multinationals with high value in intangibles. If US companies pay royalties to use IP owned abroad, purchase a product manufactured abroad by a related party, or pay for services undertaken outside the US, these supply chains will also be impacted by the Chairman Mark's anti-base erosion provisions. Further, life science companies considering post-acquisition integration of acquisitions with high value intangibles may also be impacted. Corporate tax provisions Section 199 The domestic production deduction relating to deductions for qualifying receipts derived from certain activities performed in the United States would be repealed for tax years after 2018 (a one-year delay from the House bill's proposal to repeal the deduction starting in tax years after 2017). Because the Senate Plan would extend the Section 199 deduction by one year more than the House bill, taxpayers with production or service activities that are within the scope of Section 199 may want to review claims they have already made for additional opportunities or consider making an initial claim. In addition, taxpayers with production or service activities may want to consider filing amended returns for open tax years beginning before January 1, 2019. Life sciences companies may benefit from an increased focus on Section 199 planning for tax years beginning before January 1, 2019 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. Orphan Drug Credit The 50% credit would be retained but generally would need to exceed 50% of the average expenses over a three-year period. The creditable expenses would no longer include those for testing drugs that have been previously approved for use. The provision proposes a modified orphan drug credit calculated in a manner similar to the alternative simplified credit (ASC) under Section 41(c)(5). Expenses that qualify for the credit under Section 45C generally also qualify for the research credit under Section 41, but the ASC provides a 14% credit whereas the orphan drug credit is 50%. Further, the ASC is limited to 6% if there are no qualified expenses in any one of the three prior years, whereas the orphan drug credit is limited to 25%. Therefore, eligible taxpayers would be better off claiming the orphan drug credit than the research credit. As a result of the provision's credit computation, aggregation and certain other rules similar to those in Section 41(f) would apply where there are controlled groups, mergers and acquisitions, and short tax years. These rules are currently referenced in Section 45C; however, they have little applicability outside of intra-group transactions due to the present credit's lack of a base amount computation. Notably, the provision would introduce a new limitation on the credit that would apply to drugs that were previously approved for any other condition, seemingly even if only approved for another rare disease or condition. If a drug is approved for its treatment of any condition and later receives an orphan drug designation for its treatment of a rare disease or condition, both the approved condition and the rare disease or condition are aggregated for purposes of the 200,000 persons test. This new requirement does not factor in the expected recovery of costs of developing the drug for the orphan condition, and appears to be strictly limited to 200,000 affected persons in the United States. This would severely limit the orphan drug expenses eligible for the credit, as it is common to identify a drug's therapeutic benefit for a rare disease or condition after it has been approved and marketed for treatment of a different condition. The provision would have the effect of reducing the orphan drug credit, but is clearly more taxpayer-favorable than the full repeal of the credit that was proposed in the House bill. Section 174 research or experimental expenditures Under Section 3315 of the House Bill, Section 174 would require taxpayers to treat research or experimental expenditures as chargeable to a capital account and amortized over five years (15 years in the case of foreign research). The provision would also modify Section 174 to require that all software development costs be treated as research or experimental expenditures. Any capitalized research or experimental expenditures relating to property that is disposed of, retired, or abandoned during the amortization period must continue to be amortized throughout the remainder of the period, under the provision. Under the provision, Section 174 would continue to be inapplicable to expenditures: (1) for the acquisition or improvement of land; (2) for the acquisition or improvement of property to be used in connection with research and development and is subject to the allowance for depreciation under Sections 167 or 616; or (3) for exploration expenditures to ascertain the existence, location, extent, or quality of any deposit of ore or other minerals (including oil and gas). As part of the conforming amendments to the repeal of the alternative minimum tax (Section 2001 of the House Bill), the cross-reference in Section 174(f) to Section 59(e) would be deleted, eliminating the elective 10-year amortization of research or experimental expenditures. The provision is similar to draft legislation introduced by Congressman Dave Camp in 2014 as the "Tax Reform Act of 2014," aside from the phase-in approach for domestic research under the Camp proposal. These provisions would be effective beginning in 2023. For tax years after the effective date, some correction may be needed to Section 41(d)(1), which defines qualified research (for purposes of the research credit) by reference to "research with respect to which expenditures may be treated as expenses under section 174," because Section 174 will no longer treat any expenditures as "expenses." For expenditures paid or incurred in tax years beginning after 2022, taxpayers would be required to capitalize such costs and recover such costs over five (or 15) years. The provision would remove the ability for taxpayers to recover costs incurred for research and development in the year they are incurred, a considerably negative impact for taxpayers currently treating such costs as deductible expenses. Significantly, the provision both requires amortization of these expenditures and disallows basis recovery if the property with respect to which the research or experimental expenditures are incurred (e.g., a patent) is sold, retired or abandoned. This is a departure from the general rules of basis recovery. Specifically, the provision provides that, upon disposition, retirement or abandonment, no deduction is allowed and the amortization must continue for the remainder of the amortization period. Further, the provision would add a new subsection to Section 174 that specifically includes any amount paid or incurred in connection with software development as a research or experimental expenditure (and, therefore, within the scope of the provision). Presently, these costs may be deducted currently pursuant to Revenue Procedure 2000-50. Generally, purchased software may be amortized over just 36 months pursuant to Section 167(f)(1), so the provision would put taxpayers that develop their own software in a tax position that is less favorable than taxpayers who acquire it. Clearly, the provision's five-year amortization requirement would have a dramatic effect on Life Sciences companies currently deducting their research or experimental expenditures under Section 174. Taxpayers with significant foreign research will feel an even greater impact, as the provision provides a much longer recovery period for foreign research, presumably to incentivize domestic research. These modifications to Section 174 were not reflected or addressed in the Senate Plan. ———————————————
——————————————— 1 If property is sold to a related foreign party, the sale is not treated as for a foreign use unless the property is sold by the related foreign party to another person who is unrelated and is not a US person and the taxpayer establishes to the satisfaction of the Secretary that such property is for a foreign use. | |||||||||||||||||||||
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