December 20, 2017 Life sciences sector notes significant provisions in final tax reform bill On December 15, 2017, the House and Senate conferees to the "Tax Cuts and Jobs Act" (H.R. 1) signed and released a Conference Agreement. Congress passed the final version of the Tax Cuts and Jobs Act this week and sent it to the President for signature, capping off the most significant legislative achievement of the Trump Administration to date and the first major overhaul of the federal income tax in more than 30 years. The Conference Agreement would dramatically change international and corporate tax law, and would have particular impact on the Life Sciences sector. International tax provisions The Conference Agreement reflects a compromise between the Senate and House proposals (see Tax Alerts 2017-1879 and 2017-1951), but has the same general framework, including: (a) the imposition of a transition tax on accumulated foreign earnings; (b) modification and significant expansion of Subpart F, and (c) the imposition of new and sweeping anti-base erosion rules. Transition tax Like the House and Senate bills, the Conference Agreement includes a one-time transition on the deferred foreign earnings of foreign corporations with a 10% US shareholder. The Conference Agreement would tax these earnings at 15.5% for earnings held in cash or other specified assets, and 8% for all other earnings — rates that are higher than both the Senate bill (which provided for rates of approximately 14.5% and 7.5%, respectively) and the House bill (14% and 7%, respectively). In addition to the uptick in rates, the Conference Agreement would, like the Senate's version, retroactively increase the rate on these earnings to 35% if the US shareholder inverted within 10 years — that is, if the US shareholder becomes an expatriated entity. No foreign tax credits would be available to offset the tax in this instance. This may be particularly relevant to life science companies considering the number of past inversions in the sector. GILTI and FDII The Conference Agreement, like the Senate bill, would impose a tax on a US shareholder's pro rata share of its CFCs' global intangible low-taxed income (GILTI). GILTI is generally determined on a formulaic basis and equals a US shareholder's aggregate pro rata shares of tested income and tested loss over 10% of its aggregate pro rata shares of qualified business asset investment (QBAI). Tested income means all of a CFC's gross income, reduced by applicable deductions, other than effectively connected income (ECI), subpart F income, certain high taxed income, dividends from related parties, and foreign oil and gas extraction income. The Conference Agreement provides that, like the Senate bill, the US shareholder may claim a foreign tax credit in respect of 80% of the foreign taxes paid on the income (subject to applicable foreign tax credit limitations). As noted in the previous Alerts on the impact of the House and Senate tax reform bills on the LIFE SCIENCES sector, QBAI does not include intangible property. Many life science 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 high-basis tangible assets. Accordingly, it is expected that many companies would be affected by this provision and may have significant amounts of GILTI. The Conference Agreement also, like the Senate bill, includes an incentive for US corporations to export goods and services by providing a deduction for foreign-derived intangible income (FDII). Unlike the Senate bill, however, the Conference Report does not permit tax-free repatriation of existing IP. Under the FDII provision, income from the sale of goods and the provision of services outside the United States would be effectively taxed at 13.125% for tax years beginning after December 31, 2017. This tax rate would increase after December 31, 2025, to 16.406%. FDII is the "foreign-derived" portion of "deduction eligible income," which is determined on a formulaic basis in a manner similar to the GILTI provision described earlier, except for US corporations instead of CFCs. Generally, foreign-derived income arises from product sales, royalties, and provision of services by a US company to non-US persons for use outside of the United States.1 Foreign branch income, however, is excluded. The FDII deduction may be of particular interest to companies in the life science sector that own the US intangible rights and the related functions already in the US. No repeal of Section 956; Section 954(c)(6) not made permanent Notably, unlike the House bill and the Senate bill, the Conference Agreement did not repeal Section 956, nor did it make permanent Section 954(c)(6), which generally excludes from foreign personal holding company income all dividends, interest and royalties paid by related CFCs. The continued application of Section 956 may negatively impact life science companies as they will have to continue to monitor and modify their supply chains to avoid application of Section 956. Anti-base erosion The Conference Agreement adopts the Senate bill's base erosion anti-abuse tax (BEAT) provision. The BEAT would apply to corporations (other than RICs, REITs or S corporations) that are subject to US income tax with average annual gross receipts of at least $500 million and that have made base erosion payments totaling 3% or more of the corporation's total deductions for the year. A base erosion payment generally means 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. A base erosion payment does not include cost of goods sold, except for domestic corporations that invert after November 9, 2017. A corporation would be subject to a minimum tax of 10% (5% for tax years beginning in calendar year 2018 and 12.5% for years beginning after December 31, 2025). The tax would apply to a corporation's modified taxable income for the year, which would generally equal the corporation's taxable income plus all base-erosion tax benefits (i.e., deductible payments and cost recovery deductions attributable to payments to related foreign persons). Life science companies have complex and global supply chains with many cross-border payments for goods, services, and IP, which these anti-base erosion provisions would affect. Section 367 Lastly, like the Senate bill, the Conference Agreement would expand 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" whose value is not attributable to tangible property or the services of an individual. The Conference Agreement also confirms the authority to require certain valuation methods. This would affect companies that license or sell intangibles to be used abroad. Federal tax provisions Lower corporate tax rate The Conference Agreement reflects a 21% corporate tax rate that would be effective in 2018 — an increase from the 20% rate in the bills passed by the House and the Senate. With a lower corporate tax rate of 21%, deductions would effectively be worth less in the future. 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. The corporate rate would generally be effective January 1, 2018, for both calendar-year and fiscal-year taxpayers. There are certain tax planning opportunities 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 reduction in 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 — 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 Changing the timing of deductions would necessitate an application for change in accounting method (i.e., Form 3115).For calendar-year taxpayers, the window is quickly closing for non-automatic accounting method changes, which must be filed on or before December 31, 2017, to be effective for the 2017 tax year. For calendar-year taxpayers, automatic accounting method changes must be filed on or before October 15, 2018 (i.e., the extended due date of the tax return) to be effective for the 2017 calendar tax year. Repeal of Section 199 domestic production activities deduction The deduction for domestic production activities would be repealed effective after December 31, 2017. The Conference Agreement follows the House bill provision repealing Section 199, but does not include the separate provision in the House bill that would have retroactively extended Section 199 for one year to domestic production gross receipts from Puerto Rico. 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 repealed. Particular areas of focus could include, but not be limited to, the following: — 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 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), have been taxpayer favorable in the determination of what constitutes manufacturing/production and what production activities are substantial in nature. — Companies have opportunities to review and claim contract manufacturing activities and the commensurate revenue streams as Section 199 eligible. Modification of orphan drug credit The 50% credit would be reduced to 25% and generally would need to exceed 50% of the average expenses over a three-year period. The reduced credit would apply to amounts paid or incurred in tax years beginning after December 31, 2017. 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 25%. Therefore, eligible life sciences companies would be better off claiming the orphan drug credit than the research credit. ———————————————
——————————————— 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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