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In the wake of the November 2016 US elections, Republican lawmakers are planning to move forward with comprehensive federal tax reform. Life sciences companies stand to benefit from some aspects, such as proposals to lower the corporate tax rate to 20% and to allow the immediate expensing of investments. The proposed elimination of certain deductions, however, could offset some of that benefit. And, perhaps most significantly, the proposed "border adjustments" could have dramatic effects depending on the specific supply chain profile of the business.

President Donald Trump and congressional leaders have signaled that tax reform is a high priority and that they will try to enact legislation this year. The House Republican tax reform Blueprint (the Blueprint), released in June 2016, is expected to be a starting point for this effort. Life sciences companies can begin making informed tax planning decisions by analyzing the potential effect of the Blueprint's proposals.

Key Blueprint provisions

Domestic issues

The Blueprint contains several proposals, including the lowering of corporate tax rates and the elimination of certain corporate tax preferences. While specifics are still being developed, companies should consider what deductions are significant to them and if they can or should be accelerated, as well as whether there are ways to defer revenue to 2017 or 2018, when tax rates might be lower. With a possible lower corporate tax rate of 20%, the deductions would effectively be worth less in the future, and some might disappear altogether. As such, companies may want to evaluate their deferred tax assets and liabilities and identify opportunities to accelerate deductions and defer income as part of their tax planning.

There are certain tax-planning actions life sciences companies may consider taking now regarding the timing of deductions and income recognition reported on their financial statements. Such planning would cause minimal disruption to the business, but could create permanent tax savings given the possibility of a future drop in the corporate income tax rate.

Specifically, life sciences companies can 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 the extended due date of the tax return to be effective for the 2016 calendar tax year.

US accounting rules (under ASC 740-10-35-4) require the adjustment of deferred tax assets and liabilities when there is a change in the federal income tax rate. The effect of such adjustment must be included in income from continuing operations for the period that includes the enactment date of the rate change. 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.

International issues

As they weigh the mix of tax reform proposals Congress is considering, life sciences companies also need to examine the possible effects of proposed international tax changes that could place a greater tax burden on importers, provide significant tax benefits to exporters and require tax payments for previously untaxed accumulated foreign earnings. Because the effects will depend greatly on a specific company's tax footprint, companies should model both the proposed domestic tax changes and the international tax changes discussed later.

Modeling the specific proposals now can help a company make a number of decisions going forward, including decisions surrounding the costs and benefits of moving manufacturing from overseas to the United States, given the major shifts in tax treatment that could accompany certain proposals, notably the border adjustment proposal described later. Additionally, depending on their locations and supply chains, some life sciences companies could incur ongoing future losses under some of these changes. Companies will want to analyze whether their future state could warrant a valuation allowance against such losses, or if the losses provide an opportunity for import-oriented expansion without significant tax cost.

Repatriation

Among the Blueprint's international provisions, the so-called deemed repatriation is of particular interest to the life sciences sector. The Blueprint would impose an 8.75% tax rate on previously untaxed accumulated foreign earnings held in cash or cash equivalents, and a 3.5% tax rate on all other accumulated earnings, payable over up to eight years. A similar proposal was included in former House Ways and Means Committee Chairman Dave Camp's 2014 tax reform plan, and policymakers might look to Camp's proposal for guidance in drafting the new legislation.

This deemed repatriation proposal could significantly affect life sciences companies that have earnings and cash / cash equivalent balances in foreign corporations owned by US companies that have not been repatriated. These companies should analyze the earnings and profits, tax pools, and cash / cash equivalent balances of their foreign subsidiaries to determine what the effect on their US tax liability could be if this proposal is enacted. Companies should consider whether deductions can be accelerated or income deferred to future years to reduce the effect of the "deemed repatriation" charge.

Border adjustment proposal

The Blueprint also includes a controversial "border adjustment" proposal. Under the proposal, only revenue from domestic sales would be taxable. Revenue associated with US exports would not be taxed, while domestic costs incurred to make the exported products would remain deductible. Costs incurred to purchase imported goods or services, however, would be in the tax base, and as a result would either be taxed directly or would not be deductible.

The border adjustment proposal could significantly affect life sciences companies and their supply chains, specifically with respect to their manufacturing footprint, and/or beneficial ownership of intellectual property (IP). Border adjustments could be either negative or positive depending on whether a company is a net importer or exporter. For example, a pharmaceutical company may currently maintain certain key functions outside the United States, which entitles the foreign jurisdiction to a majority of the global residual profits for a particular product leaving the United States with a large cost of goods sold deduction related to the sale of finished goods in the United States. Under border adjustability, the US company could not deduct the purchase price of such imports, which may significantly increase its US tax liability going forward. Companies should consider the effects of maintaining certain key activities and IP offshore in light of this proposal. Further, companies should start to consider the ability to transition such activities, IP and other value drivers in the supply chain back to the United States. Such costs may be material, but they need to be compared against the loss of deductions related to imports into the United States. Companies should consider not only their current product mix, but also the effects of future products and the optimal supply chain structure.

If the border adjustability proposal is enacted, the transition rules — which are yet to be determined - will be an important consideration. Given the complexities associated with manufacturing products in the life sciences industry, transitioning manufacturing to the United States (either through a third party or intercompany) will take time. Therefore, transition rules (if any) may have a material effect before the border adjustment system is fully adopted.

Conclusion

While questions about the timing and structure remain, life sciences companies should start considering the issues raised by the Blueprint and how they may be affected. Even if tax reform is revenue-neutral overall, the specific circumstances of each company may not reflect that. Life sciences companies should consider evaluating their supply chains for manufacturing and IP, evaluating sourcing options, locations of value-add activity, options for producing for or licensing to export markets, and plans for capital expansion. Each factor can influence US tax liability significantly if the Blueprint's border adjusted cash flow tax approach is adopted. Life sciences companies should also consider the future and current availability of deductions in their planning.

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