On December 22, 2017, President Trump signed into law, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for the fiscal year 2018” (“tax reform” or the “law”). The law preserves and enhances the value of the Credit for Increasing Research Activities under Internal Revenue Code (IRC) Section 41 (Research Credit) while eliminating or reducing the value of related incentives like the IRC 199 Domestic Production Activities Deduction (DPAD) and IRC 45C Orphan Drug Credit (Orphan Drug Credit).
The Research Credit was enacted in 1981 to incentivize taxpayers to increase investments in developing new or improved products, manufacturing processes, software, techniques, inventions and formulae in the United States. In 2015, the Protecting Americans against Tax Hikes Act (PATH Act) made the credit a permanent part of the IRC and expanded its benefit to certain small businesses and startups. The DPAD and ODC were enacted subsequent to the Research Credit for similar reasons.
Research Credit’s Value Enhanced
Lower Corporate Tax Rate
The law cuts the corporate tax rate from 35% to 21%. In effect, this cut increases the Research Credit’s net benefit by more than 21%, from its previous amount of 65% to the law’s 79%.
The 21% increase in the credit’s net value is due to IRC Section 280C(c).
Enacted to prevent taxpayers from getting a double benefit for their research-related expenses—i.e., a deduction and a credit for the same expenses—Section 280C(c) requires taxpayers to (1) reduce their deduction for IRC Section 174 allowable expenses by the amount of the Research Credit, or (2) elect a reduced credit generally equal to the Research Credit minus the product of the Research Credit and the maximum corporate tax rate.
With the maximum rate now at 21% instead of 35%, the reduced credit now equals 79% instead of 65% of the Research Credit, i.e., 100% less 21% instead of 100% less 35%.
Corporate Alternative Minimum Tax Repealed
The law repeals the corporate Alternative Minimum Tax (AMT) provisions. This means that taxpayers who would have been subject to AMT and who therefore generally wouldn’t have been able to use Research Credits to offset their federal income tax liability now will be able to do so.
Historically, corporations could only use the Research Credit to offset only ordinary income tax liability, and not their AMT. Starting in 2016, the PATH Act allowed eligible small businesses—viz., privately held businesses with $50 million or less in average gross receipts for the three preceding tax years—to utilize the Research Credit against their AMT.
By eliminating the AMT’s Tentative Minimum Tax for corporations, the law allows the Research Credit to reduce a taxpayer’s liability down to 25% of the amount of net regular tax liability that exceeds $25,000, a limitation imposed by IRC Section 38(c).
Modification of Net Operating Loss Deduction
The law limits the amount of Net Operating Losses (NOLs) that a taxpayer can use to offset taxable income to 80% of its taxable income for losses arising in tax years beginning after December 31, 2017. NOL taxpayers may now find the Research Credit a helpful way to offset the taxes they’ll have to pay.
The law also repeals the provision allowing for the current two-year carryback of NOLs and allows an indefinite carryforward of NOLs arising in tax years ending after December 31, 2017.
Section 199 Domestic Production Activities Deduction (DPAD) Repealed
The law repeals DPAD for tax years beginning after December 31, 2017. Section 199 previously provided a tax deduction to taxpayers deriving income from “qualified production activities” performed in the United States, which included manufacturing of tangible property and software development.
Orphan Drug Credit (ODC) Rate Reduced
For tax years beginning after December 31, 2017, the law reduces the ODC rate to 25%, down from 50%.
Even at 25%, though, the ODC is generally more beneficial than the Research Credit for the same costs
to which it applies: the ODC rate is 25%, the Research Credit’s 20%, or about 16% after Section 280C(c); the ODC calculation includes 100% of qualified contractor costs, the Research Credit’s typically only 65%; and the ODC equals 25% of qualified costs, the Research Credit 20% of only the qualified costs that exceed a base amount.
The ODC was enacted to incentivize pharmaceutical companies to develop drugs that treat diseases affecting less than 200,000 patients in the U.S. Developers of such drugs are eligible for a tax credit equal to a percentage of their qualifying costs incurred between the date the FDA grants the taxpayer orphan status and the date the FDA approves its drug for patients.
The law also allows for taxpayers to elect a reduced ODC, similar to the 280C(c)(3) election for the Research Credit.
Amortization of Research and Experimental Expenditures
For amounts paid or incurred in a tax year beginning after December 31, 2021, the law will require taxpayers to capitalize and amortize IRC Section 174 research and experimental (R&E) expenditures over a five year period, beginning with the midpoint of the taxable year in which the expenditure is paid or incurred. Costs for research conducted outside of the U.S. will be amortized over a 15-year period.
Further, expenditures for the development of any software will be treated as R&E expenditures. For purposes of this rule, software development costs are included in the definition of R&E expenditures.
Under current law, Section 174 generally allows taxpayers to deduct R&E expenditures as the amounts are paid or incurred during a tax year; alternatively, taxpayers may elect to capitalize and amortize these expenditures over a period of no less than 60 months.
The new provision will impact taxpayers treating R&E costs as deductible expenses by no longer enabling them to recover costs incurred in the year in which they are incurred. Accordingly, taxpayers currently deducting R&E costs in the year incurred will be required to file an Application to for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing such costs for tax years beginning after December 31, 2021.
With the new provisions of tax reform, taxpayers should evaluate how the changes above impact their future tax position and how the Research Credit and ODC can help minimize tax liabilities. Key takeaways are listed below:
- The cut of the corporate tax rate increases the Research Credit’s net benefit by more than 21%, from its previous amount of 65% to the law’s 79%.
- Taxpayers who would have been subject to AMT and who therefore generally wouldn’t have been able to use Research Credits to offset their federal income tax liability now will be able to do
- NOL taxpayers may now find the Research Credit a helpful way to offset the taxes they’ll now have to pay given the modification of the NOL
- While the ODC credit rate has been reduced to 25%, it still provides a meaningful benefit for eligible taxpayers, generally more beneficial than the Research
- Taxpayers seeking to maximize the benefit of immediately deducting R&E expenditures should consider the effective date of the required amortization rule (i.e., December 31, 2021) and if possible, accelerate their R&D activities prior to December 31,