Pharmaceutical R&D tax incentives
Globalization and outsourcing of R&D in the pharmaceutical industry and the impact on accessing R&D tax incentives
For the last several years, the pharmaceutical and biotech industries have been under intense pressure to introduce new products in an environment of escalating R&D costs, increasingly complex science, heightened regulatory scrutiny, increased competition and other pressures.
To remain competitive, pharmaceutical companies continue to have to do more with less. Within the last three years alone, many big pharmaceutical companies have closed major R&D centers around the world. Nevertheless, R&D spending is expected to continue to rise, from US$137 billion in 2013 to an estimated US$162 billion in 2020.1
Contract research organizations (CROs) are playing an increasingly important role in the entire drug development process. They now perform a wide range of services, including development of research models, discovery services, chemical analyses, bioanalyses, toxicological services, imaging, and clinical trial services from pre-clinical through to phase IV, as well as consulting and sales activities.
The continued reduction of internal R&D capacity of big pharmaceutical companies as well as the growth of strategic partnerships has driven increased outsourced penetration rates.2 EvaluatePharma estimates that the CRO industry will grow by approximately 40% from US$26 billion in 2013 to US$36.6 billion in 2018. The reason for this incredible growth is not only the greater efficiencies that CROs can offer, but also CROs’ improving scientific and therapeutic expertise.
Importance of R&D incentives to the pharmaceutical industry
As R&D budgets tighten, R&D incentives, such as the tax credits and enhanced tax deductions offered by many countries worldwide, become increasingly important. Pharmaceutical companies have long been big recipients of these incentives, and many rely on them to help fund their R&D programs.
However, globalization of the pharmaceutical industry and increased outsourcing have drastically changed the R&D landscape. Different countries have very different rules about who can claim these incentives. Pharmaceutical companies may be under the impression that since their R&D spending is increasing, their R&D credits or deductions will also increase; but depending on the jurisdiction, this may not be the case.
Shifting more work to CROs as well as changing the locations where R&D is performed can have a significant impact on credits earned on the same total spend. New start-up CROs may not have experience in or even knowledge of how to claim these incentives. Therefore, it is critical that pharmaceutical companies and CROs understand the specific rules surrounding these incentives in the countries where they may be undertaking R&D.
Planning R&D on a global scale
Despite operating at a global scale, it seems few companies are taking the R&D incentives into account when planning their global projects. Understanding the individual programs, the associated issues and how to address them will help all companies (pharmaceutical companies and CROs alike) receive the greatest allowable benefits and reduce controversy with the taxation authorities or other bodies administering these incentive programs.
Who is doing what for whom and where?
The eligibility rules for most countries’ R&D incentives are derived from the OECD definition of research and development. As such, the drug development process and the associated activities generally qualify for R&D incentives in most countries. The eligibility determination becomes more challenging when dealing with multinational clinical trials, or when one party is contracting another to perform some or all of the work, with some of it being conducted offshore. In these circumstances, issues as to who is entitled to claim the incentive, and what can they claim, become more difficult.
Where specific elements of a clinical trial are performed will greatly influence the amount of R&D incentives received. In addition, the nature of the agreements between the parties performing the work is critical in determining who can claim the R&D incentives. However, if agreements are not set up properly between the appropriate parties (e.g., if the agreement doesn’t properly reflect who controls the R&D or on which entity’s behalf the work is being done), situations could arise where no company can earn the incentive.
Variations of incentives by country
Below we highlight the various incentives in six countries and the different impacts they have on pharmaceutical companies and CROs. These highlights are also summarized in Table 1. Note that provincial and state incentives are also available in some countries.
The Australian R&D incentive provides tax offsets of 40% or 45% depending on the company size. Payments by Australian pharmaceutical companies to CROs for R&D are generally eligible. Some offshore expenditures are eligible. Since CROs rarely meet the IP ownership requirements, it is rare for CROs to make claims for the incentives.
The Canadian incentive comprises a 15% non-refundable federal tax credit on eligible expenditures. An enhanced refundable tax credit at a rate of 35% exists for small Canadian-controlled private corporations (CCPCs). Generally, the work must be undertaken in Canada. Payments by a Canadian pharmaceutical company to a Canadian CRO are generally eligible. CROs can claim the credit on R&D expenditures if the funding is received from a foreign client or if they encounter cost overruns when working for a Canadian client.
Mainland China’s R&D incentives include a 150% R&D superdeduction as well as a number of other programs which allow qualifying corporations to realize a flat 15% corporate tax rate. Preapproval or registration is required. Incentives are generally awarded to the party that is funding the R&D and, for some programs, has IP ownership. Unless performing their own internal R&D, CROs would generally not qualify for the R&D incentives given that they are not funding the pharmaceutical research or because they do not have IP rights.
A 100% deduction is available to companies in India for qualifying expenditures paid out or expended in scientific research related to the business. A weighted deduction of 200% is available for scientific research on in-house R&D expenditure (including capital expenditure but excluding land and building). Government approvals are required. The claimant must be able to demonstrate that the expenditure is related to the business of the claimant and they have ownership of the resulting IP. Thus, CROs located in India do not normally receive the R&D incentives. There is also a provision allowing 125% deduction on amounts paid to approved third-party R&D contractors (subject to conditions).
There are two R&D revenue schemes running concurrently in the UK. The R&D Superdeduction scheme gives large companies an additional 30% deduction in the calculation of their taxable income for qualifying R&D expenditures. The R&D expenditure credit (RDEC) is a taxable credit paid at a headline rate of 11% (from April 2015).
A 225% superdeduction is also available to certain small and medium-sized enterprises (SMEs). There is no requirement that the claimant must own the IP, nor does the work have to be performed within the UK. Generally, UK R&D tax incentives are only available to the “performer” of the research.
Incentives can also be earned by the claimant on certain qualifying expenditures paid to a sister company of the same group or for their own employees to perform work under the claimant’s control that takes place offshore. Payments made by UK pharmaceutical companies to CROs (foreign or domestic) to “perform” R&D cannot earn the incentives. CROs, on the other hand, can potentially claim the benefit instead.
The basic US federal research credit rewards businesses for an increase in their spending on research. A US taxpayer must determine the increment of its current-year qualified research expense (QRE) over a computed base amount in order to claim the research credit.
There are two methods for computing the research credit: the regular credit (which is capped at 20% on 50% of QREs) and the alternative simplified credit (14% on 50% of the average QREs over the previous three years).
The work claimed must be done within the US. Generally, a credit can be earned on 65% of the payments made to CROs, where work is done in the US, the taxpayer has a right to the research results (but the taxpayer need not have exclusive rights), and the taxpayer bears the risk of the research (which is nearly always the case). CROs who are paid to conduct R&D on behalf of their client generally cannot earn the R&D credit because this is known as “funded research.”
The above table contains only a sampling of the many differences that can exist between countries, but it emphasizes the need to understand the varying programs and their rules when planning global R&D.
Many countries reward the type of research that occurs in the pharmaceutical industry, and taking R&D incentives into consideration needs to be an integral part of the global R&D planning process.
The values of the incentives vary greatly among countries, but they are generally attractive for pharmaceutical companies conducting research in those countries, and often for CROs as well. Some countries offer enhanced incentives for SMEs that meet specific criteria. However, the rules surrounding the individual countries’ incentives are complex. For most regimes, the nature and structure of the agreements between pharmaceutical companies plays a critical component in supporting a claimant’s eligibility for R&D incentives. R&D structured properly between countries and between pharmaceutical companies and CROs can optimize the combined credits for all parties and reduce overall global costs.
How EY can help
EY’s Global R&D Incentives practice includes over 700 R&D incentives professionals worldwide who can help you navigate the complex rules, assist with the global R&D planning process, structure and evaluate agreements, and help you maintain status for the enhanced credits, if desired, to allow you to optimize your R&D incentives.
About the author
Elizabeth Pringle, MSc
Elizabeth Pringle is an Executive Director from EY’s Canadian Tax Practice and joins EY’s US NTD QS team on a 15 month secondment during which she will reside in New York City. Prior to joining EY, Elizabeth was a research scientist in both the public and private sectors and was most recently with the Canada Revenue Agency (CRA) in the Scientific Research and Experimental Development (SR&ED) Directorate. During her eight years with CRA, she held various positions including technical auditor, Research and Technology Manager and National Technology Sector Specialist and was actively involved in policy development for the SR&ED Program.
1 “World Preview 2014, Outlook to 2020,” EvaluatePharma, June 2014.
2 Healthcare Distribution & Technology: CRO Industry Guidebook, Credit Suisse LLC, 2015.