Life sciences companies have many new things to consider in light of the changes made by the 2017 tax legislation known informally as the Tax Cuts and Jobs Act (TCJA). Expensing elections for capital expenditures now have a broader scope, deductions for interest expense are subject to new limitations, and expenses for research and development will be subject to new rules for cost recovery. Several international tax developments may also affect how life sciences companies have traditionally structured activities related to research and development.
Businesses should get an early start on investigating these changes so that proper planning can be implemented to take advantage of key provisions or to mitigate the cost of others, and so that the change in corporate tax rates can be captured in 2017 financial statements as required.
Corporate Tax Rate
The corporate tax rate was reduced from a top rate of 35 percent to a flat rate of 21 percent. Additionally, the TCJA repeals the corporate alternative minimum tax (AMT). With a lower corporate tax rate, common business tax deductions are effectively less valuable. As a result, life sciences companies should evaluate their tax accounting methods to identify opportunities for accelerating deductions into 2017 (the final year of higher corporate tax rates) and for deferring income into 2018 (the first year of lower corporate tax rates).
Particular accounting method planning opportunities related to the timing of deductions for life science companies include:
- Acceleration of deductions for charge backs paid to third-party wholesalers under the recurring item exception
- Acceleration of the deduction for Medicaid rebate liabilities under the recurring item exception
- Immediate deduction of certain internal software development costs rather than amortizing them over 36 months
Life science companies should also consider planning ideas to delay the recognition of income, such as using the deferral method of Revenue Procedure 2004-34 relating to advance payments.
Business Interest Limitations
There are new limits for all types of businesses on the amount of business interest expense that can be deducted. The cap is equal to the sum of business interest income plus 30 percent of adjusted taxable income (generally, earnings before interest, taxes, depreciation and amortization, EBITDA), where unused interest expense is carried forward indefinitely. This limitation may affect financing decisions and deal structuring for mergers and acquisitions, with a new preference for equity over debt.
Net Operating Losses
The ability to carry back net operating losses (NOLs) is repealed under the TCJA for losses generated in years ending after Dec. 31, 2017. Furthermore, the new law limits NOL utilization to 80 percent of taxable income for losses arising in tax years beginning after Dec. 31, 2017. The new tax law permits indefinite carryforwards for such NOLs generated in years ending after Dec. 31, 2017. These varying effective dates have led to uncertainty in their intended application, and may be the subject of future legislative correction.
Under the TCJA, excess business losses incurred by individuals are limited to $250,000 per year ($500,000 for joint returns). Such excess business losses include the aggregate amount allocated to individuals from partnerships and S corporations. Disallowed excess business losses are taken into account by individuals as NOLs in subsequent years (which are then subject to the 80 percent limitation, but not the annual gross amount limitation).
Executive Compensation Limitations
The new law retains the $1 million limitation on deductible compensation to “covered employees” by publicly traded companies. However, for tax years beginning after Dec. 31, 2017, the TCJA changes the definition of covered employees to principal officer, principal financial officer, and the three other highest paid officers. In addition, the exceptions for commissions and performance based compensation have been eliminated.Also, employees who are covered employees in a tax year after Dec. 31, 2016, remain covered employees for all future years.
Life sciences companies should prepare an assessment of the potential impact related to executive compensation modifications. In addition, the modifications may further result in a reduction to existing deferred tax assets for compensation arrangements that do not qualify for transition relief. Note, under the transition relief rule, the new provisions would not apply to any remuneration paid under a written, binding contract in effect on Nov. 2, 2017, which is not materially modified on or after this date.
Full Capital Expensing
The new law allows companies to expense 100 percent of the cost of qualified property placed in service after Sept. 27, 2017 and before Jan.1, 2023. After 2023, bonus depreciation winds down, and is generally eliminated after 2026.
Repeal of the Domestic Production Activities Deduction (DPAD)
The new law eliminates certain business deductions, including the Section 199 Domestic Production Activities Deduction (DPAD). The DPAD provided businesses with a 9 percent deduction on income from qualifying manufacturing activities. The DPAD is repealed for tax years beginning after Dec. 31, 2017.
Previous R&D cost recovery rules permitted businesses such as life sciences companies to deduct expenditures associated with qualifying activities immediately. For tax years beginning after 2021, the TCJA requires that such expenditures incurred domestically be capitalized and amortized over five years. Furthermore, such expenditures incurred offshore for tax years beginning after 2021 will be capitalized and amortized over 15 years. In the immediate term, recall that deductions will effectively be worth less after 2017. Accordingly, life sciences companies considering the R&D credit for qualifying expenses should analyze whether electing the reduced credit under Section 280C is beneficial.
Modification of Orphan Drug Credit
For tax years beginning after Dec. 31, 2017, the new law reduces the Orphan Drug Credit rate to 25 percent of qualified clinical testing expense, down from 50 percent. In addition, the new law would allow an election for the reduced credit under Section 280C.
The new law introduces international tax provisions that fundamentally change the U.S. approach to the taxation of foreign earnings, including the implementation of a modified territorial system by providing a 100 percent dividends-received deduction (DRD) on the foreign source portion of dividends received from foreign subsidiaries. Domestic corporations will continue to apply existing Subpart F rules.
Foreign-Derived Intangible Income
Life sciences companies may also want to own new intangible property in the U.S. or consider moving existing intangible property to U.S. locations. The new law allows a U.S. corporation to deduct 37.5 percent of its foreign-derived intangible income (FDII) for taxable years through 2025 (the rate drops to 21.875 percent in subsequent years). FDII is generally income from the sale or license of property to a non-U.S. person for foreign use, or from services provided to any person, or with respect to property, located outside the U.S.
Under the TCJA, U.S. taxpayers must pay a one-time transition tax on previously untaxed foreign earnings and profits of controlled foreign corporations (CFCs) in which they have more than a 10 percent interest. The so-called transition tax is 15.5 percent on foreign earnings and profits attributed to cash or cash equivalents, and 8 percent on such earnings attributed to illiquid assets. The transition tax is needed primarily as a result of the change to a territorial regime, as previously discussed. The territorial regime is expected to encourage U.S. taxpayers to repatriate their foreign earnings, as there is no longer a tax reason to hold them indefinitely overseas.
Global Intangible Low-Taxed Income
The TCJA requires current inclusion in taxable income of a U.S. shareholder's pro rata share of its CFC global intangible low-taxed income (GILTI), similar to current Subpart F inclusion rules. The TCJA allows a deduction equal to 50 percent (2018-2025) or 37.5 percent (after 2025) of the GILTI (resulting in a 10.5 percent effective tax rate on GILTI through 2025 and a 13.125 percent effective tax rate after 2025), but the deduction is capped at taxable income. In addition, the new tax law provides an 80 percent foreign tax credit with respect to GILTI, and places the foreign taxes on GILTI in a separate foreign tax credit limitation "basket" with no carryforward or carryback permitted.
Income Tax Accounting Related to Tax Law Changes
Accounting for tax law changes
Under U.S. GAAP, changes in tax rates and tax law are accounted for in the period of enactment. For U.S. federal purposes, the enactment date for U.S. GAAP is the date the President signs the bill into law. As such, life sciences companies will need to review the impact of tax rate changes on its deferred taxes for items that are expected to reverse in tax years beginning after Dec. 31, 2017.
Valuation Allowance Assessment
Several new provisions that may impact life sciences companies' valuation allowance assessment will need to be reviewed. These provisions include the 100 percent dividends received deduction, new limitations on the use of foreign tax credits, enhanced fixed asset expensing provisions, new interest expense limitations with the establishment of carryforwards for disallowed amounts, annual limitations on the utilization of NOLs, changes to NOL carryforward and carryback periods, the elimination of the corporate alternative minimum tax, and other changes to the deduction of executive compensation.
The changes in the NOL carryforward and carryback periods, together with the new limitation on the utilization of NOLs may significantly impact valuation allowance assessments for NOLs generated after Dec. 31, 2017. ASC Topic 740 identifies four sources of taxable income to support realization of deferred tax assets. The changes in U.S. tax law will limit two of those sources in future periods with regards to NOLs.
In addition, the indefinite carryforward period for NOLs may also mean that deferred tax liabilities related to indefinite-lived intangibles (so-called "naked credits") can be considered as support for realization.
For More Information
If you have specific comments, questions or concerns about how the new tax law affects you, please contact us.
Published on March 12, 2018