Analysis of the Impact of New R&D Tax Rules on Life Sciences Companies

On January 1, 2022, a key tax change that was not delayed due to the stalled Build Back Better Act (BBBA) quietly took effect for calendar-year taxpayers. The original proposal sought to postpone the effective date of the capitalization and amortization of research and development expenditures to tax years beginning after December 31, 2025, but that did not come to pass.

For life sciences companies that rely on discovering new therapies, indications, or medical devices and invest heavily in R&D, this change carries significant tax and financial reporting implications. Especially for early-stage companies lacking sufficient cash reserves, an unexpected tax liability could have a severe impact. For established companies with substantial R&D expenses, the cash tax impact could reach billions of dollars. This change comes at a time when investors are highly focused on revenue growth from new products and services due to COVID-19-related innovation.

R&D Tax Rule Change

For decades, U.S. companies could deduct R&D expenditures in the year they were incurred. The 2017 Tax Cuts and Jobs Act (TCJA) stipulated that, starting in 2022, companies must amortize domestic R&D costs over five years and foreign R&D costs over fifteen years. This change was designed to increase government revenue to offset the corporate rate reduction under the TCJA.

Recognizing that the new amortization rules would bring significant tax and financial reporting impacts, Congress responded to concerns from taxpayers by including a provision in the BBBA to delay implementation until 2025. Notably, if the American Innovation and R&D Competitiveness Act of 2021 had passed, it would have completely repealed the rule.

In the absence of legislative change, companies will need to incorporate TCJA reporting into estimated tax payments, tax returns, and financial statements starting with the 2022 quarter. Companies reviewing R&D costs should keep in mind that the tax law update affects not only those currently claiming the R&D tax credit. The updated rules cover a broader range of expenditures, including foreign R&D, certain patents, software development, and other activities that do not qualify for the R&D tax credit. Additionally, the calculation is based on wages including fringe benefits, whereas the R&D tax credit is based on W-2 wages. Other potential impacts should also be considered, such as effects on foreign tax credits and other international tax calculations under the TCJA.

Financial Reporting Impact

Assuming mandatory R&D amortization remains in effect, companies will need to adjust their income tax provision calculations. The tax benefit of current-year expenditures, which was previously fully reflected in the current provision, will now largely shift to the deferred provision. Capitalizing rather than expensing expenditures will generate deferred tax assets; companies will need to analyze these along with other deferred tax assets to determine whether they are likely to be realized.

Deferred tax asset analysis can be complex. For example, a company may expect to use the amortization benefit in the future, but at the same time generate another benefit that cannot be used due to timing. Companies that cannot reliably project sufficient taxable income to realize the amortization benefit will need to record a valuation allowance against these deferred tax assets.

The deferral of R&D tax benefits may also affect the purchase price and purchase price allocation when acquiring in-process research and development projects. Acquiring an existing tax basis related to purchased R&D assets in a tax-free transaction could result in an increased purchase price and affect the deferred taxes recognized in the purchase price allocation.

Some companies involved in joint development, collaboration agreements, or funding arrangements may face unexpected consequences. From a tax treatment perspective, there could be a timing mismatch between revenue recognition and R&D expenditures, which previously might have offset related revenue. This mismatch could lead to a significant increase in current tax liability, or even have a permanent impact.

Ultimately, CFOs and financial leaders should ask themselves: How sensitive are our forecasts of future taxable income? In other words, does the shift to amortization jeopardize our ability to realize the benefits of deferred tax assets?

Impact on Software Development

Under the new law, software development is treated as specified research. The TCJA does not explicitly define what constitutes software development for amortization purposes. However, software development (including designing, coding, and testing new or improved software) is generally treated the same as capitalized R&D costs. If the software is used in a company's R&D activities, the current amortization costs of the software may need to be included in total R&D expenses.

This change coincides with the acceleration of digitalization in the biopharmaceutical industry. Many large biopharmaceutical companies are investing significant funds and resources in organization-wide digital transformations, involving not only enterprise resource planning (ERP) but also supply chain, clinical operations, and field sales teams.

Tax Policy Can Further Drive Growth

For certain companies, the impact of this tax change may extend to cash taxes and the effective tax rate (ETR). For purely domestic companies, the impact may be limited to cash taxes and, unless there are valuation allowance changes, will not affect the ETR. However, for multinational companies, given the numerous interdependent and complex international tax calculations affected by R&D, the potential impact on the ETR should be considered. The tax change may also affect a company's cash flow forecasts, which in turn affects other analyses and may alter the timing of a company's assessment of additional debt/equity financing. The differing effects of amortization versus current deduction could ripple through these complex and interdependent calculations.

Although the status of the BBBA has not been finalized, it is advisable to carefully model these impacts. In particular, a retroactive delay does not alleviate short-term cash tax and reporting challenges, as companies will be required to prepare tax provisions (and possibly make estimated tax payments) based on current tax law.

Looking Ahead

President Biden recently indicated that the BBBA may need to be "split up"; therefore, a delay of the amortization rule could still be included in a scaled-down version. Alternatively, Congress could propose an "extenders package" to extend other expiring tax provisions through a process separate from a full tax bill.

A coalition of business groups has also urged Congress to extend the R&D deduction. Although Congress may act to retroactively delay mandatory R&D amortization, whether and when that will happen is uncertain and could affect 2022 reporting.

The intersection of tax policy with accounting and financial reporting is broad. Close coordination between tax and financial leaders (and the finance department) is a critical necessary step in planning for possible scenarios ahead of quarterly tax filing deadlines.