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How can Life Sciences Companies claim the Federal-Level Orphan Drug Tax Credit? Can Life Sciences Companies claim both the Federal-Level R&D Tax Credit and the Federal-Level Orphan Drug Tax Credit?

R&D Tax Credits Orphan Drug Tax Credit
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Peter Scalise, SAX LLP
The Federal-Level Orphan Drug Tax Credit Program (hereinafter “ODC”) is a federal tax credit available to pharmaceutical companies working to identify cures for certain rare diseases that affect small populations and can be claimed by companies by filing Form 8820 with their federal tax return. Yes, companies can claim both the Federal-Level Orphan Drug Tax Credit on Form 8820 and the Federal-Level R&D Tax Credit on Form 6765 as long the qualitative and quantitative aspects of both tax credit programs have been fully adhered to from a statutory, administrative, and judicial interpretations perspective.

It should be duly noted that pharmaceutical companies obviously can’t receive both tax credits on the same qualifying expenses. In other words, if one tax credit is earned on a certain qualifying expense, then the other tax credit is unavailable for that same expense. The potential savings are greater for the ODC, so a company with an orphan drug designation would likely pursue that over the R&D Tax Credit. As it is possible for activities and expenses to qualify for both credits, proper cost allocation between the two credits is necessary for credit calculation purposes.

The qualitative requirements for the ODC are similar to traditional Federal-level R&D Tax Credits, in that both seek to provide tax incentives for conducting R&D activities that address technical uncertainty through an iterative process of experimentation. However, it should be duly noted that both credits must be separately calculated, and there are many critical differences to understand especially for pharmaceuticals that claim both Federal-Level R&D Tax Credits and Federal-Level Orphan Drug Tax Credits.

Pharmaceutical companies may qualify for the ODC for their drug development programs that have received orphan drug designation by the US Food and Drug Administration (hereinafter the “FDA”). This means they are developing a cure for one of the following:
• A rare disease that affects less than 200,00 persons in the USA; or
• A disease affecting over 200,000 persons in the US, but for which there is no reasonable expectation that the cost of developing and making available a drug for such disease will be recovered from sales in the USA.

Normally, eligible pharmaceutical companies see a higher rate of return on their Orphan Drug Clinical Testing Expenditures (hereinafter “CTEs”) rather than R&D Tax Credit Qualified Research Expenditures (hereinafter “QREs”). While the federal gross R&D Tax Credit typically results in a tax credit of up to 10% of QREs, the ODC provides a rate of about 25% of CTEs.

Yet another noteworthy distinction between ODC CTEs and R&D QREs is in connection to the applicable qualification rates for third party contractor expenditures. The ODC allows for 100% of qualified contractor spend to be included as a CTE, while the R&D credit caps the amount of these costs includible as a QRE at 65% (i.e., for most 3rd party contractor costs) or at 75% (i.e., select cases for third party contractors’ costs paid to qualified non-profit organizations or consortiums).

Qualification for the Orphan Drug Tax Credit and R&D Tax Credits looks to the underlying activities performed and resulting spend over the course of the development year. This will include costs for wages, supplies, and contract research expenses. Both credits follow the same pharmaceutical drug development timeline provided by the IRS pharmaceutical audit technique guidelines. These guidelines break pharmaceutical research down into four stages:
• Preclinical or Discovery Research
• Clinical Development
• Regulatory Review
• Post-Marketing

There are different activities and corresponding guidelines for each stage, and qualifying expenses will depend on the stage of a company’s pharmaceutical drug development pipeline. The ODC is calculated based on the spend associated with activities conducted in the clinical phase of the pharmaceutical drug’s development. This can include costs for internal wages for in-house activities as well as payments to contract research organizations hired to conduct human clinical testing. These costs may generally be included as CTEs only after orphan drug designation date and prior to the date of FDA approval. Taxpayers should methodically review costs incurred around these dates to ensure that the proper allocation and treatment is properly calculated as this is an area of high contention during most IRS examinations of these credit claims.

Please contact me should you like to learn more about the scope and application of these programs and thank you for your inquiry.
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