Fourth Circuit: Biotech Company Overstated Expenses in Computing Research Credit

(Parker Tax Publishing July 2024)

The Fourth Circuit affirmed the Tax Court and held that a biotechnology company that claimed both the research credit under Code Sec. 41 and the orphan drug credit under Code Sec. 45C, and had expenses that qualified as both qualified research expenses under Code Sec. 41 and qualified clinical testing expenses under Code Sec.45C, improperly excluded the expenses it treated as qualified clinical testing expenses for the three-year reference period described in Code Sec. 45(c)(5)(A). The Fourth Circuit rejected the taxpayer's argument that Code Sec. 45C(c)(2), which requires that any qualified clinical testing expenses which are also qualified research expenses be taken into account in determining base period research expenses for purposes of applying Code Sec. 41 to subsequent tax years, lost effect as a result of amendments made to Code Sec. 41 in 1989. United Therapeutics Corp. v. Comm'r, 2024 PTC 228 (4th Cir. 2024).

Background

United Therapeutics Corp. is a biotechnology company that develops products to address the unmet medical needs of patients with chronic and life-threatening conditions. For each of the tax years 2011 through 2014, United Therapeutics computed and claimed both the research credit under Code Sec. 41 and the orphan drug credit under Code Sec. 45C. Some of the company's expenses during those years qualified both as "qualified research expenses" under Code Sec. 41 and as "qualified clinical testing expenses" under Code Sec. 45C. With respect to such expenses, United Therapeutics elected to claim the orphan drug credit under Code Sec. 45C.

Code Sec. 41 offers a menu of ways to calculate its credit. In 2014 - the year at issue - United Therapeutics elected to use the "alternative simplified method " under Code Sec. 41(c)(5) (as in effect in 2014). Code Sec. 41(c)(5)(A) provides that under that method, the company's credit is equal to 14 percent "of so much of the qualified research expenses for the taxable year as exceeds 50 percent of the average qualified research expenses for the 3 taxable years preceding" the credit year. With respect to its overlapping expenses (i.e., expenses that are simultaneously "qualified research expenses" under Code Sec. 41 and "qualified clinical testing expenses" under Code Sec. 45C), United Therapeutics elected to claim the more generous Code Sec. 45C credit. That decision triggered a coordination provision in Code Sec. 45C(c). The question in this case is whether United Therapeutics properly accounted for that provision.

When calculating its "qualified research expenses" for the 2014 tax year under Code Sec. 41(c)(5)(A), United Therapeutics followed Code Sec. 45C(c)(1), which states that, except as provided in Code Sec. 45C(c)(2), any qualified clinical testing expenses for a tax year to which an orphan drug credit applies is not taken into account for purposes of the research credit for that tax year. Thus, United Therapeutics excluded the 2014 expenses it was claiming as qualified clinical testing expenses.

However, United Therapeutics also excluded the overlapping expenses it had treated as qualified clinical testing expenses for the three preceding tax years, 2011 through 2013, when it calculated its baseline "average qualified research expenses for the 3 taxable years preceding" 2014 under Code Sec. 41(c)(5)(A). That made the company's past investment in research appear smaller, which in turn made its 2014 investment look like a more dramatic increase.

According to the IRS, this latter exclusion ran afoul of the "coordination provision" of Code Sec. 45C(c)(2), which instructs taxpayers to take into account any qualified clinical testing expenses which are qualified research expenses in determining base period research expenses for purposes of applying Code Sec. 41 to subsequent tax years. After auditing United Therapeutics, the IRS issued a notice of deficiency. The company's disregard for Code Sec. 45C(c)(2), the IRS concluded, improperly inflated its Code Sec. 41 credit by about $1.2 million. United Therapeutics took its case to the Tax Court.

Before the Tax Court, United Therapeutics argued that changes to Code Sec. 41 since its enactment rendered Code Sec. 45C(c)(2) a dead letter. That result, the company argued, was compelled by 1989 amendments to Code Sec. 41. As noted above, Code Sec. 45C(c)(2) instructs taxpayers to include overlapping expenses "in determining base period research expenses" for purposes of Code Sec. 41. In 2014 as today, neither the coordination provision nor Code Sec. 41 defined "base period research expenses." But an earlier version of Code Sec. 41 did: In Code Section 41(c)(1)-(2), it defined "base period research expenses" as "the average of the qualified research expenses for each year in the base period" and defined "base period" as "the 3 taxable years immediately preceding" the credit year. Congress removed that definition in a 1989 overhaul of the provision. And when it did so, United Therapeutics argued, Congress also intended - but forgot - to eliminate Code Sec. 45C(c)(2).

Tax Court's Analysis

In United Therapeutics Corp. v. Comm'r, 160 T.C. No. 12 (2023), the Tax Court rejected United Therapeutics' argument and resolved the case in the IRS's favor. The Tax Court reasoned that, although the phrase "base period research expenses" was undefined in the 2014 statute, its ordinary meaning supported the IRS's reading, under which it applied to expenses incurred during the 3 preceding tax years Code Sec. 41(c)(5)(A) uses as a benchmark in calculating the research credit.

The term "base period," the Tax Court explained, has consistently meant "a period of time used as a standard of comparison in measuring changes . . . at other periods of time." Moreover, that is how Congress has used the term in other tax-code contexts, including the one provision (Code Sec. 41(e)(7)(B)) in which Code Sec. 41 defines the term. So the Tax Court concluded that the reference in Code Sec. 45C(c)(2) to "base period research expenses" means research expenses that are incurred during the base period - i.e., the period of time Code Sec. 41 employs as a standard of comparison.

United Therapeutics appealed to the Fourth Circuit.

Fourth Circuit's Analysis

The Fourth Circuit affirmed the judgment of the Tax Court. The Fourth Circuit agreed with the Tax Court's conclusion the ordinary meaning of "base period research expenses" was clear enough to resolve the question in this case.

The Fourth Circuit reasoned that "base period" refers to a period of time used as a standard of comparison or a reference point to measure change over time. According to the court, that is an exact match for the phrase "3 [preceding] taxable years" in Code Sec. 41(c)(5)(A) - i.e., a three-year period that functions as the benchmark against which change over time (here, subsequent increases in research expenditures) are measured. And that interpretation is consistent, the Fourth Circuit found, not only with the plain text but also with the statutory structure, enabling both halves of the coordination provision in Code Sec. 45C(c) to operate according to their terms.

And like the Tax Court, the Fourth Circuit found support for this reading in Code Sec. 41(e), where the term "base period" is used to mean a benchmark for comparison. The Fourth Circuit rejected United Therapeutics' argument that, because Congress defined "base period" only for purposes of Code Sec. 41(e), the reference in Code Sec. 45C(c)(2) to "base period research expenses" must be read as applying only to the Code Sec. 41(e) portion of the credit - and not to the Code Sec. 41(c)(5)(A) credit for "qualified research expenses" at issue here. The Fourth Circuit found that Code Sec. 45C(c)(2) mandates accounting for overlapping expenses in applying Code Sec. 41 generally to subsequent tax years. And Code Sec. 41(e) expressly defines "base period" only for the limited purpose of applying that subsection. The Fourth Circuit did not see how the plain meaning of "base period" in Code Sec. 45(C)(c)(2) could be overridden by a definition in a different Code provision that is limited to that provision alone.

The Fourth Circuit concluded that, construed according to its ordinary meaning, the reference in Code Sec. 45C(c)(2) to "base period research expenses" encompassed United Therapeutics' overlapping expenses during the three-year period used as a temporal comparison point by Code Sec. 41(c)(5)(A). In the court's view, that reading is consistent with the plain text as well as the statutory context and structure. Further, the court found that unlike United Therapeutics' position, under which Code Sec. 45C(c)(2) is ignored altogether, the court's reading contravened neither the presumption against repeal by implication nor the principle of interpretation giving effect, if possible, to every word in the statute.

For a discussion of the Code Sec. 41 credit for qualified research expenses, see Parker Tax ¶104,905. For a discussion of the orphan drug credit under Code Sec. 45C, see Parker Tax ¶106,101.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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