Biotech Company Overstated Expenses in Calculating Research Credit

(Parker Tax Publishing June 2023)

The Tax Court 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 excluding from its computations the expenses it treated as qualified clinical testing expenses for the three-year reference period described in Code Sec. 45(c)(5)(A). The court held that under Code Sec. 45C(c)(2), qualified clinical testing expenses that are also qualified research expenses must be included in determining qualified research expenses for the three-year reference period. United Therapeutics Corp. v. Comm'r, 160 T.C. No. 12 (2023).

Background

United Therapeutics Corporation is a biotechnology company that focuses primarily on the development and commercialization of products to address the unmet medical needs of patients with chronic and life-threatening conditions. During the 2014 tax year and the preceding three tax years (2011 through 2013), the company conducted research and development on potential treatments for pulmonary arterial hypertension (which ultimately leads to heart failure and death) and neuroblastoma (a rare form of brain cancer that predominantly affects children and infants), among other diseases.

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.

In claiming its research credit for the 2014 tax year, United Therapeutics elected to use the alternative simplified credit calculation under Code Sec. 41(c)(5) and the reduced credit under Code Sec. 280C(c)(3). When calculating the credit under Code Sec. 41(c)(5), the company excluded the expenses it had treated as qualified clinical testing expenses for purposes of Code Sec. 45C from both its 2014 qualified research expenses and its average qualified research expenses for the three preceding tax years (2011 through 2013).

There are five methods for calculating the amount of the research credit under Code Sec. 41. One method is the alternative simplified method - the method United Therapeutics used in 2014. Under Code Sec. 41(c)(5), a taxpayer using the alternative simplified method must compare its current year qualified research expenses to those it incurred during the three preceding years. Under Code Sec. 41(c)(5)(A), the amount of the research credit under the alternative simplified method is generally 14 percent of the amount by which the taxpayer's current year qualified research expenses exceed 50 percent of its average qualified research expenses for the three previous years. The orphan drug credit under Code Sec. 45C generally permits taxpayers who incur qualified clinical testing expenses to claim a credit equal to 50 percent of such expenses for the year, regardless of their expenditures in prior years.

Expenses that qualify for the research credit may also qualify for the orphan drug credit. Congress recognized addressed this potential for overlap in Code Sec. 45C(c). Code Sec. 45C(c)(1) generally provides that "any qualified clinical testing expenses for a taxable year to which an election under this section applies shall not be taken into account for purposes of determining the credit allowable under section 41 for such taxable year." Code Sec. 45C(c)(2) provides a coordination rule under which "any qualified clinical testing expenses for any taxable year which are qualified research expenses (within the meaning of section 41(b)) shall be taken into account in determining base period research expenses for purposes of applying section 41 to subsequent taxable years." As in effect for 2014, neither Code Sec. 45C(c)(2) nor any other Code provision defines the phrase "base period research expenses."

Every year from 2011 through 2014, United Therapeutics incurred expenses that qualified as both qualified clinical testing expenses under Code Sec. 45C(b) and qualified research expenses under Code Sec. 41(b). And each year from 2011 to 2014, United Therapeutics elected to claim the orphan drug credit for all these expenses. In 2014, United Therapeutics excluded all qualified clinical testing expenses from its Code Sec. 41 credit computations (including the calculation of the three-year average for 2011 through 2013).

In a notice of deficiency, the IRS determined that United Therapeutics overstated its research credit for 2014 by improperly excluding the expenses the company treated as qualified clinical testing expenses for the three-year reference period described in Code Sec. 41(c)(5)(A) (i.e., 2011 through 2013). According to the IRS, Code Sec. 45C(c)(2) requires qualified clinical testing expenses that are also qualified research expenses to be included in determining qualified research expenses for the three-year reference period.

United Therapeutics challenged the notice in the Tax Court. The company argued that its approach was required by Code Sec. 45C(c)(1) and that Code Sec. 45C(c)(2) is inapplicable for two reasons. First, United Therapeutics argued that the phrase "base period research expenses" should be read as a defined term because when Congress first adopted the research credit in 1981, its computation required the calculation of "base period research expenses." That term was defined in then-Code Section 44F(c)(1). When Congress first adopted the orphan drug credit in 1983, it used the same phrase - "base period research expenses" - in Code Section 44H(c)(2). Thus, United Therapeutics argued that "base period research expenses" as now used in Code Sec. 45C(c)(2) must have the defined meaning provided by old Code Section 44F(c)(1). Second, United Therapeutics contended that a consistency rule in Code Sec. 41(c)(6)(A) trumped the coordination rule in Code Sec. 45C(c)(2). Under Code Sec. 41(c)(6)(A), the qualified research expenses taken into account in computing a taxpayer's fixed base percentage must be determined on a basis consistent with the determination of qualified research expenses for the credit year. According to United Therapeutics, this rules requires consistency in calculating the two components of the alternative simplified credit - i.e., that it does not permit qualified clinical testing expenses to be excluded in qualified research expenses for the credit year but included for the three preceding years.

Analysis

The Tax Court held that the text and structure of Code Secs. 41 and 45C(c)(2) as they existed in 2014 required the result reached by the IRS in the notice of deficiency.

Based on the plain meaning of the statutory language, the court interpreted the term "base period research expenses" to mean research expenses that are incurred during the base period - i.e., the period of time Code Sec. 41 employs as a standard of comparison (or as a baseline or reference point). The court therefore determined that under Code Sec. 45C(c)(1), a taxpayer that elects to take the orphan drug credit under Code Sec. 45C must exclude qualified clinical testing expenses incurred in the year for which the election is made when calculating qualified research expenses for that year. However, the court found that under Code Sec. 45C(c)(2) the taxpayer must include qualified clinical testing expenses incurred during a reference period (i.e., a base period) prescribed by Code Sec. 41 in its calculation of qualified research expenses for that reference period so long as those qualified clinical testing expenses also meet the definition of qualified research expenses.

The court reasoned that under Code Sec. 41(c)(5), a taxpayer using the alternative simplified method must compare its qualified research expenses during the current year to the expenses it incurred during "the 3 taxable years preceding the taxable year for which the credit is being determined." In the court's view, this three-year period is a period of time that is being "used as a standard of comparison in measuring changes." In other words, the three-year period is a "base period" within the ordinary meaning of that phrase. And so, the court found that for a taxpayer that made the Code Sec. 45C election for each of the three years included in the base period, Code Sec. 45C(c)(2) requires that the taxpayer's qualified clinical testing expenses (that are also qualified research expenses) be included when calculating qualified research expenses during that period. The court explained that, working together, Code Sec. 41(c)(5) and Code Sec. 45C(c)(2) require taxpayers who have elected the more generous orphan drug credit for prior years to account for that prior-year benefit in calculating their research credit for the current year.

The court rejected United Therapeutics' arguments. First, the court found that it had to interpret Code Secs. 41 and 45C(c)(2) as in effect in 2014, not by reference to predecessor statutes. The court also found that other principles refuted United Therapeutics' position, such as the preference against repeals by implication and the need to give effect, if possible, to every clause and word when interpreting a statute. The court also rejected United Therapeutics' contention that the consistency rule in Code Sec. 41(c)(6)(A) mandated its approach. The court found that the consistency rule applies only when calculating a taxpayer's fixed base percentage, a concept that had no relevance in calculating the company's alternative simplified credit.

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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