Orphan-drug expenses enter research credit base calculation

Plain-English summary

A drug developer claimed both the orphan drug credit and the alternative simplified research credit but excluded orphan-drug clinical testing expenses from qualified research expenses in the three prior years used for the research credit calculation. The IRS concluded that section 45C(c)(2) requires prior-year qualified clinical testing expenses that also qualify as research expenses to be included in the research credit base. It interpreted the statute's older phrase “base period research expenses” to cover prior-year base expenses under both the regular credit and the alternative simplified credit. Excluding those expenses would distort the research credit's incremental design and effectively make the coordination rule inoperative without evidence that Congress intended to repeal it. Including the expenses did not violate the consistency rule because they met the definition of qualified research expenses in both the base and credit years.

Ruling snapshot

• Question: Must prior-year orphan-drug clinical testing expenses be included as qualified research expenses when computing the alternative simplified research credit?
• Outcome: advice given
• Key authorities: IRC §§ 41(c)(5), 41(c)(6), 45C(c)(2); Treas. Reg. § 1.41-9(c)(2)

Full text (IRS public release)

                            INTERNAL REVENUE SERVICE
                  NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                                  June 28, 2017

                                                         Third Party Communication: None
                                                         Date of Communication: Not Applicable
Number:                    201740018
Release Date:              10/6/2017
Index (UIL) No.:           45C.04-02
CASE-MIS No.:              TAM-100407-17

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--------------------

         Taxpayer's Name:                                ---------------------------------------------
         Taxpayer's Address:                             --------------------------
                                                         ----------------------------------------
         Taxpayer's Identification No:                   -----------------
         Year(s) Involved:                               -----------------
         Date of Conference:                             ------------------------


LEGEND

Taxpayer:                  ---------------------------------------------

Representative:            ---------------------------

Year 1:                    -------

Year 2:                    -------

Year 3:                    -------

Year 4:                    -------

Year 5:                    -------

Date 1:                    --------------------

Date 2:                    ------------------
TAM-100407-17                                           2

Date 3:                   ---------------------------

Date 4:                   --------------------

Drug 1:                   --------------

Drug 2:                   ----------------

Drug 3:                   -------------------

Disease 1:                ----------------------------------------------------

Disease 2:                ---------------------

N:                        --

ISSUE

Pursuant to § 45C(c)(2) of the Internal Revenue Code, must Taxpayer include its prior
taxable year qualified clinical testing expenses as prior taxable year qualified research
expenses when calculating the alternative simplified credit under § 41(c)(5)?

CONCLUSION

Pursuant to § 45C(c)(2), Taxpayer must include its prior taxable year qualified clinical
testing expenses as prior taxable year qualified research expenses when calculating the
alternative simplified credit under § 41(c)(5).

FACTS

Taxpayer is a -------------------- company primarily focused on developing and ---------------
--------------------------------- products ----------------------------------------------------------------------
----------------------------------------------------. During the Year 4 and Year 5 taxable years,
Taxpayer focused on developing and ----------------------- treatments for Disease 1 and
Disease 2. Taxpayer engaged Representative to conduct research credit and orphan
drug credit studies for the Year 4 and Year 5 taxable years. All of the § 45C(b)(1)(A)
qualified clinical testing expenses (QCTEs) that Representative identified relate to one
of Taxpayer's three drugs: Drug 1, Drug 2, and Drug 3.

On Date 1, the Food and Drug Administration (FDA) designated Drug 1 as an orphan
drug to treat Disease 1. The Drug 1 QCTEs during the Year 4 and Year 5 taxable years
pertain to --------------------------------------. On Date 2, the FDA designated Drug 2 as an
orphan drug to treat Disease 1. The Drug 2 QCTEs during the Year 4 and Year 5
taxable years pertain to an ----- formulation that was undergoing -------------------------------
TAM-100407-17                                          3

-------. On Date 3, the FDA designated Drug 3 as an orphan drug to treat Disease 2.
Taxpayer included all human clinical testing expenses in the Year 4 and Year 5 taxable
years for Drug 3 as QCTEs.

For its Year 4 and Year 5 taxable years, Taxpayer computed both the alternative
simplified credit (ASC) under § 41(c)(5) and the orphan drug credit under § 45C.
Except for the QCTEs that are foreign-based expenses, Taxpayer's QCTEs in taxable
years Year 4 and Year 5, as well as in the three preceding relevant taxable years (Year
1 through Year 3, and Year 2 through Year 4, respectively), qualify as qualified research
expenses (QREs) under § 41(b) and (d). Taxpayer did not include in its QREs for these
taxable years amounts determined to be QCTEs under § 45C.

The Service adjusted Taxpayer’s ASC to include Taxpayer’s prior taxable year QCTEs
for taxable years Year 4 and Year 5.

The following chart from the Form 886-A, Explanation of Items, issued on Date 4, shows
the total disputed adjustments due to this issue:
 Year 4                                             Year 5                Total
 --------                       -----------------   ------------------    ------------------
 ------------------------
 ----------------------------   -----------------   ------------------    ------------------
 ------------------------
 ----------------------------   ------------------- -------------------   -------------------
 --------------
 ----------------------------   -----------------   -----------------     -------------------
 ------------------
 -----------------------        ----------------    ----------------      ----------------
 ---------------
 ------------------------       --------------      --------------        -------------
 --------------
 ---------------------
 ---------------------          ----------------    ----------------      ----------------
 -

LAW AND LEGISLATIVE HISTORY

Applicable Statutory and Regulatory Provisions

Section 45C provides a credit for clinical testing expenses for certain drugs for rare
diseases or conditions. Section 45C(a) provides that for purposes of § 38, the orphan
drug credit for the taxable year is an amount equal to 50 percent of the QCTEs for the
taxable year.
TAM-100407-17                               4


In general, § 45C(b)(1)(A) defines QCTEs as the amounts which are paid or incurred by
the taxpayer during the taxable year which would be described in § 41(b) (defining
QREs) if § 41(b) were applied with the modifications set forth in § 45C(b)(1)(B).
Section 45C(b)(1)(B) applies § 41(b) by (i) substituting “clinical testing” for “qualified
research” each place it appears in § 41(b)(2) (relating to in-house research expenses)
and § 41(b)(3) (relating to contract research expenses) and (ii) substituting “100
percent” for “65 percent” in § 41(b)(3)(A).

Section 45C(c) provides rules for coordinating the research credit under § 41 with the
orphan drug credit. Section 45C(c)(1) provides that, except as provided in § 45C(c)(2),
any QCTEs for a taxable year to which an election under § 45C applies shall not be
taken into account for purposes of determining the research credit for such taxable year.
Under § 45C(c)(2), any QCTEs for any taxable year which are QREs (within the
meaning of § 41(b)) shall be taken into account in determining base period research
expenses for purposes of applying § 41 to subsequent taxable years.

Section 45C(d)(4) provides that § 45C shall apply to any taxpayer for any taxable year
only if such taxpayer elects to have § 45C apply for such taxable year.

Under § 41(a), for purposes of § 38, the research credit equals the sum of 20 percent of
the excess (if any) of the QREs for the taxable year over the base amount (regular
credit), 20 percent of the taxpayer's basic research payments determined under
§ 41(e)(1)(A) (basic research credit), and 20 percent of the amounts paid or incurred by
the taxpayer in carrying on any trade or business of the taxpayer during the taxable year
(including as contributions) to an energy research consortium for energy research.

Section 41(c)(1) defines the base amount as the product of the fixed-base percentage
and the average annual gross receipts of the taxpayer for the four taxable years
preceding the taxable year for which the credit is being determined (credit year).
Section 41(c)(2) provides, however, that in no event shall the base amount be less than
50 percent of the QREs for the credit year.

Section 41(c)(5) permits a taxpayer to elect the ASC in lieu of the regular credit.
Section 41(c)(5)(A) provides that at the election of the taxpayer, the research credit
determined under § 41(a)(1) shall be equal to 14 percent (12 percent in the case of
taxable years ending before January 1, 2009) of so much of the QREs for the taxable
year as exceeds 50 percent of the average QREs for the three taxable years preceding
the taxable year for which the credit is being determined.

Section 41(c)(6)(A) provides that notwithstanding whether the period for filing a claim for
credit or refund has expired for any taxable year taken into account in determining the
fixed-base percentage, the QREs taken into account in computing such percentage
TAM-100407-17                               5

shall be determined on a basis consistent with the determination of QREs for the credit
year.

Under § 1.41-9(c)(2) of the Income Tax Regulations, for purposes of the ASC, QREs for
the three taxable years preceding the credit year must be determined on a basis
consistent with the definition of QREs for the credit year, without regard to the law in
effect for the three taxable years preceding the credit year. This consistency
requirement applies even if the period for filing a claim for credit or refund has expired
for any of the three taxable years preceding the credit year.

Legislative History

Prior to the enactment of the Omnibus Budget Reconciliation Act of 1989, Pub. L. No.
101-239, 103 Stat. 2106 (the 1989 Act), § 41(a) provided for a research credit equal to
(1) 20 percent of the excess (if any) of (A) the QREs for the taxable year, over (B) the
base period research expenses, and (2) 20 percent of the basic research payments
determined under § 41(e)(1)(A). Former § 41(c)(1) defined “base period research
expenses” as the average of the QREs for each year in the base period. Former
§ 41(c)(2) generally defined “base period’ as the three taxable years immediately
preceding the taxable year for which the determination was being made. In addition,
prior to the 1989 Act, the basic research credit under § 41(e) included a separately
defined “base period” in § 41(e)(7)(B), which was the three-taxable-year-period ending
with the taxable year immediately preceding the first taxable year of the taxpayer
beginning after December 31, 1983.

On January 4, 1983, the orphan drug credit was first enacted as § 44H, as part of the
Orphan Drug Act, Pub. L. No. 97-414, 96 Stat. 2049. Section 44H was renumbered as
§ 28 on July 18, 1984, as a part of the Deficit Reduction Act of 1984, Pub. L. No. 98-
369, 98 Stat. 494. Then, § 28, including the coordination rule currently in § 45C(c)(2),
was renumbered as § 45C on August 20, 1996, as a part of the Small Business Job
Protection Act of 1996, Pub. L. No. 104-188, 110 Stat. 1755.

On December 19, 1989, Congress modified § 41 in the 1989 Act. Congress eliminated
the terms "base period research expenses” and “base period” in § 41(a)(1) and (c), and
added the term “base amount.” Congress did not amend § 41(e), other than to make
conforming amendments relevant to § 41(c). In addition, Congress added the
consistency rule under former § 41(c)(4) (the consistency rule is in the current Code in
§ 41(c)(6)).

In the legislative history to the 1989 Act, Congress explained that it was making these
changes to § 41 to modify:

       the method of calculating a taxpayer's base amount in order to enhance
       the credit's incentive effect. The committee did wish, however, to retain
TAM-100407-17                                6

      an incremental credit structure in order to maximize the credit's efficiency
      by not allowing (to the extent possible) credits for research that would
      have been undertaken in any event.
H.R. Rep. No. 101-247, at 1199 (1989).

Because businesses often determine their research budgets as a fixed percentage of
gross receipts, Congress thought that it was appropriate to index each taxpayer's base
amount to average growth in its gross receipts. By adjusting each taxpayer's base
amount, Congress believed that the credit would be better able to achieve its intended
purpose of rewarding taxpayers for research expenses exceeding amounts which would
have been expended in any case. Id. at 1200.

The legislative history is silent as to whether the change from “base period expenses” to
“base amount” should impact the coordination between § 45C and § 41.

On December 20, 2006, Congress added the ASC to § 41(c)(5) in the Tax Relief and
Health Care Act of 2006, Pub. L. No. 109-432, 120 Stat. 2922. The legislative history
for this provision also does not address the coordination of § 45C and ASC under
§ 41(c)(5).

On March 23, 2010, Congress added § 48D (the qualifying therapeutic discovery project
credit) as a part of the Patient Protection and Affordable Care Act, Pub. L. No. 111-148,
124 Stat. 119, § 9023. Virtually identical to § 45C(c)(2), § 48D(e)(2)(C)(i), provides that,
except as provided in § 48D(e)(2)(C)(ii), any expenses taken into account under § 48D
for a taxable year shall not be taken into account for purposes of determining the
research credit or the orphan drug credit allowable for such taxable year. Under
§ 48D(e)(2)(C)(ii), any expenses for any taxable year which are QREs (within the
meaning of § 41(b)) shall be taken into account in determining base period research
expenses for purposes of applying § 41 to subsequent taxable years.

ANALYSIS

Taxpayer believes that the plain language of §§ 41(c) and 45C(c) and §§ 1.41-3(d) and
1.41-9(c)(2) requires Taxpayer to exclude its QCTEs from its QREs for the three taxable
years prior to taxable Year 4 (Year 1 - Year 3) and the three taxable years prior to
taxable Year 5 (Year 2 - Year 4) when computing its ASC in the Year 4 and Year 5
taxable years. Taxpayer asserts that § 45C(c)(2) only applies to determine “base period
research expenses” and does not apply to the ASC because the term "base period
research expenses" does not appear in § 41(c)(5). Further, Taxpayer believes that,
following the 1989 Act, § 45C(c)(2) only continues to apply for purposes of determining
the basic research credit under § 41(e). Finally, Taxpayer states that the consistency
rule, under § 41(c)(6) and §§ 1.41-3(d) and 1.41-9(c)(2), requires Taxpayer to exclude
QCTEs from its QREs in the Year 1 through Year 4 base taxable years because
Taxpayer is not including QCTEs in QREs in the Year 4 and Year 5 taxable years.
TAM-100407-17                                7


LB&I believes that the term "base period research expenses" in § 45C(c)(2) is
ambiguous, and, therefore, it is appropriate to look to the legislative history to determine
its proper meaning. LB&I asserts that Congress has consistently intended that a
taxpayer must include its prior year QCTEs as prior year QREs when calculating its
current taxable year research credit, which includes the ASC. Further, LB&I states that
Taxpayer’s interpretation of § 45C(c)(2) would render the provision inoperative or
superfluous. Finally, LB&I disputes Taxpayer’s positions that (1) § 45C(c)(2) continues
to apply only for purposes of § 41(e) and (2) including QCTEs as prior year QREs
violates the consistency rule.

The term “base period research expenses” is an ambiguous term because it is
susceptible to more than one interpretation in the context of coordinating §§ 41 and
45C. Because, following the 1989 Act, the specific term “base period research
expenses” in § 45C(c)(2) is not the precise term used for purposes of § 41(a)(1) and (c),
including for the ASC in § 41(c)(5), Congress arguably intended to disconnect § 45C
from § 41(a)(1) and (c) (including for the ASC). However, Congress possibly used the
term “base period research expenses” in § 45C(c)(2) to generally refer to prior taxable
year base QREs for purposes of § 41(a)(1) and (c). Thus, prior taxable year QCTEs
that are also QREs arguably should be included as prior taxable year QREs for
purposes of calculating the research credit, regardless of the method used under
§ 41(a)(1) and (c) to calculate the credit.

We believe that the term “base period research expenses” refers to prior taxable year
base QREs for purposes of the regular credit and the ASC. Therefore, prior taxable
year QCTEs that are also QREs are treated as prior taxable year QREs for purposes of
calculating the regular credit and the ASC. This interpretation is supported by 1) the
purpose of §§ 45C(c)(2) and 41, 2) the fact that a different reading renders § 45C(c)(2)
inoperative, 3) the lack of Congressional intent to repeal § 45C(c)(2), and 4) the use of
the same term in § 48D.

The orphan drug credit under § 45C and the research credit under § 41 are intertwined.
QCTEs under § 45C are amounts which are paid or incurred by a taxpayer during the
taxable year which would be described in § 41(b), as modified to particularly apply to
the orphan drug credit. Section 45C(c)(2) further coordinates the orphan drug credit
and the research credit. Because of the interdependence of the two credits, we believe
that it is unlikely that Congress intended to disconnect them in the 1989 Act without
mentioning the 1989 Act’s impact on § 41 in § 45C(c)(2) or in the legislative history.

Taxpayer’s interpretation of the 1989 Act undermines the incremental nature of the
research credit under § 41. The legislative history to the 1989 Act supports the view
that the 1989 Act was not intended to distort the incremental nature of the § 41 credit by
excluding a class of QREs that also qualify as QCTEs from base QREs under § 41.
See H.R. Rep. No. 101-247, at 1199. Excluding QCTEs that are also QREs from the
TAM-100407-17                               8

base credit calculation results in an inaccurate determination of the relative increase in
QREs over the amount a taxpayer typically spends on research. Under Taxpayer’s
view, Taxpayer receives larger § 41 credits in Year 4 and Year 5 for expenses that are
QREs, but not QCTEs, merely because Taxpayer elected the orphan drug credit for
expenses that qualified as both QREs and QCTEs in the base years (Year 1 through
Year 4) and the credit years (Year 4 and Year 5). Taxpayer’s combined research credit
under § 41 in Year 4 and Year 5 is more than N times larger if § 45C(c)(2) is read out of
the Code. Without clear Congressional intent to provide for such a heightened credit,
we decline to find that it exists. See, e.g., Helvering v. Northwest Steel Rolling Mills,
Inc., 311 U.S. 46, 49 (1940).

Further, Taxpayer’s interpretation of § 45C(c)(2) renders the provision inoperative. If
the term “base period research expenses” under § 45C(c)(2) only refers to the literal
term “base period research expenses” as it existed in former § 41(a)(1) and (c), then
§ 45C(c)(2) has no current relevance in the Code. We are not convinced by Taxpayer’s
argument that § 45C(c)(2) only continues to be relevant for purposes of § 41(e). Prior to
the 1989 Act, § 41(c)(1) defined “base period research expenses,” and § 41(c)(2)
defined “base period” for purposes of § 41(a)(1) and (c). Section 41(e)(7)(B) distinctly
defined “base period” solely for purposes of § 41(e). Section 41(e)(7)(C)(ii) referenced
“base period research expenses,” but only for purposes of computing the regular credit
under § 41(a)(1) and (c).

In the 1989 Act, Congress revised § 41 by removing “base period research expenses”
and “base period” as it pertained to the computation of the regular credit under
§§ 41(a)(1) and (c), replacing it with “base amount,” including in § 41(e)(7)(C)(ii).
Congress did not remove the term “base period” from § 41(e) because the 1989 Act’s
revisions to § 41 did not have any impact on the term “base period” as defined under
§ 41(e). Section 41(e) has never relied on the former § 41(c) definition of “base period,”
as § 41(e) has a self-contained definition of “base period” with a distinct meaning in
§ 41(e)(7)(B). Therefore, we are not persuaded that the term “base period research
expenses” in § 45C(c)(2) exclusively applies for purposes of § 41(e).

Taxpayer’s position effectively repeals the coordination rule in § 45C(c)(2) because the
1989 Act changes the way the research credit is computed under § 41(a) and (c).
However, repealing a statutory provision by implication is not favored and is only
permitted when there is “manifest” Congressional intent to do so. See, e.g., Posadas v.
National City Bank, 296 U.S. 497, 503 (1936). The changes to § 41 in the 1989 Act do
not support the position that Congress intended to sever the nexus between §§ 41 and
45C. Congress amended § 41(c) in the 1989 Act to modify the method for calculating
the research credit under § 41(c) to incorporate gross receipts. Absent from both the
1989 Act and its legislative history is any discussion regarding § 45C(c). No clear
expression of Congressional intent to repeal the coordination rule in § 45C(c)(2) exists.
Further, § 45C(c)(2) and § 41 can be read harmoniously if the term “base period
research expenses” in § 45C(c)(2) is read to mean prior year QREs for purposes of
TAM-100407-17                               9

determining the research credit under § 41(a)(1) and (c), regardless of the method
used.

In addition, when Congress enacted § 48D on March 23, 2010, it virtually copied the
language from § 45(C)(c)(2) to § 48D(e)(2)(C) to coordinate §§ 48D and 41. If
Congress had intended that the term “base period research expenses” to refer solely to
the term as used in § 41 as it existed prior to the 1989 Act, then it would have needed to
choose a different term. The term “base period research expenses” had not existed in
§ 41 for almost 21 years by the time that § 48D was enacted. Therefore, under
Taxpayer's position, § 48D(e)(2)(C) would have been inoperative the moment it was
enacted.

Finally, LB&I’s position does not violate the consistency rule under § 41(c)(6). The
consistency rule "aims to ensure that the research tax credit due is not overstated or
understated because the taxpayer inconsistently compares QREs in the base period
years and the claim year." Trinity Industries. Inc. v. U.S., 757 F.3d 400, 411 (5th Cir.
2014). In this case, LB&I’s position does not violate the consistency rule because the
definition of QREs is consistently applied to Taxpayer's current year and prior year
expenses. The parties agree that Taxpayer's QCTEs meet the definition of QREs under
§ 41(b) and (d) for the base years and the credit years. Taxpayer received credits in the
credit years for its QCTEs and elected to claim the credit under § 45C for these
expenses, rather than the § 41 research credit. This does not change the fact that
these expenses are QREs, or mean that the consistency rule is violated merely
because Taxpayer elected the larger credit under § 45C in the Year 4 and Year 5
taxable years.

In conclusion, § 45C(c)(2) requires QCTEs to be included in base amount computations
under § 41(c), including the three-year-average base computation under § 41(c)(5)
applicable to the ASC.

CAVEATS

A copy of this technical advice memorandum is to be given to the taxpayer. Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.