Life Sciences
The life sciences industry is a major sector of economy of San Diego. The region has more than 1,100 life sciences companies and more than 80 research institutes. Major pharmaceutical companies including Pfizer, Johnson & Johnson, GlaxoSmithKline and Merck maintain a presence in San Diego to foster collaboration with major research institutions, universities and many biotech companies.
Drug discovery and development is very capital intensive. Companies need to invest hundreds of millions of dollars before they can start generating any revenue. Financing is probably the greatest risk companies face in their early stages, and I have witnessed many companies with great ideas gone bankrupt because they weren’t quite ready for major investment from VCs or financing strategies.
Even in years when companies incur no tax liability because of operating losses, proper tax planning is important to maximize the future benefits of current investments and the valuation VCs and banks look at before they hand out money. So I like to share some of the key tax planning ideas that life sciences companies should consider.
R&D credit
Up until now, start-up companies saw no immediate need for claiming Research and Development tax credit because of their net operating loss position. However, with the enactment of the Protecting Americans from Tax Hikes (PATH) Act of 2015, many small to mid-sized businesses may now use the credit against alternative minimum tax and offset the FICA employer portion of payroll tax, if certain conditions are met. Also, having a proper documentation in place can secure the credit carryforwards that can be used later years when the companies start generating taxable income. This future tax asset will have a direct impact to future cash flow and therefore impacts the value of the companies, VCs and banks evaluate when making investment decisions.
Start-up tax losses
Tax losses have limited carryforward periods. Any losses that are not used within the carryforward periods will be expired and gone. So it is very important to manage timing of deductions and utilize certain tax elections to prolong the life of tax losses. Additionally, many of these companies undergo a number of equity rounds to finance the operation. IRC section 382 limits the ability to utilize these tax losses when certain ownership changes take places. Certain tax planning can be implemented to minimize these limitations to preserve these valuable tax losses – tax assets.
Deferred compensation
Retention of key talents is one of the main challenges many early-stage life science companies face. Many companies offer noncash compensation in various forms to retain and attract these talents. There are various types of equity-based compensation that companies can choose from, and each of them have different tax and financial impact. Before implementing equity-based compensation, companies must be aware of mechanics of how these awards work and consider pros and cons.
Final Regulations under IRC section 385
IRS recently issued final regulations under IRC section 385 providing objective criteria to sustain debt treatment for tax purposes of intercompany debt issued among related parties. Without an adequate documentation required under the regulations, certain intercompany debt would be treated as stock for income tax purposes. In other words, financing cost intended to be treated as interest expense would potentially be re-characterized as dividend. Related party debt instruments issued on after April 4, 2016 must be analyzed by confident tax professionals to avoid any conflicts with taxing authorities.
International Tax Compliance Issues
BEPS, Earnings Stripping, Inversion, Cost Share Arrangement and IP migration – these are some of the key matters IRS recently provided additional compliance requirements and more stringent rules around. Tax issues related to these matters are heavily scrutinized and noncompliance can result in unimaginable consequences. Multinational companies must retain qualifying tax professionals to be in compliance with these fast revolving tax laws.