IRA tax provisions, Pillar 2 challenge life sciences companies

The life sciences sector, already strictly regulated, now must respond to many of the provisions included in the Inflation Reduction Act (IRA) of 2022. Along with the OECD’s Pillar 2 framework setting a minimum tax on cross-border profits, life sciences companies are presented with quite a number of new taxation challenges that can inhibit growth and sustainability if not properly addressed.

One key reform addressed by the IRA was prescription drug affordability. New drug price controls set by the government will significantly impact the way biopharma companies do business.

“Life science companies will need to address the impact the IRA will have on how they determine their portfolio of drugs, develop new commercialization strategies, and evaluate their pricing,” said Grant Thornton National Industry Managing Partner for Life Sciences Zara Muradali. “They’ll have to evaluate where they place their sales force, where they conduct clinical trials, and what distribution channels they will use. Any changes in their commercial strategies will impact the state and local taxes they may be paying.”

There is pending tax legislation on Capitol Hill which, if enacted, contains significant changes to what is described below, particularly to IRC Sections 174 and 163(j) and the bonus depreciation phase-out schedule. We will revise this story accordingly if those proposals become law.

New rules for research and development

In addition to measures designed to lower the cost of prescription drugs, life sciences companies are facing key new tax changes that may impact the industry’s research and development initiatives.

The Tax Cuts and Jobs Act included amendments to IRC Section 174, which had allowed businesses to deduct the full amount of their research and experimentation (R&E) expenditures as an expense in the year they were incurred. The amended IRC Section 174 now requires businesses to capitalize and amortize these expenses for a period of five years (for research in the U.S.) and over 15 years if the research is conducted outside the U.S., beginning in 2022 or later. Congress is currently considering amending these rules, and taxpayers should be both considering current law and the proposed changes in their planning.

“The idea of amortization, whether five or 15 years, will have a number of sweeping impacts on taxpayers,” said Grant Thornton Manager for Strategic Federal Tax Services Tom Hunter. From a financial statement perspective, the new Section 174 rules will create a deferred tax asset. Taxpayers will need to assess the impact on the effective tax rate related to other provisions that rely on the allocation of Section 174 costs, such as interest expense limitation under Section 163(j), tax on global intangible low-tax income, and foreign-derived intangible income.

It will also impact taxpayers at the state and local level. “Some states are conforming perfectly alongside federal rules regarding Section 174,” Hunter said. “Certain states have a delayed implementation date. Others are not following 174 at all. Taxpayers will need to look at every state and understand how Section 174 needs to be measured and how it plays out at a state tax level.”

In planning ahead, taxpayers will need to review trial balance expenditures and book-to-tax adjustments to determine the portion of each line item (if any) that should be capitalized as U.S.-based or non-U.S.-based Section 174. As a starting point in determining Section 174 costs, taxpayers can leverage a number of sources, including Historical Section 174, Rev. Proc. 2000-50 computations, Historical Section 41 research credit computations as well as their book R&D amounts. If they start from the research credit or Book R&D expenses, they will need to convert these costs to Section 174 as each starting point has different standards in measuring and defining R&D, which may inherently differ or contrast with Section 174.

For multinational businesses that conduct R&E globally, taxpayers will need to consider their IP ownership arrangements as well as any cost-sharing agreements related to R&E in order to determine which entities may bear the Section 174 capitalization.

In addition, companies are required to treat their software development costs as R&E expenditures and can no longer amortize custom software development costs over a three-year period. Companies will now need to implement a documentation approach for identifying specific Section 174 costs for this reporting. “The documentation that now needs to happen is a concern,” added Muradali. “I believe that’s because most companies are focused on how these provisions will impact their cash flow, as well as their research activities.”

Companies should also continue to monitor Congress as there are ongoing efforts to restore expensing of domestic research. If enacted, the change could be retroactive and provide significant benefits.

New funding for the IRS

The R&D tax credit is just one area in which life sciences companies must tread carefully, as the IRS is actively litigating research credit claims. “The IRA gave the IRS $80 billion in new funding, which is expected to be cut to $60 billion. Keep in mind $60 billion in new funding is still transformative, and much of it is going towards enforcement, so this is an area that’s going to remain active,” said Grant Thornton Tax Legislative Affairs Practice Leader Dustin Stamper.

The $60 billion in new funding for the IRS will impact taxpayers across the board. “This is an unprecedented amount of money for the IRS to spend and there are no restrictions on when they can spend it,” said Stamper. Most of the funding is dedicated to enforcement, so an increase in audits should be expected and the life sciences industry can expect to be a target.

New compliance initiatives recently announced by the IRS include new scrutiny on transfer pricing used by domestic life sciences companies that are owned by foreign parents. “A ramp-up in activity is underway, so you could see audit activity more quickly than you might expect,” said Stamper.

Limitations on business interest deductions

Another TCJA change is also being felt dramatically by life sciences companies. Section 163(j) limits the deduction of business interest to the sum of a taxpayer’s business interest income, floor plan financing interest, and 30% of its adjustable tax income (ATI) for a given taxable year. For tax years after 2021, amortization and depreciation are added to ATI, which is now similar to earnings before interest and taxes (EBIT).

“This is all happening at a time when interest rates are spiking to levels we haven’t seen in decades, so the impact of the 163(j) provisions just got worse in 2023,” said Stamper. “With the limit on interest deduction capped at 30%, companies now need to include depreciation and amortization, so that drives taxable income down. And that means that you hit the 30% threshold much sooner.”

Congress is considering restoring the prior calculation, which excluded depreciation and amortization, so taxpayers should keep an eye on the legislative process as that can have a meaningful impact on the amount interest expense able to be deducted immediately.

So, how does a company delay reaching the 30% limit? “There are opportunities to allocate interest expense to other types of deductions or amortized costs, some of which have different recovery periods, so there may be ways to deduct the cost,” Stamper added. “It’s worth modeling out your options for allocating interest to different things and how that might affect the limit under 163(j).”

“The bad news is that many taxpayers are staring down large and growing deferred tax assets for disallowed interest expense and they expect to carry that forward indefinitely,” said Grant Thornton Tax Senior Manager Jon Terrill. “The good news is that you may have multiple planning options at your disposal to manage interest expense efficiently in this challenging environment.”

The chart below lists some of the property and activity types that might attract interest expense. “The most attractive option for you will depend on your specific situation,” said Terrill. “For example, capitalizing interest to inventory will be an approach that is beneficial for many companies. The capitalized interest is allocated between ending inventory and cost of goods sold (COGS) each year. Any interest not recovered through the current year’s COGS will likely be recovered in the following year as the ending inventory is sold off.”

Changes in use of bonus depreciation

For many years, life sciences businesses have been able to use bonus depreciation as a tax advantage and an incentive to make new investments. The ability to use 100% bonus depreciation has expired, and businesses are only able to deduct 80% of the cost of qualifying assets placed in service in 2023, and this rate will decline to 60% for qualifying assets placed in service in 2024, declining again to 40% in 2025 and 20% in 2026—with no bonus depreciation deductions allowed after Dec. 31, 2026.

“Taken together, all these changes will have a meaningful impact on your taxes and financing and investment decisions,” said Stamper. “With 2022 taxes already filed, now is the time to be proactive and to look for ways to get a better result now that compliance is out of the way.”

Again, it’s important to consider the potential for congressional changes in your planning. Congress is considering restoring and extending 100% bonus depreciation.

More reporting for multinationals

Over the next few years, implementation of the OECD’s Pillar 2 minimum effect tax rate of 15% is expected to have a significant impact on U.S. multinationals. “While implementation is stalled here in the U.S., it is moving forward abroad, so U.S. multinationals both inbound and outbound may be affected as early as 2024,” said Stamper.

Pillar 2 brings with it a daunting increase in reporting requirements, which will require investments in additional resources and close collaboration for data gathering. “It will be important to put an infrastructure in place to modernize your tax reporting,” said Managing Director of Grant Thornton’s International Tax National Office David Zaiken. “The reporting form that we expect to come in 2025 has 52 data points.”

“There’s a whole lot of reporting that is required and companies may not be prepared to capture the data needed—or the data may not be immediately available or easily usable,” said Stamper. “That might require investment in new software implementation just for the reporting and compliance aspects of it.”