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Federal Tax Incentives:

Orphan Drug Tax Credit 

Background  

 

To encourage the development of drugs for uncommon diseases and conditions that affect less than 200,000 people in the United States, Congress passed the Orphan Drug Act of 1983, P.L. 97-414. and the Rare Diseases Act of 2002, P.L. 107-280. These acts were enacted to offer various incentives to pharmaceutical companies that develop drugs to treat uncommon diseases, and to coordinate the development of otherwise less profitable drug therapies. One of the various objectives for these incentives includes helping the U.S. stay affront of uncommon diseases before spreading into epidemic or pandemic proportions. Among these incentives is the Orphan Drug Tax Credit (ODC), established under IRC § 45C.  

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Orphan Drug Credit Calculation

The ODC is a non-refundable federal income tax credit equal to 25% of a taxpayer's qualified clinical testing expenses (QCTEs) for the current taxable year incurred beginning after December 31, 2017. See IRC § 45C(a) and Treas. Reg § 1.28-1 for details.

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The ODC rate was recently reduced from 50% to 25% pursuant to the Tax Cuts & Jobs Act of 2017. However, even at 25%, the ODC is generally more beneficial than the R&D tax credit (which the same costs are often eligible), and does not include an incremental base component. The R&D credit rate is approximately 20%, or about 15.8% after the IRC § 280C(c) election (net-benefit after 21% corporate tax rate) of qualified costs that exceed a base amount. This incremental credit hurdle to calculate the R&D credit based on qualified costs in excess of a statutory base amount further decreases the overall benefit to approximately 7.9% for each qualified dollar spent. The ODC calculation also includes 100% of qualified contractor costs (instead of 65% under the R&D tax credit). Lastly, IRC § 45C allows for taxpayers to elect a reduced ODC, similar to the IRC § 280C(c)(3) election for the R&D tax credit to avoid the credit add-back to income.

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In general, developers of such orphan drugs are eligible for the ODC credit between the date the Food and Drug Administration (FDA) grants the taxpayer orphan status and the date the FDA approves its drug for patients. However, the R&D credit can still generally be claimed for ongoing qualified research expense development costs for an orphan drug, regardless of FDA designation or post-FDA approval of the drug. 

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Qualified Clinical Testing Expenses

In general, qualified clinical testing expenses (QCTEs) are amounts paid or incurred by the taxpayer that would be described as qualified research expenses under section 41 ("R&D Tax Credit"), with the following modifications pursuant to IRC § 45C(b):

  • In IRC §§ 41(b)(2) and (3), “clinical testing” is substituted for “qualified research.”

    • IRC § 45C(b)(2)(A) defines the term "clinical testing" as any human clinical testing that is carried out under an exemption for a drug being tested for a rare disease or condition under Section 505(i) of the FDCA (or regulations issued under that section), which occurs:

  • 100% (instead of 65% or 75%) of contract research expenses are treated as clinical testing expenses. See § 45C (b)(1)(B); Treas. Reg. § 1.28-1(b)(2).

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Clinical Testing

In general, the term “clinical testing” means any human clinical testing which includes the following:

  • (1) Carried out under an exemption under section 505(i) of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 355(i)) and the regulations relating thereto (21 CFR part 312) for the purpose of testing a drug for a rare disease or condition.​​

  • (2) Occurs AFTER the date the drug is designated as a drug for a rare disease or condition under section 526 of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 360bb),​​

  • (3) Occurs BEFORE the date on which an application for the designated drug is approved under section 505(b) of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 355(b)) or, if the drug is a biological product (other than a radioactive biological product intended for human use), BEFORE the date on which a license for such drug is issued under section 351 of the Public Health Services Act (42 U.S.C. 262), and

  • (4) Conducted by or on behalf of the taxpayer to whom the designation under section 526 of the Federal Food, Drug, and Cosmetic Act applies.

  • Human clinical testing shall be taken into account only to the extent that the testing relates to the use of a drug for the rare disease or condition for which the drug was designated under section 526 of the Federal Food, Drug, and Cosmetic Act. ​

  • Testing is considered to be "human clinical testing" only to the extent that it

    • uses human subjects to determine the effect of the designated drug on humans and is necessary for the designated drug either to be approved under section 505(b) of the Federal Food, Drug, and Cosmetic Act and the regulations thereunder (21 CFR part 314), or

    • if the designated drug is a biological product (other than a radioactive biological product intended for human use), to be licensed under section 351 of the Public Health Services Act and the regulations thereunder (21 CFR part 601).

  • A human subject is an individual who is a participant in research, either as a recipient of the drug or as a control. A subject may be either a healthy individual or a patient.

  • "Human clinical testing" is NOT carried out under section 505(i) of the Federal Food, Drug, and Cosmetic Act and the regulations thereunder (21 CFR part 312) unless 

    • the primary purpose of the human clinical testing is to ascertain the data necessary to qualify the designated drug for sale in the United States, 

    • and not to ascertain data unrelated or only incidentally related to that needed to qualify the designated drug. 

  • Whether or not this primary purpose test is met shall be determined in light of all of the facts and circumstances.​

  • In general, the term “rare disease or condition” means any disease or condition which

    • Afflicts 200,000 or fewer persons in the United States, or

    • Afflicts more than 200,000 persons in the United States but for which there is no reasonable expectation that the cost of developing and making available in the United States (as defined in section 7701(a)(9)) a drug for such disease or condition will be recovered from sales in the United States (as so defined) of such drug.​

    • Determinations with respect to any drug shall be made on the basis of the facts and circumstances as of the date such drug is designated under section 526 of the Federal Food, Drug, and Cosmetic Act.

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IRS Ruling: Post-Approval Studies - (See IRS Private Letter Ruling, PLR-112529-17, October 10, 2017)

The IRS concluded that post-approval studies required as a condition of approval for accelerated approval drugs are clinical testing within the meaning of Section 45C, and that accelerated approval is not a final approval as contemplated by the cross reference to Section 505(b) in Section 45C(b)(2)(A)(ii)(II).

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Therefore, the taxpayer's qualified clinical testing expenses, as defined in Section 45C(b)(1), may include expenses for clinical trials that: (1) occur after the date the FDA granted the orphan drug accelerated approval; and (2) are required as a condition of the accelerated approval of that NDA. The expenses must be incurred before the date the taxpayer receives FDA notification that the orphan drug's post-approval study requirements are no longer necessary, or the date the FDA determines that the required post-approval study verifies and describes the orphan drug's clinical benefit.

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See IRS link for additional details, PLR-112529-17, October 10, 2017.

Testing Not Eligible for the Credit

The credit is not allowed for clinical testing conducted outside the United States unless there is an insufficient U.S. testing population and the testing is conducted by a U.S. person or by another person not related to the taxpayer. Testing conducted either inside or outside the United States by a corporation to which section 936 applies is not eligible for the orphan drug credit.

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QCTEs are often also eligible for the R&D tax credit as qualified research expenses (QREs): wages, supplies, contract research, computer lease or rental costs, as noted above. See IRC §45C(b)(1); Treas. Reg.  § 1.28-1(b). However, when these qualified expenses overlap as eligible costs for either the ODC or R&D tax credit, those expenses cannot be claimed twice for both credit incentives during a particular tax year. See IRC §45C(c). Although if overlapping qualified expenses are claimed as QCTEs, those QCTEs which also qualify as QREs in prior years are still utilized to calculate the R&D tax credit base amount. See IRC § 45C(c)(2). As such, investigative tax planning and bifurcation is often needed when claiming both credits in order to maximize the overall benefit between both incentives.

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Exclusion of Costs

Funded Research by Another Party

In computing the Orphan Drug Credit, the taxpayer shall not include any cost incurred or expected to be incurred by the taxpayer to the extent that the cost is funded or is reasonably expected to be funded by a grant, contract, or otherwise by another person (or any governmental entity). Drug funding determination shall be applied separately to each designated drug tested by the taxpayer.

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  • Clinical Testing - Taxpayer Retains No Rights 

    • If a taxpayer conducting clinical testing with respect to the designated drug for another person retains no substantial rights in the clinical testing (confers on another person the exclusive right to exploit the results) under the agreement providing for the clinical testing the taxpayer's clinical testing expenses are treated as fully funded. Incidental benefits to the taxpayer from the conduct of the clinical testing (for example, increased experience in the field of human clinical testing) do not constitute substantial rights in the clinical testing.

  • Clinical Testing - Taxpayer Retains Substantial Rights

    • If a taxpayer conducting clinical testing with respect to the designated drug for another person retains substantial rights in the clinical testing under the agreement providing for the clinical testing, the clinical testing expenses are funded to the extent of the payments (and fair market value of any property at the time of transfer) to which the taxpayer becomes entitled by conducting the clinical testing. The taxpayer shall reduce the amount paid or incurred by the taxpayer for the clinical testing expenses that would constitute qualified clinical testing expenses of the taxpayer by the amount of the funding determined under the preceding sentence.​

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Special Limitations on Foreign Testing

  • Clinical testing Conducted Outside of the United States

    • In general, expenses paid or incurred with respect to clinical testing conducted outside the United States (as defined in section 7701(a)(9)) are not eligible for credit under this section. 

      • For example, wages paid to an employee clinical investigator for clinical testing conducted in medical facilities in the United States and Mexico generally must be apportioned between the clinical testing conducted within and outside the United States. Only the wages apportioned to the clinical testing conducted within the United States are qualified clinical testing expenses.

  • Insufficient Testing Population in the United States

    • In general, if clinical testing is conducted outside of the United States because there is an insufficient testing population in the United States, and if the clinical testing is conducted by a United States person (as defined in section 7701(a)(30)) or is conducted by any other person unrelated to the taxpayer to whom the designation under section 526 of the Federal Food, Drug, and Cosmetic Act applies, then the expenses paid or incurred for clinical testing conducted outside of the United States are eligible for the credit.​

    • The testing population in the United States is insufficient if there are not within the United States the number of available and appropriate human subjects needed to produce reliable data from the clinical investigation.

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Eligible Cost of Developing & Making Available the Orphan (Designated) Drug

In general, the taxpayer's computation of the cost of developing and making available in the United States the designated drug shall include the following:

  • Only the costs that the taxpayer (or any person whose right to make sales of the drug is directly or indirectly derived from the taxpayer, e.g., a licensee or transferee) has incurred or reasonably expects to incur in developing and making available in the United States the designated drug for the disease or condition for which it is designated.

    • For example, if, prior to designation under section 526, the taxpayer incurred costs of $125,000 to test the drug for the rare disease or condition for which it is subsequently designated and incurred $500,000 to test the same drug for other diseases, and if, on the date of designation, the taxpayer expects to incur costs of $1.2 million to test the drug for the rare disease or condition for which it is designated, the taxpayer shall include in its cost computation both the $125,000 incurred prior to designation and the $1.2 million expected to be incurred after designation to test the drug for the rare disease or condition for which it is designated. The taxpayer shall not include the $500,000 incurred to test the drug for other diseases.

  • The cost computation generally include only the following:

    • Reasonable costs incurred AFTER the first indication of an orphan application for the designated drug include the following:

      • costs of obtaining data needed, and of meetings to be held, in connection with a request for FDA assistance under section 525 of the Federal, Food, Drug, and Cosmetic Act (21 U.S.C. 360aa) or a request for orphan designation under section 526 of that Act; 

      • costs of determining patentability of the drug; 

      • costs of screening, animal and clinical studies; 

      • costs associated with preparation of a Notice of Claimed Investigational Exemption for a New Drug (IND) and a New Drug Application (NDA); 

      • costs of possible distribution of drug under a “treatment” protocol; 

      • costs of development of a dosage form;

      • manufacturing costs;

      • distribution costs;

      • promotion costs; 

      • costs to maintain required records and reports; and 

      • costs of the taxpayer in acquiring the right to market a drug from the owner of that right prior to designation.

      • The taxpayer shall also include general overhead, depreciation costs and premiums for insurance against liability losses to the extent that the taxpayer can demonstrate that these costs are properly allocable to the designated drug under the established standards of financial accounting and reporting of research and development costs.

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