IMPRoVINg THE TAx cREDIT REgIME FoR LIFE ScIENcE coMPANIES

ImpROvING the tax CRedIt ReGIme

FOR LIFe SCIeNCe COmpaNIeS

EY’s Beyond Borders 20161 reports that, on a global basis, revenue, R&D spend, net income and total market capitalization for the biotech sectors reached historic highs in 2015. Scientific innovation in therapeutic areas such as immuno-oncology and orphan drugs continued at a very rapid pace. However, the same report also cited evidence of slowing growth in the sector as well, perhaps signalling that the growth has peaked. For the Canadian life sciences industry specifically, the Globe and Mail reported in April of 20152 that the biotech sector is “ready and eager” for growth but without adequate financing, it will go nowhere. The suggested solutions are that life science start-ups need to be allowed to use flow-through share financing or some similar tax freebie.

Some might say that the “tax freebie” mentioned above already exists in the form of the Scientific Research and Experimental Development (SR&ED) tax credit. Certainly life science companies have availed themselves of this benefit since its inception in 1985. However, let’s not forget that the 2012 federal budget dropped the tax credit rate for non-Canadian controlled corporations (nonccpcs) from 20 to 15 per cent - essentially taking away 25 per cent of the credit. The proxy rate also dropped from 65 to 55 percent and now only 80 per cent of payments to subcontractors and other third parties qualify instead of 100 per cent. Proxy and third party payments aside, CCPCs (which most startups are) were left relatively unscathed in that they still earn their federal SRED credit at a rate of 35 per cent. In 2014, Quebec cut their provincial R&D tax credit rates by 20 per cent. The more recent Ontario 2016 budget did not discriminate. The Ontario Innovation Tax Credit dropped from 10 to 8 per cent and the Ontario Research and Development Tax Credit dropped from 4.5 to 3.5 per cent. All told, these reductions in tax credit rates have a negative impact on life science companies.

Although not as generous as in the past, the tax credits still play a key role for life science companies. BioAlberta’s recent discussion paper3 hails the tax benefits of the SR&ED investment tax credit to the life sciences community. The paper makes recommendations for further simplification of the credit to reduce the administrative burden and also recommends increasing the tax credit rate; suggestions that would be positively viewed by all industries.

However, the BioAlberta paper does not cover the issue of lack of certainty associated

with claiming SR&ED ITCs which has been a long standing issue with claimants. As early as the mid-90s, SR&ED stakeholders have raised the issue of claimants needing to rely on the tax credits but never really knowing for sure if the Canada Revenue Agency (CRA) was going to approve their claim. Granted, lack of certainty on eligibility of the work is not as big of an issue for drug development projects but it certainly can be for drug manufacturers and those in the medical device area. In those scenarios, claimants can possibly find themselves spending significant time and effort defending claims which further add to the administrative burden associated with claiming the credits. So, what can be done to help increase certainty and reduce administrative burden? For over 15 years, the CRA provided the PreClaim Project Review service to get an opinion on the eligibility of a project. However, the opinion was non-binding so it still did not provide absolute certainty. More recently, the CRA piloted the Formal Preapproval Process (FPAP) which involved having the CRA visit the claimant on a quarterly basis to discuss the work being performed and costs being incurred in the year. The result of this “real time audit” would be the generation of an eligibility report by the CRA before the claim was actually filed. This process did provide certainty but visits by the CRA four times a year was resource-intensive for both the CRA and claimants. In March of 2016, the CRA announced two new programs that they hope will better address the certainty issue. One is the Pre-Claim Consultation (PCC) program which launched on June 29, 2016. The PCC is a free, on-demand service that tells businesses whether their work is eligible for SR&ED tax credits. Under the PCC, the CRA will identify qualifying work, provide a written decision about the eligibility of the work and provide advice on what documentation needs to be kept. On August 2, 2016, the CRA announced its new Pre-Claim Review (PCR) pilot project. The objective of a PCR is to give claimants assurance that the CRA will accept their entire claim as filed. The move by the CRA to develop better programs aimed at providing certainty is great news.

So what else? With the recent cuts to the tax credit rates, it is unlikely that the federal or provincial governments will be raising the tax credit rates any time soon. For years, industry has been requesting that the non-CCPCs earn a refundable credit (currently, only CCPCs receive a refundable tax credit) but the government has stood its ground on that as well. It is interesting to note that the US offers a very specific orphan drug tax credit aimed at incentivizing companies to invest in therapies for rare diseases and conditions that would have a limited market. The Internal Revenue Service (IRS) has also provided guidance to its examiners who are auditing research credit claims involving pharmaceutical development.4 Their directive states that examiners should not challenge the amount of a taxpayer’s qualified research expenditures if two conditions are met: first that the work involves drug discovery stage and/or preclinical and clinical trials; and second, that the taxpayer provides a signed certification statement that their research expenditures included in the research credit claim only relate to qualifying research activities for each tax year under audit. By incorporating this knowledge into their risk assessment process, the IRS makes more efficient use of their audit resources and the taxpayer minimizes their administrative burden by reducing time spent in IRS exam. An approach like the one in the US, and even one that went beyond clinical trials and included some aspect of drug manufacturing and medical device development might allow the CRA to still manage risk, optimize the use of their own resources while simultaneously reducing the administrative burden for the life science claimant.

The CRA also announced that is going to work more closely with SR&ED stakeholders and that open communication and dialogue will continue which is more great news. The announcement and launch of these new programs demonstrates the CRA’s willingness to change to meet claimant’s needs. Perhaps now, more than ever, it is important that claimants provide input and feedback to the CRA on ways to keep improving the program for all stakeholders.

In March of 2016, the CRA announced two new programs that they hope will better address the certainty issue. One is the Pre-Claim Consultation (PCC) program which launched on June 29, 2016.

References

1. Biotechnology report. Beyond borders [2016]. ey.com/beyond borders 2. Reguly, Eric, “Why is Canada’s life sciences sector flatlining?,” The Globe and Mail, 23 Apr 2015. http://www. theglobeandmail.com/report-onbusiness/rob-magazine/why-is-canadas-life-sciences-sector-flatlining/ article24030375/ 3. BioAlberta. Sustaining Life Sciences

Innovation With SR&ED Investment

Tax Credits. http://www.bioalberta. com/uploads/files/White%20Papers/

BioAlberta%20-%20Sustaining%20

Life%20Sciences%20Innovation%20

With%20SRED%20Tax%20Credits.pdf 4. Maloy, Heather C. Guidance for

Computing and Substantiating the

Credit for Increasing Research Activities under Section 41 of the Internal

Revenue Code for Activities involved in Developing New Pharmaceutical

Drugs and Therapeutic Biologics, IRS 15 October 2015. https://www.irs.gov/ businesses/guidanceforcomputingsubstantiatingpharmaceuticaldrugstherapeuticbiologics

Elizabeth Pringle is the National Life Sciences Industry Lead for Ernst & Young LLP’s Business Tax Incentives practice and an associate partner with the firm.