The orphan drug tax credit (ODC) is a federal tax credit available to pharmaceutical companies working to find cures for certain rare diseases that affect small populations. Much like the traditional R&D tax credit, the ODC provides pharmaceutical companies an opportunity to increase cash flow and reduce the cost of their development operations.
The qualification requirements for the ODC are similar to traditional R&D credits, as both seek to incentivize conducting research activities that address technical uncertainty through iterative experimentation efforts. However, both credits must be separately calculated, and there are some key nuances to understand.
Who is eligible for the orphan drug credit?
Pharmaceutical companies may qualify for the ODC for their drug development programs that have received orphan drug designation by the US Food and Drug Administration (FDA). This means they’re developing a cure for one of the following:
- A rare disease that affects less than 200,00 persons in the US, or
- A disease affecting over 200,000 persons in the US, but for which there is no reasonable expectation that the cost of developing and making available a drug for such disease will be recovered from sales in the US
How much can a company save with orphan drug tax credits versus traditional R&D credits?
Typically, eligible pharmaceutical companies see a higher rate of return on their orphan drug clinical testing expenses (CTE) than R&D credit qualified research expenses (QRE). While the federal gross R&D credit typically results in a tax credit of 10% of QRE, the ODC provides a rate of 25% of CTE.
Another important distinction between orphan drug CTE and R&D QRE lies in the applicable qualification rates for contractor costs. The ODC allows for 100% of qualified contractor spend to be included as CTE, while the R&D credit caps the amount of these costs includible as QRE at 65%.
What do the orphan drug and R&D credits apply to?
Qualification for the orphan drug and R&D credits looks to the underlying activities performed and resulting spend over the course of the development year. This will include costs for wage, supply, and contract research expenses.
Both credits follow the same pharmaceutical drug development timeline provided by the IRS pharmaceutical audit guidelines. These guidelines break pharmaceutical research down into four stages:
- Preclinical or Discovery Research
- Clinical Development
- Regulatory Review
There are different activities and corresponding guidelines for each stage, and qualifying expenses will depend on the stage of a company’s products.
What activities qualify for the orphan drug credit?
The ODC is calculated based on the spend associated with activities conducted in the clinical phase of the drug’s development. This can include costs for internal wages for in-house activities as well as payments to contract research organizations hired to conduct human clinical testing.
These costs may generally be included as CTEs only after orphan drug designation date and prior to the date of FDA approval. Taxpayers should closely monitor costs incurred around these dates to ensure that proper allocation is performed for the calculation.
Is it possible to claim both an R&D credit and orphan drug credit in the same tax year?
Yes, however, companies can’t receive both credits on the same qualifying expenses. In other words, if one credit is earned on a certain qualifying expense, then the other credit is unavailable for that same expense. The potential savings are greater for the ODC, so a company with an orphan drug designation would likely pursue that over the R&D credit.
Because it’s possible for activities and expenses to qualify for both credits, proper cost allocation between the two credits is necessary for credit calculations.
How does a company claim the credit?
Once a company receives an orphan drug designation from the FDA, it can begin tracking costs related to a specific program from that point forward to include in their orphan drug credit claim.
The process to claim the ODC coincides with income tax return filings, with analysis and documentation needed to collect the necessary quantitative and qualitative data for qualified expenses. Properly documenting the qualified nature of the expenses associated with the projects and programs is key to securing the credit in the event of an IRS examination.
We’re Here to Help
Qualification requirements for the ODC are nuanced, so it’s crucial to understand what’s necessary to substantiate a credit claim. To learn more about how the ODC can help your company increase cash flow and reduce the cost of its development operations, reach out to your Moss Adams professional.
To learn more about the R&D credit, see Five Misconceptions About R&D tax Credits—and if Your Company Qualifies or request a complimentary credit benefit estimate to learn how much your company could save.