Pharmaceutical innovators are searching for additional tax relief after the new Section 174 R&E capitalization requirement may not go away. The Orphan Drug Credit (“ODC”) represents a significant incentive offered by the U.S. government under IRC Section 45C, specifically designed to encourage pharmaceutical innovators to pioneer medications and therapies for rare diseases — conditions that touch the lives of a relatively small segment of the population.
This potent tax credit serves as a financial catalyst, enabling companies to reduce their tax liability on a dollar-for-dollar basis, thus nurturing the development of vital treatments that might otherwise be economically unfeasible.
As an integral component of the General Business Credit, it not only provides immediate fiscal relief but also includes a flexible carryover provision — allowing any unused credits to be carried back for one year or forward for two decades, ensuring that companies can harness this benefit to its fullest extent over time.
Significant Features of the Orphan Drug Tax Credit
- The credit is an elective benefit available to all taxpayers. Related taxpayers are treated as a single taxpayer for the purpose of this credit.
- The credit amounts to 25% of the Qualified Clinical Testing Expenses (QCTE) incurred by the taxpayer during the tax year.
- Typically, the deduction for qualified expenses is reduced by the amount of the credit claimed, unless the taxpayer elects a reduced credit. An election to take reduced credit should be made on a timely filed return (including extensions). Once made, the election is irrevocable for that tax year. Similar to claiming reduced R&D credit, safety elections should be made to protect the election if amended returns are needed.
- The credit applies to testing conducted within the U.S. (subject to certain exceptions; see below) to obtain approval from the Food and Drug Administration (FDA) for the commercial sale of drugs targeting rare diseases or conditions in the U.S.
- The credit is accessible from the date the FDA grants orphan drug designation to a drug until the date the FDA approves the drug for patient use.
- Qualified expenses that are funded by a government entity or by a person other than the taxpayer do not qualify for the credit.
- The annual fee on branded prescription drug sales does not apply to sales of orphan drugs for which the Section 45C ODC was allowed in any tax year. For this exclusion to apply, the ODC must have been claimed rather than simply being eligible to be claimed.
The ODC applies to a taxpayer for any tax year only if the taxpayer elects (in the time and manner as IRS regulations may prescribe) to have the credit apply for the tax year. An individual, estate, trust, organization, or corporation claiming the ODC, or any S corporation, partnership, estate, or trust that allocates credit to its shareholders, partners, or beneficiaries must complete Form 8820 and attach it to its tax return.
- Qualified clinical testing expenses are eligible for ODC. These are amounts paid or incurred by the taxpayer during the year for:
- In-house clinical testing expense
- Contract clinical testing expenses
- Eligible expenses for the ODC are similar to amounts that would qualify as research and experimental expenditures. These expenses include:
- Wages paid to employees specifically for performing clinical testing.
- Costs incurred for supplies directly used in conducting clinical testing.
- Payments made for renting personal property from another party, excluding the taxpayer, for use in clinical testing.
- Payments for qualified research undertaken by contractors, where 100% of the expenses are eligible—a notable modification from the 65% eligibility of contract research expenses for the R&D credit.
- R&D Credit and ODC can be claimed in the same year. However, if the same expense qualifies for both credits, the taxpayer can use the expenses to claim only one of these credits, and it would be more advantageous to apply the expenses to ODC until the research has been approved by the FDA.
- While R&D credit is not allowed for research activities conducted outside the United States, an ODC can be obtained for foreign clinical testing provided certain criteria are met:
- Such testing is conducted outside the United States because there is insufficient testing population in the United States and
- Such testing is conducted by a United States Person or by any other person who is not related to the taxpayer to whom the designation under section 526 of the Food, Drug and Cosmetic Act applies.