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  • Writer's pictureAleksey Krylov

Pay Taxes on Profits They Don’t Have: Biotech CFO Headaches Over?

Updated: Apr 3

Over the past couple of years, many life sciences and medical device startup CFOs have been dealing with the massive headache of paying taxes on profits they don’t have. This sounds counterintuitive but true.


Aleksey Krylov R&D Tax Impact

 

The issue is with Section 174 of the tax code, which governs how companies treat research and development (R&D) costs for tax reporting purposes. Historically, biotech and medtech startups could deduct 100% of R&D expenses from their taxable income. This was crucial for young companies often operating at a loss, allowing them to avoid taxes.

 

However, new legislation implemented in 2022 requires companies to “capitalize” the R&D expenses. This means spreading the cost out over several years instead of taking a full deduction upfront. Under the current system, the write-off period is five years for domestic R&D and 15 years for foreign expenses.

 

While all companies are impacted by this change, it disproportionately affects smaller and earlier stage startups in a negative way. Their limited cash flow makes them more reliant on upfront deductions. Having to spread the deduction over time reduces the immediate tax benefit of R&D investment. In some cases, startups may even face higher tax bills due to the reduced deduction, despite not having substantial profits. This creates a situation where they're essentially taxed on profits they don't have.

 

One example is Startup A in biotech. They spend $100 on G&A, and $150 on R&D. Let us just say that the R&D involves spending on animal testing and is done through two tranche payments in one calendar year.



 

Historically, the company would write off $250 worth of expenses. If they fund their operations through grants, they will have a zero P&L and incur no cash tax liability.


With the 2022 revisions to Section 174 code, the biotech is unable to completely write off the R&D expenses, but requires to capitalize them and expense them over the next five years. In essence, even though the $150 in cash is spent, the company can only write off $30 for tax P&L purposes. This results in a positive taxable income and cash tax liability of $25. The company does not necessarily have the spare cash reserves to pay the tax expense, but nevertheless is facing the tax bill.

 

The next scenario involves paying for R&D overseas. Depending on location, it may or may not be cheaper to do the same work as in the US. For example, one would argue that it is cheaper to conduct clinical trials in Eastern Europe but it may not be cheaper to run clinical trials in England, France or Germany. However, if the R&D spend is classified as overseas R&D, the Startup A is facing a 15-year amortization period for the same amount of $150 cash spent on R&D. This results in even higher tax liability of $29 and lower after-tax cash flow for the period.

 

You get the gist of the cash flow impact from these simplistic examples. And over the past couple of years, it has been a massive headache for life sciences CFO. I personally faced this issue when a life sciences company was struggling to raise capital in the equity capital markets, faced diminishing runway and had to make hard choices about their clinical programs when a tax season brought even more unpleasant surprises associated with tax bills.

 

The good news however is that this “capitalized R&D” rule appears to be on track to be reversed or revised by the Congress. So, the CFO headache may be soon over… assuming, of course, that the Congress does indeed pass the bill. Until then, strategic planning for biotechs must incorporate tax liability management for every full-time or fractional CFO out there.

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