By Mitch Cohen, EY Global Life Sciences Tax Leader
Life sciences companies thought they were busy enough dealing with the digital revolution while their tax departments coped with e-filings and even e-audits. But new this year, they have been confronted by a corporate tax revolution in the US.
Data, data everywhere, changing products and their taxation
Imagine a diabetes patient in 2000 taking a standardized medicine to manage blood sugar. It is the same dose of the same medicine that millions of other patients take. More recently, that patient could have an implantable sensor that logs data about drug absorption, metabolism and other systems for a doctor’s review.
Taking the high-tech approach further, a patient can undergo high-throughput screening, a method of drug discovery using robotics, data processing and sensitive detectors to quickly conduct millions of chemical, genetic or pharmacological tests. Here we enter the field known as personalized medicine.
As the activities that deliver medical value change, so does the taxation of that value. In the traditional arrangement, a significant portion of a medicine’s taxable value was assigned to intellectual property (IP) in an offshore jurisdiction and properly taxed at the foreign rate. As medicine becomes more personalized, much of that value is still IP, but its value has moved closer to the patient and some of it is more likely to be taxed locally at local rates.
Another digital development that moves taxable value is 3D printing. When a medical device breaks, the hospital can order a new part to be shipped from abroad, or it could be 3D printed on site. The hospital administrator may consider it a matter of time and shipping cost saved, but it also changes the taxation of that transaction.
For pills, 3D printing is not an option with current technology, but it’s not inconceivable that finishing, filling and packaging of medicines could happen someday soon in a pharmacy. Many years ago pharmacists routinely performed such tasks, and if they start doing so again, they may shift some value closer to the patient.
US tax reform scrambles business models
Against the backdrop of these revolutionary changes in technology that affect life sciences operations and taxation, why would one country’s tax code reform be so significant? It’s true that global life sciences companies have always adjusted to countries’ ever-changing tax codes, but US tax reform is different for two simple reasons: the US is the world’s biggest consumer of life sciences products, and it’s also the headquarters country of many large life sciences firms. In combination, those economic realities make the recent US tax reform a monumental challenge for the life sciences sector and its tax advisors.
In the media, national tax systems are often labeled as “worldwide” to mean that income earned abroad is taxable, or “territorial” to mean that only domestic income is taxable. In reality, many countries’ tax codes have worldwide and territorial features, and on that spectrum, the US code had always leaned toward worldwide.
Starting in 2018, the US’s new quasi-territorial system levies a 21% rate on corporate income (down from 35%) plus, an average tax rate of approximately 7% state-level corporate tax that is deductible from federal income, resulting in a new combined effective tax rate of about 26%.
Especially important to life sciences firms is a new deduction for C-type corporations that earn income abroad on intangible property held in the US. This deduction for so-called foreign-derived intangible income (FDII) brings the tax rate on that income down from 21% to 13.125% at the federal level, or about 19% when combined with state taxes. These significant tax cuts are forcing life sciences companies to reconsider even the most fundamental decisions about their business models.
Adjusting business models means hitting a moving target
Taxpayers must not only react, but also predict what might happen elsewhere. France and Belgium have already cut their corporate tax rates in response to the US tax reform, and others are talking. Even more critical to the calculations of life sciences firms are the reactions of low-tax jurisdictions that host off-shore operations. They still have rates lower than the US’s combined federal/state rate, but they could also feel competitive pressure.
Assume, for example, that an offshore jurisdiction has a tax rate 5 or even 10 points lower than the US. That may not be a sufficient tax advantage to attract business because of other risks not present in the US. The taxpayer’s decision to stay there or site new operations there could raise questions of economic substance; the cost of making a pharmaceutical could be higher; quality issues could arise; and if the rest of the supply chain is in the US, shipping and scheduling are more difficult.
US tax reform is causing another potential shift to business models as some companies reconsider their treasury model, the structure historically required by US law, for companies who wished to retain their offshore earnings and permanently re-invest them offshore. This could be the year that the offshore treasury center is moved or even removed altogether.
The questions posed by tax reform seem endless
These brief comments do not do justice to the complexity of the issues that US tax reform has created for life sciences companies and their tax advisors, even as both deal with different aspects of the digital revolution. Here are a few tax conversation starters that will lead tax executives toward a rational course of action:
- Is your company bringing cash back to the US? If so, consider the financial statement implications of the transition tax, and be sure to understand the ways that taxation might change depending on what the company will do with the cash.
- Is your company considering a large capital project? Taking advantage of 100% expensing in the US is an attractive option, while debt-financed deals have become less attractive. If acquiring, tax reform affects the valuation of targets, and supply chains that were rational may no longer be.
- Has your company evaluated the impact of tax reform on their compensation and benefits program? If not, the executive compensation structure needs re-examination, as do workforce strategy, sourcing, retention and location. Also consider immigration risk and compliance.
- If your company does business in multiple US states, are any decoupling from the new federal tax code?
- And the big question that embraces all of the above: is your company re-evaluating its business or operating model? If so, a principal structure may not have the advantages it once did. Consider system changes to reduce the new US Base Erosion and Anti-Abuse (BEAT) payments and rethink the rationale for off-shore shared service centers and procurement hubs. Be aware if tax reform has prompted your suppliers and contract manufacturers to change their operations.
Unlike some years where only a few tweaks are needed to maintain the status quo, 2018 is a year in which taxpayers will need to ask and answer many big questions.