ANALYSIS: Tax reforms would boost R&D by $20bn, add 600k+ jobs

A new analysis from Ernst & Young has provided American biotechs and other small research-intensive businesses the evidence they need to back up their pleas to Congress to change certain tax rules for "pre-revenue" innovators, with the report showing adoption of three proposals could increase total investment in those companies by $20.6bn and result in the creation of about 623,000 new jobs.

The analysis, which was prepared for the Coalition of Small Business Innovators (CSBI), whose membership includes the Biotechnology Industry Organization, the Advanced Medical Technology Association and the Association of Clinical Research Organizations, takes aim at three sections of the US tax code – 469, 382 and 1202 (scripintelligence.com, 27 May 2013).

Those sections of the tax code, said Detroit tax attorney James Combs, a partner at Honigman Miller Schwartz and Cohn, have not been updated and modernized to fit the needs of today's small research-intensive businesses, mostly because of a lack of a coalesced force to push for change.

The CSBI, however, is hoping to organize investors and companies adversely affected by the outdated tax rules to get changes finally enacted.

"The number one challenge that all research-intensive small companies face . . . is constantly trying to find and attract enough investment capital to enable a continued advancement of the ideas we are working on, the promising medical breakthroughs with real potential to cure disease and save lives," said Jeff Hatfield, president and CEO at Vitae Pharmaceuticals, whose firm "lives the issues of capital formation for a research-based small company literally every day."

"We are succeeding with our science, but we're still four to five years and potentially hundreds of millions of additional investment dollars away from being able to deliver the values that these emerging medical breakthroughs to the patients that need them," Mr Hatfield lamented, adding that finding the capital to drive his firm’s work often is “daunting.”

Across the research investment continuum, he said, "there just isn't enough capital being committed to long-term innovation investment to fund all the tremendous ideas that are out there."

Investment in research-focused small companies, Mr Hatfield said, often loses out to quick return, lower-risk projects.

"Important new breakthroughs are being starved, or just left behind entirely," he said.

Tax reform targeting pre-revenue research companies "would greatly improve the state of innovation in America," Mr Hatfield said. "It would allow research companies a much greater ability to attract and compete for investment dollars, critical capital, which can keep the most important discoveries rapidly moving forward to deliver more cures in the future. It would tangibly enhance the ability for those companies to advance, accelerate and expand their efforts on new breakthroughs."

And, he said, the proposed tax reforms would allow small businesses like his to add highly paid innovative research jobs.

Specifically, CSBI is seeking to relax the passive activity loss (PAL) rules in Section 469 of the US tax code to encourage investment in small R&D-intensive "pass-though" businesses.

The idea is to promote the creation of R&D partnership structures, in which individual investors would be able to finance R&D projects and then use the operating losses and tax credits generated during the research process, giving the investors a tax incentive to support research.

R&D partnership structures were used by early biotechs like Amgen, Genentech and Genzyme during the early 1980s, but in 1986, Congress enacted the PAL rules, which prevented investors from using losses to offset other income – essentially removing a major incentive to support R&D.

Robert Carroll, principal at Quantitative Economics and Statistics at Ernst & Young, said CSBI's R&D partnership structures proposal would increase investment by an estimated $10.3bn per year, resulting in 156,000 additional jobs at affected companies.

Mr Carroll noted certain restrictions would be put in place to ensure the proposed exception would only apply to small, research-intensive entities, in which 75% of the pass-through entity's total expenditures would need to be made in connection with R&D-related activities or 50% of expenditures would need to be for "qualified research expenses" – funds used for research undertaken for the purpose of discovering information which is technological in nature and intended to be used in the development of a new or improved business component of the taxpayer.

CSBI also wants Congress to remove the financing restrictions in Section 382 of the US tax code to allow small research-intensive companies to retain their net operating losses (NOLs) generated by R&D expenditures.

Section 382, which was enacted to limit tax-motivated acquisitions of corporations with NOLs, built-in losses and other tax attributes eligible to be carried forward, restricts the use of NOLs by companies which have undergone an ownership change.

By removing financing restrictions in Section 382, biotechs and other small businesses would have the freedom to raise capital without the fear of losing the value of their NOLs, which would make it more attractive to investors and purchasers looking to take those firms' research to the next level.

Reforming Section 382 would increase investment by a total of $5.5bn per year, resulting in 85,000 additional jobs at affected companies, Mr Carroll said.

CSBI also wants Congress to change the gross assets test under Section 1202, which would permanently extend the 100% capital gains exclusion from the sale of qualified small business stock (QSBS), which would reduce capital gains taxes for dispositions of equity interests in qualifying companies, increase the size limit for qualifying firms from $50m to $150m in assets and extend the exclusion to companies organized as pass-through businesses.

The extension and expansion of the QSBS provision would increase investment by $3.6bn, resulting in 355,000 additional jobs at affected companies, Mr Carroll said.

The proposals would provide a better ability to raise capital to small research-intensive companies, which he noted were "particularly harmed over the last several years with the financial crisis."

Obama plan

The E&Y analysis was released on the same day President Barack Obama also revealed his latest "grand bargain" for stimulating the economy and working out a budget deal with Congress.

Among the president's proposals was a measure aimed at simplifying tax filing for small businesses and increasing incentives to invest in those companies.

Mr Obama proposed allowing small businesses to expense up to $1m in investments, which he said would provide those firms with an incentive to invest in new plants and equipment and would remove a source of complexity in the tax code.

"Let's simplify taxes for small business owners, give them incentives to invest so they can spend less time filling out complicated forms, more time expanding and hiring," the president said on 30 July during a speech in Chattanooga, Tennessee, where he unveiled his proposal.

President Obama said his proposal also calls for lowering the tax rate for businesses that create jobs in America and closing loopholes and ending tax breaks that incentivize firms to ship jobs overseas.

"I'm willing to work with Republicans on reforming our corporate tax code, as long as we use the money from transitioning to a simpler tax system for a significant investment in creating middle-class jobs," President Obama said.