R&D Tax Credits and the Orphan Drug Credit: Key Differences and Benefits

Two of the most lucrative tax credits available to life sciences companies are the R&D credit and orphan drug credit (ODC). Both incentives provide companies with immediate or future tax benefits intended to reduce the cost of their development operations.

There are distinct similarities in the qualification requirements for the R&D credit and ODC. In fact, the ODC’s core qualification concepts come directly from the R&D credit’s provisions, which focus on incentivizing research activities that address technical uncertainty through iterative experimentation efforts.

However, both credits must be separately calculated, and there are some key differences to understand. Explore these differences and benefits of each opportunity, below.

How Much Can a Company Save with Traditional R&D Credits Versus ODC?

Typically, eligible pharmaceutical companies see a higher credit on their orphan-drug clinical testing expenses than R&D credit-qualified research expenses.

R&D Tax Credit Rates

The federal gross R&D credit utilizes a 20% or 14% rate, depending on method choice, which typically results in a tax credit of 10% of qualified research expenses due to calculation mechanics.

State R&D credit rates vary. California’s credit uses a 15% rate, which generally results in a credit for approximately 7% of qualified expenses.

ODC Rate

The ODC typically provides a tax credit of 25% of clinical testing expenses.

States don’t provide an ODC benefit, and applicable costs can generally be included with the state R&D credit calculation, if available.

Are There Eligibility Differences Between the R&D Credit and ODC?

Yes. While ODC eligibility is built on the same IRS criteria as the R&D credit, there are distinct differences.

R&D Credit Eligibility Criteria

Any company that encounters and resolves technological challenges may be eligible for the R&D tax credit. That said, eligibility depends largely on whether the company’s R&D work meets the criteria established by the IRS’s four-part test.

IRS Four-Part Test Criteria for R&D
  • Elimination of uncertainty. A company must demonstrate it has attempted to eliminate uncertainty about the development or improvement of a product or process.
  • Process of experimentation. A company must demonstrate—through modeling, simulation, systematic trial and error, or other methods—that it has evaluated alternatives for achieving the desired result.
  • Technological in nature. The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
  • Qualified purpose. The purpose of the research must be to create a new or improved product or process, resulting in increased performance, function, reliability, or quality.

ODC Eligibility Criteria

The ODC is a federal tax credit available to life sciences companies working to find cures for certain rare diseases that affect small populations. Qualification starts with the same four-part test outlined above and adds the need for receipt of orphan-drug designation by the US Food and Drug Administration (FDA).

This means a company must be developing a cure for one of the following:

  • A rare disease that affects fewer than 200,000 people in the United States.
  • A disease affecting over 200,000 people in the United States, but for which there’s no reasonable expectation that the cost of developing and providing a drug for the disease will be recovered from US sales.

What Cost Types Can Be Included in the R&D Credit and ODC?

For both the R&D credit and ODC, qualification looks at the underlying activities performed and resulting spend over the course of the development year.

Comparison of Cost-Type Qualifications

green and white comparison chart

Is It Possible to Claim Both an R&D Credit and ODC in the Same Tax Year?

Yes. Claiming both R&D credit and ODC in the same year is generally permitted. However, there are instances when an expense could meet the qualification criteria for both credits and, in that case, taxpayers may only claim one of the credits with those qualified expenses. 

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. Claiming both credits requires companies separately calculate:

  • Qualifying expenses for activities and spend coming from the company’s ODC programs
  • Activities and resulting expenses from its R&D programs—or those not involving orphan drugs candidates

Credits can then be calculated for the R&D and ODC based on qualified spend.

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.

Are Foreign Expenses Eligible for Inclusion?

R&D Credit

No. For services performed in conjunction with a company’s R&D credit, the rules look to actual location of services provided and require US-based activities. Only costs associated with research performed in the United States may be included. For contractors, actual site of performance, and not headquarter location, is determinative.

ODC

Possibly. The ODC rules allow an exception to the general exclusion of foreign-based cost, provided certain requirements are met. This could apply if a taxpayer can demonstrate the testing was conducted outside the United States because of an insufficient US testing population by a US person or by any other person who isn’t related to the applying taxpayer.

How Are the R&D Credit and ODC Claimed?

Both the R&D credit and ODC are claimed in conjunction with the company’s annual income tax returns for the year in which qualified spend occurred.

To facilitate these filings, taxpayers should perform analysis to properly calculate and document the qualified expenses. Depending on the company’s facts, this can require lookback to prior years as well.

For both credits, 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 and R&D credit are nuanced, so it’s crucial to understand what’s necessary to substantiate a credit claim. To learn more about how the ODC or R&D credit 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.