This article was updated October 9, 2023.
The orphan drug tax credit (ODC) is a federal tax credit available to pharmaceutical companies working to find cures for certain rare diseases that affect small populations. Similar to the traditional research and development (R&D) tax credit, the ODC provides pharmaceutical companies an opportunity to increase cash flow and reduce the cost of development operations.
The qualification requirements for the ODC are similar to traditional R&D credits, as both seek to incentivize conducting research activities that address technical uncertainty through iterative experimentation efforts. However, both credits must be separately calculated, and there are some key nuances to understand.
How Much Can a Company Save with Orphan Drug Tax Credits Versus Traditional R&D Credits?
Typically, eligible pharmaceutical companies see a higher rate of return on their orphan drug clinical testing expenses (CTE) compared to R&D credit qualified research expenses (QRE). While the federal gross R&D credit typically results in a tax credit of 10% of QRE, the ODC provides a rate of 25% of CTE.
Another important distinction between orphan drug CTE and R&D QRE lies in the applicable qualification rates for contractor costs. The ODC allows for 100% of qualified contractor spending to be included as CTE, while the R&D credit caps the amount of costs includible as QRE at 65%.
What Do the Orphan Drug and R&D Credits Apply To?
Qualification for the orphan drug and R&D credits depends on the underlying activities performed and the resulting spending over the course of the development year. This will include costs for wage, supply, and contract research expenses.
Both credits follow the same pharmaceutical drug development timeline provided by the IRS pharmaceutical audit guidelines. These guidelines break pharmaceutical research down into four stages:
- Preclinical or discovery research
- Clinical development
- Regulatory review
There are different activities and corresponding guidelines for each stage, and qualifying expenses will depend on the stage of a company’s products.
Key Distinctions and Eligibility for the Orphan Drug and R&D Tax Credits
While qualification criteria for the orphan drug credit and R&D credit are similar, there are certain key distinctions between the two.
R&D Credit Eligibility Criteria
A 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.
Orphan Drug Credit 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 the resulting spend over the course of the development year.
Comparison of Cost-Type Qualifications
Is it Possible to Claim Both an R&D Credit and Orphan Drug Credit in the Same Tax Year?
Yes, however, companies can’t receive both credits on the same qualifying expenses. In other words, if one credit is earned on a certain qualifying expense, then the other credit is unavailable for that same expense. 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.
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.
How Does a Company Claim the Credit?
Once a company receives an orphan drug designation from the FDA, it can begin tracking costs related to a specific program from that point forward to include in their orphan drug credit claim.
The process to claim the ODC coincides with income tax return filings, with analysis and documentation needed to collect the necessary quantitative and qualitative data for qualified expenses. Properly 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
The qualification requirements for the ODC are nuanced, so it’s crucial to understand what’s necessary to substantiate a credit claim. To learn more about how the ODC can help your company increase cash flow and reduce the cost of its development operations, reach out to your Moss Adams professional.