Domestic tax planning amid corporate tax reform

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22nd Annual Health Sciences Tax Conference Domestic tax planning amid corporate tax reform and heightened IRS controversy December 5, 2012

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This session will highlight relevant planning and controversy considerations for the life science sector, as well as legislative developments impacting federal taxation

Transcript of Domestic tax planning amid corporate tax reform

Page 1: Domestic tax planning amid corporate tax reform

22nd Annual Health Sciences Tax Conference Domestic tax planning amid corporate tax reform and heightened IRS controversy December 5, 2012

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Disclaimer

► Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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Disclaimer

Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit www.ey.com.

This presentation is © 2012 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party.

Views expressed in this presentation are not necessarily those of Ernst & Young LLP.

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Presenters

► Joseph Chirichella Senior Director Becton, Dickinson and Co.

► Kristine Mora

Ernst & Young LLP Washington, DC +1 202 327 6092 [email protected]

► Keith Nickels Ernst & Young LLP New York, NY +1 212 773 6719 [email protected]

► Millie Chun

Ernst & Young LLP Iselin, NJ +1 732 516 4104 [email protected]

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Agenda

► Domestic tax planning amid corporate tax reform and heightened Internal Revenue Service (IRS) controversy ► Research credit

► Legislative update ► Examination insights ► International incentive considerations

► Inventory ► Legislative and regulatory updates ► Section 263A Uniform Capitalization (UNICAP) ► Self-constructed assets ► Last-in, first-out (LIFO)

► Section 199 domestic manufacturing deduction ► Legislative update ► Examination and planning insights

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Research credit

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Research credit discussion topics

Legislative update from Washington

IRS Large Business & International (LB&I) research credit examination insights

Implementation and examination techniques to consider

Open discussion on IRS examination issue

Other considerations

International research and development (R&D) incentive considerations

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Legislative update from Washington

► Prospects for extension ► Avoiding the fiscal cliff ► Business extenders package ► Likelihood of extension in December lame-duck Congress

► Implications of the expiration ► Financial statement issues ► Fiscal year filers

► Comprehensive tax reform ► Elimination of “tax expenditures” impacting the health care industry

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IRS LB&I research credit examination insights ► LB&I examination and guidance initiatives

► LB&I initiatives ► Research credit stakeholder meetings ► Status of Tier 1 program

► Issue Practice Group (IPG) ► Subject matter experts (SMEs) will be agents who spend no more

than 25% of their time on the issue. ► Research credits will be grouped with general business credits. ► Local teams should have more discretion over the research

credit issue.

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Implementation and examination techniques

► Use of Pre-Filing Agreements (PFAs) ► Health science industry well-suited for PFAs

► Benefits ► Working with the IRS ► Common goal ► Currency ► Methodology certainty for four years (roll back) ► Availability of records and personnel ► Less contentious ► Resource savings

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Implementation and examination techniques

► Use of statistical sampling ► Time and costs are considerations. ► Complexity and cost of complete review of some small populations

make sampling appropriate.

► Health sciences industry potential applications ► Consider audit guideline “risk” ratings (see next slide)

► Sample “high risk” employees by department and development phase ► Sample high-level management employees ► Sample projects to minimize documentation effort

► Use of electronic surveys to facilitate process ► See illustration of web-based survey (page 13)

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Audit guideline risk ratings illustration

Research credit levels of risk Department Level of risk in each product development phase

Pre-clinical Clinical Post-clinical

Biology Low 1

Pharmacology Low 1

Chemistry Low 1

Drug Metabolism Low 1

Pharma Development Low/High 1

Analytical Chemistry Low 1 1

Pharma Tech Med 1 1 & 2

Drug Safety Med/High 1 1 & 2

Biostatistics Low 1 & 2 1 & 2

Clinical R&D Med 1 & 2 1 & 2

Medical Services High 2 & 3 2 & 3

Medical Affairs High 2 & 3 2 & 3

Regulatory Affairs High 4 4

Drug Surveillance High 4 4

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Web-based survey illustration

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Open discussion on IRS exam issues

► Intra-group reimbursements ► Foreign parent and US subsidiary contract with third party to

develop new drug ► US subsidiary makes payment to third party ► Foreign parent reimburses US subsidiary

► Collaboration agreement ► Up-front payments ► Milestone payments

► Phase IV development activities ► Allocation of domestic vs rest-of-world clinical trial costs

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Other considerations

► Impact of research spending on cost-sharing arrangements

► Section 864(f) source allocations

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Belgium Incentive type: Investment deduction (ID) or investment tax credit (ITC) Description: ID of 13.5% of investment amount (20.5% of depreciation) or ITC of 33.99% Capitalized R&D expenditures include patents, intangible assets, real estate and personal property. How to obtain: A tax ruling may be obtained from Belgian tax authorities in order to secure eligibility for ID or ITC.

International R&D incentive considerations

Brazil Incentive type: Superdeduction Description: Incremental deduction on qualifying R&D expenditure up to 200% (160% base, 180% with hiring requirement and 200% with registered patent requirement) How to obtain: Companies must have a tax clearance certificate, regarding the whole calendar year in which the incentive is taken, to qualify for the superdeduction.

UK Incentive type: Superdeduction Description: Superdeduction of 130% of qualified expenditures for large companies (higher percentage for small and medium-sized enterprises), 100% write-off of capital expenditures (RDA), tax savings How to obtain: The taxpayer must file the claim with the CT600 up to two years after the end of the accounting period to which it relates.

China Incentive type: Superdeduction Description: 150% superdeduction on qualifying R&D expenses How to obtain: The taxpayer must apply for approval with the Science & Technology Bureau and tax authorities.

Canada Incentive type: Tax credit Description: 20% tax credit on all allowable R&D expenditures How to obtain: Form T661 and T2 Schedule 31 must be filed and completed within 12 months of the deadline for income tax filing, or 18 months after the taxation year-end for corporations. France

Incentive type: Tax credit Description: 30% tax credit can be carried forward three years and if not utilized, cash reimbursement is available. Eligible expenses are capped at 100m euros (5% for the expenses above the cap) How to obtain: The taxpayer is not required to seek government pre-approval.

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Inventory

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Inventory agenda

► Legislative/regulatory update ► Section 263A (UNICAP)

► Overview ► Proposed regulations for negative Section 263A costs

► Self-constructed assets ► LIFO ► Other inventory planning

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Inventory accounting — legislative/regulatory update ► Proposed regulations

► Sales-based royalties ► Vendor allowances ► Retail inventory method ► Negative 263A costs

► President’s fiscal 2013 budget proposals: ► LIFO repeal ► Lower of cost or market (LCM) repeal ► Sub-normal goods write-downs repeal

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UNICAP planning: why now?

► Mandatory compliance in order to fall within automatic change procedures for the tangible property regulations

► Other considerations: ► Bonus depreciation ► Reduce taxable income ► Remediate potential exposure ► Net operating loss (NOL) companies ► Newly acquired entities ► Changes to book inventory costing methods

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UNICAP planning: common opportunities

► Opportunities: ► Adopt a burden rate method or new proposed modified simplified

production method (if finalized) ► Embedded costs

► R&D ► Depreciation on temporarily idle facilities ► Warranty and product liability ► Policy-making/budgeting

► Elect the historic absorption ratio ► Lock in a low rate ► Reduce administrative effort

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UNICAP planning: potential exposures

► Common exposure areas ► Book/tax differences are not allocated ► Absorption ratio has not been updated ► Operations have changed since last UNICAP study ► Contract manufacturing for retailers or distributors ► Service providers should be treated as producers ► Following book capitalization for self-constructed assets

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Other 263A considerations — self-constructed assets

► Applies to real or tangible personal property produced by the taxpayer and therefore applies to property produced by a company for use in its trade or business (self-constructed asset) ► Definition includes construct, build, install, manufacture, develop,

improve ► For example, the installation of an elevator or air conditioning system

into a company-owned building ► Includes capitalizable improvements ► The taxpayer must capitalize the required costs into the installed

property and an allocable share of mixed service costs (general and administrative).

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Other 263A considerations — self-constructed assets

► Applies to taxpayers that have property produced by a contractor ► The company that contracts to have property constructed for it is

treated as self-constructing the asset to the extent it makes progress payments or otherwise incurs cost with respect to the property.

► Indirect costs incurred by the company (e.g., construction period interest, oversight and general and administrative expenses) for which the property is being produced must be capitalized by that company as a cost of the property.

► Currently, most self-constructed asset Section 263A changes are non-automatic and must be filed by the last day of the tax year.

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UNICAP: negative 263A costs — proposed regulations

► A negative amount generally occurs when a taxpayer capitalizes a cost as a Section 471 cost that is greater than the amount required to be capitalized for tax purposes, which the taxpayer seeks to remove from inventory cost using its 263A formula.

► In Notice 2007-29, the IRS stated that, pending the issuance of additional guidance, it would not challenge the inclusion of negative amounts in calculating additional costs under Section 263A or the permissibility of aggregate negative additional Section 263A costs.

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UNICAP: negative 263A costs — proposed regulations

► Proposed regulations that generally prohibit the inclusion of negative additional 263A costs subject to a few exceptions: ► Small taxpayers ► Simplified resale method ► Modified simplified production method (discussed on next slide)

► All other taxpayers must reduce Section 471 costs using a method that approximates the manner in which the taxpayer originally capitalized the costs.

► The proposed regulations would generally prohibit treating cash or trade discounts under Reg. Section 1.471-3(b) as negative amounts under either simplified method.

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UNICAP: negative 263A costs — proposed regulations

► New modified simplified production method ► Two absorption ratios

► Preproduction ► Production

► Allows negative additional Section 263A treatment ► Reduce the distortions ► May be favorable but additional work if currently using simplified

production methods ► Pre-production costs applied to raw material AND raw material content

of work in process (WIP) and finished goods ► Many of the benefits of burden rate methods, but with less work

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UNICAP: negative 263A costs — proposed regulations

► Adopt a new definition of Section 471 costs ► Applies to all taxpayers regardless of the methods used ► All costs, other than interest, that a taxpayer capitalizes to its

inventory in its financial statements ► Must include direct labor and direct material ► Consistent with what most taxpayers are currently doing

in practice

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LIFO planning: why now?

► Maximize LIFO reserve ► Merger and acquisition activity

► Preserve LIFO reserve when LIFO inventory is moved between entities

► Adopt LIFO for private or foreign-owned companies ► Before 2012 financial statements issued

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LIFO planning: common opportunities

► Opportunities ► Automate LIFO computations ► Adopt LIFO for additional inventory ► Change from internal to external inflation indexes or vice versa ► Terminate LIFO for deflationary goods (e.g., pools with debit

LIFO reserve) ► Reconstruct base-year cost if inflationary; do not reconstruct if

deflationary ► Change pooling methodology

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LIFO planning: potential exposures

► Potential exposure areas ► Pooling methodology not appropriate (e.g., purchased for resale

inventory included in manufactured pool) ► In-transit or other inventory not on LIFO ► Item definition not detailed enough (internal index) ► Inventory not assigned to appropriate producer price index

commodity codes (inventory price index computation) ► Book LCM (Lower of Cost or Market) reserves not reversed for tax

purposes

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Other inventory planning

► Reduce taxable income ► Inventory write-downs (non-LIFO taxpayers only)

► Lower of cost or market ► Subnormal goods (e.g., expired products, obsolete inventory)

► Retail inventory method ► Inventory shrink ► Charitable contributions of inventory ► Chargebacks

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Other inventory planning

► Reverse tax planning (e.g., expiring federal tax credit, NOL, etc.) ► Stop taking inventory write-downs ► Correct UNICAP method or establish methods for entities not

currently doing a calculation ► Adopt unfavorable UNICAP methods ► Minimize LIFO deduction

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Section 199

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Section 199 agenda

► Legislative/regulatory update ► Contract manufacturing

► Benefits and burdens — industry director directive (IDD)

► Controversy update ► Other planning considerations

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Section 199 — legislative/regulatory update

► President Obama’s fiscal 2013 budget proposals: ► Broadening deduction for “advanced” technology manufacturing

activities ► Eliminating deduction against income derived from the production

of oil, gas, coal and other hard mineral fossil fuels

► CCA 201208029 (released February 24, 2012) ► Gross receipts derived from sale of leasehold rights are not

domestic production gross receipts.

► Rev. Rul. 2011-24 ► Guidance on characterizing gross receipts from

telecommunications services

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Section 199 — contract manufacturing; benefits and burdens IDD

► LB&I-4-0112-001 (released February 1, 2012) ► IDD was issued to aid examiners in determining whether a

taxpayer has the benefits and burdens of ownership under a contract manufacturing arrangement.

► IDD provides a three-step process for examiners to use in determining whether a taxpayer has the benefits and burdens of ownership.

► Steps are related to contract terms, production activities and economic risks.

► Step 1 — contract terms ► Did the taxpayer have title to the WIP (Work in Progress? ► Did the taxpayer have risk of loss over the WIP? ► Was the taxpayer primarily responsible for insuring the WIP?

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Section 199 — contract manufacturing; benefits and burdens IDD

► LB&I-4-0112-001 ► Step 2 — production activities

► Did the taxpayer develop the qualifying activity process (determined without regard to who designed the property, provided the specifications for the property or holds intellectual rights to the property)?

► Did the taxpayer exercise oversight and direction over the employees engaged in the qualifying activity (determined without regard to who designed the property, provided the specifications for the property or holds intellectual rights to the property)?

► Did the taxpayer conduct more than 50% of the quality control tests over the WIP while the qualifying activity was occurring?

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Section 199 — contract manufacturing; benefits and burdens IDD

► LB&I-4-0112-001 ► Step 3 — economic risks

► Was the taxpayer primarily liable under the “make-good” provisions of the contract, for example, the warranty, quality of work, spoilage, overconsumption or indemnification provisions?

► Did the taxpayer provide more than 50%, based on cost, of the raw materials and components used to produce the property?

► Did the taxpayer have the greater opportunity for profit increase or decrease from production efficiencies and fluctuations in the cost of labor and factory overhead?

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Section 199 — controversy update

► Tier 1 — program dissolved ► Manufacturing

► Substantial in nature ► Mere repackaging ► Contract manufacturing

► Calculations ► Section 263A

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Section 199 — opportunities and other planning considerations

► Opportunities ► Expense allocation and apportionment ► Facts and circumstances approach vs. safe harbor ► State tax considerations

► Other considerations ► Corporate rate reduction ► Impact of tangible property regulations