Opinion: How Biotechs Can Avoid Unpleasant State and Local Tax Surprises

Getting any major pharma company as a collaboration partner is great for a startup, but as we have seen many times in our practice as tax attorneys, such arrangements can sometimes drive a material difference in tax liability that could impact a startup’s cash flow and ability to invest in its business. The incredible diversity in rules governing all aspects of taxation creates a minefield that at times can seem unnavigable.

Picture the following: You and your colleagues found Startup Corp in Cambridge, Mass., with the aim of developing a groundbreaking cancer treatment. Over the next few years, the team works hard to develop the treatment, raising (and spending) money along the way. After five years, Startup Corp has spent over $100 million on development costs, with a few things to show for it, including valuable intellectual property related to your preclinical asset that is nearing Phase I trials, a top-notch research team, and state and federal income tax losses and research credits.

One day, Parkway Pharma, a major pharmaceutical company, calls you to discuss a possible collaboration deal. You—and your investors—are thrilled! Parkway Pharma is headquartered in New Jersey, and this is the first time that anyone from Startup Corp has ever conducted any business in the state. You forge a collaboration deal that includes hundreds of millions in upfront and milestone payments for rights to Startup Corp’s cancer treatment, as well as future royalties. Startup Corp agrees to shift certain key researchers and research functions to a collaboration facility on Parkway Pharma’s New Jersey campus, and to share its intellectual property with Parkway Pharma’s development teams in California, New Jersey, New York and possibly other states.

You and your finance team meticulously plan out your budget, earmarking every penny of the upfront payment for everything from capital expenses to employee compensation, including a “collaboration bonus” for your hard-working team. Your CFO does not anticipate any income tax liability, given that Startup Corp has a nearly inexhaustible supply of net operating loss carryforwards (“NOLs”) and research credits.

The next quarter, your finance team is preparing its estimated income taxes and presents you with a shocking request: millions of dollars for New Jersey corporate income tax. It gets worse. Startup Corp will need to make further multi-million-dollar payments in subsequent quarters. You wonder why the company can’t use what you understood were nearly unlimited losses and credits for the New Jersey taxes.

Startup Corp retains state tax counsel to advise, and after a review, counsel has bad news: there are no New Jersey losses, since Startup Corp never conducted any business in New Jersey. The research credits can only be used to offset Massachusetts income. And based on the terms of the collaboration agreement, it appears—but is not certain—that the collaboration-based income is New Jersey–sourced and thus will require tax payments.

As if that weren’t enough, your state tax counsel explains that since Parkway Pharma will receive and use the data Startup Corp provides to it in its facilities in California, New York and possibly other states, taxes may be due in those states as well. Once clinical trials begin, Startup Corp will be obliged to pay tax in still more states. Just as with New Jersey, there will be no losses to offset the massive state taxable income, and each state has its own rules for apportioning Startup Corp’s various income streams.

As if this weren’t bad enough already, state corporate income tax is only one aspect of state and local taxation that’s applicable to life sciences startups. Various states impose gross receipts taxes and franchise taxes based on capital (for which there are no NOLs), in addition to taxes on real and tangible personal property, excise taxes, transfer fees, taxes specific to medical products, etc. Sales and use taxes are particularly significant, as they are levied on a startup’s purchases.

There are various exemptions in many states for drugs, research and development equipment, manufacturing equipment, raw materials, and many goods and services used by biotechs. However, proper registration and documentation of the exemptions, with appropriate certificates, is essential to taking advantage of these benefits. Without careful maintenance of exemptions and the documentation supporting them, a state may assess taxes even years later.

Finally, to add insult to injury, tax laws are constantly evolving. New Jersey, California and Indiana, another large pharma state, have recently proposed new regulations with tax implications for biotechs, such as impacts on sourcing, and New York just issued transformative regulations last year.

Comprehensive state and local tax planning is absolutely essential to prevent an unwelcome surprise similar to the one described above. The keys to good tax planning include:

1. Determine your current state filing footprint (i.e., in which states you are doing business and where you should be paying tax).
2. Understand the extent to which your state tax attributes (e.g., NOLs and credits) are usable, both in terms of time (NOLs and credits expire after a number of years) and geography.
3. Scope out likely future collaboration partners and the states in which they are headquartered and have research facilities.
4. Understand key tax factors in the likely states as well as any possible incentives that are relevant to life sciences startups.
5. Request guidance and, if necessary, a pre-filing agreement from the state taxing authority related to your tax pain points (e.g., income tax apportionment, NOL use, sales and use tax liability). If you articulate your position effectively, you may be able to agree upon filing methods that result in lower tax liability than you would have without such an agreement.
6. Negotiate with the state. You’re now doing business there, which means hiring personnel, making capital investments and, potentially, establishing a long-term presence. The state is motivated to attract businesses such as yours, and obtaining an accommodation is not outside the realm of possibility.

While the above recommendations are key, it is also important to advocate for policy changes that mitigate the tax dangers of collaborations, such as allowing pre-apportioned NOL utilization for startups (e.g. applying prior year losses to a startup’s income without multiplying the prior year losses by prior year apportionment (which may have been 0%)); permitting the monetization of losses; favorable income sourcing; franchise, property, and other tax abatements; and expanded exemptions from sales and use tax for startups that spend beyond the normal exemption for research and development purchases.

Navigating state tax for a young company is exceedingly challenging, but with diligence and an eye to the future, it is indeed possible.