Possessions tax credits

Companies get tax breaks from a number of provisions Ln the Federal tax code that effectively reduce the amount of taxes they owe On earned income. (See chapter 8 for details.) Some of these tax savings are not influenced by the amount of money the company invests in R D. For example, companies that manufacture products in Puerto Rico and other U. S. possessions can take advantage of a tax credit on income from those operations (see chapter 8). The amount of the possessions tax credit that can be claimed is unaffected by how much R D the company performs. Thus, the effect of taxes on the cost of R D must be computed as if the possessions tax credit did not exist. Only those tax savings that come about from conduct of R D should be included in the analysis. 

Among other tax credits of the Federal Tax Code, two provisions are of particular relevance to the pharmaceutical industry the foreign tax credit system and the possessions tax credit. While these credits do not represent direct subsidies to the firm s R D costs, there are at least two reasons to consider their importance for pharmaceutical R D. First, they indirectly affect the location and amount of R D. These credits affect the after-tax cost of doing business in political jurisdictions outside the United States. Second, they affect pharmaceutical firms returns to R D. 

For the pharmaceutical industry, however, the possessions tax credit may be more important than the foreign tax credit.27 More than half of the total credit was claimed by firms in the pharmaceutical industry, and, on average, it reduced each fro s tax liability by more than a third. The percentage deduction in tax liability was greater for smaller companies (those with assets 250 million) than for larger companies, which suggests size may not be a barrier to establishing a subsidiary in Puerto Rico. 

In actual Federal dollars spent, Federal tax credits constitute one of the most substantial forms of government involvement in the operations of the pharmaceutical industry. In 1987, not including over 900,000 in foreign tax credits, the Federal Treasury made 1.4 billion in tax expenditures through credits to drug companies. Of this, only about 90 million was for credits whose specific policy purpose is to stimulate R D. The major part, 1.3 billion, of the lost tax revenue was due to the foreign and possessions tax credits. 

Second, taxes owed or payable depend not only on what is manufactured and sold but also on where it is manufactured. Drug companies can and do make decisions to manufacture products in jurisdictions that will afford them the best profile of after-tax cash flows. The availability of tax credits for locating manufacturing operations in U.S. possessions, such as Puerto Rico, substantially reduces the tax liability of pharmaceutical companies. (See chapter 8 for more detail.) Thus, the opportunity to make a new product in a low-tax jurisdiction means that the extra taxes incurred as a result of the introduction of a new group of products will certainly fall short of the statutory marginal corporate tax rate. 

General business credits were claimed by firms of all sizes in this industry and reduced the taxes owed by the smallest companies (those with assets under 50 million) by almost 4 percent more than for larger fins. Although genera-1 business credits for drug companies cost the Treasury 17 times more than the orphan drug credit in 1987, it still totaled less than 10 percent of the foreign tax credit and only 6 percent of the possessions credit claimed by this industry. 

Table 8-4 presents estimates of tax credits claimed by firms in pharmaceutical firms (PAC 2830) in the 1984-87 period.30 Whereas all of the credits increased in the 1984-86 period, the possessions, orphan drug, and general business credits dropped between 1986 and 1987, the first year after tax reform. Of these three, only the general business credit registered a major decline (48 percent). It is likely that the dramatic decline between 1986 and 1987 in this set of credits is attributable to the elimination of the Investment Tax Credit in the 1986 Tax Reform Act (297). The foreign tax credit actually increased between 1986 and 1987. Despite the evident trends, the numbers indicate that the relative magnitude of these credits remained roughly steady between 1984 and 1987. 

For the startup firm, tax credits are not particularly useful since it usually does not pay income taxes. Such a firm is intent on identifying or moving a product or process to the point that investors may realize a return. To the extent that it can anticipate taxable income in the future, it can carry forward R D tax credits to subsequent years, but the value of these potential future credits is diminished because of the time value of money. While the possessions and foreign tax credits can also theoretically be carried forward, a firm can earn these credits only by generating income (either abroad or in a U.S. possession). 

Table 8-I—Tax Savings for Selected Pharmaceutical Firms Attributable to U.S. Possessions Credit for Businesses in Puerto Rico, 1989 ...

Estimates of the possessions credit here represent tax expenditures for the Federal Treasury only and do not count taxes that firms must... 

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