360-degree view of tax reform: Likely implications for life sciences and health care organizations

Health Care Current | December 21, 2017

This weekly series explores breaking news and developments in the US health care industry, examines key issues facing life sciences and health care companies and provides updates and insights on policy, regulatory, and legislative changes.

My Take

360-degree view of tax reform: Likely implications for life sciences and health care organizations

By David Green, Partner, Life Sciences and Health Care Industry Leader, Deloitte Tax LLP

In the coming days, the president will sign into law the first major tax reform legislation since the 1980s. I’m still absorbing the 1,079 pages of legislative information that makes up the Congressional Conference Committee’s Tax Cuts and Jobs bill. Many key provisions included in the bill are set to go into effect on January 1, 2018 – less than two weeks from now. How might the new law impact business decisions made by life sciences and health care executives in 2018 and subsequent years? Further, how will tax reform influence their peers, their suppliers, and their customers and patients?

Impact on biopharma and medtech companies
The big news for life sciences companies is that the legislation, once enacted, will drop the top corporate tax rate from 35 to 21 percent beginning on January 1, 2018. While this provision is applicable to all companies, I suspect it will have a significant impact on global biopharmaceutical and medical device firms.

Due to life sciences companies’ size, profits, and the amount of taxes they pay, some manufacturers typically have more at stake from tax reform than other health care stakeholders. For example, a large pharmaceutical company might be headquartered in the US, but have a complex supply chain including international affiliates and unrelated global suppliers. But lowering the corporate tax rate might mean more than just a smaller tax bill. It could create the following new opportunities:

  • Lower taxes could make the US market more competitive: The US has the highest corporate income tax rate in the industrialized world, according to the Tax Foundation. As a result, many prescription drugs are manufactured elsewhere. This has led to a substantial amount of historical earnings and profits being generated offshore, often times at a lower tax rate. Tax reform will give the US a more competitive corporate tax rate. It will be lower than other significant trading partners including China, Japan, and Germany, but still higher than tax rates in the United Kingdom, Turkey, and Finland. 
  • Some companies might relocate intellectual property (IP) to the US: IP, which includes the patents, know-how, and the right to exploit these assets, can attract substantial earnings for successful therapies. Many companies have chosen to maintain their foreign IP rights offshore. Lowering the US tax rate to 13.125 percent on foreign income derived from intangibles such as intellectual property, could create a financial incentive to bring that IP to the US. Ireland has one of the world’s lowest IP tax rates at 12.5 percent. Setting the US rate close to Ireland’s could create a more competitive market in the US. 
  • Worldwide profits could be reinvested domestically: Some US-based multi-national companies have substantial foreign earnings, which have been permanently reinvested overseas. If those profits were to be repatriated, they might be taxed at the full 35 percent corporate tax rate (less credits for foreign taxes paid on those same profits) under the existing system. After a one-time “Transition Tax” of 15.5 percent on all historical accumulated earnings and profits available in cash and equivalents – and 8 percent on the rest – these companies will generally no longer face additional US taxes when the earnings come home to the US. That could create a freer flow of capital in the US where those dollars could be reinvested in research, capital equipment, and domestic job growth. 

The law could make it more difficult to borrow money, fund research
Along with the favorable provisions, the tax reform legislation also has some potentially negative implications for some stakeholders. For example, the cost of borrowing money could increase significantly. The tax deduction for business interest will be capped at effectively 30 percent of a company’s free cash flow annually. That change could make companies less inclined to use substantial amounts of debt for large acquisitions. The legislation also repeals the 9 percent tax deduction for domestic manufacturing. The repeal helps to pay for the lower tax rate and other benefits.

Congress also decided that companies should spread the cost of research over five years rather than being able to deduct it all immediately. Moreover, costs related to research conducted offshore will be amortized over 15 years. This particular rule would not become effective until 2021, unlike many other provisions that begin on January 1, 2018. Finally, the new bill halves the tax credit for research on rare diseases, known as the Orphan Drug Credit.

Impact on health plans
The most substantive change for health plans is the elimination of the Affordable Care Act’s (ACA) individual mandate penalty beginning in 2019. The ACA requires most individuals to pay a penalty (2.5 percent of annual income or $695) if they decide not to buy health insurance. The Congressional Budget Office (CBO) estimates that removing the penalty will prompt about 4 million people to go without coverage in 2019 and 13 million by 2027. Health plans will likely factor this change into their premiums for the 2019 plan year, which are submitted in the spring. As healthy people leave the risk pool, the CBO expects that eliminating the penalty will push health care premiums up to 10 percent higher. As a result, health plans might decide to stop selling coverage through the public insurance exchanges.

The overall lower corporate tax rate could offer health plans a bit of a counterweight. Many large health plans often pay close to the full 35 percent tax rate and are expected to benefit from the new 21 percent tax rate. The reduction could reduce premiums for consumers given that insurers must comply with the ACA’s medical loss ratio rules, which mandate that at least 80 percent of individual and small-group premium revenue (85 percent for large-group plans) be spent on medical expenses.

Finally, the bill reduces the threshold for the medical expense itemized deduction. For the next two years, the deduction for unreimbursed medical expenses would be available for costs exceeding 7.5 percent of income. This could encourage greater consumer spending on health care in some markets.

Impact on not-for-profit hospitals and providers
Some not-for-profit hospitals now pay tax on unrelated business income (UBI) activities (e.g., lab services, pharmacy, research projects) that might not be provided solely to patients. Rather than offsetting profitable and money-losing activities before computing the UBI tax, the bill will require hospitals to separate each of these activities and determine whether there is UBI tax on each one. This represents an added, perhaps non-recoverable, cost burden on these hospitals, which could further strain their limited resources.

The bill also includes a special 21 percent excise tax on compensation that exceeds $1 million a year, and will apply to the five highest paid officers. That places not-for profit hospitals loosely on par with the requirements of publicly traded companies. Under the bill, the compensation over $1 million of the five highest paid officers of publicly traded companies will not be deductible. This is a modification of the current rule which generally exempted performance-based pay and exempted the principal financial officer.

The holidays are always a little bit stressful. But the enactment of a major tax overhaul less than two weeks before the start of a New Year means life sciences and health care executives will be busy determining how the new law will impact the decisions they make in 2018 and beyond.

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Note: The Health Care Current is taking a break for the holidays but we’ll be back January 9, 2018. See you in the New Year!

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