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Pharmaceutical Industry Qualifying Activities

The pharmaceutical industry is a perfect candidate for R&D tax credits, which were created to encourage American businesses to innovate; they’re now offered by the federal government and 35 states. 

Pharma spends far more its revenue, by percentage, on research and development than other knowledge-based industries. The industry’s R&D expenditures increased by almost 50% between 2015 and 2019. In 2019, the average pharmaceutical company devoted almost 25% of its net revenue to research and development, net of expenses and buyer rebates. That same year, according to the Congressional Budget Office, the pharmaceutical industry directed $83 billion dollars to research and development—which, adjusted for inflation, is almost 10 times what it spent per year in the 1980s. 

When deciding whether to develop a new drug, pharmaceutical companies balance the expected revenue derived from the new product; the projected cost of development; and government policies that might impact the drug’s supply and demand.

Breakdown of Qualifying Activities

R&D spending in the pharmaceutical industry tends to follow this process:

  • invention
  • development
  • incremental innovation
  • product differentiation
  • safety monitoring or clinical trials.

According to the IRS’ Pharmaceutical Industry Research Credit Audit Guidelines – Revised – 4/30/04, the pharmaceutical product development process can be broken down into four stages:

  1. Preclinical/Discovery Research – where new compounds are discovered.
  2. Clinical Development – conducted in three (3) phases.
    Phase I – first trials in humans that test a compound for safety, tolerance and pharmacokinetics. The trials usually employ normal, healthy volunteers.
    Phase II – pilot studies to determine efficacy and safety in selected populations of patients with the disease or condition to be treated, diagnosed, or prevented. Dose and dosing regimens are assigned for magnitude and duration of effect during this phase.
    Phase III – expanded clinical trials intended to gather additional evidence of effectiveness for specific indications and to better understand safety and drug-related adverse effects.
  3. Regulatory Review – the New Drug Application (NDA) is submitted to a regulatory agency, such as the Food and Drug Administration, for marketing and manufacturing approval.
  4. Post-Marketing – activities occurring after approval to market has been granted by the appropriate regulatory agency. These activities include Phase IV studies performed to determine the incidence of adverse reactions; to determine the longterm effect of a drug; to study a patient population not previously studied; and for marketing comparisons against other products and other uses.

When deciding whether to award an R&D tax credit claim, the IRS seeks these types of documentation:

  • tax work papers
  • qualified wages
  • qualified supplies
  • qualified contract research
  • interviews
  • tour of research facility
  • organizational chart and
  • job titles, grade levels, and position descriptions.

Getting an R&D Tax Credit Analysis to see if you qualify is the first step! 

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