In an earlier blog post, I provided an overview of creative R&D financing structures utilized in the biotechnology industry over the years, and the related accounting consequences of such structures. These structures normally involve the use of a special purpose entity (SPE) that licenses one or more product candidates from a sponsor company (which retains a buyback option on the products or on the entire SPE), raises capital from third party investors and then funds research on the licensed products. The risk of development in these structures falls with the SPE, with a significant upside to the third party investors if the repurchase is eventually exercised.
Over the course of time in the biotech industry, these structures have been motivated either by profit and loss considerations (for example by recently profitable entities seeking to move some R&D expenses off the financial statements), or by purely the need to access capital (for example by loss making biotechs with reduced options for traditional fundraising). From the perspective of the sponsor company, the income tax considerations of these structures has historically been, at most, a nominal consideration, and thus the structuring dialog has focused primarily on governance and financial reporting.
From the perspective of the investor, however, income tax considerations have always played a much more central role. The first of these structures, the R&D limited partnerships of the 1980’s, were principally tax driven exercises, permitting investors to take current tax deductions for the SPE’s R&D expenses, while retaining significant upside if the sponsor company option to reacquire the technology were later exercised. Tax law changes eliminated this structure, but not the centrality of maximizing after tax gains for the investors in these creative financing structures.
Creative financing structures for the biopharma industry provide a plethora of tax challenges and intricacies that venture capital (VC) and private equity (PE) investors must consider. Some of the more common tax considerations encountered by US based VC and PE investors include management of the business onshore versus offshore, current and future use of tax attributes (i.e. the net operating losses generated by the SPE), minimizing unrelated business taxable income (UBTI) for tax-exempt investors, minimizing effectively connected income (ECI) for foreign investors, and minimizing the impact of the US anti-deferral rules (i.e. Subpart F).
There are several different variations of the SPE structure that can be used to maximize its tax efficiency. Perhaps the biggest tax consideration is what legal form the SPE will take. Commonly, third party investors want to avoid multiple levels of tax on any income realized by the SPE. Thus, an LLC or domestic partnership vehicle would be the most beneficial. However, if the third party investors include either tax-exempt or foreign investors, then a flow-through structure can present special tax problems to those investors, including UBTI or ECI, which is generally precluded by most VC/PE partnership agreements. Therefore, despite the second level of tax, investors often create the SPE as a C corporation to “block” any potential UBTI or ECI, as all investment activity is reported at the corporate and not the investor level. Importantly, using a corporate entity limits the investors’ exit strategy to a sale of the shares of the SPE, as an asset sale is usually cost prohibitive from a tax perspective.
Another way around the UBTI and ECI concerns is to create the SPV as a foreign entity. The SPV may achieve an income tax rate lower than a domestic C corp. through lower statutory tax rates and use of debt financing, while avoiding the UBTI and ECI issues encountered by flow-through domestic investment vehicles. Consequently, a foreign SPE often allows the investors to sell assets more tax efficiently than could be achieved with a US C corporation.
However, foreign SPEs present their own problems. A foreign SPE will need “substance” in the local jurisdiction to be respected for US and, sometimes, non-US tax purposes. This can involve management and operation functions being performed locally. Additionally, the US anti-deferral rules might require the US taxable investors to currently recognize income regardless of whether any funds are repatriated, creating “dry income” (an income tax liability for which no cash has been provided from the venture to satisfy). And of course, the complex withholding tax rules and applicability of income tax treaties must be fully examined and complied with, which can be burdensome on the SPE and investors.
Ultimately, the makeup of the third party investors, the stage of development of the R&D, and funding needs of the biopharma sponsor company will all play into the tax analysis, which can interact in novel ways. Only by closely considering all of the facts and business objectives of the specific investors and the sponsor can the most tax efficient structure be chosen and executed.
Thanks to my E&Y tax colleagues Blair Murphy, Mike Jacoby and Jonathan Guin for sharing their knowledge of these structures and their experiences helping private investors navigate the complicated tax rules that may apply.