BIO Statement regarding reform of the Hatch Waxman Law

Printer Friendly

Testimony of Harry H. Penner,
President and CEO, Neurogen Corporation
on behalf of the
Biotechnology Industry Organization BIO)
before the Oversight Subcommittee
House Ways and Means Committee
regarding the research and experimentation Tax Credit

May 10, 1995

Madam Chairman and members of the Subcommittee. My name is Harry H. Penner, Jr. and I am President and CEO of Neurogen Corporation of Branford, Connecticut.

I am testifying today regarding the Research and Experimentation Tax Credit (R and E Credit) on behalf of Neurogen and the Biotechnology Industry Organization (BIO).

BIO represents more than 570 biotechnology companies, academic institutions, state biotechnology centers and related organizations in 47 states and more than 20 nations. BIO members are involved in the research and development of health care, agricultural and environmental biotechnology products.

As entrepreneurs must do, let me start with the bottom-line: we support H.R. 803, legislation introduced by Congresswoman Nancy Johnson and Congressman Robert Matsui, to make the R and E Credit permanent. We very much appreciate the leadership they have shown for America's research-intensive entrepreneurs. We urge the Congress to enact this legislation before the Credit expires on June 30, 1995. We also support restructuring the Credit so it is available as an effective incentive for most biotechnology companies.

Furthermore, we recommend that the Congress consider the R and E Credit and the Orphan Drug Tax Credit in tandem. The two Credits are interrelated; both should be made permanent and restructured. We appreciate the support which Congresswoman Johnson and Congressman Matsui have given to making the Orphan Credit permanent and restructuring it and we strongly support H.R. 1566, the bill they have introduced to this end.

Let me first talk about Neurogen and its research and development program, the R and E Credit, the biotechnology industry, and our proposals for restructuring the Credit. Neurogen and Research and Development.

Neurogen is a leading neuropharmaceuticals company engaged in the design and development of breakthrough small molecule psychotherapeutic drugs.

My company was formed in 1989, went public in 1989, and has grown to more than 80 employees, some 35% of whom hold doctoral degrees.

Our company has spent more than $35 million on research since it founding, $13 million last year alone. We have no revenue yet from product sales and do not expect any revenue from product sales until 1999. We have some revenue from other sources. We find that the R and E Credit is a tremendous incentive for investments in research.

Neurogen has integrated its proprietary understanding of neurobiology and molecular biology with cutting edge medicinal chemistry technologies to pioneer the synthesis of new generation of highly receptor specific compounds. This unique series of drug candidates promises improved treatment for a broad range of neuropsychiatric disorders, including anxiety, schizophrenia, epilepsy, dementia, depression, and sleep, eating and stress disorders. More than fifty million persons in the U.S. alone suffer from these disorders and the global market exceeding $12 billion.

Neurogen is pursuing major design and development programs based on the modulation of GABA, dopomine, and neuropeptide receptors. Using combinational chemistry, the company is also developing, both for its internal use and for other biotech and pharmaceutical companies, an extensive library of high quality small molecule compounds which are designed to exhibit drug-like characteristics.

One of the molecules we have developed, NGD 91-1, has been shown to be as effective as 10 mg of Valium but with no sedation or alcohol interaction. Additional targets for this compound are dementia and sleep disorders. Another molecule, NGD 94-1, is a highly specific dopomine D4 antagonist for psychosis, or schizophrenia. We have two broad spectrum anti-psychotics, NGD 94-2 and NGD 93-1. Finally, Neurogren's neuropeptide research targets the neuropeptide associated with eating disorders, hypertension, and depression.

We are proud of the research we are doing, its importance for the well being of patients, and positive economic impact we have had on the State of Connecticut.

The R and E Tax Credit
The R and E Credit provides a 20% tax credit for qualifying research and development expenditures. It is an incremental, not a flat rate credit, and the calculation of the credit amount is complex. Not all research is included in calculation of the Credit, in fact, our industry finds that only about half of the research expenses are covered. With a 20% credit for qualified research, and at most 50% of our research covered, the true value of the credit to those companies which can claim it less than 10%.

The Orphan Credit is an alternative to the R&E Credit. Both credits are incremental credits and both are incentives for research. Firms receive only one credit for their research depending on whether it is or is not related to research on cures and therapies for "orphan" diseases or conditions (rare diseases where there is a limited patient population and limited commercial potential). The Orphan Credit is 50% for qualified research. Again, however, at most half of the research expenses are covered, and other sharp limitations apply, so the true value of the credit for the companies which can claim it is less than 25%.

We urge the Subcommittee to consider the two Credits in tandem; they are intimately related and complementary.

Economics of the Biotechnology Industry
The importance of the R and E Credit and our restructuring proposals become immediately apparent when one understands the economics of the biotechnology industry.

The biotechnology industry is one of the most research intensive industries in the civilian manufacturing sector. The average biotechnology company spends $68,000 per employee on research, more than nine times the U.S. corporate average of $7,500. In a 1994 survey by Business Week, six of the top ten firms in the U.S. in terms of research expenditures per employee were biotechnology companies, including Biogen ($208,724), Genentech ($117,594), and Genetics Institute ($107,657). Ernst & Young reports that biotechnology companies spent $7 billion on research and development in 1994, up $1.3 billion over 1993.

Bringing a biotech drug product to the market today is both a lengthy and expensive process. From the initial testing of the drug to final approval from the Food and Drug Administration can take 7-12 years, and this process can cost anywhere from $150 to $359 million. Both the length and cost of this process are a tremendous impediment for small biotechnology companies attempting to bring a product to the market.

There are currently 28 biotechnology therapeutics and vaccines on the market. Ernst & Young reports that there are 270 in human clinical development, and over 2,000 in early research stages. As products move into clinical trails, expenses increase. The need for capital for biotechnology companies to fund research is increasing right at the time when the industry is coping with a financial crisis.

The biotechnology industry experienced a net loss of $4.1 billion in 1994, and has lost over $11 billion in the last three years. In addition, biotechnology companies raised only $278 million during the first quarter 1995, compared with $762 million in the first quarter of 1994, a 63% decline.

The value of the stock of the publicly traded biotechnology companies has declined precipitously. Since January 1993 the American Stock Exchange (AMEX) biotechnology index has declined by approximately 54% and the index for biotechnology firms traded on the Chicago Board of Options Exchange (CBOE) has declined by 34%. This decline over the past 28 months is due to a variety of factors, including the proposals for controls on prescription drug prices by the Clinton Administration and others during the health care reform debate, disappointments in human clinical trials, and regulatory, tax, patent and litigation issues.

A September 1994 Ernst & Young report finds that biotech companies, on average, have 25 months of capital left at their current burn rates (the rate at which capital is being expended). According to a March 1994 report by Dr. Robert Goldberg of the Gordon Public Policy Center at Brandeis University, 75 percent of biotechnology companies have 2 or fewer years of capital left. Ernst & Young estimates that there are 1,311 companies. If 75% have 2 or fewer years of capital left at their current burn rates, a staggering 983 companies would need to return to the market for more capital.

This capital crunch means that in the struggle to survive, companies must focus on the technology which is closest to the marketplace. They may be interested in other, longer-term projects, but they need revenue to survive. Only when they have revenue can they avoid the need to raise capital from investors.

Impact of the R and E Credit on Biotechnology Research
There can be little doubt that investment in research and development is the answer to keeping the United States economy powerful during this decade and the next century. And, surely, there can be no doubt whatsoever that America's continued economic leadership is indispensable to our national security and freedom. It is the research-driven industries which traditionally have enabled the United States to meet the rapidly intensifying industrial challenge from the rest of the world.

Biotech companies are precisely the type of companies that should be given every incentive to fully explore the technology they have invented. Such companies are beyond the start-up stage, but their revenues and corresponding research budgets are growing rapidly.

These companies are the heroes of the American private sector. If anything, they should be singled out for emulation and given added stimulation. The structure of the current R and E (and Orphan) Credit does the opposite; companies often lose the credit just when they begin to market their first products. Why take away an incentive to keep spending a large portion of revenues on research just when these companies are beginning to be successful? Why force them to reduce their research?

For the biotechnology industry to maintain its leadership in light of increased competition from Japan and Europe, the U.S. industry must compete and win in terms of research breakthroughs, which translates directly into substantial, sustained investment in research and development. Biotechnology is barely a decade old and already it faces formidable international competition.

The fundamental purpose of the R and E Credit is to provide an incentive to private companies to conduct accelerated research -- research which will maintain our dominant position in critical industries which first emerged in the United States. After eight years of sporadic temporary measures, legislation is needed to offer a permanent tax credit for R&E activities. By its nature, R&E spending requires long-term commitment and planning. The various temporary measures in place since the previous law expired have not provided the stability needed to fully stimulate maximum research and development.

When a permanent R and E Credit is finally enacted, careful thought should be given to making the bill a complete mand ate for maintaining America's leadership in vital industries. It is crucial to give the maximum incentive to emerging companies in relative new industries, such as biotechnology. In the case of biotechnology, these R&E investments will translate into dramatically improved health care for generations to come.

The R and E Credit is important to fast-growing R&E-intensive companies. For these emerging, high-growth companies, an incentive to increase investment in research and development makes the difference as to whether research projects are continued or dropped. The biotechnology industry provides a good illustration of this point.

As I have said, it takes ten to twelve years and hundreds of million dollars of R&E investment to successfully develop one new biotechnology drug. Each drug candidate faces numerous scientific and regulatory hurdles, in addition to normal competitive risks, before a biotech company can market a new prescription drug. In addition, new drugs face unprecedented price and competitive pressures due to the new health care environment. This means that a biotechnology company that is successful in commercializing its first new drug cannot sit back and enjoy its success but must continue to invest ever-increasing funds in new R&E to discover new products and grow the business. This is why the Business Week survey listed biotechnology companies as the most research-intensive companies in the country.

The need to be research intensive poses a dilemma to management. It must fund high-risk research over a long period of time while showing a profit to raise equity to fund the required R&E. This requires management to keep marketing expenses, administrative expenses, and non-research costs at an absolute minimum, as well as make difficult and painful decisions on which research projects to fund and which to drop. Given the very lean marketing and administrative levels at which these companies operate, R&E becomes the swing item in the budget. Thus management is constantly forced to drop some of its promising but higher risk projects on diseases like AIDS and breast cancer in order to meet their minimum profit targets. Once the minimum profit level is met, every additional dollar of revenue can be reinvested back in R&E.

The R and E Credit is critical to these companies. An R and E Credit directly reduces the company's tax expense and thereby increases earnings. These earnings can then be reinvested back in R&E while maintaining the company's profit level. The Credit has supported research on diseases like breast cancer, cystic fibrosis, and AIDS that would otherwise not be done. A permanent credit is particularly important to the biotech industry since its research horizons are so long term. Knowing a credit will be there for the next five years allows the companies to include it is in their long-range plan and support the continuation of high-risk projects.

Some argue that the Credit is not needed since the R&E would be done in any event. That is simply not true for the biotechnology and similar emerging research-intensive industries. It very well might make the difference between finding cures for Alzheimer's, AIDS, breast cancer, blindness and similar diseases, or not.

Restructuring the R&E Credit
BIO supports H.R. 803 and supports making the R and E Credit permanent. We also support restructuring the Credit so that most biotechnology companies qualify for it.

The problems our industry has with the current R and E Credit stem largely from the fact that the Credit is a ratio of research expenditures (the numerator) to the firm's gross receipts (the denominator). Most biotechnology companies have no revenue, no gross receipts, but they have very large research expenditures. So, the numerator is large and the dominator is zero. As, soon as the firm begins to generate receipts, the denominator becomes a positive figure and it grossly distorts the fraction, the ratio, which determines the firm's R and E Credits.

This is a peculiar problem which does not exist for mature firms, or firms which have revenue at all times in their history. It is a unique problem which stems from the economics of our industry -- huge research expenditures, long development times, no revenues for many years, followed hopefully by revenues commensurate with the considerable risk which our investors have taken in funding the research. We believe that the economics of the biotechnology industry should be rewarded, not penalized by the R and E Credit. To avoid penalizing our industry, the Credit must be restructured.

BIO recommends that the R and E Credit be restructure in two ways:

1. Fixed-Base Percentage Limitation: The fixed-base percentage limitation be reduced from 16% to 8%. The 16% maximum base percentage is the limitation on qualifying research (as a percentage of sales) which may be used to calculate the R&E Credit. Many biotech companies' research and development-to-sales ratio often exceeds 16% in their early years before the company's R&E results in a product. For these companies the 16% limitation is far too high.

   As biotech companies mature and begin to generate sales, their research-to-sales ratio begins to move closer to the average for pharmaceutical companies, about 15%. This pharmaceutical average ratio is itself three times higher than the all industry average, so you can see how high the ratio is for biotech companies.

   The problems with the 16% fixed base limitation is compounded by the fact that roughly 50% of a biotech company's financial statement R and D expenses do not qualify for the R&E Credit. Overhead and other costs of R and D do not qualify for the R&E Credit. A 16% limitation, therefore, requires a biotechnology company to invest over 32% of its sales in R and D (per its financial statement) to get any R&E Credit. This is clearly too high. The practical effect is that the most biotech companies will never receive an R&E Credit once they are mature, even if they invest far more revenue in R and D than any other type of company.

   To correct the inequity of the current law, the 16% fixed base limitation should be reduced to 8%. This will still require biotech companies to spend at least 16% of sales on R and D in order to qualify for the R&E Credit.

2. Eliminate Minimum 50% Base Rule: The minimum 50% base rule for R&E Credits should be eliminated. It makes no sense that biotech companies which finally do qualify for the R&E Credit should be hit with a cap on their Credit.

   The rule actually deters and penalizes significant growth in R&E expenditures by limiting the increment on which a credit can be given once the increment is equal to 50% of the current-year spending (or once the current year spending equals twice the baseline amount). The effect of the limitation is to bring the marginal incentive effect of the credit down from the statutory 20% to only 10%. If a company has a base of $10 million increases its R&E expenditures to $20 million, the full amount of the increase. But, if it increases its R&E expenditures to $30 million, the credit will be available only on the difference between the $30 million and the artificially assigned minimum base of $15 million, not the full increase of $20 million. This is contrary to the whole purpose of the R&E Credit.

   It makes no sense to limit the credit for the firms which increase their R&E expenditures the most, but this is what the minimum 50% base rule does.

   Robert Eisner, Steven Albert, and Martin Sullivan have analyzed the current R&E Credit and made some recommendations for its reform. Specifically they have suggested certain reforms which would increase the credit's effectiveness. Their first recommendation is to "eliminate the 50 percent floor to the base." They argue that, "While this limitation does not apparently relate to a large proportion of R and D, its negative incentive effects can be considerable when it comes into play."

Cost-Effectiveness of the Credit to U.S. Competitiveness
The Joint Committee on Taxation has found that making the Credit permanent will cost approximately eight billion dollars over five years. It has not yet provided estimates of the cost of these two restructuring proposals. The Credit is a sound investment for the country in the long-term competitiveness of a critical American industry.

In 1991, the Office of Technology Assessment (OTA) found that Australia, Brazil, Denmark, France, South Korea and Taiwan (Republic of China) all had targeted biotechnology as an enabling technology. Furthermore, in 1984, the OTA identified Japan as the major potential competitor to the United States in biotechnology commercialization.

The OTA identified the manner in which Japan had targeted biotechnology. Its report stated,

In 1981, the Ministry of International Trade and Industry (MITI) designated biotechnology to be a strategic area of science research, marking the first official pronouncement encouraging the industrial development of biotechnology in Japan. Over the next few years, several ministries undertook programs to fund and support biotechnology.

The Japanese Ministry of Health and Welfare instituted a policy whereby existing drugs would have their prices lowered, while allowing premium prices for innovative or important new drugs, thus forcing companies to be innovative and to seek larger markets.

It is widely recognized that the biotechnology industry can make a substantial contribution to U.S. economic growth and improved quality of life. For example:

• The National Critical Technologies Panel, established in 1989 within the White House Office of Science and Technology Policy by an Act of Congress, calls biotechnology a "national critical technology" that is "essential for the United States to develop to further the long-term national security and economic prosperity of the United States."

• The private sector Council on Competitiveness also calls biotechnology one of several "critical technologies" that will drive U.S. productivity, economic growth, and competitiveness over the next ten years and perhaps over the next century.

• The United States Congress Office of Technology Assessment calls biotechnology "a strategic industry with great potential for heightening U.S. international economic competitiveness." OTA also observed that "the wide-reaching potential applications of biotechnology lie close to the center of many of the world's major problems -- malnutrition, disease, energy availability and cost, and pollution. Biotechnology can change both the way we live and the industrial community of the 21st century."

• The National Academy of Engineering characterizes genetic engineering as one of the ten outstanding engineering achievements in the past quarter century.

The importance of the biotechnology industry to America's competitiveness warrants making the R and E Credit permanent and restructuring it.

Detailed explanations of the fixed base limitation and minimum 50% base rule appear in the appendixes to my testimony.

Conclusion
BIO's first priority is to make the Credit permanent, but restructuring the Credit will ensure that it provides an effective incentive for research by biotechnology companies as they begin to market products, a critical time in the life cycle of a company.

BIO's proposals are for amendments to existing tax incentives, not enactment of new tax incentives. It should not be surprising that the tax code does not recognize the special strengths and needs of entrepreneurs. The tax code is old and relatively inflexible and it reflects the values of our economy as it was in the past. The problems entrepreneurs have with the tax code are similar to the problems they have with agency regulations. In both cases the terms of the law may be well intentioned, but they do not work well in the real world. BIO urges this Subcommittee to look at the tax code much as are other committees which are developing a regulatory relief program and ensure that the tax code does not unintentionally discriminate against entrepreneurs.

Thank you very much. I am ready to answer any questions you might have.

Appendices

• Explanation of the Fixed-Base Percentage Limitation
• Reducing Fixed Base Percentage Limitation from 16% to 8%
• Eliminating the 50% Minimum Base Rule

Explanation of the Fixed-Base Percentage Limitation
In restructuring the R&E Credit, BIO recommends that the fixed-base percentage limitation be reduced from 16% to 8%. Following is a detailed explanation of the fixed-base limitation:

The Revenue Reconciliation Act of 1989 made some basic changes to the computation of the credit for research activities as defined in Internal Revenue Code Section 41 for taxable years beginning after 1989. For such taxable years, a 20% tax credit is available for qualified research expenditures paid or incurred in a trade or business before July 1, 1995.

The tax credit is based upon the difference between a company's qualified research expenditures for the current year over a company-specific base amount.

The fixed base percentage is a key component factor in the computation of the credit for research activities.

The credit for research activities is currently calculated as the sum of:

1. 20% of the increase in qualified research expenses (QRE) for the current year over a base amount, and
2. 20% of the university basic research payments.

Reducing Fixed Base Percentage Limitation from 16% to 8%
BIO's recommends that the 16% maximum fixed base percentage be reduced to 8% because the 16% maximum prevents certain R&E-intensive firms from receiving any R&E Credit. Following is the explanation of this recommendation.

The R&E Credit is based on increases in the amount of sales reinvested in current year "tax qualified" R&E ("R&E") compared to the average amount of sales reinvested in R&E during the 1984-1988 period ("fixed base amount"). For example, if a company reinvested an average of 2% of sales in tax-qualified R&E during 1984-1988, it will receive an R&E credit only if it invests more than 2% of its sales in current year R&E expenditures.

An R&E-intensive company's R&E-to-sales ratio will be unsustainably high during its formative years as it invests in R&E in anticipation of future sales. As documented in a June 27, 1994 Business Week article, this is particularly evident in certain industries like biotech, where it can take over twenty years before a company has enough products on the market for its R&E-to-sales ratio to begin normalizing. The article lists six biotech companies as having "book" R&E-to-sales ratios of over 35% in 1993, the highest in the country. These ratios compare to the overall industrial average of approximately 4%.

As these emerging companies become successful in developing new products, their R&E-to-sales ratios must decline and become closer to industry averages if they are to be profitable over the long term. Unless their fixed base amount is adjusted, however these R&E-intensive companies will not receive any R&E credit in future years since their future R&E-to-sales ratios will be lower than that of the 1984-88 period. This is clearly an unfair result.

To provide partial relief to early stage R&E-intensive companies, current law provides that the "fixed base amount" cannot be greater than 16%. This can be illustrated by the following example:

Table to be corrected soon:

1984-1988 (Average)Sales	$25
R&E Expenses per Financials	$25
Actual % of Book R&E to Sales
100%"Tax R&E" Eligible for Credit (A)	$12.50
% of "Tax" R&E to Sales (A/Sales) (B)	50%
Fixed Base Amount (Lesser of B or 16%)	16%

The 16% limit is based on tax qualified R&E. Since only approximately one-half of book R&E qualifies for the R&E Credit, the 16% limit, therefore, effectively requires companies to invest over 32% of future sales in book R&E to get any credit in the future. This is an impossible base amount to exceed on a long-term basis, since the industry average is only about 4% and as shown in the Business Week survey, no industry averages over 11% on a book basis.

It is recommended that the 16% amount be reduced to 8%. The 8% amount will still require these companies to invest over 16% of sales in book R&E to be eligible for a credit. This level of R&E investment would still be more than most major R&E spenders invest, but at least would be a more reasonable "barrier" to get the credit. This can be illustrated as .follows:

	Late Stage 8% Base	Development Company 16% Base
Sales	$100	$100
R&E Expenses per Financials	$26	$26
Actual % of Book R&E to Sales	26%	26%
"Tax adjusted R&E"	$ 13 (A)	$ 13 (A)
% of "Tax" R & E to Sales (A/Sales)	13% (B)	13% (B)
Fixed Base Amount	8% (C)	16% (C)
Qualifying R&E ([B-C] x A)	$ 5 (D)	$ 0 (D)
R&E Credit (13% x D)	$ 0.65 (E)	$ 0 (E)

Eliminating the 50% Minimum Base Rule
BIO recommends that the 50% minimum base rule be eliminated. Following is a detailed explanation of the 50% minimum base rule:

The "minimum base rule" is a misnomer. The rule actually is an incremental limitation which deters and penalizes significant growth in research expenditures by limiting the increment of which a credit can be given once the increment is equal to fifty percent of current-year spending (or once the current year spending equals twice the baseline amount). the effect of the provision is to bring the marginal incentive effect of the credit down from the statutory twenty percent credit rate to only 10 percent. For example, assume a company with a base of $10 million is contemplating current-year research expenditures of $20-30 million. If the company increases its expenditures to $30 million, the credit will be available only on the difference between the $30 million and the artificially assigned minimum base of $15 million, not on the full increase of $20 million. thus, contrary to the general Congressional intent of stimulation innovation and productivity, the minimum base puts constraints on those companies that want to make the greatestresearch efforts.

There is no policy justification for exacerbating the disincentive effect of the minimum base provisions. Many start-up and emerging growth companies would be even more adversely affected by the increased limitation than they are under the present-law rules. These smaller companies typically reinvest a significant portion of their cash in additional research. Taking away R&E Credits from these companies will make it more difficult for them to remain independent and compete in the global marketplace.

About advertising opportunities