Medtech POV Blog

Federal Net Operating Losses: One Tax Reform Issue Patients Should Know

  1. Christopher L. White General Counsel & Chief Policy Officer

While much of the mainstream press and discussion around taxes reduces the issue to “corporate” or “wealth” taxes, tax policy is far more nuanced and complicated.  One tax issue overlooked by that simplification, important to patients everywhere, relates to net operating losses (“NOLs”).  Below, I describe why this issue is so important to patients and health care practitioners. 

In short, well-crafted tax policy on NOLs spurs innovation in new life-saving treatments and cures; and as we continue to emerge from the pandemic, there is no time more important for the Congress to foster further medical innovation.

Why Does NOL Tax Policy Matter? 

Particularly for small and start-up medical technology companies, access to capital is essential in funding critical research and development (R&D) for the treatments and solutions patients and caregivers need. These companies incur substantial upfront costs and expenses – necessary expenditures and negative cash flow – that generate what accountants call NOLs.  In certain cases, these operating losses are forms of investment that may not be applied for tax purposes (i.e., offset or monetized) for significant periods of time (because it may take a while before such companies can generate net taxable income). Current tax law restricts the use of the NOLs in certain ways and thereby limits investment in new cures and treatments. 

This gets complicated, but let me try to break it down:

What Are Net Operating Losses?

Different NOL rules apply to different types of taxpayers and NOLs (e.g., federal and state), but to simplify, let’s focus on the federal NOL rules that apply to eligible medtech corporate taxpayers. Generally, a taxpayer’s NOL for a tax year is equal to the amount of deductions exceeding income for the year (the “NOL Year”).  Some taxpayers are eligible to use NOLs to offset their taxable income for taxable years prior to or after the NOL Year. 

This is where it gets complicated.  NOLs arising in taxable years beginning in 2018, 2019, and 2020 may generally be carried back five taxable years preceding the NOL Year (the “5-year NOL Carryback Rule”) and carried forward indefinitely following the NOL Year.  NOLs arising in taxable year 2021 or later generally cannot be carried back, but can be carried forward indefinitely.  NOLs arising in taxable years before 2018 generally can be carried back two taxable years preceding the NOL Year and carried forward 20 taxable years following the NOL Year. 

Corporate taxpayers generally use NOLs to offset 80% of taxable income computed without regard to the allowable NOL deduction (or 100% for NOLs generated in taxable years beginning in 2018, 2019, and 2020).   

Why Are Net Operating Losses Important to Patients?

The federal tax system generally calculates tax liability based on an annual accounting period.  This annual accounting period can result in unfairness to companies that do not have consistent income or profit.  The NOL rules minimize the disparity in tax liability that would otherwise result between companies with equal average incomes by ensuring that taxes are applied to a company’s average taxable income computed over a period longer than one year—including situations where one company has up-front losses or alternating losses and profits and another has relatively constant profits. 

For companies that are not yet profitable,  NOLs may be a valuable asset on their balance sheet (i.e., deferred tax asset) since these losses can lower future taxable income and improve liquidity.

This is especially relevant for companies in the medical technology industry, particularly the small companies that comprise more than 70% of medical device makers, that incur large losses for several years before they become profitable due to heavy investment in R&D during the early stages of the business.

As a going concern, including NOLs in their valuation may help companies obtain higher pro-forma valuations and secure more favorable financing terms. 

However, there are still some challenges regarding recognition of NOLs. For instance, companies with NOLs that have an ownership change (generally, a greater than 50% shift in ownership by certain shareholders during a rolling three-year period) are subject to additional rules that substantially restrict the ability to use NOLs generated prior to the ownership change date to offset taxable income incurred after the ownership change date. This provision of the NOL rules is problematic for medical technology start-up companies, which may go through multiple ownership change events (e.g., fundraising rounds, initial public offerings, and acquisitions), and can stifle the ongoing development of innovative, life-saving technology.

NOLs generated could be a valuable asset for companies that become profitable, including medical technology companies.  However, provisions that create relief for pre-revenue companies, especially given the impact of COVID-19, are still needed.

What Can Congress Do?

Companies should be permitted to receive an advance refund for NOLs.

Fortunately, the bipartisan IGNITE American Innovation Act, introduced in the House of Representatives by U.S. Reps. Dean Phillips (D-MN) and Jackie Walorski (R-IN), and in the Senate by Sen. Robert Menendez (D-NJ), would permit advance refunds for NOLs from applicable taxable years (if certain conditions are satisfied) in lieu of carrying back the losses under the 5-year NOL Carryback Rule, to the benefit of medical technology innovation. Specifically, the legislation would allow growth companies like start-up medical technology companies to monetize up to $25 million of NOLs and R&D credits, and double the value of R&D credits (related to expenditures paid or incurred in applicable taxable years) generated by research into products to prevent, diagnose, and treat COVID-19 and future pandemic threats. 

Legislation such as the IGNITE American Innovation Act, and other reforms to the NOL rules to allow medical technology companies, particularly small and start-up ones, to fully benefit from NOLs will encourage necessary investment in innovative technologies, and in turn allow these companies to continue the R&Dneeded to introduce the next generation of treatments and cures vital to quality patient care.

That’s tax reform that really matters to patients.

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