What Life Sciences Companies Get Wrong When Building Cross-Border R&D Structures

Cross-border structures in life sciences are no longer the exception; they are the rule. Whether it’s an Israeli biotech starting up a U.S. subsidiary to tap into the talent pipeline flowing out of MIT or Stanford, a Chinese-founded company organizing its IP ownership stateside to attract U.S. venture capital, or a European pharma company establishing a U.S. entity to run clinical trials closer to the FDA, inbound structures have become table stakes in the industry.

What remains underappreciated is how much these structures, if not set up and managed correctly from day one, can create significant accounting, tax and compliance headaches down the road. The companies that navigate this smoothly aren’t necessarily the ones with the biggest budgets. They are those that treat financial and tax infrastructure as a strategic priority from the moment they incorporate in the U.S.

Foreign life sciences companies establish U.S. operations for many reasons including to gain access to a deep, specialized talent pool, proximity to leading academic medical centers and major research hospitals, stronger IP protections and U.S. investors. As the funding environment for life sciences has grown more selective, there is an increasing preference among institutional investors for U.S.-based entities that own the IP and conduct research and development (R&D) domestically. The perceived risk of investing in a purely foreign entity, particularly amid ongoing geopolitical and currency uncertainty, has made U.S. subsidiary formation even more attractive as a fundraising strategy. Further, investors often prefer U.S.-based entities that hold clear title to IP because it simplifies enforcement, due diligence and exit planning.

The cost of living and operating differential is significant, and foreign founders often experience sticker shock when they see how payroll and lab space cost in the U.S. compared to their home country. But the tradeoff in terms of investor access and market credibility is often worth the expense.

One of the first questions companies need to think through is where the R&D activity “lives,” both legally and financially. This is often decided by legal counsel and based on IP ownership strategy.

In the most common inbound structure, a foreign parent company funds a U.S. subsidiary, which hires the research team, incurs the R&D expenses, and then invoices the parent company to be reimbursed for those costs plus a markup. This is called a cost-plus arrangement, and while this approach is relatively straightforward in concept, two elements consistently create risk and confusion.

But the R&D tax credits are only as useful as the underlying documentation that substantiate true R&D costs. The credit includes a 20-year carryforward period, and the IRS has the right to examine the underlying records in the year the credits are used, not just the year they were generated. That means an unprofitable company that (a) earns a credit in Year 3 and (b) doesn’t generate taxable income until Year 15, must have documentation from Year 3 that can survive scrutiny a decade and a half later. This is the kind of nuance that can have a tremendous impact when a company finally reaches profitability and tries to benefit from those accumulated credits.

Beyond federal incentives, state-level programs can be significant. Massachusetts, for example, has a Life Sciences Center that offers additional tax credits to qualifying companies that meet specific hiring milestones. Choosing where to locate is never purely a tax decision, as there are several other factors, but understanding the tax environment of different states is worth building into the analysis early on.

The risk of exposure to this issue is not limited to under-resourced start-ups. Even experienced operators can be caught off guard. A standard document retention policy of five to seven years can inadvertently create gaps in records that were generated 15 years ago and are only examined when the need arises. 

Cap table management is another area where issues surface. The cap table is a verified, detailed record of ownership percentages, share types and investor identities. An “ownership change” exceeding 50% over a three-year period under IRS rules can potentially trigger usage limitations on pre-change losses and credits or affect how future losses and credits are utilized. Companies expecting significant financial events (fundraising round, M&A, IPO, etc.) need to proactively track any developments that may influence the carryovers. In addition, the structure and documentation of stock-based compensation used in lieu of salaries to attract talent need to be airtight as well.’

The practical takeaway is that the best time to build clean financial and tax infrastructure is before you need it. Cross-border R&D structures work. They are efficient, strategically sound, and they reflect the global nature of life sciences innovation. But like any complex structure, they require ongoing attention to the details that do not make the headlines. That attention pays off when it matters most, for instance, when they are headed into a funding round. Companies heading into a Series A or B or M&A due diligence are under closer scrutiny than they were a few years ago. Investors and acquirers want to see accurate records and the ability to produce them quickly. Discovering gaps in transfer pricing documentation or R&D credit support at that stage, is a significantly more expensive problem to fix than building the systems correctly from the start. It’s important to know that and create infrastructure from the creation of the U.S. subsidiary to achieve success.

Photo: sesame, Getty Images

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