The Court identified the elements with the clinical trial ordering party – the producer of the pharmaceutical – rather than with the Plaintiff. The SAC concludes that the Plaintiff merely carried out a specialised service for the ordering party: it did not bear the economic risk of the tested pharmaceuticals’ failure or affect the instructions, course or conclusions of the clinical trials and thereby did not meet the conditions for utilising the R&D tax deduction.

The Plaintiff, as a non-governmental health-care facility (a CRO), performed Phase-3 clinical studies, ie the systematic testing of pharmaceuticals on patients with the aim of demonstrating and verifying their curative effects and identifying any undesirable effects. In doing so, the Plaintiff is not an entity developing the pharmaceuticals: the ordering party (a pharmaceutical company) only makes use of its technical facilities and the high level of expertise of its employees (physicians) in order to carry out this development phase.

Following an analysis of the Pharmaceuticals Act, the SAC concluded that clinical studies are, generally by their very nature, activities that may be subordinated under R&D as they comprise the two defining traits of R&D – the existence of an element of novelty and clarification of scientific uncertainty. However, the SAC added that for the activities to be utilisable as part of the R&D deduction, the negative condition stipulated by the Act must also be fulfilled: ie, that the activities carried out in implementing the project must be performed by the payer itself rather than purchased as a service.

What the Frascati Manual and the Horizon 2020 Programme Say
According to the SAC, the actual research activity was performed by the ordering party (the pharmaceutical company), with the ordering party having developed the pharmaceutical, including the instructions according to which the testing phase was carried out by the Plaintiff. Therefore, as the Court ruled, the Plaintiff did not carry the increased level of business risk – it was borne by the ordering party. If the result of the clinical trial had been negative, the development of the pharmaceutical would not have proceeded to the next phase: ie, the pharmaceutical would not have been produced. According to the SAC, in this situation, the risk investment made by the clinical trial ordering party, rather than that of the Plaintiff, would have been marred.

The SAC thus refused to regard the clinical trial of a pharmaceutical performed by a CRO to constitute an independent R&D project whose input is a new active substance and the deliverable includes new findings on its actual effectiveness and safety. In its ruling, the SAC states that it regards clinical trials of pharmaceuticals to be eligible for a deduction only in relation to the development and subsequent commercial use of the pharmaceuticals as part of a single project. This is despite the fact that, globally, clinical studies are, as a rule, conducted by CROs (instead of pharmaceutical companies), which is also true of the Czech Republic.

Given this fact, it may be inferred that the authors of the Frascati Manual (the OECD’s underlying document for identifying R&D activities) as well as, say, the authors of the documents for the Horizon 2020 programme – the principal EU programme supporting R&D activities (where the documents expressly state that Phase 1-3 clinical studies meet the definition of R&D) based the documents on the fact that clinical studies are, as a rule, carried out by CROs rather than pharmaceutical companies themselves. It may also be inferred that in preparing Guidance Note D-288, lawmakers based their work on the Frascati Manual and, as a result, made it possible for Phase 1-3 clinical studies to be utilised in a deduction as they meet the definition of R&D (which, after all, the SAC confirms).

Considering countries that have included the R&D deduction in one form or another in their legislation, you will find that the legislation of many of the countries (eg, France) makes it explicitly possible to utilise specialised activities and costs incurred on Phase 1-3 clinical studies as part of the deduction. In view of the matters outlined above, it is evident that the lawmakers or authors of the documents were interested in supporting the activities and were aware that not all phases preceding the roll-out of a new pharmaceutical are typically performed by a single entity. Subsequently, it is not relevant which entity implements this phase of clinical studies and whether it is implemented independently or as part of a greater whole (eg, along with the development of the pharmaceutical).

Who Carries the Business Risk?
In the case in hand, the result is a situation where, on the one hand, it has been confirmed that clinical studies constitute R&D, but, on the other hand, an argument is put forward referring to the use of “risk capital” during the product’s development and its indivisibility from the whole being developed. However, it would be a mistake to assume that the Plaintiff did not carry the risk of a business failure. Its risk capital does not consist of the costs of bringing the development of the pharmaceutical into Phase 3, but, from its perspective, if it had selected inappropriate patients, carried out an erroneous analysis and made an incorrect expert assessment of the effects of the pharmaceutical administered by the physician, or selected and used inappropriate assessment methods, the investment would have been marred considering the costs incurred. At this point, it should be noted that while the Plaintiff’s business risk does not consist of the failure to roll out the pharmaceutical, it would be at risk of losing a contractual partner and its professional reputation on the market if it made an error during the clinical research into the pharmaceutical’s effectiveness and safety.

If the situation is misread, there is a risk of generalising the conclusions and applying them, say, to the automotive industry, whereby it could be asserted that if the payer only develops a certain component for a brand new engine, it does not bear the business risk of the failure of the entire item being developed (in this context, the engine). However, in business practice, it is entirely customary that multiple entities gradually participate in the development of a single whole, with by far not all of them bearing the business risk of achieving the target parameters. However, the situation described clearly shows how sophisticated the product or process being developed is. Distinguishing chains of development phases and assessing them from the business risk perspective could, in practice, result in the restriction of using the institutes of a deductible item by a whole series of firms performing undisputed R&D activities.

A Surprising Interpretation Given the Existing Legislation
In respect of the argument of acquiring the activities as a service, which is not, from the perspective of law, a tax deductible expense, it can also be objected that the interpretation is outside the boundaries of the existing legislation. By defining the impossibility of including a purchased service in R&D, the lawmakers had a completely different situation in mind: if the pharmaceutical company purchased the results of the Plaintiff’s work, the purchase would not be tax-deductible on the pharmaceutical company’s part. However, in this context, the Plaintiff did not purchase the service: it supplied it itself in the form of new expertly acquired findings which the ordering party ordered from it, as is customary in the industry.

Through this ruling, the SAC presented its view on the eligibility of R&D activities for a deduction, concluding that the Plaintiff lacked both the possibility of creatively affecting the instructions, course and assessment of the clinical trials, as well as the elements of novelty and business risk connected with testing a proprietary pharmaceutical.

The authors of this article believe that the ruling brings new insight into the definition of R&D activities eligible for a deduction which does not, however, decrease tax payers’ legal uncertainty. With regard to utilisation, the results of Deloitte’s latest survey indicate that uncertainty arising from ambiguous conditions of this aid constitutes the most significant barrier for almost 60% of businesses.

The article is part of dReport – December 2018, Tax news; Grants and investment Incentives.