Guidance for Computing and Substantiating the Credit for Increasing Research Activities under Section 41 of the Internal Revenue Code for Activities involved in Developing New Pharmaceutical Drugs and Therapeutic Biologics


LB&I Control No: LB&I-04-1212-014
Impacted IRM 4.51.2

December 7, 2012


All LB&I Employees


Heather C. Maloy /s/ Heather C. Maloy
Commissioner, Large Business & International Division


Guidance for Computing and Substantiating the Credit for Increasing Research Activities under Section 41 of the Internal Revenue Code for Activities involved in Developing New Pharmaceutical Drugs and Therapeutic Biologics

This memorandum provides guidance to Large Business & International examiners in determining whether a taxpayer in the pharmaceutical and biotechnology industries has appropriately computed the credit for increasing research activities under section 41 of the Internal Revenue Code (research credit) for activities involved in developing new pharmaceutical drugs and therapeutic biologics.

This Directive is not an official pronouncement of law, and cannot be used, cited, or relied on as such.  In addition, nothing in this Directive should be construed as affecting the operation of any other provision of the Code, regulations or guidance thereunder.


Section 41 of the Code provides a credit for increasing research activities.  A taxpayer’s research credit is based, in part, on qualified research expenses (QREs) paid or incurred by a taxpayer during the taxable year in carrying on any trade or business of the taxpayer.

Pharmaceutical Drugs and Therapeutic Biologics Development Process

1. In general.  The development of pharmaceutical drugs and therapeutic biologics (collectively “medicine”) may be broken down into four stages described below:

2. Stage 1.  Discovery and Preclinical Stage.  During the discovery and preclinical stage of the development process, scientists identify and perform initial tests on molecules or new compounds that may be viable candidates for the treatment of a specific condition or disease.  Scientists also conduct extensive laboratory testing of the identified promising molecules or compounds to determine their safety for testing in humans, the possibility of increasing their production, and the potential routes of administration to humans.  Generally, this work is conducted in the biology, chemistry, pharmacology, toxicology, and drug metabolism departments of pharmaceutical and biotechnology companies. 

3. Stage 2.  Clinical Trial Stage.  In general, clinical trials occur in three generally-accepted phases after a company files an Investigational New Drug Application (INDA) with the Food and Drug Administration (FDA) and the FDA approves the INDA.  Generally, these three phases are carried out consecutively such that a subsequent stage is reached only after successful completion of the preceding phase; however in some cases, a taxpayer may enter Phase II or III and then return to an earlier phase.  These three phases can be summarized as follows:

a. Phase I. The trials in this phase usually involve 20 to 80 healthy volunteers. The candidate medicine is tested in humans for the first time to determine if it is safe for humans.

b. Phase II. During this phase, the candidate medicine is administered to approximately 100 to 500 patients with the disease or condition to determine effectiveness, safety, and proper dosages.

c. Phase III. During this phase, researchers typically perform large-scale studies with approximately 1,000 to 5,000 patients to gather more information about the safety, effectiveness, and overall benefits and risks of the candidate medicine.

As an alternative to the three phase traditional clinical trial stage, an accelerated approval process may be applicable to new medicines intended for use in treating serious, rare, or life-threatening diseases that lack satisfactory treatments.  Under the accelerated approval process, the FDA may approve a medicine upon successful completion of Phase I and II clinical trials, but before the Phase III clinical trials are concluded.  Because, in these cases, the FDA approval comes before certain measures of the medicine’s effectiveness are established, the accelerated approval is contingent upon further post-approval commitment clinical trials to establish the medicine’s effectiveness and benefits and risks profile.   Phase III work may be required even after the accelerated approval by the FDA.  If the required clinical trials do not confirm the initial results upon which the accelerated approval was granted, the FDA may withdraw the approval. 

4. Stage 3.  Regulatory Review Stage.  If the clinical trials show that the candidate medicine is safe and effective, the sponsor company files with the FDA a New Drug Application (NDA) for a pharmaceutical drug or a Biologics License Application (BLA) for a therapeutic biologic to obtain the FDA’s approval for marketing and manufacturing of the new medicine for the specified indications.  Upon review of a NDA or BLA, the FDA may either: (1) approve the medicine, (2) send a letter indicating that the medicine is approvable but require additional information or studies before approval may be granted, or (3) deny approval.  The FDA may also require additional studies after an approval. In addition, after a denial, the process may revert to Stage 2 for new clinical trials. /p>

5. Stage 4.  Post Approval Stage.  Once the FDA grants approval, the medicine may be manufactured and marketed for the approved indications.  In the post approval stage, companies continue to monitor medicines and submit periodic reports to the FDA on the medicine’s newly identified side effects and performance.  Sometimes these activities are referred to as the post-marketing surveillance program.  Companies perform additional studies, generally known as Phase IV Clinical Trials, to evaluate long term effects of the medicine, including how the medicine affects a specific subgroup of patients.  Additionally, at this stage, companies may perform comparison studies with other products. 

Note: These stages are not always linear; a taxpayer may enter Stage 3 or 4 and then return to Stage 1 or 2.  If this occurs, the amounts related to Stage 1 or 2 should still be classified as such.

Examination Guidance: 

Examiners should not challenge the amount of QREs taken by a taxpayer:

(i) to the extent that the QREs, within the meaning of section 41(b) of the Code, are for “qualified research” activities (as defined in section 41(d)(1) and not excluded by section 41(d)(4)) that occur during stages 1 and 2 of the Pharmaceutical Drug and Therapeutic Biologics Development Process and clinical trials required by the FDA relating to Accelerated Approvals; and

(ii) the taxpayer provides the Certification Statement (described below). 

Certification Statement:

  1. If the amount of the QREs taken by the taxpayer is under examination at the date of this Directive, the taxpayer should provide the signed Certification Statement to the examiner within sixty days of the effective date of this Directive.

  2. Other than for instances described in 1 above, the taxpayer should provide the signed Certification Statement to the examiner within thirty days of the date that an information document request (“IDR”) is issued to the taxpayer with respect to the amount of QREs taken by the taxpayer. 

A separate Certification Statement must be submitted for each taxable year under audit.  For a consolidated Federal income tax return, the common parent is the sole agent for the group and it will sign the Certification Statement for each member of the group.  An examiner will consider any taxpayer not in compliance with these requirements ineligible for this Directive and subject to regular audit procedures.

For this Directive to apply, a taxpayer must complete all sections of the Certification Statement. The Certification Statement must be signed by an individual who is authorized to execute the taxpayer’s Federal income tax return for the taxable year under audit, and must certify, under penalty of perjury that, for the taxable year under audit, the taxpayer’s computation of QREs is consistent with section 41 of the Code. Pursuant to section 6001 of the Code, the taxpayer should retain the underlying documentation that would permit the Examiner to make a determination that the taxpayer’s computation of QREs meets the requirements of section 41 of the Code. Prior to requesting the underlying documentation, the examiner must receive approval from the territory manager.  If a taxpayer fails to properly and timely submit the requested documentation, then the Industry Director or his/her delegate may determine that this Directive does not apply to the taxpayer.


For further guidance regarding this Directive, please contact Sandra Frost, Manager, Issue Practice Group for General Business Credits, at 972-308-1582, or the Issue Practice Group for General Business Credits.

cc:    Division Counsel, LB&I
        Chief, Appeals
        Commissioner, SBSE


Pharmaceutical Drugs and Therapeutic Biologics Development Process Certification Statement


Taxpayer Name:

Taxpayer EIN:

Tax Year:



By signing this certification statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records required under section 6001 of the Code to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete.

(A) the taxpayer’s qualified research expenses (QREs) are computed in accordance with section 41(b) of the Code;

(B) in computing the QREs, the taxpayer excluded the activities listed in section 41(d)(4) of the Code; and

(C) in computing the section 41 credit, the taxpayer included the QREs relating to Stages 1 and 2 of the Pharmaceutical Drugs and Therapeutic Biologics Development Process and clinical trials required by the FDA relating to Accelerated Approvals in the amount of $ _________.

I certify, under penalty of perjury, that I have examined this certification statement, and to the best of my knowledge and belief, it is true, correct, and complete.




For corporations, the certification must be signed by an individual authorized under I.R.C. section 6062.