Tax treatment of payments in common pharmaceutical agreements.

It is often the case that a business developing a promising

pharmaceutical compound or drug lacks the economic resources to further

develop that compound or bring it to market. This is because the

development of drugs in the United States typically involves four

stages: (1) preclinical or discovery research, (2) clinical development,

(3) regulatory approval, and (4) postapproval marketing, occurring over

a period of 10-12 years.

In such instances, the developer (generally a smaller business,

often referred to as a “licensor”) frequently turns to a

larger business (licensee) with the financial, laboratory, and

regulatory resources to complete the research and bring the product to

market. The agreements between such disparatesized businesses, often

called “collaboration agreements” and payments made thereunder

have recently been the subject of significant IRS scrutiny. In October

2007, the Service outlined its position on the treatment of the various

types of payments under collaboration agreements in Coordinated Issue

Paper LMSB-04-1007-073, “Non Refundable Upfront Fees, Technology

Access Fees, Milestone Payments, Royalties and Deferred Income Under a

Collaboration Agreement”(10/18/2007) (the CIP).

Because of their disparate size and differing profit situations, it

is often the case that tax benefits can be better utilized by the larger

business, since the smaller business may be carrying net operating

losses (NOLs) and may be in a loss position.

The three specific payment types–upfront fees, milestone payments,

and commercial royalty payments–are each unique to the point in time

during the collaboration agreement at which they occur. In the CIP, the

Service states that each collaboration agreement and the payments

thereunder should be examined on a “facts and circumstances”

basis. However, it is clear from the CIP that the IRS believes that

large pharmaceutical payors of upfront fees, milestone payments, and

royalty payments should rarely be able to claim these as Sec. 174

deductions for research and experimental expenses or as expenses

includible in calculating the Sec. 41 credit for qualified research

expenses.

Upfront Fees–Preclinical/Discovery Phase

Upfront fees are payments made at the execution of an agreement or

at an agreed-upon time that are not contingent on the successful

completion of research. The IRS considers these fees to be capital

expenditures for an intangible asset. According to the IRS, upfront fees

represent payment for already-developed intellectual property, so there

is no risk to the payor (for the development of the compound to that

date, at least) and therefore no Sec. 174 deduction. There should be no

objection to the payee taking the Sec. 174 deduction (or the Sec. 41

credit) during all the years in which the initial intellectual property

is developed because in those years there was no “funding” in

place and no guarantee that anyone would “pick up the tab” for

the research. However, as noted above, initial developers of

pharmacological compounds often have little use for increased deductions

or credits.

There is little to criticize in the Service’s analysis of

upfront fees. A licensee might try to characterize such fees as

reimbursement for research expenses or contract payments for research

services, and thereby bolster the larger business’s claim to

deductibility and creditability. However, at least under the credit

rules, this would seem to run afoul of the requirement that a contract

must precede performance of outside research and development (R&D)

(Regs. Sec. 1.41-2(e)(2)(i)). However, once a collaboration agreement is

in place, this should be of no further concern.

Milestone Payments–Clinical Development and Regulatory Approval

Milestone payments are due under a collaboration agreement on the

completion of successful research. They are designed to compensate a

licensor for the increase in value of intellectual property as it

progresses through the stages of development up to the time of

marketability. In the CIP, the IRS addresses milestone payments together

with upfront payments and makes no attempt to differentiate between the

two, and it does not address the issues of risk that the payments can

alleviate. This is an over-simplification and a contradiction of

existing case law, particularly in the R&D area, where there is a

case on point in which the Federal Circuit stated (in a government

contracting situation) that the presence of milestone payments did not

negate the risk for the taxpayer doing the research (Fairchild

Industries, Inc., 71 F3d 868 (Fed. Cir. 1995)). However, there is a

chance that the IRS will nevertheless attempt to characterize milestone

payments as being “no risk” and will therefore characterize

the underlying R&D activity as ineligible for deduction or credit to

the payee.

Taxpayers should not agree to this result because there is no

guarantee that the researcher will receive the milestone payment; the

licensee/researcher is clearly at risk until the milestone payment is

received and thus should qualify for the Sec. 174 deduction or the Sec.

41 credit. It is arguable that the licensor still bears the risk for

milestone payments made for contract research performed by the larger

company since there is no benefit (in the form of future royalties) to

the licensor for the incremental research performed by the licensee

until development is completed and FDA approval is secured.

Royalty Payments on Commercialization

This is perhaps the clearest case in the CIP. Once a drug is

approved for commercial sale, there is no longer any technological risk;

all that remains is marketing risk. Any payments to the licensor at that

point are most clearly compensation for its intellectual property and

research efforts already achieved. There is no risk (at least in the

technical sense), so there can be no deductibility to the licensee under

Sec. 174 and no credit under Sec. 41. Therefore, in the CIP, the IRS

categorizes royalty payments as costs of property produced or acquired

by the taxpayer that are capitalizable under the uniform capitalization

rules of Sec. 263A.

Practice tip: Smaller companies developing compounds made subject

to collaboration agreements definitely need advice about the appropriate

characterization of their expenditures and efforts resulting in such

payments, and they can often benefit from a practitioner’s advice

about these tax benefits and a retrospective review of their prior tax

years’ efforts.

The Service’s position as expressed in the CIP could easily

result in a “whip-saw” wherein neither the payor nor the

recipient of fees under a collaboration agreement could receive R&D

tax benefits. This could happen, for example, if the payee’s IRS

exam team treated the upfront payments as funded research and disallowed

the credit and the payor’s IRS exam team treated the contract

R&D as not at risk to the payor because it is for already developed

know-how. This type of payment should not be treated as funded research

to the payee because the R&D was performed before the payee ever

knew that a third party would be willing to pay for it.

Conclusion

All payments made under pharmaceutical collaboration agreements

will receive IRS scrutiny on examination of the payor’s tax return.

Taxpayers involved in these agreements should be made aware of the

Service’s view (as expressed in the CIP) of deducting upfront,

milestone, and royalty payments under Sec. 174 and including them in

Sec. 41 credit calculations. Taxpayers receiving such payments should

have their contracts reviewed to determine that they are including the

appropriate amounts in their Sec. 174 deductions and Sec. 41 credit

calculations.

FROM GERALD H. PARSHALL JR., J.D., GAITHERSBURG, MD

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