On May 28, 2007 the Internal Revenue Service's Large and Mid-Size Business Division issued an Industry Directors Directive (LMSB-04-0407-037) outlining how examiners are to develop and resolve cases in the biotech and pharmaceutical industry dealing with biotech agreements for milestones.
Background
Small biotech and pharmaceutical companies that have discovered promising compounds but lack the economic resources or infrastructure to bring a drug to market frequently turn to larger biotech and pharmaceutical companies to provide the necessary resources to complete their research. Collaboration agreements between these parties provide a path to market for small companies, and are a means for the larger entities to increase their pipe lines less expensively than if they initiated or funded the research themselves.
Typical collaboration license or alliance agreements call for the following types of payments:
1. non-refundable up-front fees payable upon signing of the agreement;
2. milestone payments due as the research achieves certain goals; and
3. royalty payments due upon commercialization of a drug compound.
Historically, the above costs have been treated inconsistently by both taxpayers and IRS examiners under sections 41, 61, 162, 167, 174, 263(a), 263A and 451 of the Internal Revenue Code (I.R.C.). The stated intent of the directive is to:
1. provide a uniform approach for examiners evaluating potential compliance risk related to these issues;
2. outline the issue management and oversight process that has been established; and
3. introduce an initial set of audit guidelines.
Key points of the directive
Licensees
To date, licensees typically have viewed the non-refundable upfront fee and milestone payments as expenses incurred for research and experimentation and therefore fully deductible as §174 expenditures and eligible for inclusion when computing the R&D credit under §41.
The Directive clarifies that these costs are not deductible under §174 because they represent either payments to participate (entry fees) or payments for already-developed know-how, and therefore are not a cost of research that is yet to be performed. The directive states that the upfront payments are capital expenditures subject to §263(a) and that the participation privilege is an acquired intangible right with a useful life of more than one year. The milestone payments are capital expenditures, eligible for depreciation/amortization under §167 over the life of the agreement plus renewals, the remaining life of the patent, or the safe harbor amortization period of 15 years.
Licensors
The licensor typically takes the position that the receipt of such payments is deferrable into income over the life of the agreement. However, §451 provides that the amount of any item of gross income is included in gross income for the taxable year in which received by the taxpayer, unless the amount is to be properly accounted for as of a different period.
The upfront and milestone payments are capital expenditures under Section 263 (a) for the rights to exploit the technology in a specific geographic area, IRS said. The payments are eligible for depreciation or amortization under Section 167.
Conclusion
Although the IRS defines this as a Tier II issue, (emerging issues where the law is fairly well established), the IRS felt that there is a need for further development and "clarification" in this area. This directive is very informative for pharmaceutical, life sciences and biotech companies in that it details not only how an agent will develop the issues but also provides insight into the LMSB position, how that position was formulated and will be handled. The directive specifically directs IRS agents to submit a copy of all Form 5701 proposed adjustments and final resolutions to the IMT clearly indicating a high degree of oversight and control.
Publications Search Page
