At the recent Center for Business Intelligence (“CBI”) Tax and Transfer Pricing Congress, a panel of IRS speakers outlined priorities for both the Service overall and specifically for the Pharmaceutical, Biotech and Medical Devices industries. The IRS representatives included John Risacher, the new Industry Director for Retail, Food, Pharmaceuticals and Healthcare; Lori Nichols, Director of Field Operations, RFPH; Lou Milano, Technical Advisor, Pharmaceutical Industry; and Howard Cubberly, Technical Advisor, Biotech Industry.
While some of the industry-specific priorities cited by the IRS presenters support Commissioner Everson's testimony before the Senate Committee on Finance on June 16, 2006 (IR-2006-94), they generally bypassed many of the broader IRS initiatives such as e-Filing and the fast track initiative and focused on areas specifically relevant to the industry. The first three topics - cost segregation studies, licensing fees, and 936 exit strategies - are specific guidance projects; the remaining topics are issues that the IRS considers to be of significant concern for the industry.
Following is a synopsis of the discussion around each of the topics. Clearly, Lou Milano was correct when he remarked in his opening that this is not a dull industry.
Cost Segregation Studies
The specific point for discussion relative to cost segregation studies was the reclassification of building costs from an IRC 1250 property with a useful life of 39 years to an IRC 1245 property with a useful life of 5 to 7 years. Now that audit guidelines are out, the emphasis was on the materials to be requested and reviewed on the audit, which include:
1) Cost segregation study
2) Engagement letter
3) Form 3115 - change of accounting method
4) IRC 481(a) - adjustment and supporting documents
5) Asset account ledger
6) Engineering blueprints
The service also expects to conduct on-site visits to verify the claims.
Licensing Fees/Collaboration Agreements
The IRS discussed the proper treatment of non-refundable up-front fees, technology access fees, milestone payments, royalties upon commercialization and deferred income under alliances and licensing/collaboration agreements. Myriad code sections apply, making this a particularly complex issue for the industry.
According to Mr. Milano, non-refundable up-front fees and milestone payments paid under an agreement for a right to develop, market and sell a drug are considered capital expenditures under IRC 263(a)-4(d)(6) the expenditures are for the costs of:
1) creating or acquiring a separate and distinct asset.
2) the useful life of such asset extends beyond the end of the taxable year.
The expenditures are intangible costs amortizable under IRC 197 or IRC 167 over 15 years, or a life determined based on the facts and circumstances of the license agreement or remaining life of the intellectual property.
Non-refundable up-front fees and milestone payments based on the facts and circumstances should not be considered IRC 174 expenses if they do not qualify for the IRC 41 credit. IRC 174(a)(3)(vi) states that R&E does not include expenditures for the acquisition of another’s patent, model, production or process. Milestone payments made in the event that the research is successful in reaching stated goals do not meet IRC 174 and Treas. Reg. 1.174-2(b)(3) because there is no uncertainty. They also do not meet the standards of Treas. Reg 1.41-2(e)(2) because the payment is contingent on the success of the research, which is considered to pay for the product or result rather than the actual performance of research.
According to the IRS, alliances and licensing/collaboration agreements need to be reviewed for exact requirements. If research funding is part of the agreement in addition to the non-refundable up-front fees and milestone payments for the license, those R&E funding costs may qualify for IRC 174 and 41 treatment.
PwC observation: As you can see, the IRS is taking a hard look at these types of payments. Taxpayers can expect some challenges from the IRS in this area.
936 Exit Strategies
Tax Credits provided by IRC 936 and 30A will not be allowed for taxable years beginning after 12/31/2005. Notice 2005-21 deals with the issues that may arise depending on how taxpayers continue to conduct business. The three most likely scenarios are for the IRC 936 corporation to either 1) continue operating as a domestic corporation, 2) liquidate into its parent, or 3) reincorporate in a foreign jurisdiction.
Considerations of reincorporating in foreign jurisdiction: In outbound transfers of tangible and intangible property to foreign corporations, the foreign corporation shall not be considered to be a corporation for purposes of excluding gain.
Other considerations to be aware of include possible Subpart F issues; reporting requirements; and general reporting requirements of Subchapter C. An issue management team is in place and further guidance will be forthcoming.
DOJ Settlements
The speakers cited IRC 162(f) in distinguishing the treatment of compensatory versus punitive damages. The taxpayer's documentation should include all correspondence between the Department of Justice and the taxpayer, including computations submitted to the taxpayer, proposals and counter-proposals made, etc. In TAM 200502041 the Service concluded that a portion of a lump-sum payment in settlement of claims arising under the False Claims Act is nondeductible under section 162(f), and has identified the portion of the settlement payment that constitutes compensatory damages.
Research Credit
The significant issue discussed in this area was the recently issued Chief Counsel Advice dated 2/14/06 regarding the definition of a controlled group. This ruling held that a domestic corporation may NOT exclude receipts from it’s majority owned foreign subsidiaries when computing gross receipts for purposes of determining the base amount under IRS 41(c).
PwC Observation: This CCA is controversial and is directly contrary to previously issued
guidance (ILM 200233011.)
Medicaid Rebates
Rev Rul. 2005-28 published May 9, 2005 establishes that Medicaid rebates incurred by pharmaceutical manufacturers are purchase price adjustments and should be subtracted from gross receipts in determining gross income. Note that this ruling invalidates FSA 200101004 of 1/5/2001 which concluded that Medicaid rebates were a below-the-line expense.
Legally-mandated R&D
In compliance with Treas. Reg. 1.861-17(a)(4) legally-mandated R&D can be incurred solely to meet legal requirements of a political entity, and with respect to improvement or marketing of a specific product or process. The results cannot generate more than the de minimis gross income outside the geographic source. Published guidance includes a coordinated issue paper effective 6-18-2003 and an Industry Directors Directive dated 10-17-2003.
IRC 1341 and Claim of Right
According to the IRS, in order to obtain the benefits of section 1341, five requirements must be satisfied:
1) The item must have been included in gross income in a previous taxable year.
2) The inclusion occurred because the taxpayer appeared to have an unrestricted right to the item.
3) The taxpayer is entitled to a deduction for its restoration to another of the item included in gross income in the prior taxable year.
4) The deduction is allowable because it was established after the close of the year of inclusion the taxpayer did not have an unrestricted right to the item.
5) The amount of the deduction exceeds $3,000.
Patent Donations
Notice 2004-7 deals with the contribution of patents and other intellectual property to charitable organizations in excess of amounts entitled under IRC 170. The charitable contributions contain one or more of the following issues:
1) Transfer of a non-deductible partial interest.
2) Expectation or receipt of a benefit in exchange for the transfer.
3) Inadequate substantiation of the contribution.
4) Overvaluation of the IP transferred.
The Notice advises taxpayers that in appropriate cases, IRS intends to disallow all or part of these improper deductions and may impose penalties under IRC 6662. In addition, promoters and appraisers of transactions involving these improper deductions may be subject to penalties under IRC 6700, 6701 and 6694.
The American Jobs Creations Act addressed charitable contributions of patents made after 6/2004. Section 882 (IRC 170(e)(3) limits the contribution of intellectual property to the lesser of taxpayers basis or the full market value of the intellectual property.
Clearly, these are the “hot buttons” for the IRS when auditing Pharmaceutical and Life Science companies. Companies will be well advised to be prepared to respond to challenges by the IRS on these topics.
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