IRS Issues Directive on Tax Treatment of Collaboration Agreement Costs
MAY 4, 2007Industry Director Directive on the Proper Treatment of Upfront
Fees, Milestone Payments, Royalities and Deferred Income
Large and Mid-Size Business Division
LMSB Control No.: LMSB-04-0407-037
Impacted IRM 4.51.2
MEMORANDUM FOR
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, INTERNATIONAL COMPLIANCE
STRATEGY AND POLICY
DIRECTOR OF EXAMINATION, SBSE
FROM:
Retailers, Food, Pharmaceuticals, and Healthcare
SUBJECT:
Tier II Issue -- Industry Director Directive on the Proper
Treatment of Upfront Fees, Milestone Payments,
Royalties and Deferred Income Upon Entering into a
Collaboration Agreement in the Biotech and
Introduction:
This memorandum provides direction to the field concerning efficient use of examination resources relating to the audit of the proper treatment of payments made under a collaboration agreement in the biotech and pharmaceutical industries, which has been designated a Tier II compliance issue. As a result of this designation, LMSB-wide coordination is required to ensure appropriate examination coverage and a consistent approach to the development and resolution of the issue.
In general, it is common industry practice for biotech and pharmaceutical companies to enter into collaboration agreements with other biotech or pharmaceutical companies for the right to exploit the result of their promising research in certain geographic areas. Many costs are incurred relating to the execution of such agreements, including, non-refundable upfront fees upon entering into the agreement, milestone payments contingent upon the research achieving certain goals during the drug development process, and royalties due upon the commercialization of the potential drug candidate. These costs are being treated inconsistently by both taxpayers and examination personnel. Sections 41, 61, 162, 167, 174, 263(a), 263A and 451 of the Internal Revenue Code (I.R.C.) address the proper treatment of these costs. This directive and its related guidelines are intended to provide a uniform format and approach for examiners to evaluate potential compliance risk related to these issues; to outline the issue management and oversight process that has been established; and to introduce an initial set of audit guidelines.
This directive is relevant to the examination of taxpayers with both current and/or previous collaboration agreements. This directive is not an official pronouncement of law or the position of the Service and cannot be used, or cited, or relied upon as such.
Background:
Small biotech and pharmaceutical companies that have discovered promising compounds but lack the economic resources or infrastructure to bring a drug to market, have turned to larger biotech and pharmaceutical companies to provide the necessary resources to complete their research. Collaboration agreements between these parties have provided a means for these 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.
The agreement may also have an equity interest, as well as provide for funding further research costs, etc. The non-refundable upfront fee provides the pharmaceutical/biotech company with an intangible right to a promising compound that has achieved success to a particular phase of development. If the research is successful and a New Drug Application (NDA) is issued, the pharmaceutical/biotech would be given the opportunity to manufacture and market the new compound in a specific market or geographic location.
Generally, milestone payments are contingent payments based on the research having achieved certain goals such as: advancing to Phase III clinical trials, filing of an NDA, and/or achieving FDA marketing approval. These payments are, in part, designed to compensate the licensor for the increased value of the intellectual property as it progresses through its development. Though nothing is absolute within the pharmaceutical industry, the measure of success is demonstrated by the amounts to be paid as the risks somewhat diminish.
The licensee typically takes the position that payment of the non-refundable upfront fee and milestone payments are expenses incurred for research and experimentation and as such are deductible in full as I.R.C. § 174 expenditures. Since they have treated them in this fashion, they have also claimed the amounts in the computation of the Research and Development (R&D) credit under I.R.C. § 41. Generally, these type of costs are not currently deductible under I.R.C. § 174 either because they represent payments to participate (entry fees) in the research endeavor or because they represent payments for already developed know how, and thus are not a cost of research that is yet to be performed. Rather, these payments are capital expenditures subject to I.R.C. § 263(a). The participation privilege is an acquired intangible right with a useful life of more than one year. See Treas. Reg. §§ 1.263(a)-4(b)(1) and (3).
The milestone payments are contingent payments based on successfully completed research to a defined stage. Since these payments are capital expenditures, they are eligible for depreciation/amortization under I.R.C. § 167 over the life of the agreement plus renewals, the remaining life of the patent or the safe harbor amortization period of 15 years, whichever period (based on the facts and circumstances) can be determined with reasonable accuracy. The depreciation/amortization period begins upon entering into the collaboration agreement and making the payment of the non-refundable upfront fee. The milestone payments, when paid, will be added to the basis established and depreciated/amortized over the remaining useful life of the agreement.
The licensor typically takes the position that the receipt of such payments is deferrable into income over the life of the agreement. In general, I.R.C. § 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, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period.
Licensors on the cash method of accounting recognize income in the year of receipt. For licensors on the accrual method of accounting, Treas. Reg. § 1.451-1(a) provides that, under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. All the events that fix the right to receive income generally occur when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest. See I.R.C. §§ 446, 451; Treas. Reg. § 1.451-1(a); and Revenue Ruling 84-31, 1984-1 C.B. 127.
Revenue Procedure 2004-34, 2004-1 C.B. 991, allows taxpayers a limited deferral beyond the taxable year of receipt for certain advance payments. Qualifying taxpayers generally may defer to the next succeeding taxable year the inclusion in gross income for federal income tax purposes of advance payments (as defined in Section 4 of the revenue procedure) to the extent the advance payments are not recognized in revenues in the taxable year of receipt.
Except as provided in Section 5.02(2) of the revenue procedure for certain short taxable years, this revenue procedure does not permit deferral to a taxable year later than the next succeeding taxable year.
Issue Tracking:
Potential issues resulting from biotech and pharmaceutical companies entering into collaboration agreements can cut across multiple sections of the Internal Revenue Code. The type and number of issues may vary depending on the particular situation of the taxpayer under examination. A specific Uniform Issue Listing (UIL) Code has been assigned for this issue UIL Code 263.13-02. This UIL Code reflects the specific issue(s) resulting from entering into these collaboration agreements and should be used on all cases. In order to track the issue, all examiners must also use a Secondary Standard Audit Index Number (SAIN), # 340 through 347, in conjunction with the issue-specific UIL Code. If an issue and/or issues under examination involve I.R.C. §§ 41, 61, 162, 167, 174, 263(a), 263A, and/or 451, potential issue tracking codes may include, but are not limited to:
UIL CODE SECONDARY SAIN
Section 41 :
Contract Research Expense 263.13-02 340
Section 61:
Compensation for Services 263.13-02 341