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John Risacher, industry director of Retailers, Food, Pharmaceuticals and Healthcare of Large & Mid-Sized Business Division (LMSB) of the Internal Revenue Service issued a ruling to his staff on May 7, 2007. The Directive on the Proper Treatment of Upfront Fees, Milestone payments, Royalties and Deferred Income (LMSB 04-0407-037) for pharmaceutical and biotech companies was set in motion.

Michael Hadjiloucas Partner Amper, Politziner & Mattia

Looking back, the IRS has always focused on pharmaceutical companies, says Michael Hadjiloucas, a partner in the Tax Department of Amper, Politziner & Mattia and a member of the firm’s Technology Group, because of apparent profitability. "The focus has been less on biotech companies since they are usually in a loss position.

"Now the IRS has realized that both sectors work closer nowadays than before and many times there are significant payments made through these collaboration agreements that affect taxation from both sides."

In this provocative question and answer column, Hadjiloucas answers some important questions regarding collaboration agreements and associated accounting implications.

Let’s start at the beginning. What is a collaboration agreement?

It’s an agreement entered into between biotech and/or pharmaceutical companies for the right to exploit the result of their promising research in certain geographic areas. Certain cost are incurred in relation to these agreements including non-refundable upfront fees upon entering into the agreement, milestone payments contingent upon the commercialization of the potential drug development process and royalties due upon the commercialization of the potential drug candidate.

What is the purpose of this latest IRS Directive?

There is an inconsistency in how these costs are treated for tax purposes among the taxpayers and IRS agents. Thus, the purpose of the directive is to clarify the issues and

1. to provide a uniform format and approach for examiners to evaluate potential compliance risk related to the these issues;
2. to outline the Issue Management and oversight process that has been established; and
3. to introduce an initial set of audit guidelines.

What does the new ruling call for?

It primarily provides guidance to IRS agents on how to audit the proper treatment of payments made under a collaboration agreement in the biotech and pharmaceutical industries and also to collect data.

Consider it a manual. It’s an eight-page document that first explains what a collaboration agreement is along with providing a "background" explanation of why these collaboration agreements take place and what payments they call for. Second, it requests that the agents track the issues by Internal Revenue Code Section. Third, it provides specific guidance on four potential issues and step-by-step process in identifying them and how to seek help within the IRS and the Issue Management Team ("IMT") that has been set up to assist the agent with technical matters in this initiative. Finally, the directive states the IRS position on the four issues and coordination with the IMT.

Basically, it is an "audit program" for the IRS agents in relation to the collaboration agreements.

Why is the IRS concerned with these issues now?

Over the years these collaboration agreements have become more significant and more common than in the past. Further, since the biotech companies are becoming profitable, these agreements may have significant taxation implications for both biotech and pharmaceutical companies.

The issues are 1.) whether the payments are currently deductible or should be capitalized by the payer and whether amortization may be appropriate for the payer, 2.) whether payment qualifies for R&D credit, and 3) whether or not the recipient company should recognize this revenue as taxable income.

What are the potential issues companies must address?

Know the answers to the following questions:

1. Are the non-refundable upfront fee payments, technology access fees and milestone payments deductible as ordinary and necessary business expenses, research and development expenses, or are they capital expenditures subject to capitalization and amortization, if applicable?
2. Are royalty payments deductible as ordinary and necessary business expenses or capital expenditures subject to capitalization and amortization, if applicable?
3. Is the receipt of non refundable upfront fees, technology access fees and milestone payments income in the year of receipt or are they deferred over the life of the contract?
4. Do the upfront fees, technology access fees and milestone payments qualify for research tax credit?

What position does the IRS’ Directive take on these issues?

The directive states that nonrefundable payments represent payments (entry fees) to participate in the research endeavor, or they represent payments for already developed know how. Since they are not a cost of research that is yet to be performed, they are not deductible under Internal Revenue Code ("IRC") Section IRC 174 nor eligible for IRC 41 Research and Development tax credit. Rather, these payments are capital expenditures subject to capitalization and amortization rules (IRC 263(a) and 197 and the Treasury Regulations that govern them) and the participation privilege is an acquired intangible right with a useful life of more than one year.

The directive also discusses milestone payments and states that these are contingent payments based on successfully completed research to a defined stage. Since these payments are capital expenditures, they are eligible for depreciation/amortization 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 directive states that companies have been taking the position that the receipt of nonrefundable payments is deferrable into income over the life of the agreement. This may be true for financial statement purposes; however I am not aware of any situation like this for tax of receipt, all money is taxable in the year of receipt based on the Rev. Proc. 2004-34. The directives statement confirms that this is the proper treatment.

Taxpayers may defer to the next succeeding taxable year the inclusion in gross income for federal income tax purposes of advance payments to the extent the advance payments are not recognized in revenues in the taxable year of receipt as per Revenue Procedure ("Rev. Proc") 2004-34. With certain exceptions for short years the Rev. Proc. does not allow deferral to a taxable year later than the succeeding taxable year.

As stated above, these payments have been treated as qualifying expenses for research tax credit. The directive states that these payments may represent payments to participate (entry fees) in the research endeavor or they represent payments for already developed know how, thus are not a cost of research that is yet to be performed. Rather, these payments are capital expenditures subject to capitalization rules and the participation privilege is an acquired intangible right with a useful life of more than one year.

Is this the IRS position going forward?

Well, indirectly it is, however they are still gathering data and and we will hear more about it.

What is the next step for a biotech or pharmaceutical company with a collaboration agreement?

Every company that has collaborating agreements should analyze them and determine how they have been treating them for tax and book purposes in anticipation of examination scrutiny. Then they should consider whether an accounting method change may be necessary for tax purposes.

Any Last Thoughts?

Yes, these rulings all correlate to the FASB issuance of EITF 07-03 "Accounting for non-refundable advance payments for goods and services to be used in future research and development activities" which is effective for fiscal years beginning after Dec. 15, 2007.

In addition, companies should consider how this may affect them in their calculation of corporate income taxes (FASB 109) and uncertainty in corporate income taxes (FIN 48), which for some may be a major issue.

The EITF Task Force concluded that nonrefundable advance payments for future R&D activities should be deferred and capitalized. Such amounts should be recognized as an expense as the goods are delivered or related services are performed. If any entity does not expect the goods or services to be rendered, the capitalized advance payment should be charged to expense. John Pennett, partner in charge of Amper’s life science practice indicated "This statement will require companies to develop tracking mechanisms to determine the amounts of the services that should be recognized in each period, and this will likely require the cooperation of the service provider." The effect of initially adopting this EIFT will be reflected as a change in accounting principle through a cumulative effect adjustment to retained earnings.

Michael Hadjiloucas is a partner in the Tax Department of Amper, Politziner & Mattia and a member of the firm’s Life Sciences Group. He can be reached at (732) 287-1000.