Industry Director Directive on the Proper Treatment of Upfront Fees, Milestone Payments, Royalties and Deferred Income

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

Large and Mid-Size Business Division

LMSB Control No.: LMSB-04-0407-037
Impacted IRM 4.51.2

May 7, 2007

MEMORANDUM FOR INDUSTRY DIRECTORS
                                       DIRECTOR, FIELD SPECIALISTS
                                       DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
                                       DIRECTOR, INTERNATIONAL COMPLIANCE
                                       STRATEGY AND POLICY
                                       DIRECTOR OF EXAMINATION, SBSE

FROM:                          John Risacher    /s/ John Risacher
                                       Industry Director
                                       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
                                       Pharmaceutical Industries

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:

Planning and Examination Guidance:

Potential Issues:

• Issue 1 – Licensee 1/Payor Perspective
  Are non-refundable upfront fees, technology access fees and milestone payments under a collaboration agreement:
  • deductible under I.R.C. §162 as ordinary and necessary expenses paid or incurred in carrying on a trade or business?
  • allowable under I.R.C. §174 as research and experimental expenditures?
  • capital expenditures under I..R.C. §263(a) for the acquisition or creation of an intangible asset?

1 The language used, such as the term “licensee,” is not controlling.  Whether the agreement involves a true license or an assignment must be construed according to what is transferred and what is retained.

• Issue 2 – Licensee/Payor Perspective
  Are royalties paid or incurred under a collaboration agreement:
  • deductible under I.R.C. §162 as ordinary and necessary expenses paid or incurred in carrying on a trade or business?
  • capital expenditures under I.R.C. §263A?
• Issue 3 – Licensor/Payee Perspective
  Whether the receipt of non refundable upfront fees, technology access fees and milestone payments are income in the year of receipt or are deferrable over the life of the contract?
• Issue 4 – Relationship of I.R.C. §174 to I.R.C. §41 Research Credit
  Whether the upfront fees, technology access fees and milestone payments that do not qualify under I.R.C. §174 can qualify for the research credit under §41?

Issue Identification:

Step 1: Steps to Determine if Potential Issue Exists

• External Sources
  • It is recommended that the examiner, upon assignment of a pharmaceutical case, visit the company’s website for information on the company’s business practices and additional news items. The company website will most likely have a link to the SEC site.  If the taxpayer is required to file with the SEC (either Form 10K for a U.S. based company or a Form 20F for a foreign parent), the appropriate years should be downloaded as experience dictates that collaboration agreements will be identified either in the overall business activities description or in the Notes to Financial Statements due to the significance of the agreements.  The internet can also be searched based on the ticker symbol for publicly held corporations.  For smaller IC cases, the Capital IQ database possesses a wealth of information on many privately-held companies (if such access is not available, contact the industry Technical Advisor for assistance).
  • In addition, the examiner is encouraged to visit the pharmaceutical/biotech intranet web page.  Also, the industry technical advisors should be contacted to determine if there have been published articles on licensing agreements involving their taxpayer. It is always good practice to visit the business section of noted newspapers (NY Times, Wall Street Journal, etc.) for articles on the taxpayer, as this issue will generate significant appeal to the business community.  A historical file should be maintained for this and any other newsworthy articles.
• Internal Sources 
  • It is recommended that the examiner, as standard practice, review the corporate minutes to look for any mention of the company having entered into any collaboration agreements with third parties.  If the examiner is already aware of their existence from the pre-planning phase noted above, the minutes should provide the corporate insight as to the parties involved, the amount of the transaction and the company’s expectations as a result of the collaboration.
  • If the taxpayer, as licensee, has expensed the upfront fees and milestone payments based on these collaboration agreements, the examiner should consider the payments may be classified on the 1120 return under the following categories:
    • Line 26, Other Deductions, utilizing descriptions such as:
      • Legal Fees and Settlements
      • License Fees
      • Contract Research
      • Advance Payment for Research Activities
      • Miscellaneous Expense etc.
    • Form 6765, Credit for Increasing Research Activities identified as follows:
      • Part I, Section A, Regular Credit – Line 8 Contract Research
      • Part I, Section B, Alternative Incremental Credit – Line 26 Contract Research
      • Incremental Credit – Line 26 or 27 (depending on the year) Contract Research
      • Section C  - Alternative Simplified Credit  - Line 52  of Contract Research
    • Schedule M-3 as
      • Other Amortization or Impairment of Write-offs – Line 28 or
      • Other expense/deduction items with differences – Line 35
  • If the taxpayer, as licensee, has capitalized the upfront fees and milestone payments from these collaboration agreements, the examiner should consider the following during the review of the 1120 return:
    • Line 20, Depreciation/Amortization
    • Schedule L, Line 13A, Intangible Assets (relative to the useful life assigned by the taxpayer to these collaboration agreements.
  • If the taxpayer, as licensor of the Intellectual Property (IP), has treated the receipt of the non-refundable upfront fee and milestone payments as deferred income over the life of the collaboration agreement, examiners should appropriately consider whether the payments are income in the year of receipt under Treas. Reg. § 1.451-1(a), and whether deferral should be limited to the next succeeding taxable year as required under Revenue Procedure 2004-34.  Examiners should review the following line items when reviewing the 1120 to determine the taxpayer’s treatment of the receipt of such payments:
    • Line 10 of the 1120 Other Income as:
      • Contract Research
      • Advance Payment for Research Activities
      • Deferred revenue
    • Schedule M-3 as:
      • Part II, Line 20, Unearned Deferred Revenue or
      • Part II, Line 26, Other Income (loss) items with differences.
    • Schedule L of the 1120 - Line 18 - Other Current Liabilities as:
      • Deferred revenue
  • If the examination involves a CIC or IC case, a question should be posed at the opening conference to determine if the company has entered into any collaboration agreements for the current exam period or in earlier exam periods. Whatever the taxpayer’s response, such response should be reduced to writing in the initial IDR to the taxpayer or in a subsequent IDR (see sample IDR attached).  Copies of any/all collaboration agreements that were entered into for such examination period should be requested early in the examination process. Dollar criteria may be established when requesting such agreements depending on the size of the taxpayer being examined (e.g. CIC v. IC).

Step 2: Suggested Examination Resources to Examine Issue

Development of these issues is highly complex and requires a multi-functional approach including:

• the examination team;
• requesting assistance from the TA Team; 
• requesting assistance from local LMSB Counsel (failure to obtain the assistance of local LMSB Counsel may affect the viability of any proposed adjustment). This should be considered as part of the risk analysis; and
• considering assistance from other technical members of the Issue Management Team for License Fee Issues.

Step 3: Planning and Examination Risk Analysis

An Issue Management Team (IMT) has been established to ensure appropriate examination coverage and a consistent approach to the development and resolution of issues related to collaboration agreements which require the payment or receipt of non-refundable upfront fees, milestone payments, royalties, and deferred revenue.

Note: If the payment is not refundable even if the research is not performed or completed then it is, in reality, a license fee and we treat it accordingly. (No one pays for advance services without including a refund provision if the services are not provided.)

LMSB Position:

The upfront and milestone payments are capital expenditures under I.R.C. § 263(a) for the rights to exploit the technology in a specific geographic area and, as such, said payments are eligible for depreciation/amortization under I.R.C. § 167.  If the taxpayer has capitalized these payments, the period of write-off will be dictated by the terms of the agreement, plus any additional renewal options; the remaining life of the patent; or the safe harbor amortization period of 15 years.  If the taxpayer has expensed these amounts under I.R.C. § 174 and/or has taken a research credit under I.R.C. § 41, it is recommended that such amounts be capitalized as aforementioned and that the depreciation/amortization period begin on the date that the licensee and licensor entered into the agreement.

The above statements apply to the licensee, but should the taxpayer be the licensor, and treat the receipt of such payments as deferred income over the life of the agreement, examiners should appropriately consider including the payments as income in the year of receipt under Treas. Reg. § 1.451-1(a) with a potential limited deferral to the next succeeding taxable year as required under Revenue Procedure 2004-34. The position has been described in a Coordinated Issue Paper (CIP) which is currently under review at National Office before being submitted to Treasury for review and concurrence.  If approved, the CIP will be disseminated to the field for implementation.

Should the taxpayers accept the conclusions espoused by the paper, examiners are advised to enter into a closing agreement with the taxpayer utilizing Form 906 for this specific issue.

Effect on Other Guidance:

An Emerging Issue Alert dated 7/7/2005 was posted to the Biotech and Pharmaceutical website advising examiners of this potential material issue within the industry.  A CIP for the issue has currently been submitted for review to National Office, and when the paper clears the approval process, it will replace the Alert and provide specific guidance to the field for the preparation of audit plans.

Compliance Assurance Process (CAP) cases:

If the taxpayer enters into collaboration agreements during Compliance Assurance Process (CAP) years covering 2006 or 2007, the team must address this issue in accordance with the audit guidelines presented in this directive.

Issue Management Team (IMT) Coordination Process:

The Issue Management Team (IMT), which includes representatives from the Retailers, Food, Pharmaceuticals, and Healthcare (RFPH) Industry, Pre-filing and Technical Guidance (PFTG), and Field Specialist(s), has been established to provide guidance, as well as provide advice when requested on all issues under examination that are related to the proper treatment of non-refundable upfront fees, milestone payments, royalties, and deferred revenue upon entering into a collaboration agreement in the biotech and pharmaceutical industries.  Accordingly:

1. A copy of all Form 5701 proposed adjustments should be submitted to the IMT c/o Louis Milano.
2. A copy of all final resolutions at the field level should be submitted to the IMT c/o Louis Milano.

Teams can contact Louis Milano, Biotech/Pharmaceutical Technical Advisor at 908-301-2106 or Louis.Milano@irs.gov for submissions and coordination with this process.

Audit Techniques:

The attached audit guidelines outline the framework and resources to assist examiners addressing issues related to the proper treatment of non-refundable upfront fees, milestone payments, royalties, and deferred revenue upon entering into a collaboration agreement in the biotech and pharmaceutical industries.  As this IMT initiative evolves, further examination guidance may be developed to supplement the information provided in this directive and accompanying guidelines.

cc:  Commissioner, LMSB
        Deputy Commissioner, LMSB
        Deputy Commissioner, International
        Division Counsel, LMSB
        Commissioner, SBSE
        Chief, Appeals        
        Director, Performance, Quality and Audit Assistance
        Director, Strategy, Research and Program Planning        

Attachment: 
Audit Guidelines Related to the Proper Treatment of Non-Refundable Upfront Fees, Milestone Payments, Royalties and Deferred Income upon Entering into Collaboration Agreements in the Biotech and Pharmaceutical Industries