Non Refundable Upfront Fees, Technology Access Fees, Milestone Payments, Royalties and Deferred Income under a Collaboration Agreement
Effective Date: October 18, 2007
Coordinated Issue Paper
Biotech and Pharmaceutical Industries
Non Refundable Upfront Fees, Technology Access Fees, Milestone Payments, Royalties and Deferred Income under a Collaboration Agreement
This Coordinated Issue Paper addresses the tax treatment of upfront, milestone, and royalty payments pursuant to collaboration agreements that are between unrelated domestic parties in the pharmaceutical and biotechnology industries, generally for drug development. Collaboration agreements are defined below, with examples of the typical drug development scenarios that would be within the parameters of this paper. The paper does not apply to, or address, cost sharing agreements. Consult Treas. Reg. § 1.482-7 for cost sharing agreement guidance. The reader should refer to the end of the paper for an enumeration of this and other issues that are outside the parameters of this paper.
Issue 1 – Licensee/Payor Perspective
Are nonrefundable 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?
Conclusion: Generally, they are not currently deductible under I.R.C. § 162 because they are paid for the creation of an asset with a useful life of more than one year.
- allowable under I.R.C. § 174 as research and experimental expenditures?
Conclusion: They are not allowable under I.R.C. § 174 because they represent payments a) to participate (entry fees) in the research endeavor, b) for already developed know how or processes, or c) for research that is not to be performed at the taxpayer’s risk.
- capital expenditures under I.R.C. § 263(a) for the acquisition or creation of an intangible asset?
Conclusion: They are capital expenditures. The right to participate in the research (“participation privilege”) is an intangible asset with a useful life of more than one year. See Treas. Reg. § 1.263(a)-4(b)(1) and (3); Treas. Reg. § 1.263(a)-4(c)(1); and Treas. Reg. § 1.263(a)-(4)(d)(6).
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?
Conclusion: If they represent costs of acquiring an asset with a useful life of more than 1 year, they are to be capitalized under I.R.C. § 263(a). If they represent direct or indirect costs of property produced by the taxpayer or acquired for resale, these need to be capitalized under I.R.C. § 263A. Either capitalization section, I.R.C. §§ 263(a) or 263A, trumps a current deduction under I.R.C. § 162.
- capital expenditures under I.R.C. § 263A?
Conclusion: If these do not represent research and experimental expenditures within the meaning of I.R.C. § 174, and if these do represent direct or indirect costs of property produced by the taxpayer or acquired for resale, they are capital expenditures subject to the Uniform Capitalization Rules of I.R.C. § 263A. See Treas. Reg. §§ 1.263A-1(e)(3)(iii)(B) and 1.263A-1(e)(3)(ii)(U).
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?
Conclusion: These fees cannot be deferred over the life of the contract but must be included in accordance with taxpayer’s method of accounting. Cash method taxpayers recognize these items of income in the year of receipt whereas accrual method taxpayers recognize this income in the year the all-events test under Treas. Reg. § 1.451-1, is satisfied. However, if an accrual method taxpayer receives payments in advance of performance, then the income must be included in the year received unless deferral is permitted under Rev. Proc. 2004-34, 2004-1 C.B. 991.
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 I.R.C. § 41?
Conclusion: No. Under I.R.C. § 41(d)(1), an expense must be a research expenditure under I.R.C. § 174, as well as meet other research credit requirements, to be considered a qualified research expense under I.R.C. § 41(b). Since it has been concluded that these expenditures do not qualify under I.R.C. § 174, they are not eligible for the research credit. It should be noted that not all research expenditures that qualify under I.R.C. § 174 will meet the requirements to be considered “qualified” research expenses under I.R.C. § 41(b) for purposes of determining the research credit.
In order to put the issues into perspective, some definitions, a brief background of the drug development process, and some typical collaboration agreement fact patterns are provided.
Collaboration Agreements: Collaboration agreements are agreements for joint research, experimentation or development, as well as agreements for the sharing of know-how or patents for the purpose of research, experimentation or development. Collaboration agreements can take the form of a license agreement, an alliance agreement, a co-marketing agreement or a functional equivalent of such. Collaboration agreements may use different terminology for the same type of fees described in this document. The tax treatment of the payments provided for in collaboration agreements is controlled by the nature of the payments, not the label given to the payment in the collaboration agreement.
Upfront Payments: These payments may be labeled differently in any particular agreement, e.g., upfront fees, technology access fees, access user fees, license issue fees, etc. They are non-refundable payments due upon execution of the agreement, or at a later agreed upon time. Their payment is not contingent on successful completion of research.
Milestone Payments: These payments may be labeled differently in any particular collaboration agreement. They are non-refundable payments due upon the (or as the result of) successful research. These payments in part are designed to compensate the licensor for the increased value of the intellectual property as it progresses through its development, clinical or regulatory phase, and is getting closer to marketability.
PHARMACEUTICAL/BIOTECHNOLOGY DRUG DEVELOPMENT PROCESS
The pharmaceutical/biotech drug development process is generally composed of four stages: Preclinical or discovery research, clinical development, regulatory approval, and post marketing. These stages take approximately 10 to 12 years to complete.
In the preclinical or discovery research stage (typically the first two years of the discovery/development process), a compound is tested on animals and non-human systems. If the compound/molecule looks promising at this stage, it is patented. The patent prevents other companies from freely using the same compound/molecule for 20 years (life span of a patent). The Food and Drug Administration (FDA) established a set of standards (called “Good Laboratory Practice”) for this stage of development to ensure quality of animal testing and the resultant data for an Investigational New Drug Application (IND). If the IND is approved by the FDA, testing of the compound/molecule in humans can begin.
This second stage is known as clinical development. Clinical development (typically spans 5 to 7 years or years 3 through 10 of the discovery/development process), is normally conducted in three phases. In Phase I, the first trials in humans are conducted for safety, tolerance and pharmacokinetics. In Phase II, testing is done to evaluate effectiveness, dosage and safety in selected populations of patients with the disease or condition to be treated, diagnosed or prevented. In Phase III, expanded clinical trials are conducted to gather additional evidence to verify dosage and effectiveness for specific indications and to better understand safety and adverse effects. These are large-scale trials typically involving thousands of patients to prove effectiveness against a specific disease or condition.
The third stage, known as the regulatory approval stage, begins after Phase III trials have been completed (typically spans 12 to 18 months or years 11 and 12 of the discovery/development process). Sponsors file a New Drug Application (NDA) with the FDA to obtain authorization to market a new pharmaceutical product. The NDA consists of clinical and non clinical data on the product’s safety and effectiveness and a full description of the methods, facilities, and quality controls employed in manufacturing and packaging. Until the FDA grants authorization, a drug sponsor cannot market the drug in the United States.
The final stage, post-marketing studies (also called Phase IV) occurs after the product has received FDA approval. These studies are performed to determine the incidence of adverse reactions, to determine the long-term effect of a drug, to study a patient population not previously studied, and to conduct marketing comparisons against other products and other uses.
In the pharmaceutical and biotech industries it is common for companies to license from related and unrelated parties promising research candidates at various stages of discovery/development. Fees are paid in order to acquire the rights to use or exploit such promising research or know-how which may lead to the development of a bio-pharmaceutical product. Each year billions of dollars are paid in licensing fees and other commitments. Analysis indicates the inconsistent treatment of these fees by taxpayers.
TYPICAL FACT PATTERNS
The parties to the drug development scenarios addressed below are unrelated domestic parties, and are not entering into a cost sharing agreement within the parameters of Treas. Reg. § 1.482-7.
Company A (Licensor/payee) has a promising research program that is developing a potential drug candidate. Company B (Licensee/payor) is interested in A’s research and know-how for this potential drug candidate. B decides to enter a License and Development agreement with A for purpose of developing, marketing and selling the potential product if approved by the FDA. B pays a nonrefundable upfront fee of X0 millions of dollars as part consideration for rights granted under the agreement.
As part of the agreement, A will continue the research and development of the product. B will reimburse A for certain research costs up to $Y per year but no more than the actual costs incurred by A in that year.
The agreement also calls for B to pay A milestone payments contingent on certain research goals being achieved. For example, B will pay A, X1 millions of dollars upon successful completion of each of Phase I, Phase II, and Phase III drug development. B will also pay A X2 dollars upon the filing of a New Drug Application (NDA) and X3 millions of dollars upon the approval of the product by the FDA or other foreign approval agency.
The agreement also calls for B to pay A royalties upon the commercialization of a bio-pharmaceutical product. The royalties are for the right to make and sell the licensed bio-pharmaceutical product.
Company C (Licensor/payee) has a valuable proprietary platform technology (genomic database) for use in drug research. Company D (Licensee/payor/researcher) is interested in acquiring access to C’s proprietary platform technology. D enters into a technology access agreement with C for use in its drug development process. D pays a nonrefundable upfront technology access fee of X0 millions of dollars as part consideration for rights granted under the agreement.
The agreement also calls for D to pay C milestone payments contingent on certain research goals being achieved. D will pay C X1 millions of dollars upon successful completion of each of Phase I, Phase II, and Phase III drug development. D will also pay C X2 dollars upon the filing of an NDA and X3 millions of dollars upon the approval of the product by the FDA or other foreign approval agency.
The agreement also calls for D to pay C royalties upon the commercialization of a bio-pharmaceutical product which incorporates the use of the platform technology.
ANALYSIS AND DISCUSSION
When considering the tax treatment of non-refundable upfront fees, technology access fees, and milestone payments, it is essential that the examiner obtain copies of all agreements and relevant documents with respect to the transfer of the intellectual property rights at issue (e.g., patents, know-how, trade secrets, and access to these rights). Dramatically different tax consequences may result from differences in the structuring of the transactions as a sale or license.
In examining the taxpayers’ documents, the examiner needs to be cognizant that terms such as “royalties,” “licensee,” and “licensor,” are relevant but not determinative as to the nature of the transaction (i.e., sale vs. license). See Juda v. Commissioner, 877 F.2d 1078 (1st Cir. 1989), aff’g. 90 T.C. 1263 (1988) (among other cases), where the court ruled that the substance of the transaction, rather than the label applied to the transaction, is the relevant analysis for making the determination.
An initial consideration would be whether the agreement involves the sale of intangible property, rather than upfront & milestone payments under a collaboration agreement or, possibly, an agreement which is part sale and part collaboration. Typically, even where the research is clearly going to be successful, the examiner is unlikely to encounter a party that is actually selling this proven research outright, as this proven technology may be that going concern’s most valuable asset and/or it may serve as the base for the development of further intangibles. If sold the sale may be on a contingency of use basis. Be that as it may, where the upfront and milestone payments represent purchase proceeds for all substantial rights to the research, the payments are for the purchase of an asset with a useful life of more than one year, and they should be capitalized under I.R.C. § 263(a). See, Treas. Reg. § 1.263(a)-4(c)(1)(vii). Similarly, an amount paid to create a right to use intangible property, such as a license of patented technology, must generally be capitalized under Treas. Reg. § 1.263(a)-4(d)(6). This includes milestone payments that are paid, ultimately, to create the right to use the technology to manufacture or distribute marketable pharmaceuticals in the future. Capitalized amounts relating to failed research or trials may be deductible under I.R.C. § 165. For successful research, capitalization under I.R.C. § 263A may also be applicable. See issue 2.
Whether non refundable upfront fees, technology access fees, and milestone payments paid or incurred under a collaboration agreement are deductible under I.R.C. § 162, I.R.C. § 174 or are capital expenditures under I.R.C. § 263(a).
Prior to the enactment of the 1954 Internal Revenue Code, taxpayers generally deducted research and development expenses under the predecessor to I.R.C. § 162. I.R.C. § 162 and Treas. Reg. § 1.162-1(a) generally allow a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. To qualify for deduction under I.R.C. § 162, the expenditure must be (1) an expense, (2) ordinary, (3) necessary, (4) paid or incurred during the taxable year, and (5) made to carry on a trade or business. See, Commissioner v. Lincoln Savings and Loan Association, 403 U.S. 345, 352 (1971) [71-1 USTC ¶9476].
As a general rule, expenditures to develop or create an asset with a useful life beyond the taxable year must be capitalized rather than deducted in the year incurred or paid. Where the capitalized expenses are for depreciable assets, cost recovery generally is in the form of depreciation allowances. However, the cost of non-depreciable assets generally are not recovered until the asset is disposed of or abandoned. I.R.C. § 174 was enacted to encourage research by providing specific statutory authority for the current deduction or amortization of qualifying “research and experimental” (“R&E”) expenditures. See S. Rep. No. 1622, 83d Cong., 2d Sess. 33 (1954).
I.R.C. § 174 provides a limited exception to the general rule that would require the capitalization of assets with a useful life beyond the taxable year. Under I.R.C. § 174, a taxpayer may elect to currently deduct or amortize eligible R&E expenses incurred in connection with his trade or business. Thus, R&E expenses are deductible even when they are treated as capital account charges or deferred expenses for book purposes, (i.e., in the taxpayer’s books or financial statements), and when they would have been capitalized for tax purposes, in the absence of I.R.C. § 174.
A taxpayer may elect I.R.C. § 174 treatment for research conducted directly by the taxpayer and, in general, for expenses paid or incurred for research conducted on behalf of the taxpayer by another person or organization (e.g., research institute, foundation, engineering company, or similar contractor). See Treas. Reg. § 1.174-2(a)(8). However, any expenditures for research or experimentation carried on in the taxpayer’s behalf by another person are not expenditures to which I.R.C. § 174 relates, to the extent that they represent expenditures for the acquisition or improvement of land or depreciable property, used in connection with the research or experimentation, to which the taxpayer acquires rights of ownership. See Treas. Reg. § 1.174-2(a)(8).
Treas. Reg. § 1.174-2(b)(2) provides, in relevant part, that expenditures for research or experimentation which result, as an end product of the research or experimentation, in depreciable property to be used in the taxpayer's trade or business may, subject to the limitations of Treas. Reg. § 1.174-2(b)(4), be allowable as a current expense deduction under I.R.C. § 174(a).
Treas. Reg. § 1.174-2(b)(3) provides, in relevant part, that if expenditures for research and experimentation that are incurred in connection with the construction or manufacture of depreciable property by another are deductible under I.R.C. § 174(a) only if made upon the taxpayer's order and at his risk. No deduction is allowed if the taxpayer purchases another's product under a performance guarantee (whether express, implied, or imposed by local law) unless the guarantee is limited, to engineering specifications or otherwise, in such a way that economic utility is not taken into account.
Finally, Treas. Reg. § 1.174-2(b)(4) provides, in relevant part, that the deductions referred to in Treas. Reg. § 1.174-2(b)(2) and (3) for expenditures in connection with the acquisition or production of depreciable property to be used in the taxpayer's trade or business are limited to amounts expended for research or experimentation. Thus, amounts expended for research or experimentation do not include the costs of the component materials of the depreciable property, the costs of labor or other elements involved in its construction and installation, or costs attributable to the acquisition or improvement of the property.
The Internal Revenue Code does not set forth any specific definition of “research or experimental” expenditures. If the licensee/payor is acquiring the rights to know-how, processes, formula or similar property, several paragraphs of Treas. Reg. § 1.174 apply to the determination of whether the licensee/payor is entitled to include those expenditures as I.R.C. § 174 expenses. Treas. Reg. § 1.174-2(a)(1) provides, in relevant part, that the term research or experimental expenditures, as used in I.R.C. § 174, means expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product. Expenditures represent research and development costs in the experimental or laboratory sense if they are for “activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.”
Under Treas. Reg. § 1.174-2(a)(2) the term “product” includes: any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license. However, it is important to note that, Treas. Reg. § 1.174-2(a)(3)(vi), provides, as follows:The term research or experimental expenditures does not include expenditures for the acquisition of another's patent, model, production or process.
For example: If a payment is only made if the research is successful such as the approval of an NDA by the FDA, this is a form of guarantee for which the licensee is not at risk.
I.R.C. § 263(a) prohibits a deduction for capital expenditures. I.R.C. § 263(a) and Treas. Reg. § 1.263(a)-1(a) provide that no deduction is allowed for any amount paid out for permanent improvements or betterments made to increase the value of any property or estate. Treas. Reg. § 1.263(a)-2(a) provides that capital expenditures include the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year. Treas. Reg. § 1.263(a)-4 provides rules for the acquisition or creation of intangible assets (including transaction costs), and identifies those intangibles for which capitalization is specifically required.
The distinction between currently deductible expenses and expenditures subject to capitalization is fundamental in preventing the distortion of taxable income that results from the current deduction of expenditures that benefit the production of income in future taxable years. See Commissioner v. Idaho Power Co., 418 U.S. 1, 16 (1974). The Supreme Court also has ruled that expenditures that create or enhance a separate and distinct asset are subject to capitalization under I.R.C. § 263(a). See Commissioner v. Lincoln Savings & Loan Ass’n., 403 U.S. 345 (1971); Treas. Reg. § 1.263(a)-4(b)(1)(iii).
With regard to the treatment of nonrefundable upfront fees, technology access fees, and milestone payments, the determination of the proper treatment of the payment requires an examination of the facts and circumstances of each particular case, based on a thorough review of all relevant documents and agreements between the parties to determine whether the transaction is a purchase of an intangible or a license to use intangible property. In either case it is likely such payments will be required to be capitalized under I.R.C. § 263(a) and the regulations thereunder, and recovered through amortization.
In the case of created intangibles, capitalization is required for expenditures as described in eight categories of created intangibles. Included in those categories is the creation of certain contract rights. Treas. Reg. § 1.263(a)-4(d)(6) requires capitalization for
“…amounts paid to another party to create, originate, enter into, renew or renegotiate with that party---
(A) an agreement providing the taxpayer the right to use tangible or intangible property or the right to be compensated for the use of tangible or intangible property;
(B) an agreement providing the taxpayer the right to provide or to receive services (or the right to be compensated for services regardless of whether the taxpayer provides such services);”
In addition, Treas. Reg. § 1.263(a)-4(b)(1)(iii) requires capitalization for “…an amount paid to create or enhance a separate and distinct intangible asset within the meaning of paragraph (b)(3) of this section.” Treas. Reg. § 1.263(a)-4(b)(3) provides that:
“The term separate and distinct intangible asset means a property interest of ascertainable and measurable value in money’s worth that is subject to protection under applicable State, Federal, or foreign law and the possession and control of which is intrinsically capable of being sold, transferred or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business…The determination of whether a payment creates a separate and distinct intangible asset is made based on all of the facts and circumstances existing during the taxable year in which the payment is made.” Treas. Reg. § 1.263(a)-4(b)(3).
Whether royalties paid or incurred under a collaboration agreement are deductible under I.R.C. § 162 or are capitalized under I.R.C. § 263A.
The examiner must consider the nature of the payment, i.e., the purpose of the payment and whether the property being acquired is going to be used in the taxpayer’s production activities, within the meaning of I.R.C. § 263A and regulations thereunder. Though royalties are generally deductible in a manner similar to rent, the examiner should consider whether the payments are required to be capitalized under Treas. Reg. § 1.263(a)-4, as a cost to create or acquire an intangible asset.
Payments that are not required to be capitalized under Treas. Reg. § 1.263(a)-4—and the allowable amortization with respect to payments that are—may still need to be capitalized under UNICAP. See I.R.C. § 263A. I.R.C. §§ 263A(a) and (b) generally require that all direct costs and indirect costs allocable to property produced by the taxpayer or acquired for resale shall be capitalized or included in inventory, respectively. Royalty payments are specifically identified as indirect costs that must be capitalized. Treas. Reg. § 1.263A-1(e)(3)(ii)(U) states, “licensing and franchise costs include fees incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or property acquired for resale. These costs include the otherwise deductible portion (e.g., amortization) of the initial fees incurred to obtain the license or franchise and any minimum annual payments and royalties incurred by a licensee or a franchisee.”
The determination of whether royalties are an expense or are subject to the capitalization rules of I.R.C. § 263A is based on a careful examination of the particular facts and circumstances of each situation. The examiner should read Plastics Engineering & Technical Services, Inc. v. Commissioner, T.C. Memo, 2001-324. In Plastics Engineering & Technical Services, supra, the U.S. Tax Court held that royalty payments made by a taxpayer for certain assembly systems covered by patent were indirect costs to the production of the end products, and, thus, capitalized and included in inventory, pursuant to the UNICAP rules. The case is a good source for an examiner to quickly obtain the applicable law and analysis in this area.
In conclusion, one would expect that, generally, the costs are to be capitalized under I.R.C. § 263A.
Whether the receipt of nonrefundable upfront fees, technology access fees, and milestone payments are income in the year of receipt or are deferrable over the life of the contract.
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.
Taxpayers on the cash method of accounting recognize income in the year of receipt. For taxpayers on the accrual method of accounting, which will generally be the case, 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); Rev. Rul. 84-31, 1984-1 C.B. 127.Rev. Proc. 2004-34, 2004-1 C.B. 991, provides accrual method taxpayers two permissible methods of accounting for advance payments: (1) the Full Inclusion Method whereby advance payments are included in gross income when received, and (2) the Deferral Method which allows taxpayers a limited deferral beyond the taxable year of receipt for certain advance payments, including advance payments for the licensing of patents. Section 4.01(3)(c) of Rev. Proc. 2004-34.
Qualifying taxpayers with applicable financial statements (as defined in section 4.06 of Rev. Proc. 2004-34), who have adopted the Deferral Method, generally may defer to the next succeeding taxable year the inclusion of advance payments (as defined in section 4 of Rev. Proc. 2004-34) in gross income for federal income tax purposes to the extent the advance payments are not recognized in revenues in the taxable year of receipt on the taxpayer’s applicable financial statements. Taxpayers that do not have applicable financial statements must include advance payments in gross income in the year that they are earned as described in section 5.02 (3)(b) of Rev. Proc. 2004-34. Even a taxpayer that has applicable financial statements may not defer the inclusion of payments in gross income if the related obligation to perform is satisfied. Section 5.02(5)(b) of Rev. Proc. 2004-34. Except, as provided in Section 5.02(2) of Rev. Proc. 2004-34, for certain short taxable years, this revenue procedure does not permit deferral to a taxable year later than the next succeeding taxable year.
Therefore, nonrefundable upfront fees, technology access fees, and milestone payments are income in the year of receipt unless Rev. Proc. 2004-34, permits deferral to the next succeeding taxable year.
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 I.R.C. § 41.
I.R.C. § 41(d)(1) states: the term “qualified research” means research ---- (A) with respect to which expenditures may be treated as expenses under I.R.C. § 174. Therefore, any expenditure that fails to meet the I.R.C. § 174 definition of R&E expenses also will fail to qualify for the research credit under I.R.C. § 41(d)(1). It is very important to note that even if an expenditure qualifies under I.R.C. § 174, it may not qualify for the research credit under I.R.C. § 41, because there are additional requirements that must be met to qualify for the credit. See I.R.C. § 41.
The upfront payments and technology access fees under the terms of the License and Development Agreement are payments for access to existing know-how. Amounts that are paid for the acquisition of another's patent, model, production or process are ineligible for the expense election under I.R.C. § 174. Similarly, I.R.C. § 174 does not apply to any expenditure for the acquisition of depreciable or amortizable "property" to be used in connection with research or experimentation. I.R.C. § 174(c) and Treas. Reg. § 1.174- 2(b).
The milestone payments under the terms of the License and Development Agreements are contingent on research goals being achieved. Therefore, the expenditures for the research and experimentation to be conducted under the mandated milestones are not at the taxpayer’s risk. As such, the milestone payments do not constitute R&E expenditures under I.R.C. § 174 nor qualified contract research expenditures under I.R.C. § 41.
I.R.C. § 167(a) allows as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance of obsolescence) of property used in the trade or business or property used in the production of income. Amounts paid or incurred for the acquisition or creation of intangibles under Treas. Reg. § 1.263(a)-4 must be capitalized and such amounts may be the subject of an allowance for depreciation (amortization). Treas. Reg. § 1.167(a)-3(a) provides that, if the usefulness of an intangible asset in the taxpayer’s trade or business may be reasonably estimated from experience or other known factors, then an allowance for depreciation is permitted. However, if the useful life of an intangible asset is not limited, the property is not subject to depreciation.
Under the facts described, the patents and license agreements are not acquired as part of a purchase of a trade or business and therefore are not I.R.C. § 197 intangibles. Treas. Reg § 1.167(a)-14 addresses the recovery of the costs of certain intangible assets that are not I.R.C. § 197 intangibles. Treas. Reg. §§ 1.167(a)-14(c)(2)(ii) and (c)(3) provide that the basis of a right to an unspecified amount of tangible property or services over a fixed duration of less than 15 years under a contract (or granted by a governmental unit) is amortizable ratably over the period of the right including any renewal period.
Treas. Reg. § 1.167(a)-14(c)(4) provides that if the purchase price of an interest in a patent is payable on at least an annual basis as either a fixed amount per use or as a fixed percentage of revenue, then the depreciation deduction is equal to the payments paid or incurred during the taxable year. Otherwise, the basis in a patent or copyright is depreciated either ratably over its remaining useful life or under I.R.C. § 167(g) (income forecast method). If a patent or copyright becomes valueless in any year before its legal expiration, the adjusted basis may be deducted in that year.
Treas. Reg. § 1.167(a)-3(b) provides a safe harbor amortization period for certain intangible assets, whereby the taxpayer may treat an intangible asset as having a useful life equal to 15 years. This safe harbor provision excludes (1) an intangible asset which has an amortization period specifically prescribed or prohibited by the Internal Revenue Code, regulations or published guidance; (2) an intangible asset described in Treas. Reg. §§ 1.263(a)-4(c) (relating to intangibles acquired from another person), or 1.263(a)-4(d)(2) (relating to created financial interests); (3) an intangible asset which has a useful life the length of which can be estimated with reasonable accuracy; or (4) an intangible asset described in Treas. Reg. § 1.263(a)-4(d)(8) (relating to certain benefits arising from the provision, production, or improvement of real property).
With regard to the capitalization of nonrefundable upfront fees, technology access fees, and milestone payments, the examiner must consider the nature of the capital expenditures in order to estimate the amortization period (if any) under I.R.C. § 167. If the payments appropriately represent amounts paid to acquire or create an intangible as described in Treas. Reg. §§ 1.263(a)-4(c), and 1.263(a)-4(d), the examiner must consider known factors, including the terms of the underlying collaborative and other agreements, in order to reasonably estimate the useful life.
Upfront and milestone payments under a collaboration agreement that is a purchase of an interest in a patent are presumably not paid on an annual basis at a fixed rate or fixed percentage of revenues, so each payment increases the amortizable basis of the asset to be recovered ratably over the asset’s remaining useful life or under the income forecast method.
If the payments are required to be capitalized, but do not represent the cost of acquiring a patent, and it can be shown that the collaboration agreement has a limited useful life but not a fixed term, it may be appropriate for the examiner to use the 15 year safe harbor provision of Treas. Reg. § 1.167(a)-3(b). Once within the safe harbor provisions of Treas. Reg. § 1.167(a)-3(b), the payments (both upfront and milestone payments) increase the amortizable basis for the remaining portion of the 15 year period.
The examiner should contact the Technical Advisors for the Pharmaceutical/Biotech Industries for additional guidance.
OTHER CONSIDERATIONS NOT ADDRESSED IN THIS PAPER
- Is it a licensing of intangible property to a controlled entity? If the parties are controlled by the same interest, then the adequacy of the transfer price under I.R.C. § 482 needs to be examined. If the two parties to the transaction are commonly controlled, within the meaning of I.R.C. § 482, thearrangement is subject to Internal Revenue Service reallocation of income and deductions, to obtain the results that would have been obtained among independent parties dealing at arm’s length. In addition the income with respect to such transfer or license must be commensurate with the income attributable to the intangible.Treas. Reg. § 1.482-4(b).
- Is the taxpayer paying another to conduct research on the taxpayer's behalf?If so, then the examiner should consider whether the agreement involves financing/passive investment
- The examiner also needs to determine the relationship of the parties to each other. Are the parties to the transaction foreign or domestic entities? If one of the parties is a foreign entity, there may be issues of whether the royalties are derived in the active conduct of a trade or business in the United States, as well as other issues involving Subpart F, income sourcing, Foreign Tax Credit, and transfer pricing under § 482.
- The examiner should be aware of Rev. Proc. 2007-23, 2007-10 I.R.B. 675, which provides a special “net-consideration method” for certain cross-licensing agreements.
 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.
 The practical effect is that the cost recovery will be different. See the discussion on Amortization below.
 Effective for amounts paid or incurred on or after 12/31/2003.
 There are exceptions to the requirement that certain created intangibles be capitalized that are unlikely to be applicable. See. Treas. Reg. §§ 1.263(a)-4(f) (the 12 month rule), and 1.263(a)-4(d)(6)(v) (de minimis rule).
 C Certain payments, though required to be capitalized under Treas. Reg. § 1.263(a)-4, may be allowed as amortization in the year paid or incurred under Treas. Reg. § 1.167-14(c)(4).
 It needs to be noted that I.R.C. § 263A does not apply to any amount allowable as a deduction under § 174. See § 263A(c)(2). Therefore, before applying § 263A to require capitalization of any expenses in question, it must be determined that these costs are not within the purview of §174.