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Pharmaceutical Industry Overview - Significant Law and Important Issues


"This document is not an official pronouncement of the law or the position of the Service and cannot be used, or cited, or relied upon as such."

7. Significant Law and Important Issues

A. Coordinated Issues



Brief Summary of Issue

Medicaid Drug Rebates

The position is that a pharmaceutical manufacturer may not accrue its rebate liability until the taxable year it receives the bill for the rebate because the all events test has not been met. The rebate liability is not fixed until the claim for reimbursement is sent by the state medicaid agency. I.R.C. 461(a),(h); Treas Reg 1.461-1(a)(2)(i); U.S. v General Dynamics 481 U.S. 239 (1987). Issue is further explained on the ISP Bulletin Board. Appeals Settlement Guidelines have been finalized and are available on the Appeals web page.  

Legally Mandated R and E Expenses

The issue is whether a taxpayer ,when allocating and apportioning its R&E expenses between U.S. and Foreign source income under Treas. Reg. 1.861-17, can exclude a category of R&E known as “legally mandated R&E” from the total R&E pool of expense prior to allocation and apportionment.  Taxpayers have to satisfy a three prong test under Treas Reg 1.861-17(a)(4) in order to exclude any R&E expenses. The tests are : the R&E has to be undertaken to meet legal requirements imposed by a political entity,  for the improvement or marketing of specific products or processes, and the results cannot reasonably be expected to generate amounts of gross income (beyond de minimis amounts) outside a single geographic source.  Taxpayers are having problems satisfying all prongs of the test, as such, any R and E expenses that were excluded as legally mandated should be placed back into the total R and E pool of expenses to be allocated and apportioned.  This issue is fact intensive and prevalent on all pharmaceutical cases. Allowing the exclusion, if all prongs of the test are not met, can have a dramatic impact on calculations of Foreign Source Taxable income utilized in the FTC limitation fraction under I.R.C. 904, Cost Sharing or Profit Split Combined Taxable Income under I.R.C. 936 and FSC Combined Taxable Income under I.R.C. 925.

A Coordinated Issue Paper was issued on   6/18/2003, an Industry Directors Directive was issued on 10/17/2003, an Appeals Settlement Guideline was issued on 12/23/2003, and a pro forma closing agreement is also available.


B.  Emerging or Other Significant Issues



Brief Summary of Issue

  Cost Segregation


The crux of cost segregation is determining whether an asset is I.R.C. §1245 property (shorter cost recovery period property) or §1250 property (longer cost recovery period property).  The most common example of §1245 property is depreciable personal property, such as equipment.  The most common examples of §1250 property are buildings and building components, which generally are not §1245 property. [1]

The difference in recovery periods has placed the Internal Revenue Service and taxpayers in adversarial positions in determining whether an asset is §1245 or §1250 property. The Biotech/Pharmaceutical industry matrix recommends the categorization and general depreciation system recovery period of various assets utilized within the industry (refer to the cost segregation industry guide attachment A). 

Government Settlements


The issue in question is whether or not a False Claims (FCA) settlement with the DOJ is deductible in its entirety as a Sec 162 (a) deduction, or is some portion a non-deductible penalty under Sec 162 (f). 

Experience has shown that almost every defendant/taxpayer deducts the entire amount of a (FCA) settlement as a business expense.  In most cases, a portion of the civil fraud settlement payment represents a penalty that is not deductible for tax purposes. 

License Fees & Milestone Payments


In the pharmaceutical and biotech industries it is common for companies to license promising research candidates at various stages of discovery/development from related and unrelated parties. 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. Preliminary analysis indicates the inconsistent treatment of these fees by taxpayers. (see Licensing Fees Emerging Issue Alert  [7/7/2005] [doc]

Section 936 – Exit Strategy

Notice 2005-21 provides guidance to U.S. corporations allowed a credit under section 936 or 30A of the Internal Revenue Code (section 936 corporations) with regard to the termination of sections 936 and 30A for tax years after 12/31/2005. Specifically, this notice discusses certain issues that are likely to arise depending on the manner in which the business of a section 936 corporation continues to be conducted after this termination. Certain issues include : the offshore migration of intangibles under section 367 and the transfer pricing of U.S.-owned intangibles under section 482 that result from the restructuring of section 936 corporations.

[1] I.R.C. §1245 can apply to certain qualified recovery nonresidential real estate placed in service after 1980 and before 1987.  See I.R.C. §1245(a)(5).
C.  Recent or Pending Legislation

Effective Date


Summary and Impact of Legislation

For expenditures paid or incurred on or after the date final regulations are published in the Federal Register

NPRM REG-105170-97 [IRB 1998-50, 10 (Dec. 14, 1998)]

Proposed regulations relating to the computation of the credit under section 41(c) and the definition of qualified research under section 41(a).

Proposed to be applicable for taxable years ending on or after the date proposed regulations are filed with the Federal Register, but are also proposed to be retroactive in certain limited circumstances to prevent abuse. To prevent taxpayers that are members of a controlled group from together claiming in excess of 100 percent of the credit with respect to prior taxable years, the rules for allocating the group credit would apply to any taxable year beginning after December 31, 1989, in which, as a result of inconsistent methods of allocation, the members of a controlled group as a whole claimed more than 100 percent of the allowable group credit.

REG-105606-99; 65 F.R. 258-263 (January 4, 2000)


Proposed regulations relating to the computation of the credit for increasing research activities (the research credit) for members of a controlled group and the allocation of the credit under section 41(f) of the Internal Revenue Code. These proposed regulations are intended to provide guidance on the proper method for computing the research credit for members of a controlled group and the proper method for allocating the group credit to members of the group.


For taxable years of a possessions corporation beginning on or after January 25, 2000.  Taxpayers may elect to apply retroactively for any open taxable year beginning after 12/31/95. 

T.D. 8868 (January 21, 2000).Section 936 Possessions Tax Credit

Final regulations relating to when a possessions corporation that adds a substantial new line of business during a taxable year or that has a new line of business that becomes substantial during the taxable years, loses its status as an existing credit claimant for that year and all years subsequent.

D.  Specific Industry Related Tax Law

Effective Date

Code Section

Summary and Impact of Law



Clinical Testing Expenses for Certain Drugs for Rare Diseases or Conditions (Orphan Drug Credit)



Credit for Increasing Research Activities



Research and Experimental Expenditures



Income from Sources within the United States



Puerto Rico and Possession Tax Credit

E.  Important Revenue Rulings or Revenue Procedures


Effective Date

Title and Number

Summary and Impact of Ruling and Procedure


Domestic Production Activities –Notice 2005-14

This notice provides interim guidance to taxpayers regarding the deduction for income attributable to domestic production activities under section 199 of the Code. Section 199 was enacted as part of the American Jobs Creation Act of 2004, and allows a deduction equal to 3 percent (for 2005 and 2006) of the lesser of the qualified production activities income of the taxpayer for the taxable year, or the taxable income of the taxpayer for the taxable year, subject to certain limits. The applicable percentage rises to 6 percent for 2007, 2008, and 2009, and 9 percent for 2010 and subsequent years. 











Repatriation of Foreign Earnings under IRC 965 –

Domestic Reinvestment Plans and Other Guidance Under Section 965 Notice 2005-10

Limitations on Dividends Received Deduction and Other Guidance – Notice 2005-38

Foreign Tax Credit and Other Guidance Under Section 965 – Notice 2005-64

This notice provides guidance concerning new section 965 of the Internal Revenue Code (Code). It sets forth general principles and specific guidance on domestic reinvestment plans and on investments in the United States described in section 965(b)(4)(B).

This notice primarily addresses the limitations, described in section 965(b)(1), (2), and (3), on the amount of dividends that a corporation that is a U.S. shareholder of a controlled foreign corporation may treat as eligible for the dividends received deduction under section 965(a) (DRD or section 965(a) DRD), including the effects of certain transactions on such limitations.

This notice sets forth guidance on various issues arising under section 965, including issues relating to the foreign tax credit and minimum tax credit, expense allocation and apportionment, and currency translation.


Charitable Contribution of Inventory under IRC 170(e)(3)–    Rev. Rul. 85-8

When a corporation donates products to a charitable organization shortly before their expiration date, the amount allowable as a charitable contribution deduction is equal to the unrealized appreciation, not to exceed twice the taxpayers basis in such property.


Patent Contribution Deductibility to University – Rev. Rul. 2003-28

Ruling specifies when the contribution of a patent to a qualified charity is deductible under section 170(a).


Medicaid Rebates – Rev. Rul.2005-28

Medicaid rebates incurred by a pharmaceutical manufacturer are purchase price adjustments that are subtracted fro gross receipts in determining gross income rather than a deductible business expense.


Guidance Related to Section 936 Terminations – Notice 2005-21

Notice 2005-21 provides guidance to U.S. corporations allowed a credit under section 936 or 30A of the Internal Revenue Code (section 936 corporations) with regard to the termination of sections 936 and 30A for tax years after 12/31/2005. Specifically, this notice discusses certain issues that are likely to arise depending on the manner in which the business of a section 936 corporation continues to be conducted after this termination. Certain issues include: the offshore migration of intangibles under section 367 and the transfer pricing of U.S.-owned intangibles under section 482 that result from the restructuring of section 936 corporations.


Limited Deferral Permitted for Certain Advance Payments – Rev. Proc. 2004-34


This revenue procedure allows taxpayers a limited deferral beyond the taxable year of receipt for certain advance payments.   This revenue procedure also provides the exclusive administrative procedures under which a taxpayer within the scope of this revenue procedure may obtain consent to change to a method of accounting


Cost segregation/Clean rooms – Rev. Rul. 68-530

Clean rooms" in a factory building in which electronic equipment is tested do not qualify as section 38 property; however, operational equipment therein does qualify

F. Important Court Cases

Date Opinion Issued

Name of Court Case and Citation

Summary of Importance of Court Case

June 18, 1999

Talley Industries v. Comm., T.C. Memo 1999-200

Burden of proof on taxpayer to show that settlement of False Claims Act suit was compensatory in nature where agreement was silent as to nature of payment.

Aug. 30, 2005

Xilinx v. C.I.R.

Corporate taxpayer petitioned for redetermination of federal income tax deficiencies, arising from IRS's determination that taxpayer and its foreign subsidiary, with which taxpayer had cost-sharing agreement to develop intangibles, were required to share costs of employee stock options (ESOs) that taxpayer issued to its research and development (R&D) employees.

Dec. 28, 2001

Plastics Engineering & Technical Services, Inc. v. Commissioner, T.C. Memo, 2001-324.[2]


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. 

April 26, 2000

Lockheed Martin Corp. v. United States, 85 AFTR2d Par. 2000-605 ( C.A.Fed. Cir.)

Court held that taxpayer retained substantial rights in its research under regs. section 1.41-2(a) and 1.41-5(d) and thus, the research did not fall under the funded exclusion of the credit for increasing research activities.

June 29, 1998

Norwest Corporation and Subsidiaries v. Commissioner, 110 TC 454 appeal docketed sub. Non. Wells Fargo & Co. v. Commissioner, Nos. 99-3878, 99-3883 (8th Cir. Sept. 29, 1999)

Sec. 41(d)(1), I.R.C., sets forth four tests for qualified research: (1) The expenditures must qualify as expenses under sec. 174, I.R.C.; (2) the taxpayer must discover information which is technological in nature; (3) the taxpayer must discover information the application of which is intended to be useful in the development of a new or improved business component; and (4) substantially all of the research activities must constitute elements of a process of experimentation. In the conference report accompanying the Tax Reform Act of 1986, Congress set forth three additional tests for qualified research under sec. 41, I.R.C., for the development of internal use software: (1) The software must be innovative; (2) the software development must involve significant economic risk; and (3) the software must not be commercially available. The parties agree that in order for the representative internal use software activities to constitute qualified research for purposes of the tax credit, all seven tests must be satisfied

October 17, 1997

United Stationers, Inc., v. United States, 982 F. Supp. 1253 (N.D. 1997)


A corporation was denied a research and experimentation tax credit relating to its implementation of eight computer software projects. The corporation did not discover any information that was technological in nature and did not intend to expand or refine existing principles of computer science. Instead, it merely applied and built upon pre-existing information. Further, the projects did not involve a process of experimentation because there was no uncertainty with respect to the projects designs or the corporation’s development of the means to achieve its stated goals.

June 18, 1998

FMR Corp. and Subsidiaries v. Commissioner, 110 TC 402


During the years in issue, taxpayer incurred costs for developing and launching 82 Regulated  Investment Companies (RICs). The expenditures incurred in launching new RIC,s were intended to, and did, provide significant future benefits to taxpayer.  The expenditures are not currently deductible under IRC 162(a), and must be capitalized under IRC 263(a).  Further, taxpayer failed to establish a limited life for the future benefits obtained from the costs of launching RIC’s.  Taxpayer may not amoritize such costs under IRC 167.

July 8, 1998

RJR Nabisco Inc. (Formerly R.J. Reynolds Industries, Inc.) and Consolidated Subsidiaries v. Commissioner, TC Memo. 1998-252 Action on Decision, 1999-012 (Oct. 4, 1999) (nonacquiesing in decision)

A member of the affiliated group claimed a deduction pursuant to IRC 162 for graphic design expenditures relating to cigarette package designs.The IRS determined a deficiency in RJR’s consolidated income tax liability, disallowing the deduction as a section 162, IRC expense and recharacterizing the graphic design expenditures as capital expenditures.  The Court held that the graphic design expenditures for cigarette packages are advertising expenses, deductible under IRC 162.

September 9, 1994

St. Jude Medical, Inc., v. Commissioner,  34 F3d 1394 (8th Cir. 1994), Affirming in part, reversing in part and remanding the Tax Court, Dec. 47,719, 97 TC 457

A medical products developer and its related DISC were not exempted from allocating and apportioning research and development (R and D) expenditures relating to a successful heart valve to their gross export receipts in computing their combined taxable income (CTI). They were however, not required to include R and D expenditures relating to their unsuccessful attempts to develop an insulin pump and a cardiac pacemaker in their CTI computation. The R and D expense allocation moratorium of  223 of the Economic Recovery Tax Act of 1981 (P.L. 97-34) was inapplicable. The moratorium only applied for purposes of determining the geographical source of income, which is not relevant to the computation of CTI. Reg. 1.861-8, which required the developer to allocate its insulin pump and pacemaker R&D expenditures against its artificial heart valve export receipts, is unreasonable and inconsistent with congressional intent. Thus, its allocation rules are invalid as applied to DISC CTI computations. 

May 28, 1985

Eli Lilly and Company v. Commissioner of Internal Revenue,

84 T.C. 996 (1985),aff'd in part, rev'd in part, 856 F. 2d 855 (7th Cir. 1988)

U.S. parent transferred patents to its wholly owned Puerto Rican subsidiary in a section 351 transaction. Subsidiary manufactured drug and sold exclusively to U.S. parent. Tangible and intangible transfer pricing analysis by Court.



E.I.DuPont v. United States, 608 F. 2d 445 (Ct. Cl. 1979),cert. denied, 445 U.S. 962(1980)

U.S. parent established a foreign subsidiary for sales and marketing of its products abroad.  Court held that the Commissioner's reallocation of profits from subsidiary to parent were reasonable.


G.D. Searle v. Commissioner, 88 T.C. 252 (1987)

U.S. parent transferred trademarks, patents and other intangibles to wholly owned Puerto Rican subsidiary.  Court held that transfer to subsidiary caused a distortion in parent's income.


Merck & Co. v. United States 24 CI.CT., 73 , 91-2 USTC  50,45(CI.CT. 1991)

U.S. parent transferred patent for manufacture of active ingredient of drug in a section 351 transaction to its wholly owned Puerto Rican subsidiary. Court held that no 482 allocation warranted.

[2]  2000 WL 1659286 (U.S. Tax Ct. ), 82 T.C.M. (CCH) 1017, T.C.M. (RIA) 2001-324, 2001 RIA TC Memo 2001-324

G.  Technical Advice Memorandums - Field Service Advices




August 13, 1993

TAM 9346006

The Taxpayer's activities in developing of generic drugs are excluded from the definition of the term "qualified research" under the  duplication exclusion contained in  section 41 (d)(4)(C) of the Code.

October 22, 1993

FSA 1999-1023

IRS concluded that the expenses of developing a generic drug product are not qualified research expenditures eligible for the section 41 research credits.

December 14, 1994

PLR 9511011

Taxpayer requested rulings that: 1) Taxpayer and S are members of the same controlled group of  corporations under section 41(f)(5) and 2) any qualified research expenses paid or incurred by Taxpayer in performance of a development contract with S are considered to be part of Taxpayer's proportionate share of qualified research expenses giving rise to the credit for increasing research activities for the controlled group of   corporations under section 41(f)(1)(A)(ii).

October 17, 1995

PLR 9604004

The issue in this Technical Advice request is whether taxpayer's expenditures paid to another corporation for research and development activities were incurred in connection with taxpayer's trade or business so the expenditures qualify as "research and experimental expenditures" as that term is defined for section 174.

October 31, 1996

PLR 9707003

Whether the  disallowance of deductions claimed under section 174 of the Internal Revenue Code results in a change in the taxpayer's method of accounting for payments for research and experimental activities. The deductions were disallowed on the basis that the expenditures were not incurred in connection with the taxpayer's trade or business. 

June 24,1998

FSA on Patent Expense under IRC 41

Whether legal and patent expenses incurred by Taxpayer are "qualified research expenses" for purposes of computing the credit for increasing research under IRC 41.

November 24, 1999

CCA 20009012                     



As long as Rev. Proc. 63-10, 1963-1 C.B. 490, remains in effect, a section 936 corporation may take location savings into account in accordance with such revenue procedure for purposes of a cost sharing election under section 936(h)(5)(1).

March 4, 1999

TAM 199927001

Taxpayer's costs attributable to the construction of molds and other tooling used in the manufacture of plastic injection molded products are not deductible as research and experimental expenditures under I.R.C. 174.  Property was depreciable property in the hands of the customer and did not qualify.

December 8, 1999



PLR 200010040 and PLR 200010041

Following a spin-off, taxpayer permitted to switch from the percentage limitation method for calculating the section 936 credit to the economic activity credit, when a member of the former  group continued to use the percentage limitation method.

March 8, 1999

FSA 199925009

The Service determined that a pharmaceutical company must defer a deduction for the costs of samples until the time the samples are distributed.

August 9, 1999

FSA 199939035

Marketing and advertising costs incurred before a product received regulatory approval are ordinary and necessary business expenses.

October 6, 1999

PLR 200002012

A possessions corporation may revoke its section   936 election to allow a  338(h)(10) deemed asset sale election to be made and then re-elect  936 status for the tax year following the deemed sale.

October 15, 1999

PLR 200002034

The activities of a corporation and a new corporation that will acquire its manufacturing facilities will be classified under the  same SIC and NAICS codes for purposes of  936(j)(9).

January 1, 2006

TAM 200601029 

Whether, under § 165 of the Internal Revenue Code, Taxpayer may claim a loss deduction upon the expiration of a “purchase option agreement” to acquire X if Taxpayer instead acquires X by other means.


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