Audit Guidelines Related to Upfront License Fees and Milestone Payments

Attachment to Industry Directive: Treatment of Non Refundable Upfront Fees, Milestone Payments, Royalties, and Deferred Income under a Collaboration Agreement in the Biotech and Pharmaceutical Industries. Audit Guidelines Related to such Collaboration Agreements.       

The audit guidelines below are intended to provide examiners with specific assistance when developing issues involving taxpayers who have entered into collaboration agreements with unrelated parties and have paid a non-refundable upfront fee with additional milestone payments as developmental success is achieved. This guidance is based on the Issue Management Teams experience with cases to date and may be supplemented in the future on an as-needed basis as new issues arise.

Step 1:  Identification of the Issue

A.  External Sources

  1. 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 web site will most likely have a link to the SEC site. If the taxpayer is required to file with the SEC (either form 10K for U.S. based company or a form 20F for 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, and 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 TA).
  2. In addition, the examiner is encouraged to visit the pharmaceutical/biotech intranet web page and to contact the industry TA’s 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, as this issue will generate significant appeal to the business community. A historical file should be maintained for this and any other newsworthy articles.

B.  Internal Sources 

  1. It is recommended that the examiner, as standard practice review the corporate minutes for the audit in general and to look for mention of the company entering into any collaboration agreements with third parties. Should you be aware of their existence from the pre-planning phase noted in (A) above, the minutes should provide the corporate insight as to the parties, the amount of the transaction and the company’s expectations as a result of the collaboration.
  2. If the taxpayer, as licensee, has expensed the upfront fees and milestone payments from these collaboration agreements, during the review of the 1120 return, the examiner should consider the payments may be classified under the following categories:
    • Line 26 Other Deductions as:
      • Legal Fees and Settlements
      • License Fees
      • Contract Research
      • Advance Payment for Research Activities
      • Miscellaneous Expense etc.
    • Form 6765 Credit for Increasing Research Activities as:
      • 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
  3. If the taxpayer, as licensee, has capitalized the upfront fees and milestone payments from these collaboration agreements, during the review of the 1120 return, the examiner should consider the following:
    • Line 20 Depreciation/Amortization as well as Schedule L Line 13A Intangible Assets (relative to the useful life assigned by the taxpayer to these collaboration agreements.
  4. If the taxpayer, as licensor of the 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 during review of the Form 1120 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 determining 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
  5. If the examination is a CIC or IC case, at the opening conference, a question should be posed 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), early in the examination process requesting copies of any/all collaboration agreements that were entered into for such examination period.  Dollar criteria may be established when requesting such agreements depending on the size of the taxpayer being examined (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 cases risk analysis).
  • Consider 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 provide guidance to examination teams, as well as advice, on all issues under exam 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.  

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.