Royalties on Pharmaceutical Technology Taxable as Ordinary Income, Tax Court Holds

By Kim Golightly, CPA, J.D., LL.M.; Amy Sargent, J.D., LL.M.; and Fred Gordon, J.D., LL.M., Washington

In Spireas, T.C. Memo. 2016-163, the Tax Court held that royalties received by an S corporation under a license agreement are taxable as ordinary income to the S corporation's individual shareholder. Sec. 1235 capital gain treatment does not apply because the taxpayer retained substantial rights in the technology.

Facts

Spiridon Spireas is an inventor with a doctoral degree in pharmaceutical technology. Together with his former faculty adviser, Sanford Bolton, Spireas developed a "liquisolid" technology. The technology was designed to enhance the bioavailability of water-insoluble drugs and nutritional supplements. Spireas and Bolton obtained several patents on the technology. In 1997, they formed an S corporation, Hygrosol—of which each owned a 50% share—to pursue the business potential of the technology and associated patents.

In 1998, Hygrosol entered into a licensing agreement with an unrelated pharmaceutical company, Mutual Pharmaceutical Co. Inc. (Mutual), whose business involved developing and marketing new and generic drugs. After several months of negotiations, the agreement the parties reached granted Mutual rights to use the liquisolid technology on a product-by-product basis to develop, produce, and sell drugs. The agreement provided that any products for development had to be "unanimously selected" by Hygrosol and Mutual. With respect to any such unanimously selected products, Mutual was granted exclusive rights. However, Hygrosol retained rights to use the technology for nutritional supplements not requiring FDA approval, as well as for any pharmaceutical products not agreed to by the parties, and for products that were agreed to but that Mutual ultimately declined to develop. Mutual contracted to pay quarterly royalties equal to 20% of the gross profits on sales of products containing the technology.

After screening about 100 drugs, Hygrosol and Mutual agreed to pursue further development of 20 products. For each, the parties executed short engagement letters committing themselves to the pursuit of the product. In accordance with the licensing agreement, Mutual paid Hygrosol $10,000 each time the parties agreed to pursue a product. In addition, for any product that Mutual ended up selling, Mutual would pay Hygrosol 20% of the net profit. Two of the agreed-to products ultimately went on to become financially successful products in the marketplace.

On his 2007 and 2008 tax returns, Spireas reported royalties received under the 1998 license agreement as long-term capital gain. The IRS issued a notice of deficiency for each year in the approximate amounts of $4 million and $1.7 million, respectively. The IRS asserted that the royalties received were ordinary income, not long-term capital gains under Sec. 1235.

Opinion

The Tax Court explained that royalty payments received under a license agreement generally are taxed as ordinary income. However, under Sec. 1235(a), long-term capital gain treatment applies in the case of transfers "consisting of all substantial rights to a patent." The IRS argued that the instrument of transfer was the 1998 license agreement, under which Hygrosol retained substantial rights to the use of the liquisolid technology. Spireas argued that the March 2000 engagement letter for two particular formulations using the technology was in effect its own license agreement, under which Hygrosol transferred all substantial rights to those two products.

The Tax Court concluded that the 1998 license agreement was, in fact, the relevant instrument of transfer because it set forth the terms of Hygrosol and Mutual's agreement. The March 2000 engagement letter merely executed and memorialized those terms for the two products selected for development. The engagement letters did not stand on their own to define the respective parties' rights.

Having concluded that the 1998 license agreement was the instrument of transfer, the next issue for the court was whether that agreement transferred "all substantial rights" to the technology. The Tax Court concluded that it did not. Hygrosol retained rights to use the technology to develop other pharmaceutical and nonpharmaceutical products with other companies. Hygrosol specifically negotiated to retain these rights under the license agreement.

The Tax Court observed that Spireas and Hygrosol, in hindsight, might have structured the agreement differently to achieve capital gain treatment. However, under the Danielson rule (absent proof of mistake, fraud, undue influence, or duress in the formation of an agreement, taxpayers are generally held to the terms or the form of the agreement) (Danielson, 378 F.2d 771 (3d Cir. 1967)), the court found that the taxpayer could not undo the license agreement as written. Because the license agreement was the relevant instrument of transfer for the liquisolid technology, and Hygrosol retained substantial rights in the liquisolid technology under that agreement, Sec. 1235(a) did not apply to the royalties the taxpayer received under the license agreement. Accordingly, as the IRS contended, the royalties received were taxable as ordinary income.

Implications

The result in this case highlights the critical importance of the form of technology development and licensing arrangements. As the court suggests, if the parties' 1998 agreement had merely provided for joint R&D and co-development of the technology—and had granted Mutual options to acquire, under agreements to be entered into upon the exercise of those options, the exclusive marketing rights to particular product formulations once they had been identified—then the consideration received by Spireas under the later agreements may have qualified for capital gain treatment under Sec. 1235(a).

It is also noteworthy that the Tax Court did not consider whether the license agreement constitutes a "franchise" within the meaning of Sec. 1253(b)(1) (an agreement that gives a party the right to distribute, sell, or provide goods or services in a specified area), since the 1998 license agreement by its terms geographically limited Mutual's exclusive right to produce, market, sell, promote, and distribute the products containing the technology to the United States. Because the licensors retained certain powers, rights, or continuing interests in the technology under the terms of the license agreement, franchise treatment may have resulted in ordinary income under Sec. 1253(a). Although the pharmaceutical industry has argued that the definition of "franchise" should not encompass a patent license that grants the right to sell the products that embody that patent within a geographic area, there is no direct authority on this issue.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

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