Tax Treatment of Payments in Common Pharmaceutical Agreements

By Gerald H. Parshall Jr., J.D., Gaithersburg, MD

Editor: Nick Gruidl, CPA, MBT

It is often the case that a business developing a promising pharmaceutical compound or drug lacks the economic resources to further develop that compound or bring it to market. This is because the development of drugs in the United States typically involves four stages: (1) preclinical or discovery research, (2) clinical development, (3) regulatory approval, and (4) postapproval marketing, occurring over a period of 10–12 years.

In such instances, the developer (generally a smaller business, often referred to as a “licensor”) frequently turns to a larger business (licensee) with the financial, laboratory, and regulatory resources to complete the research and bring the product to market. The agreements between such disparate-sized businesses, often called “collaboration agreements,” and payments made thereunder have recently been the subject of significant IRS scrutiny. In October 2007, the Service outlined its position on the treatment of the various types of payments under collaboration agreements in Coordinated Issue Paper LMSB-04-1007-073, “Non Refundable Upfront Fees, Technology Access Fees, Milestone Payments, Royalties and Deferred Income Under a Collaboration Agreement” (10/18/2007) (the CIP).

Because of their disparate size and differing profit situations, it is often the case that tax benefits can be better utilized by the larger business, since the smaller business may be carrying net operating losses (NOLs) and may be in a loss position.

The three specific payment types—upfront fees, milestone payments, and commercial royalty payments—are each unique to the point in time during the collaboration agreement at which they occur. In the CIP, the Service states that each collaboration agreement and the payments thereunder should be examined on a “facts and circumstances” basis. However, it is clear from the CIP that the IRS believes that large pharmaceutical payors of upfront fees, milestone payments, and royalty payments should rarely be able to claim these as Sec. 174 deductions for research and experimental expenses or as expenses includible in calculating the Sec. 41 credit for qualified research expenses.

Upfront Fees—Preclinical/Discovery Phase

Upfront fees are payments made at the execution of an agreement or at an agreed-upon time that are not contingent on the successful completion of research. The IRS considers these fees to be capital expenditures for an intangible asset. According to the IRS, upfront fees represent payment for already-developed intellectual property, so there is no risk to the payor (for the development of the compound to that date, at least) and therefore no Sec. 174 deduction. There should be no objection to the payee taking the Sec. 174 deduction (or the Sec. 41 credit) during all the years in which the initial intellectual property is developed because in those years there was no “funding” in place and no guarantee that anyone would “pick up the tab” for the research. However, as noted above, initial developers of pharmacological compounds often have little use for increased deductions or credits.

There is little to criticize in the Service’s analysis of upfront fees. A licensee might try to characterize such fees as reimbursement for research expenses or contract payments for research services, and thereby bolster the larger business’s claim to deductibility and creditability. However, at least under the credit rules, this would seem to run afoul of the requirement that a contract must precede performance of outside research and development (R&D) (Regs. Sec. 1.41-2(e)(2)(i)). However, once a collaboration agreement is in place, this should be of no further concern.

Milestone Payments—Clinical Development and Regulatory Approval

Milestone payments are due under a collaboration agreement on the completion of successful research. They are designed to compensate a licensor for the increase in value of intellectual property as it progresses through the stages of development up to the time of marketability. In the CIP, the IRS addresses milestone payments together with upfront payments and makes no attempt to differentiate between the two, and it does not address the issues of risk that the payments can alleviate. This is an oversimplification and a contradiction of existing case law, particularly in the R&D area, where there is a case on point in which the Federal Circuit stated (in a government contracting situation) that the presence of milestone payments did not negate the risk for the taxpayer doing the research (Fairchild Industries, Inc., 71 F3d 868 (Fed. Cir. 1995)). However, there is a chance that the IRS will nevertheless attempt to characterize milestone payments as being “no risk” and will therefore characterize the underlying R&D activity as ineligible for deduction or credit to the payee.

Taxpayers should not agree to this result because there is no guarantee that the researcher will receive the milestone payment; the licensee/researcher is clearly at risk until the milestone payment is received and thus should qualify for the Sec. 174 deduction or the Sec. 41 credit. It is arguable that the licensor still bears the risk for milestone payments made for contract research performed by the larger company since there is no benefit (in the form of future royalties) to the licensor for the incremental research performed by the licensee until development is completed and FDA approval is secured.

Royalty Payments on Commercialization

This is perhaps the clearest case in the CIP. Once a drug is approved for commercial sale, there is no longer any technological risk; all that remains is marketing risk. Any payments to the licensor at that point are most clearly compensation for its intellectual property and research efforts already achieved. There is no risk (at least in the technical sense), so there can be no deductibility to the licensee under Sec. 174 and no credit under Sec. 41. Therefore, in the CIP, the IRS categorizes royalty payments as costs of property produced or acquired by the taxpayer that are capitalizable under the uniform capitalization rules of Sec. 263A.

Practice tip: Smaller companies developing compounds made subject to collaboration agreements definitely need advice about the appropriate characterization of their expenditures and efforts resulting in such payments, and they can often benefit from a practitioner’s advice about these tax benefits and a retrospective review of their prior tax years’ efforts.

The Service’s position as expressed in the CIP could easily result in a “whipsaw,” wherein neither the payor nor the recipient of fees under a collaboration agreement could receive R&D tax benefits. This could happen, for example, if the payee’s IRS exam team treated the upfront payments as funded research and disallowed the credit and the payor’s IRS exam team treated the contract R&D as not at risk to the payor because it is for already developed know-how. This type of payment should not be treated as funded research to the payee because the R&D was performed before the payee ever knew that a third party would be willing to pay for it.


All payments made under pharmaceutical collaboration agreements will receive IRS scrutiny on examination of the payor’s tax return. Taxpayers involved in these agreements should be made aware of the Service’s view (as expressed in the CIP) of deducting upfront, milestone, and royalty payments under Sec. 174 and including them in Sec. 41 credit calculations. Taxpayers receiving such payments should have their contracts reviewed to determine that they are including the appropriate amounts in their Sec. 174 deductions and Sec. 41 credit calculations.


Nick Gruidl, CPA, MBT, Managing Director, National Tax Department, RSM McGladrey, Inc., Minneapolis, MN

Unless otherwise indicated, contributors are members of RSM McGladrey, Inc.

If you would like additional information about these items, contact Mr. Gruidl at (952) 893-7018 or

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