Avoiding state tax surprises from collaboration agreements

Editor: Brian Myers, CPA

Life sciences companies depend on collaboration agreements and partnerships to push research forward, fill capability gaps, and bring new therapies to market. As described in more detail below, these agreements may include large upfront payments, milestone payments, and royalty payments. Additionally, cost reimbursements are often a component of collaboration agreements. However, these companies may not anticipate all of the income, franchise, and gross receipts tax (collectively, “corporate income tax”) considerations and effects of these arrangements, including at the state and local tax (SALT) level. To optimize the benefits that collaboration agreements can provide, businesses should work with SALT advisers to proactively evaluate the potential tax consequences associated with collaboration revenue streams.

Small to midsize biopharmaceutical and life science companies frequently use partnerships and collaboration agreements to fund the development and commercialization of their therapies and products. SALT considerations likely are not the focus for structuring these partnerships. However, SALT considerations often surface for many finance and tax leaders only after the ink is dry and the revenue is recognized. By then, these executives perhaps are evaluating a state tax expense they never budgeted for. This can be particularly alarming when a company is in a tax loss position and historically had little to no state tax expense. The issue is worsened when the company does not have losses available to offset state taxable income.

Many companies don’t realize that the agreement’s structure — and not just the activity behind it — can create tax obligations in states they never considered. Below is a discussion of where life science companies can run into trouble unexpectedly and how a measured, practical approach can help companies avoid being caught off guard.

Collaboration agreements aren’t always what they appear to be

Two primary elements need to be considered when analyzing the state corporate income tax effects of collaboration agreements. First, advisers must understand what the agreement represents, specifically, the income’s character and what the company is being compensated for. The second question is how the relevant receipts should be sourced for sales factor apportionment purposes. Those two elements determine where the company may have a state corporate income tax filing requirement and where an unexpected tax expense could arise.

Most contracts state that they are a “collaboration agreement” on the cover page and in the preamble, as well as throughout the document, but the label may not tell the full story. Taxpayers must take a substance–over–form approach to evaluating the agreement when analyzing its state tax consequences.

For example, a collaboration agreement may function like a license of intellectual property. It may also be structured, in substance, as a contract for research–and-development (R&D) services. Sometimes, the rights transferred are broad enough that the transaction is considered a sale of intellectual property for state income tax purposes, even if the agreement states that it is a license and the licensor retains title to the intellectual property. Each interpretation may result in different state tax outcomes.

To this point, it is vitally important to understand the facts and circumstances of the agreements, the parties’ roles and responsibilities, and the key terms. It is also critical to understand the geographic location not only of the parties to the agreement but where any other services may be performed, such as clinical trials. Speaking with tax and finance personnel is essential to understanding these collaboration agreements, but they are not the only personnel at the company with intimate knowledge of the arrangement. SALT professionals should also speak with the company stakeholders and legal counsel as well as operations teams and even the scientists conducting the work, as this will often provide the clearest picture of how the work is carried out, which is essential for determining the arrangement’s true nature.

The footprint expands faster than companies expect

Many early–stage, pre–clinical, and clinical–stage life science companies operate in only one or a limited number of states. Once the company enters into a collaboration agreement, these operations — either directly or indirectly — may shift or expand to additional states. Suddenly, the company’s state tax footprint changes in ways the company has not anticipated, and thus the company’s state corporate tax expenses will unexpectedly increase.

The reason is almost always tied to how the revenue from the collaboration agreement is sourced for apportionment purposes and, more specifically, how various types of receipts may be sourced for sales factor purposes. Depending on the nature of the agreement, revenue may be attributed to states that weren’t previously part of the company’s state corporate income tax profile. This raises a problem, especially for taxpayers that were relying on net operating losses generated in prior years to offset future taxable income. When a company expands its footprint to new jurisdictions while recognizing revenue for the first time, the company may not have any state losses available to offset it and thus its state tax expense.

Sourcing: Where complexity adds up

After a determination is made as to what the collaboration agreement represents, e.g., a license, a sale, or a service, the next challenge is sourcing the revenue for sales factor purposes. Sourcing determinations can be a significant gray area where collaboration agreements are concerned.

Most states do not provide guidance tailored to the sourcing of revenue from collaboration agreements.California, notably, is an exception where the state rules specifically contemplate certain revenue streams often resulting from collaboration agreements. California’s revised apportionment regulation, Cal. Code Regs. tit. 18, §25136–2, effective Jan. 1, 2026, includes an example of milestone payments related to R&D services. The example states that in determining where the benefit of the service is received (and should be sourced), the benefit is in the location where the customer uses the intangible property to which the R&D service predominantly relates and can be substantiated by the company’s contracts or its books and records. The example illustrates that because the milestone payments result from completing clinical trials, the revenue should be sourced to the location where the intangibles are used in performing the clinical trials.

While the California rules may offer specific guidance for milestone payments, California is an outlier among states in providing clarity for taxpayers with these fact patterns. More frequently, companies must try to interpret more general rules for sourcing receipts from services or intangible property, and taxpayers are required to make a reasonable approximation or take a practical approach. Where there is no clear guidance or examples on point, this approach warrants thoughtful construction and contemporaneous documentation.

For example, if the revenue results from the license of intangible property, many states require it to be sourced to the extent the intellectual property is used in the state. Collaboration agreements, however, often do not fit neatly into that framework. Activities may be conducted by multiple contract research and manufacturing organizations as well as laboratories and development teams in multiple states and countries. For example, a Massachusetts–based company may rely on a contract manufacturer located and operating out of state to manufacture a specific or isolated component of a drug therapy or rely on a clinical research organization to conduct clinical trials outside Massachusetts. Perhaps separate legal entities within the corporate structure perform different activities related to the collaboration agreement. Questions arise as to how to measure the extent the intangible property is used in one state as opposed to another and, even then, what is the appropriate measure. For example, patient population, development costs, or Census data all may be reasonable and practical measures of use of the intangible property but may also produce very different results. None of these approaches may be perfect, but each can be defensible, depending on the facts and circumstances, if applied consistently and supported by clear logic.

The timing of payments also complicates sourcing further:

• Upfront payments are usually received before any work begins;
• Milestone payments reflect progress at various phases of R&D; and
• Royalties generally are received only after commercialization.

Questions further arise as to whether these payments, made pursuant to the same agreement, should all be sourced in a similar manner. Should the agreement be viewed holistically for sales factor sourcing purposes, or must each payment type be analyzed and sourced based on the facts and circumstances at the time the payment is made?

A more proactive path forward

Understandably, companies might not structure collaboration agreements based on the state tax consequences. However, involving a SALT professional early helps companies prepare for the financial reporting and tax impacts. It is also incumbent upon the SALT professional to stay connected with the company as well as internal teams and to be knowledgeable about the company’s business activities in real time.

Planning ahead isn’t always possible — collaboration agreements can move quickly — but the following steps can help prevent unexpected taxes:

• Review the agreement as early as possible so SALT considerations can be evaluated before deadlines loom;
• Speak with the company’s key stakeholders who understand the agreement;
• Identify in which states the company may have nexus and understand the sales factor sourcing rules in those states;
• Model estimated state tax expense across different sourcing scenarios; and
• Document positions clearly so the company is prepared for potential audit questions.

Consistency across states also plays a role in these analyses. State taxing authorities generally require consistency in treatment of revenue, meaning that companies should not characterize revenue in one state differently than they do in another state simply because the outcome is more favorable. States expect a unified approach, and inconsistency often raises questions from taxing authorities. This, however, is not to be confused with different sourcing rules among various jurisdictions that yield different results.

This issue only becomes more complex as different payments are made across the life of an agreement. Companies need to determine whether the receipts are to be sourced in the same manner under the agreement or sourced differently based on the payment type and the facts and circumstances at the time the payment is made. Further, consideration must be given to any changes in state tax law that occurred between the time of the original analysis of the sourcing of upfront payments and that of milestone and/or royalty payments.

Why SALT should be part of the conversation

Collaboration agreements allow life sciences companies to accelerate innovation; expand their capabilities; and sustain the long, expensive path to commercialization. But the state tax consequences deserve attention early in the process.

When a SALT adviser is brought into the process at the right time, companies better understand how these agreements affect their state nexus footprint and potential state income tax liability. They can evaluate sourcing methodologies grounded in reasonable approximation and maintain consistency across states. This may not mitigate the state corporate tax expense, but it avoids unwelcome surprises and allows the company’s tax and finance teams to plan properly and move forward with more confidence.

One additional benefit from including a SALT adviser in planning is that the questions, research, and positions derived can and should be leveraged for state and local indirect taxes such as sales and use taxes and local city business license and gross receipts taxes. While outside the scope of this column, these taxes also need to be considered to ensure compliance and prevent other unanticipated tax implications resulting from the collaboration agreement revenues.

Contributors

Mark Ozerkis, J.D., is senior manager, State and Local Tax, in Boston, and Amy Letourneau, J.D., is senior manager, State and Local Tax, Washington National Tax in Houston, both with RSM US LLP. Brian Myers, CPA, is a partner at Crowe LLP in Indianapolis. Letourneau is a member, and Myers is chair, of the AICPA State and Local Taxation Technical Resource Panel. For more information about this column, contact thetaxadviser@aicpa.org.