Collaboration agreements in life sciences

Collaboration agreements explained

Typically, a collaboration agreement is between the company with the cash and the infrastructure to commercialize the product (the licensee) and a development company that owns the IP (the licensor). Collaboration agreements may include several types of funding, each potentially requiring distinct treatment for U.S. federal income tax purposes. Payments may include:

• Up-front fees
  As the name implies, these fees are typically paid upon the execution of the agreement and are usually nonrefundable. They may also be referred to as access fees or license issue fees.
  
  
• Reimbursements
  These amounts are paid to the development company to offset costs already incurred in developing the IP.
  
  
• Milestone payments
  These payments are generally made when product development reaches certain stages, such as achieving specific clinical trial outcomes or obtaining regulatory approval.
  
  
• Royalty payments
  When the product or therapy reaches the market, the development company (the licensor/payee) may receive sales-based payments through a variety of structures. For example, the company may earn a percentage of net profits, receive payment once sales exceed a certain threshold, or both.
  
  
• Options to purchase
  These payments may represent an actual sale of the IP.

Note that the agreement title and the names of the various payment types do not determine how those payments are treated for federal income tax purposes. Instead, the substance of those payments—i.e., what the licensee/payor is actually receiving in exchange for those payments—dictates the tax treatment. 

IRS guidance

In a Coordinated Issue Paper (CIP) effective Oct. 18, 2007 (de-coordinated), the Treasury Department and the IRS addressed the tax treatment of certain payments made under collaboration agreements, from both the licensee/payor and the licensor/payee perspectives.

The CIP states that the tax treatment of payments is based on the facts and circumstances pertaining to the payments themselves. However, in general, most payments made by the licensee/payor are not deductible under Internal Revenue Code (IRC) sections 174A and 41 or other IRC provisions. This is because many of the payments are likely to represent payments for IP developed before the agreement was executed—thus, the licensee/payor bore no risk for IP development.

The licensor/payee generally may not defer payments over the life of the contract and must take the payments into income based on its method of accounting. For cash method taxpayers, the income is realized in the year of receipt. For accrual method taxpayers, the income is realized in the taxable year in which the taxpayer becomes entitled to the payment pursuant to the “all events” test under Reg. section 1.461-1. As discussed below, there may be an opportunity to defer the income if the payments constitute advances for the satisfaction of future obligations.