Tax treatment of royalty monetization transactions – sale or loan?
INSIGHT ARTICLE |
A life science company that holds the right to receive a stream of future royalties may want to monetize the royalty stream. The monetization transaction would involve a significant upfront cash payment to the company from another party (the Financing Party) in exchange for some or all of the company’s rights to receive the royalty stream over time.
For tax purposes, is the royalty stream monetization a sale of property rights, or is it a loan? If the transaction constitutes a sale for tax purposes, generally:
- The upfront payment from the Financing Party to the company would constitute sale proceeds, and
- The stream of future royalty payments would constitute income to the Financing Party and not the company.
If the transaction is instead treated as a loan for tax purposes, generally:
- The upfront payment from the Financing Party to the company would constitute loan proceeds and not taxable income, and
- The future royalty stream would constitute taxable income to the company, even if the company immediately remits the payments to the Financing Party.
Note that the federal tax treatment may differ from the company’s financial reporting of the monetization transaction. Additionally, the transaction’s tax treatment may differ from descriptions set out in the governing legal documents.
Example of a royalty monetization transaction
CureCo is dedicated to finding a cure for a rare disease. CureCo has developed a pharmaceutical drug approved in a number of countries to treat the rare disease. CureCo manufactures, markets, and distributes the drug in the United States. CureCo has entered into a licensing agreement with an established European drug distributor that can market and distribute the drug in Europe (the European License Agreement). The distributor acquires exclusive rights to distribute the drug in Europe for 10 years and CureCo receives annual royalty payments based on the level of European sales of the drug.
The partnership with the distributor is a success, generating annual royalty payments averaging $30 million from 2018 – 2021. Assuming continuing viability of the drug, CureCo expects to receive annual royalty payments of $30 – $40 million from the European distributor for the next 10 years.
In 2021, CureCo would like to invest in additional new drug development, which will require a large amount of cash. A Financing Party offers to purchase the next five years’ worth of European License Agreement royalty payments for a single $100 million up-front payment. CureCo accepts the offer, and enters into a Royalty Purchase Agreement with the Financing Party.
Royalty monetization – sale or loan?
How is the royalty monetization transaction viewed from a tax perspective? Is the sale truly a sale? Or is it a loan? If it is a sale, does it result in capital gain, or ordinary income?
A transaction’s tax treatment typically is determined in accordance with its substance, not merely by its form.1 The question of substance over form may arise in regard to a taxpayer’s receipt of cash in exchange for an obligation that could be viewed as debt or as something else from a tax perspective. For example, there are many tax cases addressing whether an advance to a corporation from its shareholder should be treated as debt or equity for tax purposes. Courts generally have ruled that an advance constitutes debt if there are firm rights to and expectation of repayment,2 and not debt if firm rights to repayment or expectation of repayment is not present.3 In differentiating between debt and equity, the case law generally requires an examination of numerous factors,4 including the right to repayment of a fixed or ascertainable sum, at a fixed or ascertainable maturity date, with repayment not heavily dependent upon the borrower’s profits or revenues.5
In the case of royalty monetization transactions, the issue is whether the cash advance constitutes sale proceeds or loan proceeds. Courts have on numerous occasions addressed whether a transaction involving an upfront payment to an owner of property constitutes a sale or a loan for federal tax purposes. A key differentiating factor courts look to is whether the risk of loss and opportunity for gain with respect to the property has been shifted.6 Some cases of this type have resulted in courts holding that a transaction documented as a sale was treated as a loan for federal tax purposes,7 while others resulted in courts holding that the transaction was treated as a sale.8The chief distinguishing factor generally was whether there was certainty of repayment, or whether the purchasing or financing party instead bore the risk of loss with respect to the subject property.9
One court has succinctly summarized the tax law in this area:
For disbursements to constitute true loans there must have been, at the time the funds were transferred, an unconditional obligation on the part of the transferee to repay the money, and an unconditional intention on the part of the transferor to secure repayment. In the absence of direct evidence of intent, the nature of the transaction may be inferred from its objective characteristics....10
Accordingly, the case law’s principal focus in determining whether a sale of property rights should be treated as a loan is not the form of the transaction but whether the seller has an unconditional obligation to repay the money advanced or whether the risk of loss with respect to the subject property has instead shifted to the buyer (i.e., to the Financing Party).11 A royalty monetization transaction where the Financing Party’s rights to future repayment are not fixed or ascertainable repayment but are instead contingent on whether the property produces sufficient income would often be viewed for tax purposes as a sale rather than a loan. However, each transaction should be analyzed on its own facts.
Income from royalty monetization transactions – ordinary income or capital gain?
If a royalty stream monetization transaction is treated for federal income tax purposes as a sale and not loan, the income that the company realizes in the transaction often is characterized as ordinary income under the substantial rights test and/or the assignment of income doctrine.
Capital gains and losses are generated by the sale or exchange of a capital assets. Capital assets are defined to include all property, other than specifically enumerated types of property.12 Intangible assets are frequently licensed or leased in exchange for royalties. The owner’s receipt of royalty income is taxed as ordinary income, not as capital gain.13 The owner (licensor) must generally include any advance royalty or rental payments in gross income for the year in which the owner receives the payments, regardless of the period covered or the method of accounting the owner uses.14
License versus sale of IP
The distinction between capital gain and ordinary income15 is one of the principal reasons why it is important to characterize intangible asset transfers as sales or licenses for tax purposes.16 To distinguish a license from a sale, the courts and the IRS typically apply a “substantial rights” test, which looks to whether the transferor retained a substantial right in the asset.17 For example, a patent holder’s transfer of a nonexclusive right to use a patent asset typically would not qualify for sale treatment because it is not a transfer of all substantial rights.18
An intangible asset transfer generally is treated as a license and not sale of the underlying asset if it consists of only a right to use the asset for a period less than the estimated useful life of the asset.19 In Pickren, for example, the court determined that the transfer of a formula for liquid wax products for a 25-year period was a license and not sale of the underlying asset because the useful life of the formula extended beyond the 25-year period.20 The transfer was not a sale because the remainder interest retained by the transferor comprised a substantial right in the asset.21
Assignment of income doctrine
Property that produces ordinary income may generate capital gain when it is sold. Examples include a sale of real property that generates ordinary rental income or a sale of stock or bonds that yields ordinary dividend or interest income. Taxpayers’ ability to treat the sale of an ordinary income stream as generating capital gain is subject to various limitations besides the substantial rights test discussed above; one of these limitations is the assignment of income doctrine.22
For example, in the seminal P.G. Lake case, the Supreme Court ruled that proceeds received by the transferors in exchange for the assignments of oil payment rights represented assignments of the transferors’ rights to receive future income and were therefore taxable as ordinary income.23 In several cases, taxpayers assigned rights to compensation for service they rendered and pointed to contingencies or valuation difficulties, hoping their transactions would not fall within the scope of the assignment of income doctrine. However, courts generally rejected these attempts and treated these transactions as assignments of the right to receive ordinary income.24
Accordingly, if a royalty stream monetization transaction is treated for federal income tax purposes as a sale, the income that the company realizes in the transaction often is characterized as ordinary income. Each monetization transaction, however, should be analyzed on its specific facts.
Royalty stream monetization transactions often are treated as sales and not loans for federal income tax purposes. However, each transaction must be judged based on its particular facts and circumstances. The transaction’s characterization under tax rules may differ from its characterization in legal document or its characterization for financial accounting purposes. Due to the complexities surrounding royalty monetization transactions, taxpayers entering into them should consult with their tax advisors.
1See, e.g., Frank Lyon v. United States, 435 U.S. 561, 573 (1978) (“[t]he Court has never regarded the simple expedient of drawing up papers as controlling for tax purposes when the objective economic realities are to the contrary.”) (internal quotation marks and citations omitted); Higgins v. Smith, 308 U.S. 473 (1940); Gregory v. Helvering, 293 U.S. 465 (1935).
2 See, e.g., Gilbert v. Comm’r, 248 F.2d 399 (2d Cir. 1957), on remand, 17 T.C.M. 29 (1958), aff'd, 262 F.2d 512 (2d Cir.), cert. denied, 359 U.S. 1002 (1959).
3 See, e.g., United States v. Title Guarantee & Trust Co., 133 F.2d 990 (6th Cir. 1943). See also Slappey Drive Indus. Park v. United States, 561 F.2d 572 (5th Cir. 1977).
4See, e.g., Bauer v. Comm’r, 748 F.2d 1365 (9th Cir. 1984); Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972).
5 See Gilbert, supra. See generally Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369 (1971) (“when money is advanced ... not for the return of the principal, but for payment of a percentage of profits or sales, indefinitely or for a specified period, the arrangement lacks even the form of debt ...”)
6See United Surgical Steel Co. v. Comm'r, 54 T.C. 1229-1230 (1970); Town & Country Food Co. v. Comm'r, 51 T.C. 1057 (1969); Grodt McKay Realty Inc. v. Comm'r, 77 T.C. 1221 (1981). See also Illinois Power Co. v. Comm'r, 87 T.C. 1417 (1986); Coleman v. Comm'r, 87 T.C. 178 (1986), aff’d, 833 F. 2d 303 (3d Cir. 1987).
7An interesting application of the question of sale versus loan involves taxpayers with expiring tax net operating losses (NOLs) who arrange to sell future income in an effort to utilize the benefits of the losses in the current year. In Hydrometals, for example, a taxpayer with an expiring NOL took the following steps: The company sold a fixed amount of its receivables to a buyer (who had borrowed cash from a bank to finance the purchase), purchased certificates of deposit with the sale proceeds, deposited these certificates with the bank that had loaned funds to the buyer, and agreed to maintain these certificates until the buyer received the revenue it had purchased. Because the buyer’s repayment was virtually guaranteed, the court concluded that the “sale” was in substance a loan. Hydrometals, Inc. v. Comm’r, T.C. Memo. 1972-254, aff’d per curiam, 485 F.2d 1236 (5th Cir. 1973). See also Mapco, Inc. v. United States, 556 F.2d 1107 (Ct. Cl. 1977).
8 In Stranahan, for example, the court concluded that a tax-motivated sale of future dividends was actually a sale and not a loan. The taxpayer, who desired to generate taxable gain to offset a large interest deduction, sold the right to receive future stock dividends. The court held that although the sale was motivated solely by tax savings, the transaction could not be recharacterized as a loan, because a genuine risk did exist that enough dividends might not be declared in the future to fully repay the buyer for his cash outlay. Stranahan v. Comm'r, 472 F.2d 867 (6th Cir. 1973). See also Cotlow v. Comm’r, 228 F.2d 186 (2d Cir.1955) (assignment of life insurance policy renewal commissions treated as a sale and not a loan because buyer bore the risk that the policies would not be renewed).
9See, e.g., Stranahan, supra; Cotlow, supra; Mapco, supra. The issue of sale versus loan characterization can similarly arise in the context of factoring. Factoring refers to where a company sells its receivables to a financing party, called a factor. Generally, if the sale to the factor is at arms-length and the factor assumes risk of loss with respect to the receivables, the sale is respected for tax purposes. See, e.g., CCA 200519048 (Jan. 27, 2005) (risk of loss had shifted to factor and taxpayer must therefore include as income the factor’s lump sum payment).
10Geftman v. Comm'r, 154 F.3d 61 (3d Cir. 1998) (internal quotation marks omitted).
11In various contexts, courts have emphasized that ownership of property for tax purposes does not depend merely on legal title. See, e.g., Grodt McKay Realty Inc. v. Comm'r, 77 T.C. 1221 (1981).
12Sections 1222(1). Section 1221(a)(3) excludes certain patents and other intangible property from capital asset treatment. The exclusion applies to certain property created by the holder's personal efforts (or property received in exchange for such property). This article does not further discuss the section 1221(a)(3) exclusion.
14Reg. sections 1.61-8(a) and -8(b).
15Capital gain treatment generally is more advantageous for taxpayers than ordinary income treatment, for reasons that differ for differently situated taxpayers and that this article does not discuss.
16We have used the terms “sale” and “license” for the sale of colloquial clarity here. We note also that the substantial rights test authorities discussed below generally hold that a transfer that fails to transfer all substantial rights results in ordinary income treatment without concluding whether the transfer is or is not treated as a sale for federal income tax purposes. Aside from its relevance to the capital versus ordinary character question, another reason that treatment of a transaction as a sale may be important is that sale transactions generally permit the seller to recover the tax basis of the property sold. See generally Section 1001. Since life science companies engaging in royalty stream monetization transactions generally have little if any tax basis in their monetized royalty rights, this article does not address basis recovery.
17See Section 1235(a) and Reg. section 1.1235-2 (regarding transfer of substantial rights to a patent); Pickren v. United States, 378 F.2d 595 (5th Cir. 1967) (right to terminate transfer agreement at will is retention of substantial right when trade secret's useful life extends beyond term of agreement); Cubic Corp. v. United States, 72-1 U.S.T.C. ¶ 9165 (S.D. Cal. 1971) (license agreement because owner transferred less than all of substantial rights); Rev. Rul. 64-56, 1964-1 C.B. 133, amplified by Rev. Rul. 71-564, 1971-2 C.B. 179. Transfer of all substantial rights within a specified jurisdiction or territory may receive sale treatment even if rights in other jurisdictions or territories are retained. See Glen O’Brien Partition Co. v. Comm’r, 70 T.C. 492 (1978); Rev. Rul. 64-56, supra, amplified by Rev. Rul. 71-564, supra.
18See generally Reg. section 1.1235-2.
19See Reg. section 1.1235-2(b)(1)(i) (patents).
21Id. See also Rev. Rul. 64-56, supra (transfer of know-how is a sale only if the transfer is exclusive and perpetual).
22See, e.g., Hort v. Comm’r, 313 U.S. 28 (1941); Comm’r v. P.G. Lake, Inc., 356 U.S. 260 (1958). See also Rev. Rul. 69-471, 1969-2 C.B. 10 (wife’s receipt of a lump sum, pursuant to a divorce degree, in exchange for relinquishment of rights with respect to husband's retirement pay is ordinary income under the assignment of income doctrine).
23P.G. Lake, supra (the “... substance of what was assigned was the right to receive future income”).
24See, e.g., O'Neill v. Comm’r, 23 T.C.M. 7(1964) (“[p]etitioner argues that where a taxpayer sells a right to receive income which has not accrued or which cannot be ascertained with accuracy, then the gain realized from such sale is a capital gain. We cannot agree.”); Turner v. Comm’r, 38 T.C. 304 (1962) (sale of rights to receive future commissions on renewal of insurance policies).