Collaboration agreements are often seen as a means for life sciences, biotechnology, and other companies to share the risks often associated with developing a new drug, medical device, or other cutting-edge technologies. These agreements can take many forms, but most often involve the “transfer” of rights to intellectual property (IP) to an unrelated third party in exchange for (1) upfront payments, not contingent nor refundable; (2) milestone payments, contingent on the achievement of some predetermined outcome; or (3) share of profits; or (4) an equity investment.
The agreements often outline what each party is responsible for and the rights each party has with respect to the development. Depending on the terms, the agreement could be called an Asset Purchase Agreement, a Co-marketing Agreement, or a Licensing Agreement. It is necessary to understand that the tax consequences of these agreements may differ depending upon the rights transferred, and oftentimes, there is a question as to whether IP has been sold or licensed.
The differentiating factor between the sale or licensing of IP for tax purposes is related to control. If the seller relinquishes all control to the IP, then the transaction will be treated as a sale for tax purposes. However, if the seller retains control of the IP, a licensing agreement exists. Internal Revenue Code (IRC) §12351 guides corporate taxpayers in analyzing whether a transaction is a sale vs. a license.
When IP is shared in a collaborative agreement, the contractual terms must be explicit on the control aspect, or else unintended tax consequences may arise. The character of income, as capital gain or as ordinary, depends on whether the terms of a collaboration agreement will result in sale treatment or licensing treatment. Capital gain results from a sale of IP, and ordinary income is when a licensing agreement is in effect.
In determining how to structure a collaboration agreement best, understanding the resulting character of income is critical as there are planning opportunities associated with both:
- There is currently no income tax rate differential between capital gain and ordinary income for regular corporations. However, a corporation with capital losses may be desirous of sale treatment as the corresponding gain on sale can be offset by the capital losses to the extent available.
- For all entities, corporate or otherwise, sale treatment would allow for the recognition of gain under the installment method if payments were to be made in subsequent years.
- For all entities, a licensing agreement would typically result in ordinary income recognition for the transferor in accordance with IRC §451. The timing of the income recognition for tax purposes will depend on the character of the transaction and when the cash is received. It is possible that upfront payments could be subject to a one-year deferral under IRC §451(c).
WG observation: As outlined above, multiple considerations must be analyzed when structuring a collaboration agreement. The tax classification and the underlying tax attributes of the transferor should be considered, but as with all transactions or agreements, the tax consequences are only one side of the equation and should be weighed against other general business considerations.
