IRS Takes Aggressive Position in Challenging the Treatment of a License Agreement as a Sale of a Capital Asset

Recently, a Memorandum in Support of Motion for Summary Judgment was filed by the Internal Revenue Service (the “IRS”) in the Tax Court case Mylan Inc. & Subsidiaries v. Commissioner of Internal Revenue (Docket Nos. 16145-14 and 27086-14). Mylan’s opposition brief to the IRS’s motion followed shortly thereafter. This case illustrates the importance of exercising care when transferring intellectual property rights if you intend to benefit from capital gains treatment. An improperly structured sale may be recharacterized by the IRS as a license, resulting in a much larger tax liability for the transferor than what was anticipated.

The IRS’s position, simply put, was that Mylan, having granted a license and a sublicense to a drug product to Forest Labs in a contract, cannot subsequently re-characterize the transaction as the sale of a capital asset allowing Mylan to claim treatment of income derived from this transaction as a capital gain. The IRS cites Code Section 1221 and Brown v. Commissioner, 380 U.S. 563, 571-72 (1965), for the proposition that Mylan must show that it sold a capital asset to be entitled to capital gain treatment.

The dispute in this case stems from an agreement originally entered into between Mylan and Forest in 2006, referred to as a license agreement, and the fact that Mylan treated it as such, characterizing payments received from Forest during 2006 and 2007 as ordinary income, and taking advantage of income deferral under IRS Revenue Procedure 2004-34, 2004-1 C.B. 991 (June 1, 2004). Rev. Proc. 2004-34 allows for the deferral of income when an accrual method taxpayer receives advanced payments for the use, including by license, of intellectual property until the year after their receipt.

By way of background, the 2006 agreement between Mylan and Forest transferred responsibility for all ongoing and future development activities of Nebivolol, and the costs associated therewith, to Forest. Mylan first secured the rights to Nebivolol from Janssen Pharmaceutica NV in 2001, with all rights granted under the contract with Janssen personal to Mylan, but subsequently sublicensed those rights, including all commercialization activities, to Forest in 2006 for $75 million, royalties, and a series of milestone payments. The Janssen contract was attached to, and made a part of, the 2006 contract.

The IRS challenge focuses on the 2008 amendment to the 2006 contract. According to the IRS’s motion for summary judgment, Forest gained additional responsibilities with respect to Nebivolol as a result of the 2008 amendment, including responsibilities related to drug development activities, interactions with regulatory authorities, drug promotion, labeling and package design, and prosecution of patent infringement. Mylan, in turn, retained the right to acquire all commercial supplies of Nebivolol from Janssen, as well as the right to receive information regarding Forest’s contacts with regulatory authorities, to attend Forest’s meetings, with regulatory authorities and to provide input towards Forest’s marketing plans, strategies, and pricing of the drug, among others. The IRS further argues that Mylan also retained the right, albeit on a co-exclusive basis with Forest, to develop and commercialize Nebivolol for the treatment of migraine headaches, and required that Forest obtain Mylan’s consent prior to assigning or sublicensing its rights under the contract to third parties.

Mylan took the position that the 2008 Amendment resulted in a sale of its rights under the original 2001 agreement with Janssen, and reported payments from Forest from 2008 to 2011 as capital gain. In its opposition papers, Mylan points out that its 2001 license from Janssen was a capital asset under Code Sections 1221 and 1231, and that Mylan consistently treated it as such. Mylan urges the Tax Court to focus on whether Mylan retained any “substantial” rights to Nebivolol, and points to two Third Circuit cases, Merck & Co. v. Smith, 261 F.2d 162 (3rd Cir. 1958) and E.I. du Pont de Nemours and Co. v. U.S., 432 F. 2d 1052 (3rd Cir. 1970), in which the courts held that the transfer of all substantial rights in a patent can result in an assignment, qualifying the transferor for capital gains treatment. Mylan further expands on this concept by arguing that “[the Respondent’s] merely listing purported “rights” [retained by Mylan] does not answer the controlling question of whether such rights were “substantial” and “is supported by absolutely no witness declarations or evidence beyond the contracts themselves.”

The IRS argues that the 2008 amendment is merely an extension of the 2006 license agreement, which not only uses licensing terminology but also provides for milestone payments and royalties, just like a license agreement would, and therefore that payments from Forest to Mylan for the years 2008 through 2011 are ordinary income to Mylan. Mylan argues, on the other hand, that labels and terminology do not control whether an agreement constitutes a sale or a license for federal income tax purposes, and that the IRS’s mere listing of the rights retained by Mylan after the 2008 agreement without any substantive discussion as to why the rights are significant is not enough to meet the IRS’s burden in the case.

The IRS’s position in this case would appear to be a more severe position than the IRS has taken in several recent Tax Court cases such as Estate of Bolton v. Commissioner of Internal Revenue (settled before decision – Docket No. 9836-13) and Spiridon Spireas et al. v. Commissioner of Internal Revenue (Docket No. 10729-13) where even though the contracts involved self-designated exclusive intellectual property licenses the IRS contested the claim of capital gains treatment mainly on the issue of whether the licenses transferred all substantial rights to the asset. Since the Tax Court in the Spireas case had been holding up final briefing after trial awaiting the decision in the Bolton case, it would be interesting to see if the Mylan Tax Court proceedings were delayed to obtain the benefit of a decision in the Spireas case.