IRS’ Aggressive Position Challenging the Treatment of a License Agreement as a Sale of a Capital Asset Rejected on Summary Judgment

We previously reported that the Internal Revenue Service (the “IRS”) took an aggressive position in challenging the treatment of a license agreement as a sale of a capital asset in the Tax Court case Mylan Inc. & Subsidiaries v. Commissioner of Internal Revenue (Docket Nos. 16145-14 and 27086-14). Recently, Tax Court Judge Laro denied the IRS’s Motion for Summary Judgment in Mylan’s challenge of the IRS’s determination that Mylan’s 2008 amendment to the contract with Forest Labs was not a sale of its interest in rights to a certain drug product but merely an extension of the parties’ 2006 license agreement, giving rise to ordinary income to Mylan.

In its Tax Court petition, Mylan argued that it sold “all substantial rights” to a drug named Nebivolol and sought a redetermination of tax deficiencies related to proceeds from the sale which Mylan treated as capital gain. The IRS argued that Mylan had to treat the transaction as a license agreement generating ordinary income.

In denying the motion for summary judgment, the Tax Court considered whether the tax treatment should be determined based solely on the literal reading of the agreements among the parties. The IRS argued that, pursuant to Commissioner v. Danielson, 378 F. 2d 771, 775 (3d Cir. 1967), taxpayers are bound by the terms of their agreement. Mylan argued that Danielson does not apply, citing to Merck & Co. v. Smith, 261 F.2d 162 (3d Cir. 1958) and E.I. du Pont de Nemours & Co. v. United States, 432 F.2d 1052 (3d Cir. 1970), and pointing out that, in determining whether all substantial rights to a patent were transferred, the Court must consider not only the terms of the contracts but also the intent of the parties.

The Tax Court held for Mylan. The Tax Court first pointed to the difference between Danielson, Merck, and E.I. du Pont de Nemours and stated: “In Danielson, a taxpayer sought to change the tax consequences of a transaction by challenging the validity of the underlying contract’s terms, specifically, allocation of consideration between the sale of stock and the covenant not to compete, because the taxpayer believed these terms did not reflect the agreement of the parties. In Merck and E.I. du Pont de Nemours, the taxpayers did not seek to alter or challenge the agreements in question. Instead, the taxpayers disagreed with the Commissioner’s interpretation of those contracts and characterization of the related payments for tax purposes.”

The Tax Court then found that the case before it was a question not of Mylan arguing substance over form in an attempt to modify the terms of its contract after the fact, but rather a question of interpreting the terms of the actual contract itself: “Here, unlike in Danielson, petitioners do not seek to change the tax consequences of the transaction by challenging the underlying agreements and reforming the contractual terms . . . . The question presented here is a question of proper tax characterization of the proceeds of valid and enforceable contracts, and we are mindful that the Commissioner and taxpayers often disagree on this issue.”

The Tax Court then further found that there were ambiguities in the 2008 agreement with respect to what rights were actually transferred to Nebivolol, which, combined with Mylan’s alleged business reasons for selling its rights to the drug, created issues of material fact in dispute. Interpreting the facts in the light most favorable to Mylan as the party opposing the motion, the Tax Court denied the IRS’s motion for summary judgment.

The case of Spiridon Spireas et al. v. Commissioner of Internal Revenue (Docket No. 10729-13), which many thought would directly affect the outcome in Mylan, has not yet been decided.

George M. Gould, Counsel in the Gibbons Intellectual Property Department, and Peter J. Ulrich, Director in the Gibbons Corporate Department, authored this post.
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