17 - Third Circuit Characterized Pharmaceutical Deal As License, Royalties As Ordinary Income

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1 17 - Third Circuit Characterized Pharmaceutical Deal As License, Royalties As Ordinary Income Spireas v. Comm., (CA 3 3/26/2018) 121 AFTR 2d The Court of Appeals for the Third Circuit, affirming the Tax Court, has upheld IRS's determination that amounts received by a taxpayer from a pharmaceutical company were royalties paid pursuant to a license to use certain technology for limited purposes. These amounts were taxable as ordinary income rather than as capital gains. The Court also found that the taxpayer had waived the argument he attempted to advance on appeal by failing to present it in the lower court. Background on sale of patents. Royalty payments received under a license agreement are generally taxed as ordinary income under Code Sec. 61. However, under Code Sec. 1235(a), certain sales of patents generate long-term capital gains to the seller even if the patent was held by the seller for less than one year. Specifically, that Code section provides that a transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent will be considered the sale or exchange of a capital asset held for more than one year (i.e., long term), regardless of whether or not payments in consideration of the transfer are (1) payable periodically over a period generally coterminous with the transferee's use of the patent, or (2) contingent on the productivity, use, or disposition of the property transferred. Code Sec. 1235(d) provides that this special long-term capital gain treatment doesn't apply if the sale is between related persons. For purposes of Code Sec. 1235, all substantial rights (i.e., all rights which are then of value) must be transferred. (Reg (b)(1)) The retention of the right to terminate the transfer at will is considered the retention of a substantial right. (Reg (b)(4)) Also, for purposes of Code Sec. 1235, it isn't necessary that the property transferred be patented or subject to a patent application at the time of transfer. (Reg (a)) Rather, it is sufficient that the taxpayer transfer all substantial rights to a patentable product that is held as a trade secret. In Merck & Co. v. Smith, (CA ) 2 AFTR 2d 6161, and E.I. du Pont de Nemours & Co. v. U.S., (CA ) 26 AFTR 2d , the Third Circuit held that the transfer of all substantial rights in a patent can result in a disposition for tax purposes, qualifying the transferor for capital gains tax treatment, while a transfer of anything less is called a license, with proceeds taxed at ordinary income tax rates. In both cases, the Court of Appeals examined not only the 51

2 terms of the contracts but also the intent of the parties and found that all substantial rights were transferred. In so holding, it found that the precise wording and terms of the agreements were not necessarily controlling if the substance of transaction was in fact a transfer of all substantial rights. In general, to ascertain whether all substantial rights are transferred, courts look to see what rights were retained and whether, in the aggregate, they have substantial value. (E.I. du Pont) Background on raising issues on appeal. With certain exceptions (e.g., a trial court's lack of jurisdiction, an intervening change in law, or to prevent a miscarriage of justice), the courts of appeals generally will not consider on appeal contentions not raised before the trial court. In U.S. v. Joseph, (CA ) 730 F.3d 336, the Third Circuit stated that in applying this rule, merely raising an issue that encompasses the appellate argument was not enough. Whether an argument could be raised was determined by the degree of particularity with which it was raised in the trial court that is to say, the party must do so with exacting specificity. Two features characterized arguments raised on appeal as having been previously raised in the trial court: they both depended on the same legal rule or standard, and they both depended on the same facts. Facts. Spiridon Spireas immigrated to the U.S. from Greece in '85 and completed master's and doctoral studies in pharmaceutical technology and industrial pharmacy. His dissertation addressed techniques designed to improve the solubility of drugs not easily dissolved in water, and he subsequently became a renowned expert in the science of drug delivery. In '97, Spireas and Sanford Bolton (his former faculty adviser, since deceased) organized Hygrosol Pharmaceutical Corporation (Hygrosol) for the purpose of exploiting liquisolid technologies they were developing. Hygrosol is an S corporation that, at all relevant times, was owned in equal shares by Spireas and Bolton. Hygrosol received the royalties at issue in this case, which flowed equally through to Spireas and Bolton. Four U.S. patents were issued that related to liquisolid technology. One was issued solely to Spireas, and the others were issued to him and Bolton jointly. Mutual Pharmaceutical Company, Inc. (Mutual) was a company whose business focused on developing and marketing generic drugs. On Dec. 23, '97, Mutual sent Spireas and Bolton a proposal that would grant it an exclusive license to use the liquisolid technology. Spireas rejected the proposal, but the parties later agreed to a nonexclusive license to use the liquisolid technology in connection with specific products within the pharmaceutical field which were agreed to by the parties ('98 license agreement). Between '98 and 2002, the parties in fact selected more than 20 products for further development, memorialized in short engagement letters. 52

3 Of those 20 products, two resulted in commercial success, felodipine and propafenone. In March 2000, Spireas and Mutual entered into an engagement letter (the 2000 engagement letter) in accordance with the '98 agreement that engaged Spireas to develop, using liquisolid technology, a generic version of a blood-pressure drug called felodipine. At the point he signed the 2000 engagement letter, he had completed roughly 30% of the work that ultimately resulted in the liquisolid formulation of felodipine. Felodipine was independently patentable based on the difficulty in adapting the liquisolid technology to the idiosyncrasies of the drug but for which no patent was sought because the parties didn't want competitors to see the disclosures that a patent application would require. The felodipine formulation was invented by Spireas sometime between May 10, 2000 and May of Mutual received royalties paid on the ultimate sale of profits. Meanwhile, Spireas pursued ways of marketing liquisolid technology beyond the pharmaceutical field, and he also had development deals with other drug companies to develop pharmaceutical products using the liquisolid technology. At the time the '98 license agreement was entered into, the right to exploit liquisolid technology in the health and nutrition fields had substantial value. Spireas and his wife, on their joint returns for 2007 and 2008, reported royalties received under the '98 license agreement as long-term capital gain. IRS, on the other hand, characterized the royalties as ordinary income and determined deficiencies totaling nearly $6 million. The issue. The question before the Court was whether royalties paid on the technology license agreement should be treated as ordinary income or as capital gains. Spireas earned $40 million in such royalties over just two tax years, if these earnings were ordinary income, he would owe a 35% tax; if they were capital gains, he would owe 15%. Tax Court decision. The Tax Court upheld IRS's determination that amounts received by the taxpayer from the pharmaceutical company were royalties paid pursuant to a license to use certain technology for limited purposes. In so holding, the Court found that the taxpayer retained valuable rights to the technology that precluded capital gain treatment under Code Sec These amounts were taxable as ordinary income. Having concluded that the liquisolid technology was the relevant object of what had been transferred, the Court then easily determined that the '98 license agreement did not transfer all substantial rights to it. The rights granted were limited to the pharmaceutical industry and further restricted to specific products selected by and agreed to by all parties, leaving Spireas with retained rights that had substantial value. Notably, the '98 license agreement didn't transfer rights to the formulation of any specific drug (because no such formulations existed at the time). (Spireas, TC Memo ) 53

4 Spireas appealed the Tax Court decision, arguing that his royalty payments qualified for capital-gains treatment under Code Sec because he had received them in exchange for all substantial rights to liquisolid felodipine. Spireas claims the '98 license agreement prospectively assigned Mutual the relevant rights long before he actually invented that particular formulation. IRS countered that Spireas had waived any argument based on a prospective transfer of rights by not presenting it to the Tax Court. Appellate decision. The Third Circuit majority agreed with IRS, the amounts at issue were taxable as ordinary income rather than as capital gains. The Court also found that the taxpayer had waived the argument he attempted to advance on appeal by failing to present it in the lower court. While the Third Circuit acknowledged that Spireas had consistently relied on both the '98 agreement and the 2000 engagement letter, and had argued that they operated in conjunction to transfer to Mutual rights to liquisolid felodipine, the Court found notably absent from this discussion any mention of when Spireas claimed that the transfer of rights in liquisolid felodipine took place. The Court found that Spireas could not argue on appeal that he transferred rights to felodipine in '98 after he took the contrary position in the Tax Court. Under Code Sec. 1235's test for capital-gains treatment, changing the date on which Spireas granted Mutual rights to liquisolid felodipine changed the legal theory on which his position depended. Spireas's royalty payments were entitled to capital-gains treatment only if Mutual paid them in exchange for a transfer of property consisting of all substantial rights to the liquisolid formulation of felodipine. Spireas couldn't make that argument for the first time on appeal because it depended on a different legal standard for when that formulation became property than his argument to the Tax Court. The Third Circuit reasoned that Code Sec is explicit that in order to secure capital-gains treatment, an inventor must make a transfer of property rights that he actually possesses at the time of the grant. Accordingly, Spireas had to explain: (1) when he granted Mutual rights to liquisolid felodipine, and (2) how he obtained a property interest in that formulation prior to the grant. The account Spireas presented to the Tax Court was clear: he granted Mutual its rights after the invention of the liquisolid formulation was complete, which happened sometime after March And, the Tax Court found so, concluding that Spireas' invention of the felodipine formulation occurred sometime between May 10, 2000 and May This conclusion by the Tax Court necessarily meant that under the terminology of patent law, Spireas "reduced it to practice" (i.e., tested and operated it successfully under operating conditions) within the same timeframe. The Court reasoned that Spireas's original theory hinged on a post-invention transfer of rights. On that account, Spireas reduced the felodipine formulation to 54

5 practice around May 2000 (giving him, in theory, the property interest that the statute requires) and only later passed his interest on to Mutual. But Spireas now abandoned that theory, insisting instead that he transferred rights to Mutual in '98 (assigning his rights to future products). Because that was at least two years before the invention of the felodipine formulation, Spireas's current position could not depend on the legal standard of reduction to actual practice to establish that he held a property right at the time of transfer. Nor could it depend on the same facts as did his argument to the Tax Court, the timing of felodipine's invention central among them. Spireas's sole claim on appeal was therefore waived under Joseph. Dissenting opinion. A dissenting Judge in the Third Circuit found that the majority opinion misconstrued Spireas' arguments before the Tax Court and misapplied the waiver rules. According to the dissent, the majority confuses the legal transfer of rights to the felodipine formulation (and other products) with the physical transfer (i.e., the handover or disclosure) of the felodipine formulation. The majority also incorrectly concludes that, as a matter of law, Spireas could not have transferred rights to the liquisolid felodipine formulation until it was reduced to practice. The dissent found that the facts supported that rights to the future drug formulations were transferred in exchange for royalty payments. That transfer of rights occurred via legal instrument (the '98 agreement), which granted rights to future products in exchange for 20% royalty payments, operating in conjunction with the 2000 engagement letter, which identified the felodipine formulation as a product under the '98 agreement. The actual felodipine formulation was physically transferred or handed over to Mutual later, at least several months after March 2000, once Spireas had completed its development. In addition, the dissent noted that waiver is a prudential doctrine, not an absolute rule. The dissent found the majority's reliance on Joseph, a criminal case, misplaced. The purpose of the waiver doctrine is to provide parties an opportunity to offer all evidence they believe relevant to the issues and ensure that litigants may not be surprised on appeal by a final decision there on issues upon which they have had no opportunity to introduce evidence. Here, the evidentiary record was fully developed. The relevant documents, primarily the '98 agreement and the 2000 engagement letter, had been available to all parties from the outset of the litigation. On appeal, neither Spireas, nor IRS in its response, relied on any evidence not presented to the Tax Court. The substantive question of whether the '98 agreement effected a transfer of future rights to the products could be resolved fully based on the existing record. 55