Recently we’ve encountered a unique situation highlighting the importance of analyzing the underlying agreements and transactions under the lens of US GAAP and US Federal tax, as the ultimate result can be wildly different.
A pharmaceutical company, “Pharma Co.”, entered into an agreement to develop, license, and commercialize their product in partnership with a third-party manufacturer and distributor, “3 PM”. Under this partnership, Pharma Co. retained the right to receive royalties from 3 PM based on 3 PM’s future sales of the products. To help expedite the development and ultimate commercialization of the product Pharma Co. entered into a Funding Agreement with a private equity company, “PE.” The terms of this funding agreement dictated that PE would provide Pharma Co. with $25 million to expedite the activities under the partnership with 3 PM in exchange for a percentage of future product revenue that Pharma Co. is entitled to receive.
Under US GAAP, a sale of future revenue typically involves an entity receiving an up-front payment from an investor in exchange for granting the investor the right to receive a specified percentage or amount of the future revenue of a particular product or service of the entity for a defined period. Whether the up-front payment received from the investor should be classified as debt or deferred income depends on the specific facts and circumstances. ASC 470-10-25-2 provides several factors to be considered, and the presence of any one of the following factors independently creates a rebuttable presumption that debt classification is appropriate:
- The transaction does not purport to be a sale (that is, the form of the transaction is debt).
- The entity has significant continuing involvement in generating the cash flows due to the investor (for example, active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).
- The transaction is cancelable by either the entity or the investor through payment of a lump sum or other transfer of assets by the entity.
- The investor’s rate of return is implicitly or explicitly limited by the transaction terms.
- Variations in the entity’s revenue or income underlying the transaction have only a trifling effect on the investor’s rate of return.
- The investor has any recourse to the entity relating to the payments due to the investor.
Under the terms of the Funding Agreement, Pharma Co. has significant continuing involvement in the generation of cash flows due to PE. As a result, the $25 million up-front payment is treated as debt for US GAAP purposes.
Currently, there are no Treasury Regulations when determining if an instrument should be treated as debt versus equity. As a result, taxpayers have had to rely on numerous court rulings and non-quantitative multifactor tests. The factors considered generally include (1) the name given to the instrument; (2) the degree of risk undertaken by the holder; (3) the parties’ intent; (4) whether the issuer is thinly capitalized; (5) whether a third party would have lent the same amount of money on similar terms; (6) subordination to the issuer’s other debts; (7) source of payments; (8) fixed maturity date; (9) right to enforce payment upon default; (10) and participation in management, etc.
After weighing the above relevant factors and facts and circumstances involved in the Funding Agreement, it was concluded that the up-front $25 million payment is not debt for US Federal income tax purposes. Furthermore, because Pharma Co. received an up-front payment in exchange for selling a future income stream, this transaction is considered a sale, and the payment received is considered ordinary income includible in gross income the year it was received.
From a US Federal income tax perspective, weighing the relevant facts and circumstances with each capital transaction is essential, as evidenced above. The multifactor test to determine if a capital transaction is considered debt or equity for tax purposes is not as clear-cut as it is for US GAAP, which can cause many headaches if the determination is not well supported and documented. Had the Pharma Co. analysis not been conducted on a timely basis, likely, the requisite quarterly estimated tax payments on $25 million of ordinary income would have been underpaid or missed altogether, resulting in significant penalties and interest at the time of filing the corporate income tax return.
If you have any questions, please contact your WG business advisor.