3rd Circuit denies capital gain treatment of patent royalties

Tax Hot Topics: Decision upholds Tax Court ruling

Tax Hot Topics newsletterIn a split decision on March 26, the U.S. Court of Appeals for the Third Circuit held in Spireas v. Commissioner, No. 17-1084 (3d. Cir. 2018) that a pharmaceutical scientist waived his right to raise new arguments for treating royalty payments from a licensing agreement as long-term capital gains.  

The decision affirms the Tax Court’s decision in Spireas v. Commissioner, T.C. Memo. 2016-163 (Aug. 24, 2016), which ruled that royalty payments to Spiridon Spireas from licensing his patented technology were taxable as ordinary income because he did not transfer property with substantially all of the rights to a patent.

Spireas was a pharmaceutical scientist specializing in the development of “liquisolid” technologies, a new method of drug formulation in the science of drug delivery. Spireas and his colleague, Sanford Bolton, created an S corporation, Hygrosol, to take advantage of the growing demand for liquisolid technologies in the pharmaceutical industry. They each held a 50% interest in Hygrosol, and the S corporation received the royalties at issue in this case.

In 1998, Hygrosol, Spireas, and Bolton entered into a licensing agreement with Mutual Pharmaceutical Company, Inc., and its affiliate, United Research Laboratories, Inc. (collectively, Mutual), under which Mutual would receive a license to use the technology only in connection with specific products that the parties agreed to develop. The agreement granted the following rights to Mutual in regards to the liquisolid technology owned by the licensors:

  • Mutual had the right to use the liquisolid technology to develop, produce, and sell new and generic pharmaceutical drugs within the United States on a product-by-product basis, but only with unanimous consent from all parties to the agreement (including Spireas, Bolton and Hygrosol).
  • Mutual may not produce products that the licensors were pursuing with other companies, including non-pharmaceutical items such as nutritional supplements.
  • If Mutual decided to stop pursuing certain products after development commenced, the licensors were free to offer these products to other parties.
  • Rights to the liquisolid technology would revert to the licensors if Mutual failed to keep its commitments under the agreement.
  • 20% of the gross profit from any sales of developed products would be paid to Hygrosol quarterly.

In 2000, Spireas entered into an engagement letter with Mutual for $30,000 to develop three specific drugs, one of which was the drug felodipine. The U.S. patent had expired for this drug, and Spireas proceeded in developing a new formulation of felodipine that Mutual produced and marketed with commercial success. The engagement letter did not provide any additional rights or royalty payments other than those detailed in the 1998 agreement.

For taxable years 2007 and 2008, Spireas reported over $40 million in royalties from Mutual’s felodipine sales as long-term capital gains under Section 1235. Section 1235(a) provides that transfers of property consisting of substantially all the rights to a patent by any holder are considered sales or exchanges of long-term capital assets, without regard to whether payments are made periodically or contingent upon the property’s productivity, use, or disposition. A holder of property under Section 1235(b) generally includes the creator of the property. To obtain capital gain treatment, royalty payments must be made pursuant to a property transfer under Section 1235.

Spireas argued that the 2000 engagement letter was another licensing agreement that transferred all his substantial rights in the felodipine formulation to Mutual. The IRS determined that the royalties should have been reported as ordinary income because Spireas had not transferred all substantial rights of the liquisolid technology or the felodipine formulation to Mutual. The Tax Court upheld the IRS’s determination, indicating that the 1998 licensing agreement limited Mutual’s use of the liquisolid technology to the pharmaceutical industry and production of specific products contingent on the licensors’ approval. As for the felodipine formulation, the Tax Court held that the 1998 agreement was the actual instrument of transfer, and that the 2000 engagement letter merely fulfilled the conditions of the 1998 agreement. Based on this, Spireas could not have transferred rights to the felodipine formulation because it did not exist at the time of the agreement. Therefore, Spireas had not transferred all the rights to the liquisolid technology or the felodipine formulation to Mutual, and the royalty payments he received under the licensing agreement should have been reported as ordinary income, according to the court.

Eddie Adkins
Washington National Tax Office
T +1 202 521 1565

Jeffrey Martin
Washington National Tax Office
T +1 202 521 1526

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