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Measuring the Returns for the Functions Performed and Risks Borne by a Start-Up Pharmaceutical Company

Published online by Cambridge University Press:  10 September 2019

Richard P ROZEK
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Abstract

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I. Introduction

Research-based pharmaceutical companies must comply with the tax regulations in the countries in which they operate. There are unique tax problems for relatively new or start-up companies, given that they often incur losses due to research and development (R&D), manufacturing, regulatory, and marketing costs incurred prior to generating positive profits from sales of finished products. Such companies also have limited marketplace data to use in an analysis of their actual behaviour as a participant in the industry. In this paper, I focus on a start-up integrated, multinational company (Start-Up) engaged in discovering, developing, supplying, and commercialising innovative pharmaceutical therapies. In addition, suppose Start-Up has current sales and profits from its initial brand pharmaceutical product Quick Cure.Footnote 1 To satisfy tax requirements across countries, Start-Up needs to evaluate the arm’s length considerations due its individual entities performing specific functions and bearing associated risks with respect to Quick Cure in the countries in which it operates.

For purposes of this paper, the primary functions and locations of the three entities within the vertical structure of Start-Up are:

  • Start-Up-Inventor conducts basic and clinical R&D activities on pharmaceutical solutions to medical problems, obtains patents when possible for resulting inventions, and licenses intellectual or intangible property to affiliates including patents and know-how. It performs these functions in the USA;

  • Start-Up-Developer/Supplier licenses intangible property from Start-Up-Inventor; funds clinical trials and other ongoing R&D; prepares dossiers for USA and foreign regulatory filings; performs manufacturing of active pharmaceutical ingredients (APIs); finishes and packages the final product; bears responsibility for bad debt, unsold product, foreign exchange risks, and product liability; coordinates logistics activities among affiliates; and funds the patient assistance program. These functions are performed in a country outside the USA that has a lower tax rate than the USA;

  • Start-Up-Marketer markets and distributes products in the USA.

Start-Up-Inventor, Start-Up-Developer/Supplier, and Start-Up-Marketer constitute the vertical chain within Start-Up by which biomedical research is transformed from ideas in the laboratory to final products provided to patients. Start-Up-Inventor and Start-Up-Marketer pay taxes in the USA, and Start-Up-Developer/Supplier pays taxes in a country other than the USA. The intercompany transfer of the intangible property embodied in Quick Cure from Start-Up-Inventor to Start-Up-Developer/Supplier, and the transfer of finished, packaged Quick Cure product from Start-Up-Developer/Supplier to Start-Up-Marketer are the controlled transactions. These two transactions are for transfers of intangible and tangible property, respectively.

My analysis follows the Internal Revenue Service Final Section 482 Regulations (TD 8552) for Intercompany Transfer Pricing, issued 1 July 1994 (Section 482 regulations).Footnote 2 The governing principle for valuing both intangible and tangible property in the Section 482 regulations is the arm’s length standard, which requires identifying the result that would have been realised had uncontrolled entities engaged in the same transaction under the same circumstances as in the controlled transaction.Footnote 3

Start-Up-Inventor and Start-Up-Marketer are the least complex entities in the vertical chain. These entities perform well-defined functions that can be evaluated using internal data from Start-Up and public data for the functions performed and risks borne in the controlled transactions. I refer to the approach described in this paper as the Vertical Chain Method. It is the best method for determining the arm’s length considerations that should be provided to Start-Up-Inventor, Start-Up-Developer/Supplier, and Start-Up-Marketer for performing all other functions and bearing the associated risks.

The remainder of the paper is organised as follows:

  • Section II presents the functional analysis of Start-Up’s worldwide pharmaceutical activities related to Quick Cure;

  • Section III describes the Section 482 regulations, data available, and the basis for my conclusion on the best method given the available data;

  • Section IV explains the process to derive arm’s length considerations due each Start-Up entity for performing specified functions associated with Quick Cure under the Vertical Chain Method;

  • Section V summarises the results.

II. Start-Up’s worldwide pharmaceutical activities

The economic portion of a tax analysis typically begins by gathering information on the company from reviewing internal documents and public data, interviewing employees of the company, and conducting site visits to the company’s facilities. To illustrate a solution to the tax issues facing a new entrant into the research-based pharmaceutical industry, I describe the functions performed by the hypothetical Start-Up around the world below.

Start-Up is an integrated, multinational company engaged in discovering, developing, manufacturing, and commercialising innovative pharmaceutical therapies to treat specific diseases and disorders. It has corporate headquarters in the USA. In addition, it has manufacturing plants and facilities for certain other functions incorporated in a European country with a lower tax rate compared to the USA.

Start-Up has invested in R&D activities for pharmaceutical therapies that resulted in identifying Quick Cure, a product approved by the US Food and Drug Administration (FDA). It is continuing to conduct basic and clinical R&D on other therapies. Periodically, Start-Up submits new information to the FDA or regulatory agencies outside of the USA regarding its R&D activities. This entity is referred to as Start-Up-Inventor.

To reduce risks of supply disruptions, Start-Up is self-sufficient with respect to manufacturing functions. It established facilities in Europe to produce sufficient quantities of the APIs for Quick Cure to meet requirements worldwide. It also has European manufacturing plants that formulate, process, package, warehouse, and ship Quick Cure. Specifically, the functions performed by Start-Up in Europe benefit Start-Up in the USA. The functions performed in Europe for Quick Cure include licensing the rights to the intangible property in Quick Cure (licensee); organising, managing, and funding ongoing R&D activities for the product; producing APIs and finished product, providing back-office activities (human resources, legal, information technology, investor relations); advising management on global activities in health care; collecting and maintaining information for regulatory authorities; implementing quality control/assurance; releasing batches and shipping finished product to the USA; bearing foreign exchange and inventory risks; absorbing bad debts, and paying for product liability insurance and the Start-Up patient assistance program. This entity is referred to as Start-Up-Developer/Supplier and is located in a country with a lower tax rate than the USA.

Start-Up’s primary commercial pharmaceutical programs in the USA are focused on marketing and distributing Quick Cure.Footnote 4 The sales force for Quick Cure is currently comprised of sales representatives in the USA with experience selling products for the medical issues Quick Cure has received approvals from the FDA to treat. This entity is referred to as Start-Up-Marketer.

III. Tax regulations, best method, and best data

1. The section 482 Regulations

The governing principle for determining transfer prices in the Section 482 regulations is the arm’s length standard.Footnote 5 Whether the price in a controlled transaction constitutes an arm’s length result must be evaluated using a method or methods selected under the “best method rule”.Footnote 6 The best method rule in the Section 482 regulations requires that the method selected provide the most reliable measure of an arm’s length result given the facts and circumstances of the controlled transaction. Under this rule, there are two primary factors to be considered:

  • the degree of comparability between the controlled and uncontrolled transactions; and

  • the quality of the data and assumptions used in the analysis.Footnote 7

2. Methods described in the section 482 Regulations – intangible property

The Section 482 regulations specify the following methods for determining the arm’s length result for the transfer of intangible property:

  • comparable uncontrolled transaction (CUT) method;

  • comparable profits method; and

  • comparable and residual profit split methods.

The regulations also permit the use of unspecified methods.

There is no preferred method among those listed. Rather, whether the result of a controlled transaction constitutes an arm’s length result must be evaluated using a method or methods selected under the “best method rule”.Footnote 8 The best method is determined based on the facts and circumstances of the controlled transaction including the degree of comparability between the controlled and uncontrolled transactions, the completeness and accuracy of the underlying data, the reliability of the assumptions, the sensitivity of the results to deficiencies in the data and assumptions, and possibly confirmation of the results by another method.Footnote 9

3. Methods described in the Section 482 regulations – tangible property

The Section 482 regulations specify the following methods for determining the arm’s length result for the transfer of tangible property:

  • comparable uncontrolled price method;

  • cost plus method;

  • comparable profits method;

  • resale price method; and

  • profit split method.

The regulations also permit the use of an unspecified method if it provides a more reliable arm’s length result than the specified methods. These methods are well known and are described in various sources.Footnote 10

4. The best method: vertical chain method

(a) Structure of the pharmaceutical industry

The pharmaceutical industry has a complex vertical structure from inventors to patients including the following participants.

  • inventors at academic institutions, government laboratories, and research-based pharmaceutical companies discover promising approaches to treating diseases;Footnote 11

  • developers conduct clinical trials and obtain regulatory approvals for products emerging from the discovery phase;Footnote 12

  • lawmakers/regulators set standards for determining whether pharmaceutical products are safe and effective and produced under appropriate manufacturing practices, and they review applications from companies seeking approvals under the standards;

  • suppliers obtain regulatory approvals for manufacturing activities, obtain raw materials, and produce APIs and finished, packaged products;Footnote 13

  • marketers disseminate relevant information about the therapeutic properties of products to members of the health care community (patients, physicians, pharmacists, and payers);Footnote 14

  • wholesalers (local, regional, and national) obtain products from manufacturers or marketers and resell the products to institutions such as pharmacies, food stores, hospitals, or federal facilities;

  • retailers (eg chain and independent pharmacies), hospitals, and federal facilities provide pharmaceuticals directly to patients based on instructions (eg prescriptions) from physicians;

  • third-party payers (government and private) collect premiums from tax revenues, employers, or individuals to pay for all or part of the patients’ pharmaceutical bill; and

  • patients use pharmaceutical products to treat their diseases either paying all the costs for a product out-of-pocket or relying on a third-party payer to absorb a share of the costs.

Investing in pharmaceutical R&D projects is risky, time-consuming, and expensive. On average, only five of every 5,000 compounds evaluated in the basic research phase enter into clinical trials and only one of these five products ultimately receives approval for marketing in the USA.Footnote 15 The R&D process for new chemical entities requires 10 to 15 yearsFootnote 16 and costs an average of $802 million.Footnote 17 One study found that only three of every 10 approved pharmaceutical products had sales revenue that exceeded the average after-tax development costs of a new product.Footnote 18 Not only is this process costly, it is risky since many projects fail. For the few projects that ultimately progress through the extensive clinical trial phases, a regulatory agency such the FDA must approve the underlying product as safe and effective, the associated manufacturing sites as complying with current good manufacturing practices (cGMPs), and the information materials the company intends to disseminate to the health care marketplace as accurate. Even after passing these hurdles, commercial success of a product is still not guaranteed. Many factors influence the acceptance of a pharmaceutical product in the marketplace including the:

  • prevalence of the disease that the product treats;

  • number of people afflicted with the disease who seek treatment;

  • therapeutic properties and side-effect profile of the product;

  • approved indications for the product;

  • price and third-party reimbursement policies for the product;

  • availability of competing products or medical procedures; and

  • extent to which patients, physicians, pharmacists, and payers are aware of the product and its properties.

There are no sales of the product during pre-approval R&D and no guarantee that a commercially viable product will result. Pharmaceutical products that complete pre-approval R&D must undergo regulatory review to determine whether the product is safe and effective for commercial sale. The specific requirements of this process differ across countries or regions. Generally, pharmaceutical companies must submit clinical data regarding the safety and efficacy of the product for human use to regulatory agencies. If a regulatory agency such as the FDA determines that the product meets the required standards, the product will be approved for commercial sale.

During the R&D process, the inventor produces experimental quantities of the product at pilot plants. Simultaneously with submitting scientific data for regulatory review, the inventor designs the process to manufacture commercial quantities of the product. This activity includes acquiring raw materials, manufacturing API, and finishing and packaging the final product. The regulatory agency must approve the sources of the raw materials, the sites at which the manufacturing activities take place, and the specific production processes used to ensure that the product meets safety requirements and has the specified identity, strength, quality, and purity characteristics. Changing any of these factors requires obtaining a supplemental approval from the regulatory agency. The regulatory agency often conducts inspection of the manufacturing sites and reviews the production records to verify that the product is manufactured according to cGMPs. If the regulatory agency identifies a violation of its cGMP standards, it may shut down operation of the plant pending correction of the problem. For a given product, these activities are not necessarily performed at a single site.

If a regulatory agency approves a pharmaceutical product, the company prepares for commercial launch of the product. The product launch is a critical stage in the marketing of a pharmaceutical product. During this time, the marketer incurs expenses associated with preparing and disseminating information about the product to health care providers, payers, and patients to educate them about the product. The marketer incurs these expenses without knowing the commercial potential of the product. There is risk associated with the launch of a product.

Post-approval, pharmaceutical companies perform R&D to pursue additional indications for the product or provide additional information about use of the product, possibly for marketing. Risks of therapeutic and generic competition as well as changes in government policies, other market forces, or macroeconomic factors remain. In addition, even after a product has been approved for commercial sale, there is a risk that broad-based use of the product may reveal adverse side effects. In some cases, the side effects may be so severe that the product is withdrawn from commercial sale. Such competition or potential policy changes reduces sales of the product.

(b) Data from Start-Up and public sources

Evaluating the methods specified in the Section 482 regulations to determine the best method to apply to the controlled transactions depends on the data available. Interviews with personnel familiar with Start-Up’s history, product portfolio, and operations in the USA and Europe; and review public data on Start-Up and the product Quick Cure are reliable sources of data to identify the functions performed and risks borne by Start-Up-Inventor, Start-Up-Developer/Supplier, and Start-Up-Marketer within the vertical structure of the pharmaceutical industry described above.

To determine the arm’s length considerations due each affiliate for its activities in actual situations, examine data from a variety of sources including:

  • Start-Up’s agreements with third parties for intangible and tangible property in the pharmaceutical industry;Footnote 19

  • agreements available from public sources for the transfer of intangible and tangible property in the pharmaceutical industry;

  • Start-Up’s supply agreements with third-party CMOs; and

  • information on companies that perform manufacturing activities for pharmaceutical products on a contract basis.

In the present hypothetical situation, Start-Up is a hypothetical company with limited actual data. Assuming it has some limited number of transactions with third parties to provide information on its behaviour in the marketplace for intangible and tangible property, these transactions supplemented by public data on similar transactions provide the best information to use in determining arm’s length considerations due the least complex components of the vertical chain. In the example, Start-Up-Inventor and Start-Up-Marketer are the least complex components performing functions related to Quick Cure. They are the focal points of this analysis.

The breadth of activities Start-Up-Developer/Supplier performs and risks it assumes make it the complex component of the vertical chain. The functions performed by Start-Up-Developer/Supplier involve funding clinical trials and other ongoing R&D, and preparing dossiers for USA and foreign regulatory filings; performing manufacturing of APIs, finishing, and packaging; bearing responsibility for bad debt, unsold product, and product liability; coordinating logistics activities among affiliates; and funding Start-Up’s patient assistance program. Given Start-Up-Developer/Supplier’s ongoing development functions, manufacturing investments and associated risks, liability, and coordinating, managing, and planning functions, especially in an expanding company, applying a return to Start-Up-Developer/Supplier’s manufacturing costs based on third-party companies that perform contract manufacturing activities is not sufficient to determine the consideration due Start-Up-Developer/Supplier for the breadth of functions it performs and risks it assumes.

(c) Best data available

A taxpayer’s uncontrolled transactions (ie agreements it negotiates with third parties) for performing relevant functions/bearing associated risks and the documents, including commercial or financial analyses of the transaction, prepared for management review generally constitute the most reliable set of data for determining an arm’s length result. Both licence agreements for intangible property and marketing/co-marketing agreements for tangible property are relevant.Footnote 20 If such market-based agreements exist, they reflect the terms of transfer that the taxpayer negotiated with unrelated parties during the ordinary course of business. These agreements contain detailed information on the functions performed and risks borne by each party. While some of the terms in the agreements may not be identical to the controlled transactions, they often satisfy the standard for acceptable comparable transactions.Footnote 21 The Section 482 regulations state that a transfer pricing analysis should be based on such data where available.Footnote 22 Most importantly, when the taxpayer is one of the unrelated parties in the transactions, the resulting agreements provide evidence of the taxpayer’s own arm’s length behaviour.

Start-Up-Inventor, Start-Up-Developer/Supplier, and Start-Up-Marketer conduct activities for Quick Cure at different levels within the vertical chain: discovering, developing, supplying, and marketing the pharmaceutical product. After identifying the functions performed and risks assumed by each of these entities for Quick Cure, search for Start-Up uncontrolled transactions comparable to the transfers of intangible and tangible property associated with Quick Cure. In the context of the hypothetical company Start-Up, the Vertical Chain Method, described in detail below, is the best method to determine the considerations due Start-Up-Inventor, Start-Up-Developer/Supplier, and Start-Up-Marketer for functions performed and risks borne for activities associated with Quick Cure. Where possible, the Vertical Chain Method utilises the company’s own behaviour in uncontrolled transactions for specific types of pharmaceutical property. It captures the results of the company negotiating at arm’s length with other pharmaceutical companies when essentially a singular purpose (rights to either intangible or tangible property) is the focus of the negotiation.

A company such as Start-Up has limited experience as an active participant in the markets for intangible and tangible property compared, for example, to the established pharmaceutical companies listed in the Fortune 500. It has not yet developed the sophisticated financial modelling approach to analyse potential agreements with third parties. Nevertheless, it is necessary to examine situations in which Start-Up enters uncontrolled transactions for both intangible (eg licences for patents and/or know-how) and tangible (eg agreements for marketing/co-marketing) property in the pharmaceutical industry. The financial analyses prepared by established companies provide estimates of the profit potential, most reliably measured by calculating the net present value (NPV) of the benefits to be realised as a result of the transfer, of an agreement with a third party.Footnote 23 The relevant uncontrolled transactions have essentially a single focus; namely, either Start-Up licensing (licensing-in or licensing-out) the rights to intangible property embodied in a pharmaceutical product or Start-Up negotiating for rights to market/co-marketing pharmaceutical products. Selecting such uncontrolled transactions with very specific purposes avoids the problem that a broader agreement encompassing more activities reflects the result of arm’s length bargaining, but the individual components (eg licence to intangible property) of the transaction may not reflect arm’s length terms due to trade-offs with other components of the transaction. Exclude from any analysis agreements that were contract service agreements, agreements with substantial collaboration between the two parties, agreements with CMOs for limited manufacturing functions, and non-exclusive agreements for limited rights to Start-Up’s intangible property. Also, exclude agreements that resulted from litigation (or the threat of litigation) or were in draft form. After applying these screening criteria, the agreements that remain involve Start-Up dealing with third parties for intangible or tangible property and are comparable to the controlled transactions. These data provide information on Start-Up’s actual arm’s length behaviour in the pharmaceutical industry. These agreements provided useful, but limited, information to analyse Start-Up’s arm’s length behaviour when negotiating for intangible and tangible property in the pharmaceutical industry. It is necessary to supplement Start-Up’s internal data with data from public sources. In addition, to determine the value of the manufacturing know-how for Quick Cure transferred to Start-Up-Developer/Supplier, public data may be helpful given that a new entrant into the pharmaceutical industry such as Start-Up probably has not engaged in transactions with third parties that specifically address the value of manufacturing know-how.

IV. Arm’s length considerations for Start-Up’s affiliates

1. Intangible and tangible property embodied in Quick Cure

(a) Start-Up’s data

The focus of the analysis in this paper is on a company that is introducing its first product to patients, physicians, pharmacists, and payers. Start-Up’s relative brief time as a participant in the research-based pharmaceutical industry means that there are relatively few agreements with financial analyses for intangible or tangible property involving Start-Up and third parties. Established research-based companies are often active participants in the marketplace for intangible pharmaceutical property. Such companies have numerous agreements with financial analyses to use in measuring arm’s length prices for tax purposes. I assume Start-Up has three relevant agreements with third parties or uncontrolled transactions for intangible property and three agreements for tangible property, which will be described below.Footnote 24 Start-Up has signed agreements, but does not have financial analyses of the agreements. Without such analyses, the CUT method (intangible property) or the resale price method (tangible property) cannot be applied. Furthermore, limited public information on relatively new entrants in the research-based pharmaceutical industry comparable to Start-Up means the CPM and profit split methods cannot be used to analyse Start-Up’s transfer prices for intangible property. Similarly, the specified methods for tangible property cannot be used.

(b) Public data

Given that Start-Up is a new entrant into the research-based pharmaceutical industry with relatively few third-party agreements for intangible and tangible property embodied in pharmaceutical products, public data is relevant information for Start-Up’s tax analysis. Specifically, consider royalty rates observed in the pharmaceutical industry generally. To obtain public data on industry royalty rates, helpful sources exist such as:

  • Windhover’s Pharmaceutical Strategic Alliances (Windhover);Footnote 25

  • Compact Disclosure;Footnote 26

  • RoyaltySource ® Intellectual Property Database; and

  • les Nouvelles.Footnote 27

From such databases,Footnote 28 it is possible to identify licence agreements among pharmaceutical companies for intangible property in which royalty rates as a%age of sales are available. Calculate the mean of the royalty rates from the descriptions of agreements in the public data. Also, determine the interquartile range for these royalty rates. Compare the results to other studies in the licensing literature. For example, a study by Sharon Finch found industry average royalty rates for products in the Phase III stage of development to be between 10.0% and 20.0% of sales.Footnote 29 Public databases also have information on marketing/co-marketing agreements for tangible property.

(c) Arm’s length consideration due Start-Up-Inventor

(i) Intangible property

Assume that in the three uncontrolled transactions for intangible property, Start-Up negotiated royalty rates of 5.0%, 10.0%, and 15.0% of net sales for licensing intangible property embodied in pharmaceutical products.Footnote 30 To illustrate the Vertical Chain Method, assume the interquartile range of royalty rates for licensing intangible property in the pharmaceutical industry from public data is 4.0% to 16.0% of sales.Footnote 31 Given the information from Start-Up’s experience licensing intangible property and the public data, the arm’s length consideration due to Start-Up-Inventor from Start-Up-Developer/Supplier for discovering and developing the intangible property is in the range of 5.0% to 15.0% of net sales of Quick Cure. Start-Up’s own agreements provide the primary basis for the range and the public data confirm the range is consistent with pharmaceutical industry practice.

(ii) Manufacturing know-how

Start-Up-Inventor developed the know-how associated with producing initial quantities of Quick Cure. When Start-Up-Developer/Supplier was established, Start-Up-Inventor transferred the know-how associated with the manufacturing process for Quick Cureto Start-Up-Developer/Supplier. Start-Up-Inventor should receive a royalty from Start-Up-Developer/Supplier on future sales of Quick Cure for the transfer of manufacturing know-how.Footnote 32

To determine an arm’s length royalty rate for transferring know-how, review public data sources such as those listed above for information on know-how licence agreements between uncontrolled parties. Identify any relevant agreements for know-how with royalty information available. If some individual agreements specify a range for the royalty rates to apply to know-how, calculate the midpoint of the specified range of royalty rates for know-how. Compare the results to arm’s length rates in the licensing literature. For example, in a study published by les Nouvelles, a respondent from the pharmaceutical industry reports that the “company typically pays 0-2% royalties for process, formulation, or software technology”.Footnote 33 To illustrate the Vertical Chain Method, Start-Up-Inventor should receive a royalty rate of 2.0% of net sales of Quick Cure for the manufacturing know-how it provided to Start-Up-Developer/Supplier.

(iii) Total consideration

Start-Up proposed that the total royalty rate provided to Start-Up-Inventor equal 12.0% of net sales of Quick Cure to third parties (ie 10.0% for intangible property plus 2.0% for manufacturing know-how). The rate proposed by Start-Up is within our arm’s length range (ie 5.0% to 15.0% of net sales for intangible property plus 2.0% for manufacturing know-how). It is consistent with the midpoint royalty rate from the interquartile range (10.0%) assumed from the public data on the pharmaceutical industry.

2. Marketing and distributing Quick Cure

To identify comparable uncontrolled transactions for finished, packaged pharmaceutical product from Start-Up-Developer/Supplier to Start-Up-Marketer, review the agreements Start-Up entered with third parties to identify those agreements for rights to market/co-market pharmaceutical products. Eliminate agreements that do not involve marketing activities or required extensive development efforts after the date of the agreement. Identify only the agreements that primarily involve marketing/co-marketing rights to pharmaceutical or health care products. Start-Up negotiated these agreements at arm’s length so they reflect Start-Up’s own behaviour as a third party in transactions for marketing rights.

(a) Start-Up’s agreements

As discussed above, the focus of the analysis in this paper is on a company that is introducing its first internally developed product to patients, physicians, pharmacists, and payers. Similar to the situation for Start-Up with regard to intangible property, the relative brief time that Start-Up has been involved as an entity in the research-based pharmaceutical industry means that there are relatively few agreements for tangible property involving Start-Up and third parties. Established research-based companies are often active participants in the marketplace for tangible pharmaceutical property. Such companies have numerous agreements with financial analyses for tangible property to use in an analysis of tax obligations.

(b) Arm’s length consideration due Start-Up-Marketer

The uncontrolled transactions a company entered into with third parties for marketing/co-marketing activities associated with pharmaceutical or health care products is the best data for a transfer pricing analysis in the situation at issue. Assume for this analysis that in the three marketing/co-marketing agreements Start-Up negotiated with third parties (uncontrolled transactions) specify gross margins of 50.0%, 55.0%, and 60.0% of net sales of associated products as compensation to Start-Up. Assume the range of margins from the pharmaceutical literature on marketing and co-promotion agreements is 40.0 to 60.0%.Footnote 34 In the controlled transactions, Start-Up’s marketing activities are focused on designing the marketing message, identifying relevant physician groups, and disseminating the message primarily through detailing (direct contact of identified physicians). Consider whether Start-Up-Marketer bears the same costs as in the uncontrolled transactions. Costs such as product liability, clinical studies conducted for marketing purposes (which are sometimes referred to as Phase IV studies), inventory (product return or expiry), patient assistance programs, or bad debt may or may not be incurred by Start-Up-Marketer. Costs not borne means risks not assumed. Adjust the gross margin for Start-Up-Marketer to reflect the actual functions performed and risks/costs borne. For example, a gross margin of 50.0% of net sales of Quick Cure to third parties is consistent with Start-Up-Marketer performing the message design and detailing functions, but not bearing many other risks. A gross margin closer to the high end (eg 60.0% of net sales) is consistent with Start-Up-Marketer performing the detailing function and bearing most or all of the other risks.

Relying on Start-Up’s uncontrolled transactions with third parties, an arm’s length consideration (ie gross margin) due Start-Up-Marketer for marketing and distributing Quick Cure is in the range of 50.0% to 60.0% of net sales.

3. Remaining functions and risks for Quick Cure

(a) Functions performed by Start-Up-Developer/Supplier

Start-Up-Developer/Supplier is responsible for a number of activities for Quick Cureincluding licensing intangible property from Start-Up-Inventor; funding ongoing development and preparing dossiers for USA and foreign regulatory filings; performing and/or arranging for manufacturing of APIs, finishing, and packaging; bearing responsibility for bad debt, unsold product, and product liability; and coordinating logistics activities among Start-Up’s affiliates. Start-Up-Developer/Supplier incurs the expenses associated with funding all ongoing development (both clinical and Phase IV). The later stage clinical trials funded by Start-Up-Developer/Supplier are expensive as they involve testing the products in broad patient populations in multiple locations.Footnote 35 Information obtained during these clinical trials may lead the developer to alter its regulatory strategy with regard to seeking approval for specific indications, modify future development activities to address the extent of potential side effects or investigate new uses for a product, or, in some cases, abandon a project altogether.Footnote 36

In addition, assume Start-Up-Developer/Supplier performs and/or arranges for the manufacture of Start-Up’s products. If necessary, Start-Up-Developer/Supplier is responsible for identifying and managing CMOs performing specified manufacturing activities. Start-Up-Developer/Supplier must invest in establishing the API and finishing plants. Start-Up-Developer/Supplier incurs risks in making these investments prior to receiving approval for Quick Cure. Start-Up-Developer/Supplier coordinates activities performed by CMOs and at its own plant, obtains and maintains regulatory approvals for the manufacturing processes, and assumes liability risk of selling these products.Footnote 37 Generally, Start-Up-Developer/Supplier’s responsibilities associated with manufacturing Quick Cure include:

  • manufacturing or procuring API;

  • contracting or conducting finishing and packaging;

  • coordinating the maintenance of adequate supplies of API and finished products;

  • arranging for transportation of finished products to distribution facilities in the USA;

  • forecasting demands for finished products;

  • paying product liability insurance costs;

  • bearing inventory and exchange rate risks;Footnote 38

  • expanding manufacturing facilities for APIs and finishing/packaging to meet increasing demands for the products;

  • planning for production of other products currently in late stages of the R&D pipeline;

  • participating in project development teams for new products; and

  • ensuring the quality of finished products in light of regulatory standards in the USA and other countries.

To achieve these goals, Start-Up-Developer/Supplier is responsible for producing experimental quantities at a pilot plant; designing the process to manufacture commercial quantities of the product; and obtaining regulatory approval for the sources of the raw materials, the sites at which the manufacturing activities take place, and the specific production processes used to ensure that the product meets safety requirements and has the specified identity, strength, quality, and purity characteristics.

(b) Arm’s length consideration due Start-Up-Developer/Supplier

As an integrated research-based pharmaceutical company, Start-Up performs activities that span the vertical chain in the pharmaceutical industry including conducting discovery R&D; development; manufacturing finished, packaged products; and marketing and distributing products throughout the world. These functions are performed in multiple countries. Each country has its own tax laws. Suppose Start-Up has organised its functions into three internal entities: Start-Up-Inventor, Start-Up-Developer/Supplier, and Start-Up-Marketer. Each entity reports income and pays taxes in either the USA or a European country with a lower tax rate than the USA. To assess the shares of net sales of Quick Cure to third parties that Start-Up should report in each country, use Start-Up’s uncontrolled transactions as well as public data on transactions for intangible and tangible property in the pharmaceutical industry. The Vertical Chain Method involves valuing explicitly the contributions made by Start-Up-Inventor and Start-Up-Marketer. The residual amount represents the arm’s length consideration due Start-Up-Developer/Supplier for performing all other functions and bearing the associated risks.

4. Illustrating the vertical chain method

In the example of Start-Up described above, the arm’s length consideration due to Start-Up-Inventor for developing the intangible property and manufacturing know-how transferred to Start-Up-Developer/Supplier for Quick Cure equals 12.0% of net sales of Quick Cure to third parties (ie 10.0% for intangible property plus 2.0% for manufacturing know-how). Given the limited functions performed by Start-Up-Marketer, the arm’s length consideration due to Start-Up-Marketer for marketing Quick Cure is 50.0% of net sales of Quick Cure to third parties. The residual (ie 38.0% of net sales) represents the total arm’s length consideration due Start-Up-Developer/Supplier for performing the remaining functions and bearing the associated risks described above. Given the functions performed and risks enumerated above borne by Start-Up-Developer/Supplier, shares of net sales of Quick Cure for Start-Up-Inventor and Start-Up-Marketer equal to 12.0% and 50.0%, respectively, would be appropriate. Correspondingly, a share of net sales of Quick Cure equal to the residual (100.0% – 12.0% – 50.0% = 38.0%) would be appropriate for Start-Up-Developer/Supplier.

If management at Start-Up shifted some functions from Start-Up-Developer/Supplier to Start-Up-Inventor, such as conducting the clinical R&D for Quick Cure, a royalty rate higher than 12.0% of net sales of Quick Cure would be required. If the functions and risks borne by Start-Up-Marketer increased, the share of net sales due Start-Up-Marketer should be increased. For example, if Start-Up-Marketer bears foreign exchange and inventory risks; absorbs bad debts, and pays for product liability insurance and the patient assistance program, Start-Up-Marketer should earn more than 50.0% of net sales of Quick Cure.

V. Conclusion

To comply with tax regulations in countries with different tax rates, Start-Up must determine arm’s length considerations due to Start-Up-Inventor, Start-Up-Developer/Supplier, and Start-Up-Marketer for performing functions and bearing risks associated with the pharmaceutical product Quick Cure. Using the Section 482 regulations for the USA to illustrate the issues for a relatively new participant in the research-based pharmaceutical industry, I applied the arm’s length standard in light of the best data available. No single specified method in the Section 482 regulations emerged as appropriate. An unspecified method, referred to as the Vertical Chain Method, is the best method in this case. Using Start-Up’s limited uncontrolled transactions for intangible and tangible property together with public data as the foundation for the Vertical Chain Method, calculate the arm’s length considerations, expressed as %ages of net sales of Quick Cure, due Start-Up-Inventor and Start-Up-Marketer for the functions performed and risks borne by each entity. The residual amount represents the range of arm’s length considerations due Start-Up-Developer/Supplier. These arm’s length considerations should allow the three components of Start-Up to cover their respective expenses and earn arm’s length returns for their respective functions performed and risks borne.

Footnotes

*

PhD in economics from the University of Iowa and Independent Consultant in Alexandria, Virginia, USA. Staff members at NERA Economic Consulting in Washington, DC provided assistance in gathering and processing information relied upon for the underlying analysis. However, they are not responsible for the opinions expressed in this paper.

1 Quick Cure is a convenient name to use for the brand pharmaceutical product in the hypothetical situation considered in this paper. A company would probably seek trademark protection for an actual brand name and use the appropriate trademark designation when referring to the product.

2 See also the Final §6662 Transfer Pricing Penalty Rules (TD 8656), 61 Fed Reg 4876, issued 9 February 1996.

3 Reg Sec 1.482-1(b)(1).

4 Distributing Quick Cure to hospitals, federal facilities, and wholesalers in the USA.

5 Reg Sec 1.482-1(b)(1).

6 Reg Sec 1.482-1(c).

7 Reg Sec 1.482-1(c)(2)(i) and (ii).

8 Reg Sec 1.482-1(c).

9 Reg Sec 1.482-1(c)(2). For a description of each method, see RP Rozek, “Valuing the Residual Intellectual Property in Mature Pharmaceutical Products” (2018) 9(2) EJRR 337.

10 Reg Sec 1.482–3(a). See Rozek, RP et al, “A Market-Based Approach for Tangible Property Transfer Pricing” (2005) 13 Transfer Pricing Report 1110–1115.

11 Imitators do not develop brand products, but, rather, wait until the patents or other forms of exclusivity for the brand products expire and then offer generic versions of the products.

12 Financing for inventors and developers comes from sources such as retained earnings, government support (eg appropriations and grants), and venture capital. Developers may rely on contract research organisations to perform some activities.

13 Sometimes a supplier relies on contract manufacturing organisations (CMOs) to produce the API or finish/package a product. The contract manufacture merely responds to orders from the supplier.

14 Marketers may engage contract sales organisations to disseminate certain well defined messages about a product.

15 “More Than 800 Medicines and Vaccines in Testing Offer Hope in the Fight Against Cancer” (Medicines in Development for Cancer, Pharmaceutical Research and Manufacturers of America (PhRMA) 2009) p 103.

16 PhRMA, Pharmaceutical Industry Profile 2006 (Washington, DC, PhRMA 2006) p 52 and PhRMA, supra, note 15, p 103.

17 The $802 million amount represents the total capitalised cost and is stated in 2000 dollars. Average out-of-pocket costs were estimated to equal $403 million: JA Di Masi et al, “The Price of Innovation: New Estimates of Drug Development Costs” (2003) 22 Journal of Health Economics 151.

18 See PhRMA, Pharmaceutical Industry Profile 2006 (Washington, DC, PhRMA 2006) p 52 and H Grabowski and J Vernon, “A New Look at the Returns and Risks to Pharmaceutical R&D” (1990) 16(7) Management Science 804.

19 Review data on Start-Up’s licences, acquisitions, co-marketing/co-promotion agreements, and distribution agreements.

20 See RP Rozek, “Applying the Best Method Rule When Reliable Internal Comparable Intangibles Exist” (1996) 12 Tax Notes International 1191; and RP Rozek et al, “A Market-Based Approach for Tangible Property Transfer Pricing” (2005) 13 Transfer Pricing Report 1110. These papers describe the types of adjustments that are necessary to the uncontrolled transactions in transfer pricing analyses.

21 “In order to be considered comparable to a controlled transaction, an uncontrolled transaction need not be identical to the controlled transaction, but must be sufficiently similar that it provides a reliable measure of an arm’s length result. If there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results”: see Reg Sec 1.482-1(d)(2).

22 Reg Sec 1.482-1(c)(2) states “[d]ata based on results of transactions between unrelated parties provides the most objective basis for determining whether the results of a controlled transaction are arm’s length”. Furthermore, fewer adjustments are necessary when the taxpayer is a party to the agreements in both the controlled and uncontrolled transactions.

23 Reg Sec 1.482-4(c)(2)(iii)(B)(1)(ii).

24 Start-Up enters such agreements for a variety of reasons. For example, it may expand its product portfolio by licensing technology from another pharmaceutical company. It may gain experience marketing pharmaceutical products by co-marketing a product with an established company.

25 Windhover is a comprehensive industry guide to pharmaceutical and biotechnology alliance activity. Data are available beginning in January 1991. The database is updated periodically. It provides summary information about transactions in the pharmaceutical industry. The summary information does not always identify factors such as the stage of development for the underlying technology at the time of the licence or the contribution of the licensor to developing manufacturing know-how.

26 The database is from the US Securities and Exchange Commission.

27 This journal is published by the Licensing Executives Society.

28 Data from public sources are not as complete as data from the taxpayers’ own experiences of licensing intangible property. There is limited information available in the public domain on the terms of an agreement. Information on such factors as the complete milestone payments, equity investments, territory, and exclusivity provisions are often not available.

29 S Finch, “Royalty Rates: Current Issues and Trends” (2001) 7(3) Journal of Commercial Biotechnology 228.

30 The absence of financial analyses of the agreements means lump sum payments cannot be considered. Estimates of sales for the associated products are necessary to calculate an effective royalty rate in an agreement with lump sum payments.

31 The range stated is to illustrate the method. It is not derived from any specific database.

32 The obligation to develop manufacturing know-how is not typical in Start-Up’s uncontrolled transactions for intangible property.

33 DM McGavock et al, “Factors Affecting Royalty Rates” (1992) XXVII(2) les Nouvelles 109.

34 For example, one article states that “[e]arly-stage royalties are a strong contrast to the end-stage co-commercialisation agreements (such as co-marketing and co-promotion agreements), which often attract very high royalty levels, in the range of 40–60[%] (Table 6)”: S Finch, “Royalty Rates: Current Issues and Trends” (2001) 7(3) Journal of Commercial Biotechnology 228.

35 To the extent that Start-Up-Developer/Supplier relies on other affiliates to conduct or monitor clinical studies, Start-Up-Developer/Supplier continues to bear the risks, but compensates the affiliate for its efforts.

36 Start-Up may abandon research projects at any time if it determines that the underlying compound is unsafe or ineffective.

37 As discussed above in connection with our review of data available from Start-Up and public sources, Start-Up-Developer/Supplier performs more functions and bears greater risks than CMOs.

38 Start-Up-Marketer can return any unsold products to Start-Up-Developer/Supplier.