The NOLs, and maybe the R&D credits....are significant components in the valuation of these companies.

Reprinted with permission from Wolters Kluwer. © 2016 CCH Incorporated and its affiliates. All rights reserved.

Wolters Kluwer had the opportunity this past week to sit down with Pepper Hamilton LLP partners Todd Reinstein, Washington, D.C., and Joan Arnold, Philadelphia, to discuss current tax issues particularly relevant to the life sciences and tech industries. Reinstein and Arnold, along with another Pepper Hamilton partner, conducted a seminar on April 20 in Newport Beach, California, on domestic and international transactions involving corporate tax issues. The following are edited excerpts from that interview.

Wolters Kluwer: What are some of the typical corporate transactions that you have seen lately, especially within the tech and life sciences areas? Are these industries different from the regular corporate set-up; do they need to apply different strategies?

Joan Arnold — Those industries have several things in common that are not necessarily found in other industries. First of all, particularly in the life sciences area, their generation of net operating losses (NOLs) is usually significant, because they are frequently being sold at a time when they haven’t started to earn revenue. Instead, they’ve been spending money to develop a product, to get to a point where they think it might be viable. So they usually have big NOLs if they’re domestic companies.

If they are foreign companies, what likely gets overlooked is that they are PFICs – passive foreign investment companies – because the only revenue that they have raised gets placed into a bank account or investment fund. Even though they don’t think of themselves as an investment company, they have become PFICs since the only revenue they have is from passive income. This seems particularly prevalent in the life sciences area.

The other interesting aspect in the life sciences area is the way that the purchase price is put together. The purchase price is rarely a lump sum and a note. It is commonly an upfront payment and then milestone payments that are made as the drugs, for example, hit certain marks. And then, there is frequently a long “tail.” Whether that tail is a royalty if you’ve done an asset deal, or it’s an earn-out if you’ve done a stock deal, it has a pretty significant impact on what the sellers realize on an after-cash basis. That method of structuring of the deal is fairly unique to the life sciences area.

Wolters Kluwer: So there are usually competitive goals between the buyer and the seller?

Joan Arnold — Yes there are, because the buyer wants to put on its books for tax purposes the amount they are paying, as part of the purchase price, so they can amortize it. They also want to treat that long tail as a royalty, so that they can deduct it as they pay it. If you sell stock, you can’t say it’s a royalty, because you haven’t sold intellectual property; you’ve only sold stock. And a buyer wants to sell stock, because they don’t want to deal with two levels of tax. So it’s a challenging competition.

Wolters Kluwer: Are there other issues in this industry that require some foresight?

Todd Reinstein — Another thing that I see in these transactions is that, even though they’re building up a big tax loss carryforward, during their “pre-revenue” phase, not all these life science companies want to spend the time or the money to apply the Section 382 rules that limit the use of NOLs following certain ownership changes. This attitude makes sense from the immediate perspective that they’re not paying any tax and they’re not in the midst of a sale.

What typically happens is once the deal starts going, you’ll have a buyer say, “I’m not going to pay anything of extra value for the stock that relates to the tax losses, because I know this is going to cause an ownership change and I don’t know if you’ve had previous ownership changes that could have locked down the value of the NOLs at a lower amount.” That’s the buyer’s perspective.

Then you go to the seller’s side, and they’ll want to get as much as they can for selling the stock. So if I’m representing the seller, I’ll go through all these equity issuances to try and prove out that they haven’t had an ownership change, if the facts work out that way. So the NOLs, and maybe the R&D credits, which are also a tax attribute carryforward, are significant components in the valuation of these companies. Overall, over the last 10 years, there’s been more of an emphasis and a sophistication on the impact of Section 382 and how to value these losses.

Wolters Kluwer: Are state laws a consideration?

Todd Reinstein — Yes. I think the state and local tax component is very important, because of the way that tax losses are handled, for example. A technology company or a life sciences company may not just have federal losses and credits that they are carrying forward; a lot of times they have state tax items as well that can be significant. And the rules in every state about how to carry forward a loss and how to apply 382 can be different.

Wolters Kluwer: Your seminar focuses on C corporations. Are these businesses also structured as partnerships, or is that not done?

Joan Arnold — There is a myth that in order to attract venture money as a start-up, the company has to be a C corporation. I would say that 10 years ago that may have been the case. But a well-advised start-up today would be in the form of a limited liability company (LLC). LLCs can provide a wonderful tax benefit, particularly on exit. But there is still a school of thought that the start-ups have to be C corps, which in part is why you have all these problems.

Wolters Kluwer: You referred to intellectual property (IP). Does that include everything that we’ve talked about, or does it include other considerations?

Joan Arnold — The other big thing with respect to IP is whether you should be going offshore with your IP, to develop a deferral structure, so that you can keep your profits taxed at a non-U.S. rate until you bring them back. First, it’s how do you get the IP out, and how much return can the IP earn offshore. Clients think they can put the IP offshore, and that’s all you have to do. That doesn’t get you much of a return. You actually have to do something outside the U.S.

Todd Reinstein — If you have a life sciences company, the typical cycle would be first to do the research and the clinical trials, and perhaps get the drug approved. What then often happens is that a large pharmaceutical company – either a U.S. or a foreign one – will come along and say “Oh, we like that drug. We’d like to add it to our portfolio.”

Typically what happens in these situations is there is an upfront milestone payment, where they’ll buy the U.S. rights or the worldwide rights for that particular pharmaceutical, and then as they sell that drug, they’ll pay back a royalty, based on sales. Why that’s so important from a tax perspective is that you have all these NOLs and then you many times have a huge, like a nine-figure number, milestone payment all the way upfront. The question is, can you use the losses to shelter the income, first from that upfront payment and then later on as you get the royalties; what are you going to do with that money – are you going to reinvest it with new research and create new NOLs? There are all sorts of decision points a life sciences company goes through. Sometimes they’ll factor those royalty streams, and there are tax issues associated with that as well.

Wolters Kluwer: What are the post-deal tax opportunities once the operation is sold?

Todd Reinstein — From a buyer’s perspective, typically, let’s say you have a large pharmaceutical company – they’re really looking at acquiring that particular product to sell it, and they’ll buy the stock of the company. From a tax perspective, the issues you have are, if that company joins your consolidated group (if you’re a typical large pharma company), even if you have an ownership change, how do you use those losses to offset the taxable income of the group subject to the Section 382 change, and what is the limitation amount. That’s a big issue.

Other things you have to be careful about – if you’re the buyer, from a tax perspective, and you bring this life sciences company into the group — you have to be very careful about moving assets around the group and basically depleting the company of anything. There are very stringent rules in Section 382 that say if you don’t operate the business, if you fail continuity of business enterprise within two years of the change, which you typically do when you buy 100 percent of the stock, then you could blow up the NOLs, regardless of the limit. The limit sets to zero under the tax rules. So one of the challenges I always have on the buyer’s side is to make sure the tax guys are communicating with the operation guys; they’re not just moving assets around their group.

Joan Arnold — From the seller’s perspective, if you’ve got basis in your stock, the question is when can you recover the basis, so that you’re not paying tax upfront, that you might have to get back as a capital loss at the end because you may never get those payments. Working with the installment method, particularly when the earn-out is royalty-based for the life of the patent, raises some pretty significant accounting issues for the sellers of the stock of those companies.

Wolters Kluwer: Are there solutions to those issues?

Joan Arnold — When you’re negotiating the deal, you might do a trade-off. You might say, I don’t want this tail that goes on for 15 years; give me more milestone payments. Let’s take a guess as to what those would be like, and increase my milestone, so that then I know the maximum amount that I can earn, and therefore I know exactly how I can allocate my basis. But you have to work that into the deal as you’re negotiating it.

Wolters Kluwer: In our recent conversations with you, you both commented that recent regulations under Code Sec. 385 and on inversions may create problems when you’re evaluating transactions. Can you discuss that?

Joan Arnold — I think that the new Section 7874 regulations could cause you to foot fault into an inversion unintentionally, because there are rules with respect to aggregating prior transactions that cause an inversion because you don’t get to count the foreign company’s stock.

Todd Reinstein — The Section 385 proposed regulations are affecting transactions right now. These regulations as written are applicable to instruments issued on or after April 4, 2016. Once the final regulations are promulgated, you have 90 days, and then these rules take effect for all the instruments that were issued on or after April 4, 2016. So, say a business does an all cash D reorganization, with a loan going up and interest deductions being taken. But then a couple of years from now, those instruments are going to be under these rules and it’s going to be a problem.