Waiver Leads to Double Tax Liability on Patent Royalties

McDermott Will & Emery

McDermott Will & Emery

Declining to address whether certain technology licensing royalties should be subject to taxation as income or capital gains, the US Court of Appeals for the Third Circuit found that the patentee-taxpayer had waived his claim on appeal, and affirmed the decision of the Tax Court that the royalties should be treated as income. Spireas v. Comm’r of Internal Revenue, Case No. 17-1084 (3d Cir., Mar. 26, 2018) (Hardiman, J) (Roth, J, dissenting).

Spiridon Spireas is an inventor of a drug delivery technology that must be adapted to each drug sought to be delivered. In 1998, Spireas and a drug company entered into an agreement whereby the drug company would have the exclusive rights to utilize the drug delivery technology, but only to develop products that the company and Spireas would unanimously select. The drug company also received the exclusive rights to produce, market, sell, promote and distribute those products. Spireas was entitled to a 20 percent royalty on the gross profits the drug company earned.

In 2000, Spireas and the drug company agreed to use the technology to develop a generic version of a blood-pressure drug called felodipine. The development was successful, and, in 2007 and 2008, sales of the product generated royalties exceeding $40 million. 

Spireas reported the royalties as capital gains on his 2007 and 2008 tax returns. In 2013, the Commissioner sent Spireas a notice of deficiency for 2007–2008, asserting that that the royalties should have been treated as ordinary income. Spireas petitioned the US Tax Court for a redetermination, arguing that capital gains treatment was appropriate because the 1998 and 2000 agreements combined to transfer to the drug company all of Spireas’s rights in the particular formulation of felodipine. The Tax Court agreed with the Commissioner, reasoning that no transfer of rights could have taken place in 1998 with respect to the felodipine product because it had not yet been invented.

On appeal, Spireas claimed that the 1998 agreement prospectively assigned to the drug company the relevant rights to the felodipine product. The Third Circuit disagreed, explaining that Spireas’s theory was inconsistent with his assertion in Tax Court that a transfer of rights took place sometime after the felodipine product was invented, between the end of 2000 and spring 2001. Finding that Spireas had failed to raise a prospective assignment argument in Tax Court, the Third Circuit held that Spireas had waived that argument. 

In dissent, Judge Roth took the position that the arguments were sufficiently consistent to avoid waiver and would have found for Spireas on the merits.

Practice Note: The problem in this case arises from difficulty defining exactly the property right in which Spireas transferred all substantial rights. The Tax Court relied on the fact that Spireas failed to transfer all substantial rights to the drug delivery technology in general, but the Third Circuit acknowledged that a patentable invention (it was not disputed that the felodipine product was independently patentable) may be subject to capital gains treatment even without a patent or patent application. Precision in describing the transferred right(s)—and maintaining consistency regarding that issue—is likely to be instrumental when attempting to obtain favorable tax treatment.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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