Doctor’s Royalty Income from Patent Is Ordinary Income, Not Capital Gain

March 31, 2018

The Third Circuit affirmed a Tax Court ruling that a doctor’s royalty income from a patent that he received under a licensing agreement was ordinary income, not capital gains, because by retaining the right to decide how the technology was used, the doctor had failed to transfer substantially all rights to the patent. The Third Circuit also found that the doctor’s argument on appeal was waived because it depended on a different legal theory and different facts than the argument he made before the Tax Court. Spireas v. Comm’r, 2018 PTC 83 (3d Cir. 2018).

Background

Spiridon Spireas is a pharmaceutical scientist who invented “liquisolid technology,” a set of drug delivery techniques meant to facilitate the body’s absorption of water-insoluble molecules taken orally. The technology is not one-size-fits-all. Each application is specific to a particular drug, and creating a clinically useful liquisolid formulation of a given drug requires creating, through trial and error, a process specific to the substance involved.

Because each formulation was unique, commercializing the technology was complex process. Before a drug could go to market in liquisolid form, a specific formulation had to progress from conception to prototyping to extensive further development. Like many inventors, Spireas could not develop the technology alone, so in June 1998 he signed a licensing agreement with Mutual Pharmaceutical Co., an established drugmaker.

Spireas’s agreement with Mutual established a comprehensive framework for licensing liquisolid technology to Mutual, selecting prescription drugs to develop, developing and selling those drugs, and paying Spireas royalties out of the proceeds. Mutual received exclusive rights to use the technology, but only to develop liquisolid drug products that were unanimously selected by written agreement between Mutual and Spireas. The parties memorialized their selections of which products to develop in formal engagement letters. Once an agreement was made, the process continued with the development of a practical liquisolid formulation, clinical testing, FDA approval, and marketing. As sales were made and funds were received, Mutual would pay Spireas a 20 percent royalty on the gross profits.

In March 2000, Spireas and Mutual signed an engagement letter to develop a generic version of a blood pressure drug called felodipine. Spireas put forth considerable efforts to adapt the technology to felodipine and completed his efforts in a relatively short amount of time. When he signed the engagement letter, he had completed roughly 30 percent of the work that ultimately resulted in the liquisolid formulation of felodipine that he finished inventing sometime after May 2000. The FDA approved felodipine and Mutual marketed it to great success.

Spireas’s royalties for 2007-2008, the years at issue, totaled just over $40 million, which he reported as capital gains on his tax returns. In 2013, the IRS sent a notice of deficiency stating that the royalties were ordinary income, and it assessed around $5.8 million in additional tax. Spireas petitioned the Tax Court for a redetermination.

Analysis

Royalty payments received under a license agreement are generally taxed as ordinary income. However, Code Sec. 1235(a) provides a transfer of all substantial rights to a patent is treated as a sale or exchange of a capital asset held for more than one year. Under Reg. Sec. 1.1235-2(b)(1), “all substantial rights” means all rights to a patent which are of value at the time the rights are transferred.

An inventor must transfer property rights that the inventor actually possesses at the time of the grant, and to possess a transferable property interest the inventor generally must have reduced it to actual practice. Under Reg. Sec. 1.1235-2(e), an invention is reduced to actual practice when it has been tested and operated successfully under normal operating conditions.

Before the Tax Court, the IRS argued that Spireas failed transfer all of his rights to liquisolid technology as required under Code Sec. 1235 because Mutual could only sell those products that it and Spireas unanimously selected. Spireas acknowledged that he had retained valuable rights in the overall technology but emphasized that he had transferred away all of his rights to the liquisolid formulation of felodipine, and that the transfer took place sometime in 2000 or 2001, after the felodipine formulation was invented.

The Tax Court agreed with the IRS, finding that Spireas could not have transferred the rights to any particular liquisolid products in 1998 because no products existed at that time. According to the Tax Court, the only rights Spireas could have granted in 1998 were the rights to use the liquisolid technology and to make and sell any products using the technology. The Tax Court held that, since Spireas had granted far less than all substantial rights to the overall liquisolid technology, the royalty payments he received in 2007 and 2008 did not satisfy the requirements of Code Sec. 1235 and were therefore taxable as ordinary income.

Spireas appealed to the Third Circuit. On appeal, he argued that the transfer of his rights occurred in 1998 with the execution of the licensing agreement, which he claimed prospectively assigned to Mutual his rights to liquisolid felodipine. The IRS responded that Spireas had waived that argument by not presenting it to the Tax Court. The IRS claimed that under Third Circuit precedent, Spireas’s argument on appeal had to be based on the same legal rule and facts as the argument he made before the Tax Court, and that his new argument failed this test.

The Third Circuit affirmed the Tax Court and held that Spireas had waived his argument that he prospectively transferred the rights. The court explained that the under the waiver rule, Spireas’s argument on appeal had to depend on the same legal rule and the same material facts as the argument he presented to the Tax Court.

The Third Circuit found the legal theory Spireas presented to the Tax Court was that he acquired a property interest in liquisolid felodipine when the invention was complete, either in 2000 or 2001. In the Third Circuit’s view, that determination implied a finding by the Tax Court that the formulation had been reduced to actual practice at that time. Thus, the Third Circuit found that Spireas’s original theory was that he made a post-invention transfer of his rights to Mutual around May 2000, which is the time that he acquired a property interest in the invention.

The Third Circuit found that Spireas abandoned that theory on appeal, and instead had argued that he prospectively transferred his rights in 1998, two years before the invention of liquisolid felodipine. According to the Third Circuit, Spireas’s argument for a prospective transfer could not depend on a theory of “actual reduction to practice” because it depended on a different legal standard for when the formulation became property than his argument to the Tax Court. The Third Circuit also reasoned that the prospective transfer could not depend on the same facts (including the timing of felodipine’s invention) as those supporting his Tax Court argument.

For these reasons, and because Spireas offered no reasons why the court should excuse his waiver, the Third Circuit declined to evaluate his new argument on appeal and affirmed the Tax Court’s decision.

Observation: In a dissenting opinion, one judge would have held that Spireas’s arguments before the Tax Court and on appeal were consistent. In the view of the dissenting judge, Spireas consistently argued that the physical delivery of the formulation occurred in 2000 pursuant to the 1998 transfer of the legal rights to the formulation, and that such rights were the consideration for the royalty payments Spireas received. The dissent also disagreed with the majority’s view that an invention must be reduced to practice in order for Code Sec. 1235 to apply, and reasoned that by the logic of the majority opinion, the 2000 engagement letter could not have transferred the rights because it also predated the felodipine formulation’s reduction to practice.

 

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