The IRS has privately ruled that a taxpayer could defer reporting income from intellectual property payments until the tax year following the tax year of receipt of the payments under a revenue procedure governing advance payments.
Background. Under the accrual basis method of accounting, income is reported when: (1) all events have occurred which establish the right of the taxpayer to receive the income; and (2) the amount can be determined with reasonable accuracy. (Reg. § 1.451-1(a)) All the events that fix the right to receive income occur when the first of the following events happens:
- the required performance takes place;
- payment is due; or
- payment is made. (Rev Rul 84-31, 1984-1 CB 127)
Certain taxpayers may use the deferral method described in Rev Proc 2004-34, 2004-22 IRB 991, Sec. 5.02(1)(a). A taxpayer using the deferral method must include an advance payment in gross income in the tax year of receipt to the extent recognized in revenues in its applicable financial statement in that year, and include the remaining amount of the advance payment in gross income in the next succeeding tax year.
A payment received by a taxpayer for the use (including by license or lease) of intellectual property, such as patents and similar intangible property rights, is an advance payment if including the payment in gross income for the tax year of receipt is a permissible method of accounting for federal income tax purposes (without regard to Rev Proc 2004-34) and the payment is recognized by the taxpayer (in whole or in part) in revenues in its applicable financial statement for a subsequent tax year. (Rev Proc 2004-34, Sec. 4.01(3))
A taxpayer may adopt any permissible method of accounting for advance payments for the first tax year in which the taxpayer receives advance payments. (Rev Proc 2004-34, Sec. 8.01)
Facts. Taxpayer is engaged in Business. Before Date 1, Taxpayer owned or controlled certain intellectual property (the IP), including patents and know-how, related to Product. Taxpayer and Company entered into an agreement as of Date 1 (the Agreement), under which Taxpayer granted Company an exclusive license to develop, use, offer for sale, sell, sublicense and otherwise commercialize any products for human use containing Product that are made by a process covered by the IP (licensed products). The license granted to Company was co-exclusive with Taxpayer so that Taxpayer could exercise its rights and perform its obligations under the Agreement. Under the Agreement, Taxpayer and Company will collaborate in developing, marketing, and obtaining regulatory approval for, licensed products. They agreed how they would share the costs of development of the initial licensed product for Indication X and Indication Y.
In consideration for entering into the Agreement Company is obligated to: (1) pay Taxpayer a nonrefundable initial license fee (the Fee) in Year I; (2) make payments to Taxpayer if and when certain milestones in the development of the IP are met (the Milestone Payments); and (3) if licensed products are commercialized, make payments of royalties to Taxpayer based on the level of sales of the product (the royalty payments).
The Milestone Payments are solely for the use of the IP and compensate Taxpayer for the increased value of the IP as it progresses through each stage of development, testing, and regulation. No part of the Milestone Payments is compensation for services.
Taxpayer has a certified audited financial statement, accompanied by the report of an independent CPA, which is used for credit purposes, reporting to shareholders, and other substantial non-tax purposes, and is an applicable financial statement as defined in Rev Proc 2004-34, Sec. 4.06(2). Taxpayer anticipates that it will recognize the Fee in revenues in the applicable financial statement over Period 1, rather than in the year of receipt. Taxpayer received no advance payments, as defined in Rev Proc 2004-34, Sec. 4.01, before Year 1. Taxpayer anticipates that current financial reporting rules will require it to recognize the Milestone Payments in income in the tax year of receipt, but will include the Milestone Payments in income in its applicable financial statement in a subsequent tax year to the extent financial reporting rules permit.
Deferral OK’d. Based on the language of the Agreement and Taxpayer’s representations, IRS concluded that the Fee and the Milestone Payments are payments for the use of intellectual property and are advance payments within the meaning of Rev Proc 2004-34, Sec. 4.01, to the extent the Taxpayer recognizes the payments in its applicable financial statement for a tax year following the tax year of receipt. Therefore, IRS concluded that, under Rev Proc 2004-34, Sec. 5.02, it is a proper method of accounting for Taxpayer to defer to the next succeeding tax year following the year of receipt the inclusion in gross income of the Fee and each Milestone Payment to the extent that they are recognized by Taxpayer (in whole or in part) in revenues in its applicable financial statement for a tax year subsequent to the tax year of receipt. Because Year 1 is the first tax year in which Taxpayer receives an advance payment, Taxpayer may adopt the deferral method of Rev Proc 2004-34, Sec. 5.02 in Year 1, under Rev Proc 2004-34, Sec. 8.01.