One day after the Tax Court invoked the Danielson case to reject a taxpayer’s attempt to argue substance over form to restructure an agreement for tax purposes in Makric Enterprises, Inc. v. Commissioner, TC Memo 2016-44, the Court turned down the IRS’s attempt to argue the same case should block a taxpayer from arguing a transaction represented a sale of its interests in rights to a chemical compound.

In the case of Mylan, Inc. and Subsidiaries v. Commissioner, TC Memo 2016-45 the IRS was arguing for summary judgement, based on the Danielson decision, that the taxpayer had to treat its transaction as a license agreement generating ordinary income and not a sale of its rights generating capital gains.

As we discussed in analyzing the Makric case, the Danielson rule refers to a Third Circuit case (Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967), vacating and remanding 44 T.C. 549 (1965)) that strictly limited the situations in which the taxpayer, as opposed to the IRS, could challenge the tax treatment of a transaction the taxpayer had entered into with a “substance over form” argument.

As the Tax Court summarized that holding in its opinion in the current case:

On appeal, the Court of Appeals rejected the Tax Court’s reasoning and adopted the following rule of law: “[A] party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.” Commissioner v. Danielson, 378 F.2d at 775. The Court of Appeals reasoned that the trial courts are required to examine the substance of a transaction in cases where the Commissioner attacks the formal agreement. Id. at 774-775 (citing Commissioner v. Court Holding Co., 324 U.S. 331, and Gregory v. Helvering, 293 U.S. 465). At the same time, because taxpayers can control what arrangements to make in the first place, there is no disparity in allowing only the Commissioner to challenge the contract while requiring taxpayers to be bound by the terms of their agreements. Id. at 775. Among the reasons cited in support of the new rule, the Court of Appeals stated that taxpayers’ attacks on their own agreements “would nullify the reasonably predictable tax consequences of the agreement to the other party” and the Commissioner would be forced to litigate against both parties to the agreement to collect taxes properly due. Id.

Thus, if the terms of an agreement are unambiguous with regard to an item, the tax consequences of that portion of the agreement generally cannot be challenged by the taxpayer unless the taxpayer can show that court would allow the taxpayer to alter the contract in a court action.

In the case before the court the taxpayers had modified an earlier sub-licensing agreement with regard to its right to a drug that it had obtained various exclusive rights to the produce, market, etc. the product in the United States and Canada.  The company had retained significant rights and responsibilities in that arrangement, and the sublicensee had the right to terminate the agreement under certain conditions, including a right to terminate the agreement “at any time if it reasonably believed that safety or efficacy issues were likely to negatively affect regulatory approvals or commercial use of the nebivolol-containing products.”

Two year later (2008) the agreement was modified.  Mylan was seeking to obtain cash and improve its credit standing in order to pursue acquisitions.  Mylan gave up most of its rights at this point, though it still was the exclusive importer of this drug from the foreign developer and manufacturer of the drug and received a 1% fee on the imports.  The Company was still obligated to make certain payments to the foreign entity, but the sublicensee agreed to pay Mylan as those amounts were due.  But otherwise the company was generally no longer involved with this drug.

The sublicensee entered into negotiations with the foreign company, negotiations that Mylan was under an obligation to assist with, and four years later (2012) the sublicensee purchased from the foreign entity all patents it held, resulting in the termination of foreign entity’s agreement with Mylan.

Mylan argued that the 2008 modification payment represented a sale of its interests in the rights and thus should be treated as a taxable disposition of those rights, with the net gain taxable as a capital gain.  However the, IRS pointed out, the 2008 modification was not structured as a disposition or assignment of Mylan’s rights, nor did either of the parties to the agreement seek the foreign company’s approval of a transfer.  Therefore, the IRS argued, this was merely an acceleration of payments due under the original licensing agreement, an agreement all parties treated as a simple license agreement generating ordinary income.

However, the taxpayers argued that this contract was not unambiguous, and thus they were not looking to modify the terms of the agreement after the fact.  As the opinion pointed out:

First, petitioners point out in their briefs and affidavits filed in support thereof that in the pharmaceutical industry terms such as “exclusive license” or “exclusive sublicense” often indicate a disposition of intellectual property when coupled with  a transfer of substantially all rights in such property. See, e.g., E.I. du Pont de Nemours, 432 F.2d 1052; Merck, 261 F.2d 162. We also observe that the 2008 amendment indeed transferred additional rights to nebivolol to Forest, to the exclusion of Mylan. This makes the 2006 agreement, as amended, ambiguous on its face because the plain language of the contract is susceptible to more than one interpretation. See Greenfield, 780 N.E. 2d at 170.

When the terms of a contract are ambiguous, we look to extrinsic evidence to ascertain the intent of the parties. See id. Here, we interpret the facts in the light favorable to petitioners as the party opposing the motion for summary judgment. See Craig v. Commissioner, 119 T.C. at 260. Petitioners state that by the time of the 2008 amendment, Mylan had significant business reasons to sell its rights in nebivolol. Specifically, Mylan needed cash after acquiring another company and wanted to limit its risk with respect to the future success of nebivolol. Both Mylan and Forest indicated in their press releases and the filings with the SEC that Mylan’s commercial rights with respect to nebivolol were terminated by the 2008 amendment.

Petitioner also asserts that any remaining rights Mylan may have had under the 2006 agreement, as amended, were of no substantial value to Mylan, thus satisfying the test for a disposition outlined by the Court of Appeals in E.I. du Pont de Nemours.

The court thus finds this is a question not of a request to modify the terms after the fact by a taxpayer arguing substance over form, but rather a question of interpreting the nature of the actual contract itself.

Thus the Court denied the IRS’s attempt to shut down the case before making an inquiry into those facts, deciding that the taxpayer has the right to demonstrate that this contract modification is properly interpreted as a sale of its interests.

A key difference between this case and the Makric case is that the parties here aren’t challenging the contract itself.  In Makric clearly the contract as written failed to conform to what the seller wanted as the tax structure, but the seller simply failed to note this fact before entering into the agreement. 

Here Mylan is arguing that the contract as written is properly interpreted for tax purposes as a sale.  Ultimately Mylan may or may not be able to convince the Court this is case—but as they are not arguing to ignore the language, but rather how it should be interpreted, the IRS cannot simply carry the day by pointing to Danielson.