Spireas v. Comm'r of Internal Revenue, 17-1084

• Citation: 886 F.3d 315
• Decision Date: 26 March 2018
• Docket Number: No. 17-1084,17-1084
• Parties: Spiridon SPIREAS, Appellant v. COMMISSIONER OF INTERNAL REVENUE
• Court: United States Courts of Appeals. United States Court of Appeals (3rd Circuit)

886 F.3d 315

Spiridon SPIREAS, Appellant

v.COMMISSIONER OF INTERNAL REVENUE

No. 17-1084

United States Court of Appeals, Third Circuit.

Argued October 10, 2017

Opinion Filed: March 26, 2018

As Amended June 1, 2018

Brian Killian [Argued], Robert R. Martinelli, Michael E. Kenneally, Morgan, Lewis & Bockius LLP, 1111 Pennsylvania Ave., NW, Washington, DC 20004, William F. Colgin, Jr., Morgan, Lewis & Bockius LLP 1400, Page Mill Road, Palo Alto, CA 94304, Attorneys for Appellant

David A. Hubbert, Acting Assistant Attorney General, Bruce R. Ellisen, Clint A. Carpenter [Argued], United States Department of Justice, Tax Division, P.O. Box 502, Washington, DC 20044, Attorneys for Appellee

Before: HARDIMAN, SHWARTZ, and ROTH, Circuit Judges.

OPINION OF THE COURT

HARDIMAN, Circuit Judge.

This appeal requires us to decide whether royalties paid on a technology license agreement should have been treated as ordinary income or as capital gains. The distinction is significant for taxpayers like the Appellant, Dr. Spiridon Spireas, who earned $40 million in such royalties over just two tax years. If those earnings were ordinary income, Spireas owed a 35 percent tax; if they were capital gains he owed 15 percent.

Spireas claimed the favorable capital gains treatment pursuant to 26 U.S.C. § 1235(a), which applies to money received "in consideration of" "[a] transfer ... of property consisting of all substantial rights to a patent." The Commissioner of Internal Revenue disagreed that Spireas was entitled to § 1235(a) treatment, finding that Spireas should have treated the royalties as ordinary income. Accordingly, the Commissioner gave Spireas notice of a $5.8 million deficiency for the 2007 and 2008 tax years. Spireas petitioned the Tax Court for a redetermination of the deficiency, but after a brief trial the Tax Court agreed with the Commissioner. Spireas appeals that final order.¹

I

Royalties paid under a license agreement are usually taxed as ordinary income. An exception to this general rule is found in section 1235 of the Internal Revenue Code, which affords special treatment to payments earned from certain technology transfers. The statute provides that "[a] transfer ... of property consisting of all substantial rights to a patent ... by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year." 26 U.S.C. § 1235(a). Payments made "in consideration of," id. , transfers that meet the statutory criteria are taxed at a long-term capital gains rate that can be about half of that applicable to ordinary income. Compare 26 U.S.C. § 1(a), (i)(2) (2008) (providing a top marginal rate of 35 percent for married taxpayers filing jointly), with 26 U.S.C. § 1(h)(1)(A)–(C) (2008) (providing a top rate of 15 percent for most long-term capital gains).² Section 1235's basic requirements are straightforward. To qualify for automatic capital-gains treatment, income must be paid in exchange for a "transfer of property" that consists of "all substantial rights" to a "patent."³ Id. § 1235. As this case illustrates, not every transfer of "rights" will suffice because the statute grants capital gains treatment only to transfers of property .

II

A

Spireas is a pharmaceutical scientist who, with Dr. Sanford Bolton, invented "liquisolid technology."⁴ That term describes certain drug-delivery techniques meant to facilitate the body's absorption of water-insoluble molecules taken orally. It is not, however, a one-size-fits-all solution. Rather, each application of "liquisolid technology ... is specific to a particular drug." App. 50–51 (Stipulation ¶ 21). And creating a clinically-useful liquisolid formulation of a given drug is not a matter of rote recipe; it requires creating, through trial and error, a process specific to the substance involved.

The uniqueness of each liquisolid formulation meant that commercializing the technology was a tricky business. Before a drug could go to market in liquisolid form, a specific formulation had to "progress from ... conception to ... prototyp[ing] ..., to extensive further development, to a form that c[ould] be ... sold to the public, to actual manufacture for sale ... , and, finally, to actual marketing to the public." See 1-6 William H. Byrnes & Marvin Petry, TAXATION OF INTELLECTUAL PROPERTY AND TECHNOLOGY § 6.02[1] (2017). Like most inventors, Spireas was unable to do all that alone, so in June 1998 he signed a licensing agreement with an established drugmaker, Mutual Pharmaceutical Co. (the 1998 Agreement).⁵ The 1998 Agreement established a comprehensive framework for licensing liquisolid technology to Mutual, selecting prescription drugs to develop using the technology, developing and selling those drugs, and paying Spireas royalties out of the proceeds.

Under the 1998 Agreement, Spireas granted Mutual two sets of exclusive rights: a circumscribed grant of rights to liquisolid technology and a much broader set of rights to specific drug formulations developed using that technology. First, the 1998 Agreement granted Mutual "[t]he exclusive rights to utilize the Technology," but "only to develop [liquisolid drug] Products that Mutual ... and [Spireas] ... [would] unanimously select." App. 69 (1998 Agreement § 2.1.1) (emphasis added). Second, Mutual received "[t]he exclusive right to produce, market, sell, promote and distribute ... said Products." Id. (1998 Agreement § 2.1.2).

Having allocated Spireas and Mutual their respective rights to the liquisolid technology and liquisolid products, the 1998 Agreement established a multistep process for producing marketable products and paying Spireas for his work. That process began when Spireas and Mutual "select[ed] a specific Product to develop." App. 72 (1998 Agreement § 5.1). Selections had to be unanimous and made in writing. The parties' practice was to memorialize their selections in letters noting the "formal engagement of [Spireas] and Mutual" for a particular product. 1 T.C. Rec. 262–75. Once the parties were so engaged with respect to a particular drug, the process continued with the development of a practical liquisolid formulation, clinical testing, FDA approval, and actual marketing. And as sales were made and funds were received, Mutual would pay Spireas a 20 percent royalty on the gross profits it earned from liquisolid products.⁶

B

In March 2000, Spireas and Mutual entered into an engagement letter (the 2000 Letter) in accordance with the 1998 Agreement. The 2000 Letter engaged Spireas to develop, using liquisolid technology, a generic version of a blood-pressure drug called felodipine.⁷ That development process succeeded after what the Tax Court found was "considerable work ... to adapt [liquisolid technology] to felodipine's

idiosyncrasies." Spireas v. Comm'r of Internal Revenue , T.C. Memo 2016-163, 2016 WL 4464695, at *6 (Aug. 24, 2016). Spireas completed those efforts in relatively short order. "When he signed the March 2000 engagement letter, [Spireas] had completed roughly 30% of the work that ultimately resulted in" the liquisolid formulation of felodipine that he finished inventing "sometime after May 2000." Id. at *6, *10.

The FDA approved Mutual's Abbreviated New Drug Application for liquisolid felodipine, and Mutual marketed it to great success. During the relevant time period, Spireas's royalties on felodipine sales totaled just over $40 million. Spireas reported all of those royalties as capital gains on his personal returns for tax years 2007 and 2008.

In 2013, the Commissioner sent Spireas a notice of deficiency for 2007–2008. "The deficiencies arose from [the Commissioner's] conclusion that the Royalties [Spireas] received under [the 1998 Agreement] are taxable as ordinary income rather than as capital gain." Spireas , 2016 WL 4464695, at *1. The Commissioner determined that the royalties under the 1998 Agreement should have been treated as ordinary income, and Spireas therefore owed some $5.8 million in additional taxes.

C

After receiving the Commissioner's notice of deficiency, Spireas petitioned the United States Tax Court for a redetermination, and a brief trial was held. The main dispute in the Tax Court was whether Spireas had satisfied § 1235's requirement that he transfer "all substantial rights to a patent." Spireas , 2016 WL 4464695, at *8–9. IRS regulations define "all substantial rights to a patent" to mean "all rights ... which are of value at the time the rights to the patent ... are transferred." 26 C.F.R. § 1.1235-2(b)(1) ; see also E.I. du Pont de Nemours & Co. v. United States , 432 F.2d 1052, 1055 (3d Cir. 1970).

As the Tax Court put it, the parties' differences were "encapsulated in the question: ‘All substantial rights to what ?’ " Spireas , 2016 WL 4464695, at *9. The Commissioner argued that the dispositive point was Spireas's admitted failure to transfer all his rights to liquisolid technology generally . Mutual was not free to exploit every one of the technology's "potential application to thousands of drugs," id. at *12, and could only develop and sell those "Products that Mutual ... and [Spireas] ... unanimously select[ed]," App. 69 (1998 Agreement § 2.1.1). 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 . Spireas , 2016 WL 4464695, at *9.

The Tax Court agreed with the Commissioner. It held that Spireas could not have transferred the rights to any particular liquisolid products in 1998 because no products existed at that time. Id. Thus, the only rights Spireas could have granted Mutual in 1998 were in liquisolid technology generally—"the rights to use the liquisolid technology ... and to make and sell any ‘Products containing the Technology.’ " Id. And since Spireas had granted Mutual 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...