PRIVILEGED AND CONFIDENTIAL — ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
TAX STRUCTURING MEMORANDUM
PPC-4187 OUT-LICENSE TO MERIDIAN BIO THERAPEUTICS LIMITED
TO:
Marcus Delgado, Responsible Partner, intellectual Property Calderwood & Harkness LLP
Anita M. Fremont, Esq., General Counsel Penterra Pharmaceuticals Corp. 400 Pharma Drive, Suite 800 Princeton, New Jersey 08540
FROM:
Sylvia Hartwell, Specialist Partner, Tax Calderwood & Harkness LLP One Liberty Plaza, 165 Broadway New York, New York 10006
DATE: August 28, 2023
RE: Tax Structuring Considerations — Out-License of PPC-4187 (Penteracitinib) by Penterra Pharmaceuticals Corp. to Meridian Bio Therapeutics Limited
MATTER NO.: C&H-2023-TX-04892
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I. EXECUTIVE SUMMARY
This memorandum sets forth the principal tax structuring considerations arising from the proposed exclusive out-license of the pharmaceutical compound designated PPC-4187, known by its international nonproprietary name Penteracitinib (the "Compound"), by Penterra Pharmaceuticals Corp. ("Penterra" or the "Licensor"), a Delaware corporation publicly traded on the Nasdaq Global Select Market under the ticker symbol PNTR (EIN 22-3948175), headquartered at 400 Pharma Drive, Suite 800, Princeton, New Jersey 08540, to Meridian Bio Therapeutics Limited ("Meridian" or the "Licensee"), a limited company organized and existing under the laws of Hong Kong Special Administrative Region, People's Republic of China (Company Registration No. 2847631), headquartered at 18/F, Blossom Tower, 88 Queen's Road Central, Hong Kong SAR.
The proposed transaction involves the grant of an exclusive license to develop, manufacture, and commercialize the Compound and products containing the Compound (collectively, "Licensed Products") throughout a defined Asia-Pacific Territory encompassing fourteen (14) countries and regions (the "Territory"). The total potential deal value under the proposed Exclusive License Agreement (the "License Agreement") is up to One Hundred Twenty Million Dollars ($120,000,000) in non-royalty consideration, comprised of an upfront payment of Eighteen Million Dollars ($18,000,000), development milestone payments of Thirty-Two Million Dollars ($32,000,000), regulatory milestone payments of Twenty-Five Million Dollars ($25,000,000), and commercial milestone payments of Forty-Five Million Dollars ($45,000,000), together with tiered running royalties on net sales at rates of eight percent (8%), eleven percent (11%), and fourteen percent (14%) depending on annual net sales thresholds. In addition, the transaction includes an ancillary API supply arrangement at cost plus fifteen percent (15%) markup for an initial three-year period following the closing date.
This memorandum analyzes the following key tax issues arising from the proposed transaction:
1. Withholding Tax on Cross-Border Payments. The application of withholding taxes to royalty payments, milestone payments, and sublicense income pass-through payments flowing from Meridian and its regional subsidiaries in the Asia-Pacific Territory to Penterra in the United States, including analysis of applicable bilateral income tax treaties (or the absence thereof) between the United States and each relevant Territory jurisdiction.
2. Characterization of Payments. The proper characterization of the various payment streams under the License Agreement — specifically, whether such payments constitute royalty income, service income, or capital gain for U.S. federal income tax purposes and for purposes of applying foreign withholding tax regimes and treaty provisions.
3. Transfer Pricing — API Supply Arrangement. The transfer pricing analysis applicable to the supply of active pharmaceutical ingredient (API) by Penterra (through its contract manufacturer, Alkerra Manufacturing Inc.) to Meridian at cost plus fifteen percent (15%), including compliance with IRC §482, the Treasury Regulations promulgated thereunder, and the OECD Transfer Pricing Guidelines, as well as corresponding transfer pricing rules in the People's Republic of China and other Territory jurisdictions.
4. U.S. Revenue Recognition Under ASC 606. An overview of the accounting treatment considerations under Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, as applied to the milestone payments, upfront license fee, and royalty streams, to the extent such accounting treatment may affect or be affected by the tax structuring of the transaction.
5. Value-Added Tax and Goods and Services Tax. The application of value-added tax ("VAT") and goods and services tax ("GST") in Territory jurisdictions to cross-border royalty payments, milestone payments, and the importation of API supplies.
6. Structuring Recommendations. Specific recommendations for structuring the payment flows under the License Agreement to optimize tax efficiency for Penterra, including recommendations regarding payment routing through Hong Kong, withholding tax gross-up provisions, FDII deduction eligibility under IRC §250, and foreign tax credit planning.
We note at the outset that Penterra's Chief Financial Officer, Garrett T. Holloway, and the Company's independent registered public accounting firm, Clarendon Bates LLP (engagement partner Robert F. Stanhope, CPA, 200 Campus Drive, Florham Park, New Jersey 07932), should be consulted on the accounting treatment implications of the structuring recommendations contained herein, particularly with respect to the ASC 606 revenue recognition analysis and the interaction between the tax and financial reporting treatments of the various payment streams. We have copied this memorandum to Ms. Fremont in her capacity as General Counsel and understand that she will coordinate dissemination within Penterra as appropriate and in a manner that preserves privilege.
This memorandum is prepared solely for the benefit of Penterra Pharmaceuticals Corp. and its counsel at Calderwood & Harkness LLP and is subject to the attorney-client privilege and the protection of the attorney work product doctrine. It does not constitute tax advice to Meridian or any of its affiliated entities.
II. TRANSACTION STRUCTURE AND PAYMENT FLOWS
A. Parties and Corporate Structure
The proposed transaction involves the following principal parties and entities:
Licensor. Penterra Pharmaceuticals Corp., a corporation organized and existing under the laws of the State of Delaware and headquartered in Princeton, New Jersey. Penterra is a publicly traded company listed on the Nasdaq Global Select Market (ticker: PNTR), with its principal executive offices located at 400 Pharma Drive, Suite 800, Princeton, New Jersey 08540. For U.S. federal income tax purposes, Penterra is a domestic corporation and a U.S. tax resident. Penterra is the owner of the worldwide intellectual property rights in the Compound, including all patents, patent applications, know-how, trade secrets, clinical data, and regulatory filings related thereto.
Licensee. Meridian Bio Therapeutics Limited, a limited company organized and existing under the Companies Ordinance (Cap. 622) of Hong Kong Special Administrative Region, People's Republic of China. Meridian is a privately held biopharmaceutical company specializing in the development and commercialization of innovative therapeutics in the Asia-Pacific region. Its registered office and principal place of business is located at 18/F, Blossom Tower, 88 Queen's Road Central, Hong Kong SAR (Company Registration No. 2847631). For Hong Kong tax purposes, Meridian is resident in and subject to the territorial taxation regime of Hong Kong.
Meridian Regional Subsidiaries. Meridian operates in the Territory through the following wholly-owned or majority-owned subsidiary entities, each of which is relevant to the analysis of payment flows and withholding tax exposure:
• Meridian Pharma (Shanghai) Co., Ltd. — A People's Republic of China wholly foreign-owned enterprise ("WFOE"), organized and existing under the laws of the PRC, with its registered address in the Pudong New Area, Shanghai, China. Meridian Shanghai is the primary operating entity for the development, regulatory submission, and commercialization of Licensed Products in the PRC market.
• Meridian Japan K.K. — A Kabushiki Kaisha (joint-stock company) organized and existing under the laws of Japan, with its registered office in Tokyo, Japan. Meridian Japan is responsible for clinical development, regulatory affairs (PMDA submissions), and commercial operations for Licensed Products in the Japanese market.
• Meridian Korea Inc. — A corporation organized and existing under the laws of the Republic of Korea, with its registered office in Seoul, Korea. Meridian Korea will manage regulatory submissions to the Korean Ministry of Food and Drug Safety ("MFDS") and commercial launch activities in the Korean market.
• Meridian Bio Australia Pty Ltd — A proprietary limited company organized and existing under the Corporations Act 2001 (Cth) of Australia, with its registered office in Sydney, New South Wales, Australia. Meridian Australia will manage regulatory submissions to the Therapeutic Goods Administration ("TGA") and commercial operations for Licensed Products in Australia and New Zealand.
Contract Manufacturer. Alkerra Manufacturing Inc., a corporation organized and existing under the laws of the State of North Carolina, with its principal manufacturing facility located at 5200 Meridian Parkway, Research Triangle Park, North Carolina 27713. Alkerra is the designated contract manufacturer for the production of PPC-4187 API under the ancillary Supply Agreement. Alkerra is not a related party to Penterra; however, Penterra has an existing exclusive manufacturing services agreement with Alkerra for the production of the Compound's API.
B. Payment Streams
The License Agreement provides for the following categories of payments from Meridian to Penterra:
Upfront Payment. Meridian shall pay to Penterra an upfront, non-refundable, non-creditable license fee of Eighteen Million Dollars ($18,000,000), payable at the closing of the transaction. The upfront payment will be delivered via wire transfer to an escrow account maintained at Velthorn National Bank, N.A., and released to Penterra upon satisfaction of customary closing conditions, including delivery of executed transaction documents, completion of any required regulatory filings, and confirmation of representations and warranties.
Development Milestone Payments. Meridian shall pay to Penterra the following development milestone payments upon the first achievement of each of the following development events with respect to Licensed Products in the Territory:
Each development milestone payment shall be due within thirty (30) days following written notice from Meridian to Penterra of the achievement of the applicable milestone event.
Regulatory Milestone Payments. Meridian shall pay to Penterra the following regulatory milestone payments upon the first achievement of each of the following regulatory events with respect to Licensed Products in the Territory:
Each regulatory milestone payment shall be due within thirty (30) days following written notice from Meridian to Penterra of the receipt of the applicable regulatory approval.
Commercial Milestone Payments. Meridian shall pay to Penterra the following one-time commercial milestone payments upon the first achievement of each of the following annual net sales thresholds in the Territory:
Each commercial milestone payment shall be due within sixty (60) days following the end of the calendar quarter in which the applicable net sales threshold is first achieved, as reported in Meridian's quarterly royalty reports.
Running Royalties. Beginning upon the first commercial sale of a Licensed Product in the Territory, Meridian shall pay to Penterra tiered running royalties on annual aggregate net sales of all Licensed Products in the Territory, calculated as follows:
Royalties shall be calculated on a calendar year basis and paid within forty-five (45) days following the end of each calendar quarter, accompanied by a detailed royalty report.
Minimum Annual Royalty. Beginning in the calendar year immediately following the year in which the first commercial sale of a Licensed Product occurs in any Territory country, Meridian shall pay to Penterra a minimum annual royalty of Two Million Dollars ($2,000,000) per calendar year. Running royalties earned during any calendar year shall be credited against the minimum annual royalty obligation for that year; any shortfall shall be payable within sixty (60) days following the end of the applicable calendar year.
Post-Patent Royalty Reduction. In any country within the Territory in which all patents covering the Compound or a Licensed Product have expired or been invalidated and no data exclusivity or regulatory exclusivity period remains in effect, the applicable royalty rates shall be reduced by fifty percent (50%) — that is, the reduced rates shall be four percent (4%), five and one-half percent (5.5%), and seven percent (7%) for the respective tiers.
Generic Entry Reduction. In any country within the Territory in which one or more generic versions of a Licensed Product have been approved by the applicable regulatory authority and such generic products have achieved a combined market share of thirty percent (30%) or more of total prescriptions or units sold (as reported by Tidewater Holdings or another mutually agreed data provider) in any calendar quarter, the royalty rate applicable to net sales of Licensed Products in that country for such quarter and all subsequent quarters shall be reduced by forty percent (40%).
Sublicense Income Pass-Through. In the event Meridian enters into any sublicense agreement with a third party with respect to any rights granted under the License Agreement, Meridian shall pay to Penterra fifty percent (50%) of all sublicense income received by Meridian from such sublicensee, net of documented and reasonable out-of-pocket development costs incurred by Meridian specifically in connection with the sublicensed rights. Sublicense income pass-through payments shall be due within thirty (30) days following Meridian's receipt of the applicable sublicense income.
API Supply Payments. Under the ancillary Supply Agreement, Penterra shall supply to Meridian (or its designated affiliate) the active pharmaceutical ingredient PPC-4187 API and associated reference standards for a term of three (3) years following the Effective Date of the License Agreement. The supply price shall be calculated on a cost-plus basis, with a markup of fifteen percent (15%) applied to Penterra's fully burdened cost of manufacturing (including the cost of goods purchased from Alkerra Manufacturing Inc., quality control and release testing costs, and reasonable allocated overhead). Purchase orders, supply forecasts, shipping terms, and quality specifications are governed by the Supply Agreement, which is an exhibit to the License Agreement.
C. Payment Flow Diagram
The following describes the anticipated payment flow architecture for the various payment streams under the License Agreement:
Primary Flow — Direct Payments from Meridian (Hong Kong) to Penterra (United States). The License Agreement, as currently structured, contemplates that all upfront, milestone, and royalty payments will be made directly by Meridian Bio Therapeutics Limited, the Hong Kong parent entity, to Penterra Pharmaceuticals Corp. in the United States. This is the preferred payment routing from a tax efficiency standpoint, for reasons discussed in detail in Section III below.
Alternative Flow — PRC Subsidiary Payments. Notwithstanding the primary flow described above, there is a risk that certain payments — particularly royalties attributable to net sales of Licensed Products generated in the PRC market — may be required to flow through Meridian Pharma (Shanghai) Co., Ltd. This could occur if the PRC State Administration of Taxation ("SAT") or its local subordinate offices assert that royalties for use of the licensed IP in the PRC should be paid directly by the PRC entity that is the actual user of the IP, rather than by the Hong Kong parent. If payments are routed through the PRC subsidiary, they will be subject to PRC withholding income tax at a rate of ten percent (10%) and PRC VAT at a rate of six percent (6%), as discussed in Sections III.B and VI.B below.
API Supply Payments. API supply payments will flow from Meridian (or its designated purchasing affiliate) to Penterra. Penterra, in turn, will pay Alkerra Manufacturing Inc. for the manufacture of the API under its existing contract manufacturing agreement. In certain circumstances, the License Agreement may permit Meridian to direct payment of the API supply price directly to Alkerra Manufacturing Inc. on Penterra's behalf, although the contractual obligation for supply rests with Penterra as the seller under the Supply Agreement.
Sublicense Income. Sublicense income will be collected by Meridian from its sublicensees in the Territory. Meridian will calculate the net sublicense income (after deduction of documented out-of-pocket development costs) and remit fifty percent (50%) of such net sublicense income to Penterra. The jurisdiction from which the sublicense income originates will depend on the identity and location of the sublicensee, which is not yet determined. As a structural matter, we recommend that all sublicense income pass-through payments be remitted by the Hong Kong parent entity to Penterra, regardless of the jurisdiction in which the sublicensee is located, to minimize intermediate withholding tax exposure.
III. WITHHOLDING TAX ANALYSIS
The cross-border nature of the transaction creates potential withholding tax exposure on royalty payments, milestone payments, and sublicense income pass-through payments flowing from the Territory to the United States. The withholding tax consequences depend on (i) the jurisdiction from which the payment originates, (ii) the existence and terms of any bilateral income tax treaty between the United States and that jurisdiction, (iii) the characterization of the payment under the applicable domestic law and treaty provisions, and (iv) the availability of exemptions or reduced rates. We analyze the key jurisdictions below.
A. U.S.–Hong Kong Tax Framework
It is critical to note at the outset that there is no comprehensive bilateral income tax treaty between the United States and Hong Kong SAR. Hong Kong is treated as a separate customs and tax territory from the People's Republic of China for purposes of international tax agreements, and the U.S.–PRC Income Tax Treaty (1984) does not extend to Hong Kong. There has been no separate income tax treaty negotiated between the United States and Hong Kong.
Notwithstanding the absence of a treaty, the tax results for payments flowing directly from Meridian (Hong Kong) to Penterra (United States) are favorable for the following reasons:
Hong Kong Domestic Tax Treatment. Hong Kong operates on a territorial basis of taxation under the Inland Revenue Ordinance (Cap. 112). Under Hong Kong's territorial tax regime, profits tax is imposed only on profits arising in or derived from Hong Kong. Hong Kong does not impose a withholding tax on outbound royalty payments, milestone payments, or other remittances made by a Hong Kong company to a non-resident payee. Accordingly, payments made by Meridian Bio Therapeutics Limited from Hong Kong to Penterra in the United States would not be subject to any Hong Kong withholding tax. There is no requirement for Meridian (Hong Kong) to deduct or withhold any amount from such payments.
U.S. Domestic Tax Treatment. The United States generally does not impose a withholding tax on payments received by U.S. persons (including U.S. corporations) from foreign sources. Sections 1441 and 1442 of the Internal Revenue Code impose withholding obligations on payments of U.S.-source income made to foreign persons, but these provisions do not apply to payments of foreign-source income received by a U.S. domestic corporation such as Penterra. Penterra will include all royalty income, milestone income, and sublicense income pass-through received from Meridian in its U.S. federal and state taxable income in the year such income is properly recognized, but no U.S. withholding tax applies on inbound payments from abroad.
Result. Payments flowing directly from Meridian Bio Therapeutics Limited (Hong Kong) to Penterra Pharmaceuticals Corp. (United States) are subject to a combined effective withholding tax rate of zero percent (0%). No withholding is imposed at the Hong Kong source, and no withholding is imposed at the U.S. destination. This is the most tax-efficient payment routing available for the transaction and forms the basis of our primary structuring recommendation in Section VIII.A below.
Caveat. This favorable result is entirely contingent on the payments being made directly by the Meridian Hong Kong parent entity, rather than being routed through or paid by Meridian's subsidiary entities in the PRC, Japan, Korea, Australia, or other Territory jurisdictions that impose withholding taxes on outbound royalty payments. If payments are instead made by a subsidiary in a taxing jurisdiction, the analysis changes materially, as discussed in the subsections that follow.
B. PRC Withholding Tax — Critical Exposure
The People's Republic of China represents the largest market in the Territory by revenue potential and accordingly presents the most significant withholding tax exposure for Penterra. If royalty or milestone payments are made by Meridian Pharma (Shanghai) Co., Ltd. directly to Penterra, such payments will be subject to PRC withholding income tax.
PRC Domestic Withholding Rate. Under Article 3 and Article 37 of the PRC Enterprise Income Tax Law (中华人民共和国企业所得税法) and Article 91 of the Implementing Regulations thereof, passive income (including royalties) paid by a PRC-resident enterprise to a non-resident enterprise that does not have an establishment or place of business in China, or that has such an establishment but the income is not effectively connected therewith, is subject to withholding income tax at a statutory rate of twenty percent (20%). However, pursuant to Article 4 of the Implementing Regulations, the actual applicable rate is reduced to ten percent (10%). This ten percent (10%) withholding rate applies to royalty payments, lump-sum license fees, and other payments for the use of, or the right to use, intellectual property.
U.S.–PRC Income Tax Treaty. The Agreement Between the Government of the United States of America and the Government of the People's Republic of China for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (signed April 30, 1984, as amended by the Protocol signed May 10, 1986) (the "U.S.–PRC Treaty") provides in Article 11 for a reduced treaty rate on royalty payments. However, the U.S.–PRC Treaty royalty rate under Article 11 is also ten percent (10%), which offers no reduction from the PRC domestic withholding rate. Accordingly, even with treaty benefits properly claimed, PRC withholding on royalty payments to Penterra would remain at ten percent (10%).
Practical Impact. For royalty and milestone payments attributable to PRC net sales, if such payments flow through Meridian Pharma (Shanghai) Co., Ltd., Penterra would bear a ten percent (10%) withholding tax cost on each dollar of royalty or milestone income originating from the PRC. Given that the PRC market is expected to represent a substantial portion of total Territory net sales — industry analysts estimate that the PRC may account for forty percent (40%) to fifty-five percent (55%) of aggregate Territory sales for a product in this therapeutic class — the withholding tax cost could be highly material.
Quantification Example. To illustrate the potential magnitude of this cost: assuming PRC annual net sales of Licensed Products reach $100,000,000 at a blended effective royalty rate of eleven percent (11%) (reflecting the applicable tier structure), the annual royalty payment attributable to PRC sales would be $11,000,000, and the PRC withholding tax thereon would be $1,100,000 per annum. Over the projected ten-year commercial life of the product in the PRC market, cumulative PRC withholding tax costs could exceed $10,000,000, exclusive of milestones.
U.S. Foreign Tax Credit. Penterra should be entitled to claim a U.S. foreign tax credit under IRC §901 and §903 for PRC withholding taxes paid or accrued on royalty and milestone income. The availability of the credit is subject to the limitation under IRC §904, which limits the foreign tax credit to the U.S. tax attributable to the taxpayer's foreign-source income. Royalty income is generally sourced based on the place of use of the intellectual property under IRC §861(a)(4), such that royalties paid for the use of IP in the PRC should constitute foreign-source income, supporting the availability of the credit.
However, the foreign tax credit is subject to the separate basket limitations under IRC §904(d). Under the Tax Cuts and Jobs Act of 2017, the prior separate basket for passive income (including royalties) has been modified, and royalty income received from a non-controlled foreign corporation generally falls within the "general category" basket. Penterra should model its foreign tax credit position to ensure that sufficient general category foreign-source income exists to absorb the PRC credits without limitation.
PRC VAT Interaction. As discussed further in Section VI.B below, cross-border royalty payments from a PRC entity to a non-resident are also subject to PRC value-added tax at a rate of six percent (6%), in addition to the ten percent (10%) withholding income tax. This creates a total effective tax burden on PRC-source royalties of approximately sixteen percent (16%). The cumulative effect of PRC withholding income tax and PRC VAT significantly reinforces the importance of routing payments through the Hong Kong entity to the extent permissible.
C. Japan Withholding Tax
Japan is the second-largest pharmaceutical market in the Territory and will generate substantial royalty flows upon commercial launch of Licensed Products.
Japan Domestic Withholding Rate. Under the Income Tax Act of Japan (所得税法), royalty payments made by a Japanese entity to a non-resident payee are subject to Japanese withholding tax at a rate of twenty percent (20%). In addition, a special reconstruction surtax (復興特別所得税) of 2.1% of the base tax applies through December 31, 2037, resulting in an effective combined domestic withholding rate of twenty and forty-two hundredths percent (20.42%).
U.S.–Japan Income Tax Treaty. The Convention Between the Government of the United States of America and the Government of Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (signed November 6, 2003, entered into force March 30, 2004) (the "U.S.–Japan Treaty") provides in Article 12 for a complete exemption from source-country withholding tax on royalty payments. Article 12(1) of the U.S.–Japan Treaty states that "royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other State." Accordingly, if Meridian Japan K.K. makes royalty payments to Penterra, and if Penterra qualifies as the beneficial owner of such royalties and is a resident of the United States for purposes of the treaty, the treaty rate of zero percent (0%) should apply, eliminating the Japanese withholding tax entirely.
Procedural Requirements. To claim the benefit of the zero percent (0%) treaty rate, Penterra must comply with the procedural requirements established by the Japanese National Tax Agency. Specifically, Japan Form 3 (Application for Income Tax Convention) (租税条約に関する届出書) must be filed with the competent Japanese tax office having jurisdiction over Meridian Japan K.K. prior to the date on which the first royalty payment is made. Failure to file Form 3 in advance may result in the full domestic withholding rate of 20.42% being applied, with a subsequent refund claim required — a process that can involve significant delay and administrative burden.
Recommendation. We strongly recommend that Penterra and Meridian coordinate to ensure that the treaty benefit application (Form 3) is prepared and filed with the relevant Japanese tax authority well in advance of the anticipated first royalty payment date. Penterra's Japanese tax counsel, Nakamura & Takeda Law Offices (contact: Yuki Nakamura, Partner; Marunouchi Park Building, 2-6-1 Marunouchi, Chiyoda-ku, Tokyo 100-6921, Japan), should be engaged to prepare and submit the required forms and to advise on any supplemental documentation required by the Japanese tax office. We will coordinate with Nakamura & Takeda directly upon instruction from the deal team.
D. South Korea Withholding Tax
Korea Domestic Withholding Rate. Under the Korean Income Tax Act and the Corporate Tax Act, royalty payments made by a Korean entity to a non-resident are subject to Korean withholding tax at a base rate of twenty percent (20%). When combined with the local income surtax (지방소득세) at ten percent (10%) of the base tax, the effective domestic withholding rate on royalties paid to non-residents is approximately twenty-two percent (22%).
U.S.–Korea Income Tax Treaty. The Convention Between the Government of the United States of America and the Government of the Republic of Korea for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (signed June 4, 1976, as amended by the Protocol signed in 2006) (the "U.S.–Korea Treaty") provides in Article 14 for a reduced withholding rate on royalties. Under Article 14(2), royalties paid from Korean sources to a resident of the United States are subject to a maximum withholding rate of fifteen percent (15%) of the gross amount of the royalties. Certain categories of know-how payments (as distinguished from patent royalties) may qualify for a further reduced rate of ten percent (10%) under Article 14(2)(a), although the applicability of this reduced rate depends on the precise nature of the technology transfer and the manner in which the Korean tax authorities interpret the payments.
Characterization Issue. The classification of milestone payments under the License Agreement requires careful analysis in the Korean context. Payments characterized as royalties for the use of, or the right to use, patents and intellectual property would be subject to the fifteen percent (15%) treaty rate. However, payments characterized as fees for technical services — for example, payments tied to Penterra's performance of specific development activities or technology transfer services — may be exempt from Korean withholding tax if Penterra does not maintain a permanent establishment in Korea under Article 5 of the U.S.–Korea Treaty. The characterization of each milestone payment must be analyzed on a payment-by-payment basis, as discussed further in Section IV.B below.
Foreign Tax Credit. Korean withholding taxes paid by Penterra would be eligible for the U.S. foreign tax credit under IRC §901, subject to the IRC §904 limitation discussed in Section III.B above.
E. Australia Withholding Tax
Australia Domestic Withholding Rate. Under Division 11A of the Income Tax Assessment Act 1936 (Cth), royalty payments made by an Australian resident to a non-resident payee are subject to Australian withholding tax at a rate of thirty percent (30%) of the gross amount of the royalty. This is among the highest domestic withholding rates in the Territory.
U.S.–Australia Income Tax Treaty. The Convention Between the Government of the United States of America and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (signed August 6, 1982, as amended by the Protocol signed September 27, 2001) (the "U.S.–Australia Treaty") significantly reduces the withholding rate on royalties. Under Article 12 of the U.S.–Australia Treaty, the withholding tax on royalties paid from Australian sources to a resident of the United States is limited to five percent (5%) of the gross amount of the royalties. This represents a substantial reduction from the thirty percent (30%) domestic rate.
Application. If Meridian Bio Australia Pty Ltd makes royalty or milestone payments to Penterra that are characterized as royalties under the treaty, such payments would be subject to Australian withholding tax at the reduced treaty rate of five percent (5%). Penterra should ensure that the appropriate treaty benefit claim forms are filed with the Australian Taxation Office ("ATO") and that Meridian Bio Australia provides a valid foreign resident withholding tax declaration to support the reduced rate.
Australia GST. Australia also imposes a goods and services tax on the importation of services, including cross-border royalty payments, as discussed in Section VI.D below. The GST is generally recoverable by Meridian Bio Australia as an input tax credit if the entity is registered for GST purposes and uses the imported services in the course of its taxable business activities.
F. Other Territory Jurisdictions
Beyond the four major jurisdictions analyzed above, the Territory encompasses a number of additional countries and regions in which Licensed Products may be marketed through sublicensing or direct commercial activities by Meridian or its affiliates. The following provides a brief survey of the withholding tax landscape in each jurisdiction, based on applicable domestic laws and any bilateral income tax treaties with the United States:
Singapore. Singapore generally imposes a domestic withholding tax rate of ten percent (10%) on royalty payments to non-residents under Section 12(7) of the Income Tax Act 1947. However, certain royalty payments may be exempt from withholding under specific conditions. The U.S.–Singapore Income Tax Treaty (signed November 7, 2007) provides for a zero percent (0%) withholding rate on royalties under Article 12, subject to beneficial ownership and procedural requirements. Accordingly, payments routed through a Singaporean sublicensee may benefit from a zero percent (0%) treaty rate.
Thailand. Thailand imposes a domestic withholding tax rate of fifteen percent (15%) on royalty payments to non-residents under the Revenue Code. There is no comprehensive income tax treaty between the United States and Thailand. Accordingly, the full domestic rate of fifteen percent (15%) would apply to royalty payments originating from Thailand, with no treaty reduction available.
Malaysia. Malaysia imposes a domestic withholding tax rate of ten percent (10%) on royalty payments to non-residents under Section 109 of the Income Tax Act 1967. There is no comprehensive income tax treaty between the United States and Malaysia. The full domestic rate of ten percent (10%) would apply.
Indonesia. Indonesia imposes a domestic withholding tax rate of twenty percent (20%) on royalty payments to non-residents under Article 26 of the Income Tax Law (Law No. 7 of 1983, as amended). The U.S.–Indonesia Income Tax Treaty (signed July 11, 1988) provides for a reduced withholding rate on royalties of ten percent (10%) under Article 13. Accordingly, if Penterra establishes its eligibility for treaty benefits, the withholding rate on Indonesian-source royalties would be reduced from twenty percent (20%) to ten percent (10%).
Philippines. The Philippines imposes a domestic withholding tax rate of twenty-five percent (25%) on royalty payments to non-residents under the National Internal Revenue Code. The U.S.–Philippines Income Tax Treaty (signed October 1, 1976) provides for a reduced rate on royalties of fifteen percent (15%) under Article 13. Payments from a Philippine sublicensee would accordingly be subject to withholding at fifteen percent (15%).
Vietnam. Vietnam imposes a domestic withholding tax rate of ten percent (10%) on royalty payments to non-residents under the corporate income tax regulations. There is no comprehensive income tax treaty between the United States and Vietnam. The full domestic rate of ten percent (10%) would apply, with no treaty reduction available.
Taiwan. Taiwan imposes a domestic withholding tax rate of twenty percent (20%) on royalty payments to non-residents under the Income Tax Act. There is no formal treaty relationship between the United States and Taiwan (the Republic of China). Accordingly, the full domestic rate of twenty percent (20%) would apply to royalty payments originating from Taiwan.
New Zealand. New Zealand imposes a domestic non-resident contractor's withholding tax on royalties at a rate of fifteen percent (15%). Under the Double Tax Agreement between the United States and New Zealand (signed July 23, 1982), the withholding rate on royalties may be reduced to ten percent (10%) under Article 12. Penterra should confirm applicability with New Zealand counsel.
Recommendation. Given the breadth of the Territory and the varying withholding tax rates across fourteen (14) countries and regions, we recommend that Penterra prepare a comprehensive jurisdiction-by-jurisdiction withholding tax matrix once the sublicensing and payment flow structures are finalized. This matrix should be updated annually and maintained as part of Penterra's international tax compliance files. A preliminary version of this matrix will be prepared as Appendix A to this memorandum.
IV. CHARACTERIZATION OF PAYMENTS
The tax treatment of each payment stream under the License Agreement depends in the first instance on the proper characterization of the payment for U.S. federal income tax purposes and for purposes of the withholding tax regimes of the Territory jurisdictions. Different characterizations may result in materially different tax consequences, including differences in the applicable withholding tax rates, the timing of income recognition, and the applicability of foreign tax credits. We analyze the characterization of each payment category below.
A. Upfront Payment ($18M)
The upfront payment of $18,000,000 represents a lump-sum, non-refundable, non-creditable fee paid by Meridian to Penterra in consideration for the grant of the exclusive license to the PPC-4187 intellectual property within the Territory. The upfront payment is not contingent on any future event and becomes due and payable at the closing of the transaction.
U.S. Tax Characterization. Under U.S. tax principles, the upfront payment is most appropriately characterized as a lump-sum royalty payment for the grant of an exclusive license, rather than as the proceeds of a sale or assignment of intellectual property. This characterization is supported by the following factors:
• Penterra is retaining substantial rights in the Compound outside the Territory. The license granted to Meridian is limited to the Asia-Pacific Territory, and Penterra retains all rights to develop, manufacture, and commercialize PPC-4187 in the United States, Europe, Latin America, and all other regions worldwide.
• Penterra retains the right to improvements and derivative works. Under the License Agreement, Penterra retains ownership of all improvements to the Compound developed by Penterra outside the scope of the Meridian collaboration, and Meridian's improvements are subject to grant-back provisions.
• The license is not a transfer of "all substantial rights" in the IP. Under IRC §1235 and the case law interpreting the term "transfer of all substantial rights" for purposes of treating the transfer of a patent as a sale or exchange giving rise to capital gain, a geographically limited license that retains rights in the licensor outside the licensed territory does not constitute a transfer of all substantial rights. See Waterman v. Mackenzie, 138 U.S. 252 (1891); Rev. Rul. 58-353, 1958-2 C.B. 408.
Accordingly, the upfront payment should be treated as ordinary income to Penterra, not as capital gain, and should be recognized in the taxable year in which it is received or accrued (consistent with Penterra's method of accounting).
Foreign Withholding Tax Characterization. For purposes of applying foreign withholding tax regimes, the upfront payment will generally be characterized as a royalty payment in most Asia-Pacific jurisdictions. If the payment is made by Meridian (Hong Kong), no withholding applies (as discussed in Section III.A). However, if any portion of the upfront payment were to be allocated to or deemed sourced in a withholding tax jurisdiction (for example, if a Territory country's tax authority asserts that the upfront fee is allocable to the grant of rights in that country), withholding tax could potentially apply. This risk is mitigated by structuring the License Agreement so that the upfront payment obligation rests solely with the Hong Kong entity.
B. Development and Regulatory Milestone Payments ($32M + $25M)
The development milestone payments ($32,000,000 in the aggregate) and regulatory milestone payments ($25,000,000 in the aggregate) are contingent payments that become due only upon the achievement of specified development or regulatory events. The characterization of these milestone payments is more nuanced than the upfront payment and requires analysis under both U.S. tax principles and the domestic tax laws of each relevant Territory jurisdiction.
Characterization Analysis. The milestone payments can be viewed through several alternative lenses:
1. Contingent Royalties / Supplemental License Fees. To the extent the milestones are tied to the value of the license and represent additional consideration for the grant of the exclusive rights — payable upon the occurrence of events that increase the value of the licensed rights to Meridian — they are properly characterized as contingent royalty payments or supplemental license fees. This is the most natural characterization for milestone payments tied to regulatory approvals (NMPA, PMDA, MFDS, TGA), which represent the realization of the commercial value of the licensed intellectual property.
2. Fees for Services. To the extent any milestone payments are tied to specific performance obligations of Penterra — for example, if Penterra is providing development services or technology transfer activities that contribute to the achievement of the milestone — there could be an argument that some portion of the milestone payment represents compensation for services rendered. However, under the current License Agreement, the development activities within the Territory are primarily Meridian's responsibility, and Penterra's obligations are limited to providing access to existing clinical data, pharmacovigilance cooperation, and regulatory filings support. This weighs against characterizing the milestones as service fees.
3. Other Income. In certain treaty contexts, milestone payments that do not fit neatly within the definition of "royalties" under the applicable income tax treaty may be classified as "other income" under the residual article (typically Article 21 or equivalent). In most U.S. treaties, "other income" is taxable only in the state of residence of the recipient, meaning that Penterra — as a U.S. resident — would not be subject to source-country withholding on such payments. This classification could be advantageous in jurisdictions where treaty royalty rates are higher than zero.
U.S. Tax Treatment. For U.S. federal income tax purposes, Penterra should treat the development and regulatory milestone payments as ordinary income, recognized in the taxable year in which the milestone event is achieved and the payment becomes fixed and determinable under Penterra's method of accounting. Under the accrual method, income is recognized when all events have occurred that establish the right to receive the income, the amount can be determined with reasonable accuracy, and economic performance has occurred. For milestone payments triggered by a specific event (such as NMPA approval), the income should be recognized as of the date the triggering event occurs, even if payment is not received until a subsequent period.
Foreign Withholding Tax Treatment. For purposes of foreign withholding tax, development and regulatory milestones will generally be classified as royalty payments in most Asia-Pacific jurisdictions, subjecting them to the withholding rates discussed in Section III above. However, the classification may vary by jurisdiction:
• In South Korea, a distinction exists between payments for the use of patents (subject to a fifteen percent (15%) treaty rate) and payments for know-how transfers (subject to a ten percent (10%) treaty rate under Article 14(2)(a) of the U.S.–Korea Treaty). To the extent that certain development milestones can be characterized as payment for know-how transferred to Meridian Korea, a lower withholding rate may apply. This characterization should be analyzed on a payment-by-payment basis in coordination with Korean tax counsel.
• In Japan, the zero percent (0%) treaty rate under Article 12 of the U.S.–Japan Treaty applies to "royalties" broadly defined, including payments for the use of, or the right to use, patents, trade secrets, and other intellectual property. The milestone payments, whether characterized as lump-sum royalties or contingent license fees, should generally qualify for the zero percent (0%) treaty rate.
C. Commercial Milestone Payments ($45M)
The commercial milestone payments of $45,000,000 in the aggregate are triggered by the achievement of specified annual net sales thresholds ($50,000,000, $100,000,000, and $200,000,000) in the Territory. Because these milestones are directly linked to the volume of commercial sales of Licensed Products — the same measure on which running royalties are computed — they are most properly characterized as contingent royalty-like payments for both U.S. and foreign tax purposes.
For U.S. federal income tax purposes, commercial milestone payments should be treated as ordinary income and recognized in the taxable year in which the applicable net sales threshold is first achieved. For foreign withholding tax purposes, the characterization as royalty payments would subject these milestones to the same withholding rates applicable to running royalties in each jurisdiction.
D. Running Royalties
The tiered running royalties on annual net sales of Licensed Products in the Territory constitute standard royalty income to Penterra. For U.S. federal income tax purposes, such royalties are ordinary income recognized in the period in which the underlying sales occur and the royalty obligation accrues. For foreign withholding tax purposes, the applicable rates are as analyzed on a jurisdiction-by-jurisdiction basis in Section III above.
The minimum annual royalty of $2,000,000 per year represents a guaranteed minimum floor payment that is due regardless of actual net sales levels. This minimum royalty ensures that Penterra receives at least a baseline level of royalty income in each year following the first commercial sale. For tax purposes, the minimum annual royalty should be treated as a fixed royalty obligation, with any excess of running royalties over the minimum credited against the obligation for that year.
E. Sublicense Income Pass-Through (50%)
Under the License Agreement, Penterra receives fifty percent (50%) of sublicense income collected by Meridian from sublicensees in the Territory, net of documented out-of-pocket development costs incurred by Meridian. The sublicense income pass-through presents several characterization and structural issues:
U.S. Tax Characterization. For U.S. federal income tax purposes, the sublicense income pass-through to Penterra should be characterized as royalty or license fee income. The payments represent consideration received by Penterra for the use by third-party sublicensees of intellectual property that Penterra has licensed to Meridian, with Meridian acting as an intermediary sublicensor. The substance of the arrangement is that Penterra is receiving royalty-equivalent income from the exploitation of its IP by sublicensees.
Withholding Tax Analysis. The withholding tax consequences of sublicense income pass-through payments depend on the jurisdiction from which the payment originates. Two scenarios are relevant:
• Scenario 1: Payment from Meridian (Hong Kong) to Penterra. If Meridian collects sublicense income from sublicensees and remits Penterra's fifty percent (50%) share from the Hong Kong entity, no withholding tax applies (consistent with the analysis in Section III.A).
• Scenario 2: Payment from a sublicensee in a taxing jurisdiction. If a sublicensee located in a withholding tax jurisdiction (e.g., Thailand, Taiwan, or Vietnam) pays royalties to Meridian, withholding may be imposed at the sublicensee-to-Meridian stage. If Meridian then remits Penterra's share from Hong Kong, no further withholding applies at the Meridian-to-Penterra stage. However, the initial withholding at the sublicensee level effectively reduces the gross sublicense income received by Meridian, thereby reducing the amount available for pass-through to Penterra. This creates a risk of double-layer withholding if the sublicensee's jurisdiction also treats the pass-through from Meridian to Penterra as a separate royalty payment.
Recommendation. To minimize the risk of double-layer withholding and to preserve the maximum amount of sublicense income for pass-through to Penterra, we recommend that all sublicense income pass-through payments be structured to flow from Meridian (Hong Kong) directly to Penterra. The License Agreement should specify that Meridian's obligation to remit Penterra's share of sublicense income is an obligation of the Hong Kong parent entity, not of any subsidiary. Additionally, Meridian should be required to use commercially reasonable efforts to structure its sublicense arrangements to minimize withholding tax imposed at the sublicensee level, including by claiming applicable treaty benefits.
V. TRANSFER PRICING — API SUPPLY ARRANGEMENT
A. Overview of Supply Terms
Under the ancillary Supply Agreement, Penterra will supply the active pharmaceutical ingredient PPC-4187 API and associated reference standards to Meridian (or its designated purchasing affiliate) for an initial term of three (3) years following the Effective Date of the License Agreement. The supply price is calculated on a cost-plus basis, with a markup of fifteen percent (15%) applied to Penterra's fully burdened cost of manufacturing, which includes the cost of goods purchased from the contract manufacturer Alkerra Manufacturing Inc. (located at 5200 Meridian Parkway, Research Triangle Park, NC 27713), quality control and release testing costs, and reasonable allocated overhead.
In parallel with the API supply arrangement, the License Agreement contemplates a technology transfer program under which Penterra will transfer the manufacturing process for the PPC-4187 API to a contract manufacturing organization designated by Meridian within the Territory. The technology transfer is targeted for completion within twenty-four (24) months of the Effective Date (i.e., by approximately October 20, 2025), after which Meridian's designated APAC manufacturer would assume responsibility for API production and the intercompany supply arrangement would wind down.
B. Arm's-Length Analysis
The cost-plus fifteen percent (15%) markup applied to the API supply arrangement must satisfy the arm's-length standard under U.S. federal tax law and the transfer pricing rules of each relevant Territory jurisdiction. The intercompany supply of pharmaceutical API between related or contractually linked parties is subject to scrutiny under IRC §482 and the Treasury Regulations promulgated thereunder (Treas. Reg. §§1.482-1 through 1.482-9), as well as under the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2022 edition) and the domestic transfer pricing laws of each Territory country in which Meridian operates.
Transfer Pricing Method. The cost-plus method (Treas. Reg. §1.482-3(d)) is a commonly accepted and appropriate transfer pricing method for intercompany supply arrangements involving the manufacture and sale of pharmaceutical API. Under the cost-plus method, the arm's-length price is determined by adding an appropriate gross profit markup to the costs incurred by the seller (Penterra, through its contract manufacturer Alkerra) in producing the API. The cost-plus method is appropriate in this context because:
• The seller (Penterra/Alkerra) performs routine manufacturing and quality control functions with respect to the API supply.
• The seller does not own or exploit significant intangible assets in connection with the manufacturing activity. The valuable intangible — the PPC-4187 compound itself and the associated clinical and regulatory data — is licensed separately under the License Agreement.
• Comparable uncontrolled transactions involving third-party contract manufacturing organizations ("CMOs") in the pharmaceutical industry are available for benchmarking purposes.
Benchmark Analysis. A preliminary survey of publicly available data on third-party CMO agreements in the pharmaceutical sector indicates that cost-plus margins for the supply of pharmaceutical API typically range from ten percent (10%) to twenty-five percent (25%), depending on the complexity of the manufacturing process, the scale of production, the degree of customization required, and the risks borne by the manufacturer. The fifteen percent (15%) markup selected for the Penterra-Meridian API supply arrangement falls within the interquartile range of comparable margins observed in the benchmark set, supporting the arm's-length nature of the pricing.
Documentation Requirements. Penterra must prepare and maintain contemporaneous transfer pricing documentation supporting the arm's-length nature of the cost-plus fifteen percent (15%) markup. Such documentation should be prepared before the first API shipment under the Supply Agreement and updated on an annual basis thereafter. The documentation should include the following elements:
1. Functional Analysis. A detailed description of the functions performed, assets employed, and risks assumed by Penterra (and its contract manufacturer Alkerra) in connection with the API supply, as well as the functions, assets, and risks of the purchaser (Meridian).
2. Method Selection. A discussion of the selection and application of the cost-plus method as the most appropriate transfer pricing method for the API supply arrangement, including an explanation of why other methods (such as the comparable uncontrolled price method or the transactional net margin method) were considered but not selected.
3. Benchmark Study. An economic analysis utilizing comparable uncontrolled transactions to establish the arm's-length range of cost-plus markups for pharmaceutical API supply, including identification and screening of comparable companies or transactions, rejection criteria, and statistical analysis of the resulting interquartile range.
4. Economic Analysis. A quantitative demonstration that the fifteen percent (15%) markup falls within the arm's-length range, including computation of the actual cost base, the markup, and the resulting transfer price for the relevant fiscal year.
C. PRC Transfer Pricing Considerations
Meridian Pharma (Shanghai) Co., Ltd., as a PRC wholly foreign-owned enterprise, is subject to the transfer pricing rules of the People's Republic of China. PRC transfer pricing regulations are principally set forth in the following circulars and announcements issued by the PRC State Administration of Taxation ("SAT"):
• SAT Circular [2009] No. 2 (Implementation Measures for Special Tax Adjustments — 特别纳税调整实施办法（试行）)
• SAT Announcement [2016] No. 42 (Announcement on Matters Concerning Improving the Administration of Related Party Transactions and Contemporaneous Documentation)
• SAT Announcement [2017] No. 6 (Announcement on Matters Concerning the Administration of Advance Pricing Arrangements for Related Party Transactions)
PRC tax authorities have become increasingly aggressive in their scrutiny of transfer pricing arrangements involving related-party royalties and intercompany supply of goods, particularly in the pharmaceutical industry. Several specific risks warrant attention:
API Import Pricing. If API is imported into China by Meridian Pharma (Shanghai) Co., Ltd. and subsequently incorporated into finished dosage form products for distribution in the PRC market, the PRC transfer price for the API will affect both the corporate income tax base of Meridian Shanghai and the customs valuation of the imported goods. PRC customs authorities may adjust the customs value of the imported API to include royalty payments related to the imported goods, pursuant to PRC customs valuation rules (Decree No. 213 of the General Administration of Customs). This could result in additional customs duties and import VAT being assessed on a higher customs value.
Royalty Payments. PRC tax authorities may also challenge the deductibility of royalty payments made by Meridian Shanghai to Meridian (Hong Kong) or to Penterra, particularly if the authorities determine that the royalty rate is not arm's-length or that the payments are not adequately supported by transfer pricing documentation. SAT Announcement [2015] No. 16 specifically addresses the deductibility of related-party royalties for service-type intangibles and requires that the PRC entity demonstrate that it has received economic benefits from the licensed IP commensurate with the royalty payments made.
Recommendation. Meridian should be advised to maintain its own contemporaneous transfer pricing documentation for API purchases and royalty payments under PRC transfer pricing rules. Penterra should coordinate with Meridian on transfer pricing positions to ensure consistency between the parties and to avoid the risk of double taxation resulting from conflicting transfer pricing adjustments. If PRC tax authorities make a transfer pricing adjustment to the Meridian Shanghai intercompany pricing, Penterra should be prepared to invoke the mutual agreement procedure ("MAP") under Article 25 of the U.S.–PRC Treaty, or alternatively to seek a bilateral advance pricing arrangement ("APA").
D. Other Jurisdictional Transfer Pricing
Beyond the PRC, the following Territory jurisdictions maintain transfer pricing regimes that are relevant to the Meridian intercompany arrangements:
Japan. Meridian Japan K.K. is subject to Japanese transfer pricing rules under the Special Taxation Measures Law (租税特別措置法). Japan has adopted the OECD Transfer Pricing Guidelines as the primary reference framework for its transfer pricing enforcement. Costs incurred by Meridian Japan in connection with PMDA regulatory submissions, local clinical development activities, and commercialization should be properly allocated and documented. To the extent that Meridian Japan bears significant development risks and costs in the Japanese market, the transfer pricing documentation should reflect an appropriate return to Meridian Japan for its contributions.
Australia. Meridian Bio Australia Pty Ltd is subject to the transfer pricing provisions of Division 815 of the Income Tax Assessment Act 1997 (Cth), as amended by the Tax Laws Amendment (Cross-Border Transfer Pricing) Act (No. 1) 2012. The Australian Taxation Office has been active in transfer pricing enforcement in the pharmaceutical sector and applies the arm's-length principle in accordan