PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT DO NOT DISTRIBUTE WITHOUT PRIOR CONSENT OF CALDERWOOD & HARKNESS LLP
TAX DUE DILIGENCE MEMORANDUM
May 28, 2024
FROM: Leonard Cross, Partner, Tax Calderwood & Harkness LLP 200 Park Avenue, 42nd Floor New York, NY 10166
TO: Oliver Mackenzie, Partner, M&A — Calderwood & Harkness LLP Megan Chu, Associate, M&A — Calderwood & Harkness LLP
CC: Harrison Wexford, Partner, M&A — Calderwood & Harkness LLP Derek Okonkwo, Associate, M&A — Calderwood & Harkness LLP Thomas F. Holbrook, General Counsel, Penterra Pharmaceuticals Corp. Catherine M. Burgess, CFO, Penterra Pharmaceuticals Corp.
RE: Tax Due Diligence Review — Veridian Biosciences, Inc. (Proposed Acquisition by Penterra Pharmaceuticals Corp.)
MATTER NO.: 1018-00008
This memorandum constitutes a privileged and confidential attorney-client communication and attorney work product prepared by Calderwood & Harkness LLP for the sole benefit of Penterra Pharmaceuticals Corp. and its advisors in connection with the proposed acquisition of Veridian Biosciences, Inc. This memorandum may not be distributed, disclosed, or otherwise made available to any person or entity without the prior written consent of Calderwood & Harkness LLP.
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I. EXECUTIVE SUMMARY
A. Purpose and Scope of Review
This memorandum presents the findings of the tax due diligence review conducted by Calderwood & Harkness LLP in connection with Penterra Pharmaceuticals Corp.'s ("Penterra" or the "Buyer") proposed acquisition of 100% of the outstanding capital stock of Veridian Biosciences, Inc. ("Veridian" or the "Company") for an aggregate cash purchase price of Nine Hundred Million Dollars ($900,000,000) (the "Transaction"). The Transaction is structured as a stock purchase pursuant to the terms of that certain Stock Purchase Agreement dated as of May 15, 2024 (the "SPA"), by and among Penterra, Veridian, and the stockholders of Veridian identified therein (the "Sellers"). No asset purchase alternative is currently under consideration by the parties.
Our tax due diligence review has been undertaken to identify and evaluate material tax risks and exposures associated with Veridian and the Transaction, to assess the impact of the Transaction on Penterra's tax position, and to recommend appropriate protective measures and planning opportunities in connection with the Transaction. This memorandum should be read in conjunction with the detailed appendices referenced herein.
B. Company Overview
Veridian is a Delaware corporation (EIN 84-2193047) with its principal office and laboratory operations located at 550 Gateway Drive, Cambridge, Massachusetts 02142. Veridian is a privately held, clinical-stage biotechnology company focused on the development of novel T-cell engager therapeutics based on its proprietary VeriTCE platform. Veridian's pipeline includes VRD-4187 (currently in Phase 2 clinical trials) and several additional preclinical candidates.
As a clinical-stage company, Veridian has generated no product revenue since its inception in 2016. For the fiscal year ended December 31, 2023 ("FY2023"), Veridian reported total revenue of $0 and a net loss of approximately $87.3 million, as reflected in its audited financial statements. Veridian's independent auditor is Northbridge Accounting Group LLP (engagement partner: Patrick Calloway), which has audited Veridian's financial statements for fiscal years 2021 through 2023.
Following the closing of the Transaction, Veridian will become a wholly owned subsidiary of Penterra.
C. Summary of Key Findings
Based on our review, we have identified the following key findings and risk areas:
Net Operating Loss Carryforwards. Veridian has a significant federal net operating loss ("NOL") carryforward of approximately $312 million as of December 31, 2023. A Section 382 ownership change occurred in Q3 2020 in connection with Veridian's Series C financing round, imposing an annual limitation of approximately $5.9 million per year on approximately $148 million of pre-change NOLs. Post-change NOLs of approximately $164 million are not currently subject to the Section 382 limitation from the 2020 ownership change. However, the proposed acquisition by Penterra will itself constitute a new ownership change under Section 382, subjecting all $312 million in accumulated NOLs to a new annual limitation estimated at approximately $40.5 million per year (subject to confirmation of the applicable long-term tax-exempt rate at closing).
Section 338(h)(10) Election. We have analyzed the potential benefits of a Section 338(h)(10) election and concluded that no such election is recommended. The tax cost of the deemed asset sale would exceed the present value of the incremental amortization deductions from the stepped-up basis, particularly given the constraints on NOL utilization imposed by Section 382.
State Tax Nexus. Veridian currently files income or franchise tax returns in Massachusetts, California, and Maryland. We have identified a potential nexus risk arising from employees working remotely from other states, although the dollar exposure is likely low given Veridian's ongoing losses.
R&D Tax Credits. Veridian has claimed federal and state R&D tax credits in each tax year from 2017 through 2022, with aggregate federal credits of approximately $18.5 million. Our review indicates that the positions taken are supportable, but we recommend that documentation practices be strengthened to withstand potential IRS scrutiny.
Section 280G. The Transaction will constitute a "change in control" under Section 280G of the Internal Revenue Code ("Code"), and certain payments to disqualified individuals may trigger excise tax liability and loss of corporate deductibility. Detailed Section 280G calculations should be completed prior to closing, and the stockholder approval safe harbor should be evaluated.
Tax Controversies. No material pending tax controversies, audits, or examinations have been identified. Veridian has not been the subject of any IRS examination since its inception.
Transfer Taxes. Transfer taxes on the stock sale are the responsibility of the Sellers pursuant to SPA § 6.8. Based on current law, transfer tax liability in connection with the Transaction is expected to be negligible to zero.
D. Overall Risk Assessment
We assess the overall tax risk associated with the Transaction as Moderate. The primary risk driver is the Section 382 limitation that will constrain Penterra's ability to utilize Veridian's substantial NOL carryforwards following the acquisition. While the new annual limitation (estimated at approximately $40.5 million per year) represents a material improvement over the existing $5.9 million limitation applicable to the pre-2020 NOL tranche, the Section 382 constraints nonetheless significantly reduce the present value of the NOL asset relative to its undiscounted value. The remaining risk items identified — state nexus, R&D credit documentation, and Section 280G exposure — are addressable through the recommendations set forth in Section XIII below.
E. Documents Reviewed
In conducting our tax due diligence review, we reviewed the following categories of documents, which were made available through the virtual data room maintained by Veridian and its counsel, Zalcourt Archer & Cole LLP:
• Federal income tax returns (Form 1120) for tax years 2019 through 2022, and draft schedules for FY2023
• State income and franchise tax returns for Massachusetts, California, and Maryland for tax years 2019 through 2022
• Audit workpapers and tax provision analyses prepared by Northbridge Accounting Group LLP for FY2021 through FY2023
• Corporate organizational documents, including certificate of incorporation, bylaws, and all amendments thereto
• Capitalization tables and stock ledgers reflecting all equity issuances from inception through the date of the SPA
• Series A, Series B, Series C, and Series D financing round transaction documents, including stock purchase agreements, investors' rights agreements, and board resolutions
• Third-party R&D tax credit studies for tax years 2017 through 2022
• Transfer pricing documentation (confirmed as not applicable; no foreign operations)
• State nexus analyses prepared by Northbridge Accounting Group LLP
• Employment tax filings, including Forms 941, W-2, and 1099, for 2022 and 2023
• Payroll records and independent contractor agreements
• Correspondence with federal and state taxing authorities
• Equity incentive plan documents, option grant agreements, and Section 409A valuation reports
• Stock Purchase Agreement dated May 15, 2024
II. TRANSACTION STRUCTURE AND TAX CONSIDERATIONS
A. Stock Purchase Structure
The Transaction is structured as a stock purchase in which Penterra will acquire 100% of the outstanding capital stock of Veridian from the Sellers for an aggregate cash purchase price of $900,000,000. No alternative acquisition structure (such as an asset purchase or a statutory merger treated as an asset acquisition) is under consideration. Following the closing, Veridian will become a wholly owned subsidiary of Penterra and will be included in Penterra's consolidated federal income tax return group.
Under the stock purchase structure, Veridian's tax attributes — including its federal and state NOL carryforwards, R&D credit carryforwards, Section 174 capitalized expenditure amortization, and tax basis in its assets — will carry over to Penterra. These attributes will remain with the Veridian entity and will be available for use by Veridian in future periods, subject to applicable limitations, most notably the Section 382 annual limitation on the use of pre-change NOLs and credits, and the separate return limitation year ("SRLY") rules applicable to members joining a consolidated group.
A significant consequence of the stock purchase structure is that Penterra will not receive a step-up in the tax basis of Veridian's underlying assets. Penterra's tax basis in the Veridian stock will equal the $900 million purchase price, but the inside tax basis of Veridian's assets (principally its intellectual property, laboratory equipment, and capitalized Section 174 expenditures) will remain at their historical cost basis, which is substantially lower than the purchase price. This "basis differential" between the outside stock basis and the net inside asset basis will only be recognized for tax purposes if Penterra subsequently disposes of or liquidates Veridian.
B. Section 338(h)(10) Election Analysis
We have evaluated whether Penterra and the Sellers should jointly make an election under Section 338(h)(10) of the Code in connection with the Transaction. A Section 338(h)(10) election would treat the stock purchase as a deemed asset acquisition for federal income tax purposes, resulting in a step-up of the inside tax basis of Veridian's assets to fair market value. Such an election requires the consent of both the buyer and the selling stockholders (or, in the case of a consolidated subsidiary, the selling consolidated group).
The potential benefits and costs of a Section 338(h)(10) election are summarized as follows:
Potential Benefits. The primary benefit of a Section 338(h)(10) election would be the step-up of the inside tax basis of Veridian's assets — principally its intellectual property (the VeriTCE platform, VRD-4187, and other pipeline candidates) — to fair market value. The stepped-up basis in amortizable intangible assets would generate amortization deductions under Section 197 over a 15-year period, providing a stream of future tax deductions to Penterra. Given the $900 million purchase price and the relatively low historical tax basis of Veridian's assets, the incremental step-up would be substantial.
Costs and Constraints. The Section 338(h)(10) election would trigger a deemed asset sale at the Veridian entity level, generating a substantial taxable gain. This gain would be calculated as the difference between the deemed sale price (which, under the applicable Treasury Regulations, approximates the stock purchase price grossed up for certain liabilities) and the adjusted tax basis of Veridian's assets. While Veridian's $312 million in NOL carryforwards would be available to offset a portion of this gain, several factors limit the effectiveness of this shelter:
(i) Approximately $148 million of the NOLs are subject to the existing Section 382 annual limitation of approximately $5.9 million per year resulting from the 2020 ownership change, severely restricting the amount of these NOLs that could be utilized against the deemed sale gain in the year of the deemed sale;
(ii) The remaining approximately $164 million in post-2020 NOLs could partially offset the gain, but the $900 million deemed sale price (less the relatively low inside asset basis) would generate taxable gain far in excess of the available NOLs;
(iii) The pre-2018 NOLs (approximately $28 million) are subject to the 80% of taxable income limitation applicable to post-2017 NOLs under Section 172(a)(2); while the pre-2018 NOLs themselves are not subject to this limitation, the post-2017 NOLs that constitute the bulk of the carryforwards are; and
(iv) The resulting tax liability would be immediate (payable in the year of the deemed sale), whereas the incremental amortization deductions from the stepped-up basis would be realized over 15 years.
We conducted a present value analysis comparing the incremental amortization deductions from the stepped-up asset basis (Discounted at an appropriate after-tax discount rate) against the upfront tax cost of the deemed asset sale (net of NOL utilization). Our analysis indicates that the present value of the incremental amortization deductions does not exceed the present value of the tax cost of the deemed sale, even under optimistic assumptions regarding the allocation of purchase price to amortizable assets. Accordingly, the Section 338(h)(10) election is not advantageous for Penterra.
Recommendation. We recommend that no Section 338(h)(10) election be made. The Transaction should proceed as a straight stock purchase without any deemed asset sale election. We have coordinated with the Sellers' tax counsel, Elaine Sato of Zalcourt Archer & Cole LLP, and both parties are in agreement that no Section 338(h)(10) election will be made.
C. Tax Basis in Veridian Stock
The Sellers' aggregate tax basis in Veridian stock varies by investor and vintage of investment. Veridian has raised a total of approximately $420 million in venture capital through its Series A through Series D financing rounds. The key stockholders and their approximate equity stakes on a fully diluted basis are as follows:
Under the stock purchase structure, each Seller will recognize gain or loss on the sale of its Veridian shares, with the character (capital or ordinary) and amount of gain or loss depending on the individual Seller's tax basis in its shares and its holding period. The institutional investors (which hold their shares through fund vehicles structured as partnerships or limited liability companies) will generally recognize long-term capital gain on the sale, as they have held their respective shares for more than one year. Founder shares held by Dr. Marek and Dr. Chandrasekaran are also expected to qualify for long-term capital gain treatment.
The characterization and computation of Sellers' gain or loss is principally a Sellers' tax issue. Penterra's primary concern in this regard is ensuring that the Sellers' tax obligations do not create any post-closing tax liabilities or withholding obligations for Veridian. The SPA appropriately addresses this concern through the tax indemnification provisions discussed in Section IX below.
III. NET OPERATING LOSS CARRYFORWARD ANALYSIS
A. Overview of Veridian's NOLs
Veridian's most significant tax attribute is its federal NOL carryforward, which we estimate at approximately $312 million as of December 31, 2023. A detailed year-by-year breakdown of NOL generation, utilization, and carryforward is set forth in Appendix A. The NOL carryforward is composed of the following:
Pre-2018 NOLs. NOLs generated in tax years prior to the effective date of the Tax Cuts and Jobs Act (i.e., tax years ending on or before December 31, 2017) are estimated at approximately $28 million. These NOLs were generated in Veridian's 2016 and 2017 tax years, the first two years of the Company's existence. Pre-2018 NOLs are subject to a 20-year carryforward limitation under the former Section 172 rules; accordingly, the 2016 NOLs will begin to expire in 2036 and the 2017 NOLs will begin to expire in 2037. Pre-2018 NOLs are not subject to the 80% of taxable income limitation that applies to post-2017 NOLs; they may be used to offset 100% of taxable income in a given year, subject to the Section 382 annual limitation discussed below.
Post-2017 NOLs. NOLs generated in tax years beginning after December 31, 2017 are estimated at approximately $284 million. Under the amendments to Section 172 enacted by the Tax Cuts and Jobs Act, post-2017 NOLs have an indefinite carryforward period (they do not expire) but are subject to a limitation under Section 172(a)(2) that restricts the NOL deduction to 80% of taxable income in any given year. The remaining 20% of taxable income is not sheltered by NOLs and is subject to tax at the applicable corporate rate.
Veridian has had no taxable income since its inception in 2016. All NOLs generated by Veridian remain fully available for carryforward, subject only to the Section 382 limitations described below. No NOLs have been utilized to offset taxable income in any prior year.
We note that Veridian's FY2023 net loss of $87.3 million will further increase the NOL carryforward as reflected on the 2023 federal income tax return. The 2023 return has not yet been filed as of the date of our diligence review; an extension of time to file has been obtained, and the return is due October 15, 2024. Our estimate of $312 million in total NOL carryforwards as of December 31, 2023 is based on the audited financial statements prepared by Northbridge Accounting Group LLP and our review of the Company's tax provision workpapers.
B. Section 382 Ownership Change Analysis — 2020 Series C Round
1. Background on Section 382. Section 382 of the Code imposes an annual limitation on the ability of a "loss corporation" to use its pre-change NOLs following an "ownership change." The purpose of Section 382 is to prevent trafficking in loss corporations — that is, to prevent the acquisition of a loss corporation principally for the purpose of utilizing its NOL carryforwards to shelter the acquirer's income.
An "ownership change" occurs when the aggregate percentage of stock owned by one or more "5-percent shareholders" (as defined under Section 382 and the Treasury Regulations thereunder) increases by more than 50 percentage points over the lowest percentage owned by such shareholders at any time during the applicable "testing period." The testing period is generally the shorter of (a) the three-year period ending on the testing date or (b) the period since the most recent ownership change (if any). For purposes of this analysis, the term "5-percent shareholders" includes both individual shareholders who own 5% or more of the loss corporation's stock and groups of shareholders who individually own less than 5% but are aggregated into a single "public group" under the applicable regulations.
Following an ownership change, the annual Section 382 limitation is calculated as the product of (a) the fair market value of the loss corporation's stock immediately before the ownership change, and (b) the applicable long-term tax-exempt rate published by the IRS for the month of the ownership change. This annual limitation caps the amount of pre-change NOLs that may be used to offset taxable income in any given post-change year. Any unused limitation amount may be carried forward to future years, subject to certain rules.
In addition, Section 382(h) provides that if the loss corporation has a "net unrealized built-in gain" ("NUBIG") at the time of the ownership change (i.e., the aggregate fair market value of its assets exceeds the aggregate adjusted tax basis of its assets), the annual Section 382 limitation may be increased by the amount of recognized built-in gains during the five-year "recognition period" following the ownership change. Conversely, if the loss corporation has a "net unrealized built-in loss" ("NUBIL"), recognized built-in losses during the recognition period may be treated as pre-change losses subject to the Section 382 limitation.
2. 2020 Ownership Change. Our review of Veridian's capitalization history, stock ledger, and Series C financing documents confirms that Veridian experienced an ownership change within the meaning of Section 382 in Q3 2020, in connection with its Series C financing round. In the Series C round, Boreal Health Partners Fund III, LP ("Boreal") invested as the lead investor, and a significant number of new shares of Series C Preferred Stock were issued, resulting in substantial dilution of existing stockholders and a corresponding increase in the aggregate ownership percentage of new investors.
Based on our analysis of the ownership shifts during the three-year testing period ending on the date of the Series C closing, the aggregate increase in ownership by 5-percent shareholders exceeded 50 percentage points, triggering an ownership change. A detailed computation of the ownership shift analysis is set forth in Appendix B.
The consequences of the 2020 ownership change are as follows:
Pre-Change NOLs. NOLs generated prior to the Q3 2020 ownership change date are classified as "pre-change NOLs" and are subject to the annual Section 382 limitation. We estimate the pre-change NOLs at approximately $148 million, consisting of all NOLs generated from Veridian's inception in 2016 through the date of the Q3 2020 ownership change.
Post-Change NOLs. NOLs generated from the Q3 2020 ownership change date through December 31, 2023 are classified as "post-change NOLs" with respect to the 2020 ownership change and are not subject to the Section 382 limitation arising from that change. We estimate the post-change NOLs at approximately $164 million.
Annual Section 382 Limitation. The annual limitation on the use of the $148 million in pre-change NOLs is approximately $5.9 million per year. This amount was calculated as the product of (a) the fair market value of Veridian immediately before the ownership change (based on the Series C pre-money valuation) and (b) the long-term tax-exempt rate in effect for the month of the ownership change. At this rate, full utilization of the $148 million in pre-change NOLs would take approximately 25 years, assuming taxable income is available in each year to absorb the full limitation amount.
NUBIG Analysis. We reviewed Veridian's asset composition as of the 2020 ownership change date to determine whether a NUBIG existed that could have increased the annual Section 382 limitation. At the time of the ownership change, Veridian's assets consisted primarily of cash and cash equivalents (from prior financing rounds), intellectual property with low historical tax basis (principally the VeriTCE platform and associated know-how, which had been developed internally and therefore carried a minimal basis reflecting only capitalized costs), and laboratory equipment. Our analysis indicates that Veridian did not have a net unrealized built-in gain position as of the ownership change date, as the aggregate fair market value of its assets (excluding cash) did not meaningfully exceed the aggregate adjusted tax basis. Accordingly, no Section 382(h) increase to the annual limitation was available with respect to the 2020 ownership change.
3. Impact of the Proposed Acquisition on Section 382. The proposed acquisition by Penterra will constitute a new ownership change for Veridian under Section 382. Penterra will acquire 100% of the outstanding stock of Veridian, representing a more-than-50-percentage-point increase in ownership by a single 5-percent shareholder (Penterra). This ownership change is unavoidable in a stock acquisition of this nature.
Upon the occurrence of this new ownership change, the following consequences will result:
New Annual Limitation. All $312 million of accumulated NOLs — both the $148 million pre-2020 tranche and the $164 million post-2020 tranche — will become subject to a new annual Section 382 limitation. The new annual limitation will be calculated based on the fair market value of Veridian immediately before the acquisition, multiplied by the applicable long-term tax-exempt rate in effect for the month of the ownership change. Using the $900 million purchase price as a proxy for value (which is appropriate under Treasury Regulation § 1.382-7) and an estimated long-term tax-exempt rate of approximately 4.5% (based on recently published rates; the actual rate will be determined at closing), the new annual limitation is estimated at approximately $40.5 million per year.
This represents a significant improvement over the existing $5.9 million per year limitation applicable to the pre-2020 NOL tranche. However, it imposes a cap on Penterra's annual use of Veridian's entire $312 million NOL pool.
Stacking of Section 382 Limitations. The pre-change NOLs from the 2020 ownership change (approximately $148 million) will be subject to the more restrictive of (i) the existing $5.9 million per year limitation from the 2020 ownership change, which continues to apply, and (ii) the new limitation arising from the acquisition. This reflects the "Section 382 within a Section 382" stacking rule, under which a subsequent ownership change does not eliminate or supersede a prior Section 382 limitation but rather imposes an additional layer of limitation. Practically, because the existing $5.9 million per year limitation is more restrictive than the new $40.5 million per year limitation, the existing limitation will continue to govern the $148 million tranche.
Net Effect for Penterra. The net effect for Penterra is as follows:
• Approximately $164 million of post-2020 NOLs will be usable at up to the new annual limitation rate (i.e., approximately $40.5 million per year less the $5.9 million "reserved" for the pre-2020 tranche, resulting in approximately $34.6 million per year available for the post-2020 tranche);
• Approximately $148 million of pre-2020 NOLs will remain usable at only $5.9 million per year; and
• The aggregate annual NOL utilization across both tranches is capped at approximately $40.5 million per year.
Present Value Analysis. At the statutory federal corporate tax rate of 21%, the undiscounted tax benefit of $312 million in NOLs would be approximately $65.5 million. However, the time value of money and the Section 382 limitations significantly reduce the present value of this benefit. Using a discount rate of 8% (approximating Penterra's after-tax weighted average cost of capital) and assuming full utilization of the annual limitation in each year, the present value of the NOL carryforwards post-acquisition is estimated at approximately $37 million to $42 million, depending on assumptions regarding the timing and amount of Veridian's future taxable income within the Penterra consolidated group. This present value analysis is subject to significant uncertainty, particularly with respect to the timing at which Veridian (or the Penterra consolidated group) will generate sufficient taxable income to absorb the annual limitation.
We note that the 80% of taxable income limitation applicable to post-2017 NOLs under Section 172(a)(2) further constrains the annual utilization of these NOLs, as 20% of taxable income will remain exposed to tax even in years when the Section 382 limitation is not the binding constraint.
C. State NOL Considerations
The Section 382 limitation and its impact on Veridian's NOL carryforwards operate primarily at the federal level. However, the states in which Veridian files income tax returns have their own rules governing the treatment of NOL carryforwards and ownership change limitations. The key state-level considerations are summarized below:
Massachusetts. Massachusetts generally conforms to the federal NOL rules but imposes its own limitations. Notably, Massachusetts imposes a 20-year carryforward limitation on all NOLs, regardless of the year generated; it does not recognize the indefinite carryforward period applicable to post-2017 NOLs at the federal level. Massachusetts also imposes its own Section 382-like limitation under Massachusetts General Laws Chapter 63, which generally mirrors the federal Section 382 limitation but may differ in certain computational details. Veridian's Massachusetts NOL carryforwards are significant, as the majority of its activities are apportioned to Massachusetts.
California. California has historically suspended the use of NOL deductions in certain tax years for taxpayers with income exceeding specified thresholds, although these suspensions have been temporary in nature. California has its own ownership change rules similar to Section 382 but with certain differences, including the use of a different applicable rate in calculating the annual limitation. California's NOL carryforward period generally mirrors the federal rules for tax years beginning after 2018 (indefinite carryforward for post-2018 NOLs). Veridian's California NOLs are relatively modest, reflecting the limited proportion of its activities apportioned to California.
Maryland. Maryland generally conforms to the federal NOL rules and has not enacted significant independent NOL limitations beyond those imposed by the Code. Veridian's Maryland NOLs are relatively small, consistent with the limited scope of its Maryland operations.
Detailed state NOL schedules are included in the working papers accompanying Appendix C.
IV. STATE TAX NEXUS ANALYSIS
A. Current Filing Positions
Veridian currently files income or franchise tax returns in the following states:
Massachusetts. Veridian maintains its principal office and laboratory operations at 550 Gateway Drive, Cambridge, Massachusetts. The majority of Veridian's employees — estimated at approximately 120 of its 148 total employees — are based in Massachusetts. Veridian clearly has income tax nexus in Massachusetts based on its substantial physical presence (office, laboratory, employees) and economic activity in the state. Massachusetts is Veridian's domiciliary state for apportionment purposes.
California. Veridian maintains a small team of employees, principally clinical operations personnel, based in California. The presence of employees performing services in California establishes payroll nexus for California income and franchise tax purposes. Veridian files California franchise tax returns (Form 100) reflecting California-apportioned income (losses).
Maryland. Veridian has a small number of employees — clinical research staff — based in Maryland. As with California, the presence of employees performing services in Maryland establishes payroll nexus. Veridian files Maryland income tax returns reflecting Maryland-apportioned income (losses).
Veridian does not currently file income tax returns in any states other than Massachusetts, California, and Maryland.
B. Nexus Risk Assessment
Delaware. Veridian is incorporated in Delaware. However, Delaware does not impose a corporate income tax on corporations that are merely incorporated in Delaware but do not maintain physical presence or conduct business within the state. Veridian does not have offices, employees, or other physical presence in Delaware beyond its registered agent. Accordingly, no Delaware income tax filing is required. Veridian does pay the Delaware annual franchise tax, as required of all corporations organized under Delaware law.
Remote Employee Analysis. In the period following the COVID-19 pandemic, Veridian has permitted several employees to work remotely from locations outside of Massachusetts, California, and Maryland. However, Veridian has not conducted a comprehensive nexus analysis to evaluate whether the presence of these remote employees creates income tax filing obligations in additional states. Based on our discussions with Veridian's management and our review of payroll records, we understand that a limited number of employees have worked remotely from states including New York, New Jersey, Connecticut, and North Carolina during 2022 and 2023.
The presence of employees working remotely in a state can create income tax nexus for the employer, potentially triggering a filing obligation and requiring the employer to apportion a portion of its income (losses) to that state. Many states have adopted "factor presence" or economic nexus standards that may apply independently of physical presence. Although the dollar exposure for Veridian is likely low — given its $0 revenue and ongoing losses, Veridian would not owe income tax in any additional state — the filing obligation itself may exist regardless of whether tax is owed. Failure to file required returns can result in penalties, interest, and the tolling of applicable statutes of limitation.
Recommendation. Penterra should require Veridian to complete a comprehensive state nexus review either prior to closing or promptly following closing, and should include appropriate indemnification protections in the SPA for any pre-closing tax exposure arising from unfiled state returns. We understand that the SPA already includes broad tax indemnification provisions for pre-closing periods (discussed in Section IX below), which should provide adequate protection.
C. Apportionment. Veridian apportions its income (losses) among filing states using the applicable state apportionment formulas. Massachusetts has adopted a single sales factor apportionment formula for most corporate taxpayers, but applies an alternative formula for certain types of entities. Given that Veridian has no revenue, its apportionment is effectively driven by property and payroll factors. Massachusetts is the dominant state for apportionment purposes, reflecting the concentration of Veridian's employees and assets in the Commonwealth.
D. State Tax Credits
Veridian has claimed Massachusetts R&D credits and life sciences tax incentives, which are discussed in detail in Section VI below. Veridian has also claimed California R&D credits in prior years; the California R&D credit carryforward amounts are modest, reflecting the limited proportion of Veridian's qualified research expenditures apportioned to California.
V. FEDERAL INCOME TAX RETURN REVIEW
A. Filing History and Status
Veridian has filed federal income tax returns (Form 1120) for each tax year from 2016 (its first tax year following incorporation) through 2022. All returns were timely filed (including those filed pursuant to valid extensions of time). The FY2023 return (for the tax year ending December 31, 2023) has not yet been filed as of the date of our diligence review. Veridian has obtained a valid extension of time to file the 2023 return, which is due on October 15, 2024.
All returns reviewed were prepared by Northbridge Accounting Group LLP. We have reviewed the returns for tax years 2019 through 2022 in detail, and reviewed summary schedules for the 2016 through 2018 returns (which are beyond the standard three-year statute of limitations, although they remain relevant due to the NOL carryforward analysis discussed in Section III above). No amended returns have been filed for any tax year.
B. Open Tax Years
Under the standard three-year statute of limitations set forth in Section 6501(a) of the Code, the IRS generally has three years from the date a return is filed (or the due date of the return, if later) to assess additional tax. Assuming that Veridian's 2021 return was timely filed (including on extension), the earliest open tax year for assessment purposes is 2021.
However, two important qualifications apply:
First, because Veridian has claimed NOL carryforwards from closed tax years (2016 through 2020), the IRS retains the right under Section 6501(h) to examine the year in which the NOL was generated, even if that year's statute of limitations has otherwise expired, to the extent the NOL is carried forward and utilized in an open tax year. This means that if Veridian (or the Penterra consolidated group) utilizes NOLs in a future year, the IRS could examine the computation of those NOLs in the year of generation.
Second, if Veridian had a "substantial omission" of gross income in any tax year (defined as an omission exceeding 25% of the gross income stated on the return), the statute of limitations would be extended to six years under Section 6501(e). We have not identified any evidence of substantial omissions of gross income. Given that Veridian has had $0 revenue in each year since inception, this provision is unlikely to apply.
C. Tax Positions and Reserves
Our review of Veridian's audited financial statements for FY2021 through FY2023 indicates that Veridian has recorded no uncertain tax position reserves under ASC 740-10 (formerly FIN 48). Northbridge Accounting Group LLP's audit workpapers and tax provision analyses confirm that no material uncertain tax positions have been identified. All tax positions taken on the federal returns reviewed appear to be supportable with a "more likely than not" level of confidence, which is the recognition threshold under ASC 740-10.
The principal tax positions taken by Veridian on its federal returns include the computation and carryforward of NOLs, the claiming of R&D tax credits under Section 41, the capitalization and amortization of Section 174 expenditures (for tax years 2022 and 2023), and the treatment of various operating expenses as currently deductible. We have not identified any positions that appear aggressive or inconsistent with applicable authority.
D. Audit History
Veridian has not been the subject of any IRS examination or audit since its inception in 2016. We reviewed Veridian's correspondence files and confirmed that no notices of proposed adjustment, revenue agent reports, notices of deficiency, or other communications from the IRS regarding potential adjustments have been received. There are no pending federal tax controversies of any kind.
The absence of audit history is consistent with Veridian's profile as a clinical-stage company generating losses and no revenue. Such companies are generally at low risk of IRS examination.
VI. RESEARCH AND DEVELOPMENT TAX CREDITS
A. Federal R&D Credits (Section 41)
Veridian has claimed federal R&D tax credits under Section 41 of the Code in each tax year from 2017 through 2022. The estimated aggregate federal R&D credits claimed over this period total approximately $18.5 million. A year-by-year summary of credits claimed is set forth in Appendix D.
As a clinical-stage company with no revenue and no taxable income, Veridian has not been able to utilize any of these R&D credits to offset federal income tax liability. The credits have accumulated as general business credit carryforwards under Section 38. Under Section 41(h) and Section 38(c), the general business credit (including R&D credits) can be used to offset regular tax liability and alternative minimum tax liability, but cannot create or increase a net operating loss. Accordingly, the R&D credit carryforwards exist as a separate tax attribute from the NOL carryforwards and are available for use in future years when Veridian (or the Penterra consolidated group) generates sufficient tax liability.
Following the acquisition, Penterra will be able to utilize Veridian's R&D credit carryforwards, subject to the Section 383 limitation. Section 383 of the Code parallels Section 382 and limits the post-change use of pre-change tax credits. The annual Section 383 limitation on credit usage generally mirrors the Section 382 NOL limitation — that is, the same annual limitation amount ($40.5 million, as estimated above) applies, reduced by any NOLs actually utilized in the year. In practice, because the Section 382 limitation is first applied to NOLs and the remaining limitation (if any) is then available for credits, the annual credit usage may be constrained in years when the full NOL limitation is utilized.
We note that Veridian may also be eligible to elect the payroll tax offset for R&D credits under Section 41(h)(4)(B), which allows qualifying small businesses (those with gross receipts of less than $5 million and no more than five years of gross receipts) to apply R&D credits against payroll tax liability rather than income tax liability. However, Veridian has been in existence since 2016 (more than five years), and therefore no longer qualifies for this election.
B. R&D Credit Documentation
Our review of Veridian's R&D credit documentation indicates that the credits have been claimed based on third-party R&D tax credit studies prepared for each applicable tax year. The studies identify qualified research expenditures ("QREs") by category, including:
• Employee wages for research scientists, clinical development personnel, and other employees engaged in qualified research activities;
• Payments to contract research organizations ("CROs") for the conduct of clinical trials and other research activities (treated as QREs at the applicable percentage under Section 41(b)(3)); and
• Supplies consumed in the conduct of qualified research in Veridian's Cambridge laboratory.
Our review of the R&D credit studies indicates that they were prepared using reasonable methodologies and that the identification of QREs appears generally appropriate. The R&D credit positions taken are, in our view, supportable under applicable law and IRS guidance.
However, we noted that the documentation supporting the "four-part test" under Treasury Regulation § 1.41-4 — specifically, the requirements of (i) technological uncertainty, (ii) process of experimentation, (iii) technological in nature, and (iv) permitted purpose — could be strengthened for certain activities. While the overall documentation is adequate, certain project descriptions lack the specificity that would be desirable to withstand close IRS scrutiny, particularly in light of the IRS's increased focus on R&D credit claims and the heightened documentation requirements that the IRS has imposed for refund claims.
Recommendation. Penterra should ensure that Veridian strengthens its R&D credit documentation practices going forward. Specifically, Veridian should implement a contemporaneous documentation protocol that requires project leads to document the four-part test elements for each qualifying project on an ongoing basis, rather than relying solely on after-the-fact reconstruction during the annual credit study process. This is particularly important given the IRS's increased scrutiny of R&D credit claims and the recent IRS Chief Counsel memoranda addressing documentation standards.
C. Section 174 Capitalization
Under the amendments to Section 174 of the Code enacted by the Tax Cuts and Jobs Act, effective for tax years beginning after December 31, 2021, taxpayers are required to capitalize specified research and experimental ("R&E") expenditures and amortize them ratably over a five-year period (for domestic expenditures) or a fifteen-year period (for foreign expenditures). This represents a significant change from the prior law, under which taxpayers could elect to currently deduct R&E expenditures or to capitalize and amortize them over a 60-month period.
Veridian's FY2022 and FY2023 tax returns reflect compliance with the Section 174 capitalization requirement. Based on our review:
• FY2022: Veridian capitalized approximately $62 million in specified R&E expenditures and began amortizing these amounts over a five-year period (all expenditures were domestic).
• FY2023: Veridian capitalized approximately $71 million in specified R&E expenditures and continued the amortization of prior-year capitalized amounts.
A detailed schedule of capitalized Section 174 expenditures and the corresponding amortization is set forth in Appendix F.
The Section 174 capitalization requirement has a meaningful impact on Veridian's tax profile. By requiring capitalization rather than current deduction of R&E expenditures, the provision increases the annual NOL generated by Veridian (because a smaller current deduction results in a larger taxable loss for the year), while also creating a stream of future amortization deductions. The net effect is a timing difference: the total deduction over the amortization period is the same, but the annual deduction is smoothed over five years rather than being recognized in the year of expenditure.
Our review has not identified any issues with Veridian's implementation of Section 174 capitalization. The Company appears to have correctly identified specified R&E expenditures, classified all expenditures as domestic (consistent with Veridian's exclusively domestic operations), and computed the five-year amortization schedule in accordance with the statute and applicable guidance.
VII. EMPLOYMENT AND PAYROLL TAX MATTERS
A. Employment Tax Compliance
As of the date of the SPA, Veridian has 148 employees. Our review of Veridian's employment tax compliance includes the following:
Federal Employment Taxes. We reviewed Veridian's Form 941 (Employer's Quarterly Federal Tax Return) filings for all quarters in 2022 and 2023. Our review indicates that Veridian has timely filed all required Form 941 returns and has timely remitted all required deposits of federal employment taxes, including the employer and employee shares of FICA (Social Security and Medicare taxes) and federal income tax withholding. No discrepancies or deficiencies were noted.
State Withholding and Unemployment Taxes. We reviewed Veridian's state income tax withholding filings and state unemployment tax (SUTA) filings for Massachusetts, California, and Maryland for the 2022 and 2023 periods. Veridian appears to be in compliance with applicable state withholding and SUTA requirements. No deficiencies or delinquencies were noted. Veridian's SUTA rates are at or near the standard new employer rate in each state, which is consistent with its limited claims history.
B. Independent Contractor Classification
Veridian engages various consultants and independent contractors, particularly in connection with its clinical operations. These engagements include scientific advisors, clinical research consultants, regulatory affairs consultants, and certain IT and administrative support functions.
Our review of Veridian's worker classification methodology indicates that the Company has generally applied the IRS common-law factors (as codified in the Treasury Regulations under Section 3121(d)) to distinguish between employees and independent contractors. We reviewed a sample of independent contractor agreements and noted that the agreements generally include provisions characteristic of an independent contractor relationship, including the contractor's right to control the manner and means of performing the work, the absence of employee benefits, and the contractor's responsibility for its own taxes.
We have not identified any IRS or state agency audit, inquiry, or correspondence regarding worker classification issues. No Form SS-8 determinations have been requested by either Veridian or any of its workers.
Recommendation. Penterra should confirm that Veridian's independent contractor agreements and classification practices comply with applicable state law requirements, which may be more stringent than the federal common-law test. In particular, California's AB-5 statute (codified at California Labor Code § 2750.3) and the related Borello and Dynamex tests impose a more restrictive standard for independent contractor classification. Given that Veridian has clinical operations personnel in California, any misclassification under California law could give rise to back employment tax liability, penalties, and potential misclassification claims.
C. Equity Compensation Tax Issues
Veridian maintains an equity incentive plan under which stock options have been granted to employees, directors, and consultants. The ESOP pool represents approximately 9.8% of Veridian's fully diluted equity. The options issued under the plan include a mix of incentive stock options ("ISOs") qualifying under Section 422 of the Code and nonqualified stock options ("NQSOs").
Section 409A Compliance. Section 409A of the Code imposes stringent requirements on nonqualified deferred compensation arrangements, including stock options. A stock option that is granted with an exercise price below the fair market value of the underlying stock on the date of grant is treated as deferred compensation subject to Section 409A, and failure to comply with Section 409A's distribution, timing, and documentation requirements results in immediate income inclusion and a 20% penalty tax on the option holder. Our review of Veridian's option grant documentation indicates that all options were granted with exercise prices at or above the fair market value of the underlying common stock, as determined by independent Section 409A valuations (commonly known as "409A valuations") performed annually by a qualified independent appraiser. We did not identify any apparent Section 409A issues.
Tax Consequences of Closing. Upon closing of the acquisition at the $900 million purchase price, vested stock options will be cashed out (in accordance with SPA provisions), triggering the following tax consequences:
• NQSOs: Option holders will recognize ordinary compensation income equal to the difference between the per-share purchase price received and the exercise price of the option. This compensation income is subject to federal income tax withholding and FICA/FUTA taxes. Veridian (as the employer) will be required to withhold applicable taxes and will be entitled to a corresponding compensation deduction under Section 162(a).
• ISOs: To the extent ISO holders sell their shares in the acquisition, the tax consequences depend on whether the applicable holding period requirements have been met (one year from the date of exercise and two years from the date of grant). If the holding periods are not satisfied, the disposition is a "disqualifying disposition," and the gain is treated as ordinary compensation income to the same extent as an NQSO exercise.
Penterra, as the successor employer, will inherit applicable withholding obligations for compensation income recognized by Veridian employees in connection with the closing.
Section 280G "Golden Parachute" Analysis. The acquisition will constitute a "change in control" within the meaning of Section 280G of the Code. Under Section 280G, payments made to or for the benefit of certain "disqualified individuals" (officers, highly compensated employees, and significant stockholders) that are contingent on a change in control and that, in the aggregate, equal or exceed three times the individual's "base amount" (generally, the average annualized compensation over the five-year period preceding the change in control) are treated as "excess parachute payments." Excess parachute payments are subject to (i) a 20% nondeductible excise tax imposed on the recipient under Section 4999, and (ii) a denial of the payor corporation's deduction under Section 280G.
Our preliminary analysis indicates that the following individuals may be "disqualified individuals" for purposes of Section 280G:
• Dr. Julian Marek, co-founder and Chief Executive Officer, holding approximately 8.4% of fully diluted equity;
• Dr. Priya Chandrasekaran, co-founder and Chief Scientific Officer, holding approximately 6.2% of fully diluted equity;
• Steven R. Kessler, Chief Financial Officer, a named officer of Veridian; and
• Dr. Anne-Marie Fontaine, Chief Medical Officer, a named officer of Veridian.
The payments contingent on the change in control for these individuals include the cash-out of vested stock options, acceleration of unvested options (if applicable), and any change-in-control bonuses or severance payments provided under their employment agreements. Our review of Veridian's equity plan and employment agreements indicates that these agreements do not contain Section 280G "gross-up" provisions (under which the employer would indemnify the disqualified individual for the Section 4999 excise tax).
Because Veridian is a privately held corporation, the "shareholder approval" safe harbor under Section 280G(b)(5)(B) may be available. Under this safe harbor, parachute payments to disqualified individuals are exempt from Section 280G if the payments are approved by a vote of stockholders holding more than 75% of the voting power of the corporation, after adequate disclosure. This stockholder approval process should be coordinated with the stockholder written consent process contemplated by the SPA.
Recommendation. Detailed Section 280G calculations for each disqualified individual should be completed prior to closing. The calculations should be prepared by a qualified compensation consultant or tax advisor and should identify the excess parachute payment amount, if any, for each disqualified individual. If excess parachute payments exist, the stockholder approval safe harbor under Section 280G(b)(5)(B) should be pursued in coordination with Zalcourt Archer & Cole LLP (Elaine Sato) as Sellers' counsel. A preliminary Section 280G analysis is included in Appendix E.
VIII. TRANSFER TAX ANALYSIS
A. SPA Provision
Pursuant to SPA § 6.8, all transfer, documentary, stamp, registration, and similar taxes arising from or in connection with the transactions contemplated by the SPA are the responsibility of the Sellers. This allocation is standard for a stock purchase transaction and provides Penterra with appropriate protection against unanticipated transfer tax liability.
B. Applicable Transfer Taxes
We have evaluated the transfer tax implications of the Transaction under applicable federal, state, and local law:
Delaware. Delaware formerly imposed a stock transfer tax on the sale or transfer of shares of Delaware corporations. However, the Delaware stock transfer tax was repealed effective January 1, 2018, and does not apply to transactions occurring on or after that date. Accordingly, no Delaware stock transfer tax will be imposed on the Transaction.
Massachusetts. Massachusetts does not impose a securities transfer tax on the sale or transfer of shares of stock. Accordingly, no Massachusetts transfer tax will be imposed on the Transaction.
Federal. There is no federal securities transaction tax currently in effect under United States law.
Other Jurisdictions. We have not identified any other state or local jurisdiction that would impose a transfer tax on the Transaction based on the current facts.
C. Estimated Transfer Tax Exposure
Based on current law and the facts of the Transaction, transfer tax liability in connection with the stock purchase is expected to be negligible to zero. No material transfer tax exposure has been identified. The SPA provision allocating any unanticipated transfer tax liability to the Sellers provides Penterra with appropriate protection in the event of any unforeseen transfer tax obligation.
IX. PRE-CLOSING TAX INDEMNIFICATION
A. SPA Indemnification Provisions
The SPA provides a comprehensive tax indemnification framework under which the Sellers indemnify Penterra and Veridian for all taxes attributable to pre-closing tax periods (i.e., taxable periods ending on or before the Closing Date) and the pre-closing portion of any Straddle Period. The key provisions of the tax indemnification framework are summarized below:
Classification as Fundamental Representation. The Sellers' tax representations and warranties are classified as "Fundamental Representations" under the SPA. This classification carries enhanced protections for Penterra:
• Survival Period: Fundamental Representations survive for the full statute of limitations applicable to the tax in question, plus 60 days. This ensures that Penterra may bring indemnification claims for the entire period during which a taxing authority could assess additional tax. By contrast, the general representations under the SPA survive for only 18 months following the Closing Date.
• Indemnification Cap: The indemnification cap for breaches of Fundamental Representations is 100% of the purchase price ($900 million). This is significantly more protective than the general indemnification cap of $180 million (20% of purchase price), which applies to breaches of non-fundamental representations.
Indemnification Basket. The SPA includes an indemnification basket of 1% of the purchase price, or $9 million. This is structured as a "tipping basket" (as opposed to a true deductible), meaning that if the aggregate indemnifiable losses exceed $9 million, Penterra may recover from the first dollar of loss, not merely the amount in excess of the basket. The tipping basket applies to general representation breaches; we note that Fundamental Representation breaches (including tax representations) are typically excluded from the basket, and we recommend confirming this with the M&A team.
Indemnification Escrow. At closing, $180 million of the aggregate purchase price will be deposited with Fidelis National Escrow Corp. as the escrow agent (the "Indemnification Escrow"). The Indemnification Escrow serves as security for the Sellers' indemnification obligations under the SPA. The escrow amount of $180 million (20% of purchase price) is consistent with market practice for transactions of this size and profile.
B. Straddle Period Allocation
The SPA provides for the allocation of taxes for any taxable period that includes but does not end on the Closing Date (a "Straddle Period"). The allocation methodology is as follows: