**PRIVILEGED AND CONFIDENTIAL — ATTORNEY-CLIENT COMMUNICATION**
Marcus,
I am writing to advise you that on Friday, October 13, our office received the Notice of Proposed Adjustment (NOPA) issued by the Internal Revenue Service on October 12, 2023, in connection with the ongoing examination of Penterra Pharmaceuticals Corp. (EIN: 22-3741856) under Exam Team ID LB&I-NE-TP-2022-00641. The NOPA covers all four tax years under examination — TY 2017, 2018, 2019, and 2020.
The purpose of this email is to provide you, Deborah, and your team with an initial high-level summary and preliminary assessment of the NOPA and its proposed adjustments. Garrett Simmons and Leila Nazari are already at work on a comprehensive NOPA analysis memorandum, which we expect to complete within the week. A copy of the NOPA itself will be transmitted to you under separate cover via our secure document portal.
Given the magnitude of the proposed adjustments and the procedural deadlines that will follow, I strongly recommend that we schedule an immediate conference call — ideally Monday, October 16, or Tuesday, October 17 — with you, Deborah, and CFO Rajesh Iyer to discuss the NOPA in detail and align on next steps. Please let me know your availability at your earliest convenience.
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**I. SUMMARY OF PROPOSED ADJUSTMENTS**
The IRS has proposed net aggregate adjustments of **$380.4 million** across TY 2017–2020. The adjustments consist of three components:
**A. Cost-Sharing Arrangement (CSA) Adjustments — $235.01 Million**
The IRS proposes increasing Penterra Biopharma Ireland Ltd.'s ("PBI") cost-sharing percentages by approximately 8–12 percentage points in each examination year, asserting that PPC's projections of reasonably anticipated benefits understated U.S.-source value. The year-by-year breakdown is as follows:
- **TY 2017:** Increase from 38.2% to 48.2% (+10.0 pp) × $487.3M total qualified R&D costs = additional **$48.73M** - **TY 2018:** Increase from 39.6% to 50.6% (+11.0 pp) × $523.8M = additional **$57.61M** - **TY 2019:** Increase from 41.1% to 52.3% (+11.2 pp) × $561.2M = additional **$62.85M** - **TY 2020:** Increase from 42.7% to 53.7% (+11.0 pp) × $598.4M = additional **$65.82M**
The IRS's position appears rooted in a fundamental challenge to the underlying Platform Contribution Transaction (PCT) valuation. Specifically, the Service asserts that the $312M PCT payment made at the inception of the CSA undervalued PPC's pre-existing intangible property. Using an income method with a 7.2% discount rate and different revenue projections, the IRS values the pre-existing IP at $852M — a delta of $540M. Although the PCT occurred in 2012, which is outside the examination years, the IRS is leveraging this revaluation as a basis to recharacterize the ongoing cost-sharing ratios for TY 2017–2020.
**B. Legacy IP Royalty Rate Adjustments — $188.04 Million**
The IRS proposes increasing the royalty rate on legacy compound licenses from PPC's applied rate of 4.5% of net sales to 11.0%, citing comparable uncontrolled transaction (CUT) data drawn from third-party pharmaceutical licensing agreements. The adjustment reflects a 6.5 percentage point increase applied to non-Americas legacy net sales:
- **TY 2017:** $814.6M × 6.5% = **$52.95M** - **TY 2018:** $762.3M × 6.5% = **$49.55M** - **TY 2019:** $691.8M × 6.5% = **$44.97M** - **TY 2020:** $624.1M × 6.5% = **$40.57M**
**C. Correlative Offset — ($42.65 Million)**
The exam team has allowed a correlative offset of $42.65M to avoid double-counting between the CSA and royalty adjustments.
**D. Net Proposed Adjustment: $380.40 Million**
It is important to note that this figure represents the aggregate *income* adjustment, not the proposed additional tax. At the 21% corporate rate applicable to TY 2018–2020 (with TY 2017 subject to a blended rate given the TCJA transition), the proposed additional tax liability would be approximately **$79.9 million**, exclusive of penalties and interest.
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**II. PROPOSED PENALTY**
The NOPA asserts a substantial valuation misstatement penalty under IRC § 6662(e) at 20% of the underpayment attributable to the § 482 allocation, which would amount to approximately **$15.98 million** ($380.4M × 21% × 20%).
Notably, the IRS did *not* assert the 40% gross valuation misstatement penalty under IRC § 6662(h), although the NOPA expressly reserves the right to do so.
We believe PPC has strong penalty protection grounds. Crestfield & Associates prepared contemporaneous transfer pricing documentation for all four examination years that satisfies the requirements of IRC § 6662(e)(3)(B). In addition, PPC has a robust reasonable-cause defense grounded in the quality and thoroughness of the economic analyses underlying its intercompany pricing. We will address this in detail in our forthcoming memorandum.
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**III. ECONOMIC SUBSTANCE CHALLENGE**
The NOPA includes an assertion that PBI lacked sufficient economic substance to justify its role as IP owner and CSA participant. The IRS contends that key DEMPE functions — Development, Enhancement, Maintenance, Protection, and Exploitation — remained in the United States, and that PBI was not the true economic owner of the intangible property.
In my assessment, this is the weakest element of the IRS's position. The evidentiary record of PBI's substantive operations is extensive:
- PBI grew from 52 employees at establishment to 185 employees during the examination period; - PBI's board convened 42 meetings in Dublin over TY 2017–2020; - PBI incurred €47.2 million in cumulative regulatory expenditures; - PBI exercised independent pricing decisions across 68 country markets; and - PBI maintained approximately 18,000 square feet of dedicated office space at Sandyford Business Park, Dublin.
We are confident this argument will not withstand scrutiny, but we will of course prepare a thorough rebuttal.
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**IV. INITIAL ASSESSMENT AND DEFENSE POSTURE**
While a more detailed analysis will follow in the Simmons/Nazari memorandum, I want to share my preliminary assessment: the proposed adjustments are substantially overstated, and PPC's transfer pricing positions are well-supported by rigorous economic analysis and thorough contemporaneous documentation.
Specifically:
- **Royalty Rate:** The Whitmore Valuation Group's CUT analysis identified 14 comparable pharmaceutical license agreements with an interquartile range of 3.1%–6.8% and a median of 4.4%. PPC's applied rate of 4.5% falls squarely within the arm's-length range. The IRS's proposed rate of 11.0% appears to rest on selectively chosen comparables that are distinguishable on multiple grounds, including therapeutic area, stage of development, and exclusivity terms.
- **CSA Cost-Sharing Ratios:** The CPM/TNMM analysis tested PBI's operating margins against 22 comparable companies and confirmed that PBI fell within the interquartile range in all four examination years. The IRS's proposed cost-share percentages would push PBI well outside the arm's-length range, a result that itself undermines the Service's position.
- **PCT Valuation:** Whitmore's discounted cash flow analysis, employing a 9.8% weighted average cost of capital, supports a valuation range of $278M–$361M for the PCT. The $312M payment falls comfortably within that range. The IRS's use of a 7.2% discount rate is aggressive and materially understates the risk inherent in early-stage pharmaceutical intellectual property.
I should note that the IRS's positions are informed in significant part by the economic analysis of Dr. Alan Washburne, which we will need to rebut in detail. You may recall our meeting with Dr. Washburne on August 15, 2023. Having now reviewed the full articulation of his analysis in the NOPA, I have identified specific vulnerabilities in both his CUT selection methodology and his discount rate assumptions that we intend to exploit.
It is my view that a well-prepared defense should result in a resolution at a small fraction of the proposed amount.
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**V. NEXT STEPS AND PROCEDURAL TIMELINE**
Receipt of the NOPA triggers a procedural sequence that we must manage carefully:
The IRS will issue a **30-Day Letter** — likely within the next few weeks — which will formally present PPC with the option to (a) file a written Protest to request consideration by IRS Appeals, or (b) bypass Appeals and petition the U.S. Tax Court. I **strongly recommend the Appeals route**, which historically yields favorable settlement outcomes in transfer pricing cases and avoids the considerable cost, time, and uncertainty of Tax Court litigation. We will discuss this in more detail on our call.
In the meantime, the following immediate action items require attention:
1. **Conference Call:** I propose a call on Monday, October 16, or Tuesday, October 17, with you, Deborah, and Rajesh Iyer to discuss the NOPA in detail and align on strategy. Please let me know your availability.
2. **Detailed NOPA Analysis Memorandum:** Garrett Simmons and Leila Nazari are preparing a comprehensive memorandum analyzing each element of the NOPA and assessing the IRS's legal and economic positions. We are targeting completion within the week.
3. **Coordination with Whitmore Valuation Group:** I will contact Dr. Helena Vasquez at Whitmore to begin preparing the economic rebuttal to Dr. Washburne's analysis. Given the scope of work required, it is important that we engage Whitmore promptly.
4. **Initial Response Letter to the IRS:** We will prepare a letter to Supervisory Revenue Agent Gerald Meskill and Revenue Agent Patricia Dunleavy acknowledging receipt of the NOPA and reserving all of PPC's rights, including the right to challenge the proposed adjustments and penalties in full.
5. **FIN 48 Reserve Assessment:** PPC's current ASC 740-10 (FIN 48) reserve of $62.4 million related to the Irish IP structure will need to be reassessed in light of the NOPA. I will coordinate with Martin Ogilvy at Crestfield & Associates on this. Rajesh and his financial reporting team should be looped in as well.
6. **Hargrove Credit Facility:** Marcus and Deborah — I want to flag that you should consider whether the proposed adjustment may trigger any notification obligations under the tax-indemnity or material-tax-event covenants in PPC's $1.5 billion revolving credit facility with Hargrove National Bank. We are happy to review the relevant provisions and advise on whether disclosure is required.
7. **Irish Coordination:** Leila Nazari will update Ciarán Thornbury at Thornbury & Keogh in Dublin on the NOPA. Any settlement of a U.S. adjustment may have significant implications for PBI's Irish tax positions, including its Knowledge Development box claims, and we want to ensure a coordinated approach across jurisdictions from the outset.
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**VI. CLOSING**
I recognize that the headline number is significant. However, I want to assure you that, based on my initial review, I am confident in the strength of PPC's transfer pricing positions and in the quality of the economic analyses and contemporaneous documentation supporting them. The IRS's proposed adjustments reflect an aggressive posture that I believe will not hold up through the administrative process.
That said, the importance of acting promptly cannot be overstated. I would like to get all of us on a call early this week so that we are fully aligned on strategy before we engage with the Service.
Please call me at your convenience on my direct line (215-555-0147) or my mobile (215-555-0398) to schedule. Deborah, the same invitation extends to you.
Finally, I must remind all recipients that this communication is protected by the attorney-client privilege and constitutes confidential legal advice. Please do not forward or distribute this email to anyone outside the addressees without first consulting with us.
I look forward to speaking with you shortly.
Best regards,
Leonard Cross Partner, Tax Department Calderwood & Harkness LLP 1735 Market Street, Suite 3100 Philadelphia, PA 19103 Direct: (215) 555-0147 Mobile: (215) 555-0398 Email: lcross@calderwoodharkness.com
C&H Matter No. 1018-00009