PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION ATTORNEY WORK PRODUCT
Marcus,
I am writing to provide a quarterly status update on the IRS Large Business & International Division examination of Penterra Pharmaceuticals Corp. for tax years 2017–2020 (Exam Team ID: LB&I-NE-TP-2022-00641; C&H Matter No. 1018-00009). As you know, the examination opened on May 16, 2022, and we are now approximately ten months into the process. While the examination is progressing largely as anticipated, there are several developments — most notably the assignment of an IRS economist — that warrant your attention.
**IDR Status and Progress**
As of today, the IRS has issued in excess of 30 Information Document Requests. We have responded to all IDRs on or before their respective deadlines, with a single extension obtained for IDR No. 14 (intercompany service fees), for which we secured a 30-day extension from Revenue Agent Patricia Dunleavy in September 2022.
Of particular note, we successfully narrowed the scope of IDR No. 26 after filing a written objection on February 15, 2023, challenging the breadth of the request. The IRS agreed to limit the scope, which was a favorable outcome and reduces unnecessary document production burden.
We anticipate that remaining IDRs — which based on the current pace may ultimately total in the range of 45–50 — will focus on PBI's independent decision-making processes, pricing documentation across PBI's 68 non-Americas country markets, and additional financial detail concerning the cost-sharing arrangement.
On the document production front, Garrett Simmons continues to coordinate with Susan Lam and Martin Ogilvy at Crestfield & Associates regarding contemporaneous transfer pricing documentation and return-level data. Separately, Leila Nazari remains in regular contact with Ciarán Thornbury at Thornbury & Keogh in Dublin for Irish-side documentation, including PBI's Irish Revenue filings, Knowledge Development box claims (reflecting PBI's 6.25% effective rate), and banking records from Glenmore Bank Ireland plc. Both workstreams are proceeding smoothly.
**IRS Exam Team Focus Areas — Emerging Picture**
Based on the pattern of IDRs to date and our informal interactions with the exam team, we have identified three primary areas of IRS focus:
1. *CSA Cost-Sharing Ratios.* The IRS appears to be questioning PBI's cost-sharing percentages — 38.2% in 2017 rising to 42.7% in 2020 — and the methodology for calculating reasonably anticipated benefits under Treas. Reg. § 1.482-7. Several IDRs have targeted the revenue projection methodology used to derive the RAB shares, the total qualified R&D cost pool (approximately $487.3M in 2017 growing to $598.4M in 2020), and the allocation of costs between CSA and non-CSA activities.
2. *Legacy IP Royalty Rate.* Multiple IDRs have sought third-party comparable license agreements and the basis for PPC's 4.5% royalty rate on legacy compound net sales in non-Americas markets ($814.6M in 2017, declining to $624.1M in 2020 as legacy products mature). The trajectory of the requests suggests the IRS is building a case that comparable pharmaceutical royalties support a higher rate.
3. *PBI Economic Substance / DEMPE Functions.* The IRS has requested extensive documentation concerning PBI's personnel, governance structures, decision-making authority, and functional contributions to the development and commercialization of covered intangibles. This line of inquiry suggests a potential challenge to PBI's substance as IP owner and CSA participant, with the IRS likely to argue that key DEMPE functions — Development, Enhancement, Maintenance, Protection, and Exploitation — remained with PPC in the United States.
None of these focus areas is unexpected, and our defense posture on each is well developed, as I discuss further below.
**IRS Economist Involvement — Dr. Alan Washburne**
This is the most significant new development since our last update. The IRS Transfer Pricing Practice has assigned Dr. Alan Washburne as the IRS economist to the examination. We learned of this assignment through recent communications with the exam team.
Based on the information available, Dr. Washburne appears to be conducting his own independent economic analysis, likely focusing on three areas:
- *PCT Valuation:* Re-examining PBI's original $312M lump-sum platform contribution transaction payment made in 2012, potentially applying an income-method / Discounted cash flow approach using different assumptions — including revenue projections and discount rates — than those employed by PPC at the time of the transaction. - *Legacy IP Royalty Rate:* Developing his own arm's-length range using an independent selection of comparable uncontrolled transaction comparables. - *Cost-Sharing Percentages:* Testing the reasonableness of PBI's RAB shares against alternative benefit projections.
I want to flag that although 2012 (the year of the PCT payment) falls outside the 2017–2020 exam years, the IRS may well attempt to use its PCT valuation analysis as a basis for recalibrating the ongoing CSA cost-sharing ratios and royalty rates applicable to the years under examination. This is a recognized IRS strategy in CSA cases and one we have been preparing for.
The assignment of an IRS economist elevates the seriousness of the examination and signals that the IRS is preparing the analytical foundation for potentially significant proposed adjustments.
We are coordinating closely with Dr. Helena Vasquez and Dr. Rohan Chakrabarti at Whitmore Valuation Group, who are engaged under Kovel arrangement (reference 1018-00009-KV), to ensure our defense economic analyses are robust and anticipate Dr. Washburne's likely approach. Whitmore has completed substantial work to date, including:
- A CUT analysis identifying 14 comparable pharmaceutical license agreements, yielding an interquartile range of 3.1%–6.8% with a median of 4.4% — which firmly supports PPC's 4.5% royalty rate. - A CPM/TNMM analysis using 22 comparable companies, with PBI's operating margins falling within the interquartile range in all four exam years. - A PCT DCF analysis producing an arm's-length range of $278M–$361M using a 9.8% weighted average cost of capital, placing PBI's $312M payment well within range.
Whitmore will now turn to developing a rebuttal framework in anticipation of Dr. Washburne's analysis, refining their work as more details of the IRS economist's approach emerge.
**Updated Functional Analysis**
We have completed, together with Whitmore, a revised and updated functional analysis of PBI dated March 15, 2023. This updated analysis incorporates additional PBI employee interviews and documentary evidence gathered during the IDR process.
The updated analysis reinforces PBI's substantive functions and economic presence. Key data points include: 185 employees as of the end of 2020 (up from 52 at establishment in 2012); 42 board meetings held in Dublin over the 2017–2020 period; €47.2M in cumulative regulatory expenditures; independent pricing decisions across 68 country markets; approximately 18,000 square feet of office space at Sandyford Business Park; and PBI's role as principal for non-Americas commercialization of Veritaxol, Imvara, and Cerulon.
PBI's growing headcount and expanding autonomous operations over the exam period are strong facts for the substance defense, and we believe they significantly undercut any attempt by the IRS to characterize PBI as lacking meaningful DEMPE functions. The updated functional analysis report is being finalized and will be circulated to you separately.
**Anticipated NOPA Timeline**
Based on the current pace of the examination, I estimate the IRS will complete its IDR review by mid- to late-summer 2023. Following completion of the IDR phase, IRS Chief Counsel Attorney Franklin Rosario, along with Senior Counsel Donna Hirabayashi, will work with the exam team and Dr. Washburne to prepare the Notice of Proposed Adjustment.
My best estimate is NOPA issuance in the fall 2023 timeframe, likely October 2023. If the NOPA proposes significant adjustments, PPC would receive a 30-Day Letter shortly thereafter, at which point the company would have the option to file a formal Protest to IRS Appeals or, alternatively, to proceed directly to the United States Tax Court. We will discuss these procedural options in greater detail as we approach the NOPA stage.
**Privilege Log and Document Production Protocol**
We continue to maintain a comprehensive privilege log for documents withheld from IDR responses on attorney-client privilege and work-product grounds. As a reminder, I would ask that you ensure all internal PPC communications regarding the examination continue to be routed through Calderwood & Harkness to preserve privilege, consistent with the privilege protocol memorandum we circulated in June 2022. This is particularly important as the examination intensifies.
**Budget and Fees**
Fees are currently tracking within the original estimate of $4.5M–$7.0M for the examination phase. Sylvia Hartwell is managing billing oversight and can provide a more detailed breakdown at any time upon request. I would note that if the matter proceeds to a contested NOPA and IRS Appeals, total costs will likely trend toward the higher end of that range, and we may need to revisit the estimate depending on the scope of the proposed adjustments. Whitmore Valuation Group fees are also tracking within expected parameters given the scope of economic work completed and the rebuttal work we anticipate.
**Coordination with Irish Advisors**
Thornbury & Keogh continues to support the examination defense on the Irish side. T&K has provided PBI's Irish tax filings, Knowledge Development box documentation, and substance evidence as needed. Leila Nazari will continue to serve as the primary liaison with Ciarán Thornbury, and we will keep you apprised of any issues that arise on the Irish front.
**Next Steps and Action Items**
1. We will continue to respond to remaining IDRs as they are issued, maintaining our track record of timely and complete responses. 2. The Whitmore team will finalize the rebuttal framework in anticipation of Dr. Washburne's analysis as more details of his approach emerge. 3. I plan to request a mid-examination conference with Supervisory Revenue Agent Gerald Meskill, targeted for May 2023, to discuss the examination's status and attempt to narrow remaining issues. 4. I recommend that we schedule a call in the coming weeks with you, Deborah, and Raj Iyer to discuss the implications of the IRS economist's involvement and to begin preliminary discussions about PPC's posture in the event a significant NOPA is issued. My office will reach out to coordinate calendars. 5. We will provide prompt updates on any further developments regarding Dr. Washburne's analysis or other material examination developments.
Marcus, I am available to discuss any aspect of this update at your convenience. Our next quarterly status report (covering Q1 2023 activity) will be circulated separately on its usual schedule.
Please do not hesitate to reach out with any questions in the interim.
Best regards,
Leonard Cross Partner Calderwood & Harkness LLP 1735 Market Street, Suite 3100 Philadelphia, PA 19103 Tel: (215) 555-4200 lcross@calderwoodharkness.com