Matter Reference: C&H Matter No. 1018-00009
Marcus,
I wanted to provide you with a substantive update on the IRS LB&I examination (Exam Team ID LB&I-NE-TP-2022-00641) of PPC's transfer pricing for tax years 2017–2020. As you know, the examination has been open since May 16, 2022 — now over 14 months — and we are nearing the conclusion of the IDR phase. To date, the exam team has issued over 40 IDRs (we expect the final count will reach approximately 47 by September), and we have provided substantive responses to all outstanding requests. The information-gathering phase is largely winding down.
The purpose of this email is to share intelligence we have gathered from recent interactions with the exam team regarding the direction of the IRS economist's analysis, and to discuss our strategic positioning ahead of anticipated proposed adjustments. Given the sensitivity of what follows, I want to underscore that this communication is protected by the attorney-client privilege and work-product doctrine and should not be shared beyond the individuals on this email without prior discussion.
**IRS Economist Activity — Dr. Alan Washburne**
Since the mid-examination conference on May 25, 2023, it has become increasingly clear that Dr. Alan Washburne, the IRS Transfer Pricing Practice economist assigned to the case, has been deeply engaged in his independent economic analysis. While we have a formal meeting with Dr. Washburne scheduled for August 15 — which will be the first structured opportunity to discuss his methodology directly — informal exchanges and IDR follow-up communications with Lead Revenue Agent Patricia Dunleavy, as well as the nature and specificity of Dr. Washburne's recent information requests, have given us meaningful insight into the direction of his work.
Dr. Washburne appears to be focusing on two primary areas:
*PCT Valuation / CSA Cost-Sharing Ratios.* Dr. Washburne is applying an income method to revalue the pre-existing IP contributed by PPC in the 2012 PCT, and he appears to be using a materially lower discount rate than PPC's 9.8% WACC. Based on the questions posed and the data he has requested, our strong sense is that he is working with a WACC in the range of 7.0%–7.5%. If he ultimately lands at or near the low end of that range, this would significantly increase the imputed value of the pre-existing IP and, more importantly for the exam years, provide the basis for challenging the ongoing cost-sharing ratios for 2017–2020. The IRS's likely theory is that PBI's share of reasonably anticipated benefits has been understated, meaning PBI should be bearing a materially larger share of qualified R&D costs.
*Legacy IP Royalty Rate.* Dr. Washburne has been requesting additional comparable license data beyond what we provided in our IDR responses, and the nature of his questions strongly suggests he has identified a set of CUT agreements with royalty rates materially higher than PPC's 4.5% rate. My assessment is that the IRS may assert a rate in the range of 10%–12%, based on comparables that we believe are distinguishable on the basis of product lifecycle stage, exclusivity provisions, and territory scope. I will address our rebuttal posture on this below.
**Anticipated Adjustment Amounts**
I want to give you my best current estimate of the likely magnitude of the proposed adjustments, recognizing that the formal Notice of Proposed Adjustment has not yet been issued and these figures remain preliminary:
*CSA cost-sharing adjustments:* The IRS is likely to propose increasing PBI's cost-sharing percentage by approximately 8–12 percentage points per year. Given total qualified R&D costs ranging from $487.3 million in 2017 to $598.4 million in 2020, this could translate to proposed additional payments from PBI to PPC in the range of $40 million to $70 million per year, or roughly $200 million to $250 million in aggregate across the four exam years.
*Royalty rate adjustments:* If the IRS pushes the royalty rate from 4.5% to the 10%–12% range, the incremental royalty on non-Americas legacy compound net sales (ranging from $814.6 million in 2017 to $624.1 million in 2020 as products mature) could be in the range of $35 million to $55 million per year, or approximately $150 million to $200 million in aggregate.
*Combined exposure:* Gross proposed adjustments potentially in the range of $350 million to $450 million before any correlative offsets. There is some overlap between the CSA and royalty positions that should yield a correlative offset, but my experience is that the exam team may or may not concede that in the initial NOPA — it often becomes a point of negotiation at Appeals.
I want to emphasize that these are the IRS's anticipated opening positions. They are not, in my judgment, reflective of PPC's actual exposure at resolution.
**Economic Substance / DEMPE Challenge**
In addition to the primary § 482 positions, I have picked up signals that IRS Chief Counsel Attorney-Advisor Franklin Rosario may press an economic substance argument challenging PBI's role as a bona fide IP owner and CSA participant. The theory would be that key DEMPE functions — Development, Enhancement, Maintenance, Protection, and Exploitation — remained with PPC in the United States, and that PBI lacks the substance to support its contractual entitlements under the CSA and license agreements.
I view this as the weakest element of the IRS's case. The evidentiary record of PBI's operational substance is strong: PBI grew from 52 employees at inception in 2012 to 185 by 2020; the board held 42 meetings in Dublin over the 2017–2020 period; PBI incurred cumulative regulatory expenditures of approximately €47.2 million; PBI made independent pricing decisions across 68 country markets; and the entity operates out of 18,000 square feet of office space at Sandyford Business Park. The functional analysis we prepared with Whitmore in October 2022 (updated in March 2023) and the 12 PBI employee interviews we conducted in Dublin provide substantial rebuttal material. That said, we should not be complacent — the DEMPE argument is one the IRS has been deploying with increasing frequency, and we need to ensure our documentary record is organized and comprehensive.
**Strategic Positioning**
In light of the foregoing, I recommend the following strategic posture as we move toward the anticipated NOPA:
First, *pre-NOPA engagement with Dr. Washburne.* The August 15 meeting is critical. We intend to use that session to understand Dr. Washburne's methodology and comparable selection in detail before the NOPA is finalized. This will allow us and Whitmore to prepare targeted, specific rebuttals rather than responding to a finished product. I will circulate a proposed agenda for that meeting separately.
Second, *Whitmore Valuation Group preparedness.* I recommend that Dr. Helena Vasquez and Dr. Rohan Chakrabarti at Whitmore begin preliminary work on a rebuttal to the IRS economist's analysis now, rather than waiting for the NOPA. The key areas of focus should be: (a) defending the appropriateness of the 9.8% WACC against the anticipated ~7.2% rate, including the risk premium adjustments specific to PPC's therapeutic areas; (b) the CUT comparable selection for the royalty rate — our 14 CUT agreements show an interquartile range of 3.1%–6.8% with a median of 4.4%, which squarely supports PPC's 4.5% rate; and (c) the CPM/TNMM analysis of PBI's operating margins against the 22 comparable companies, confirming that PBI's results fall within the arm's-length range. I have already spoken with Dr. Vasquez, and she is confident in the defensibility of PPC's positions — particularly the PCT valuation within the $278 million to $361 million range (which comfortably encompasses the $312 million actual payment) and the CUT analysis supporting the 4.5% royalty rate.
As a reminder, Whitmore is operating under the Kovel arrangement (reference 1018-00009-KV, executed June 20, 2022), ensuring that all of their analyses in connection with this matter remain within the scope of the attorney-client privilege.
Third, *documentation strengthening.* We should continue assembling and organizing the documentary record of PBI's economic substance, particularly the DEMPE functions matrix and board-level decision-making evidence. If the economic substance argument materializes in the NOPA, we want to be in a position to respond comprehensively and immediately.
Fourth, *penalty protection.* I want to remind you that PPC's contemporaneous transfer pricing documentation, prepared by Crestfield & Associates under Susan Lam's supervision, provides the foundation for a reasonable-cause defense under IRC § 6662(e)(3)(B). The IRS may assert a substantial valuation misstatement penalty at 20% on any proposed § 482 allocation, so the penalty-protection posture needs to be airtight. If there are any gaps in the contemporaneous documentation for any of the four exam years, we need to identify and address them now.
Fifth, *FIN 48 / ASC 740-10 considerations.* Depending on the magnitude of the proposed adjustments when they arrive, PPC may need to reassess its existing $62.4 million FIN 48 reserve for uncertain tax positions. I will coordinate with Martin Ogilvy at Crestfield as the audit cycle approaches, but you and Deborah should be thinking about whether the current reserve level remains adequate in light of the exposure estimates outlined above.
**Timeline**
Based on the pace of the examination, I anticipate the NOPA will likely issue in Q4 2023, most probably in October. There may be a few additional IDRs in August and September, but as noted, the substantive information gathering appears largely complete. After the NOPA issues, PPC will have 30 days — potentially extendable by agreement — to file a formal Protest to IRS Appeals.
I also want to flag the statute of limitations posture. The Forms 872 extending the statute for TY 2017 are in place through December 31, 2024, and the TY 2018 extension runs through the same date. TY 2019 and TY 2020 statutes remain open without need for extension at this time. We will need to monitor the TY 2017 and 2018 extensions carefully as we move through Appeals, but there is adequate runway for now.
**Next Steps**
I would like to schedule a call with you early next week — Deborah as well, if her schedule permits — to discuss the following:
1. The likely magnitude and direction of the proposed adjustments and our defensive posture. 2. Internal communication to Rajesh Iyer and Catherine Falk regarding the examination status — the numbers I have outlined above are large enough that the C-suite should be briefed, and I would welcome your thoughts on the appropriate timing and framing for that conversation. 3. Whether there is value in proactively engaging IRS Supervisory Revenue Agent Gerald Meskill or Attorney-Advisor Franklin Rosario before the NOPA issues, either to signal the strength of PPC's positions or to explore whether any narrowing of issues is possible at the exam level. 4. Budget implications — our overall fee estimate for the examination phase remains at $4.5 million to $7.0 million, and fees are currently tracking within that range. Sylvia is monitoring the budget closely, and I do not anticipate any surprises, though the rebuttal work at Whitmore may push toward the upper end depending on the scope of what the NOPA ultimately contains.
Could you let me know your availability for a call on Monday or Tuesday of next week? I am flexible on timing.
**Closing Thoughts**
Marcus, I want to be direct: the anticipated adjustment amounts are significant in absolute terms, and I want you to be prepared for that. But I remain confident that PPC's transfer pricing positions are well-supported and defensible. The economic analysis, the comparables data, and the substance record are all strong. The numbers the IRS is likely to propose represent their opening positions, and our experience at Appeals — where these cases are almost invariably resolved — is that significant reductions are achievable, often in the range of 40%–70% of the initial proposed adjustments. We are well-positioned, and we will be even better positioned once we have engaged directly with Dr. Washburne and completed the targeted rebuttal work.
I am happy to discuss any of this by phone at your convenience. Please do not hesitate to call my cell if you would like to talk before our scheduled call next week.
Best regards,
Leonard Cross Partner, Tax Department Calderwood & Harkness LLP 1735 Market Street, Suite 3100 Philadelphia, PA 19103 Direct: (215) 864-7200 lcross@calderwoodharkness.com
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