**PRIVILEGED & CONFIDENTIAL — ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT**
Sylvia,
I wanted to share some observations about where the IRS exam team appears to be headed based on the patterns we're seeing in the IDRs and what's come up during our recent interactions with the agents. We're now roughly four and a half months into the examination (opened May 16), and we've received upwards of 20 IDRs so far, so we're starting to get a clearer picture of their focus. This is all re Matter No. 1018-00009.
**1. Legacy IP Royalty Rate**
The exam team — Lead Revenue Agent Dunleavy in particular — has been asking increasingly pointed follow-up questions about the 4.5% royalty rate on the legacy compounds licensed from PPC to PBI. Several IDRs have drilled into the comparable license agreements PPC relied upon and the basis for selecting 4.5%. My read is that the IRS is building a case that the royalty rate is too low, and I suspect they have their own CUT data pointing to a higher arm's-length rate.
That said, I think we're in a strong position here. Whitmore's CUT analysis identified 14 comparable uncontrolled pharmaceutical license agreements with an interquartile range of 3.1%–6.8% and a median of 4.4%. PPC's 4.5% rate sits right at the median, which is about as defensible as it gets. There's an additional point worth keeping in our back pocket: legacy compound non-Americas net sales have been declining — from $814.6M in 2017 down to $624.1M in 2020. These are aging product lines, and the declining revenue trajectory itself supports a lower royalty rate as the IP matures and residual value diminishes.
That said, we should make sure Whitmore's CUT analysis and comparability adjustments are bulletproof. I'd also recommend making sure Dr. Helena Vasquez is prepared to defend the comparable selection criteria and any adjustments if the IRS pushes back on specific comparables.
**2. PBI Economic Substance / DEMPE Functions**
We've seen a clear cluster of IDRs focused on PBI's operations and decision-making infrastructure — headcount data (growth from 52 employees in 2012 to 185 in 2020), board minutes (42 board meetings across the 2017–2020 exam period), office lease details (~18,000 sq. ft. at Sandyford Business Park), PBI's independent pricing decisions across 68 country markets, and detailed information about regulatory expenditures (€47.2M cumulative across 2017–2020). They've also been asking specifically about Aidan Naughton's role as PBI Managing Director.
I read this as the IRS teeing up a potential economic substance challenge — the argument being that key DEMPE functions (Development, Enhancement, Maintenance, Protection, Exploitation) remained in the U.S. and PBI was merely a shell or conduit entity. Classic playbook.
Here's the thing, though: this is actually one of our strongest areas of defense. PBI has real substance — real employees making real commercial and regulatory decisions, independent board governance in Dublin, and significant ongoing investment. The functional analysis we prepared with Whitmore (dated this month) thoroughly documents PBI's substantive role across all DEMPE categories, and the 12 PBI employee interviews that Simmons and Nazari conducted in August and September provide strong first-person evidence of autonomous decision-making.
I think we should consider proactively presenting PBI substance evidence at an appropriate point rather than waiting for the IRS to frame the narrative in a way that forces us into a reactive posture. For what it's worth, the IDR responses to IDR No. 8 (personnel/headcount data), IDR No. 9 (board minutes), and IDR No. 12 (office lease/physical presence) have already been submitted and are comprehensive, so the factual record on this front is already quite strong.
**3. IRS Economist — Dr. Alan Washburne**
Based on the nature of certain IDR requests and questions during our interactions, it's apparent that the IRS Transfer Pricing Practice economist, Dr. Alan Washburne, is actively involved in the examination. The requests for detailed revenue projection data and R&D cost pool breakdowns ($487.3M–$598.4M across the exam years) suggest he may be building an independent valuation model — possibly to challenge the PCT payment ($312M) and/or the cost-sharing ratio calculations.
This is an area I want to flag and watch closely. The PCT payment itself is from 2012, which is outside the 2017–2020 exam years, but the IRS could use a PCT undervaluation theory to attack the ongoing cost-sharing ratios. PPC's cost-sharing percentages (PBI's share ranging from 38.2% to 42.7%) are based on reasonably anticipated benefit projections. If Washburne uses different revenue assumptions or a lower discount rate, the IRS could assert that PBI's share should be higher. Whitmore's DCF/income method analysis supports the $312M PCT as within the arm's-length range of $278M–$361M, using a WACC of 9.8%, so we have a solid foundation — but we should anticipate that the IRS economist may see things differently.
**4. Coordination Items**
A few operational notes:
- Simmons is doing an excellent job managing the IDR response process and coordinating document collection from PPC and from Susan Lam's team at Crestfield & Associates, which prepared the original contemporaneous transfer pricing documentation. He's kept the process organized and on schedule. - Nazari has been handling Irish coordination with Ciarán Thornbury at Thornbury & Keogh regarding PBI and PMI documentation, which has been running smoothly. - Marcus Whitfield at PPC has been responsive and well-organized in assembling documentation on his end, which has made a real difference.
One thing I'd like your views on: at some point, should we request a mid-examination conference with Supervisory Revenue Agent Gerald Meskill to try to narrow the issues and gauge the exam team's direction? I'm not suggesting now — we're still too early — but perhaps in the spring of 2023, once the IDR process has largely run its course. I'd value your instincts on the timing.
**5. Budget**
Brief note on fees: the examination is tracking within the expected fee range so far, but if the royalty rate, PBI substance, and the CSA cost-sharing methodology all become contested issues simultaneously, the matter could trend toward the upper end of the $4.5M–$7.0M estimate we provided. Let's discuss at our next internal meeting.
**6. Next Steps**
Let me know if you have any thoughts on the above, or if you're hearing anything from the client side that I should be factoring in. I'm planning to send Marcus a more formal quarterly status update shortly.
Thanks, Sylvia.
Best,
Leonard
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**Leonard Cross** Partner, Tax Department Calderwood & Harkness LLP 1735 Market Street, Suite 3100 Philadelphia, PA 19103 T: (215) 554-8200
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