Dear Helena,
Thank you for executing the Kovel engagement letter yesterday, June 20, 2022. We are pleased to have Whitmore Valuation Group on board for this matter, and I wanted to provide a comprehensive kickoff memorandum so that your team can begin mobilizing promptly.
As confirmed in the engagement letter, Whitmore Valuation Group LLC is retained under a Kovel arrangement (see United States v. Kovel, 296 F.2d 918 (2d Cir. 1961)). All work performed by Whitmore in connection with this engagement is undertaken at the direction of counsel and is intended to be protected by the attorney-client privilege and the work-product doctrine. I want to emphasize at the outset the critical importance of maintaining privilege protocols throughout this engagement. All communications regarding substantive analysis, conclusions, and strategy should flow through Calderwood & Harkness. Whitmore personnel should have no direct contact with the IRS — including any member of the IRS examination team — without C&H's prior written authorization.
**I. CLIENT AND MATTER BACKGROUND**
Our client is Penterra Pharmaceuticals Corp. ("PPC"), a publicly traded specialty pharmaceutical and biotechnology company (Nasdaq: PPCA), headquartered at 2200 Independence Boulevard, Princeton Junction, New Jersey 08550.
PPC is currently under examination by the IRS Large Business & International Division. The examination was opened on May 16, 2022, and has been assigned Exam Team ID: LB&I-NE-TP-2022-00641. The tax years under examination are 2017, 2018, 2019, and 2020. The IRS exam team is led by Supervisory Revenue Agent Gerald Meskill (Team Manager), with Lead Revenue Agent Patricia Dunleavy heading the day-to-day audit work. Notably, the IRS has assigned an in-house economist to this examination — Dr. Alan Washburne of the IRS Transfer Pricing Practice — which signals the seriousness with which the Service is approaching the transfer pricing issues.
The examination focuses on the transfer pricing methodology used in PPC's Irish intellectual-property-holding structure, which involves its subsidiary Penterra Biopharma International DAC ("PBI"), organized in Ireland. PBI is 100% owned through Penterra Holdings Luxembourg S.à r.l. ("PHL"), a disregarded entity for U.S. federal income tax purposes. PHL is, in turn, 100% owned by PPC.
PPC maintained contemporaneous transfer pricing documentation for all four years under examination, prepared by Crestfield & Associates LLP (transfer pricing partner: Susan Lam). We will provide Whitmore with copies of this documentation as part of the initial data package.
**II. THE IP STRUCTURE UNDER EXAMINATION**
The intercompany arrangements at issue involve the following principal components:
*A. Cost-Sharing Arrangement ("CSA")*
Effective July 1, 2012, PPC and PBI entered into a qualified cost-sharing arrangement under Treas. Reg. § 1.482-7. Under the CSA, PBI acquired the rights to develop and exploit PPC's pharmaceutical IP portfolio outside the Americas (defined as North America, Central America, South America, and the Caribbean) in exchange for (i) a platform contribution transaction ("PCT") payment, and (ii) ongoing cost-sharing payments proportional to the parties' reasonably anticipated benefits ("RAB").
*B. Platform Contribution Transaction Payment*
PBI paid a lump-sum PCT payment of $312 million to PPC on July 1, 2012, representing the buy-in to PPC's pre-existing IP portfolio, which consisted primarily of clinical-stage and approved oncology compounds.
*C. Cost-Sharing Ratios (2017–2020)*
The cost-sharing ratios for the examination years, based on reasonably anticipated benefits, were as follows:
- **2017:** PBI share of 38.2% × $487.3M total qualified R&D costs = $186.15M - **2018:** PBI share of 39.6% × $523.8M total qualified R&D costs = $207.42M - **2019:** PBI share of 41.1% × $561.2M total qualified R&D costs = $230.65M - **2020:** PBI share of 42.7% × $598.4M total qualified R&D costs = $255.52M
*D. Legacy IP Royalty*
Separate from the CSA, PPC licenses pre-2012 legacy compounds to PBI under a license agreement providing for a royalty of 4.5% of net sales in the non-Americas territory. The relevant figures are:
- **2017:** Non-Americas net sales of $814.6M; royalty of $36.66M - **2018:** Non-Americas net sales of $762.3M; royalty of $34.30M - **2019:** Non-Americas net sales of $691.8M; royalty of $31.13M - **2020:** Non-Americas net sales of $624.1M; royalty of $28.08M
*E. Key Products*
PPC's key pharmaceutical products — and the products that will be central to the economic analysis — include:
- **Veritaxol** (oncology): 2020 global revenue of $3.12B; non-Americas revenue of $1.34B - **Imvara** (immunology): 2020 global revenue of $1.87B; non-Americas revenue of $0.79B - **Cerulon** (rare disease): 2020 global revenue of $0.62B; non-Americas revenue of $0.28B
*F. PBI Profile*
PBI is a substantive operating entity, and its profile will be important to the functional analysis. PBI is located at 4th Floor, Claremont House, Sandyford Business Park, Dublin, Ireland, occupying approximately 18,000 square feet of office space. The subsidiary grew from 52 employees at the time of the CSA's inception in 2012 to 185 employees by 2020, under Managing Director Aidan Naughton. PBI's functions include regulatory affairs, medical affairs, commercial strategy, and supply chain management. PBI bore market risk for the non-Americas territory and maintained independent pricing across 68 country markets. Its board of directors held 42 board meetings during the 2017–2020 period, all conducted in Dublin. PBI incurred €47.2 million in cumulative regulatory expenditure over the examination period and maintains its banking relationship with Glenmore Bank Ireland plc.
*G. Contract Manufacturer*
Penterra Manufacturing Ireland Ltd. ("PMI"), based at Ringaskiddy, Co. Cork, operates under a cost-plus 8% arrangement with PBI. PMI employs approximately 620 people.
**III. ANTICIPATED IRS CHALLENGE AREAS**
While the examination is still in its early stages, the composition of the IRS exam team — particularly the assignment of Dr. Washburne as an in-house economist — and the nature of the structure at issue allow us to anticipate challenges in the following areas:
1. **PCT Valuation:** The IRS is likely to argue that the $312 million PCT payment undervalues the pre-existing IP transferred to PBI. We anticipate the IRS economist may employ the income method with a lower discount rate and/or more aggressive revenue projections than those used in PPC's original valuation, which would inflate the calculated value of the buy-in.
2. **CSA Cost-Sharing Ratios:** The IRS may contend that PBI's cost-sharing percentages (ranging from 38.2% to 42.7%) understate PPC's share of reasonably anticipated benefits, thereby shifting an inadequate portion of R&D costs to PBI.
3. **Legacy IP Royalty Rate:** The IRS may challenge the 4.5% royalty rate as being below arm's length, potentially proposing a significantly higher rate based on their own selection of comparable uncontrolled transactions.
4. **Economic Substance / DEMPE:** The IRS may challenge PBI's substance as an IP owner and CSA participant, arguing that the key Development, Enhancement, Maintenance, Protection, and Exploitation ("DEMPE") functions remained in the United States. This line of attack would draw on both U.S. regulations and OECD principles.
**IV. SCOPE OF WHITMORE'S ECONOMIC ANALYSIS**
We will need Whitmore to prepare the following deliverables, all at the direction of counsel:
1. **Functional Analysis (in coordination with C&H):** Assist in documenting PBI's functions, assets, and risks in detail. Analyze the allocation of functions between PPC and PBI to support PBI's role as a bona fide CSA participant and IP owner with genuine economic substance. This analysis will be critical to countering any DEMPE-based challenge.
2. **Comparable Uncontrolled Transaction (CUT) Analysis — Royalty Rate:** Identify and analyze comparable uncontrolled pharmaceutical license agreements to benchmark the 4.5% royalty rate applicable to the legacy IP license. Establish the interquartile range and median from the comparable set and demonstrate that PPC's rate is arm's length under Treas. Reg. § 1.482-4.
3. **Comparable Profits Method (CPM) / Transactional Net Margin Method (TNMM) Analysis:** Test PBI's operating margins against comparable distributors and IP-holding companies to confirm that PBI's margins fall within an arm's-length range. This will serve as a corroborative analysis.
4. **Income Method / DCF Analysis — PCT Valuation:** Independently revalue the PCT using updated revenue projections and an appropriate discount rate (weighted average cost of capital, or WACC). The objective is to demonstrate that the $312 million PCT payment falls within an arm's-length range. This is critically important work. The selection and defense of the appropriate WACC will likely be a central point of contention, as the IRS economist may apply a lower discount rate that mechanically inflates the valuation. Your team's analysis on this point must be rigorous and well-supported.
5. **Benchmarking Study:** Conduct comprehensive comparable company and comparable transaction database searches (e.g., Vireo Health IT, Sundial Health IT, Bureau van Dijk) with fully documented and defensible screening criteria.
6. **Rebuttal of IRS Economist's Analysis:** As the examination progresses and Dr. Washburne produces his analysis, Whitmore will need to prepare a detailed, point-by-point rebuttal. We will coordinate on timing as the IRS work product becomes available.
**V. APPLICABLE LEGAL AND REGULATORY FRAMEWORK**
For your team's reference and to ensure the economic analyses are grounded in the applicable legal standards, the key authorities include:
- **IRC § 482** — allocation of income and deductions among commonly controlled entities - **Treas. Reg. § 1.482-1(d)** — the arm's-length standard and the best method rule - **Treas. Reg. § 1.482-4** — methods applicable to transfers of intangible property, including the CUT method for royalty benchmarking - **Treas. Reg. § 1.482-7** — qualified cost-sharing arrangements, including the PCT and cost-sharing payment requirements - **IRC § 6662(e)** — the substantial valuation misstatement penalty; note that PPC's contemporaneous documentation provides penalty protection under § 6662(e)(3)(B). Whitmore's analyses should be prepared to a standard consistent with penalty-protection requirements. - **OECD Transfer Pricing Guidelines** (2017 edition; 2022 revisions) — persuasive (though not binding) authority, particularly Chapter VI (Special Considerations for Intangibles) and Chapter VIII (Cost Contribution Arrangements) - **Key case law:** *Altera Corp. v. Commissioner* and *Harborview Corporation, Inc. v. Commissioner* — Garrett Simmons and Leila Nazari are preparing detailed case analyses for our team and will share them with Whitmore.
**VI. INITIAL DATA AND DOCUMENT REQUIREMENTS**
I would ask that you and Dr. Chakrabarti begin preparing to review the following materials, which Garrett Simmons will transmit via our secure file transfer portal within the next several days:
- PPC's contemporaneous transfer pricing documentation for TY 2017–2020, as prepared by Crestfield & Associates - The CSA agreement effective July 1, 2012, together with all amendments - The legacy IP license agreement (4.5% royalty) - The original PCT valuation report and supporting workpapers ($312M valuation) - R&D cost pool composition and allocation methodology for each year ($487.3M–$598.4M across the four years) - Revenue data by product (Veritaxol, Imvara, Cerulon) and by territory (Americas vs. non-Americas) for 2017–2020 - PBI financial statements (Irish statutory accounts) for 2017–2020 - PBI organizational charts, headcount data, and role descriptions - PMI contract manufacturing agreement (cost-plus 8%) - PPC consolidated financial data (FY 2020: revenue of $6.82B; pre-tax income of $1.47B; PBI FY 2020: revenue of €2.14B; pre-tax income of €1.06B)
**VII. COORDINATION AND COMMUNICATION PROTOCOLS**
To ensure efficient coordination and the preservation of privilege:
- **Day-to-day contact:** Garrett Simmons will serve as the primary point of contact between C&H and Whitmore. Leila Nazari will also assist with data coordination and document management. - **Privilege:** I must reiterate — all substantive communications regarding analysis, methodology, and conclusions should be directed through C&H. This is essential to preserving the Kovel privilege. - **No direct contact:** Whitmore should not communicate directly with PPC personnel or with the IRS without C&H's prior written consent. - **Billing:** As set forth in the executed Kovel letter, the blended rate is $650/hour. Please submit monthly invoices to C&H, attention Sylvia Hartwell.
**VIII. TIMELINE AND MILESTONES**
The IRS has already begun issuing Information Document Requests ("IDRs"), and we expect to receive 47 or more IDRs over the coming months. With that in mind, the following target milestones will guide our work:
- **October 2022:** Completion of the functional analysis and initial benchmarking work - **November–December 2022:** Completion of the CUT, CPM/TNMM, and PCT DCF analyses - **Mid-2023:** Possible issuance of a Notice of Proposed Adjustment ("NOPA") by the IRS; rebuttal work would follow - **Late 2023–2024:** The examination could extend through late 2023, with IRS Appeals proceedings likely in 2024
Whitmore should plan for the possibility of presenting findings at an IRS Appeals conference, should the matter proceed to that stage.
**IX. NEXT STEPS**
1. **Kickoff Call:** I would like to propose an initial kickoff call for the week of June 27 — participants would include myself, Sylvia Hartwell, Garrett Simmons, you, and Dr. Chakrabarti. The objective will be to walk through the CSA structure and key products in greater detail. Please let us know your team's availability, and Garrett will coordinate scheduling.
2. **Document Transmission:** Garrett will begin transmitting the initial data package via our secure portal this week.
3. **Work Plan:** I would appreciate it if you could provide a preliminary work plan and staffing estimate within two weeks of receiving the initial data package.
4. **Irish Coordination:** I should also note that C&H is coordinating with Thornbury & Keogh (partner: Ciarán Thornbury), PBI's Irish tax advisors in Dublin, on dual-jurisdiction aspects of this matter, including Knowledge Development box ("KDB") claims. Whitmore may need to coordinate with Thornbury & Keogh regarding Irish financial data and related matters, but any such coordination should be conducted only through C&H.
**X. CLOSING**
Helena, I am confident in the strength of PPC's transfer pricing positions, and I believe Whitmore's expertise in pharmaceutical and life sciences valuation will be invaluable as we build our defense. We have a substantial amount of work ahead, but I look forward to working with you and Rohan on this matter.
Please do not hesitate to reach out if you have any questions in the meantime.
Best regards,
**Leonard Cross** Partner, Tax Department Calderwood & Harkness LLP 1735 Market Street, Suite 3100 Philadelphia, PA 19103 T: (215) 864-7200 E: lcross@calderwoodharkness.com
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