PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE / ATTORNEY WORK PRODUCT
MEMORANDUM
TO: Marcus Whitfield, VP, Global Tax, Penterra Pharmaceuticals Corp. Deborah Staines, General Counsel, Penterra Pharmaceuticals Corp.
CC: Sylvia Hartwell, Partner, Calderwood & Harkness LLP
FROM: Leonard Cross, Partner, Calderwood & Harkness LLP Garrett Simmons, Associate, Calderwood & Harkness LLP
DATE: September 22, 2022
RE: FIN 48 (ASC 740-10) Reserve Analysis — Penterra Pharmaceuticals Corp. Transfer Pricing Positions Related to Irish IP-Holding Structure (TY 2017–2020)
MATTER NO.: 1018-00009
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I. Executive Summary
The purpose of this memorandum is to provide a detailed legal analysis supporting Penterra Pharmaceuticals Corp.'s ("PPC" or the "Company") evaluation and quantification of its uncertain tax position ("UTP") reserves under Accounting Standards Codification Topic 740-10 ("ASC 740-10"), formerly Financial Accounting Standards Board Interpretation No. 48 ("FIN 48"), with respect to the intercompany transfer pricing arrangements between PPC and its Irish subsidiary, Penterra Biopharma International DAC ("PBI"). These arrangements encompass the cost-sharing arrangement ("CSA"), the legacy intellectual property royalty arrangement, and the platform contribution transaction ("PCT") valuation that undergird the allocation of income between PPC and PBI for federal income tax purposes.
Calderwood & Harkness LLP ("C&H") has assessed both (i) the more-likely-than-not recognition threshold applicable to each discrete transfer pricing position, and (ii) the measurement of the largest amount of tax benefit from each position that is greater than 50% likely to be realized upon ultimate settlement with the Internal Revenue Service ("IRS"). Based on the analysis set forth herein, C&H recommends that PPC maintain a FIN 48 reserve of $62.4 million with respect to its transfer pricing positions involving the CSA cost-sharing ratio, the legacy IP royalty arrangement, and the indirect impact of the PCT valuation on the examination years. This recommended reserve is stated on a pre-tax adjustment basis and represents the cumulative probable adjustment across all positions for tax years ("TY") 2017 through 2020, after application of the ASC 740-10 measurement methodology and estimated correlative offsets under Treasury Regulation § 1.482-1(g).
This analysis is informed by the fact that the IRS Large Business & International Division ("LB&I") opened an examination of PPC's Forms 1120 for TY 2017–2020 on May 16, 2022 (Examination Team ID: LB&I-NE-TP-2022-00641). The examination is currently in its early Information Document Request ("IDR") response phase. As of the date of this memorandum, the IRS examination team has begun issuing IDRs, and PPC anticipates that approximately 47 IDRs will be issued over the course of the examination. Initial IDRs were issued beginning in June 2022 and have focused on the intercompany agreements, transfer pricing documentation, and corporate structure of PBI. No Notices of Proposed Adjustment ("NOPAs") have been issued as of the date hereof.
This memorandum is intended for use by PPC management—specifically Marcus Whitfield (VP, Global Tax) and Deborah Staines (General Counsel)—and by Crestfield & Associates LLP ("Crestfield"), PPC's independent auditor (engagement partner: Martin Ogilvy), in connection with PPC's financial reporting obligations under ASC 740-10. It should be noted that PPC was not enrolled in the IRS Compliance Assurance Process ("CAP") for any of the tax years at issue, and accordingly the Company did not have the benefit of real-time IRS review of its transfer pricing positions during the filing years.
The analysis herein is based on information available as of September 22, 2022, and reflects the early stage of the IRS examination. As the examination progresses and additional information becomes available regarding the IRS's areas of focus and proposed positions, C&H recommends that the reserve be reassessed on a quarterly basis, as more fully described in Section XII below.
II. Background
A. PPC Corporate Overview
Penterra Pharmaceuticals Corp. is a Delaware corporation headquartered at 2200 Independence Boulevard, Princeton Junction, New Jersey 08550. The Company's common stock is publicly traded on the Nasdaq Global Select Market under the ticker symbol "PPCA." PPC's Employer Identification Number is 22-3741856.
PPC is a specialty pharmaceuticals and biotechnology company focused on the discovery, development, manufacture, and commercialization of innovative therapeutics in oncology, immunology, and rare-disease indications. The Company operates globally through a network of subsidiaries and affiliates, with commercial operations spanning more than 70 countries across the Americas, Europe, the Middle East, Africa, and the Asia-Pacific region.
For fiscal year 2020, PPC reported consolidated revenue of approximately $6.82 billion, pre-tax income of approximately $1.47 billion, and employed approximately 14,500 individuals worldwide. The Company's executive leadership during the tax years at issue includes:
• Chief Executive Officer: Catherine Falk
• Chief Financial Officer: Rajesh Iyer
• General Counsel: Deborah Staines
• Vice President, Global Tax: Marcus Whitfield
PPC's global tax department, under the direction of Mr. Whitfield, is responsible for the Company's worldwide tax compliance, planning, and reporting obligations, including the maintenance of transfer pricing documentation and the evaluation of uncertain tax positions for financial reporting purposes.
B. Corporate Structure Relevant to Transfer Pricing
The corporate structure relevant to the transfer pricing positions at issue is as follows:
PPC (U.S. Parent) — Penterra Pharmaceuticals Corp. is the ultimate parent corporation and the U.S. taxpayer for federal income tax purposes. PPC directly owns all of the issued and outstanding equity interests in Penterra Holdings Luxembourg S.à r.l.
PHL (Luxembourg Holding Company) — Penterra Holdings Luxembourg S.à r.l. ("PHL") is a Luxembourg private limited liability company (société à responsabilité limitée) organized under Luxembourg law, with its registered office at 14, rue Aldringen, L-1118 Luxembourg, and registered with the Luxembourg Registre de Commerce et des Sociétés under No. B 168452. PHL functions as an intermediate holding company within PPC's international corporate structure. For purposes of U.S. federal income tax, PHL has elected to be treated as a disregarded entity (a "check-the-box" election under Treasury Regulation § 301.7701-3), and accordingly its income and assets are treated as directly owned by PPC for U.S. tax purposes. PHL directly owns all of the issued and outstanding share capital of PBI.
PBI (Irish IP-Holding and Commercial Principal) — Penterra Biopharma International DAC ("PBI") is an Irish designated activity company incorporated on March 15, 2012, with its registered office at 4th Floor, Claremont House, Sandyford Business Park, Dublin D18 K7T4, Ireland. PBI's Irish Tax Reference Number is 3218764T. PBI serves as the intellectual property holding company and the non-Americas commercial principal within the PPC group. As the non-Americas commercial principal, PBI is responsible for the commercialization of PPC's pharmaceutical products in all territories outside the Americas (defined as North America, Central America, South America, and the Caribbean). PBI holds the rights to develop and exploit PPC's pharmaceutical IP portfolio in these non-Americas territories pursuant to the CSA described below.
PMI (Irish Contract Manufacturer) — PBI directly owns all of the issued and outstanding share capital of Penterra Manufacturing Ireland Ltd. ("PMI"), an Irish private limited company with its registered office at Unit 7, Ringaskiddy Industrial Estate, Co. Cork T12 PX29, Ireland, and registered with the Irish Companies Registration Office under CRO No. 512347. PMI operates as a contract manufacturer for PBI, employing approximately 620 employees at its Ringaskiddy manufacturing facility. PMI's manufacturing activities are compensated under a cost-plus arrangement at a markup of 8% on total costs, in accordance with an intercompany contract manufacturing agreement between PBI and PMI.
C. Key Intercompany Arrangements
The transfer pricing positions at issue in the IRS examination arise from two principal intercompany arrangements between PPC and PBI, as well as the PCT payment made in connection with the establishment of the CSA. Each of these arrangements is described below.
1. Cost-Sharing Arrangement (CSA)
Effective July 1, 2012, PPC and PBI entered into a Qualified Cost Sharing Arrangement (the "CSA") governed by Treasury Regulation § 1.482-7. Under the CSA, PBI acquired the right to develop and exploit PPC's pharmaceutical intellectual property portfolio—including patents, trade secrets, regulatory data, clinical trial data, manufacturing know-how, and related intangible assets—in all territories outside the Americas. PPC retained corresponding rights with respect to the Americas territory.
As a condition of PBI's entry into the CSA, PBI was required to make a platform contribution transaction ("PCT") payment to PPC, representing compensation for PBI's acquisition of a co-development interest in PPC's pre-existing IP portfolio (principally clinical-stage and approved oncology compounds). The PCT payment was determined to be $312 million, payable as a lump sum on July 1, 2012. The valuation of the PCT payment is discussed in greater detail in Section II.C.3 below.
Under the ongoing cost-sharing provisions of the CSA, each controlled participant bears a share of the annual qualified research and development ("R&D") costs incurred in connection with the further development and enhancement of cost-shared intangible property. PBI's share of qualified R&D costs is determined based on reasonably anticipated benefits ("RAB"), computed in accordance with Treasury Regulation § 1.482-7(e). For the tax years under examination, PBI's cost-sharing percentages and corresponding dollar amounts were as follows:
PBI's cost-sharing percentage increased over the 2017–2020 period from 38.2% to 42.7%, reflecting the increasing share of anticipated benefits attributable to the non-Americas territories as PPC's key products—particularly Veritaxol and Imvara—achieved growing market penetration and revenue in those markets. The RAB projections underlying these cost-sharing ratios were prepared contemporaneously and updated annually by PPC's transfer pricing team, with assistance from Crestfield & Associates.
2. Legacy IP Royalty Arrangement
In addition to the CSA, PBI licenses from PPC certain pre-2012 legacy pharmaceutical compounds that were not included in the CSA or that were subject to separate licensing terms. Under the intercompany license agreement, PBI pays PPC a royalty at a rate of 4.5% of net sales of the licensed legacy compounds in the non-Americas territory. This royalty arrangement is governed by the arm's-length standard under Treasury Regulation § 1.482-4, which addresses transfers of intangible property.
For the tax years at issue, legacy compound non-Americas net sales and corresponding royalty payments were as follows:
The declining trajectory of legacy compound net sales reflects the maturity and lifecycle stage of these products, several of which have lost patent exclusivity and are subject to generic competition in various non-Americas markets. This declining revenue profile is a significant factor in assessing the arm's-length character of the 4.5% royalty rate, as discussed further in Section IV.B below.
3. Key Products
PPC's pharmaceutical product portfolio includes several significant products that drive the transfer pricing analysis. The following table sets forth key revenue data for fiscal year 2020:
Veritaxol is PPC's flagship oncology product and the Company's largest revenue contributor, accounting for approximately 45.7% of consolidated revenue in FY 2020. Veritaxol received FDA approval in 2013 and has since been approved in more than 60 countries worldwide. Imvara, an immunology therapeutic, received FDA approval in 2015 and has experienced significant growth in both Americas and non-Americas markets. Cerulon, a rare-disease therapeutic, was approved in 2017 and serves a smaller but high-value patient population across global markets. Each of these products is covered by the CSA and is thus relevant to the cost-sharing ratio analysis.
D. PBI's Operational Profile
A critical factor in any IRS examination of PPC's transfer pricing positions will be the substance and operational capacity of PBI. C&H has reviewed the available evidence regarding PBI's operational profile, which is summarized below and which supports the conclusion that PBI is a substantive entity with meaningful economic activities and decision-making authority.
As of December 31, 2020, PBI employed 185 individuals, a substantial increase from the 52 employees present at PBI's establishment in 2012. PBI's workforce includes professionals in regulatory affairs, medical affairs, commercial strategy and marketing, supply-chain management, market access, pharmacovigilance, and general administration. PBI's Managing Director is Aidan Naughton, who reports to PPC's Chief Commercial Officer but exercises significant operational autonomy with respect to non-Americas commercial operations.
PBI occupies approximately 18,000 square feet of office space at its Sandyford Business Park location in Dublin. During the 2017–2020 period, PBI's board of directors held a total of 42 meetings in Dublin, reflecting active governance and decision-making at the entity level. PBI's board includes both PPC-designated directors and independent Irish directors with pharmaceutical industry experience.
During the 2017–2020 period, PBI incurred cumulative regulatory expenditures of approximately €47.2 million in connection with regulatory submissions and marketing authorization applications across 68 country markets outside the Americas. PBI maintains independent pricing authority for its products across all 68 non-Americas country markets, negotiating directly with national health authorities, pharmacy benefit managers, and hospital formulary committees. PBI conducts its banking operations through Glenmore Bank Ireland plc and maintains its own treasury function for non-Americas cash management.
PBI is subject to Irish corporation tax at the standard trading income rate of 12.5%. Beginning in fiscal year 2016, PBI has been eligible for the Knowledge Development box ("KDB") rate of 6.25% on qualifying intellectual property income derived from qualifying assets. PBI's Irish tax advisors are Thornbury & Keogh, Dublin, led by partner Ciarán Thornbury, who advises PBI on Irish corporation tax compliance, KDB eligibility, and transfer pricing documentation requirements under Irish domestic law (as amended to implement the OECD Transfer Pricing Guidelines and the EU Anti-Tax Avoidance Directives).
E. Transfer Pricing Documentation
PPC maintains contemporaneous transfer pricing documentation for all four tax years under examination, prepared by Crestfield & Associates LLP (transfer pricing partner: Susan Lam; audit engagement partner: Martin Ogilvy). The documentation establishes and supports the methodologies applied to the CSA cost-sharing ratio and the legacy IP royalty arrangement, with reference to the applicable provisions of Treasury Regulation § 1.482-7 (cost-sharing arrangements) and Treasury Regulation § 1.482-4 (transfers of intangible property), respectively. The documentation was prepared with the intent of meeting the contemporaneous documentation requirements for penalty protection under Internal Revenue Code ("IRC") § 6662(e) and the corresponding regulatory provisions of Treasury Regulation § 1.6662-6.
The transfer pricing documentation includes, among other elements: (i) a description of the controlled transactions and the intercompany agreements governing them; (ii) a functional analysis of PPC and PBI, including the functions performed, assets employed, and risks assumed by each entity; (iii) a selection and application of the best method for determining arm's-length results; (iv) an economic analysis, including the identification of comparable uncontrolled transactions and the computation of arm's-length ranges; and (v) supporting financial data and projections.
F. IRS Examination Status
The IRS opened an examination of PPC's federal income tax returns (Forms 1120) for TY 2017–2020 on May 16, 2022, pursuant to Letter 2205-A. The examination is being conducted by the LB&I Division, Northeast Area, Transfer Pricing Practice. The IRS examination team consists of the following individuals:
• Supervisory Revenue Agent (Team Manager): Gerald Meskill
• Lead Revenue Agent: Patricia Dunleavy
• IRS Economist: Dr. Alan Washburne
• IRS Chief Counsel Attorney-Advisor: Franklin Rosario
• IRS Senior Counsel: Donna Hirabayashi
C&H was engaged by PPC on June 2, 2022, to represent PPC in connection with the IRS examination. Form 2848 (Power of Attorney and Declaration of Representative) was filed with the IRS on June 8, 2022, authorizing Leonard Cross, Sylvia Hartwell, Garrett Simmons, and Leila Nazari of C&H to represent PPC before the IRS with respect to the examination of TY 2017–2020.
In addition, PPC and C&H have retained Whitmore Valuation Group LLC ("WVG") as an independent economic expert to provide valuation and economic analysis support in connection with the examination. WVG's engagement is structured under a Kovel arrangement, pursuant to a letter agreement dated June 20, 2022 (reference: 1018-00009-KV), such that WVG's work product is performed at the direction of, and under the supervision of, C&H and is protected by the attorney-client privilege and work-product doctrine. The WVG engagement is led by Dr. Helena Vasquez, with support from Dr. Rohan Chakrabarti.
As of the date of this memorandum, the examination remains in its early IDR-response phase. The IRS has issued initial IDRs requesting copies of PPC's intercompany agreements, transfer pricing documentation, corporate organizational charts, board minutes for PBI and PPC, R&D cost allocation workpapers, and financial statements for PBI and PMI. PPC anticipates that approximately 47 IDRs will be issued over the course of the examination, and C&H is coordinating PPC's responses to ensure consistency, completeness, and the preservation of privileged materials.
III. ASC 740-10 Framework
A. Overview of the Two-Step Process
ASC 740-10, which codifies the provisions originally set forth in FIN 48, establishes a two-step process for recognizing and measuring tax benefits associated with uncertain tax positions.
Step 1 — Recognition. A tax position is recognized in the financial statements only if it is "more likely than not" (i.e., a likelihood of more than 50%) that the tax position will be sustained upon examination by the relevant taxing authority, including resolution of any related appeals or litigation processes. This determination is to be made based solely on the technical merits of the position, taking into account all available evidence and the applicable tax law, regulations, administrative pronouncements, and judicial authority. The recognition assessment must assume that the taxing authority has full knowledge of all relevant information—a presumption that is particularly significant in the present case given that the IRS has opened an active examination of the very positions at issue.
Step 2 — Measurement. If the recognition threshold is met in Step 1, the entity must then measure the amount of tax benefit to be recognized in its financial statements. Under the measurement standard, the entity recognizes the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the taxing authority. This measurement is typically performed using a cumulative probability approach, in which the entity develops a range of possible outcomes, assigns probabilities to each outcome, and identifies the largest amount of benefit for which the cumulative probability exceeds 50%. Importantly, the measurement step requires the exercise of significant judgment, informed by the entity's understanding of the technical merits, the likely positions of the taxing authority, and the anticipated course of any settlement or litigation.
Tax positions that fail the more-likely-than-not recognition threshold in Step 1 must be fully reserved (i.e., no tax benefit may be recognized). Positions that meet the recognition threshold proceed to the measurement step, where the amount of recognized benefit may be less than the full benefit claimed on the tax return if the cumulative probability analysis indicates that some portion of the benefit is at risk.
B. Applicable Guidance
The specific provisions of the Accounting Standards Codification governing the recognition, measurement, and disclosure of uncertain tax positions are as follows:
• ASC 740-10-25-6 through 25-17 — These paragraphs set forth the recognition standard, including the more-likely-than-not threshold, the requirement to evaluate the position based on technical merits, the presumption of examination with full knowledge, and the treatment of related positions.
• ASC 740-10-30-7 through 30-9 — These paragraphs set forth the measurement standard, including the requirement to measure the largest amount of benefit exceeding 50% cumulative probability, the use of probability-weighted outcomes, and the consideration of settlement as a factor in measurement.
For purposes of the ASC 740-10 analysis, a "tax position" is broadly defined to include both (i) a position taken or expected to be taken in a tax return, and (ii) a decision not to file a tax return or not to take a particular position on a return. In the present case, each discrete transfer pricing position—the CSA cost-sharing ratio, the legacy IP royalty rate, and the PCT valuation—constitutes a separate "tax position" for FIN 48 purposes, as each involves a distinct factual and legal determination regarding the arm's-length character of the intercompany pricing.
Furthermore, under ASC 740-10, the entity must presume that the position will be examined by a taxing authority with full knowledge of all relevant information. This presumption is of particular significance here, given that the IRS has, in fact, opened an examination of PPC's returns for the relevant tax years and has specifically focused its initial IDRs on the intercompany transfer pricing arrangements. Accordingly, the "full knowledge" presumption is not merely hypothetical; it reflects the actual posture of the Company's tax positions.
C. Unit of Account
A threshold issue in any FIN 48 analysis is the determination of the appropriate "unit of account"—that is, the level of disaggregation at which uncertain tax positions should be evaluated. C&H has identified three discrete uncertain tax positions for purposes of this analysis:
1. CSA Cost-Sharing Ratio — PBI's proportionate share of qualified R&D costs under the CSA, which ranged from 38.2% to 42.7% during TY 2017–2020.
2. Legacy IP Royalty Rate — The 4.5% royalty rate applied to PBI's non-Americas net sales of licensed legacy compounds under the intercompany license agreement.
3. PCT Valuation — The $312 million lump-sum PCT payment made by PBI to PPC in 2012 as a buy-in to PPC's pre-existing IP portfolio, and the indirect impact of that valuation on the CSA and royalty positions during the examination years.
Each of these positions is analyzed separately in the recognition and measurement steps below. However, the analysis also takes into account the interrelationships between these positions—most importantly, the potential for correlative adjustments under Treasury Regulation § 1.482-1(g) in the event that the IRS proposes adjustments to both the CSA cost-sharing ratio and the legacy IP royalty rate. The correlative adjustment issue is addressed in detail in Section V.E below.
IV. Step 1 — Recognition Analysis (More-Likely-Than-Not Threshold)
A. CSA Cost-Sharing Ratio Position
PPC's Position. PPC's position is that PBI's cost-sharing percentages of 38.2% (TY 2017), 39.6% (TY 2018), 41.1% (TY 2019), and 42.7% (TY 2020) are arm's-length and are based on reasonably anticipated benefits ("RAB") computed in accordance with Treasury Regulation § 1.482-7(e). The RAB methodology used by PPC measures each controlled participant's anticipated share of benefits from cost-shared intangibles by reference to projected revenue splits between the Americas territory (retained by PPC) and the non-Americas territory (assigned to PBI).
Technical Merits. The technical merits supporting PPC's cost-sharing ratio position are as follows:
Contemporaneous RAB projections. The RAB projections underlying PBI's cost-sharing percentages were prepared contemporaneously for each tax year and updated annually to reflect the most current revenue forecasts and market data available at the time of the computation. The projections take into account product-specific revenue trajectories for each of PPC's key compounds (including Veritaxol, Imvara, and Cerulon), market-by-market commercial expectations, regulatory approval timelines, patent expiry dates, competitive dynamics, and anticipated pricing trends.
Regulatory compliance. The methodology employed by PPC is consistent with Treasury Regulation § 1.482-7(e)(1), which provides that RAB are to be measured by reference to the benefits each controlled participant is reasonably anticipated to derive from cost-shared intangibles. Revenue-based projections are a commonly accepted measure of RAB and are widely used by pharmaceutical companies with similar intercompany arrangements. The regulations do not prescribe a single, exclusive methodology for computing RAB, but revenue-based projections are recognized as an appropriate proxy for anticipated benefits in many circumstances, particularly where the intangible property at issue generates revenue streams that are directly attributable to specific territorial rights.
Consistency with product lifecycle trends. PBI's increasing cost-sharing percentage over the 2017–2020 period (from 38.2% to 42.7%) is consistent with the observed trends in the non-Americas revenue share of PPC's key products during this period. Veritaxol, Imvara, and Cerulon each experienced increasing market penetration and revenue growth in non-Americas markets relative to Americas markets during these years, driven by expanding regulatory approvals, favorable reimbursement decisions, and growing patient populations in Europe, Asia-Pacific, and other non-Americas regions. The upward trajectory of PBI's cost-sharing percentage thus reflects actual commercial developments and is not an artifact of artificially conservative projections.
Crestfield documentation support. The contemporaneous transfer pricing documentation prepared by Crestfield & Associates for each of the four exam years provides a detailed description of the CSA, the RAB methodology, and the underlying projections and assumptions. This documentation constitutes an important element of PPC's overall defense of the cost-sharing ratio position and also serves as the foundation for the penalty protection analysis under IRC § 6662(e), discussed in Section VI below.
Potential IRS Challenge
Based on C&H's experience with IRS examinations of pharmaceutical company cost-sharing arrangements, and informed by the early IDR requests received in this examination, we anticipate that the IRS may challenge PPC's cost-sharing ratio on one or more of the following grounds:
• The IRS may assert that PPC's revenue projections understate the non-Americas benefits and that PBI's cost-sharing percentage should be higher—potentially in the range of 48% to 54%—based on alternative revenue projections that assume more aggressive growth in non-Americas markets, the inclusion of additional value drivers not reflected in PPC's projections, or a different treatment of pipeline products and pre-launch compounds.
• The IRS may challenge PPC's projection methodology on the ground that it does not adequately account for the relative value of the non-Americas rights vis-à-vis the Americas rights, or that it improperly excludes certain categories of benefits (such as the value of regulatory exclusivities or data packages obtained by PBI in connection with non-Americas regulatory submissions).
• IRS Economist Dr. Alan Washburne may develop an alternative RAB computation based on different assumptions regarding product lifecycle, pricing trajectories, or market size in non-Americas territories, which could result in a higher cost-sharing percentage for PBI.
Assessment. Based on the foregoing analysis, C&H concludes that it is more likely than not that PPC's cost-sharing ratio position will be sustained upon examination on the technical merits. The position is grounded in a well-established RAB methodology that is consistent with the applicable regulations, supported by contemporaneous documentation, and reflective of actual commercial developments. While there is meaningful risk that the IRS may propose some upward adjustment to PBI's cost-sharing percentage, C&H believes that PPC's position as filed is defensible and would more likely than not be sustained in its entirety, or substantially in its entirety, upon examination and through any administrative appeal or litigation.
Recognition Conclusion. The CSA cost-sharing ratio position meets the more-likely-than-not recognition threshold under ASC 740-10-25-6. C&H proceeds to the measurement step for this position (Section V.B below). However, because there is meaningful risk of some adjustment, the measurement analysis will reflect a range of possible outcomes with associated probabilities.
B. Legacy IP Royalty Rate Position
PPC's Position. PPC's position is that the 4.5% royalty rate applied to PBI's non-Americas net sales of legacy pharmaceutical compounds is arm's-length, and that this rate is supported by an application of the comparable uncontrolled transaction ("CUT") method under Treasury Regulation § 1.482-4(c)(2).
Technical Merits. CUT analysis. Whitmore Valuation Group, under the Kovel arrangement, has conducted a CUT analysis (in progress as of the date of this memorandum; preliminary results are available) that identifies 14 comparable uncontrolled pharmaceutical license agreements involving the licensing of mature pharmaceutical compounds to unrelated licensees for territorial exploitation. These comparable agreements were identified through a systematic search of publicly available databases (including Vireo Health IT, Royalty Source, and SEC filings) and were screened for comparability based on factors including the therapeutic area, product maturity and lifecycle stage, territorial scope of the license, exclusivity terms, and the nature and extent of the licensed intangible property.
The interquartile range of royalty rates observed in the 14 comparable agreements is 3.1% to 6.8% of net sales, with a median rate of 4.4%. PPC's 4.5% royalty rate falls at approximately the median of the interquartile range, well within the arm's-length range established by the CUT analysis. Under Treasury Regulation § 1.482-1(e)(2), when a taxpayer's controlled transaction price falls within the interquartile range of comparable uncontrolled transactions, the IRS generally may not make an adjustment.
CUT method as preferred method. The CUT method is identified under Treasury Regulation § 1.482-4(c)(2) as the preferred method for evaluating the arm's-length character of royalty rates when reliable comparable uncontrolled transactions exist. The availability of 14 comparable agreements with sufficient factual similarity to the PPC-PBI licensing arrangement provides a robust evidentiary foundation for PPC's position. The use of the CUT method is further supported by the guidance in Treasury Regulation § 1.482-1(c) (the "best method" rule), which favors the method that provides the most reliable measure of an arm's-length result under the circumstances.
Declining product lifecycle supports lower royalty rate. The legacy compounds licensed to PBI under the royalty arrangement are mature, late-lifecycle products that have experienced declining revenue in the non-Americas territory over the period at issue. Non-Americas net sales of legacy compounds declined from $814.6 million in TY 2017 to $624.1 million in TY 2020—a decrease of approximately 23.4% over the four-year period. This declining trajectory reflects the loss of patent exclusivity, increasing generic competition, and the substitution of newer PPC products (such as Veritaxol and Imvara) in the treatment landscape. The maturity and declining profitability of the legacy compounds supports a lower royalty rate, as the licensed intangible property has diminished value relative to newly developed, high-growth compounds.
Potential IRS Challenge
C&H anticipates that the IRS may challenge PPC's royalty rate on one or more of the following grounds:
• The IRS may select a different set of CUT comparables, potentially including agreements involving higher royalty rates for licensed pharmaceutical IP. Based on past IRS practice in pharmaceutical transfer pricing examinations, it is possible that the IRS may propose a royalty rate of 11% or above, relying on comparables that may involve earlier-stage, higher-growth products or different territorial scopes.
• The IRS may challenge the comparability of PPC's selected CUT comparables, asserting that differences in the terms, scope, or economic conditions of the comparable agreements render them unreliable or require adjustments that would shift the interquartile range upward.
• The IRS may argue that PPC's 4.5% rate does not reflect the full value of the licensed intangible property, particularly if the IRS takes the position that the legacy compounds retain significant residual value beyond what is reflected in their current revenue trajectory.
Assessment. Based on the foregoing analysis, C&H concludes that it is more likely than not that PPC's 4.5% royalty rate will be sustained upon examination on the technical merits. The position is at approximately the median of a well-supported CUT interquartile range, is consistent with the declining lifecycle of the licensed compounds, and is established using the preferred method under the applicable regulations. While the IRS may propose a higher rate, C&H believes that PPC's CUT analysis provides strong support for the arm's-length character of the 4.5% rate, and that PPC would more likely than not prevail upon examination and through any administrative appeal or litigation.
Recognition Conclusion. The legacy IP royalty rate position meets the more-likely-than-not recognition threshold under ASC 740-10-25-6. C&H proceeds to the measurement step for this position (Section V.C below). As with the CSA position, the measurement analysis will reflect a range of possible outcomes and associated probabilities.
C. PCT Valuation Position
PPC's Position. PPC's position is that the $312 million PCT payment made by PBI to PPC on July 1, 2012, in connection with PBI's entry into the CSA, was arm's-length and within the range of arm's-length outcomes computed under the income method / Discounted cash flow ("DCF") approach. Specifically, PPC's valuation analysis yields an arm's-length range of $278 million to $361 million, with a central tendency value of approximately $312 million, using a weighted average cost of capital ("WACC") of 9.8% as the discount rate.
Technical Merits. Income method / DCF valuation. The PCT valuation was prepared by Whitmore Valuation Group using the income method prescribed by Treasury Regulation § 1.482-7(g), which requires the use of a present-value methodology to determine the arm's-length buy-in payment for the controlled participant's acquisition of a co-development interest in pre-existing intangible property. The income method involves projecting the future cash flows attributable to the pre-existing IP, discounting those cash flows at an appropriate risk-adjusted discount rate, and allocating the resulting present value between the controlled participants based on their respective rights under the CSA.
WACC of 9.8%. The 9.8% WACC used in PPC's PCT valuation reflects pharmaceutical-industry risk premiums, the specific risk profile of the transferred IP portfolio (which consisted of oncology compounds in various stages of clinical development at the time of the PCT), and appropriate beta comparables drawn from publicly traded pharmaceutical and biotechnology companies with similar product-stage and therapeutic-area profiles. The WACC also reflects 2012 market conditions, including prevailing risk-free interest rates, equity risk premiums, and credit spreads applicable at the time of the PCT. C&H notes that the WACC determination is a critical input to the PCT valuation, as relatively small changes in the discount rate can produce significant changes in the computed present value.
Regulatory compliance. The PCT payment methodology is compliant with Treasury Regulation § 1.482-7(g), and the lump-sum payment structure is permissible under the regulations. The arm's-length range of $278 million to $361 million encompasses the $312 million PCT payment actually made, providing support for the conclusion that the PCT was priced at arm's length.
Potential IRS Challenge
C&H anticipates that the IRS may challenge the PCT valuation on one or more of the following grounds:
• The IRS may apply a lower discount rate than PPC's 9.8% WACC, which would increase the computed present value of the pre-existing IP and correspondingly increase the arm's-length PCT payment. Based on our experience, the IRS Economist (Dr. Alan Washburne) may propose a WACC of approximately 7.2%, which would yield a PCT value of approximately $852 million—a delta of approximately $540 million from PPC's $312 million PCT payment. This represents the most significant quantitative risk associated with the PCT position.
• However, C&H notes that the PCT itself was executed in 2012, which is outside the TY 2017–2020 examination years. The IRS cannot directly propose a transfer pricing adjustment to the PCT payment for the examination years unless it asserts that the PCT payment should have been structured as installment payments extending into the exam years (an unlikely but not impossible argument).
• More realistically, the IRS may use the PCT undervaluation theory as a springboard to challenge the ongoing CSA cost-sharing ratios and royalty rates for the examination years. Specifically, the IRS may argue that if the PCT payment was insufficient, then PBI's rights under the CSA are correspondingly undervalued, and PBI's ongoing cost-sharing payments and royalty rates should be adjusted upward to compensate PPC for the shortfall. This indirect impact is the primary risk associated with the PCT position for the examination years.
Assessment. Based on the foregoing analysis, C&H concludes that it is more likely than not that PPC's PCT valuation will be sustained upon examination on the technical merits. The $312 million PCT payment falls within the arm's-length range computed under the income method / DCF approach, and the 9.8% WACC is supportable based on industry data and 2012 market conditions. While the IRS may assert a lower WACC and a higher PCT value, C&H believes that PPC has a strong factual and legal basis for its position, and that the position would more likely than not be sustained upon examination.
The primary risk associated with the PCT position is its indirect impact on the CSA and royalty positions for the examination years, rather than a direct adjustment to the PCT payment itself. This indirect risk is incorporated into the measurement analysis for the CSA and royalty positions (Sections V.B and V.C below), and is also addressed separately in Section V.D.
Recognition Conclusion. The PCT valuation position meets the more-likely-than-not recognition threshold under ASC 740-10-25-6. C&H proceeds to the measurement step, in which the indirect impact of the PCT valuation on the exam-year positions is incorporated into the reserve calculation. Although no separate direct adjustment is modeled for the PCT, the influence of the IRS's potential PCT theories on the probability weightings for the CSA and royalty positions is reflected in the measurement analysis.
V. Step 2 — Measurement Analysis
A. Methodology
Under ASC 740-10-30-7, once a tax position has met the more-likely-than-not recognition threshold, the entity must measure the largest amount of tax benefit from that position that is greater than 50% likely of being realized upon ultimate settlement with the taxing authority. C&H has applied a cumulative probability approach to each of the three identified uncertain tax positions.
For each position, C&H has developed a range of possible outcomes—spanning from full sustain (no adjustment) to the IRS's full proposed adjustment, and including intermediate outcomes reflecting partial adjustments at various levels. Each outcome has been assigned a probability based on C&H's assessment of the technical merits, the likely IRS positions, the strength of PPC's factual record, and the anticipated course of any settlement or litigation. The cumulative probabilities are then computed from the most favorable outcome (full sustain) to the least favorable outcome (full IRS adjustment), and the measurement amount is the largest benefit amount at which the cumulative probability exceeds 50%.
The following additional considerations inform the measurement analysis:
Applicable tax rates. The tax impact of any proposed adjustment must be computed using the applicable federal corporate income tax rate for each examination year. For TY 2017 (the final year before the effective date of the Tax Cuts and Jobs Act of 2017 ("TCJA")), the applicable rate is 35%. For TY 2018 through TY 2020, the applicable rate is 21%, reflecting the TCJA's reduction of the corporate rate effective January 1, 2018.
Interrelationships between positions. The measurement must account for the interrelationship between the CSA and royalty positions, including the potential for correlative adjustments under Treasury Regulation § 1.482-1(g) that would prevent double-counting of the same income. This issue is addressed in Section V.E below.
Interest and penalties. The measurement must include any interest that would be owed on an underpayment resulting from a sustained adjustment, accrued at the applicable federal underpayment rate under IRC § 6621. The potential for IRC § 6662(e) substantial valuation misstatement penalties is assessed separately in Section VI.
B. CSA Cost-Sharing Ratio — Measurement
C&H has modeled the following range of outcomes for the CSA cost-sharing ratio position, expressed as percentage-point increases to PBI's cost-sharing percentage:
Cumulative probability analysis. Applying the cumulative probability approach from the most favorable to the least favorable outcome:
• Outcome 1 (full sustain): Cumulative probability = 25%. This does not exceed 50%.
• Outcome 1 + Outcome 2 (adjustment of 0–5 pp): Cumulative probability = 25% + 30% = 55%. This exceeds 50%.
Accordingly, the largest amount of benefit that is greater than 50% likely of being realized corresponds to the benefit level at which the cumulative probability first exceeds 50%—that is, the benefit level assuming an adjustment in the range of 2 to 5 percentage points. The measured reserve for the CSA position therefore reflects the tax impact of an approximately 2-percentage-point increase in PBI's cost-sharing ratio, which represents the boundary at which the 50% cumulative probability threshold is reached.
Dollar impact calculation. The dollar impact of a 2-percentage-point increase in PBI's cost-sharing percentage, applied to the total qualified R&D cost pool for each examination year, is as follows:
The CSA cost-sharing ratio component of the total FIN 48 reserve is computed on this basis, with the specific reserve amount reflecting the boundary adjustment at the 50% cumulative probability threshold and the resulting tax and interest impact across all four examination years.
C. Legacy IP Royalty Rate — Measurement
C&H has modeled the following range of outcomes for the legacy IP royalty rate position:
Cumulative probability analysis. Applying the cumulative probability approach:
• Outcome 1 (full sustain at 4.5%): Cumulative probability = 30%. This does not exceed 50%.
• Outcome 1 + Outcome 2 (adjustment to 5.0%–6.8%): Cumulative probability = 30% + 35% = 65%. This exceeds 50%.
Accordingly, the measured benefit corresponds to the benefit level at which a cumulative probability of 50% is first reached—representing an adjustment from 4.5% to approximately 5.0%, the lower bound of the Outcome 2 range. The measured reserve for the royalty position reflects the incremental tax impact of a 0.5-percentage-point royalty rate increase applied to non-Americas legacy compound net sales.
Dollar impact calculation. The dollar impact of a 0.5-percentage-point increase in the royalty rate, applied to non-Americas legacy compound net sales for each examination year, is as follows:
The legacy IP royalty rate component of the total FIN 48 reserve is computed on this basis, with the specific reserve amount reflecting the boundary adjustment at the 50% cumulative probability threshold and the resulting tax and interest impact across all four examination years.
D. PCT Valuation — Indirect Impact on Exam Years
As discussed in Section IV.C above, the PCT was executed in 2012, which is outside the TY 2017–2020 examination years. Accordingly, C&H does not model a separate direct adjustment to the PCT payment for purposes of the FIN 48 reserve calculation.
However, the risk that the IRS will use the PCT undervaluation theory to support adjustments to the ongoing CSA cost-sharing ratios and royalty rates for the examination years is real and must be accounted for. Specifically, if the IRS asserts that PBI paid an insufficient buy-in for its co-development interest in PPC's pre-existing IP, the IRS may argue that the ongoing CSA and royalty arrangements during the examination years should be adjusted to compensate for the shortfall. This argument could take the form of higher cost-sharing percentages for PBI, higher royalty rates, or both.
C&H has incorporated the indirect impact of the PCT valuation risk into the probability weightings assigned to the CSA and royalty positions in Sections V.B and V.C above. Specifically, the probability assigned to higher-adjustment outcomes (Outcomes 3, 4, and 5) for both the CSA and royalty positions reflects, in part, the risk that the IRS will advance a PCT undervaluation theory as support for more aggressive adjustments during the examination years. To the extent the IRS's PCT theory gains traction during the examination, the probability weightings may need to be revised upward in future reassessments of the reserve.
E. Correlative Offset
Under Treasury Regulation § 1.482-1(g), when the IRS proposes adjustments to more than one controlled transaction between the same controlled parties, the adjustments must be coordinated to avoid double-counting of the same income. In the present case, both the CSA cost-sharing ratio and the legacy IP royalty rate relate to intercompany payments from PBI to PPC for the use of, or access to, PPC's intellectual property in the non-Americas territory. If the IRS proposes upward adjustments to both the CSA cost-sharing percentage and the royalty rate, a correlative offset may be appropriate to prevent PPC from being treated as having received two increases in compensation for the same set of rights or intangible assets.
The magnitude of the correlative offset depends on the specific nature and magnitude of the adjustments proposed. Based on C&H's analysis of the interrelationship between the CSA and royalty positions, and taking into account the economic overlap between the two arrangements, C&H estimates that the correlative offset could reduce the total gross exposure by a meaningful amount—potentially in the range of $30 million to $50 million, depending on the adjustment levels ultimately sustained. This estimate is necessarily imprecise at this stage of the examination and will be refined as the IRS's positions become clearer.
The correlative offset is incorporated into the aggregate reserve calculation as a reduction to the gross reserve, as described in Section V.F below.
F. Aggregate Reserve Calculation
The aggregate FIN 48 reserve recommended by C&H reflects the cumulative measured exposure across the three identified uncertain tax positions, net of the estimated correlative offset, as follows:
• CSA cost-sharing ratio position: Reserve component reflecting the measured tax impact of the probable adjustment, computed as described in Section V.B.
• Legacy IP royalty rate position: Reserve component reflecting the measured tax impact of the probable adjustment, computed as described in Section V.C.
• PCT indirect impact: Embedded in the probability weightings assigned to the CSA and royalty positions, as described in Section V.D. No separate reserve component.
• Less: Estimated correlative offset benefit. Reduction to the gross reserve reflecting the estimated correlative offset under Treasury Regulation § 1.482-1(g), as described in Section V.E.
Tax impact. The tax impact of the measured adjustments is computed by applying the applicable federal corporate income tax rate to the pre-tax adjustment amounts for each examination year: 35% for TY 2017 and 21% for TY 2018 through TY 2020.
Interest. Interest on the federal tax underpayment must be accrued on the measured reserve at the applicable federal underpayment rate under IRC § 6621. Interest is computed from the original due date of the return for each examination year through the projected date of settlement or payment. The interest component is included in the aggregate reserve.
Penalties. The potential for IRC § 6662(e) substantial valuation misstatement penalties is assessed separately in Section VI below. As discussed therein, C&H recommends a $0 penalty reserve based on PPC's strong penalty protection under the reasonable-cause defense.
Recommended total FIN 48 reserve: $62.4 million. This figure represents the cumulative pre-tax adjustment amount reserved across all positions for TY 2017–2020, after application of the ASC 740-10 measurement methodology, the correlative offset, applicable tax rates, and accrued interest. The detailed computation supporting this aggregate reserve amount is set forth in Appendix B.
G. Reserve Allocation by Tax Year
The total reserve of $62.4 million is allocated among the four examination years in proportion to the measured exposure for each year, reflecting year-specific R&D cost pools, legacy compound net sales bases, and applicable tax rates.
TY 2017. The TY 2017 reserve allocation is based on the R&D cost pool of $487.3 million (for the CSA position), legacy non-Americas net sales of $814.6 million (for the royalty position), and the applicable federal tax rate of 35%. TY 2017 represents a proportionally larger share of the total reserve due to the higher tax rate in effect for that year.
TY 2018. The TY 2018 reserve allocation is based on the R&D cost pool of $523.8 million, legacy non-Americas net sales of $762.3 million, and the applicable federal tax rate of 21%.
TY 2019. The TY 2019 reserve allocation is based on the R&D cost pool of $561.2 million, legacy non-Americas net sales of $691.8 million, and the applicable federal tax rate of 21%.
TY 2020. The TY 2020 reserve allocation is based on the R&D cost pool of $598.4 million, legacy non-Americas net sales of $624.1 million, and the applicable federal tax rate of 21%.
The year-by-year allocation is set forth in detail in the reserve calculation workpaper summary in Appendix B.
VI. Penalty Considerations
A. IRC § 6662(e) Substantial Valuation Misstatement Penalty
IRC § 6662(e) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax attributable to a "substantial valuation misstatement" under IRC § 482. A substantial valuation misstatement exists when the net IRC § 482 transfer price adjustment for a taxable year exceeds the lesser of (i) $5 million, or (ii) 10% of the taxpayer's gross receipts. If a § 482 adjustment were sustained at the levels proposed by the IRS at its full position, the penalty threshold would clearly be exceeded.
The potential penalty exposure is significant. By way of illustration, if the IRS were to sustain a net § 482 adjustment of approximately $380.4 million across the examination years, and assuming a blended tax rate of approximately 21% (applicable to TY 2018–2020, which constitute the majority of the exposure), the resulting underpayment would be approximately $79.9 million, and the 20% penalty thereon would be approximately $15.98 million. This figure is illustrative only and is based on the IRS's full proposed position, which C&H does not believe is the most likely outcome. Nevertheless, the magnitude of the potential penalty underscores the importance of the penalty protection analysis set forth below.
B. Penalty Protection — Reasonable Cause Defense
IRC § 6662(e)(3)(B) provides a statutory exception to the substantial valuation misstatement penalty where the taxpayer establishes that it had reasonable cause for its transfer pricing treatment and acted in good faith. The reasonable-cause defense is available if the taxpayer demonstrates that: (i) it maintained contemporaneous documentation as required by Treasury Regulation § 1.6662-6, setting forth the determination of the transfer pricing method and result; and (ii) the transfer pricing was established with a reasonable belief that the method and result were consistent with the arm's-length standard of IRC § 482.
C&H has reviewed PPC's contemporaneous transfer pricing documentation for each of the four examination years, which was prepared by Crestfield & Associates under the direction of Susan Lam (transfer pricing partner). The documentation meets the requirements of Treasury Regulation § 1.6662-6, including:
• A description of the controlled transactions and the selection of the transfer pricing method (the RAB method for the CSA and the CUT method for the legacy IP royalty);
• An analysis of the comparability factors and the identification of comparable uncontrolled transactions or arrangements;
• A description of the relevant economic analysis, including projections, assumptions, and data sources;
• A statement of the arm's-length range and the placement of the controlled transaction result within that range; and
• A description of the principal documents relied upon in preparing the documentation.
The documentation was prepared on a timely basis, prior to the filing of PPC's federal income tax return for each examination year, and was maintained and available for production to the IRS upon request, consistent with the regulatory requirements.
Based on the foregoing, C&H concludes that PPC's reasonable-cause defense under IRC § 6662(e)(3)(B) is strong and is more likely than not to prevail in the event that the IRS proposes a substantial valuation misstatement penalty. PPC maintained the required contemporaneous documentation, applied recognized transfer pricing methods, and established its transfer pricing with a reasonable belief that the method and result were consistent with IRC § 482.
Recommendation: $0 penalty reserve. C&H recommends that PPC maintain a $0 penalty reserve with respect to the IRC § 6662(e) substantial valuation misstatement penalty, as PPC's reasonable-cause defense provides strong penalty protection that is more likely than not to be sustained upon examination.
VII. Interaction with GILTI, BEAT, and Other TCJA Provisions
For TY 2018 through TY 2020, any IRC § 482 adjustment that increases PPC's U.S.-source income would correspondingly reduce PBI's pre-tax income, and may thereby affect the computation of PBI's "tested income" under the Global Intangible Low-Taxed Income ("GILTI") provisions of IRC § 951A. Specifically, to the extent that a § 482 adjustment shifts income from PBI (a controlled foreign corporation) to PPC (the U.S. shareholder), PBI's tested income under GILTI would decrease, potentially resulting in a reduction in PPC's GILTI inclusion. This GILTI offset effect would partially mitigate the net tax cost of any § 482 adjustment.
Similarly, an IRC § 482 adjustment that increases PPC's deductible payments from PBI (in the form of higher cost-sharing payments or royalties) could potentially affect the computation of PPC's "base erosion percentage" and "modified taxable income" under the Base Erosion and Anti-Abuse Tax ("BEAT") provisions of IRC § 59A. The interaction is complex and depends on whether the additional intercompany payments are treated as "base erosion payments" under IRC § 59A(d) and whether PPC's base erosion percentage exceeds the applicable threshold.
These GILTI and BEAT interactions may partially mitigate or complicate the net tax impact of any IRC § 482 adjustment for TY 2018–2020. However, consistent with the position-by-position analysis required by ASC 740-10, the FIN 48 reserve is appropriately calculated on the basis of the primary IRC § 482 adjustment without netting any potential GILTI or BEAT offsets. The ASC 740-10 framework requires that each uncertain tax position be evaluated independently, and the potential for offsetting benefits under other provisions of the Code does not reduce the measured reserve for the primary transfer pricing positions.
A detailed analysis of the GILTI and BEAT interactions, including the quantification of any potential offset effects, is being prepared separately by C&H in coordination with PPC's tax department. That analysis will be set forth in a separate memorandum, which will be cross-referenced to this FIN 48 reserve analysis.
VIII. Impact of Active IRS Examination on FIN 48 Analysis
The opening of the IRS examination on May 16, 2022, raises the question of whether the active examination should affect PPC's FIN 48 analysis. Under ASC 740-10-25-6, the recognition assessment is to be made based solely on the technical merits of the tax position, regardless of whether the position is currently under examination by a taxing authority. The standard specifically requires the entity to presume that the position will be examined by a taxing authority with full knowledge of all relevant information. Accordingly, the existence of the active IRS examination does not change the recognition analysis: PPC's transfer pricing positions would be evaluated against the more-likely-than-not threshold in the same manner regardless of whether the IRS had opened an examination.
However, the active examination does provide additional information that may inform the probability weighting in the measurement step. As the examination progresses—through the IDR phase, any informal or formal communication of the IRS's proposed positions, the issuance of any NOPAs, and any settlement discussions or Appeals proceedings—PPC and C&H will gain increasing visibility into the IRS's likely positions, the specific factual and legal theories the IRS intends to advance, and the magnitude of any proposed adjustments. This information may warrant adjustments to the probability weightings assigned to the various outcomes in the cumulative probability analysis, which could result in changes to the measured reserve.