New Jersey Life Science Cluster Where International Biotech Innovations Are Brought To Market

Thursday, December 1, 2005 - 01:00

Legal Structure; LLCs Are Not Always Transparent

Advice in structuring life science collaboration entities must incorporate advice as to the tax regimen of the jurisdiction of the foreign equity owners. For example, the broad acceptance in the United States of LLCs as a tax transparent enterprise is not universally accepted overseas and their use to form a domestic U.S. collaborative entity for a foreign enterprise can lead to unexpected results. In December 2000, the UK Inland Revenue (now known as Her Majesty's Revenue and Customs following a merger of government bodies) published a list of various overseas entities, confirming which of them it considered to be tax "transparent" and which "opaque." A U.S. LLC enterprise that has elected to be "transparent" is nonetheless deemed "opaque" for UK tax purposes (so it is taxed like a company, as an entity in its own right, and its members are only taxed on distributions received), whereas a U.S. "transparent" limited partnership ("LP") is deemed "transparent" for UK tax purposes (so its income is imputed to its members who are taxed on their proportional share of the LP's profit). This treatment in England of a U.S. LLC as "opaque" and not "transparent" entity results in first, the U.S. losses of an enterprise LLC not being passed through to its English owners and not being recognized as losses in England; second, the distributions from a U.S. enterprise LLC to its English owners being taxed by Revenue and Customs at the higher corporate income tax rate as compared to lower personal rates and third, any taxes paid in the United States by the enterprise LLC not being available as tax credits in England. In such a circumstance, a better structural alternative to consider is that of an LP which has the same federal and state tax transparency as an LLC in the U.S. and has the benefit of also being considered transparent under the current English classification schedule.

It is not uncommon for clients to want to structure and start upon their collaboration immediately, contemplating one or more alternative candidates from several different jurisdictions and only later obtain a fuller understanding of the tax consequences of the structure when the selection of the candidate is finalized. A tactical consideration in this circumstance is to take advantage of conversion provisions of LLC and LP state governance statutes that permit the owners of such entities by majority vote to simply elect to convert the entity from LLC to LP and vice versa as their circumstances and tax-planning dictate.

Debt/Equity Ratio

In connection with the formation and capitalization of an operating enterprise, counsel often suggests that the client utilize a combination of loans as well as an equity capital investment. Although there is no capital tax upon formation here in the United States, counsel may generally recommend that the ratio of debt to equity of the U.S. operating enterprise not exceed a ratio of U.S. $3 to U.S. $2. The reason for this limitation is that a higher debt to equity ratio may result in a portion of the interest paid by an operating corporation to its owners being deemed to be in the nature of a dividend and not deductible for purposes of computing taxable or net income.

Collaboration Licensing Variations.

It is always possible that an offshore life science innovation is simply sold or exclusively licensed to a larger life science enterprise that has ongoing clinical trials, established regulatory and marketing operations and is better capitalized for funding development of the innovation. However, in the author's experience, innovators seldom take this approach often for good reasons such as only they may have the full understanding of the underlying technology upon which the innovation is founded. In our experience, it is more likely that the collaboration proceeds on some manner of a joint development basis, typically employing the respective strengths of both the offshore innovator and our region's better capitalized enterprise (the "licensee collaborator") and thereby sharing the risks and rewards of the success or failure of the innovation's development into a marketable product.

One frequently used variation is seen when a licensee collaborator pays the innovator an initial upfront royalty payment for the exclusive working license to use the innovation in a specified field of use and/or geographic area and the innovator retains the remaining rights outside the field of use and/or geographic area. Often, additional milestone royalty payments can be made to the extent development successfully proceeds. Based on the circumstances, there can be a myriad of variations including the innovator retaining the right to co-market in its home country or the licensee collaborator having options of first negotiation or right of matching a best offer for the licensing of the innovation outside the specified field of use. Other features can include the licensee collaborator funding the innovator under an ongoing research and development contract with future funding extensions of the contract to the extent the innovation successfully proceeds through clinical testing and regulatory approvals. Such variations provide funding for the innovator to continue development in its home country and typically develop the innovation both within and without the licensed field of use. With the validation of the innovation in the marketplace created by the licensee collaborator funding development of the innovation in a specified field of use, the innovating enterprise often finds itself better situated in attracting venture capital for its own further innovation development efforts. A further variation to consider is where the licensee collaborator loans the innovator the funding required for product development and clinical trials, such loan to be either convertible into innovator equity (often limited to a non-controlling 19.9% interest); paid back at a percentage of product sales when the innovation becomes commercialized or written off if commercialization ultimately does not take place.

To guide the innovation through the development process, the innovator and licensee collaborator often form a steering committee to manage the joint collaboration process, the control of which may lay with the innovator during early development and with the licensee collaborator as the innovation goes into clinical trials, preliminary market approval ("PMA") and product commercialization. Even though GMP and production processes may not be initially known, the innovating enterprise may enter into a manufacturing agreement at to-be-determined prices with its collaborator licensee as a further commitment of the parties to the joint collaboration process.

Other Observations; Patent Prosecution.

For an innovator enterprise to have its innovation patented is often considered a key step in the innovation commercialization and venture capital sources typically want to see an innovation protected by an active IP portfolio. Here too international trade counsel can assist its foreign clients in recognizing comparative advantages of the patent prosecution process in the U.S. market. In general, the cost of preparing and filing a patent application for an innovation in any country that is a signatory to the Paris Convention can range from U.S. $5,000 to U.S. $50,000 and beyond (particularly when working with pharmaceuticals or biotechnology) and take years to accomplish depending on the innovation's complexity. The act of filing a patent application is an important milestone under the doctrine of absolute novelty as it is applied outside the United States; the dissemination of a patentable innovation into the commercial market prior to the patent application filing thereafter renders the innovation as no longer novel and thus no longer patentable. One can imagine the chagrin of the CEO of a foreign innovator enterprise watching his chief scientist at an academic symposium scrawling the basis of the not yet filed innovation on the blackboard to demonstrate his point to the audience. In contrast, our view is that the U.S. patent system is much friendlier to the innovator. Unlike most of the rest of the world which adheres to a "first-to-file" system, the U.S. "first-to-invent" system provides the innovator one year to file its patent application from the first date of commercial market dissemination of the innovation. Thus, the innovation inadvertently disclosed at a European symposium cannot be patented in Europe but could still be patented in the United States if filed within one year from its disclosure at the symposium, a major consideration as the U.S. remains the world's largest healthcare market.

One of the major elements of preparing a patent application is the lengthy and costly effort in crafting its claims. To encourage innovation, the U.S. patent system has adopted a parallel provisional patent application regimen by which, for example, a scientist's power point slide disclosing an innovation to be shown at Friday's symposium can be simply filed with the U.S. PTO under a cover letter received Thursday as a provisional patent application. This simple description of the innovation without any requirement to provide claims puts the innovation on record as of the date of provisional filing and establishes a priority filing date for the non-provisional or "utility" patent application which must be filed on or before the expiration of one year from the provisional filing date. Once filed, the initial power point slide description can be amended from time to time with more comprehensive disclosure, all of which remains confidential. The U.S. provisional patent process permits innovations to be protected while funds are raised for the enterprise to pay for the cost of preparing the innovation's definitive (non-provisional or "utility") patent application having claims directed to the innovation described in the application.

Part III of this article will appear in a subsequent issue of this publication.

Stanley U. North is a Member of Sills Cummis Epstein & Gross P.C. and was recently appointed First Chair of the International Trade and Investment Committee of the International Law Section of the New Jersey State Bar Association.

Please email the author at snorth@sillscummis.com with questions about this article.