Arsene Taxand - Corporate Tax management and strategy

Amortization of intangible assets: toward recognition of amortization of the customer base?

In three recent, long-awaited decisions relating to the amortization of the rights held with regard to marketing authorizations for pharmaceutical specialties, the Conseil d'Etat (French Supreme administrative court) had the opportunity to clarify its case law relating to the amortization of intangible assets. These decisions open new horizons with regard to the amortization of the customer base attached to brands of products.

Furthermore, a question arises with regard to the application of this case law under the new accounting standards.

1. Nature of the rights held with regard to the marketing authorizations for pharmaceutical specialties

Three intangibles are supporting elements for a pharmaceutical specialty: the patent for the molecule, the marketing authorization (autorisation de mise sur le marché or "AMM"), which is the regulatory approval for the specialty, and the brand name under which the specialty is marketed.

The patent is obtained after completion of fundamental research and grants its holder an exclusive right to use the molecule commercially for a period of twenty years, which may be extended for a maximum period of five years (Articles L 611-2 and 3 of the French Code of Intellectual Property).

After termination of the fundamental research phase, the next step is the development of the specialty which comprises various stages that are described in minute detail by the French Public Health Code (code de la santé publique or "CSP"), including clinical trials. The results of this work are recorded in technical dossiers, which are filed with the health authorities and make it possible to obtain the marketing authorization in accordance with the procedure described in Articles R 5121-21 et seq. of the French Public Health Code.

The marketing authorization is issued for a period of five years and is renewable at the end of such period. If the marketing authorization does not grant its holder a specific right of exclusivity, it is afforded legal protection for ten years. It must be noted that a marketing authorization for a generic product may only be obtained at the end of this period on the basis of the first dossiers filed (simplified procedure provided for in Article R 5121-29 2° c) of the French Public Health Code).

It thus appears that, in practice, pharmaceutical specialties benefit from twofold protection (patent protection and protection of the technical dossiers).

Finally, it should be noted that the marketing authorization is issued on a personal basis and may be transferred with the agreement of its holder, who then transfers the technical dossiers for the marketing authorization to his successor (the procedure provided for in Article R 5121-46 of the French Public Health Code).

Furthermore, the holder of the marketing authorization may authorize a third party to use its technical dossiers with a view to applying for a second marketing authorization that will enable commercial use of the same specialty under a different brand name (procedure provided for in Article R 5121-29 2° a) of the French Public Health Code).

It can therefore be considered that the rights of the holder of a marketing authorization are transferable.

2. Possibility of amortizing the rights held with regard to a marketing authorization

The question of amortization of the expenditure incurred in order to obtain a marketing authorization does not arise for the entity which developed the pharmaceutical specialty inasmuch as the expenses for compiling the technical dossiers with a view to obtaining the marketing authorization are regarded as research expenditure that is immediately tax deductible on the basis of Article 236 of the French Tax Code.

On the ot her hand, the purchase price of the technical dossiers relating to a marketing authorization or the price paid to use existing dossiers in order to obtain a second marketing authorization for the same product must be recognized as a fixed asset inasmuch as these dossiers include the results of research work completed by a third party (and cannot therefore be considered as research expenditure) and these dossiers make it possible to obtain an authorization that meets the three conditions required by the Conseil d'Etat for recognizing intangible assets (beneficial effect on the company's operations, durable use and transferability).

With regard to amortization of the rights acquired in this manner, the decisions by the Conseil d'Etat commented on in this article appear to adopt precisely the same line of reasoning as prior court decisions.

As is the case for any fixed asset, the line of reasoning followed by the Supreme Court regarding amortization is split into two stages:

- Firstly, the question of the principle of amortization is examined:

An intangible asset can only give rise to an annual amortization charge "if it is normally foreseeable, at the time of its creation or its purchase by the company, that its beneficial effects will come to an end on a given date."

- Secondly, in the event of a positive answer to the first question, the question of the amortization period is then dealt with.

The amortization period is the expected length of the beneficial effects of the intangible on the company's operations, as such period is "accepted based on customary practice in the profession or justified by circumstances specific to the company of which the company has to establish the actual existence."

2.1 The principle of amortization

According to the law officer, Mr. Stéphane Verclytte, whose opinion is set out under the October 14, 2005 decisions, an assessment of the amortizable character of the rights with regard to the marketing authorization may not be made independently of the drug itself. In this regard, these rights are only the supporting elements used to sell the drug and their period of use may not be extended beyond the useful life of the drug itself.

The foreseeable nature of the end of the beneficial effects of a drug is unquestionable inasmuch as, like any product which is the result of scientific research, a drug will necessarily become obsolete in the future due to evolutions in science.

According to the statistics of the Agence française de sécurité sanitaire des produits de santé (the French agency for the safety of healthcare products) cited by the law officer, it appears that drugs have a useful life that is limited in time (with an average lifespan of 8 years for drugs sold in hospitals and 14 years for drugs sold in retail pharmacies).

The Supreme administrative court therefore logically overturned the decisions of the Paris Administrative Court of Appeal that held that the rights of the plaintiffs with regard to the marketing authorizations were not amortizable.

This line of reasoning can be transposed to the brand name under which the drug is sold in order to conclude that the brand can also be amortized over the useful life of the drug inasmuch as it constitutes one of the supporting elements used to sell the drug, like the technical dossiers and the marketing authorization.

It can thus be considered that the customer base attached to a drug, which is undeniably an element that is separable from the ongoing business assets, may be amortized over the useful life of the drug to which it is attached.

The wording of the decisions commented on here appears to imply that, in the eyes of the Conseil d'Etat, the principle of amortization is only accepte d if the period of use of the intangible is foreseeable.

In actual fact, the requirement of foreseeability concerns the end of the beneficial effects of commercial use of the intangible, namely the irreversible nature of the loss in value, and not the period of use.

If the taxpayer had to demonstrate the foreseeable date of the end of the beneficial effects of the intangible, it would demonstrate both the amortizable character and the amortization period of such intangible. The line of reasoning would then only consist of one stage and customary practices would not serve any useful purpose.

It will be noted in this regard that in its December 28, 2005 decision, the Conseil d'Etat admitted the principle of amortization but rejected the period applied by the company (5 years), which duly confirms that the Court reasons in two stages.

2.2 The amortization period

With regard to the period of amortization of the rights to sell drugs, the Conseil d'Etat held that the taxpayers did not demonstrate the existence of customary practices, but did not preclude the potential existence of such practices (in particular, in the case judged on December 28, 2005).

For his part, the law officer, Mr. Verclytte, questions the existence of customary practices on the ground "that it is doubtful that it [the practice] is widespread in light of the tax authorities' position on principle." Such a demonstration consisting in arguing that the unfounded obstruction made on principle by the French tax authorities to the deduction of the amortization of the rights relating to marketing authorizations prevents the existence of customary practices may be seen as surprising.

Although companies may have been refused the right to deduct the amortization of the rights with regard to the marketing authorizations for tax purposes, it nevertheless remains that the vast majority of pharmaceutical laboratories deduct this amortization in their statutory financial statements (and not only in their consolidated financial statements) and this amortization is then added back below the line for tax purposes. Thus, according to a study carried out by the federation of pharmaceutical companies (syndicat des entreprises pharmaceutiques or "LEEM"), more than three-quarters of the laboratories amortize the purchase price of technical dossiers over an amortization period of between five and ten years.

Customary practices therefore seem to us to result from accounting practice, especially if this practice is not in contradiction with the tax principles.

While awaiting recognition by the courts of the existence of customary practices in the field of pharmaceuticals, the amortization period to be applied should correspond to the "normal period of use" of the intangible asset (assessment of the amortization period in accordance with the "circumstances specific to the company" is only required when the company wishes to depart from customary practices, which presupposes that such customary practices must exist.)

With regard to determination of the normal period of use, it can be noted, from the above-mentioned opinion of the law officer, Mr. Verclytte, that two possible methods can be used:

- this period of use could be determined on the basis of an analysis of the market to which the specialty belongs (average period of use determined by category of specialty);

- it could also correspond to the estimated useful life of the specialty applied at the time of its acquisition with a view to determining its purchase price (the specific period applied in each particular case).
In practice, these two methods should lead to identical amortization periods (except in special cases, the estimated useful life of a specialty at the time of its acquisition should be the average useful life of specialties belonging to the same category).

In order to determine the normal period of use of the rights to sell a pharmaceutical specialty, an assessment will need to be made of the market to which such specialty belongs (it is not inconceivable that, in the long run, customary practices may be recognized by major category of specialty).

Like any question which is based on an assessment of the facts, the burden of proof should rest with the taxpayers.

Save in exceptional circumstances, the courts should accept amortization periods of between 5 and 15 years and it is reasonable to believe that the shorter the amortization period applied by the company, the greater the evidence that will be required (the Conseil d'Etat was particularly undemanding in terms of proof with regard to the period of 15 years applied in one of the two cases judged on October 14, 2005, whereas it proved to be implacable in the case judged on December 28 of the same year where the period in question was 5 years).

The question raised is whether the amortization period for specialties protected by a patent must be the same as the residual life of the patent (or of the technical dossiers if this is longer).

Undeniably, the value of a drug decreases considerably when the patent and technical dossiers fall into the public domain due to the appearance of generics, although the drug continues to have a certain value.

We consider that it should be possible to apply the residual period of patent protection and of the life of the technical dossiers on condition that the foreseeable nature of the loss of almost the entire value of the specialty upon the expiration of this period can be demonstrated. If no such demonstration can be made, the loss in value suffered by the specialty as a result of the appearance of generics may only be recognized by booking a provision for impairment.

In actual fact, it appears that straight-line amortization does not make it possible to reflect the significant loss in value sustained by the original pharmaceutical specialties at the time of appearance of generics.

3. The impact of the new accounting standards

The impact of the new accounting standards that came into force from January 1, 2005 onwards on the principles laid down by the Conseil d'Etat with regard to the amortization of intangible assets should also be analyzed.

It should be noted that the new accounting standards do not make any distinction between tangible and intangible assets.

In accordance with Article 322-1.1 of the French Chart of Accounts as resulting from CRC regulation No. 2002-10 of December 12, 2002, a fixed asset is amortizable or depreciable when its useful life for the entity is determinable. According to CNC (French National Accounting Board) recommendation No. 2002-07 of June 27, 2002, a fixed asset is considered as having an undeterminable period of use where there is no foreseeable limit to the period during which it is expected that the fixed asset will procure economic benefits for the company.

There are therefore certain similarities between the terms used by Conseil d'Etat and this new accounting definition. However, there is an essential difference between the two: the notion of customary practices is still in force from a tax standpoint, whereas it can no longer be applied from an accounting perspective.

Accordingly, from an accounting perspective, a fixed asset can only be amortized if the date of the end of its beneficial effects is determinable, which means that the assessment of the amortizable character of a fixed asset and of its amortization period is governed by a single-stage reasoning, whereas from a fiscal standpoint, a two-phase reasoning is still applied (principle followed by the period).

However, in the absence of customary practices recognized by the courts from a fiscal standpoint, the two approaches should have exactly the same effect.

Roland Schneider