Recent shifts in international trade policies have led to the imposition of new tariffs prompting life science companies to reassess their license agreements to understand the potential impact of these new tariffs on royalty calculations under such agreements.
Understanding Net Sales Deductions
Marketers of pharmaceutical drug products often owe royalties to their licensors of intellectual property rights covering the manufacture, use or sale of such products. In most license agreements, such royalties are calculated based on “Net Sales,” which typically refers to gross sales of a unit of drug product minus specific permitted deductions. Common permitted deductions include returns, discounts, and certain taxes directly related to the sale. These deductions usually pertain to the final sale to the end customer or distributor of such drug product. Notably, deductions might include sales taxes or customs duties explicitly stated in the invoiced price for a unit of drug product and not reimbursed by the buyer.
Tariffs as Part of Cost of Goods Sold (COGS)
Tariffs incurred upstream by marketers of drug products, especially those paid during the importation of the finished product or its active ingredient or intermediates from outside of the U.S., are generally considered part of the Cost of Goods Sold (COGS). As these costs are incurred before the drug product is sold, they are typically not deductible from gross sales when calculating Net Sales for purposes of determining royalties owed to an upstream licensor, unless the license agreement explicitly allows it. This distinction underscores the importance of understanding how different costs are categorized within financial and contractual frameworks.
Domestic Sales and Tariff Implications
For transactions where a U.S.-based marketer of a drug product sells to a U.S.-based end customer or distributor, tariffs are generally not a factor, as these sales do not involve imported goods subject to tariffs. Therefore, in such domestic scenarios, tariff considerations are unlikely to impact Net Sales calculations and associated royalty payments. Where a U.S.-based marketer of a drug product has purchased the finished form of such product, its API or other raw materials from a foreign manufacturer, the imposition of tariffs on that purchase will normally not result in an allowable deduction of such tariffs in calculating Net Sales and corresponding royalties owed to an upstream licensor. Typically, import tariffs or “custom duties” are specified to be deductible from gross sales to determine Net Sales only “if paid by the buyer.” In this context, “the buyer” is the end customer or distributor of the drug product, not the importing marketer itself. Therefore, unless, the end customer or distributor pays the tariffs directly (e.g., shown separately on invoice) or the license agreement defines “buyer” more broadly or the marketer/company seller is acting as a distributor that pays on behalf of the buyer and can pass through the tariffs as a cost, the marketer/company seller likely will owe royalties on the full pre-tariff gross sales of the drug product.
The Importance of Reviewing Contract Language
There is great variability in how license agreements define Net Sales and allowable deductions. It will be critical for companies to carefully review the language of their contracts. Specific language in the license agreement will dictate whether tariffs can be deducted by marketers of drug products when calculating royalties. Additionally, direct cross-border sales may have unique considerations that could affect these calculations.
For a comprehensive analysis tailored to your company’s specific situation, we encourage you to contact Karen Spindler or Mary Beth Maloney.