United States: New Jersey Tax Court Rules That Joint License Agreement Created a Partnership and Required use of Separate Accounting Method

The New Jersey Tax Court, in Chiron Corporation v. Division of Taxation 2004 N.J. LEXIS 20 (NJ Tax Ct., Docket No. 000120-1999), ruled that entry into a joint license, research and supply agreement created a partnership for New Jersey tax purposes and that the corporate partner had to use the "separate entity method" to apportion its distributive share of the partnership’s business income.

Chiron Corp., a Delaware corporation with its headquarters in California, was engaged primarily in the business of manufacturing antigens and antibodies usable for detecting the hepatitis C virus and HIV and manufacturing other biological agents usable to detect human diseases. It did not engage in any separate business in New Jersey.

Because it lacked adequate capabilities to manufacture, market and sell test kits using its technology, Chiron entered into a joint license, research and supply agreement with Ortho Diagnostics Systems, Inc., an unrelated corporation, which had offices and operations in New Jersey. Pursuant to this agreement, Chiron agreed to conduct a research program for the development of antigens and antibodies to be used for diagnostic testing and Ortho agreed to perform clinical and pre-clinical trials with respect to any antigens and antibodies developed by Chiron. Under the agreement, Chiron also agreed to supply Ortho’s requirements for antigens and antibodies and Ortho agreed to purchase its entire requirements from Chiron. Chiron granted Ortho an exclusive worldwide license to Chiron’s inventions and discoveries developed during the research program and any patents which Chiron might obtain in connection with the research. In return, Ortho granted to Chiron a worldwide nonexclusive royalty free license for inventions and discoveries relating to Ortho’s use of antigens and antibodies and development of test kits using the antigens and antibodies.

The parties did not separately execute a partnership agreement or form a special purpose entity — such as an LLC —for purpose of this endeavor. While the joint business filed a federal partnership income tax return (using its own federal tax ID number), it did not file partnership tax returns in New Jersey. Chiron did file a New Jersey Corporation Business Tax Return and reported its income from the joint business as income from the "Ortho Joint Venture."

A partnership is treated as a flow-through entity for New Jersey tax purposes. When a corporate partner includes a distributive share of partnership income in its apportionable tax base, it also includes a share of the partnership’s factors in its apportionment formula. There are two methods by which a partnership’s factors can be reflected in the corporate partner’s apportionment formula — the "flow through method" and the "separate entity method."

If the corporate partner and partnership are engaged in a unitary business, New Jersey requires use of the flow-through method so that all of the corporation’s income from the unitary business — including the partnership income — is apportioned together. Under the flow-through method, the corporate partner’s factors are combined with the partner’s share of the partnership’s factors. If the corporate partner and the partnership are not engaged in a unitary business, New Jersey requires that the "separate entity method" be used. Under the "separate entity method," the partner’s distributive share of partnership income is separately apportioned by the partnership’s own factors.

Chiron took the return position that its joint business with Ortho constituted a joint venture — and not a partnership — for New Jersey tax purposes and that one-half of its sales of antibodies and antigens to the joint venture constituted, in effect, sales to itself (so it excluded such "self-sales" in the numerator and the denominator of its receipts factor). In court, Chiron also argued that, even if the joint business constituted a partnership, it was entitled to utilize the flow-through method because it was engaged in a unitary business with the joint business. The New Jersey Division of Taxation argued that the joint business constituted a partnership and that Chiron had to use the separate entity method.

The Tax Court first held that the joint business constituted a separate partnership domiciled in New Jersey for tax purposes, finding no basis for treating joint ventures and partnerships differently. Therefore, the Tax Court held that the sales to the joint business had to be included in the numerator of the sales factor. The Tax Court then held that Chiron was not entitled to use the flow-through method to apportion its distributive share of the partnership’s business income, concluding that Chiron was not unitary or integrated with the joint business — even though Chiron derived most of its revenue from the joint business.

The decision serves as a reminder that one does not need to enter into a formal partnership agreement or form a limited partnership or an LLC to create a partnership for federal and state income tax purposes. Entry into a joint research and licensing agreement can create a partnership for tax purposes. The decision also demonstrates how taxing authorities will argue for or against a finding of unitary business based on the amount of tax revenues that will be generated. In this case, the New Jersey Division of Taxation argued against a finding of unitary business because the amount of Chiron’s distributive share of the joint business’ income allocated to New Jersey under the separate entity method was lower than the amount that would have been allocated under the flow through method. Query whether the New Jersey Division of Taxation would have argued against use of the flow-through method under these facts if it resulted in greater tax revenues.

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