Royalties on Revenue: can you Deduct Rebates?

The English High Court recently decided a dispute over royalty payments in relation to a pharmaceutical product. The main issue was whether rebates given to industry intermediaries could be deducted from the "gross income" on which royalties were based. The court found that rebates were properly deductible, even though they were not mentioned in the agreement. This case provides useful guidance for other parties involved in royalty agreements, especially in the pharmaceutical sector.

The claimant, Eteboxagu AB, was due royalties on sales of a drug called NITYR by the defendant, Cycle Pharmaceuticals Ltd, in the US market. Under the agreement, Cycle had to pay Eteboxagu a royalty of 5% of its "Relevant Revenues" from sales of NITYR. The agreement defined "Relevant Revenues" as "Cycle’s gross income from the sale of and/or generated by the Product excluding VAT and transport costs". 

Cycle sold NITYR through distributors and specialty pharmacies. As is customary in the US, Cycle offered rebates on the price of NITYR. Cycle deducted these rebates from its gross income before calculating the royalties. Eteboxagu argued that this was wrong, and that rebates should be treated as part of the gross income.

The court disagreed with Eteboxagu, and held that rebates were deductible from gross income, even though this was not expressly stated in the agreement. The court interpreted the agreement in light of what a reasonable person would have understood the parties to have meant by the language that they had used, taking into account such background knowledge as was either known or reasonably available to both of them at the date of the contract. The court found that the parties intended "gross income" to mean Cycle's effective income after rebates, not the nominal amount invoiced. This was consistent with the economic reality of Cycle's income, as rebates reduced the actual consideration received by Cycle. The court also noted that FRS accounting standards supported this view. 

This case illustrates the importance of clearly defining the terms of royalty agreements – especially defining revenue – and of taking into account the economic realities of the relevant market. It also shows that rebates in the pharmaceutical industry can affect the calculation of royalties, even where they are not expressly mentioned in the relevant agreement. We would expect deductions from “Relevant Revenues” to be clearly defined. This case shows the perils of failing to do that.