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In Mylan, Inc. & Subsidiaries v. Commissioner, the Tax Court has held that a pharmaceutical company may deduct under IRC Section 162 the legal expenses incurred in defending against patent infringement lawsuits that may arise after an abbreviated new drug application (ANDA) filing, but must capitalize the costs of preparing the notice letters required to obtain FDA approval of the ANDA under IRC Section 263(a).

Facts

Mylan is a group of affiliated corporations that manufactures brand name and generic pharmaceuticals. To obtain FDA approval for generic versions of brand name drugs, Mylan submitted ANDAs and certifications that "any patent 'is invalid or will not be infringed by the manufacture, use, or sale' of the generic version," also known as paragraph IV certifications.

Once Mylan filed the ANDAs and paragraph IV certifications, and as required under FDA rules, it "sent formal notice letters to the brand name drug manufacturers and patentees implicated by the certifications," setting forth the details of the patents' invalidity or the reasons that the manufacture, use or sale of the generic versions did not infringe the patents. From 2012 through 2014, Mylan defended itself against lawsuits brought under 35 U.S.C. Section 271(e)(2) in response to the ANDAs and paragraph IV certifications. If the FDA approved a drug before the lawsuit was concluded, Mylan continued defending the suit and, at times, chose to launch the generic drug before the lawsuit was resolved.

In 2012, 2013 and 2014, Mylan incurred legal fees of approximately $46 million, $38 million and $39 million, respectively, to prepare notice letters and litigate the lawsuits. Mylan filed income tax returns for the 2012, 2013 and 2014 tax years, and deducted the legal expenses, "broadly attribut[ing the expenses] to the litigation of [the] Section 271(e)(2) suits." The IRS denied the deductions, except for the deductions for legal expenses incurred in 2014 for drugs already approved by the FDA and commercially launched. The IRS asserted that the other legal expenses were nondeductible capital expenditures that had to be capitalized under IRC Section 263(a) and amortized under IRC Section 197. It issued notices of deficiency for the 2012, 2013 and 2014 tax years in the amounts of approximately $16.4 million, $12.6 million and $21 million. Mylan filed suit in the Tax Court.

Holding

Preparing notice letters

Treas. Reg. Section 1.263(a)-4(b)(i)(v) requires taxpayers to capitalize amounts paid to facilitate the acquisition or creation of an intangible, including rights obtained from a governmental agency (e.g., rights under a trademark, copyright, permit). In Santa Fe Pac. Gold Co. v. Commissioner, 132 T.C. 240, 262 (2009), the Tax Court found that under the "origin of the claim" test, "the substance of the underlying claim or transaction out of which the expenditure in controversy arose governs whether the item is a deductible expense or a capital expenditure, regardless of the motives of the payor or the consequences that may result from the failure to defeat the claim."

The court ruled that the legal fees incurred for preparing and sending out the notice letters required as part of the ANDA-approval process must be capitalized, concluding that the "notice letters constitute amounts incurred 'investigating or otherwise pursuing' the transaction of creating FDA-approved ANDAs."

Patent infringement litigation

With respect to the litigation expenses related to the Section 271(e)(2) lawsuits, the court concluded that the lawsuits are not a step in the FDA-approval process for generic drugs, finding that those lawsuits have "no bearing on the FDA's safety and bioequivalence review." Therefore, the court ruled that the expenses Mylan incurred to defend the lawsuits "were not 'paid to facilitate' the transaction and are not required to be capitalized."

Citing Urquhart v. Commissioner, 215 F.2d 17 (3d Cir. 1954), rev'g 20 T.C. 944 (1953), the court held that the litigation expenses incurred as a result of the infringement suits against Mylan are deductible under IRC Section 162(a) as ordinary and necessary business activities.

Implications

The Tax Court's decision is consistent with a long history of case law that holds that patent infringement litigation costs are deductible as ordinary and necessary business expenses and is a welcome clarification that these costs remain deductible when incurred in the ANDA context. As the Tax Court noted in its analysis, "Congress' decision to coordinate effective FDA approval with the outcome of a Section 271(e)(2) suit does not convert such litigation into a link in the ANDA approval chain. To the contrary, a Section 271(e)(2) suit serves the same function as a normal patent infringement suit." Taxpayers who incur ANDA-related patent infringement litigation costs, and who have historically deducted these costs, have new certainty in their tax positions. Taxpayers who have been capitalizing and amortizing these costs pursuant to IRS guidance should consider filing an accounting method change to begin deducting such costs, which would also include a favorable IRC Section 481(a) adjustment.

Additionally, the Tax Court distinguished deductible patent infringement litigation costs from the legal fees incurred to prepare and distribute the notice letters to the brand name drug manufacturers and patentees. The Tax Court explained that the associated costs must be capitalized and amortized because these notice letters are a required step in the ANDA process, unlike the patent infringement litigation. However, the legal fees incurred to prepare the notice letters are likely a much lower cost to taxpayers than the legal fees incurred to defend against a patent infringement suit, and the tax impact could be relatively minor when compared to the deductibility of the litigation fees. In light of the distinct tax treatment prescribed by the Tax Court for the two different types of legal fees, taxpayers may find it necessary to begin separately tracking their notice letter preparation fees from their litigation fees. Taxpayers who have historically deducted both types of legal fees should consider filing an accounting method change to begin capitalizing and amortizing the notice letter preparation fees.

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