August 22, 2023
Third Circuit upholds Tax Court's ruling that pharmaceutical company may deduct legal fees incurred in defending against patent infringement lawsuits
In Mylan v. Commissioner, the US Court of Appeals for the Third Circuit (Appeals Court) affirmed a Tax Court ruling that patent infringement litigation expenses resulting from ANDA filings are ordinary and necessary business expenses that may be deducted under IRC Section 162(a). See Tax Alert 2021-0991 for the Tax Court ruling.
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 with certifications that the patents for the branded drugs at issue were invalid or would not be infringed by the manufacture, use or sale of the generic version, also known as paragraph IV certifications.
Once Mylan filed the ANDAs with paragraph IV certifications, it sent formal notice letters, as required by the FDA, 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 on 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 with paragraph IV certifications. If the FDA approved a drug before the lawsuit was concluded, Mylan continued defending the lawsuit 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 attributing the expenses to litigating these lawsuits. 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 for approximately $16.4 million, $12.6 million and $21 million. Mylan filed suit in the Tax Court.
Tax Court ruling
The Tax Court concluded that the lawsuits were not a step in the FDA-approval process for generic drugs, finding that they have "no bearing on the FDA's safety and bioequivalence review." Therefore, the Tax Court held that the expenses Mylan incurred to defend the lawsuits were not paid to facilitate the transaction and were not required to be capitalized. Citing Urquhart v. Commissioner, 215 F.2d 17 (3d Cir. 1954), rev'g 20 T.C. 944 (1953), the Tax Court held that the litigation expenses incurred as a result of the infringement lawsuits against Mylan were deductible under IRC Section 162(a) as ordinary and necessary business activities.
Third Circuit affirms
The IRS appealed the decision to the Third Circuit, which affirmed the Tax Court's ruling. The Appeals Court cited its earlier ruling in Urquhart for the precedent that patent infringement litigation expenses are ordinary and necessary business expenses that are deductible under IRC Section 162(a).
While Treas. Reg. Section 1.263(a)-4 and -5 governed when to capitalize expenses related to intangible assets, the Appeals Court said, the issue is when the amount is paid to "facilitate" the acquisition or creation of intangibles. Under the regulations, an amount is paid to facilitate acquiring or creating an intangible "if the amount is paid in the process of investigating or otherwise pursuing the transaction." Further, "[i]n determining whether an amount is paid to facilitate a transaction, the fact that the amount would (or would not) have been paid but for the transaction is relevant, but is not determinative" (see Treas. Reg. Section 1.263(a)-4(e)(1)(i)).
Mylan argued that ANDA litigation costs resulting from the paragraph IV certifications do not facilitate the acquisition of FDA approval since approval can be granted regardless of whether the litigation has resolved. The IRS argued that a generic drug company's choice to make a paragraph IV certification is part of the statutory process for achieving approval of an ANDA.
The Appeals Court agreed with Mylan and the Tax Court that the patent infringement lawsuits were not a step in the FDA-approval process for generic drugs and therefore did not facilitate FDA approval. "Win or lose, the outcome of patent litigation is irrelevant to the FDA's review; the generic is considered either safe and effective, or not," the Appeals Court said, noting that generic drugs can be marketed even if patent litigation is pending as long as the FDA approves the ANDA and the company is willing to take that risk. Further, the Appeals court explained, " … even if the generic manufacturer loses the patent suit after receiving effective approval, the FDA does not revoke or suspend approval, but merely converts the approval to a tentative approval effective after the expiration of the relevant patents." "Patent litigation, if it occurs at all after a paragraph IV certification, does not facilitate the acquisition of an FDA-approved ANDA because the two processes are distinct and ultimately separate," the Third Circuit said. The Third Circuit was unwilling to extend the concept of "facilitative" to any amount paid in the process of investigating or pursuing the acquisition of an intangible asset, as the IRS suggested.
The IRS argued that the origin and nature of the claim that caused Mylan's litigation expenses was the FDA approval and required capitalization. This argument failed recently in Actavis Laboratories FL Inc. v. United States, 161 Fed.Cl. 334 (2022), where the Federal Court of Claims, quoting United States v. Gilmore, 372 U.S. 39 (1963), said "deductibility of 'litigation costs of resisting a claim depends on whether or not the claim arises in connection with the taxpayer's profit-seeking activities … It does not depend on the consequences that might result to a taxpayer's income-producing property from a failure to defeat the claim for … that 'would carry us to far'.'" In Actavis, the Court found that patent infringement claims were akin to claims for trespass, a tort action, and that case law did not support the government's construction of the 'origin of the claim' test. For many of the same reasons cited by the Third Circuit in Mylan, the Federal Court of Claims granted the taxpayer's motion for summary judgment, finding that the litigation expenses to defend a patent infringement suit under the Hatch-Waxman Act were deductible.
Although not at issue in the appeal to the Third Circuit, the Tax Court held 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." The notice letters are distinguished from the litigation costs because notice letters are a required step for FDA approval of a generic drug, unlike patent infringement litigation, since FDA approval can be granted regardless of how the litigation resolves.
The Third Circuit's statement that there was no valid distinction in tax treatment of litigation costs between the party prosecuting the patent infringement claim and the party defending the claim, or whether the costs are incurred as a result of the Hatch-Waxman Act or after a drug is commercially marketed, demonstrates the court's finding that the taxpayer's litigation costs were not in pursuit of the acquisition or creation of an intangible asset. This decision, and its reasoning, are similar to the Federal Court of Claims summary judgment order in Actavis and provides another strong basis on which to claim a deduction for litigation costs triggered under the Hatch-Waxman Act. The Third Circuit has also provided a careful analysis of what it means for a cost to "facilitate" a transaction for purposes of Treas. Reg. Section 1.263(a)-4, which may be useful for analyzing whether costs related to intangible creation or acquisition must be capitalized.
Taxpayers that incur ANDA-related patent infringement litigation costs, and have historically deducted these costs, have new certainty in their tax positions. Taxpayers that have been capitalizing and amortizing these costs under IRS guidance should consider filing an accounting method change to begin deducting such costs, which would result in a favorable IRC Section 481(a) adjustment.
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor