Generic drug manufacturer can deduct patent infringement suit expenses

By James A. Beavers, CPA, CGMA, J.D., LL.M.

A generic drug manufacturer, as part of applications for Food and Drug Administration (FDA) approval to produce and market generic versions of brand-name drugs, made certifications that the patents for the brand-name drugs were invalid or would not be infringed by the production and marketing of generic versions and sent letters to brand-name drug manufacturers giving notice of these certifications, which allowed the brand-name manufacturers to immediately file patent infringement lawsuits. The Tax Court held that the generic drug manufacturer must capitalize the legal expenses related to the notice letters because they were required as part of the FDA approval process; however, it held that the manufacturer could deduct its legal expenses from the patent infringement lawsuits that arose out of the certifications because the patent litigation was distinct from the approval process.


Mylan Inc. is a U.S. corporation that manufactures brand-name and generic pharmaceutical drugs. During the period in question, 2012 through 2014, Mylan sought FDA approval to manufacture generic versions of many brand-name drugs. In order to bring generic copies of brand-name drugs to market, under rules enacted in the Hatch-Waxman Act, P.L. 98-117, generic drug manufacturers like Mylan must submit applications (called abbreviated new drug applications, or ANDAs) to the FDA for approval to market and sell generic versions of the drugs.

As part of an ANDA, the applicant manufacturer may make what is known as a paragraph IV certification. This is a certification that the listed patents for the brand-name drug for which the applicant is seeking approval were invalid or would not be infringed by the manufacture of generic versions of the drug by the applicant. When the applicant makes such a certification, it is required to send notice letters to the brand-name drug manufacturer and any patentees of the drug, stating that the applicant company has made such a certification.

The practical importance of a paragraph IV certification by an applicant manufacturer is that under the Hatch-Waxman regime, it constitutes an act of patent infringement, giving the brand-name manufacturer and patentees the right to immediately bring a patent infringement suit against the applicant (a Section 271(e)(2) suit). The only difference between a Section 271(e)(2) lawsuit and a patent infringement lawsuit brought after a drug is being marketed is that the question of infringement must focus on what the ANDA applicant will likely market if its application is approved, rather than on a drug that is already being marketed. After an ANDA applicant makes a paragraph IV certification and sends notice letters to the applicable brand-name manufacturer and patentees, the manufacturer and the patentees frequently initiate Sec. 271(e)(2) lawsuits, and the ANDA applicants have significant legal expenses from these lawsuits.

Mylan, being a prolific manufacturer of generic drugs, had millions of dollars in legal expenses in 2012 through 2014 related to its preparation of ANDA applications and the notice letters it was required to send to brand-name manufacturers and patentees when these applications included a paragraph IV certification. It also had millions of dollars of legal expenses incurred in the various Section 271(e)(2) suits arising out of paragraph IV certifications that it was a party to in those years. Mylan timely filed a consolidated Form 1120, U.S. Corporation Income Tax Return, for each of its 2012, 2013, and 2014 tax years. On those returns Mylan took deductions of $46,991,172, $39,684,483, and $44,060,180, respectively, for legal fees and expenses.

These deductions for the years fell into the following categories: (1) legal fees incurred to prepare paragraph IV notice letters and defend Section 271(e)(2) suits in 2012 through 2014; (2) legal fees Mylan incurred with respect to generic drugs for which no Section 271(e)(2) suit was ever brought, or were brought but disposed of before the respective year for which the fees were claimed, and generic drugs for which Section 271(e)(2) suits were brought (or joined by Mylan) following the respective year for which the fees were claimed; and (3) legal fees incurred in 2014 with respect to drugs that had already been approved by the FDA and commercially launched.

The IRS examined Mylan's 2012 through 2014 returns and determined that, except for the third category of expense (i.e., the amounts incurred for previously approved and launched copies), all of Mylan's legal expenses were nondeductible capital expenditures required to be capitalized under Sec. 263(a) and amortized over 15 years under Sec. 197. Thus, it denied all of Mylan's current-year deductions for legal expenses, except for those in the third category, and issued notices of deficiency of $16,430,947 for 2012, $12,618,695 for 2013, and $20,988,657 for 2014.

Mylan petitioned the Tax Court for redetermination of the IRS's determinations for its 2012 through 2014 tax years.

Legal principles

An expenditure generally must be capitalized where it is determined that the expenditure either: (1) creates or enhances a separate and distinct asset, or (2) otherwise generates significant benefits for the taxpayer extending beyond the current tax year. Regs. Sec. 1.263(a)-4(b)(1) requires taxpayers to capitalize amounts paid, among others: (1) to acquire an existing intangible; (2) to create certain types of intangibles identified in Regs. Sec. 1.263(a)-4(d); (3) to create or enhance various "separate and distinct" intangibles; and (4) to create or enhance a "future benefit" identified in subsequent guidance published by the IRS.

Regs. Sec. 1.263(a)-4(d)(5)(i) provides, with respect to rights obtained from a governmental agency, that "[a] taxpayer must capitalize amounts paid to a governmental agency to obtain, renew, renegotiate, or upgrade its rights under a trademark, trade name, copyright, license, permit, franchise, or other similar right granted by that governmental agency." Whether this subsection applies is based on the facts and circumstances and disregards differences in the labels used in the regulations for an intangible and the labels used by the taxpayer and other parties to a transaction.

Regs. Sec. 1.263(a)-4(d)(9)(i) provides that a "taxpayer must capitalize amounts paid to another party to defend or perfect title to intangible property if that other party challenges the taxpayer's title to the intangible property." In the preamble to the proposed regulations (REG-125638-01), the IRS explained that this rule "is not intended to require capitalization of amounts paid to protect the property against infringement and to recover profits and damages as a result of infringement."

In addition to the direct cost of creating intangibles, a taxpayer must capitalize certain facilitative costs. These costs facilitate the acquisition or creation of an intangible, among other things, described in Regs. Sec. 1.263(a)-4(d). Per Regs. Sec. 1.263(a)-4(e)(1)(i):"[A]n amount is paid to facilitate the acquisition or creation of an intangible (the transaction) if the amount is paid in the process of investigating or otherwise pursuing the transaction." Whether an amount is paid in the process of investigating or otherwise pursuing a transaction is a facts-and-circumstances question, and whether or not the amount would have been paid but for the transaction is relevant but is not determinative.

The deductibility of a legal expense generally depends upon the origin and character of the claim with respect to which the expense was incurred. Under this "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" (Santa Fe Pac. Gold Co., 132 T.C. 240, 264 (2009)).

Patent law distinguishes suits for the defense of title to intellectual property from patent infringement litigation, and applying the origin-of-the-claim test to each type of lawsuit yields different results. Defense of title litigation is considered to involve the disposition or acquisition of a capital asset, and expenses in litigating such a suit have been treated as capital.

Patent infringement generally involves a claim by the patent owner for damages, in the form of lost income, caused by another party's infringement on a patent. Thus, an award of damages is ordinarily an award of compensation for gains or profits lost by the patent owner and is taxable to the patent owner as income in the year received. Accordingly, the Third Circuit (the circuit to which an appeal by Mylan would lie) held in Urquhart, 215 F.2d 17 (3d Cir. 1954), rev'g 20 T.C. 944 (1953), that litigation expenses from patent infringement suits are ordinary and necessary business expenses that are deductible in the year incurred.

The Tax Court's decision

The Tax Court held that Mylan was required to capitalize its legal expenses related to its issuance of notice letters but could currently deduct its expenses from Section 271(e)(2) patent infringement lawsuits. The Tax Court characterized the issue in dispute in the case as "whether the legal fees at issue were incurred to facilitate the acquisition of a right obtained from a Government agency." It first determined what the underlying transaction was and then moved to the question of whether Mylan's legal fees for preparing notice letters and for defending itself in Section 271(e)(2) lawsuits were paid in the process of investigating or otherwise pursuing that transaction.

Determination of the transaction: Both Mylan and the IRS described the relevant transaction at issue as the acquisition of an FDA-approved ANDA with a paragraph IV certification. Mylan asserted that the acquisition of an FDA-approved ANDA with a paragraph IV certification occurs when the FDA completes its scientific and technical review and issues either a tentative or final approval letter. The IRS disagreed, asserting that the acquisition of an FDA-approved ANDA with a paragraph IV certification occurs after the approval of an ANDA with a paragraph IV certification becomes effective.

The Tax Court observed that the right from the FDA to market a drug in interstate commerce is not conferred upon the ANDA applicant until the ANDA is effective. Consequently, the relevant intangible, a right obtained from a government agency, has not been created until the ANDA is effective. Therefore, the Tax Court adopted the IRS's interpretation of the transaction

Legal fees related to notice letters: The Tax Court found that the notice letters were part of the ANDA because sending the notice letters is a required step in securing an FDA-approved ANDA for applicants making a paragraph IV certification. The court came to this conclusion because under 21 U.S.C. Section 355(j)(2)(B)(i), an applicant that makes a paragraph IV certification "shall include" in its ANDA a statement that the applicant "will give notice" as outlined in 21 U.S.C. Section 355(j)(2)(B). Thus, under Regs. Sec. 1.263(a)-4(d)(5)(i), the legal expenses associated with the notice letters were required to be capitalized.

Legal fees incurred in Section 271(e)(2) lawsuits: The court found that although the filing of an ANDA with a paragraph IV certification, in addition to starting the FDA review process, triggers the opportunity for patent litigation, this did not transform patent litigation arising from a paragraph IV certification into part of the ANDA approval process created by the Hatch-Waxman Act. It further found that under the origin-of-the-claim test, legal fees from patent infringement litigation were ordinary and necessary business expenses. Therefore, Mylan did not have to capitalize its legal expenses from Section 271(e)(2) suits brought in response to the paragraph IV certifications and could deduct them in the year incurred.

The Tax Court gave several reasons why it believed that the ANDA approval process did not include the patent infringement litigation. First, the court noted that the purpose of the ANDA review was to ensure the safety and bioequivalence of the drug that was the subject of an ANDA application. However, the outcome of a Section 271(e)(2)suit does not have any effect on the FDA's safety and bioequivalence review, which indicated to the court that it was not part of the approval process.

Second, the court reasoned that the patent litigation framework implemented by the Hatch-Waxman Act also failed to suggest that the litigation was part of the approval process. The court determined that the framework was put in place to promote the prompt resolution of patent issues and that the IRS had failed to show how "encouraging early and expeditious patent litigation" was an element of the applicant obtaining effective FDA approval of an ANDA with a paragraph IV certification.

Third, the Tax Court rejected the IRS's contention that certain statutory provisions that linked the effective date of approval of an ANDA to the outcome of Section 271(e)(2) suits made patent litigation a part of the ANDA approval process. The court observed that a Section 271(e)(2) suit was not required for approval of an ANDA. It further observed that a brand-name drug manufacturer does not have an obligation to bring a suit in response to an ANDA with a paragraph IV certification and that the opportunity for a Sec. 271(e)(2) suit primarily benefited the patent holder. Thus, the court stated that it could not conclude that Sec. 271(e)(2) litigation, which was controlled by and primarily benefited patent holders, is a step in the approval process.

Finally, the Tax Court found that while Regs. Sec. 1.263(a)-4(e)(1)(i), which states that "the fact that the amount would (or would not) have been paid but for the transaction," is a relevant but not dispositive factor, would appear, on the surface, to favor the IRS's position, on closer consideration, it did not. The Tax Court found that even absent the transaction (the ANDA application with paragraph IV certification), the patent holder would seek to defend its intellectual property against a potential infringer, and the generic manufacturer would incur the same litigation costs in defending such suit. Thus, the court concluded that it could not find that an ANDA applicant would not incur patent infringement litigation expenses but for making an ANDA application with a paragraph IV certification.

With respect to the origin-of-the-claim test, the court determined that, under the test, Section 271(e)(2) litigation expenses should be treated as deductible ordinary and necessary business expenses. The court explained that under the test, in the case of patent infringement litigation, a court inquires whether the origin of the claim litigated is in the process of acquisition, enhancement, or other disposition of a capital asset. To answer this question, the court looked to the Third Circuit's holding in Urquhart, which it noted that the IRS had explicitly endorsed in the preamble to its proposed regulations on the capitalization of intangible assets (REG-125638-01). In Urquhart, the Third Circuit took the position that patent infringement litigation did not involve a defense of the ownership of property, but rather it arose out of a dispute over the exploitation of the invention embodied in a patent. Thus, the expenses of patent holders were not required to be capitalized and could be deducted in the current year.

The Tax Court saw no reason why Mylan's legal expenses from Section 271(e)(2) suits should be treated differently. Although Section 271(e)(2) litigation, unlike most patent infringement litigation, usually occurs before marketing and sale of the product in question (here, the generic drug), the purpose of the suit remains to protect the patent holder's future business profits. Consequently, the legal expenses that Mylan incurred in the various Section 271(e)(2) suits it was involved in arose out of the ordinary and necessary activities of its generic drug business and were deductible.


As is discussed in detail in a Federal Circuit case cited by the Tax Court, Glaxo, Inc. v. Novopharm, Ltd., 110 F.3d 1562 (Fed. Cir. 1997),from a patent law standpoint, a Section 271(e)(2) suit is equivalent to a traditional patent infringement lawsuit. An argument can be made that the legal expenses incurred in a patent infringement lawsuit would be better matched with the activities they benefit by deducting them over a period of years, and thus they should be capitalized. Nonetheless, the IRS made and lost that argument in the Third Circuit in Urquhart and effectively abandoned the argument by adopting the Third Circuit's position in the regulations, so the Tax Court properly rejected the IRS's attempts to resurrect it in Mylan's case.

Mylan Inc., 156 T.C. No. 10 (2021)

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