by Dennis Crouch
In a recent tax appeal, the Third Circuit court of appeals afformed that legal expenses incurred by generic drug makers to defend against patent infringement suits brought under the Hatch-Waxman Act are deductible as ordinary and necessary business expenses. This aligns with longstanding precedent treating patent litigation defense costs as deductible for the alleged infringer.
Mylan had deducted over $100 million in litigation expenses for the periods of 2012-2014 it occurred in defending patent infringement lawsuits brought against the generic manufacturer after it submitted abbreviated new drug applications (ANDAs) with paragraph IV certifications challenging the respective patents. The IRS disallowed the deductions and issued notices of deficiency to the company — concluding that instead the litigation costs should be capitalized under I.R.C. § 263 (and associated regulations) as costs to acquire intangible assets (the FDA drug approvals). The capitalization process requires amortization over 15 years rather than permitting immediate tax relief offsetting current income.
Mylan petitioned the U.S. Tax Court for redetermination and won a holding that litigation costs were deductible business expenses, rejecting the IRS’s position that they should be capitalized. The IRS Commissioner then appealed to the 3rd Circuit who affirmed.
In the appeal, the IRS argued that litigation costs should be capitalized under Treas. Reg. §1.263(a)-4(b)(1)(v) as amounts paid to facilitate the acquisition of the FDA drug approvals, which are intangible assets. The 3rd Circuit rejected that argument, holding that lawsuits by the branded manufacturers do not facilitate FDA approval. The court noted that the FDA can approve an ANDA regardless of the litigation outcome and also that not every ANDA results in litigation so it is not a required step in the process. Although litigation is a contemplated aspect of the Hatch-Waxman process, that does not convert the litigation into an approval requirement. The court also noted that disparate tax treatment between generics and brands would undermine Hatch-Waxman.
The Third Circuit had previously held that litigation expenses a patentee incurs in enforcing its patents are ordinary and necessary business expenses because they are “peculiarly normal to the business in which … [patentee] taxpayers [a]re engaged.” Urquhart v. Commissioner, 215 F.2d 17, 19 (3d Cir. 1954). The court in Mylan reasoned that generic manufacturers defending infringement suits are engaged in functionally the same activity as patentees enforcing patents. Thus, the court concluded that deductibility should not differ based on whether litigation expenses are incurred by the patentee or alleged infringer. In the court’s view, “[i]t makes no difference in deciding the question of deductibility whether the patent litigation expenses are incurred by the patentee or the alleged infringer. Nor does it matter that the deductibility question arises in the context of an ANDA suit.”
Generic manufacturers relying on deductibility of these litigation costs will benefit from the ruling. If the fees had to be capitalized, it would substantially increase costs and undermine their incentives to challenge weak patents under Hatch-Waxman.