Can pharma firms deduct fees in Hatch-Waxman suits?
For taxpayers, the ability to deduct the entirety of an expense in the current year can be extremely important to their business. The Internal Revenue Service (IRS) and Department of Justice Tax Division continue to assert that, for patent infringement legal fees to be deductible, the issue must be capitalised—rather than deducted.
In two notable cases involving drug makers Mylan and Actavis, however, the taxpayers prevailed at the trial court level where the courts ruled that they could deduct these legal fees.
Generic drug manufacturers are now following two circuit court cases, where the outcomes will affect the tax treatment of patent infringement litigation expenses under the Hatch-Waxman Act. The Third Circuit and US Court of Appeals for the Federal Circuit each are set to decide cases, Mylan v Commissioner and Actavis Laboratories v United States, to decide whether pharmaceutical companies are able to deduct— rather than capitalise legal fees— for defending against patent infringement lawsuits.
A deduction for an ordinary and necessary business expenditure may be taken in the current year and yields an immediate corresponding reduction in taxable income.
In contrast, a capital expenditure typically results in the recovery of a taxpayer’s expenditure over a longer period (eg, 15 years) through amortisation and depreciation deductions.
In both the Mylan and Actavis cases, the taxpayers are generic drug manufacturers who filed Abbreviated New Drug Applications (ANDAs) with the US Food and Drug Administration (FDA).
The Hatch-Waxman Act sets forth the procedure for regulatory approval of both new branded drugs and generic versions of branded drugs. Generic drug manufacturers must complete an ANDA, which is an expedited process for the approval of generic equivalent drugs and relies upon the safety and efficacy data of the reference drug. If a generic drug manufacturer demonstrates that its generic drug has the same active ingredients as, and is technically equivalent to, an already approved brand name drug, the FDA will approve the ANDA.
Origin of the claim
Generally, patent litigation expenses for both sides in a litigation have been tax deductible in the year incurred. However, in 2011, the IRS issued a chief counsel memorandum stating that taxpayers who incurred expenses defending Hatch-Waxman Act patent infringement suits must capitalise those expenses.
The IRS stated it would apply the origin of the claim test, which looks at the nature of an event or transaction, and then the tax consequences that flow from that event. The IRS concluded that the patent infringement litigation originated from the company’s action to obtain an asset for its sale or use in its trade or business and the expenses related to the litigation were therefore capital in nature.
Then, the IRS looked at whether the legal fees to defend against a patent infringement lawsuit after a company filed ANDAs were within the scope of IRC § 1.263(a)-4, which identifies categories of intangibles that must be capitalised, including amounts to acquire, create, or enhance an intangible. The IRS took the position that the origin of patent litigation legal fees is obtaining an FDA-approved ANDA, which includes both the filing of an ANDA and defending against any lawsuits.
The IRS concluded in its memo that this series of steps could not be separated and was part of a single plan by the drug manufacturer to obtain an FDA-approved ANDA before the patents’ expiration. The IRS stated, therefore, that the litigation expenses must be capitalised over several years rather than deducted in the year the expenses are incurred.
‘Defence against attack’
Both Actavis and Mylan filed tax returns for multiple tax years claiming deductions for Hatch-Waxman patent litigation expenses, and the IRS denied the taxpayers’ deductions. Mylan filed a suit challenging the IRS’s determination in the US Tax Court, while Actavis filed its case in the US Court of Federal Claims. In both cases, the government maintained its position from the 2011 IRS memo that the litigation expenses were incurred to facilitate the acquisition of FDA-approved ANDAs and intangible assets, and therefore must be capitalised. The taxpayers in both cases argued that the Hatch-Waxman litigation expenses were incurred defending their business practices from attack and therefore were ordinary and deductible expenses.
In both cases, the courts ruled for the taxpayers that the Hatch-Waxman patent infringement litigation costs were deductible as expenses. In Mylan, the court stated in its 2021 opinion that “[a]lthough a generic drug manufacturer must assert in an ANDA with a paragraph IV certification that listed patents covering the brand name drug are invalid or not infringed by the generic version, the manufacturer is not required to undertake affirmative litigation to establish that point as a condition of entering its generic on the market,” and therefore the litigation does not appear to relate to the acquisition or enhancement of any right of a generic manufacturer and thus does not need to be capitalised.
The court in Actavis similarly held in its 2022 opinion that the litigation expenses were deductible because they originated from the brand-name drug companies’ patent assertion efforts, and held that the patent infringement litigation expenses were not incurred to facilitate FDA approval or enhance the finally approved ANDAs.
The government has appealed both of these cases. The Third Circuit heard oral argument in the Mylan appeal on January 12, 2023. In Actavis, the parties submitted their briefs to the Federal Circuit, but oral argument has not been scheduled yet.
In Mylan, the Tax Court also addressed whether legal fees incurred for the preparation, assembly, and transmission of formal notification letters as required by the ANDA process were deductible. The Tax Court ruled for the IRS on this issue, holding that these legal fees associated with preparing ANDAs and paragraph IV certifications facilitated the FDA approval of the generic drugs and were required to be capitalised, rather than deducted as expenses.
Takeaways for generic drug makers
Both the Third Circuit and Federal Circuit are expected to issue opinions in the Mylan and Actavis cases soon, possibly by year end, providing more clarity to generic drug manufacturers about how to treat patent infringement litigation costs, particularly those related to ANDAs.
In the meantime, generic pharmaceutical manufacturers should take steps to make sure they are properly tracking expenses. For example, litigation and patent legal fees should be tracked separately from fees associated with notice procedures and other tasks associated with the creation of the intangible asset.
If the Mylan or Actavis decisions are upheld, companies may be able to deduct the patent infringement litigation costs, but not the costs related to preparing the ANDAs and paragraph IV certifications themselves.
Carina Federico is a partner at Crowell & Moring. She can be contacted at cfederico@crowell.com
Anne Li is a partner at Crowell & Moring. She/he can be contacted at ali@crowell.com
