Pharmaceutical companies stand to benefit from a recent court ruling enabling them to recognize federal income tax deductions for the costs of litigation to defend against patent infringement. The decision was in line with another recent ruling that favored taxpayers on a question of whether costs to defend patent litigation must be capitalized. The rulings strengthen the foundation for generic drug companies to recognize current year deductions for potentially significant litigation costs. Companies that have either capitalized litigation costs previously or anticipate litigation costs should discuss with their tax advisor the ability to deduct those costs.
In a decision that favors taxpayers, the Court of Federal Claims in Actavis Laboratories FL Inc. v. United States held on Aug. 19, 2022, that a generic drug manufacturer’s costs to defend Hatch-Waxman patent litigation are deductible business expenses for which no capitalization is required. This decision is in line with the Tax Court’s recent holding in Mylan, Inc. & Subsidiaries v. Comm’r, 156 T.C. 137 (2021) and represents another taxpayer win on the question of whether costs to defend patent litigation in connection with the filing of an Abbreviated New Drug Application must be capitalized.
To facilitate the release of affordable generic drugs, Congress in 1984 passed legislation (referred to as the Hatch-Waxman Act) providing a simplified way for drug manufacturers to obtain Food and Drug Administration approval for generic drugs without undergoing burdensome studies required for new branded drugs. To obtain approval under this simplified process, generic drug manufacturers must file an Abbreviated New Drug Application (ANDA) that meets certain technical requirements, including showing that the generic drug contains the same active ingredient or is biologically equivalent to the brand-name drug.
The ANDA process also requires the applicant to illustrate that the generic will not infringe on the brand-name drug manufacturer’s patents. One way to do this is through a “paragraph IV certification” whereby the applicant certifies that the applicable brand-name patents are either invalid or will not be infringed by the applicant’s use or sale of the proposed ANDA drug. A paragraph IV certification triggers a 45-day period during which the brand-name manufacturer may bring a patent infringement suit against the generic drug manufacturer (Hatch-Waxman litigation).
In cases where the brand-name drug manufacturer initiates Hatch-Waxman litigation, the FDA generally must stay approval of the ANDA for 30 months, at which point FDA approval may become effective unless the court has found that the patent was valid and infringed.
If the generic drug manufacturer is found to infringe on the applicable patent(s), FDA approval will not be effective until the infringed patent expires. If the 30-month stay ends while litigation is ongoing, the FDA may approve the ANDA notwithstanding that the applicant may later be found to infringe the brand name drug manufacturer’s patents. In this case, the generic drug manufacturer may be liable to the patent owner for damages and lost profits.
In Actavis Laboratories FL. Inc. v. United States, the taxpayer was a generic drug manufacturer that filed several ANDAs with paragraph IV certifications. Several of the brand-name drug manufacturers subsequently brought Hatch-Waxman patent infringement suits against the taxpayer, resulting in the taxpayer incurring litigation expenses to defend the suits. The taxpayer deducted such costs as ordinary and necessary business expenses in the years incurred; however, the IRS refused to allow such deductions and instead required the taxpayer to capitalize the costs as amounts paid or incurred to facilitate the acquisition of the FDA-approved ANDA, an intangible asset.
Capitalization under section 263(a) of the Internal Revenue Code
Section 263(a) of the Internal Revenue Code generally requires a taxpayer to capitalize any amounts paid or incurred in acquiring or improving tangible and intangible property. When determining whether litigation costs must be capitalized under section 263(a), courts apply the “origin of the claim” test, as established by the Supreme Court in United States v. Gilmore, 372 U.S. 39 (1963).
Under the origin of the claim test, litigation costs will be capitalized if the origin of the claim litigated is in the process of acquisition of a capital asset. As discussed by the court in Actavis, the origin of the claim test is a narrow one that is not dependent on the taxpayer’s primary purpose in incurring the costs, but rather looks to whether the “origin of particular litigation lies in the process of acquisition.” (citing Woodward v. Comm’r, 397 U.S. 572, 578 (1970)).
Separate from the origin of the claim test, Treas. Reg. § 1.263(a)-4 provides rules to determine whether costs relating to the acquisition or creation of intangible property must be capitalized. Under these rules, a taxpayer generally must capitalize amounts paid to acquire an intangible asset; facilitate the acquisition or creation of an intangible asset; or create or enhance a separate and distinct intangible asset. An amount facilitates the acquisition or creation of an intangible asset if it is paid in the process of investigating or otherwise pursuing the transaction, as determined based on all facts and circumstances.
The court’s analysis
In its analysis of whether the litigation costs must be capitalized, the court took a two-step approach. First, the court applied the origin of the claim test to determine the nature and character of the costs. Second, the court applied the rules of Treas. Reg. §1.263(a)-4 to determine whether such costs fall within one of the categories to require capitalization.
In applying the origin of the claim test, the court found that the origin of Hatch-Waxman litigation is in the patent-holder’s desire to protect its profit-seeking activities and to prevent the generic drug manufacturer from engaging in its generic drug business. The court noted that Hatch-Waxman litigation involves only issues of patent validity and infringement and does not involve questions of property ownership. In other words, the litigation does not question whether the patent-holder owns the applicable patent, but only whether the patent is valid and whether the defending party has trespassed or infringed the patent.
The court recognized that the litigation may have some relation to the taxpayer’s ANDA filing but stressed that the origin of the claim test asks whether the litigation expenses are directly related to the acquisition or disposition of a capital asset. Here, the ANDA process does not require litigation, and FDA approval is not affected by the outcome of the litigation. Thus, although the form of the litigation arose in the context of the taxpayer seeking FDA approval of its ANDAs, the court determined that the substance of the litigation was a property trespass action not directly related to the acquisition or creation of a capital asset.
Next, the court analyzed whether the taxpayer’s litigation expenses either facilitated approval of the taxpayer’s ANDAs or otherwise enhanced the ANDAs, either of which requires capitalization under Treas. Reg. §1.263(a)-4.
The court noted that under applicable regulations, the FDA must approve an ANDA as long as the application satisfies various technical requirements. Although an ANDA with paragraph IV certification requires the taxpayer to certify that patents associated with the branded drug are either invalid or will not be infringed, FDA approval is not dependent on litigating or successfully defending a resulting patent infringement suit. Even where such litigation results in a finding that the taxpayer infringed the branded drug company’s patent, FDA approval may still be obtained, although approval is only effective once the patent expires.
In light of this, the court concluded that the only effect the Hatch-Waxman litigation has is to delay the effective date of the FDA approval. Thus, in the court’s view, litigation expenses paid during such litigation “can never be amounts ‘paid in the process of investigating or otherwise pursuing’ an approved ANDA [because] they do nothing to advance ANDA approval.”
The court used the same reasoning to conclude that the amounts at issue did not enhance the taxpayer’s approved ANDAs, stating that the litigation costs cannot be said to “enhance” the value of the taxpayer’s ANDAs; at most, the costs “merely prevent [an approved ANDA’s] further diminishment through extended delays to its effectiveness.”
Because the costs were not required to be capitalized under either the origin of the claim test or under the rules of Treas. Reg. §1.263(a)-4, the court found that the taxpayer was entitled to claim current deductions for such amounts.
The court’s holding in Actavis is extremely favorable to taxpayers engaged in patent litigation defense as a result of filing an ANDA with paragraph IV certification, and is in line with the April 2022 Tax Court decision in Mylan Industries.
Taxpayers that have previously capitalized litigation expenses incurred to defend Hatch-Waxman litigation should discuss with their tax advisors whether they can take a position to deduct any of these costs, including any accounting method change implications.
The IRS is currently appealing the Tax Court’s Mylan Industries decision to the Court of Appeals for the Third Circuit, arguing that litigation costs incurred to defend Hatch-Waxman litigation are required to be capitalized under Treas. Reg. §1.263(a)-4 as facilitating the acquisition of FDA approved ANDAs. It’s unknown at this point whether the Service’s position will ultimately prevail in the 3rd Circuit; however, the Federal Claims Court’s decision in Actavis illustrates its agreement with the Tax Court and strengthens the foundation for generic drug companies to recognize current year deductions for potentially significant litigation costs.