Drug patent litigation expenditures are held deductible

The U.S. Court of Federal Claims held that pharmaceutical patent litigation expenses under the Hatch-Waxman Act were deductible business expenses under Sec. 162. The court arrived at this conclusion by applying the “origin of the claim” test articulated in Gilmore, 372 U.S. 39 (1963), to determine whether the litigation costs must be capitalized under Regs. Sec. 1.263(a)-4.

Facts: Actavis Laboratories FL Inc., formerly Watson Pharmaceuticals, is a generic drug manufacturer. During 2008 and 2009, Actavis filed seven abbreviated new drug applications (ANDAs) with the U.S. Food and Drug Administration (FDA) to try to gain approval to sell a generic version of seven brand-name drugs. The ANDA process is part of the Drug Price Competition and Patent Term Restoration Act of 1984, P.L. 98-417, commonly known as the Hatch-Waxman Act. To comply with the ANDA process, Actavis included “paragraph IV certifications,” which certify that any listed patent “is invalid or will not be infringed by the manufacture, use, or sale” of the proposed ANDA generic drug (21 U.S.C. §355(j) (2)(A)(vii)(IV)). Filing a paragraph IV certification is itself considered an act of infringement that gives the company holding the brand an immediate right to sue, the court noted (citing Caraco Pharmaceutical Laboratories, Ltd. v. Novo Nordisk A/S, 566 U.S. 399 (2012); see also 35 U.S.C. §271(e)(2)(A)).

However, the mere act of filing an ANDA with a paragraph IV certification “does not itself initiate litigation” under 35 U.S.C. Section 271(e)(2), “much like the development of a product does not initiate litigation” under 35 U.S.C. Section 271(a); “each act gives a patent holder the right, but not the obligation, to sue,” the court further noted. If the patentholder files an infringement suit within 45 days, the FDA is required to withhold approving the generic, usually for a 30-month period, while the parties litigate the patent’s validity or infringement.

Actavis was sued by the patentholders of the seven drugs that it submitted through the ANDA process in 2008 and 2009. This resulted in Hatch- Waxman litigation expenses by Actavis of $3,882,951 in 2008 and $8,481,237 in 2009. For each of those years, Actavis deducted the respective amounts on its tax returns. In 2016, the IRS issued a notice of deficiency for the returns, disallowing the deduction of the litigation expenses.

Issues: As a result of cross-motions for summary judgment, the primary issue before the court was whether the litigation expenses constituted ordinary and necessary business expenses and were currently deductible under Sec. 162 or whether they were required to be capitalized under the origin-of-the-claim test and Regs. Sec. 1.263(a)-4.

The court first considered the origin-of-the-claim test articulated in Gilmore, noting that “the deductibility of litigation expenses generally depends on the origin and character of the claim which caused the expenses” (Woodward, 397 U.S. 572 (1970)). Of particular importance is the distinction between defending a business and its policies (deductible) versus the process of acquisition (capitalized). Hatch-Waxman litigation is unique in that it “involves only questions of patent validity and infringement and therefore receives different treatment than suits over asset title under the origin of the claim test and tax law” (Urquhart, 215 F.2d 17 (3d Cir. 1954)). Ultimately, the court found that the origin of the claims that Actavis litigated was not in the process of acquisition of the ANDAs but in the branded drug companies’ “patent enforcement efforts to maintain their business profits and cease plaintiff ’s generic drug business activities” (citing Woodward, 397 U.S. at 577–78 and Gilmore, 372 U.S. at 48–49).

Next, the court examined Regs. Sec. 1.263(a)-4 to determine whether the litigation expenses were (1) a part of the ANDA transaction; (2) facilitated the acquisition or creation of the approved ANDA; or (3) otherwise enhanced the approved ANDA. If the litigation expenses met any of these criteria, they would be required to be capitalized, as the parties agreed that an FDA-approved ANDA is a qualifying intangible under the regulation.

The court concluded that Regs. Sec. 1.263(a)-4 did not require capitalization of the litigation expenses. “The legal expenses incurred — which originate from the branded drug companies’ patent enforcement — do not ‘facilitate the acquisition or creation of ’ the approved ANDA, as they are not ‘paid in the process of investigating or otherwise pursuing the transaction,’” the court stated. Furthermore, “the expenses do not make acquiring ANDA approval ‘easier’ or ‘render [it] less difficult,’” and “do not ‘enhance’ the approved ANDA; they only prevent its further diminishment.”

In its final step, the court examined whether the expenses were deductible under Sec. 162. Finding support in Urquhart, the court noted that “litigation expenses for taxpayers ‘engaged in the business of exploiting and licensing patents … are peculiarly normal’ to their business.” Additionally, citing Mylan, Inc., 156 T.C. 137 (2021), the court explained that “[l]ike expenses incurred pursuing patent infringement claims, expenses incurred defending patent infringement claims have also historically been deductible under [Sec.] 162(a).” Furthermore, the court relied on a 2014 IRS Office of Chief Counsel memo that stated that “in general, costs to defend against a claim of patent infringement are deductible on the theory that the taxpayer is protecting or maintaining its income-generating business.” Thus, the court reasoned that “absent any precedent to the contrary, a patent infringement defendant’s legal expenses are, like the patent owner’s, tax deductible.” Finally, having concluded that “patent infringement claims are property trespass claims sounding in tort” (citing Schillinger, 155 U.S. 163 (1894)), the court noted that “expenses incurred defending against tort claims are also deductible business expenses” (Kornhauser, 276 U.S. 145, 153 (1928)).

Holding: The Hatch-Waxman patent litigation expenses originated from “the branded drug companies’ patent enforcement efforts — a claim sounding in tort,” not from the process of acquiring an intangible capital asset, the court stated. Furthermore, Regs. Sec. 1.263(a)-4 does did not require their capitalization. Ultimately, the court concluded that Actavis’s litigation expenses were deductible and that it was entitled to summary judgment.

It is important to note that the government has appealed. As a result, it may be advisable to wait for a ruling by the Court of Appeals for the Federal Circuit before relying on the reasoning articulated by the trial court.

■ Actavis Laboratories, FL, Inc., 161 Fed. Cl. 334 (2022)

— Olivia Larson is a student in the School of Industrial and Labor Relations; John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business; and Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy, all at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA’s tax editor.