Patent infringement litigation defense costs are not facilitative

In Mylan, Inc., 76 F.4th 230 (3d Cir. 2023), the Third Circuit affirmed the Tax Court’s opinion that patent infringement litigation expenses resulting from abbreviated new drug application (ANDA) filings are deductible as ordinary and necessary business expenses under Sec. 162(a). Further, it rejected the IRS’s argument that such costs facilitate acquiring or creating an intangible under Sec. 263(a) and Regs. Sec. 1.263(a)-4.

Facts: Pharmaceutical companies seeking Food and Drug Administration (FDA) approval to manufacture a generic version of an existing branded drug must submit the ANDA with a certification that the patent for the branded drug is either invalid or would not be infringed by the manufacture of the generic. Simultaneously, the companies must also send formal notice letters to the brand drug manufacturers and patentholders, which often triggers patent infringement lawsuits against the company submitting the ANDA. The outcome of the lawsuit has no bearing on the FDA’s approval of the ANDA, which, in some cases, is approved before the resolution of the litigation.

Mylan Inc. and its subsidiaries manufacture branded and generic pharmaceuticals. From 2012 to 2014, Mylan incurred legal fees to prepare notice letters and defend against patent infringement lawsuits, which it deducted on its tax returns for those years. The IRS denied the deductions and asserted that the expenses must be capitalized.

The Tax Court heard the case and issued an opinion that bifurcated the legal fees between those for preparing the notice letters and those for defending against the patent infringement litigation (Mylan, Inc., 156 T.C. 137 (2021)). For the former expenses, the court agreed with the IRS that the costs were required to be capitalized to the ANDA as a right granted by the government under Sec. 263(a) and amortized over 15 years under Sec. 197. For the latter, however, the court agreed with the taxpayer that the amounts were deductible as ordinary and necessary expenses under Sec. 162(a). The IRS appealed the decision to the Third Circuit, which upheld the Tax Court’s ruling.

Issues: The Third Circuit stated that the main issue on appeal was whether an amount is paid to “facilitate” the acquisition or creation of an intangible asset, such as an ANDA. Under Regs.

Sec. 1.263(a)-4, taxpayers must capitalize both the amount paid to acquire or create the intangible and amounts paid to facilitate the acquisition or creation of the intangible. Regs. Sec. 1.263(a)-4(e)(1)(i) states that an amount is paid to facilitate the acquisition or creation of an intangible “if the amount is paid in the process of investigating or otherwise pursuing the transaction” and that “[i]n determining whether an amount is paid to facilitate a transaction, the fact that the amount would (or would not) have been paid but for the transaction is relevant, but is not determinative.”

Before the Third Circuit, the IRS asserted that the term “facilitate” should be interpreted broadly. It argued that Mylan’s choice to make the certification as part of receiving approval for an ANDA was part of the statutory process. Similarly, the resulting lawsuit and litigation costs would only have occurred as a part of the statutory process for the application and, therefore, were facilitative.

Mylan argued that ANDA litigation costs do not facilitate the acquisition of FDA approval because that approval can be granted whether or not the litigation has been resolved.

Holding: The Third Circuit held in favor of Mylan. It rejected the IRS’s argument for a broad interpretation of the word “facilitate” to mean any and all amounts paid in the process of investigating or pursuing the acquisition of an intangible asset and agreed with Mylan that the patent infringement lawsuits are not a required step in the FDA approval process for generic drugs. The court stated, “Win or lose, the outcome of patent litigation is irrelevant to the FDA’s review; the generic is considered either safe and effective, or not.”

Once approved by the FDA, generic drugs can be marketed and sold prior to resolution of the patent infringement litigation. If the generic manufacturer ultimately loses the lawsuit, FDA approval is not revoked but rather converted to a tentative approval until after the expiration of the relevant patents. Accordingly, while related, FDA approval of the ANDA and the patent infringement litigation are ultimately two separate processes.

While the patent infringement lawsuit might not have occurred but for the actions Mylan took through the ANDA process, that does not mean that the lawsuit (and related legal fees) facilitated the FDA approval process and acquisition of the ANDA.

The Third Circuit’s conclusion appears to be consistent with the intent of the regulations as described in the preamble to proposed intangible regulations (REG-125638-01, 67 Fed. Reg. 77701 (Dec. 19, 2002)), in which the IRS provided insights into the “facilitate” standard. The preamble stated:

The facilitate standard is intended to be narrower in scope than a “but-for” standard. Thus, some transaction costs that arguably are capital under a but-for standard, such as costs to downsize a workforce after a corporate merger (including severance payments) or costs to integrate the operations of merged businesses, are not required to be capitalized under a facilitate standard. While such costs may not have been incurred but-for the merger, the costs do not facilitate the merger itself.

The Third Circuit noted that although the legal costs would not have been incurred but for the ANDA, the costs did not facilitate the ANDA.

The Third Circuit’s holding in favor of Mylan is welcome news for generic drug manufacturers, especially coming after a similarly taxpayer-favorable decision in Actavis Laboratories, FL, Inc., 161 Fed. Cl. 334 (2022) (see “Tax Matters: Drug Patent Litigation Expenditures Are Held Deductible,” JofA (August 2023)). Furthermore, all taxpayers may appreciate the court’s careful analysis of Regs. Sec. 1.263(a)-4 and what it means for a cost to “facilitate” a transaction under the regulation.

Taxpayers that have previously deducted legal fees associated with patent infringement lawsuits may have new certainty in the position taken. If taxpayers, on the other hand, have capitalized such costs in prior years, they now have an opportunity to discontinue capitalizing such amounts going forward and may want to consider filing an accounting method change to deduct amounts previously capitalized, which would result in a favorable adjustment under Sec. 481(a).

■ Mylan, Inc., 76 F.4th 230 (3d Cir. 2023)

— Sharon Kay, CPA, is partner, and Caleb Cordonnier, CPA, is senior manager, both with Grant Thornton LLP in its Washington, D.C., National Tax Office. To comment on this column, contact Paul Bonner, the JofA’s tax editor.