Mylan Inc. v. Commissioner (156 T.C. No. 10)

On April 27, 2021, the Tax Court issued its opinion in Mylan Inc. v. Commissioner (156 T.C. No. 10). The underlying issues presented in Mylan Inc. v. Commissioner were (1) whether the legal expenses incurred in preparing notice letters to brand name drug companies of petitioner’s intent to make generic versions of its drugs as part of the FDA approval process to do the same were capital or ordinary expenses; and (2) whether the legal expenses incurred in defending against subsequent patent infringement suits were ordinary or capital in nature.

Background to Mylan Inc. v. Commissioner

The petitioner is a manufacturer of brand name and generic pharmaceutical drugs. From 2012 through 2014 it incurred significant amounts (tens of millions of dollars) of legal expenses in preparing notice letters and defending patent infringement lawsuits related to its generic versions of certain brand name drugs. On its 2012 through 2014 Federal income tax returns, the petitioner claimed deductions for the legal fees as ordinary and necessary business expenses under IRC § 162(a). The IRS subsequently disallowed these deductions, determining that the legal expenses were required to be capitalized pursuant to IRC § 263(a).

The Short Version

The Tax Court opinion spends quite a few pages on the registration of brand name and generic drugs with the FDA, the patenting procedures, and the litigation involved.  While interesting, tremendously complex, and obviously quite profitable, it is so very far afield of tax that we will avoid it like the treadmill.

If you want to make a generic drug, you must jump through hoops.  Also, you will be sued for patent infringement.

There, I just saved you 16 pages.

The Legal Fees Breakdown

In sum, there are really two discernible types of expenses.  There are costs for wanting to make generic drugs, and there are costs of defending your right to do so.

We’re at 20 pages now.

Deductibility Versus Capitalization: General Principles

IRC § 162(a) allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” An expense is “ordinary” if it is customary or usual within a particular trade, business, or industry or relates to a common or frequent transaction in the type of business involved. See Deputy v. du Pont, 308 U.S. 488, 495 (1940). An expense is “necessary” if it is appropriate and helpful to the operation of the taxpayer’s business. See Commissioner v. Tellier, 383 U.S. 687, 689 (1966).

By contrast, IRC § 263(a) provides that “[n]o deduction shall be allowed” for a capital expenditure. Deductions are exceptions to the “norm” of capitalization. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Where IRC § 162 and IRC § 263 each apply to a given expenditure, the capitalization requirement controls and functions to bar the deduction. See IRC § 161; see also Commissioner v. Idaho Power Co., 418 U.S. 1, 17-18 (1974).

The “primary effect” of a payment’s classification as a deductible business expense or nondeductible capital expenditure is seen in the timing of the taxpayer’s cost recovery. INDOPCO, 503 U.S. at 83. Whereas a deduction for an ordinary and necessary business expenditure may be taken in the current year with a corresponding reduction in taxable income, a capital expenditure typically results in recovery of a taxpayer’s expenditure over a longer period through amortization and depreciation deductions. Id. at 83-84. IRC § 263, thus prevents a taxpayer from utilizing currently a deduction properly attributable, through amortization, to later tax years when the capital asset becomes income producing. Idaho Power Co., 418 U.S. at 16.

Whether a given expenditure is deductible under section 162 or must instead be capitalized under IRC § 263(a) turns on the particular facts of each case. An expenditure, no matter its type, may be deductible in one setting but nevertheless required to be capitalized in another.

An expenditure generally must be capitalized where it is determined that the expenditure either: (1) creates or enhances a separate and distinct asset, or (2) otherwise generates significant benefits for the taxpayer extending beyond the current taxable year. INDOPCO, Inc., 503 U.S. at 87. As adopted, Treas. Reg. § 1.263(a)-4(b)(1) requires the capitalization of amounts paid, inter alia: (1) to acquire an existing intangible; (2) to create certain types of intangibles identified in Treas. Reg. § 1.263(a)-4(d); (3) to create or enhance various “separate and distinct” intangibles; and (4) to create or enhance a “future benefit” identified in subsequent guidance published by the IRS.

Relevant Intangibles

With respect to rights obtained from a governmental agency, Treas. Reg. § 1.263(a)-4(d)(5)(I) specifies: “A taxpayer must capitalize amounts paid to a governmental agency to obtain, renew, renegotiate, or upgrade its rights under a trademark, trade name, copyright, license, permit, franchise, or other similar right granted by that governmental agency.”

Whether an amount is paid to create an intangible under paragraph (d) is determined on the basis of “all of the facts and circumstances, disregarding distinctions between the labels used in this paragraph (d) to describe the intangible and the labels used by the taxpayer and other parties to the transaction.” Treas. Reg. § 1.263(a)-4(d)(5)(I)(1). Treas. Reg § 1.263(a)-4(d)(9)(I) provides that a “taxpayer must capitalize amounts paid to another party to defend or perfect title to intangible property if that other party challenges the taxpayer’s title to the intangible property.”

Facilitative Costs

The direct costs of creating intangibles are not the only costs that must be capitalized under Treas. Reg. § 1.263(a)-4. Taxpayers are further required to capitalize any amounts paid to facilitate an acquisition or creation of, inter alia, an intangible described in Treas. Reg. § 1.263(a)-4(d). See Treas. Reg. § 1.263(a)-4(b)(1)(v). This provision “recognizes that capitalization is required not only for the cost of an asset itself, but for the ancillary expenditures incurred in acquiring, creating, or enhancing the intangible asset.” See Woodward v. Commissioner, 397 U.S. 572 (1970).

Indeed, an amount is paid to facilitate the acquisition or creation of an intangible (the transaction) if the amount is paid in the process of investigating or otherwise pursuing the transaction. Treas. Reg. § 1.263(a)-4(e)(1)(I). Whether an amount is paid in the process of investigating or otherwise pursuing a given transaction is determined on the basis of all of the facts and circumstances. Id. The fact that the amount would (or would not) have been paid but for the transaction is relevant, but this is not necessarily determinative. Id. For purposes of this inquiry, the term transaction means all of the factual elements comprising an acquisition or creation of an intangible and includes a series of steps carried out as part of a single plan. Treas. Reg. § 1.263(a)-4(e)(3).

Litigation Expenses

The deductibility of a legal expense generally depends upon the origin and character of the claim with respect to which the expense was incurred. See United States v. Hilton Hotels Corp., 397 U.S. 580, 583 (1970); Woodward, 397 U.S. at 577-578; United States v. Gilmore, 372 U.S. 39, 48-49 (1963). Under this “origin of the claim” test, the substance of the underlying claim or transaction out of which the expenditure in controversy arose governs whether the item is a deductible expense or a capital expenditure, regardless of the motives of the payor or the consequences that may result from the failure to defeat the claim. Santa Fe Pac. Gold, 132 T.C. 240, 264-65 (2009); see also Woodward, 397 U.S. at 578.

Thus, legal expenses directly connected with (or pertaining to) the taxpayer’s trade or business are deductible under IRC § 162 as ordinary and necessary business expenses, while expenses arising out of the acquisition, improvement or ownership of property are capital expenditures under IRC § 263(a) and are not currently deductible. Commissioner v. Heininger, 320 U.S. 467 (1943); Commissioner v. Tellier, 383 U.S. 687, 689-690 (1966); INDOPCO, 503 U.S. at 83.

Patent law has long distinguished suits for the defense of title to intellectual property from patent infringement litigation. The former involves the disposition or acquisition of a capital asset, and expenses in litigating such a suit have been treated as capital–even before the Supreme Court embraced the origin of the claim test. See, e.g., Estate of Baier v. Commissioner, 533 F.2d 117, 120 (3d Cir. 1976) (holding that litigation expenses incurred incident to a dispute over the terms of a disposition are capital), aff’g 63 T.C. 513 (1975); Safety Tube Corp. v. Commissioner, 168 F.2d 787 (6th Cir. 1948) (requiring legal fees to be capitalized where controversy involved title and ownership of a patent), aff’g 8 T.C. 757 (1947).

Patent infringement litigation is a different creature altogether, sounding in tort. See Schillinger v. United States, 155 U.S. 163, 169 (1894); Giesecke+Devrient GmbH v. United States, 150 Fed. Cl. 330, 344 (2020). Such litigation is a far cry from removing a cloud of title, or defending ownership of property. Urquhart v. Commissioner, 215 F.2d 17, 20 (3d Cir. 1954). Usually what a patent owner loses from infringement is the acquisition of a just and deserved gain from the exploitation of the invention embodied in his patent. Mathey v. Commissioner, 177 F.2d 259, 263 (1st Cir. 1949). Therefore, an award of damages in patent [infringement] litigation is ordinarily an award of compensation for gains or profits lost by the patent owner and hence is taxable to him as income in the year received. Id.

As the U.S. Court of Appeals for the Third Circuit, to which an appeal in these cases would lie absent a stipulation to the contrary, IRC § 7482(b)(1)(B), has observed, litigation expenses for taxpayers “engaged in the business of exploiting and licensing patents are peculiarly normal” to their business, Urquhart, 215 F.2d at 19. For taxpayers engaged in the trade or business of creating and licensing intangible assets, the costs incurred in prosecuting an action for infringement will most likely be deductible as a business expense.

Moreover, costs incurred by a business to defend against tort claims generally have been held deductible for the current taxable year. See, e.g., Kornhauser v. United States, 276 U.S. 145, 153 (1928). Both we and our predecessor have permitted the deduction of costs incurred in defending patent infringement suits. The deductibility of these expenses is consistent with the treatment of damages paid in the wake of such litigation. Schnadig Corp. v. Gaines Mfg. Co., 620 F.2d 1166, 1169 (6th Cir. 1980) (“When an infringer is required to pay damages to a design patentee, the amount so paid is deductible from his income tax.”).

Issue at the Heart of the Case

The parties dispute whether the legal fees at issue were incurred to facilitate the acquisition of a right obtained from a Government agency.

The Two Sides

The parties before us both describe the relevant transaction as the acquisition of an FDA-approved ANDA with a paragraph IV certification. However, the parties ascribe very different meanings to this general formulation.

Mylan asserts that the acquisition of an FDA-approved abbreviated new drug application (ANDA) with a certification that any patent “is invalid or will not be infringed by the manufacture, use, or sale” of the generic version (a “paragraph IV certification”) occurs when the FDA completes its scientific and technical review and issues either a tentative or final approval letter.

On the other hand, the IRS asserts that the acquisition of an FDA-approved ANDA with a paragraph IV certification refers to obtaining effective approval of an ANDA with a paragraph IV certification.

The Tax Court found the IRS’s interpretation more persuasive.

Tax Court Findings

Treas. Reg. § 1.263(a)-4(b)(i)(v) requires capitalization of amounts paid to facilitate the acquisition or creation of an intangible. As relevant here, created intangibles include certain rights obtained from a governmental agency, such as rights under a trademark, trade name, copyright, license, permit, franchise, or other similar right granted by that governmental agency. Treas. Reg. § 1.263(a)-4(d)(5)(i).

Although the FDA will approve an ANDA and send the applicant an approval letter as long as it satisfies the scientific and technical requirements set forth in 21 C.F.R. § 314.127, this approval does not confer any rights on an applicant until it becomes “effective,” see 21 U.S.C. § 355(j)(5)(B); 21 C.F.R. § 314.107(a). Only at that point does the right attach, which then allows for a generic drug to be “introduced or delivered for introduction into interstate commerce.” 21 C.F.R. § 314.107(a); see also 21 U.S.C. sec. 355(a) (stating that “[n]o person shall introduce or deliver for introduction into interstate commerce any new drug, unless an approval of an application filed pursuant to subsection (b) or (j) of this section is effective with respect to such drug”).

The petitioner did not show, and the Tax Court did not find, any authority demonstrating that approval before it becomes effective confers rights equivalent to “rights under a trademark, trade name, copyright, license, permit, franchise, or other similar right granted by that governmental agency.” Treas. Reg. § 1.263(a)-4(d)(5)(i). The Tax Court, therefore, adopted the IRS’s interpretation of the transaction.

The Legal Fees for the Paragraph IV Notice Letters

An applicant for an ANDA with a paragraph IV certification “shall give notice” to “each owner of the patent that is the subject of the certification” and the holder of the NDA with respect to the brand name drug covered by such patents. 21 U.S.C. § 355(j)(2)(B)(iii). The notice is required to inform the recipients of the ANDA submission and to explain in detail “the factual and legal basis of the opinion of the applicant that the patent is invalid or will not be infringed.” 21 U.S.C. § 355(j)(2)(B)(iv). After providing that notice, the applicant is required to submit an amendment to its ANDA reflecting that the notice had been given. See 21 C.F.R. § 314.95(b).

This notice requirement is also a part of the ANDA itself. Under 21 U.S.C. § 355(j)(2)(B)(i), the applicant that makes a paragraph IV certification “shall include” in its ANDA a statement that the applicant “will give notice” as outlined in 21 U.S.C. § 355(j)(2)(B). And failure to provide such notice has tangible consequences as certifications become effective only upon notification.

The notice described above thus is a required step in securing an FDA-approved ANDA for those applicants that make a paragraph IV certification. Treas. Reg. § 1.263(a)-4(e)(3). Although Mylan argues that the notice serves to facilitate patent litigation, Congress has made the notice a prerequisite for ANDA approval.

Consequently, the Tax Court held that the legal expenses Mylan incurred to prepare, assemble, and transmit such notice letters constitute amounts incurred “investigating or otherwise pursuing” the transaction of creating FDA-approved ANDAs, Treas. Reg. § 1.263(a)-4(e)(1)(i). Such legal fees, therefore, must be capitalized, Treas. Reg. § 1.263(a)-4(l), Example (1).

The Litigation Expenses

The Tax Court reached a different conclusion with respect to Mylan’s IRC § 271(e)(2) litigation expenses incurred during the years at issue. In the Hatch-Waxman Act, Congress sought to encourage the entry of low-cost generic drugs into the marketplace while softening the risk to cost-intensive innovation by giving brand name drug manufacturers the opportunity to avail themselves of patent law protections before sustaining damages. Among other changes made to accomplish these objectives, the Hatch-Waxman Act moved up the timeline of patent litigation with respect to generic copies of brand name drugs subject to a patent listed in the Orange Book. Although the filing of an ANDA with a paragraph IV certification triggers the opportunity for patent litigation as well as the FDA review process, this statutory design does not transform patent litigation into a step in the ANDA approval process. Therefore, the patent litigation expenses at issue are not subject to capitalization.

The Origin of the Claim

The origin of the claim test likewise indicates that IRC § 271(e)(2) litigation expenses should be treated as deductible ordinary and necessary business expenses. Under this test, we inquire “whether the origin of the claim litigated is in the process of acquisition”, enhancement, or other disposition of a capital asset. Woodward, 397 U.S. at 577; see also Santa Fe Pac. Gold Co., 132 T.C. at 264-265.

The legal expenses at issue arose out of actions initiated by patent holders to protect their intellectual property from infringement and exploitation. A district court’s inquiry in a suit brought under IRC § 271(e)(2) is the same as it is in any other infringement suit, which is to say, whether the patent in question is invalid or will not be infringed by the manufacture, use, or sale of the drug for which the ANDA is submitted. See 21 U.S.C. § 355(j)(2)(A)(vii)(IV). Patent infringement suits are creatures of tort, with an aim of preventing and recovering damages to the patent holder’s business of exploiting its patent, see Urquhart, 215 F.2d at 20.

The litigation expenses at issue here likewise arose out of patent infringement claims. See Santa Fe Pac. Gold Co., 132 T.C. at 264-265. The substance of the underlying claim or transaction out of which the expenditure in controversy arose governs whether the item is a deductible expense or a capital expenditure. Id. Under the reasoning of Urquhart, the litigation expenses of the patent holders that initiated infringement suits against Mylan seem clearly deductible.


The Tax Court held that the disputed legal expenses that Mylan incurred during the years at issue to prepare paragraph IV notice letters must be capitalized pursuant to IRC § 263(a), whereas expenses incurred to litigate IRC § 271(e)(2) suits are currently deductible pursuant to IRC § 162(a).

(156 T.C. No. 10) Mylan, Inc. v. Commissioner

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