Mylan Inc. & Subsidiaries v. Commissioner of Internal Revenue (U.S. Tax Court April 27, 2021)

Under the Internal Revenue Code (“Code”) Section 162, ordinary and necessary business expenses are deductible, but Code Section 263 disallows a deduction for capital expenditures (“no deduction shall be allowed” for a capital expenditure). Capital expenditures must be capitalized and are generally recovered as depreciation or amortization deductions over a period of years. “Ordinary” expenses are those “customary or usual within a particular trade” and “necessary” if they are appropriate and helpful to the business’ operation. For a typical patent infringement litigation, the litigation costs to both the patentee and the alleged infringer are considered ordinary business expenses, not capital expenses.

Like many large generic pharmaceutical companies, Mylan spends millions of dollars in Hatch-Waxman patent litigation under 35 U.S.C. Sec. 271(e)(2) each year. In the years 2012 through 2014, Mylan spent approximately $130 million to prepare Paragraph IV notice letters and litigate the resulting Section 271(e)(2) patent infringement actions, and Mylan deducted that total amount as ordinary business expenses. Upon audit, the Internal Revenue Service (“IRS”) disallowed the deductions, other than a small portion, characterizing the costs as capital expenditures rather than ordinary business expenses. Mylan challenged the results in the Tax Court. On April 27, 2021, the Tax Court issued a decision reversing in part the determination of the IRS. The Court found some of Mylan’s costs to be ordinary business expenses and some to be capital expenditures.

Under the Income Tax Regulations, an expenditure that “creates or enhances a separate and distinct” intangible asset must be capitalized. Regarding rights obtained from a governmental agency, “[a] taxpayer must capitalize amounts paid to a governmental agency to obtain … its rights under a trademark, trade name, copyright, license, permit, franchise or other similar right granted by that governmental agency”, as well as amounts “paid to facilitate …an acquisition or creation” of the intangible right.

According to the IRS, Mylan’s litigation expenses were incurred to facilitate the acquisition of a right from the FDA, that right being an FDA approved Abbreviated New Drug Application (“ANDA”). The Tax Court agreed with the IRS as to the Paragraph IV notice letters, finding them to be a necessary step in the process of making a Paragraph IV certification and obtaining FDA approval of an ANDA. Therefore, Mylan’s legal expenses “incurred to prepare, assemble, and transmit” the notice letters constituted “investigating or otherwise pursuing’ the transaction of creating FDA approve ANDAs” were capital expenditures that had to be capitalized.

In contrast, the Tax Court found that patent litigation was not an element in the FDA approval process. The Court stated that the Hatch-Waxman Act simply moved up the timing of what is otherwise an ordinary patent litigation, so it begins before the product is marketed. As the Court noted, although “the filing of an ANDA triggers the opportunity for patent litigation as well as the FDA review process”, the FDA approval process is generally separate from the existence, or timing, of any patent litigation. Thus, the FDA continues its safety and bioequivalence review of the ANDA apart from the pendency of the litigation, and its review of the ANDA does not include analysis of patent issues. Moreover, the branded company may decide not to sue in response to a Paragraph IV certification, and the lawsuit is not necessary to obtain FDA approval.

Applying the “origin of the claim” test to determine whether the legal fees should be deductible as ordinary and necessary business expenses, the Tax Court reached the same result. Hatch-Waxman litigation resolves the question of patent rights, providing the patent owner or rights holder the opportunity to protect its intellectual property rather than providing the generic company the acquisition or enhancement of a right from the FDA. Under the origin of the claim test, the Court found the litigation “arose out of the ordinary and necessary activities of the drug business” and the litigation costs, like those arising from any other patent litigation, are “accordingly deductible”.

The Court concluded that the legal expenses to prepare Paragraph IV letters should be capitalized pursuant to Code Section 263(a). Under Code Section 197, certain capitalized expenses, such as the legal expenses to prepare the Paragraph IV letters, must be amortized over a 15-year period, while the Hatch-Waxman litigation expenses are currently deductible.

Based on this decision, Mylan is able to avoid much of the $50 million tax deficiency bill from the IRS that disallowed the deduction of Mylan’s litigation expenses. However, this may not be the final word on the deductibility of Hatch-Waxman litigation costs. Either side may appeal the aspect of the decision adverse to it.

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