Hatch-Waxman patent suits may be deductible litigation expenses

The United States Court of Appeals for the Federal Circuit affirmed a Court of Federal Claims decision, holding that a taxpayer could deduct expenses related to defending patent infringement lawsuits initiated under the Hatch-Waxman Act.

In Actavis Laboratories FL Inc. v. United States (Docket 23-1320), the Federal Circuit analyzed the taxpayer’s Hatch-Waxman litigation expenses, finding that the litigation expenses are deductible as ordinary and necessary business expenses under the origin of the claim test and are not required to be capitalized as an amount that facilitates the acquisition of an intangible asset.

The Hatch-Waxman Act of 1984 established an expedited process for obtaining the United States Food and Drug Administration (FDA) approval to market and sell generic versions of previously approved branded drugs. Under this Act, an Abbreviated New Drug Application (ANDA) submitted to the FDA must address any patents covering the reference branded drug. By submitting a Paragraph IV certification, the ANDA filer asserts that any patent covering the branded drug is either invalid or will not be infringed upon by the ANDA filer’s generic drug. Under this certification, the ANDA filer may obtain effective FDA approval but must notify the patent owner of the factual and legal bases for its assertions. Filing an ANDA with a Paragraph IV certification is considered an act of patent infringement, giving the patent owner a cause of action against the ANDA filer. If the branded drug owner files a patent infringement claim, it can prevent the FDA from approving the ANDA for up to 30 months.

Section 162(a) and the regulations thereunder generally provide that a taxpayer may deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business. In contrast, Section 263(a) and the regulations thereunder provide rules for amounts that are required to be capitalized, including certain amounts paid to acquire or create intangibles. For example, taxpayers must capitalize amounts paid to obtain certain rights from a governmental agency. Taxpayers are also required to capitalize amounts paid to facilitate the acquisition or creation of intangibles.

The Taxpayer in Actavis is a pharmaceutical company that filed several ANDAs with the FDA to market and sell generic versions of branded drugs already available in the United States. In response, branded drug manufacturers holding New Drug Applications (NDAs) and patents initiated patent infringement lawsuits against the taxpayer under the Hatch-Waxman Act. The taxpayer incurred over $12 million in Hatch-Waxman Act litigation expenses during 2008 and 2009 and deducted these expenses as ordinary and necessary business expenses under Section 162. The IRS issued a notice of deficiency, stating that the expenses must be capitalized under Section 263 and Treas. Reg. Sec. 1.263(a)-4 as amounts paid to facilitate the creation of an intangible asset. The taxpayer paid the deficiencies and filed suit against the government in the Court of Federal Claims when the IRS failed to act on the overpayment refunds claimed on its amended 2008 and 2009 returns.

The origin of the claim test, established by case law including the Supreme Court rulings in United States v. Gilmore, 372 U.S. 39 (1963) and Woodward v. Comm’r, 397 U.S. 572, 577 (1970), is fundamental to analyzing the federal income tax treatment of litigation expenses. Citing Woodward and Gilmore, the Federal Circuit stated that applying the origin of the claim test requires determining “whether the origin of the claim litigated is in the process of acquisition” of a capital asset. The taxpayer’s motivation for making the expenditure and the consequences of the litigation for the taxpayer are irrelevant.

Ruling in favor of the taxpayer, the Federal Circuit concluded that the application of the origin of the claim test demonstrates that Hatch-Waxman litigation expenses are deductible as ordinary and necessary business expenses. The Federal Circuit determined that these expenses originate from patent infringement claims rather than the acquisition of FDA approval of an ANDA. Acknowledging that the taxpayer was pursuing the capital asset of an FDA-approved ANDA, the Federal Circuit stated that Hatch-Waxman litigation does not determine whether the ANDA is approved. The Federal Circuit reasoned that such litigation typically proceeds in parallel with FDA review and the outcomes are independent. Although the litigation may affect the timing of when FDA approval becomes effective, it does not affect whether the FDA grants such approval.

The Federal Circuit disagreed with the government’s argument that the Paragraph IV certification initiated the Hatch-Waxman lawsuit, stating that litigation is not automatic and is beyond the taxpayer’s control. The government cited Woodward, in which the Supreme Court found that litigation expenses were capitalizable because they were incurred in the process of acquiring an asset. The Supreme Court determined that the litigation was to determine the price at which the taxpayer would acquire an asset and the sales process could not have been completed without the price being set. The Federal Circuit distinguished the facts in this case from Woodward, reasoning that resolution of the patent litigation is not a pre-requisite to FDA approval.

Citing the same reasons for its origin of the claim conclusion, the Federal Circuit determined that the Hatch-Waxman litigation expenses are not capitalizable under Section 263. The Federal Circuit found that such amounts do not facilitate the “transaction” of the taxpayer’s acquisition of an intangible asset because the litigation is not part of the process of pursuing FDA approval. This ruling aligns with the Tax Court’s decision in Mylan, Inc. v. Commissioner, 156 T.C. 137, 161-62 (2021), where the Tax Court ruled in favor of a taxpayer with similar facts.

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