IRS concludes patent defense legal fees for generic drug approvals are capitalizable

In a recent IRS field attorney advice (FAA) memorandum (FAA 20154502F), the IRS concluded that certain legal fees incurred by a taxpayer to defend a patent infringement suit were Section 263(a) costs that should be capitalized to a Section 197 intangible.

The legal fees were incurred in conjunction with seeking approval from the FDA for a new generic drug vis-à-vis an Abbreviated New Drug Application (ANDA) with “Paragraph IV” certification. The IRS looked to the origin of the claim doctrine when it rebuffed the taxpayer’s assertions that the expenses were incurred in the ordinary course of business and currently deductible under Section 162.

The Drug Price Competition and Patent Term Restoration Act (P.L. 98-417), commonly known as the Hatch-Waxman Act, was passed by Congress in 1984 with the intent to encourage the development and sale of generic versions of FDA-approved innovator drugs to increase public access to lower-cost medicines. To achieve this, the Hatch-Waxman Act provides that when certain conditions are met, the generic drug approval can “piggyback” on the safety and efficacy studies conducted for the FDA-approved innovator drug that it mimics. This expedited approval process is achieved through the filing of an ANDA and enables generic drug makers to position themselves to market and sell the generic drugs immediately upon expiration of the mimicked innovator drug’s patent, if not earlier. Without ANDAs and certain other provisions of the Hatch-Waxman Act, generic drug makers would be forced to begin the FDA approval process only upon expiration of the innovator drug’s patent, providing an extended exclusivity to innovator drug makers.

When a generic drug maker files an ANDA, one of four certifications must accompany the ANDA:
  • Paragraph I: Patent information on the drug has not been filed with the FDA.
  • Paragraph II: The original patent has expired.
  • Paragraph III: The date on the patent will expire. (The FDA will not finally approve until the patent expires.)
  • Paragraph IV: The patent is invalid or will not be infringed.
A Paragraph I, II, or III certification generally will not result in patent infringement, and thus, legal defense fees are less likely to be incurred. However, courts have opined that a Paragraph IV certification is a de facto act of infringement and often means it ill provoke litigation.  

To entice generic drug makers to file a Paragraph IV certification in spite of the risk of costly litigation, Congress included a provision in the Hatch-Waxman Act that would provide a 180-day exclusivity period to the first filer of a substantially complete ANDA with Paragraph IV certification, in which such certification is lawfully maintained throughout the approval process. The ANDA filer who obtains the 180-day exclusivity is able to gain dramatic financial benefits and market share because its generic version is the only generic drug on the market that is allowed to compete with the higher-priced innovator drug. If the owner of the innovator drug’s patent does bring suit, however, FDA approval of the generic drug ANDA is not allowed to be effective until the court rules that the patent is not infringed or generally the expiration of 30 months, whichever is sooner.

In the FAA, the IRS said that legal fees incurred in litigation should be analyzed in the context of a two-step process when determining whether the fees must be capitalized. First, the origin of the claim doctrine must be applied to ascertain the nature and character of the expenditures. Second, the regulations related to the capitalization of intangibles must be applied to determine if capitalization of the expenditures is required.  

The taxpayer in the FAA filed an ANDA with a Paragraph IV certification, seeking the 180-day exclusivity.  

Based on the facts, the IRS concluded that the FDA approval of an ANDA creates for the applicant an intangible under Treas. Reg. Sec. 263(a)-4(d)(5)(i). Because approval of an ANDA under Paragraph IV cannot be given until the litigation is resolved, the infringement suit is so integral to the approval process that the litigation costs to defend the suit are incurred in the process of pursuing the ANDA. That is, although the IRS recognizes in the analysis that costs to defend against a claim of patent infringement generally are deductible, the IRS states that under these facts, the otherwise deductible legal costs must be capitalized because they are incurred to facilitate the creation of the ANDA. Therefore, the legal fees must be capitalized to the ANDA intangible.

The IRS also concluded that FDA approval of the ANDA and the connected litigation costs are a Section 197 intangible within the meaning of Treas. Reg. Sec. 197-2(b)(10). Accordingly, the capitalized expenditures are amortizable over a 180-month period.

Also, the annual cost recovery of the legal fees under Section 197 are further subject to capitalization pursuant to the uniform capitalization rules of Section 263A, meaning that as the costs are amortized, such amounts must be taken into account when determining the tax basis of product inventory and are allowed as a deduction only once such product is sold or disposed.

This FAA appears to be consistent with, and expands upon, prior informal guidance issued by the IRS.  Last year, the IRS released a generic legal advice memorandum 2014-006 that similarly held that these same litigation costs are capitalizable. In FAAs 20114703F and 20114900F, the IRS stated that legal fees to research patents to make the Paragraph IV certifications must be capitalized as costs that facilitate creating the ANDA, which is a franchise.   

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