A recent Tax Court decision addressed the deductibility of legal expenses and the so-called “origin-of-the-claim” doctrine. The Mylan decision demonstrates that the deductibility of a legal expense generally depends on the origin and character of the underlying claim or transaction out of which the legal expense was incurred. An expenditure, such as legal expenses, may be deductible in one setting but nevertheless required to be capitalized in another. Legal expenses directly connected with (or pertaining to) the taxpayer’s trade or business are deductible under I.R.C. Section 162 as ordinary and necessary business expenses, while expenses arising out of the acquisition, improvement, or ownership of property are capital expenditures under I.R.C. Section 263(a) and are not currently deductible.
Mylan, Inc. & Subsidiaries v. Commissioner, 156 T.C. No. 10| April 27, 2021 | Docket No. 26976-16 | Urda, J.
Short Summary: Mylan, Inc. & Subsidiaries (“Mylan”) is a manufacturer of brand name and generic pharmaceutical drugs. To obtain Food & Drug Administration (“FDA”) approval for generic versions of brand name drugs, Mylan was required to provide a certification regarding the status of any patents that the FDA had listed as covering the respective brand name drug.
Mylan certified that listed patents covering the respective brand name drug were invalid or Mylan’s generic version would infringe on them. This type of certification automatically counts as patent infringement and often provokes litigation under 35 U.S.C. Section 271(e)(2). Mylan was required to send notice letters to the brand name drug manufacturer and any patentees stating that Mylan made this certification.
Mylan incurred legal expenses to prepare notice letters and to defend against patent infringement suits. On its 2012, 2013, and 2014 federal income tax returns, Mylan deducted its legal expenses as ordinary and necessary business expenditures.
Key Issues:
- What is the proper characterization of legal expenses incurred to prepare notice letters to send to the brand name drug manufacturer and any patentees?
- What is the proper characterization of legal expenses incurred to defend patent infringement lawsuits?
Primary Holdings:
- Mylan had to capitalize the legal expenses incurred to prepare notice letters because these expenses were necessary to obtain FDA approval of Mylan’s generic drugs.
- The legal expenses incurred to defend patent infringement suits were deductible as ordinary and necessary business expenses because the patent litigation was distinct from the FDA approval process.
Key Points of Law:
- I.R.C. Section 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.”
- I.R.C. Section 263(a) provides that no deduction shall be allowed for a capital expenditure.
- Where I.R.C. Section 162 and I.R.C. Section 263 each apply to a given expenditure, the capitalization requirement controls and functions to bar the deduction. See R.C. Sec. 161.
- Treasury Regulation Section 1.263(a)-4(b)(i)(v) requires capitalization of amounts paid to facilitate the acquisition or creation of an intangible, which includes “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.”
- Since Congress made the notice a prerequisite for approval, the legal expenses incurred to prepare, assemble, and transmit the notice letters constitute amounts incurred “investigating or otherwise pursuing” the transaction of creating FDA approved applications, and thus the amounts must be capitalized. See Reg. Section 1.263(a)-4(e)(1)(i).
- It is the patent holder’s decision whether to bring litigation. If the patent holder does not file a suit, the generic drug manufacturer is under no obligation to demonstrate that a patent is invalid or not infringed to obtain FDA approval. Since the patent holder controls litigation and is the primary beneficiary of litigation, litigation is not a step in the FDA approval process for the generic drug. Expenses incurred in defending Section 271(e)(2) suits were not “paid to facilitate” the transaction, and thus the expenses are not required to be capitalized.
- Under the origin of the claim test, litigation expenses incurred in defending Section 271(e)(2) suits (e., patent infringement suits arising in response to the generic drug maker’s certification) arose out of the ordinary and necessary business activities of the taxpayer’s generic drug business and accordingly are deductible.
Insight: The Mylan decision demonstrates that the deductibility of a legal expense generally depends on the origin and character of the underlying claim or transaction out of which the legal expense was incurred. An expenditure, such as legal expenses, may be deductible in one setting but nevertheless required to be capitalized in another. Legal expenses directly connected with (or pertaining to) the taxpayer’s trade or business are deductible under I.R.C. Section 162 as ordinary and necessary business expenses, while expenses arising out of the acquisition, improvement, or ownership of property are capital expenditures under I.R.C. Section 263(a) and are not currently deductible.
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