There is welcome clarity for branded pharmaceutical companies seeking to deduct legal fees incurred in defending their patents against challenges to market exclusivity by generic companies. This clarity comes after a year of uncertainty arising from a negative opinion expressed by the IRS in a chief counsel memorandum ("CCM") in January 2013, which the IRS seems to have now reversed in a second CCM issued 20 months later. (CCMs are generic legal advice prepared by the IRS Office of Chief Counsel for IRS field agents and other employees conveying the chief counsel's legal interpretation of a tax matter.)
FDA approval must be obtained before a new drug may be legally marketed and sold in the United States. To expedite the availability of less costly generic drugs, an abbreviated new drug application ("ANDA") may be submitted by generic applicants. The ANDA applicant must make certifications regarding the existing patents owned by the branded pharmaceutical company. A common certification of generic applicants is a so-called "Paragraph IV" ANDA, in which the applicant asserts that the patent is invalid, unenforceable, or will not be infringed. The generic applicant is required to promptly notify the drug patent holder of its Paragraph IV ANDA, and the drug patent holder may file an infringement suit against the ANDA applicant to prevent the FDA from approving the ANDA.
Most branded pharmaceutical companies have historically deducted the costs of suing such generic ANDA applicants because, under the operative "origin of the claim" test, the litigation arises out of the taxpayer's ordinary business activity. This is supported by case law, including Urquhart v. Commissioner, which held that expenses incurred by a patent holder suing for infringement were deductible. This deductibility was further promulgated by the capitalization regulations of Treasury Regulations §1.263(a)-4, the preamble to which cited Urquhart, requiring capitalization of litigation costs only if incurred to facilitate the creation, acquisition, or defense of, or perfection of title to, intangible property.
Despite these established rules, on January 18, 2013, the IRS in CCM 20131001F concluded that certain legal fees incurred by patent holders suing generic applicants pursuant to Paragraph IV ANDAs were not deductible and instead must be amortized over the remaining lives of the asserted patents. The CCM reasoned that, where an alleged infringer raises an invalidity defense, proving validity constitutes the defense or perfection of title to the asserted patent even where ownership of the patent is not in dispute.
On September 12, 2014, the IRS released CCM AM 2014-006 concluding that legal fees incurred by patent holders bringing infringement lawsuits pursuant to Paragraph IV ANDAs are in most cases deductible as ordinary and necessary business expenses, regardless of whether an invalidity defense is raised. Although the 2014 CCM does not mention the 2013 CCM, the contrary conclusion in the later CCM suggests that the IRS Office of Chief Counsel has reversed its view regarding the deductibility of these expenses. The new CCM states that litigation fees may be capitalized if the true ownership of the patent is at issue in the litigation, but notes that such an ownership dispute would be highly unusual in the context of a Paragraph IV ANDA.
Interestingly, although the legal fees incurred by the patent holder are deductible under the new guidance, the legal fees incurred by the generic manufacturer in the same lawsuit are generally nondeductible according to the IRS Office of Chief Counsel.