Drug Company Challenges Capitalization of Patent Litigation Costs

TEVA PHARMACEUTICALS USA, INC. & SUBSIDIARIES,
1090 Horsham Rd.
North Wales, PA 19454,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

PETITION

Teva Pharmaceuticals USA, Inc. & Subsidiaries (“Teva” or “Petitioner”) hereby petition for a redetermination of the deficiency in tax for the taxable years ended December 31, 2009 (“2009 Tax Year”) and December 31, 2010 (“2010 Tax Year”) set forth by the Commissioner of Internal Revenue (“Respondent”) in the Notice of Deficiency dated June 28, 2019 (bearing symbols AP:EX:PA:PHI:MAA) (the “2009-2010 Notice”).

This is a case for a redetermination of a tax deficiency principally necessitated by Respondent's determination that generic drug companies, alone among all defendants in patent infringement litigation, must capitalize rather than deduct their patent infringement defense costs in certain actions brought by branded drug companies. Respondent's position is based upon a fundamental misunderstanding of generic drug patent infringement litigation and how it relates to the Food & Drug Administration's (“FDA”) separate process for approving generic drugs for sale. Because generic drug companies' patent infringement defense costs are ordinary business expenses like all other companies' patent infringement defense costs, the Court should determine that those costs are deductible and redetermine the deficiency in tax set forth by Respondent. In addition, Respondent erred by denying Teva the research and development credits generated by an acquired company, and by requiring the capitalization of some legal expenses that were not actually generic drug patent infringement defense costs.

1. Petitioner is Teva Pharmaceuticals USA, Inc. & Subsidiaries. As of the date of this filing, Teva's principal place of business and mailing address is 1090 Horsham Road, North Wales, Pennsylvania 194544090. Teva is a corporation organized under the laws of Delaware.

2. Teva timely filed electronically its federal income tax returns for 2009 and 2010 with the Ogden Submission Processing Campus of the Internal Revenue Service in Ogden, Utah.

3. Respondent's Appeals Office in Philadelphia, PA mailed the 2009-2010 Notice on June 28, 2019, a copy of which is attached hereto as Exhibit A.

4. In the 2009-2010 Notice, Respondent determined deficiencies in income tax in the following amounts:

Year	Deficiency
2009	$32,702,467
2010	$11,610,462

5. The entirety of the 2009-2010 Notice and the deficiencies stated therein are in dispute.

ASSIGNMENT OF ERROR

6. The determination of tax set forth in the 2009-2010 Notice is based on the following errors:

a. Respondent erred in determining that costs incurred in defense of patent infringement litigation in the amounts of $53,254,033 for the 2009 Tax Year and $41,782,650 for the 2010 Tax Year, referred to as Hatch-Waxman defense costs, were not ordinary and necessary business expenses and therefore were not deductible under 26 U.S.C. § 162.

b. Respondent erred by determining that the Hatch-Waxman defense costs of $53,254,033 for the 2009 Tax Year and $41,782,650 for the 2010 Tax Year were required to be capitalized under section 263(a) of the Internal Revenue Code and section 1.263(a)-4 of the Treasury Regulations. Accordingly, Respondent also erred in increasing Teva's taxable income by $53,254,033 for the 2009 Tax Year and by increasing the taxable income for the 2010 Tax Year by $41,782,650.

c. Even if Respondent is correct that Hatch-Waxman defense costs must be capitalized, Respondent erred in its calculation of the amounts required to be capitalized for both the 2009 and 2010 Tax Years, as Respondent both misclassified $8.4 million in legal expenses as being related to Hatch-Waxman litigation which were not, and did not allow deductions for $15,864,278 in legal expenses related to FDA applications that were abandoned or withdrawn during tax years 2009 and 2010, and so are separately deductible under 26 U.S.C. § 165.

d. Respondent erred by imposing a Section 481(a) adjustment in the amount of $57,391,252 for the 2009 Tax Tear and by increasing Teva's taxable income for the 2009 Tax Year by that amount. This amount was based on Respondent's incorrect determination that Hatch-Waxman defense costs incurred by Teva during the 2004 through 2008 Tax Years are not deductible. In addition, $17,080,902 of those expenses were related to FDA applications that Teva either abandoned or withdrew during the 2004 through 2008 Tax Years, and so they are separately deductible under 26 U.S.C. § 165. Moreover, even if Respondent is correct that the generic drug patent litigation costs at issue must be capitalized, such a conclusion would not constitute a change in method of accounting with respect to which an adjustment may be imposed under 26 U.S.C § 481(a).

e. Even if Respondent did not err in its determination of the deductibility of patent litigation expenses, Respondent erred in allowing amortization deductions in the amount of, and decreasing taxable income by, only $855,805 for the 2009 Tax Year and $1,071,115 for the 2010 Tax Year.

f. Respondent erred in disallowing the additional research credit carryover from the taxable year ending 2008 to the 2009 Tax Year in the amount of $9,850,191 as a result of the calculation required by 26 U.S.C. § 41(f)(3) due to the acquisition of the business of Barr Pharmaceuticals, Inc., in 2008.

LEGAL BACKGROUND AND FACTUAL ALLEGATIONSHATCH-WAXMAN LITIGATION COSTS

7. It has long been settled that the costs of defending against claims of patent infringement brought under 35 U.S.C. § 271 are deductible and need not be capitalized. Thus, if one branded drug company sues another branded drug company for patent infringement, the defendant can deduct its costs for litigating issues such as infringement, patent validity and enforceability, preliminary and permanent injunctive relief, and damages. See Urquhart v. Commissioner, 215 F.2d 17 (3d Cir. 1954).

8. When a branded drug company brings a patent infringement action against the seller of a proposed generic version of its drug under 35 U.S.C. § 271, the nature of the patent infringement litigation is the same. The FDA is not a party to the litigation, and the lawsuit does not directly dispute whether defendant is entitled to FDA approval for its generic drug. Instead, the parties will litigate the same questions of infringement, patent invalidity and/or enforceability, and potentially injunctive relief and damages, as in any other patent infringement case.

9. Yet Respondent does not allow generic drug defendants to deduct their patent infringement defense costs. Instead, Respondent requires their defense costs to be capitalized. Respondent's reasoning is this: under the Drug Price Competition and Patent Term Restoration Act, Pub. L. 98-417, 98 Stat. 1585, known as the “Hatch-Waxman Act,” the FDA sometimes must delay approving an otherwise approvable application to sell a generic drug until after 30 months have elapsed in a patent litigation; sometimes, based on the outcome of the litigation, will convert a previously-issued full generic drug approval into an approval conditioned on expiration of the asserted patents; and sometimes may reward a generic drug company that prevails in litigation with so-called “generic exclusivity” for a limited period of time. Based merely on the fact that patent infringement litigation brought against an applicant to sell a generic drug might, as a collateral matter, impact the timing and nature of the FDA's approval of the generic drug for sale, the Internal Revenue Service (“IRS”) requires the generic drug company's defense costs to be capitalized to the FDA application, rather than deducted.

10. Respondent's position is arbitrary and inconsistent with law, improperly looking at the “potential consequences upon the fortune” of the generic drug company from the patent litigation, rather than at the “origin and character of the claim with respect to which an expense was incurred.” U.S. v. Gilmore, 372 U.S. 39, 49 (1963). The origin and character of the claim in a Hatch-Waxman case is a patent owner's allegation under 35 U.S.C. § 271 that its patent rights will be infringed by defendant's product or method of using it, just like in all other patent infringement cases. Supreme Court precedent forecloses Respondent's conclusion that a generic drug company must capitalize its costs of litigating issues such as infringement, validity and enforceability, while any other defendant may deduct its costs of litigating the very same issues against the very same plaintiff over the very same patent.

11. The disadvantageous tax treatment of generic drug companies with respect to millions of dollars in litigation costs undermines Congress's intent in passing the Hatch-Waxman Act, which was to encourage generic market entry. This Court should reject Respondent's treatment of generic drug makers' patent-litigation expenses, and redetermine the deficiency in tax set forth by Respondent.

The Internal Revenue Code and Treasury Regulations

12. The Internal Revenue Code distinguishes between expenses that can be deducted in the year in which they are incurred and those that must be capitalized to a specific piece of tangible or intangible property.

13. Deductible expenses are governed by 26 U.S.C. § 162(a), which states that “[t]here shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business[.]”

14. 26 U.S.C. § 263(a) provides that expenses cannot be deducted if they are “paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.”

15. A Treasury regulation explains how these statutory provisions apply in the context of the acquisition of intangible property. See Treas. Reg. § 1.263(a)-4. As relevant here, the regulations require capitalization of “[a]n amount paid to create an intangible described in paragraph (d),” or “[a]n amount paid to facilitate (within the meaning of paragraph (e)(1) of this section) . . . creation of [such] an intangible.” Id. § 1.263(a)-4(b)(ii), (v).

16. Paragraph (d) addresses when an amount is paid to “create” an intangible. That paragraph provides, in relevant part, that in the context of an intangible consisting of “rights obtained from a governmental agency,” a “taxpayer must capitalize amounts paid to a governmental agency to obtain, renew, renegotiate, or upgrade its rights under a . . . license, permit, franchise, or other similar right granted by that governmental agency.” Id. § 1.263(a)-4(d)(5)(i).

17. Paragraph (e) then addresses when an amount is paid to “facilitate” the creation of such an intangible. That paragraph provides:

[A]n amount is paid to facilitate the acquisition or creation of an intangible (the transaction) if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or otherwise pursuing the transaction is determined based on all of the facts and circumstances. In determining whether an amount is paid to facilitate a transaction, the fact that the amount would (or would not) have been paid but for the transaction is relevant, but is not determinative.

Id. § 1.263(a)-4(e)(1)(i) (emphasis added). The “transaction” means “all of the factual elements comprising . . . creation of [the] intangible.” Id. § 1.263(a)-4(e)(3).

18. The result of these provisions, read together, is that an expenditure must be capitalized as “facilitat[ing]” the creation of an intangible only if it is made in “pursuing” the “creation of [the] intangible.”

19. Whether a given litigation expense must be capitalized under these provisions is analyzed by looking to the “origin of the claim.” Woodward v. Commissioner, 397 U.S. 572, 577 (1970). What matters is not “the consequences of the litigation,” or the “taxpayer's motives or purposes in undertaking defense of the litigation, but rather. . . the origin and character of the claim against the taxpayer.” Id. at 578; see also Gilmore, 372 U.S. at 48. “In determining whether legal fees expended in litigation are to be capitalized or deducted, courts look to the origin, character and nature of the claim pursued during the litigation.” Baylin v. United States, 30 Fed. Cl. 248, 254 (1993).

20. Patent litigation expenses normally are deductible as ordinary business expenses, not expenses that must be capitalized as pursuit of the creation of an intangible. See Urquhart, 215 F.2d at 20-21.

21. So long as the patent litigation does not involve a challenge to title to the patent, a company defending against a claim of patent infringement is permitted to deduct all of its costs of defending against the patentee's claims of patent infringement, and seeking to defeat any motions for preliminary and permanent injunctive relief.

The Hatch-Waxman Act

22. In 1984, Congress enacted the Drug Price Competition and Patent Term Restoration Act, Pub. L. 98-417, 98 Stat. 1585, known as the Hatch-Waxman Act. The Hatch-Waxman Act was designed to overcome existing obstacles to approval and distribution of generic drugs.

23. The first obstacle involved the process for obtaining FDA approval to market a generic drug. Prior to the Hatch-Waxman Act, a generic drug company needed to replicate the brand drug company's safety and efficacy studies. See 35 U.S.C. § 355(b)(1). This added significant cost to seeking generic approval. The Hatch-Waxman Act eliminated this requirement. It allows a generic drug company to submit an Abbreviated New Drug Application, or “ANDA,” which only requires that the generic drug company show that its product has the same active ingredient, route of administration, dosing, and labeling as a previously-approved drug, and that the proposed generic drug product is bioequivalent to the previously-approved drug. See 35 U.S.C. § 355(j)(2)(A)(ii)-(v). Whether the FDA approves an ANDA is governed entirely by whether the ANDA makes the required safety and efficacy showings. Id. § 355(j)(4). If the FDA decides to deny an ANDA because the generic drug company cannot satisfy safety and efficacy requirements, the question of whether the proposed generic drug infringes any brand drug companies' patents is largely moot.

24. The second obstacle involved the process by which claims of patent infringement could be brought against generic drug companies. Prior to the Hatch-Waxman Act, a patent holder might bring an infringement lawsuit against a generic drug company for the product development activities that go into making a generic version of a drug. Such infringement lawsuits posed a substantial barrier to generic drug development. The Hatch-Waxman Act resolved that issue by creating a “safe harbor” for generic drug development activities that, but for the safe harbor, would constitute patent infringement. See 35 U.S.C. § 271(e)(1). The safe harbor allows generic drug companies to develop their products without confronting patent infringement litigation “too early” in the process. Such development activities include, for example, creating samples of drugs for submission to the FDA for safety and efficacy testing, which otherwise could constitute acts of alleged infringement.

25. In introducing such a safe harbor for development activities, however, Congress also took care not to require patent infringement litigation to be brought “too late” in the process either — for example, only once the generic drug company had “launched” its generic drug onto the market after obtaining FDA approval. This also could create a disincentive for generic drug companies to enter the market, as they could not know whether their product would survive patent infringement litigation until they already had made a considerable investment in launching. The generic drug companies also would run the risk of substantial damages awards (including potentially treble damages for willful patent infringement) if they lost the infringement litigation after launching.

26. To address such timing issues, the Hatch-Waxman Act created a mechanism through which patent infringement disputes could be resolved before the generic drug company entered the market. Specifically, the Act allows branded drug companies, as part of their New Drug Applications (“NDAs”), to inform the FDA of any patent that claims the brand drug or a method of using that drug such that the patent could “reasonably be asserted” against a future generic drug product. See 21 U.S.C. § 355(b)(1). The FDA must then publish those patents in what is referred to as the “Orange Book.” Id. If a generic drug company submits an ANDA seeking approval for a generic drug that, if approved, would potentially infringe an Orange Book patent that will not have expired at the time of the proposed commercial manufacture and distribution, the ANDA filer must certify to the FDA that the patent “is invalid or will not be infringed” by the manufacture, use, or sale of the generic drug. Id. § 355(j)(2)(A)(vii)(IV). The ANDA filer must also serve that certification, known as a “¶ IV certification,” on the brand company and all patent owners. Id. § 355(j)(2)(B).

27. The Hatch-Waxman Act also makes it an act of patent infringement for a generic drug company to submit an ANDA with a ¶ IV certification. See 35 U.S.C. § 271(e)(2). This provision gives the branded drug company the option — but does not require it — to commence patent infringement litigation upon the generic's filing of such an ANDA. In effect, the combination of the Hatch-Waxman Act's “safe harbor” in section 271(e)(1), and the infringement provision in section 271(e)(2), is to temporarily delay the ability of branded drug companies to sue generic drug companies over patent infringement, shifting it from the drug development stage (when otherwise-infringing samples of product might be created) to when the generic drug company seeks FDA approval.

28. Patent litigation that is based on the filing of an ANDA is commonly referred to as “Hatch-Waxman litigation.” A Hatch-Waxman patent infringement case is like any other patent infringement case. A Hatch-Waxman plaintiff does not contend that the ANDA itself — a mere application — practices its patent; it instead alleges that the generic drug, or its method of use, as described in the ANDA and determined through testing of samples of the generic product, would infringe.

29. If the branded drug company prevails in the Hatch-Waxman litigation, then the FDA may still approve the ANDA, but the approval will be “tentative” until the patents asserted in the litigation have expired, at which point it converts to a full approval. Thus, whether the FDA ultimately will approve the ANDA is not impacted by Hatch-Waxman litigation at all. Only the timing of when the generic drug company may enter the market — immediately upon full approval of the ANDA, or only upon expiration of any valid and infringed Orange Book patents — is affected.

30. In summary, the relationship between Hatch-Waxman litigation and the FDA's consideration of an ANDA is uncertain — a Hatch-Waxman lawsuit may never be filed and is unnecessary for ANDA approval — and at most can have a collateral impact on the timing of ANDA approval. Hatch-Waxman litigation, on the other hand, is just like any other patent infringement litigation brought under 35 U.S.C. § 271. The ultimate question is whether defendant's product or method of using it infringes one or more of plaintiff's valid and enforceable patents.

Respondents Uniquely Unfavorable Tax Treatment of Generic DrugCompanies' Hatch-Waxman Litigation Expenses

31. Respondent and the IRS have taken the position that a defendant's Hatch-Waxman litigation costs are not deductible as ordinary business expenses — like all other defendants' patent litigation costs — but instead must be capitalized.

32. For example, the IRS Office of the Chief Counsel has released four memoranda stating that generic drug companies cannot deduct Hatch-Waxman litigation expenses, but instead must capitalize them as expenses incurred to create the ANDA that is the basis for the brand company's claim of patent infringement. Office of Chief Counsel, Internal Revenue Service, Memoranda 20114901F (released Dec. 9, 2011); 20131001F (released March 8, 2013); AM2014-006 (released Sept. 12, 2014); 20154502F (released Nov. 6, 2015).

33. The IRS memoranda recognize that, “[i]n general, costs to defend against a claim of patent infringement are deductible on the theory that the taxpayer is protecting or maintaining its income-generating business.” AM2014-006, at 5; 20154502F, at 37. The IRS also concedes that costs incurred in Hatch-Waxman litigation are not amounts paid to the government for purposes of Treas. Reg. § 1.263(a)-4. See AM2014-006, at 5.

34. The IRS memoranda nevertheless conclude that Hatch-Waxman litigation is an “integral step” in “pursuing FDA approval of an ANDA with IV certification,” and thus the litigation expenses must be capitalized to the ANDA. AM2014-006, at 5. According to the IRS, the “origin” of the claim in Hatch-Waxman litigation is the generic's attempt to “obtain an FDA-approved ANDA with a ¶ IV certification. [The generic drug company] had to defend itself in the 35 U.S.C. § 271(e)(2) suit brought by [the brand] in order to obtain FDA approval of [the drug] effective prior to the expiration of the patents.” 20154502F, at 40.

35. The IRS's position misstates the relationship between the FDA's ANDA approval process and any patent infringement litigation that may occur in parallel in court. Hatch-Waxman litigation is not litigation brought against the FDA either to order or prevent approval of an ANDA. FDA is not a party to the litigation at all. Hatch-Waxman litigation is in no way an “integral step” in “pursuing FDA approval of an ANDA with a ¶ IV certification,” and the generic company does not “[have] to defend itself' in such litigation “in order to obtain FDA approval of [the drug] effective prior to the expiration of the patents.” The generic ANDA applicant does not initiate Hatch-Waxman litigation, and — as sometimes happens — the brand company may decide, for its own reasons, not to bring a patent infringement action against a generic drug company that submitted an ANDA with a ¶ IV certification. Thus, the FDA may approve an ANDA, even one with a ¶ IV certification, without any Hatch-Waxman litigation occurring at all.

36. The “origin of the claim” in Hatch-Waxman litigation — the event from which the taxpayer's costs proximately result — is the plaintiff branded drug company's decision to allege that defendant's proposed generic drug or method of using it (as described in the ANDA and determined through testing of samples of the generic product) would infringe plaintiff's patent(s). See 35 U.S.C. § 271(e)(2). This is no different than the same plaintiff alleging that any other defendant, such as the maker of a non-generic drug, is trespassing on the plaintiff's patent rights by committing any other act of infringement identified in section 271. See 35 U.S.C. § 271(a) (“whoever without authority makes, uses, offers to sell, or sells any patented invention . . . or imports into the United States any patented invention during the term of the patent therefor, infringes the patent.”). The Hatch-Waxman Act merely affects the timing of the process with respect to generic drug companies, by deferring it under the safe harbor until the generic drug company seeks FDA approval.

37. The Federal Circuit has recognized that the fundamental nature of Hatch-Waxman litigation is no different from that of “any other infringement suit”:

[A] district court's inquiry in a suit brought under 35 U.S.C. § 271(e)(2) is the same as it is in any other infringement suit, viz., whether the patent in question is “invalid or will not be infringed by the manufacture, use, or sale of the drug for which the [ANDA] is submitted.” 21 U.S.C. § 355(j)(2)(A)(vii)(IV) (emphasis added). The only difference in actions brought under 35 U.S.C. § 271(e)(2) is that the allegedly infringing drug has not yet been marketed and therefore the question of infringement must focus on what the ANDA applicant will likely market if its application is approved, an act that has not yet occurred. The occurrence of the defined “act of infringement” does not determine the ultimate question whether what will be sold will infringe any relevant patent.

Glaxo v. Novopharm, 110 F.3d 1562, 1569 (Fed. Cir. 1997); see Abbott Labs. v. TorPharm, Inc., 503 F.3d 1372, 1379 (Fed. Cir. 2007) (noting lack of “any authority, be it statute, case law, or legislative history of the Hatch-Waxman Act, suggesting that suits commenced under the provisions of the Act are to be treated any differently than patent infringement suits under 35 U.S.C. § 271(a)”); Bayer Schering Pharma AG v. Lupin, Ltd., 676 F.3d 1316, 1325 (Fed. Cir. 2012) (“Section 271(e)(2)(A) defines the filing of an ANDA as an act of infringement, but it does not alter the underlying patent infringement analysis. . . .”); Allergan, Inc. v. Alcon Labs., Inc., 324 F.3d 1322, 1331 (Fed. Cir. 2003) (recognizing timing as the only difference between typical infringement claims and those brought under section 271(e)).

38. The defendant in “any other infringement suit” would be entitled to deduct its litigation costs. Construing the Hatch-Waxman Act to have the effect of imposing uniquely disadvantageous tax treatment on generic drug companies is inconsistent with the Act's fundamental purpose of encouraging generic market entry. In Urquhart, the seminal case concerning the deductibility of costs incurred in patent infringement litigation, the Third Circuit explained that the precise form of the patent infringement litigation (in that case, a declaratory judgment action) is irrelevant to the tax treatment of the litigation expenses:

Infringement litigation is a far cry from removing a cloud of title, or defending ownership of property. Here, it arose out of and related directly to the exploitation of the invention embodied in the patent. And, in our view, the purposes and intent are the same whether the Urquharts commenced the action, or maneuvered Pyrene into taking the initial litigative step.

Urquhart, 215 F.2d at 20; cf. Treas. Reg. § 1.263(a)-4(e)(5) (Example 6) (copyright litigation costs deductible). The same reasoning applies to patent infringement litigation that happens to have been commenced in response to the filing of an ANDA, rather than in response to some other act of infringement; the character of “[t]he litigation which [gives] rise to the expenditures in issue” in both situations remains “commonplace patent infringement litigation.” Urquhart, 215 F.2d at 19; see also Glaxo, 110 F.3d at 1569.

39. The IRS's position rests on the mere possibility that Hatch-Waxman litigation will, as a collateral matter, impact when an ANDA becomes fully approved, and hence when the generic drug company may begin distributing its drug product. The IRS's analysis thus improperly focuses on the “potential consequences upon the fortune of the taxpayer” of Hatch-Waxman litigation, rather than on the “origin and character of the claim with respect to which an expense was incurred.” Gilmore, 372 U.S. at 49. While an ANDA that is fully approved sooner may be more desirable than an ANDA that is fully approved later, “[w]hether the litigation succeeds or fails is not a factor, and whether its result indirectly enhances capital values is not a factor.” McKeague v. United States, 12 Cl. Ct. 671, 675 (1987); Newark Morning Ledger Co. v. United States, 416 F. Supp. 689, 697 (D.N.J. 1975) (“[W]hether the litigation succeeds or fails is not a factor, and whether its result indirectly enhances capital values is not a factor. The only considerations that control the question are the nature and origin of the expense incurred.”), aff'd, 539 F.2d 929 (3d Cir. 1976).

40. The IRS's differentiation between generic drug companies sued for patent infringement under 35 U.S.C. § 271(e), and all other defendants sued for patent infringement under 35 U.S.C. § 271(a), is the sort of improper distinction based on collateral consequences and subjective purpose that the Supreme Court warned against in Gilmore, when it disclaimed a legal test under which:

If two taxpayers are each sued for an automobile accident while driving for pleasure, deductibility of their litigation costs would turn on the mere circumstance of the character of the assets each happened to possess, that is, whether the judgments against them stood to be satisfied out of income- or non-income-producing property. We should be slow to attribute to Congress a purpose producing such unequal treatment among taxpayers, resting on no rational foundation.

Gilmore, 372 U.S. 48. So too here: there is no “rational foundation” for a rule that a non-generic drug company with an NDA whose drug is accused of infringing a patent is entitled to deduct its defense costs, but a generic drug company with an ANDA whose drug is accused by the very same plaintiff of infringing the very same patent is not.

41. At bottom, the uncertain collateral implications of a Hatch-Waxman patent infringement litigation with respect to an ANDA are irrelevant under the “origin of the claim” test, and do not distinguish the origin of the claim and character of Hatch-Waxman litigation from other patent infringement litigation. Generic drug companies should be entitled to deduct their cost of defending against patent infringement claims, just like all other patent infringement defendants may do.

Teva's Patent Litigation and the 2009 and 2010 Notice

42. Teva, as a generic drug company, has made and sold generic versions of brand-name drugs for years, including the years at issue in this case. Teva is thus routinely involved in infringement disputes and litigation with brand-name drug companies. As ordinary and necessary business expenses, Teva deducts the legal fees incurred in defending against patent infringement suits. Teva deducted such litigation costs in both 2009 and 2010, and in prior years.

43. In both 2009 and 2010 and in prior years, Teva was a named defendant in Hatch-Waxman litigation seeking to prevent it from selling generic versions of drugs for which Teva had submitted ANDAs to the FDA. Teva incurred and paid costs in defending against these suits and deducted the costs incurred as ordinary and necessary business expenses. Respondent does not (and cannot) dispute that Teva incurred and paid the disputed legal fees in 2009 and 2010 and in prior years.

44. Respondent mistakenly denied these deductions based on the incorrect determination that the costs incurred were in pursuit of intangible assets, and were thus required to be capitalized under 26 U.S.C. § 263(a) and the applicable Treasury Regulations. The legal fee deductions in 2009 and 2010 were not paid to obtain approval of its ANDAs from the FDA, but instead were paid to resolve patent issues typical of all other patent infringement cases. The fees, totaling $53,254,033 in 2009 and $41,782,650 in 2010, were properly deductible. Respondent should not have disallowed Teva's claimed deductions and increased Teva's taxable income by those amounts.

45. Based on the same reasoning, Respondent imposed a Section 481(a) adjustment on Teva in 2009 with respect to Hatch-Waxman defense costs Teva had deducted in its 2004 through 2008 Tax Years. That adjustment in the amount of $57,391,252 was improper for the same reason that Teva is entitled to deduct its Hatch-Waxman defense costs in 2009 and 2010. Moreover, $17,080,902 of that amount relates to ANDAs that Teva abandoned or withdrew between 2004 and 2008. Even if Respondent is correct concerning the treatment of Hatch-Waxman defense costs generally, expenses relating to abandoned or withdrawn ANDAs remain properly deductible in the year of abandonment under 26 U.S.C. § 165.

46. Likewise, even if Respondent is correct concerning the treatment of generic drug patent infringement defense costs generally, Respondent mistakenly limited Teva to a $207,570 deduction for the 2010 Tax Year for the balance of nonamortized ANDA capitalized costs incurred from 2004 through 2010 for which Teva abandoned or withdrew its ANDA. Instead, Teva is entitled to a deduction in the amount of $8,668,358 for 2009 and $7,195,920 for 2010, which is the full amount of non-amortized capitalized costs incurred with respect to generic drugs for which, as of 2009 and 2010 respectively, Teva had either abandoned or withdrawn its ANDA. In addition, Respondent misclassified $8.4 million of Teva's legal expenses in 2009 and 2010 as being Hatch-Waxman defense costs, when in fact they related to drugs for which no ANDA was ever filed. These expenses, in an amount to be determined, remain deductible even if Respondent is correct about the treatment of generic drug patent infringement costs.

INCREASED RESEARCH ACTIVITIES CREDITS

The Internal Revenue Code

47. Sections 38 and 41(a) of the Internal Revenue Code generally allow credits to qualifying taxpayers for certain research and development (“R&D”) activities.

48. Generally, section 41(a) provides that R&D credits shall be calculated in “an amount equal to the sum of . . . 20 percent of the excess (if any) of . . . the qualified research expenses for the taxable year, over . . . the base amount,” in addition to other specified amounts. Section 41(b)(1) defines “qualified research expenses” (“QREs”) as the sum of “in-house research expenses” and “contract expenses” that are “paid or incurred by the taxpayer during the taxable year.” Section 41(c)(1) defines “base amount” as the product of “the fixed-base percentage” and the “average annual gross receipts of the taxpayer for the 4 taxable years preceding the taxable year for which the credit is being determined.” Section 41(c)(3) in turn defines “fixed-base percentage” as “the percentage which the aggregate [QREs] of the taxpayer for taxable years beginning after December 31, 1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for such taxable years.”

49. Thus in the typical situation, a taxpayer calculates its research credit by: (1) adding up its total QREs; (2) calculating its base amount by multiplying its average annual gross receipts for the previous four tax years by its fixed-base percentage; (3) ascertaining the amount by which its QREs exceed its base amount (if any); and (4) taking 20% of that excess amount. Broadly speaking, the statutory scheme rewards a company that has increased R&D over its historic average, while denying credits to companies that have not done so.

50. Section 41(f) contains additional “special rules” for particular research-activity-credit scenarios.¹ One such rule, 26 U.S.C. § 41(f)(3)(A), deals with circumstances in which one company acquires another company either in full or part, and addresses how the acquiring company should include the QREs of the acquired/partially-acquired company. Congress's intent was to avoid skewing the distribution of R&D credits, by having the acquiring company include the acquired company's historic R&D amounts both in its base amount and it its current tax year.

51. As operative for the period at issue in this Petition, 26 U.S.C. § 41(f)(3)(A) read, in pertinent part:

[F]or purposes of applying this section for any taxable year ending after such acquisition, the amount of qualified research expenses paid or incurred by the taxpayer during periods before such acquisition shall be increased by so much of such expenses paid or incurred by the predecessor with respect to the acquired trade or business as is attributable to the portion of such trade or business or separate unit acquired by the taxpayer, and the gross receipts of the taxpayer for such periods shall be increased by so much of the gross receipts of such predecessor with respect to the acquired trade or business as is attributable to such portion. (emphases added).

52. Thus, where a taxpayer takes over the major portion of the trade or business of another in the midst of a tax year, then for that tax year (“any taxable year ending after such acquisition”), the acquiror's QREs shall be increased by the acquired/partially-acquired company's QRE's for “periods before such acquisition.” “Periods before such acquisition” include the four prior years used in calculating the base amount, and the portion of the current tax year before the acquisition. Taking into account the acquired/partially-acquired company's QRE's in both the four prior years to determine the base amount, and in the current tax year to determine the acquiror's R&D credits, is consistent with both the plain statutory text and Congress's purpose of avoiding any skewing of R&D credits as a result of acquisitions.

53. Despite the clear command of section 41(f)(3)(A)'s text, the IRS has taken another view. The IRS has read this provision as requiring the acquiror to increase its base amount to reflect the acquired/partially-acquired company's QREs in the four prior tax years, but not to allow the acquiror to include current-tax-year, pre-acquisition QREs in determining its R&D credit. In effect, IRS has radically altered the statutory text, replacing the broad statutory language “for purposes of applying this section,” with the far narrower “for purposes of determining the base amount,” and replacing the broad statutory language “periods before such acquisition” with the far narrower “tax years before such acquisition.”

54. The IRS's interpretation of former section 41(f)(3)(A) is inconsistent with the plain text and leads to absurd results that are directly contrary to Congress's intent. Under the IRS's interpretation, an acquiror is effectively punished: its base amount will be increased due to the acquired/partially-acquired company's historic QREs, but it will receive no benefit from the acquired/partially-acquired company's current-tax-year QREs. All else being equal, the acquiring company will be made to look as if it has cut its current-year R&D expenses from its historic average, even if the reality is far different. On the other hand, a partially-acquired company could receive a windfall: under section 41(f)(3)(B), its base amount will be reduced by the same extent to which the acquiring company's base amount is increased, yet it will retain the benefit of all of its current tax year QREs. This will make the partially-acquired company appear to have increased its current-year R&D expenses from its historic average, even if the reality was far different. This is precisely the skewing that Congress intended to avoid.

Teva's Acquisition of Barr and Associated QREs

55. Teva acquired the business of Barr Pharmaceuticals, Inc. (“Barr”) on December 23, 2008. Barr was a developer of patented and innovative prescription drugs that engaged in extensive research and development activities, including in tax year 2008.

56. Barr and Teva were both taxpayers for calendar year 2008. In its 2008 tax return, Teva included in its R&D credit calculations Barr's QREs for the full 2008 tax year, including $114,189,643 of QREs incurred by Barr from January 1, 2008 through December 23, 2008, the acquisition date and the end of Barr's short year 2008. Teva also used Barr's R&D expenses from the prior four years in calculating its base amount.

57. As noted above, the then-operative version of section 41(f)(3)(A) mandated that Teva include these amounts in its research credit calculation. Respondent nonetheless disallowed Teva's additional research credit carryover from tax year 2008 to tax year 2009 stemming from Barr's QREs in the amount of $9,850,191, the full credit to which Teva is entitled. According to the IRS, Teva was required to include Barr's numbers in determining its base amount, but could not include Barr's 2008 QREs in determining its credit.

58. Respondent erred in disallowing an additional research credit carryover from tax year 2008 to tax year 2009 in the amount of $9,850,191. Respondent's position was wrong as a matter of law, and led to an over-determination of Teva's tax liability.

WHEREFORE, Petitioner prays that this Court hear this proceeding and determine:

1. That Respondent erred as alleged in each assignment of error described at paragraphs 6(a) through 6(f), above.

2. That Teva properly and correctly reported in its 2009 and 2010 tax returns the deduction of $53,254,033 for the 2009 Tax Year and $41,782,650 for the 2010 Tax Year for legal fees as ordinary and necessary business expenses under 26 U.S.C. § 162.

3. That, even if Teva were required to capitalize its Hatch-Waxman defense costs, Respondent miscalculated the amounts that it disallowed for both the 2009 and 2010 Tax Years, by disallowing $8.4 million in legal costs that were not actually Hatch-Waxman defense costs, and by disallowing $15,864,278 in costs related to ANDAs that Teva either abandoned or withdrew in 2009 and 2010.

4. That no Section 481 adjustment should be imposed in the 2009 Tax Year, and that if any Section 481 adjustment is imposed, it be reduced by at least the $17,080,902 amount related to ANDAs that Teva or abandoned or withdrew between 2004 and 2008.

5. That, even if an adjustment under 26 U.S.C. § 481 were appropriate, Respondent miscalculated the adjustment and the amortization consequences of that adjustments for both the 2009 and 2010 Tax Years.

6. That Teva is entitled to research credit carryover from tax year 2008 to tax year 2009 in the amount of $9,850,191.

7. That the deficiencies claimed in the 2009-2010 Notice are erroneous, and that there is no deficiency for either the 2009 or 2010 Tax Year.

8. Grant Petitioner such other and further relief as this Court deems just and appropriate.

Dated: September 25, 2019

Respectfully submitted,

Kevin P. Martin
Tax Court Bar No. MK0301
kmartin@goodwinlaw.com
David J. Zimmer
Tax Court Bar No. MK0301 ZD0078
GOODWIN PROCTER LLP
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Boston, Massachusetts 02210
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