Firms Seek Certainty on Deductibility of Litigation Costs

On behalf of the Pharmaceutical Research and Manufacturers of America ("PhRMA") and the Generic Pharmaceutical Association ("GPhA"), we are writing in response to Notice 2014-18 to request published guidance on separate, but related, tax issues of great significance to the associations' members.¹ The issues relate to the tax treatment of litigation costs of pursuing or defending against patent infringement claims brought by a "Brand company" (i.e., a pharmaceutical company that holds a patent or license to a patent for a branded drug) against a "Generic company" that has filed an abbreviated new drug application ("ANDA") with a Paragraph IV certification, as defined below, (an "ANDA ¶ IV") requesting the approval of the Food and Drug Administration ("FDA") to market a generic bioequivalent of a branded drug.

As discussed below, the costs of pursuing or defending against patent infringement claims have always been held to be currently deductible. Recently, however, Internal Revenue Service ("IRS") examiners, based on advice from IRS attorneys, have begun disallowing current deductions and requiring capitalization of the costs of patent infringement litigation incurred by both Brand and Generic companies after the filing of an ANDA ¶ IV ("Paragraph IV litigation"). See Field Attorney Advice ("FAA") 20131001F; FAA 20114703F; and FAA 20114901F. This recent change in IRS examination position would have a significant and negative impact on the pharmaceutical industry as a whole, and would defeat one of the main purposes of the Drug Price Competition and Patent Term Restoration Act of 1984 (informally known as the "Hatch-Waxman Act" or "Hatch-Waxman") to increase competition and lower drug prices.

We respectfully request that published guidance be issued promptly to confirm that Paragraph IV litigation costs of both Brand and Generic companies continue to be currently deductible.

Hatch-Waxman created the ANDA process, which reduced the otherwise prohibitive costs of obtaining FDA approval to market a generic drug by eliminating the requirement that the Generic company replicate the Brand company's tests for proving safety and efficacy. Under the ANDA process, to obtain FDA approval to market a generic drug, the Generic company must substantiate that its drug: (i) has the same active ingredient, dosage form, strength, and intended use as the relevant brand drug; and (ii) is bioequivalent to the branded drug (i.e., the generic drug affects the body, with respect to safety and efficacy, in essentially the same manner as the referenced branded drug) (together, the "Scientific Determinations"). The FDA generally takes more than 30 months to review and approve a Generic company's Scientific Determinations.

Hatch-Waxman also introduced procedures to encourage the challenge of patents by Generic companies and to enable the resolution of any patent infringement issues regarding a particular generic drug during the time the FDA is reviewing the Scientific Determinations for the drug. Under these procedures, the Generic company must identify any patent(s) listed in the FDA's Approved Drug Products with Therapeutic Equivalence Evaluations, commonly known as the "Orange Book," covering the branded drug for which the generic drug is bioequivalent. If a Generic company is seeking to market its generic drug before the listed patents expire, the Generic company must certify in its ANDA ¶ IV that the listed patent(s) are invalid, unenforceable and/or the generic drug will not infringe the listed patent(s) (a "Paragraph IV certification"). The Generic company is required to provide to the holder of any listed patent notice of the filing of the ANDA ¶ IV.

Under Hatch-Waxman, the filing of an ANDA ¶ IV constitutes a technical act of patent infringement and thus provides jurisdiction for a court to address any patent infringement challenges immediately. 35 U.S.C. § 271(e)(2). If the Brand company files a patent infringement lawsuit within a designated 45-day period, the FDA is precluded from approving the ANDA ¶ IV for 30 months (the "Stay") unless the Generic company wins the litigation before the end of that 30-month period. A Brand company is not required to file a patent infringement lawsuit, and if it chooses to file a lawsuit, it is not required to file it during the designated 45-day period. If the Brand company does not file a patent infringement lawsuit within the 45-day period, there is no Stay. However, in this event, the Generic company may file a declaratory judgment action against the Brand company to force early resolution of possible patent infringement claims.

These procedures introduced by Hatch-Waxman did not change the nature of patent infringement litigation, but by design significantly increased the likelihood that any such litigation would be addressed in a court during the same time period that the FDA is reviewing the Scientific Determinations. "[T]he whole point of the [Hatch-Waxman] Act's [P]aragraph IV certification scheme is to let private parties sort out their respective intellectual property rights through patent infringement suits while the FDA focuses on its primary task of ensuring that drugs are safe and effective. This division of labor is appropriate because the FDA has no expertise in making patent law judgments." aaiPharma Inc. v. Thompson, 296 F.3d 227, 241 (4th Cir. 2002). In Paragraph IV litigation, the court's inquiry "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." Glaxo, Inc. v. Novopharm, Ltd., 110 F.3d 1562, 1569 (Fed. Cir. 1997).

Once the 30-month Stay has expired, and the FDA has reviewed the Scientific Determinations, the FDA can approve the ANDA ¶ IV notwithstanding that Paragraph IV litigation may still be ongoing. The FDA's approval of the ANDA ¶ IV allows the Generic company to market the generic drug, but does not protect the Generic company from pending or future claims of damages should the Brand company ultimately prevail in the patent infringement litigation. Thus, if a Generic company begins marketing its generic drug upon receiving FDA approval but prior to resolving the patent infringement claims, the Generic company remains at risk for damages in the form of the Brand company's lost profits. If there is Paragraph IV litigation, and the Generic company loses that litigation, the patent law remedies for infringement require that final FDA approval to market the generic drug be delayed until after the expiration of the litigated patent with the latest expiration date. 35 U.S.C. § 271(e)(4)(A).

The first Generic company to file an ANDA ¶ IV may be granted by the FDA an exclusivity period of 180 days during which the FDA will not approve another ANDA ¶ IV for the same branded drug. Our experience is that Generic companies generally are granted an exclusivity period (either alone or to be shared with another Generic company) with respect to about 20% of their ANDA ¶ IVs. Engaging in Paragraph IV litigation is not a requirement to be eligible for the 180-day exclusivity period. A Generic company generally does not know until after it files its ANDA ¶ IV whether it was the first to file. Even if a Generic company is the first to file, its eligibility for the exclusivity period can be forfeited in many ways. The obstacles to obtaining the exclusivity period are so significant that obtaining the exclusivity period is considered to be an extraordinary achievement. Although obtaining an exclusivity period is desirable, a Generic company rarely, if ever, withdraws its ANDA ¶ IV or decides not to defend against patent infringement claims after learning it was not the first to file an ANDA ¶ IV.

Treasury regulations finalized more than a decade ago adopted this historic treatment regarding patent litigation. Specifically, under Treasury Regulations section 1.263(a)-4(d)(9), a taxpayer must capitalize amounts paid to defend or perfect title to a patent if the other party challenges the taxpayer's title to the patent. The Treasury Department's preamble to the proposed regulations made clear that the rule requiring taxpayers to capitalize costs of defending or perfecting title to intangible property applies only where the other party challenges the taxpayer's title to the intangible property and "is not intended to require capitalization of amounts paid to protect the property against infringement and to recover profits and damages as a result of an infringement. As under current law, these costs are generally deductible. See, e.g., Urquhart v. Commissioner, 215 F.2d 17 (3d Cir. 1954)." PREAMBLE TO PROP. REGS., GUIDANCE REGARDING DEDUCTION AND CAPITALIZATION OF EXPENDITURES, 67 Fed. Reg. 77701, 77705 (Dec. 19, 2002).

Patent infringement litigation between a Brand company and a Generic company would rarely, if ever, involve a challenge to the Brand company's title to the patent, and thus, the litigation costs of the Brand company are currently deductible. Deduction of such costs reflects good tax policy because a Brand company that prevails in patent infringement litigation does not obtain any right or intangible asset that it did not already have. Rather, a court's decision in favor of the Brand company merely confirms that the Brand company's patent gives the Brand company the right to exclude others from using that patent. Thus, the Brand company is merely protecting and enforcing the rights that it already had under its patent, and the costs incurred in doing so are appropriately deductible as a tax policy matter.

Before Hatch-Waxman, patent infringement litigation between a Brand company and a Generic company generally commenced after the Generic company had begun to market its generic drug. Hatch-Waxman did not change the nature of this patent infringement litigation, but merely provided a mechanism to address any patent infringement claims before the generic drugs are marketed. The objective was straight-forward. There was a concern that less expensive generic drugs were not being made available to consumers due to the existence of patents that may be invalid or contain claims that were overbroad, or for other similar reasons arising as a result of the uncertainty and complexity associated with the patent laws. Hatch-Waxman's objective was to provide a mechanism that would allow Generic companies to challenge those patents before the Generic companies had begun marketing their generic drugs, so that Generic companies would not be exposed to liability for damages should their assessments of the patent laws be wrong. That objective was effectuated by providing that the procedural act of filing an ANDA ¶ IV constitutes an act of infringement that gives a court jurisdiction to adjudicate patent infringement claims without potentially infringing sales having to occur.

The fact that the procedural act of filing an ANDA ¶ IV constitutes a technical act of infringement that can result in Paragraph IV litigation does not change the origin of the claims in that litigation. The well-established "origin of the claim doctrine" "does not contemplate a mechanical search for the first in the chain of events which led to the litigation," but rather requires an examination of the issues involved in the litigation, the nature and objectives of the litigation, the defenses asserted, the background of the litigation, and all the facts pertaining to the controversy. Boagni v. Commissioner, 59 T.C. 708, 713 (1973) (footnote omitted), acq., 1973-2 C.B. 1; Rev. Rul. 80-119, 1980-1 C.B. 40. See also, Estate of Morgan v. Commissioner, 332 F.2d 144, 151 (5th Cir. 1964), acq. 1966-2 C.B. 3.

Paragraph IV litigation occurs between Brand companies and Generic companies and does not involve the FDA as a party. The issues involved in Paragraph IV litigation are the very same issues involved in any patent infringement litigation and in particular in any patent infringement litigation involving a Brand company and a Generic company. Paragraph IV litigation, like all patent infringement litigation, addresses whether patent rights are infringed. The patent infringement issues addressed in the litigation are entirely separate from the Scientific Determinations addressed in the FDA approval process. Patent rights and FDA approval are addressed in entirely separate parts of the United States Code (patent rights in Title 35 and FDA approval in Title 21), and the administration of patent rights and FDA approval are handled by separate agencies of the Federal Government (the U.S. Patent & Trademark Office ("USPTO") and the FDA). Similarly, patent cases are appealable to the Federal Circuit Court of Appeals, whereas cases relating to FDA actions are appealable to any of the eleven Federal Circuit Courts of Appeal.

In addition, the results to a Generic company of obtaining FDA approval are entirely different from the results of winning patent infringement litigation. FDA approval allows the marketing of a generic drug but does not protect the Generic company from patent infringement claims or any associated liability damages. FDA approval is based solely on satisfying the Scientific Determinations. The existence or lack of Paragraph IV litigation does not impact whether the Scientific Determinations are satisfied or facilitate the making of the Scientific Determinations, and winning Paragraph IV litigation is not a prerequisite to obtaining FDA approval. Winning Paragraph IV litigation confirms that the Generic company is not liable to the Brand company for damages, but it does not provide the Generic company with approval to market its generic drug.

The position taken in the FAAs is that Hatch-Waxman, by establishing an early determination process on issues of patent infringement, converted deductible litigation costs into costs that must be capitalized as costs of obtaining FDA approval notwithstanding that the nature of the patent infringement litigation, the facts that must be proven, the applicable laws, and the outcome of any litigation are the same as any other type of patent infringement litigation. In effect, the FAAs would treat a Generic company's Paragraph IV litigation costs differently than the costs of other patent infringement litigation, which inevitably would lead to the peculiar result that the tax consequences to the Generic company would be dependent solely on whether a Brand company chooses to file a patent infringement lawsuit within the 45-day period following notice of the filing of the ANDA ¶ IV.

The position in the FAAs is that a Generic company's costs of Paragraph IV litigation must be capitalized as costs of "facilitating" FDA approval because the litigation takes place within a framework created by the FDA regulations and the litigation itself is a customary or expected step in the process of the Generic company's obtaining such FDA approval. Separately, IRS attorneys have asserted that a Generic company's Paragraph IV litigation costs "facilitate" the FDA approval because the litigation can affect the date on which the Generic company can begin marketing its drug.

The IRS assertions do not support the position that a Generic company's Paragraph IV litigation costs must be capitalized. Whether the FDA will approve an ANDA ¶ IV ultimately will turn on the FDA's review and approval of the Scientific Determinations, not on whether there is Paragraph IV litigation or the outcome of that litigation. An objective of Hatch-Waxman was to provide procedures to encourage resolution of patent infringement claims at the same time the FDA is confirming the Scientific Determinations. If Paragraph IV litigation is filed, the Stay attendant to that litigation generally does not interfere with FDA approval, because it ordinarily would have taken the FDA that much time to have confirmed the Scientific Determinations. If the Paragraph IV litigation is not concluded by the time the Stay expires, the FDA may approve the ANDA ¶ IV as long as the Scientific Determinations have been confirmed.

If the Generic company loses Paragraph IV litigation, the FDA still will approve the ANDA ¶ IV if the Scientific Determinations are confirmed, but that approval will not become final until the patent expires. Delaying final FDA approval in such a case is not an unexpected result, but instead is similar to the remedy available to patent holders in the case of most other patent infringement litigation. Specifically, if a court determines that an alleged infringer's activities infringe on a patent, the alleged infringer may be prevented from engaging in those activities until after the patent expires.

In contrast, if the Generic company wins Paragraph IV litigation, the FDA may approve the ANDA ¶ IV as soon as the Scientific Determinations have been confirmed. Like any alleged infringer, a Generic company that prevails in patent infringement litigation does not obtain any right or intangible asset and is not granted any special privileges by reason of winning the litigation that the Generic company did not already have. Winning the Paragraph IV litigation merely confirms that the Generic company was correct that its actions would not infringe on a valid patent. Such a court's holding and its effect are the same regardless of whether the patent infringement litigation occurs before or after the Generic company has begun to market its generic drug. Allowing the Generic company to deduct its patent infringement litigation costs, without regard to when or how that litigation arises and without regard to the outcome of that litigation, is consistent with established tax principles and reflects good tax policy.

The FAAs appear to find particular relevance in the fact that a Generic company ultimately may be granted a 180-day exclusivity period to market its generic drug. That fact, however, does not support a position that the Generic company's Paragraph IV litigation costs must be capitalized. A grant of exclusivity by the FDA is based on the Generic company's being the first to file an ANDA ¶ IV with respect to a particular branded drug and on satisfying the Scientific Determinations timely. Paragraph IV litigation is not a prerequisite to the grant of an exclusivity period, and such litigation does not secure the right to an exclusivity period.

In conclusion, the issues involved in patent infringement litigation are complex and uncertain, and Hatch-Waxman merely provided a mechanism that allows a court to clarify the rights possessed by a patent holder and to determine before the generic drug is marketed whether those rights would be infringed by the generic drug. In effect, Hatch-Waxman instituted an early determination process for the resolution of patent infringement issues without changing the underlying nature or origin of those issues or the litigation. The early determination process mitigates the risk to the Generic company of being held liable for the Brand company's lost profits that may far exceed the Generic company's anticipated profits and thus encourages Generic companies to take the risk associated with bringing generic drugs to the market. Forcing Generic companies to capitalize litigation costs that have always been deductible would be not only contrary to established legal principles, but would also be inconsistent with good tax policy and the public policy goal of Hatch-Waxman to prevent uncertain questions of patent law from delaying the entry into the market of lower-cost generic drugs.

For these reasons, we respectfully request that published guidance be issued as soon as possible confirming that litigation costs incurred by Brand and Generic companies in pursuing or defending against patent infringement claims are currently deductible today as they have always been. If you have any questions or desire any additional information, please do not hesitate to contact us at 202-371-7280 (Jody Brewster) or at 646-471-1660 (Cristy Turgeon).