Tax Deductions for Non-Facilitating Costs for IP, M&A & Real Estate

One of the most common disputes between taxpayers and the IRS revolves around the question of whether certain expenses are deductible in the current year or need to be capitalized and recovered over time. This expense versus capitalization issue arises in various contexts.

We have considered a number of these disputes on this site. It comes up in real estate transactions, for example. The cost of acquiring property is typically capitalized and recovered over time through depreciation deductions. Similarly, the expenses related to acquiring software are subject to similar treatment. Costs incurred to acquire a business or M&A fees are also examples. It can even include loan costs, such as the cost of standby letters of credit.

Recently, the court addressed these rules in the case of Mylan, Inc. v. Commissioner, Nos. 22-1193, 21-1194, 22-1195 (3d Cir. 2023), involving a generic drug manufacturer seeking FDA approval for its drug. The case addresses the seemingly broad term “facilitate” in the context of expenses that facilitate the acquisition or creation of intellectual property. This shows how important it is to consider the nature of expenses before assuming that they have to be capitalized, such as M&A costs and real estate acquisition costs.

Facts & Procedural History

This case involves a generic drug manufacturer who filed an application to certify that its generic drug would not infringe on patents held by brand-drug manufacturers. This started the patent litigation process which ended up costing the taxpayer $46,158,403, $38,211,911, and $38,618,993 in legal fees in 2012, 2013, and 2014.

The taxpayer deducted these costs on its tax returns each year. The IRS audited the tax returns and disallowed the deductions. The IRS took the position that the costs had to be capitalized and then the costs recovered over time through amortization deductions.

Litigation ensued in the U.S. Tax Court, which found for the taxpayer. The IRS appealed, which resulted in the current court opinion.

Expense v. Capitalization

When it comes to tax deductions, one of the factors to consider is whether the cost or outlay can be expensed or has to be capitalized.

Costs that can be expensed are deducted in the current year. The immediate deduction of expenses reduces the business’s taxable income for that year, resulting in a lower tax liability.

On the other hand, costs that are capitalized are deducted over time. These costs are spread out over the asset’s useful life through a process called amortization (for intangible assets) or depreciation (for tangible assets). The idea behind capitalization is to match the costs of acquiring the asset with the revenue it generates over its useful life. Our tax laws set out a number of rules that determine the time period over which capitalized costs are deducted.

The expense versus capitalization concept is a timing concept. The tax deduction is allowable. The question is when it is allowable. This brings in present value of money concepts, as taxpayers generally prefer to pay less in tax up front so they can use those funds to invest or make additional profits. The IRS often prefers the opposite.

Expense v. Capitalization Under Indopco

The Indopco, Inc. v. Commissioner, 503 U.S. 79 (1992) case is the leading case that addresses the expense versus capitalization issue. In Indopco, the U.S. Supreme Court considered whether M&A expenses were immediately deductible. The central issue was whether the taxpayer’s legal and professional fees incurred during a takeover were currently deductible as ordinary and necessary business expenses or must be capitalized as part of the cost of acquiring the target company. The Court held that expenses incurred in the acquisition of a business, even if they were not creating any specific long-term asset, should be capitalized and treated as part of the cost of acquiring the business. This meant that these types of expenses couldn’t be deducted in the year they were incurred, but instead, they had to be amortized or depreciated over the useful life of the assets acquired.

Expense v. Capitalization Under Section 263

Section 263 of the tax code addresses the capitalization of certain costs and provides guidelines for when expenses must be capitalized rather than expensed and immediately deducted. It deals with costs related to acquiring, producing, or improving tangible and intangible assets.

Under Section 263, businesses are generally required to capitalize costs that result in the creation or acquisition of a “real” or “tangible” asset, one with a useful life that extends beyond the current tax year. Again, capitalization means that costs must be added to the basis of the asset and recovered over time through depreciation (for tangible assets) or amortization (for intangible assets) over the asset’s useful life.

Here is a summary of the concepts found in Section 263:

1. Improvements to Tangible Property: Costs incurred for improvements to tangible property must generally be capitalized. Improvements are expenses that add to the value of the property, prolong its useful life, or adapt it to new uses. Examples include significant renovations, expansions, or betterments to buildings or machinery.
2. Acquisition of Tangible and Intangible Property: The cost of acquiring tangible and intangible property must be capitalized. This includes the purchase price, legal fees, and other acquisition costs.
3. Production of Tangible and Intangible Property: The cost of producing tangible and intangible property, which involves creating or manufacturing an asset, must be capitalized.
4. Intangible Drilling and Development Costs: For oil and gas industry taxpayers, certain intangible drilling and development costs must be capitalized.
5. Research and Experimental Expenditures: While research and experimental expenditures are generally required to be capitalized, there are specific rules and exceptions for certain start-up and R&D costs that are set out in Section 174.

There are also several nuanced rules that say when these rules apply and how they apply. For example, this includes de minimis rules that allow businesses to deduct certain small-dollar amounts or low-value assets as expenses rather than capitalizing them. Congress has changed these rules over time to provide various incentives to acquire property, etc., and to try to make them more generous for small businesses and individual taxpayers.

Deducting Legal Costs for Patents

These capitalization rules have to be compared to the general business expense deduction rule in Section 162. Section 162 allows for the immediate deduction of ordinary and necessary business expenses. Thus, to be eligible to be immediately deducted, patent legal costs must be an “ordinary and necessary” business expense.

An “ordinary expense” is generally one that is common and accepted in the industry. A necessary expense is one that is directly related to the conduct of the taxpayer’s trade or business.

When a business incurs patent litigation costs to defend or enforce an existing patent, these expenses are typically allowed as ordinary and necessary business expenses. This is based on the idea that a business’ natural reaction to being sued is to defend itself. As a result, these defense expenses can be fully deducted in the year they are incurred.

However, the tax treatment of patent litigation costs is more complex when the litigation pertains to acquiring a patent. In these cases, the costs are often capital expenditures, and they have to be capitalized rather than deducted given the rules described above.

Patent Litigation Costs the Under Hatch-Waxman Act

This brings us to the particular type of patent litigation involved in this case. This case did not involve the more standard patent litigation to defend or acquire a patent. It involved patent litigation under the Hatch-Waxman Act.

The question is whether patent litigation costs for litigation under the Hatch-Waxman Act by generic drug manufacturers can be expensed or have to be capitalized and amortized over time. To answer the question, the court provides an overview of this type of litigation.

This type of litigation is used by generic drug manufacturers to essentially contest patents held by brand drug manufacturers. The generic drug manufacturer can submit an Abbreviated New Drug Application (“ANDA”). In the ANDA, the generic drug manufacturer can certify that the brand-drug manufacturer patents are either invalid or will not be infringed by the generic drug. With this certification, the brand-drug manufacturer can sue the generic drug manufacturer. This starts the patent litigation process.

What Does “Facilitate” Mean?

This brings us to the IRS’s position. The IRS focused on the timing aspect of the ANDA being followed by patent litigation. According to the IRS’s arguments, this two-step litigation process means that the costs “facilitate” the granting of FDA approval for the generic drug manufacturer. Because they “facilitate” the FDA approval for the generic drug manufacturer, the costs must be capitalized and cannot be immediately expensed.

The IRS’s position is based on the meaning of “facilitation” in the regulations:

An 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.

The U.S. Tax Court sided with the taxpayer. It held that the timing of this two-step process does not convert these costs into expenses that facilitate the FDA approval. The appeals court agreed.

Both courts specifically noted that FDA approval can be granted even if this process is unsuccessful, etc. Both noted that the FDA approval process is distinct from patent litigation and winning or losing a patent litigation suit does not impact the FDA’s final decision on drug approval.

The Takeaway

The court’s interpretation of the term “facilitate” in the context of ANDA litigation costs has broader implications beyond just patent litigation. It provides a guiding principle for determining whether certain expenses related to the acquisition or creation of intangible assets, including M&A costs and even real estate acquisition costs, should be capitalized or expensed for tax purposes.

Similar to the ANDA litigation costs discussed in the court decision, M&A costs and real estate acquisition costs may be deemed facilitating expenses if they are incurred in the process of investigating or otherwise pursuing the acquisition. However, costs that are not directly tied to the acquisition process are more likely to be considered ordinary business expenses that can be deducted.