SCOTUS Reports

Tag: Section 197

  • Mylan, Inc. & Subsidiaries v. Commissioner, 156 T.C. No. 10 (2021): Capitalization and Deductibility of Legal Expenses in Pharmaceutical Industry

    Mylan, Inc. & Subsidiaries v. Commissioner, 156 T. C. No. 10 (2021)

    In a significant ruling, the U. S. Tax Court determined that Mylan, a generic drug manufacturer, must capitalize legal fees for preparing FDA notice letters but can deduct costs for defending patent infringement suits. This decision impacts how pharmaceutical companies handle legal expenses related to FDA approvals and patent disputes, clarifying the tax treatment of such expenditures.

    Parties

    Mylan, Inc. & Subsidiaries (Petitioner), a U. S. corporation and manufacturer of generic and brand name pharmaceutical drugs, filed petitions against the Commissioner of Internal Revenue (Respondent) to challenge determinations of tax deficiencies for the years 2012, 2013, and 2014. The cases were consolidated in the U. S. Tax Court.

    Facts

    Mylan incurred significant legal expenses from 2012 to 2014 in two categories: (1) preparing notice letters to the FDA, brand name drug manufacturers, and patentees as part of the process for obtaining FDA approval for generic versions of drugs, and (2) defending against patent infringement lawsuits initiated by these manufacturers and patentees. These lawsuits were triggered by Mylan’s submission of Abbreviated New Drug Applications (ANDAs) with paragraph IV certifications, asserting that certain patents listed in the FDA’s Orange Book were invalid or not infringed by Mylan’s generic drugs.

    Procedural History

    Mylan deducted its legal expenses as ordinary and necessary business expenditures on its 2012, 2013, and 2014 tax returns. Following an IRS examination, the Commissioner determined these expenses were capital expenditures required to be capitalized and disallowed Mylan’s deductions, issuing notices of deficiency for tax deficiencies amounting to $16,430,947 for 2012, $12,618,695 for 2013, and $20,988,657 for 2014. Mylan filed timely petitions for redetermination with the U. S. Tax Court, which consolidated the cases and held a trial.

    Issue(s)

    Whether the legal expenses Mylan incurred for preparing notice letters required to be sent as part of the FDA approval process for generic drugs must be capitalized under section 263(a) of the Internal Revenue Code?

    Whether the legal expenses Mylan incurred for defending against patent infringement lawsuits brought by brand name drug manufacturers and patentees are deductible as ordinary and necessary business expenses under section 162(a)?

    Rule(s) of Law

    Section 162(a) of the Internal Revenue Code allows deductions for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 263(a) mandates capitalization of expenditures that create or enhance a separate and distinct asset or generate significant future benefits for the taxpayer. Section 1. 263(a)-4(b)(1)(v), Income Tax Regs. , requires capitalization of amounts paid to facilitate the acquisition or creation of certain intangibles, including rights obtained from a governmental agency.

    Holding

    The U. S. Tax Court held that the legal expenses Mylan incurred to prepare notice letters are required to be capitalized because they were necessary to obtain FDA approval of Mylan’s generic drugs. Conversely, the legal expenses incurred to defend patent infringement suits are deductible as ordinary and necessary business expenses because the patent litigation was distinct from the FDA approval process.

    Reasoning

    The court’s reasoning differentiated between the two types of legal expenses based on the origin and character of the claims and the applicable legal standards:

    For the notice letter expenses, the court applied the regulation under section 1. 263(a)-4(b)(1)(v), which requires capitalization of expenses facilitating the creation of an intangible asset. The court found that the notice letters were a required step in securing FDA approval, thus facilitating the acquisition of an intangible asset (effective FDA approval).

    For the litigation expenses, the court employed the “origin of the claim” test, focusing on whether the litigation arose from the acquisition, enhancement, or disposition of a capital asset. The court determined that the patent infringement suits were tort claims, not related to the acquisition or enhancement of Mylan’s intangible assets. The court also considered the policy objectives of the Hatch-Waxman Act, which encourages the entry of generic drugs into the market while protecting brand name drug manufacturers’ patent rights. The court found that the litigation was a mechanism for brand name manufacturers to protect their intellectual property rights, not a step in the FDA approval process for Mylan.

    The court also analyzed relevant regulatory examples and the nature of patent infringement litigation, concluding that such litigation expenses are typically deductible as ordinary and necessary business expenses for companies engaged in the business of exploiting and licensing patents.

    Disposition

    The court sustained the IRS’s determinations regarding the capitalization of expenses for preparing notice letters and ruled that the litigation expenses for defending patent infringement suits were deductible as ordinary and necessary business expenses. The court also upheld the IRS’s determination that Mylan’s capitalized expenses were subject to amortization over a 15-year period under section 197 of the Internal Revenue Code.

    Significance/Impact

    This case clarifies the tax treatment of legal expenses in the pharmaceutical industry, particularly for generic drug manufacturers. It establishes that expenses for preparing FDA-required notice letters are capital expenditures due to their role in facilitating FDA approval, whereas expenses for defending patent infringement suits are deductible as ordinary and necessary business expenses. This ruling impacts how pharmaceutical companies structure their legal strategies and manage their tax liabilities. It also underscores the distinction between expenses related to regulatory compliance and those arising from tort claims, which may influence how other industries categorize similar expenses for tax purposes. Subsequent courts and the IRS may refer to this decision when addressing similar issues, potentially affecting the tax treatment of legal expenses across various sectors.

  • Broz v. Comm’r, 137 T.C. 46 (2011): At-Risk Rules, Debt Basis, and Amortization of Intangibles in S Corporations

    Broz v. Commissioner, 137 T. C. 46, 2011 U. S. Tax Ct. LEXIS 37 (U. S. Tax Court 2011)

    In Broz v. Comm’r, the U. S. Tax Court ruled on multiple tax issues involving an S corporation in the cellular industry. The court held that shareholders were not at risk for losses due to pledged stock in a related corporation, lacked sufficient debt basis to claim flowthrough losses, and could not amortize FCC licenses without an active trade or business. The decision clarifies the application of at-risk rules and the requirements for amortizing intangibles, impacting tax planning for S corporations.

    Parties

    Robert and Kimberly Broz (Petitioners) v. Commissioner of Internal Revenue (Respondent). The Brozs were shareholders in RFB Cellular, Inc. , and Alpine PCS, Inc. , both S corporations. They were also involved in related entities including Alpine Operating, LLC, and various license holding entities.

    Facts

    Robert Broz, a former banker, founded RFB Cellular, Inc. (RFB), an S corporation, to operate cellular networks in rural areas. RFB acquired licenses from the Federal Communications Commission (FCC) and built networks in Michigan. The Brozs later formed Alpine PCS, Inc. (Alpine), another S corporation, to expand RFB’s operations into new license areas. Alpine bid on FCC licenses and transferred them to single-member limited liability companies (Alpine license holding entities) which assumed the FCC debt. RFB operated the networks and allocated income and expenses to Alpine and the license holding entities. The Brozs financed these operations through loans from CoBank, with Robert Broz pledging his RFB stock as collateral. Despite these efforts, no Alpine entities operated on-air networks during the years at issue, and none met the FCC’s build-out requirements.

    Procedural History

    The IRS issued a notice of deficiency determining over $16 million in tax deficiencies for the Brozs for the years 1996, 1998, 1999, 2000, and 2001, along with accuracy-related penalties. The Brozs petitioned the U. S. Tax Court, where several issues were resolved by concessions. The remaining issues involved the enforceability of a settlement offer, the allocation of purchase price to equipment, the Brozs’ debt basis in Alpine, their at-risk status, and the amortization of FCC licenses.

    Issue(s)

    1. Whether the Commissioner of Internal Revenue is bound by equitable estoppel to a settlement offer made and subsequently withdrawn before the deficiency notice was issued?
    2. Whether the Brozs properly allocated $2. 5 million of the $7. 2 million purchase price to depreciable equipment in the Michigan 2 acquisition?
    3. Whether the Brozs had sufficient debt basis in Alpine to claim flowthrough losses?
    4. Whether the Brozs were at risk under section 465 for their investments in Alpine and related entities?
    5. Whether Alpine and Alpine Operating were engaged in an active trade or business permitting them to deduct business expenses?
    6. Whether the Alpine license holding entities are entitled to amortization deductions for FCC licenses upon the grant of the license or upon commencement of an active trade or business?

    Rule(s) of Law

    1. Equitable Estoppel: The doctrine of equitable estoppel requires a showing of affirmative misconduct by the government, reasonable reliance by the taxpayer, and detriment to the taxpayer. See Hofstetter v. Commissioner, 98 T. C. 695 (1992).
    2. Allocation of Purchase Price: When a lump sum is paid for both depreciable and nondepreciable property, the sum must be apportioned according to the fair market values of the properties at the time of acquisition. See Weis v. Commissioner, 94 T. C. 473 (1990).
    3. Debt Basis in S Corporations: A shareholder can deduct losses of an S corporation to the extent of their adjusted basis in stock and indebtedness. The shareholder must make an actual economic outlay to acquire debt basis. See Estate of Bean v. Commissioner, 268 F. 3d 553 (8th Cir. 2001).
    4. At-Risk Rules: A taxpayer is at risk for losses to the extent of cash contributions and borrowed amounts for which they are personally liable, but not for pledges of property used in the business. See Section 465(b)(2)(A) and (B), I. R. C.
    5. Trade or Business Requirement for Deductions: Taxpayers may deduct ordinary and necessary expenses incurred in carrying on an active trade or business. See Section 162(a), I. R. C.
    6. Amortization of Intangibles: Intangibles, such as FCC licenses, are amortizable over 15 years if held in connection with the conduct of an active trade or business. See Section 197, I. R. C.

    Holding

    1. The court held that the Commissioner was not bound by equitable estoppel to the withdrawn settlement offer.
    2. The court found that the Brozs’ allocation of $2. 5 million to equipment in the Michigan 2 acquisition was improper and sustained the Commissioner’s allocation of $1. 5 million.
    3. The court determined that the Brozs did not have sufficient debt basis in Alpine to claim flowthrough losses because they did not make an actual economic outlay.
    4. The court held that the Brozs were not at risk for their investments in Alpine and related entities because the pledged RFB stock was related to the business and they were not personally liable for the loans.
    5. The court found that neither Alpine nor Alpine Operating was engaged in an active trade or business and therefore could not deduct business expenses.
    6. The court held that the Alpine license holding entities were not entitled to amortization deductions for FCC licenses upon the grant of the licenses because they were not engaged in an active trade or business.

    Reasoning

    The court’s reasoning was grounded in the application of established tax principles to the unique facts of the case. For equitable estoppel, the court found no affirmative misconduct by the Commissioner and no detrimental reliance by the Brozs. Regarding the allocation of purchase price, the court rejected the Brozs’ allocation because it did not reflect the fair market value of the equipment, which had depreciated over time. On the issue of debt basis, the court applied the step transaction doctrine to ignore the Brozs’ role as a conduit for funds from RFB to Alpine, finding no economic outlay by the Brozs. For the at-risk rules, the court determined that the RFB stock was property related to the business and thus could not be considered in the at-risk amount. The court’s analysis of the trade or business requirement for deductions was based on the lack of operational activity by Alpine and its subsidiaries. Finally, the court interpreted section 197 to require an active trade or business for amortization of FCC licenses, rejecting the Brozs’ argument that the mere grant of a license was sufficient.

    Disposition

    The court’s decision was entered under Rule 155, indicating that the parties would need to compute the tax liability based on the court’s findings and holdings.

    Significance/Impact

    The Broz decision provides important guidance on the application of at-risk rules, debt basis limitations, and the requirements for amortizing intangibles in the context of S corporations. It clarifies that shareholders cannot claim flowthrough losses without an actual economic outlay and that pledges of related business property do not count towards the at-risk amount. The decision also reinforces the necessity of an active trade or business for deducting expenses and amortizing intangibles, impacting tax planning and structuring of business operations, especially in rapidly evolving industries like telecommunications.