Patent infringement litigation costs are deductible business expenses

Plain-English summary

A manufacturer licensed patented technology from an affiliate and shared litigation costs under the license agreement. The patent case concerned whether a competitor infringed the patent and whether the patent was validly issued, not who owned legal title. Applying the origin-of-the-claim test, the IRS distinguished costs of protecting against infringement from capital expenditures to defend or perfect title. It ruled that the manufacturer's past and future allocated litigation costs were deductible as ordinary and necessary business expenses under section 162(a).

Ruling snapshot

• Question: Must the manufacturer capitalize its share of patent litigation costs, or may it deduct them under section 162?
• Outcome: Approved
• Key authorities: IRC §§ 162(a), 263(a); Treas. Reg. § 1.263(a)-4; United States v. Gilmore, 372 U.S. 39 (1963)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201536006 [Third Party Communication:
Release Date: 9/4/2015 Date of Communication: Month DD, YYYY]
Index Number: 162.00-00
Person To Contact:
------------------------- ----------------------, ID No. -----------------
-------------------------------------------------- Telephone Number:
------------------------ --------------------
--------------------------- Refer Reply To:
------------------------------------------- CC:ITA:B03
PLR-109578-15
Date:
June 01, 2015

TY: ------

LEGEND:

Taxpayer = --------------------------------------------------

Affiliate = ---------------------------------------------------------

Technology = ----------------------------------

$A = ------------

$B = ------------

Year X = ------

Year Y = ------

Year Z = ------

Dear -------------:

This is in response to your letter dated February 24, 2015. In your letter, you requested
that the IRS rule that the legal costs arising out of a patent infringement case that the
taxpayer has incurred in Year Y and will incur in subsequent tax years are deductible as
ordinary and necessary business expenses under section 162 of the Internal Revenue
code. The request is based on section 162 of the Code.

FACTS

Affiliate of Taxpayer owns a patent covering certain Technology. Taxpayer
manufactures products based on the technical specifications and standards Affiliate
PLR-109578-15 2

provides using Technology. Taxpayer entered into a license agreement with Affiliate
that provides Taxpayer with the technical knowledge to manufacture products protected
by Affiliate’s patent. Taxpayer pays a royalty to Affiliate for use of the patent based on a
percentage of sales revenue generated by the products covered by the patent.
Taxpayer manufactures and sells these products in the United States.

Taxpayer claims that another company has manufactured products infringing Affiliate’s
patent. Taxpayer asserts that the company is selling these products in the United
States in direct competition with Taxpayer. The license agreement between Taxpayer
and Affiliate requires Taxpayer to notify Affiliate if Taxpayer receives any information
about a third party violating the intellectual property owned by Affiliate. Under the
agreement, Affiliate has sole control of the defense and any related settlement
negotiations with the third party. Additionally, the agreement states that expenses
incurred in defending the intellectual property are shared by both Taxpayer and Affiliate,
based on the proportion of the economic benefit derived from sales of products covered
by the intellectual property. If any settlement occurs where the Taxpayer or Affiliate
receives funds from a third party, the proceeds are also shared in the same manner of
allocation.

In Year X, Taxpayer filed a patent infringement claim against the company it believes is
infringing Affiliate’s patent. The company sought a declaratory judgment in federal court
against the Taxpayer in Year X in which it claimed that it is not infringing upon Affiliate’s
patent and that the patent was not validly issued. None of the claims asserted that
Affiliate did not have legal title to the patent. Taxpayer and Affiliate have incurred
approximately $A in legal costs in Year Y to litigate against the company infringing upon
Affiliate’s intellectual property, and have apportioned these costs in the allocation
method described in the license agreement. Approximately $B in legal costs are
expected to be incurred in Year Z and they will continue to be incurred in subsequent
tax years until the case is settled with the competing company.

LAW AND ANALYSIS

Section 162(a) of the Code generally allows a deduction for all ordinary and necessary
expenses paid or incurred during the taxable year in carrying on a trade or business.

Section 263(a) generally requires capitalization of amounts paid for permanent
improvements or betterments made to increase the value of any property or estate.

Section 1.263(a)-4 of the regulations provides rules for applying § 263(a) to an amount
paid to acquire or create intangibles.

Under § 1.263(a)-4(b)(1)(ii), a taxpayer must capitalize an amount paid to create an
intangible described in § 1.263(a)-4(d).
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Under §1.263(a)-4(d)(5)(i), a taxpayer must capitalize amounts paid to a governmental
agency to obtain, renew, renegotiate, or upgrade its rights under a trademark, trade
name, copyright , license, permit, franchise, or other similar right granted by that
governmental agency.

Section 1.263(a)-4(d)(9)(i) requires a taxpayer to capitalize amounts paid to another
party to defend or perfect title to intangible property if that other party challenges the
taxpayer’s title to the intangible property.

Taxpayer’s litigation costs are ordinary and necessary under § 162(a) because they are
incurred pursuant to a legal obligation under a license agreement related to Taxpayer’s
trade or business. The primary issue is whether they are deductible under the origin of
the claim test established in United States v. Gilmore, 372 U.S. 39 (1963). The test
generally determines whether an amount incurred in litigation is currently deductible
under § 162(a). See also Woodward v. Commissioner, 397 U.S. 572 (1970); United
States v. Hilton Hotels Corp., 397 U.S. 580 (1970). In Gilmore, the Court held that “the
origin and character of the claim with respect to which an expense was incurred, rather
than its potential consequences upon the fortunes of the taxpayer, is the controlling
basic test of whether the expense [is] ‘business’ or ‘personal’ and hence whether it is
deductible or not...”. Gilmore at 49.

In applying the origin of the claim test, the taxpayer’s purpose in undertaking or
defending a particular piece of litigation is not relevant. See Woodward at 578. The
origin of the claim test is an objective inquiry to determine the origin and character of the
claim, taking into account all of the facts and circumstances; it is not a test dependent
on the formal titles to pleadings or subjective motives. Thus, while legal fees paid by a
business in connection with business-related litigation generally are deductible as
ordinary and necessary expenses under § 162, litigation fees with their origin in a
capital transaction are required to be capitalized under the origin of the claim test.

A taxpayer must capitalize amounts paid to another party to defend or perfect title to
intangible property if that other party challenges the taxpayer’s title to the intangible
property. § 1.263(a)-4(d)(9)(i); Safety Tube Corp. v. Commissioner, 168 F.2d 787 (6th
Cir. 1948) (legal fees required to be capitalized where controversy was over which party
had title and ownership of the patent). This rule, however, is “not intended to require
capitalization of amounts paid to protect property against infringement and to recover
profits and damages as a result of an infringement, which are generally deductible as
ordinary and necessary business expenses under § 162(a). See, e.g., Urquhart v.
Commissioner, 215 F.2d 17 (3rd Cir. 1954) (expenditures made by a licensor of patents
to protect against infringement and to recover profits and damages were made to
protect, conserve, and maintain business profits, and not to defend or perfect title to
property). Whether an amount is paid to defend or perfect title, on the one hand, or to
protect against infringement, on the other, is a factual matter.” Preamble to Prop. Regs.
PLR-109578-15 4

Guidance Regarding Deduction and Capitalization of Expenditures, 67 Fed. Reg.
77701-01 at 77705, 2003-1 C.B. 373.

The federal tax treatment of costs incurred in a patent infringement suit depends on the
nature of the claims. Patent infringement costs are capital if they are incurred for the
defense or perfection of title to the patent. On the other hand, patent infringement costs
are deductible if they are incurred to protect against infringement of the patent. If the
costs are incurred for both purposes, then a direct tracing, if possible, or a reasonable
allocation of costs if a direct tracing is not possible, is necessary to determine the
proper treatment of the patent infringement costs for federal tax purposes.

Taxpayer incurred litigation costs pursuant to a license agreement with Affiliate to
protect the patent Taxpayer licensed. The nature of the claims against the competitor
infringing the patent and the counterclaims of the competitor are not those of a dispute
of legal title or ownership of the patent, but of a dispute over whether the competitor
infringed upon Affiliate’s patent and whether Affiliate’s patent was properly issued.
These challenges do not raise the issue of whether the patent holder is the true owner
of the patent. These expenses are deductible as ordinary and necessary business
expenses under § 162(a) of the Code.

CONCLUSION

We conclude that the litigation costs Taxpayer incurred or will incur pursuant to its
license agreement with Affiliate in the patent litigation with its competitor are deductible
as ordinary and necessary business expenses under § 162(a) of the Code.

Except as expressly provided herein, no opinion is expressed or implied concerning the
federal income tax consequences of any aspect of any transaction or item discussed or
referenced in this ruling.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.
PLR-109578-15 5

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                 Sincerely,



                                 Christopher F. Kane
                                 Chief, Branch 3
                                 (Income Tax & Accounting)

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