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October Term, 2013

June 19, 2014

Today the Supreme Court issued two decisions, described below, of interest to the business community.

Patent Act—Patent Eligibility of Computer-Implemented Inventions

Alice Corp. Pty. Ltd. v. CLS Bank International, No. 13-298 (described in the December 6, 2013, Docket Report)

Section 101 of the Patent Act broadly defines the scope of patent eligibility to include “any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof.” 35 U.S.C. § 101. But the Supreme Court has long recognized an implied exception for laws of nature, physical phenomena, and abstract ideas, because granting a patent monopoly for these “building blocks” of human ingenuity would impede innovation.

Today, in a unanimous decision written by Justice Thomas, the Court in Alice Corp. v. CLS Bank International, No. 13-298, held that a patent-ineligible abstract idea cannot be made patent-eligible through inclusion of generic references to computer implementation. This widely awaited decision provides important clarity regarding the application of Section 101 to computer-implemented inventions.

The patents at issue related to a “computerized scheme for mitigating ‘settlement risk’—i.e., the risk that only one party to an agreed-upon financial exchange will satisfy its obligation.” They “facilitate[d] the exchange of financial obligations between two parties by using a computer system as a third-party intermediary.” The Court held that these claims are “drawn to the abstract idea of intermediated settlement, and that merely requiring generic computer implementation fails to transform that abstract idea into a patent-eligible invention.”

The Court began its analysis by explaining the two-step inquiry required by Section 101. A court first must determine “whether the claims at issue are directed to one of th[e] patent-ineligible concepts.” If they are, the second step in the analysis is “a search for an ‘inventive concept’—i.e., an element or combination of elements that is ‘sufficient to ensure that the patent in practice amounts to significantly more than a patent upon the [ineligible concept] itself.’”

Here, the claims were “drawn to the abstract idea of intermediated settlement.” The Court held that “the concept of intermediated settlement is ‘a fundamental economic practice long prevalent in our system of commerce’” and that “[t]he use of a third-party intermediary . . . is also a building block of the modern economy.” Intermediated settlement is therefore “an ‘abstract idea’ beyond the scope of § 101.” Notably, the Court declined to “delimit the precise contours of the ‘abstract ideas’ category in this case” because “[i]t is enough to recognize that there is no meaningful distinction between the concept of risk hedging in Bilski [v. Kappos, 561 U.S. ___ (2010)] and the concept of intermediate settlement at issue here.”

Turning to the second step of the analysis, the Court stated that “[a] claim that recites an abstract idea must include ‘additional features’ to ensure ‘that the [claim] is more than a drafting effort designed to monopolize the [abstract idea].” The “mere recitation of a generic computer cannot transform a patent-ineligible abstract idea into a patent-eligible invention. . . . Thus, if a patent’s recitation of a computer amounts to a mere instruction to ‘implement’ an abstract idea ‘on . . . a computer’ . . . that addition cannot impart patent eligibility.” Because “each step” in the claims here “does no more than require a generic computer to perform generic computer functions,” the Court determined that the function performed by the computer was “purely conventional” and therefore did not satisfy Section 101.

Explaining the “additional features” that would have been sufficient to satisfy Section 101, the Court pointed out that the claims “do not, for example, purport to improve the functioning of the computer itself. Nor do they effect an improvement in any other technology or technical field. Instead, the claims at issue amount to ‘nothing significantly more’ than an instruction to apply the abstract idea of intermediated settlement using some unspecified, generic computer.”

In a brief concurring opinion, Justice Sotomayor, joined by Justices Ginsberg and Breyer, stated that she “adhere[s] to the view that any ‘claim that merely describes a method of doing business does not qualify as a process under §101’”—a position that the Court rejected in its Bilski decision.

Any questions about the case should be directed to Andrew J. Pincus (+1 202 263 3220) in our Washington office.

Internal Revenue Service—Investigatory Summonses—Right to Evidentiary Hearing

United States v. Clarke, No. 13-301 (described in the January 13, 2014, Docket Report)

The Supreme Court held today that taxpayers are entitled to examine IRS agents in a summons-enforcement proceeding where taxpayers “point[] to specific facts or circumstances plausibly raising an inference of bad faith.” The Court held that circumstantial evidence could meet this burden but that naked allegations were insufficient. This case has implications for all taxpayers under audit, especially regarding how they handle Information Document Requests (IDRs) under the new IDR-enforcement program.

Section 7602(a) of the Internal Revenue Code authorizes the Service to summon documents and testimony to, among other things, “ascertain[] the correctness of any return.” If a summons recipient refuses to comply, the Service may bring an enforcement action in district court. Enforcement proceedings are summary in nature and the Service makes a prima facie case by showing that it satisfied the so-called Powell factors: (i) that the investigation was for a legitimate purpose, (ii) that the inquiry may be relevant to that purpose, (iii) that the Service does not already have the requested information, and (iv) that the Service followed the administrative steps required by the Code. See United States v. Powell, 379 U.S. 48, 57–58 (1964). Because the proceedings are summary, district courts often deny requests for evidentiary hearings, as was the case here.

In 2010, Dynamo Holdings Limited Partnership refused the Service’s third request to extend the statute of limitations for assessing the partners’ tax liabilities for the tax years 2005 through 2007. Shortly after that refusal, the Service summoned several individuals associated with the partnership. None complied. The Service issued a Final Partnership Administrative Adjustment in December 2010, and Dynamo petitioned the Tax Court for readjustment two months later, in February 2011. Two months after that, the Service brought a summons-enforcement action in district court. In response, the taxpayer argued that the Service had two improper purposes, (i) punishing Dynamo for refusing to extend the statute of limitations and (ii) evading the Tax Court’s limitations on discovery. The district court found these defenses irrelevant and declined to conduct an evidentiary hearing. The Eleventh Circuit reversed, holding that the allegation of an improper purpose entitled the taxpayer to an evidentiary hearing.

In a unanimous opinion by Justice Kagan, the Supreme Court vacated the judgment of the Eleventh Circuit. The Court agreed with the Eleventh Circuit that a taxpayer is entitled to examine an IRS agent when the taxpayer “can point to specific facts or circumstances plausibly raising an inference of bad faith,” including circumstantial evidence, but concluded that “[n]aked allegations of improper purpose are not enough.” Because the Eleventh Circuit held that the mere allegation of improper motive entitled the taxpayer to an evidentiary hearing, the Court remanded the case for application of the new standard.

Clarke offers several lessons for taxpayers under audit. First, the Court left open the possibility that affidavits could establish the needed circumstantial evidence for an evidentiary hearing. Second, the Court left several possibilities open as improper purposes making summonses unenforceable. Third, the case demonstrates the need for taxpayers to document their interactions with the Service during an audit to establish their need for an evidentiary hearing.

The Court did not resolve the so-called Westreco question—whether the Service can summon information for use in Tax Court litigation once that litigation has begun. The Court deemed that question beyond the scope of the question presented by this case.

The Court’s opinion should also remind taxpayers of the importance of documenting their interactions with the Service. The opinion comes as the Service is establishing its new IDR enforcement process. That process, described in directive LB&I-04-0214-004 (Feb. 28, 2014) and here, sets out specific deadlines and notice requirements for escalating an IDR to summons enforcement, including a delinquency notice (Letter 5077), a pre-summons letter (Letter 5078), and then a summons. Depending on the circumstances, the Service’s failure to follow these procedures could plausibly raise an inference of bad faith. For that reason—among others—taxpayers should consider establishing robust procedures for documenting their interactions with the Service, especially regarding requests for information.

Any questions about this case should be directed to Brian Kittle (+1 212 506 2187) in our New York office or Geoffrey Collins (+1 312 701 8633) in our Chicago Office.

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