New tax law modifies rules for deductibility of settlement payments in enforcement actions
July 2018 | SPECIAL REPORT: WHITE-COLLAR CRIME
Financier Worldwide Magazine
July 2018 Issue
In many civil and criminal resolutions involving government enforcement matters, the settling defendant entity or individual is required to ‘disgorge’ any profits or other ill-gotten gains that resulted from the alleged misconduct. Disgorgement is often a component of settlements with the Securities and Exchange Commission (SEC). Defendants investigated by the Department of Justice regarding alleged violations of the Foreign Corrupt Practices Act (FCPA), Civil False Claims Act, antitrust laws, government contract laws and other federal statutes may be required to disgorge profits as well.
In the past, corporate and individual defendants have often deducted these disgorged payments as business expenses on their annual tax returns. They have also amended prior tax returns under the view that previously reported profits that are relinquished can rightfully result in a tax adjustment to offset the previously declared profits. The deductibility of a disgorgement payment had the potential to significantly reduce the overall cost of settling enforcement actions with the government.
Under previous law, whether a disgorgement payment qualified as tax deductible generally came down to whether the Internal Revenue Service (IRS) viewed the payment as compensatory or punitive. The enforcement agencies settling the matter had little interest or discretion in affecting how the disgorgement payment was classified for tax purposes, and the IRS served as the initial arbiter of the payment’s deductibility.
In December 2017, Congress passed tax reform legislation that drastically alters the landscape for defendants negotiating enforcement settlements with the government. The law redefines what settlement payments in enforcement actions can be tax deductible, limiting deductibility to two carve-outs: (i) restitution; and (ii) amounts incurred to come into compliance with the violated law. Until we have regulations clarifying what is covered by the second carve-out, restitution will be the best path toward ensuring deductibility of a settlement payment. The law also imposes new requirements on the settling agency to identify deductible settlement payments in the settlement documents and report their classification to the IRS.
As a result of these changes, enforcement agencies entering into settlement agreements now have the responsibility and broad discretion to weigh in on a settlement payment’s tax classification. Defendants settling federal enforcement actions must take heed of these changes and advocate during the settlement negotiation process for classification of their settlement payments as restitution. Failure to do so will foreclose tax deductibility of their settlement payments down the road, and could substantially increase the cost of settlement.
However, identification of a settlement payment as restitution in a settlement agreement is not sufficient to guarantee tax deductibility. The new law specifically contemplates that the IRS can look behind any taxpayer-favourable characterisation and conclude instead that the payment does not constitute restitution (26 U.S.C.A. § 162(f)(2)(A) (West 2017)). Recent case law and IRS internal guidance suggest that the IRS may disfavour granting tax deductibility to settlement payments that aim to disgorge ill-gotten gains. Settling defendants should arm themselves with facts to convince the IRS that their disgorgement payments are compensatory, and therefore do meet the definition of restitution, in order to maximise the likelihood of tax deductibility.
Tax reform law redefines tax deductibility of settlement payments in federal enforcement actions
Prior to passage of tax reform, penalties a company or individual paid generally were not considered tax deductible under Section 162(f) of the Internal Revenue Code. Section 162(f) specifically prohibited the deduction of any “fine or similar penalty paid to a government for the violation of any law” (26 U.S.C. 162(f) (2012)). The policy behind this rule was that a taxpayer should not be permitted to enjoy a tax benefit from the payment of an amount intended to be punitive. In contrast, compensatory damages, which are intended to remedy a specific harm caused by the taxpayer, rather than to punish the taxpayer, were not considered fines or penalties and could be deducted. Whether a disgorgement payment was tax deductible generally came down to whether the IRS deemed the payment compensatory or punitive under the facts of the particular case.
In December 2017, Congress passed, and the president signed into law, tax reform legislation that amends Section 162(f) and alters going forward the requirements to secure the tax deductibility of certain payments made to government agencies. The legislation shifts the relevant test away from whether a settlement payment is a ‘fine’ or ‘penalty’ and now prohibits the deductibility of payments made to the government “in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law”. The legislation carves out potential exceptions if the taxpayer can establish that the amounts paid or incurred: (i) constitute restitution; or (ii) are made “to come into compliance with any law which was violated or otherwise involved in the investigation or inquiry”.
The new tax law also creates additional hoops to jump through before a settlement payment may be characterised as tax deductible. In order to qualify as tax deductible, the settlement payment must be identified in the relevant court order or settlement agreement as restitution or a payment made to come into compliance with the law. Such identification is necessary, but not sufficient, to guarantee tax deductibility of a settlement payment. Furthermore, the legislation requires the government to report the amount and classification of the payment to the IRS.
Enforcement action settlement agreements should identify settlement payments as restitution to maximise the chances of tax deductibility
As a result of the tax law’s new identification and reporting requirements, non-tax enforcement authorities will play a key role in determining whether settlement payments in government enforcement actions are tax deductible. Traditionally, enforcement agencies have negotiated the terms of a settlement agreement and left to the IRS the decision of whether a settlement payment qualifies for deductibility. However, the new tax law’s requirement that the government classify the nature of a settlement payment in the settlement agreement gives enforcement agencies significant (though not ultimate) authority to determine the tax deductibility of a settlement payment.
The new tax law now puts the onus on settling defendants and their lawyers to convince enforcement agencies to characterise settlement payments as one of the tax law’s two carve-outs permitting tax deductibility. Restitution appears to be the best path toward maximising the likelihood of tax deductibility. The second carve-out, for amounts incurred to come into compliance with the violated law, remains vague and undefined. Therefore, settling defendants seeking to secure tax deductibility for enforcement action settlement payments should argue for payment in the form of restitution and for the payment to be identified as such in the settlement agreement.
A recent settlement by data services company Dun & Bradstreet to resolve FCPA-related charges with the SEC shows that enforcers are already impacting the tax deductibility of settlement payments. On 23 April 2018, the SEC released an administrative order requiring Dun & Bradstreet to pay over $9m, of which $6m constitutes disgorgement of profits and $2m is a “civil money penalty” (In re Dun & Bradstreet Corp., Exchange Act Release No. 57866, SEC File No. 3-18446 (Apr. 23, 2018)). The order states that “[a]mounts ordered to be paid as civil money penalties... shall be treated as penalties paid to the government for all purposes, including all tax purposes”. The order does not address the tax implications of the disgorgement payment. Given that the order does not explicitly describe the disgorgement payment as restitution, the door should be closed to any argument Dun & Bradstreet might make seeking to deduct the disgorgement payment from its taxes. Prior to passage of the new tax reform bill, the SEC’s silence in its order might have allowed Dun & Bradstreet to argue that the disgorged amount was not a penalty, and therefore, tax deductible.
The IRS remains the final arbiter whether an enforcement action settlement payment is tax deductible
Even if enforcers agree to characterise a settlement payment as restitution, however, the IRS remains free to challenge the tax deductibility of settlement payments to government agencies. To the extent that such payments disgorge ill-gotten gains, settling defendants should be aware of relevant case law and internal IRS guidance that may foreshadow the IRS’s unwillingness to view certain disgorgement payments as tax deductible. In October 2016, the United States Supreme court ruled in Kokesh v. SEC that disgorgement in SEC enforcement cases constituted a penalty, thereby rejecting the SEC’s long-held position that disgorgement is an equitable remedy.
In November 2017, just weeks before passage of the tax reform bill, the IRS released an internal memorandum in response to Kokesh, concluding that disgorgement payments for violations of federal securities laws were not tax deductible. In its analysis, the IRS adopted the Supreme court’s reasoning in Kokesh, in which the court found that “SEC disgorgement ... bears all the hallmarks of a penalty: It is imposed as a consequence of violating a public law and it is intended to deter, not compensate” (Kokesh v. SEC, 137 S. Ct. 1635, 1644 (2017)). Because the Supreme Court determined that disgorgement payments in securities cases are punitive rather than compensatory, the IRS concluded that Section 162(f) bars tax deductions for disgorgement payments made for violating federal securities laws. The internal memorandum came a year after the IRS released a prior internal memorandum prohibiting a taxpayer from deducting the disgorged amount of an FCPA settlement.
While both of these internal IRS memoranda are non-precedential, they signal the IRS’s increased reluctance to deem certain disgorgement payments tax deductible, at least in the context of securities enforcement actions. Where disgorgement payments compensate victims for the amount of harm suffered, the IRS has been more willing to view them as tax deductible. Where disgorgement payments simply deprive the settling company or individual of ill-gotten gains, the IRS has been less willing.
As a result, defendants settling enforcement actions with the government should be prepared to argue to the IRS why their settlement payments are compensatory rather than punitive. This holds true even for defendants which have secured the necessary classification of their settlement payments as restitution in their settlement agreements. Ultimately, the IRS remains the final arbiter of enforcement action settlement payments’ tax deductibility.
Lauren Briggerman and Kirby Behre are members, and George Hani is a member and chair of the Tax Department, at Miller & Chevalier. Ms Briggerman can be contacted on +1 (202) 626 5966 or by email: firstname.lastname@example.org. Mr Behre can be contacted on +1 (202) 626 5960 or by email: email@example.com. Mr Hani can be contacted on +1 (202) 626 5953 or by email: firstname.lastname@example.org.
© Financier Worldwide
Lauren Briggerman, Kirby Behre and George Hani
Miller & Chevalier