Approximately ten years ago, the SEC for the first time sought disgorgement in a Foreign Corrupt Practices Act enforcement action. Since then, disgorgement has become the predominate component of most SEC FCPA settlement amounts.
Non-FCPA disgorgement case law clearly holds that while the remedy of disgorgement “may well be a key to the SEC’s efforts to deter others from violating the securities laws … disgorgement may not be used punitively.”
Against this backdrop, it is most interesting to note that this recently released  IRS Office of Chief Counsel Memorandum concludes that disgorgement paid in an FCPA enforcement action is not deductible because the “payment was primarily punitive.”
Be warned the memorandum is a confusing read because of its many “codes words” and redactions.
The issue presented in the memorandum was whether “I.R.C. § 162(f) prohibits a deduction for an amount paid as disgorgement to the Securities and Exchange Commission for violating the U.S. Foreign Corrupt Practices Act.”
Section 162 of the Internal Revenue Code allows deductions for “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business” but section 162(f) states that no deduction shall be allowed “for any fine or similar penalty paid to a government for the violation of any law.”
In rather a cryptic and redacted fashion, the memo states under the heading “Taxpayer’s Violations of the FCPA” as follows:
“Taxpayer is incorporated and headquartered in the United States. Taxpayer is a provider of Products. Taxpayer directly owns all the shares of Subsidiary. Subsidiary owns all the shares of Disregarded Entity. For federal income tax purposes, Subsidiary is treated as a corporation and Disregarded Entity is disregarded as an entity separate from its owner. Disregarded Entity manufactured and sold Products in Country. Disregarded Entity’s books and records were consolidated into Taxpayer’s books and records and reported by Taxpayer in its financial statements. From Year 1 to Year 2, some of Disregarded Entity’s executives and employees intentionally falsified Disregarded Entity’s books and records related to approximately $A of things of value given to government officials in Country. Taxpayer failed to implement adequate internal accounting and financial controls designed to detect and prevent, among other things, corruption-related violations, including FCPA violations. [Redaction] The things of value included Items and were given to obtain business benefits for Disregarded Entity in Country.”
Under the heading “Resolution of Taxpayer’s FCPA Violations, the memo states (again in cryptic and redacted fashion) as follows:
“On Date 1, Taxpayer entered into a Consent Agreement in which it consented to the entry of a final judgment in a civil proceeding to be brought against it by the SEC. Taxpayer agreed that it would be permanently restrained and enjoined from violating sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 (Exchange Act) [15 U.S.C. §§ 78m(b)(2)(A) and 78m(b)(2)(B)]. Also, Taxpayer agreed to pay disgorgement of $B, representing profits gained as a result of the conduct alleged in the complaint, together with prejudgment interest in the amount of $C, for a total of $D. The agreement provided that Taxpayer waived any claim of Double Jeopardy based upon the settlement of the proceeding, including the imposition of any remedy or civil penalty. Additionally, the agreement provided that Taxpayer understood and agreed to comply with the terms of 17 C.F.R. § 202.5(e), which provides in part that it is the SEC’s policy “not to permit a defendant or respondent to consent to a judgment or order that imposes a sanction while denying the allegations in the complaint or order for proceedings.”
On Date 2, the SEC filed a complaint against Taxpayer. The complaint alleged that Taxpayer violated section 13(b)(2)(A) of the Exchange Act [15 U.S.C. § 78m(b)(2)(A)] by failing to make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflected the transactions and disposition of assets. The complaint also alleged that Taxpayer violated section 13(b)(2)(B) of the Exchange Act [15 U.S.C. § 78m(b)(2)(B)] because – by failing to ensure that it maintained adequate internal controls sufficient to record the nature and purpose of payments, or to prevent improper payments, to government officials – Taxpayer failed to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that its transactions and the disposition of its assets were recorded correctly, accurately, and in accordance with authorization of management. The prayer for relief requested that Taxpayer be permanently enjoined from violating sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act [15 U.S.C. §§ 78m(b)(2)(A) and 78m(b)(2)(B)]; Taxpayer be ordered to disgorge ill-gotten gains wrongfully obtained as a result of its illegal conduct, plus prejudgment interest thereon; and the court grant such other relief as it may deem just and appropriate.
On Date 2, Taxpayer entered into a [redacted] with the United States of America, acting through the DOJ. In the [redacted], Taxpayer consented to the filing by the DOJ of a Criminal Information charging it with [redacted]. The [redacted] included provisions concerning implementation of a corporate compliance program and ensuring an adequate internal accounting controls system. Taxpayer agreed to pay a monetary penalty in the amount of $E to the United States Treasury within a specified time after the court’s sentencing of Disregarded Entity for FCPA-related violations. In the [redacted], Taxpayer agreed “that no United States tax deduction may be sought in connection with the payment of any part of this $E penalty.” The [redacted] provided that the $E penalty would be reduced by any criminal penalties imposed by the court on Disregarded Entity in connection with its guilty plea to a [redacted] Criminal Information charging it with [redacted].
On Date 2, Disregarded Entity entered into a plea agreement with the United States of America, acting through the DOJ. Under the plea agreement, Disregarded Entity agreed to plead guilty to a [redacted] Criminal Information charging it with [redacted] Disregarded Entity agreed to pay a criminal fine of $F, subject to the sentencing court’s acceptance of the guilty plea and entering of a final judgment consistent with the plea agreement. On Date 2, the court accepted Disregarded Entity’s guilty plea and imposed a criminal penalty of $F.
On Date 3, Taxpayer paid by wire transfer to the United States Treasury the $F fine imposed by the court on Disregarded Entity. As a result of the imposition of that criminal penalty on Disregarded Entity, the penalty imposed on Taxpayer was reduced on a dollar-for-dollar basis to $G.
On Date 4, the district court entered the final judgment against Taxpayer in the civil proceeding brought against it by the SEC. Taxpayer paid $D to the SEC after the final judgment was entered. The SEC sent the funds to the United States Treasury.”
After reviewing Section 1.162-21(b)(1) of the Income Tax Regulations and certain case law, the memo states: “a payment imposed primarily for purposes of deterrence and punishment is not deductible under section 162(f).”
The memo next states “we think disgorgement in federal securities law cases can be primarily compensatory or primarily punitive for federal tax law purposes depending on the facts and circumstances of a particular case.”
Later, the memo states “we think disgorgement can be primarily punitive for tax purposes in some cases, where it serves primarily to prevent wrongdoers from profiting from their illegal conduct and deters subsequent illegal conduct.”
Thereafter, the memo states:
“For FCPA cases in particular, it is important to consider the sharply defined Congressional policy to deter and punish such violations, as shown in the overall statutory scheme of the FCPA as well as section 162(c)(1) of the Code.
In the instant case, we think the absence of certain facts is determinative. Here, there simply is nothing indicating that the purpose of the disgorgement payment was to compensate the United States Government or some non-governmental party for its specific losses caused by Taxpayer’s violations of the FCPA.* Consequently, we think the disgorgement payment is not deductible pursuant to section 162(f) because the payment was primarily punitive.”
* A particularly cryptic and heavily redacted footnote states:
“Moreover, during [redacted], Taxpayer settled a [redacted] This fact was not included in Taxpayer’s analysis or your request for advice. Consequently, we recommend that you develop the facts concerning what was paid by whom and how Taxpayer treated these amounts for tax purposes. [redacted] If the disgorgement payment to the SEC did not in any way reduce the [redacted], then that indicates the disgorgement was not compensatory for purposes of section 162(f).”
I just love how the memorandum ends: “Please call Robert Basso at (202) 317-7011 if you have any questions.”
Read the memo and you are likely to have a few questions.
For additional analysis, see here from Miller & Chevalier.