A guest post today from Ropes & Gray attorneys Ryan Rohlfsen, Kat Gregor, Yana Grishkan, and Elizabeth Smith.
The amounts paid to the government pursuant to Foreign Corrupt Practices Act resolutions typically include criminal penalties and civil fines, including disgorgement or forfeiture of ill-gotten gains. Unsurprisingly, a significant question companies face when making payments to the government to resolve alleged FCPA violations is whether any portion of the payments is deductible for tax purposes.
Prior to the enactment of the Tax Cuts and Jobs Act (“TCJA”) in December 2017, the Internal Revenue Code (the “Code”) prohibited deductions of “any fine or similar penalty paid to a government for the violation of any law.” The recent tax reform, however, has made substantial changes to the rules governing tax deductibility of such payments. Although the Code still generally disallows deductions for payments paid to or at the direction of the government in relation to the violation of any law or an investigation, Section 162(f) of the Code makes an exception for amounts paid as restitution, remediation, or to come into compliance with the laws.
This post explains how the final regulations interpreting Section 162(f) of the Code ((T.D. 9946) (the “Final Regulations”) released on January 14, 2021, impact the deduction of amounts paid to the government in connection with an FCPA violation. Further, it highlights considerations companies should keep in mind while negotiating resolutions of governmental investigations of FCPA violations. The Final Regulations will apply to taxable years beginning on or after January 14, 2021.
Deductibility Under Section 162(f) Before the TCJA
Prior to the enactment of the TCJA, Section 162(f) prohibited the deduction of fines and penalties paid in connection with a violation of law. Taxpayers could, however, deduct compensatory damages such as remediation costs.
In May 2016, the IRS Chief Counsel issued an advice memorandum, stating that the disgorgement payment to the SEC in a corporate FCPA action was not tax-deductible, finding that it constituted a non-deductible “penalty paid to a government for the violation of any law” under Section 162(f). The IRS reaffirmed its position following the June 2017 Supreme Court decision in Kokesh v. SEC which held that a disgorgement payment in an SEC securities law case constituted a penalty for statute of limitation purposes.
Deductions Under New Section 162(f)
Section 162(f) changed the requirements for taxpayers to deduct amounts paid to the government pursuant to court-ordered judgments, settlement agreements, non-prosecution agreements, deferred prosecution agreements, and decisions by certain boards/commissions. In addition, because a government or governmental entity is the real party in interest in qui tam cases, Section 162(f) likely applies to any amount paid to the relator (including any share ultimately paid by the government or governmental entity), regardless of whether the government or governmental entity intervenes in the suit.
Section 162(f) now includes a facts-and-circumstances test that must be met for payments to be deductible as restitution, remediation, or amounts paid to come into compliance with the law. Further, the Final Regulations remove earlier proposed regulations’ per se prohibition on deductions for disgorgement or forfeiture payments, and instead include a facts-and-circumstances test that must be met for disgorgement or forfeiture payments to be deductible. This is a reversal of the position the IRS took in the wake of the Kokesh decision, and was influenced by the Supreme Court’s July 2020 decision in Liu v. SEC, which clarified that disgorgement may be an equitable remedy that serves compensatory purposes—rather than a per se penalty—in certain circumstances.
Under the Final Regulations, payments are deductible as restitution, remediation, or amounts paid to come into compliance if:
- the amount is otherwise deductible under chapter 1;
- the order or settlement agreement identifies the payments, not in excess of net profits, as restitution, remediation, or an amount paid to come into compliance with a law (the “Identification Requirement”);
- the taxpayer establishes the amount was paid as restitution, remediation, or to come into compliance with the law (the “Establishment Requirement”);
- the origin of the taxpayer’s liability is restitution, remediation, or an amount to come into compliance with the law; and
- the amount is not disbursed to the general account of the government or governmental entity for general enforcement purposes.
Clarifications to the Identification Requirement
Section 162(f) contains an Identification Requirement that the order or agreement identify the amounts that are paid as restitution, remediation, or to come into compliance with a law. One way to meet this requirement is for the settlement agreement or order to state that the amounts paid constitute “restitution,” “remediation,” or “an amount paid to come into compliance with law” or to use a different form of those words (e.g., “remediate” or “comply with a law”). The Final Regulations provide that this requirement may also be met if the agreement or order specifically describes the damage done, harm suffered, or manner of non-compliance with the law and describes the action required of the taxpayer to provide restitution, remediation, or to come into compliance with the law.
The Final Regulations recognize that the precise amount of a payment that relates to restitution, remediation, or coming into compliance with the law may be unknown upon entering into a settlement or the issuance of an order, including when the applicable agreement or order specifies only a lump sum payment. Further, a settlement agreement or order may apply to multiple taxpayers and not allocate the payment amongst them. The Final Regulations provide that the Identification Requirement may be met even if the order or settlement agreement (1) does not allocate the total lump-sum payment amount or multiple damage award among restitution, remediation, or to come into compliance; (2) is among multiple taxpayers; or (3) does not provide an estimated payment amount. To meet the Identification Requirement in such circumstances, the agreement or order must contain language specifically stating or describing that the amount will be paid or incurred as restitution, remediation, or to come into compliance with the law.
In addition, the Final Regulations removed the initially proposed provision allowing the IRS to challenge the characterization of an amount identified in an order or settlement agreement as paid for restitution, remediation, or to come into compliance with the law.
Clarifications to the Establishment Requirement
Section 162(f) contains an Establishment Requirement that the taxpayer must substantiate, with documentary evidence, the legal obligation to pay, the amount, the amount paid, and the date the amount was paid. In the case of a lump sum payment or multiple damage award that includes a combination of restitution, remediation, and coming into compliance with the law, the taxpayer must establish the exact amount paid or incurred for each purpose to meet the Establishment Requirement. Likewise, if an order or agreement involves multiple taxpayers, each taxpayer must establish the amount it paid or incurred as restitution, remediation, or to come into compliance with the law.
The Final Regulations provide a non-exhaustive list of documents that can be used to fulfill the Establishment Requirement, such as receipts; the legal or regulatory provision related to the violation or potential violation of any law; documents issued by the government or governmental entity relating to the investigation or inquiry, including court pleadings filed by the government requesting restitution, remediation, or demanding that defendant take action to come into compliance with the law; judgment; decree; documents describing how the amount to be paid was determined; and correspondence exchanged between the taxpayer and the government before the order or settlement agreement became binding. This includes documentary evidence in a foreign language if provided along with a complete and accurate certified English translation.
Of note, however, the Final Regulations provide that a report filed by a government or governmental entity in compliance with Section 6050X of the Code is not sufficient documentation to satisfy either the Establishment Requirement or Identification Requirement. This is so even though Section 6050X requires the U.S. government to file information returns (Form 1098-F) with the IRS to report payments received from taxpayers pursuant to an order or settlement agreement, including identifying any portions constituting restitution, remediation, or payments to comply with the law.
The Final Regulations further clarify that the Establishment Requirement may be met if the amount is paid to a segregated fund or account established by or at the direction of a government or governmental entity to restore a person, government, governmental entity, property, environment, or natural resource harmed, injured or damaged by an actual or potential legal violation, even if the ultimate recipient, or each ultimate use, of the payment is not designated or is unknown.
Payments to a Government’s General Account and Reversion of Excess Amounts
The Final Regulations prohibit the deduction of amounts paid to the general account of a governmental or governmental entity for general enforcement purposes. However, certain payments may still be deductible as restitution or remediation if they are paid to a segregated fund of (or established at the direction of) the government or governmental entity, even if a portion reverts to the government or governmental entity’s general account if the fund is not exhausted (e.g., due to amounts going unclaimed). The taxpayer must have reasonably expected at the time it made the payment that the amount would be used for restitution to harmed persons, and must establish that it made the payment for the identified purpose (e.g., by showing a cancelled check).
Finally, if a portion of the payment reverts to the taxpayer for the taxpayer’s benefit, then that portion is not deductible, and the taxpayer will be required to include those amounts in income under the tax benefit rule.
Key Implications
Taxpayers making payments to a government or governmental entity in connection with an investigation or enforcement action by U.S. authorities, including in connection with potential violations of the FCPA, should consider whether the Final Regulations interpreting Section 162(f) of the Code impact their approach to documenting and substantiating a settlement or payment. To substantiate the deductibility of payments made as restitution, remediation, or to come into compliance, companies may consider taking the following steps, among others:
- As possible, negotiate to ensure that orders and settlement agreements are explicit that amounts are paid as restitution (or other deductible payment), or describe the alleged harm and actions required to provide restitution;
- Negotiate to include the specific amount paid as restitution (or other deductible payment) in an order or settlement agreement, or otherwise maintain documentation containing enough facts to determine such amount;
- As possible, negotiate to ensure that payments under a settlement or order are not made to the general account of the government or governmental entity used for general enforcement purposes;
- Review the record of negotiations with the government to confirm there are no inconsistencies with the language in the order or settlement agreement before taking a tax position; and
- Maintain contemporaneous files of substantiation and other records that may be necessary to defend deductions if later reviewed by the IRS.
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