On May 22, 2015, the Internal Revenue Service released an IRS Field Attorney Advice (FAA 20152103F), in which the IRS Office of Chief Counsel (OCC) expressed its informal view that the evidence suggests that the amount a taxpayer paid the United States as an equitable disgorgement of profits under a consent decree with the Food and Drug Administration (FDA) was not a non-deductible payment in the nature of a fine or penalty. The FAA falls short of stating that the payment is deductible, just that the evidence does not suggest it was a fine or penalty that would be precluded from being deducted.

The taxpayer developed and manufactured certain drugs. FDA found alleged violations at the taxpayer’s drug manufacturing operation. FDA and the taxpayer agreed to the terms of a consent decree ordered by the District Court (Consent Decree). The Consent Decree included: (1) detailed injunctive provisions concerning the taxpayer’s manufacturing practices; (2) taxpayer’s agreement to pay equitable disgorgement of profits to the United States Treasury for the period during which the alleged violations occurred; and (3) taxpayer’s agreement to pay certain potential liquidated damages, certain potential amounts of equitable disgorgement, and certain potential future costs of FDA and the United States relating to ongoing enforcement of the terms of the Consent Decree.

The FAA noted that the Consent Decree provided that “[t]he parties acknowledge that the payment(s) under this Decree are not a fine, penalty, forfeiture, or payment in lieu thereof.” It appears that the taxpayer made none of the potential payments identified in item (3) of the immediately preceding paragraph. The FAA also noted that an FDA contact informed the IRS “that FDA views disgorgement as an equitable remedy, not intended as punitive, intended to be a deterrent for other FDA-regulated companies, but not compensatory.”

Section 162(f) of the Internal Revenue Code (IRC) provides that no deduction shall be allowed under IRC § 162(a) for any fine or similar penalty paid to a government for the violation of any law. Compensatory damages paid to a government are not a fine or penalty. In evaluating the characterization of a payment for purposes of IRC § 162(f), the courts look to the origin and character of the liability giving rise to the payment, according to the FAA.

The claims against the taxpayer in the FAA arose from claimed violations of §§ 331(a) and (k) of the Federal Food, Drug, and Cosmetic Act (FD&C Act). The claimed violations are enforceable by injunction under § 332(a), by criminal fines and penalties under § 333(a), and by seizure of goods under § 334. Disgorgement is not specifically authorized by the FD&C Act, but the FAA noted that § 332 has been interpreted broadly to invoke the court’s full equity jurisdiction, including the power to order disgorgement.

After reviewing the purposes of the statutory provisions, the FAA stated that the remedy in equity (the disgorgement) takes on the purposes of the statutory origin, which includes both enforcement and compensation. Because of this, the FAA stated that the intent of the parties must be examined to determine the goal the disgorgement payment was meant to further.

The FAA noted that the Consent Decree states that the parties acknowledge that the payment was not a fine, penalty, forfeiture, or payment in lieu thereof. It goes on to state, however, that, while this language may be clear on its face, it is ambiguous, because there is no evidence that it was intended to address the tax consequences of payments made under the Consent Decree.

The FAA stated that disgorgement, in general, has a deterrent purpose. It goes on to say, however, that it was explained to the IRS that FDA does not view disgorgement as compensatory or punitive, but that it is intended to be a deterrent for other FDA-regulated companies. FDA’s intent is, therefore, ambiguous noting that, while disgorgement is generally viewed as a deterrent measure, “the FDA has denied a punitive intent in this case.”

Given these ambiguities, and noting that no single factor is dispositive, the FAA concluded that “the facts and circumstances taken as a whole do not indicate that the amount the Taxpayer paid as equitable disgorgement under the consent decree was a fine or similar penalty for purposes of § 162(f). . . When [the language in the Consent Decree stating that the disgorgement payment is not a fine, penalty, forfeiture, or similar payment in lieu thereof is] viewed in conjunction with the FDA contact’s statement that the disgorgement was not meant to be punitive, and the FDA’s decision not to bring a claim under the other, more clearly penal provision of § 333 of the FDCA, the facts indicate that the FDA did not intend to punish the Taxpayer. On balance, the evidence suggests that disgorgement payment was not a non-deductible fine or penalty for purposes of § 162(f).”

The FAA’s conclusion is not surprising under the facts. What is notable, however, is that the IRS felt compelled to examine the issue notwithstanding the clear statement in the Consent Decree that the parties acknowledge that the disgorgement payment is not a fine or penalty. Had the Consent Decree to specifically stated that the equitable disgorgement payment was not a fine or penalty for Federal income tax purposes, it appears that the IRS would have found it necessary to examine the intent of the parties. The take away from the FAA is that any settlement agreement should specifically state that the parties do not intend the payment to be a fine or penalty for all purposes, including Federal income tax purposes.