On May 22, 2015, the IRS released a field service advice (“FSA”) memorandum regarding the application of I.R.C. § 162(f) to a consent decree between a taxpayer and the Food and Drug Administration (“FDA”).15 The issue presented in the FSA was whether the decree’s equitable disgorgement provision was a “fine or other penalty” within the meaning of section 162(f). Although the Service acknowledged that disgorgements have deterrent effects, the Service stated that the FDA’s intent was not punitive. Hence, the Service concluded that the disgorgement was not a nondeductible expense.
Taxpayer (a drug manufacturer) and the FDA reached the consent decree after the United States sued the taxpayer in US District Court for violations of the Federal Food, Drug and Cosmetics Act (“FDCA”).16 On behalf of the FDA, the United States sought a permanent injunction, disgorgement and other equitable relief for violations of 21 U.S.C. §§ 331(a) and (k), which restrict the transport and creation of adulterated drugs. Although “[d]isgorgement is not specifically authorized by the FDCA,” the Service noted that courts have interpreted the FDCA to include “the court’s full equity jurisdiction, including” disgorgement.17
The consent decree placed certain restrictions on the taxpayer’s “manufacturing practices” and required disgorgement of profits made during the period of violations. Paragraph k of the decree provided: “the parties acknowledge that the payment(s) under this Decree are not a fine, penalty, forfeiture or payment in lieu thereof.” 18 In addition, the parties acknowledged that “the FDA views disgorgement as an equitable remedy, not intended as punitive, intended to be a deterrent for other FDA-regulated companies, but not compensatory.”19
Section 162(a) provides that “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business” can be deducted from taxable income. However, section 162(f) prohibits taxpayers from deducting fines or penalties “paid to a government for the violation of any law.” The issue, then, is whether the equitable disgorgement was a non-deductible fine or penalty.
The Service concluded that the disgorgement was not a non-deductible fine. The key is to examine the “origin and character of the liability giving rise to the payment.”20 Payments imposed for punitive or deterrent purposes are fines within the meaning of section 162(f); however, compensatory damages are not. If the statute that gave rise to liability serves both punitive and compensatory purposes, then courts must examine the parties’ intent to determine the nature of the payment.21
The Service acknowledged that the FDCA serves both punitive and compensatory purposes. The FDCA “protect[s] public health” by stopping and deterring violations, but also “protect[s] consumer’s financial interests” through compensatory remedies intended to make consumers whole.22 Because of this dual purpose, the parties’ intent is determinative. But the FDA’s intent was ambiguous because, although equitable disgorgement is usually a deterrent, “the FDA  denied a punitive intent” in paragraph k of the consent decree.23 The Service concluded that the totality of the circumstances pointed to a non-punitive intent. The Service observed that paragraph k does not explicitly mention the tax consequences of the disgorgement, indicating that it was not meant to implicate section 162(f). (Paragraph k may relate to “double jeopardy concerns.”24) Moreover, the Service posited that the United States, on behalf of the FDA, could have sued for violations of section 333 of the FDCA, which are “more clearly penal.” Hence, the FDA did not intend to penalize the taxpayer through disgorgement. As such, the disgorgement payment to the FDA was not a fine or penalty for purposes of section 162(f).