On May 30, 2007, the IRS issued a new Directive on tax deductibility of amounts paid to the government in settlement agreements under the False Claims Act ("FCA") as well in settlements of other regulatory investigations. See IRS, Directive #1 on Government Settlements, LMSB-04-0507-042 (May 30, 2007), available at http://www.irs.gov/businesses/article/0,,id=171034,00.html . Deductibility has been an area of frequent dispute between business taxpayers and the IRS because FCA settlements, as a matter of DOJ policy, do not specify the portion that is compensatory--and therefore deductible as an ordinary and necessary business expense--or the amount that is attributable to a fine or penalty, and therefore not deductible. Although the new Directive does not change the substantive law governing this dispute, its procedures, techniques, and even its guidance on identifying potential settlements highlight existing problems for taxpayers evaluating FCA settlement options. Importantly, while the Directive was announced in the context of FCA settlements, the IRS made clear that this policy will also apply to settlements of environmental, securities, and similar investigations.
The IRS Directive incorporates research and conclusions contained in a Government Accountability Office report to the Senate Committee on Finance, chaired by Senator Charles Grassley. See GAO Report, Tax Administration: Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments, Report # GAO-05-747 (issued Oct. 18, 2005) ("GAO Tax Administration Report"), available at http://www.gao.gov/htext/d05747.html . This GAO report also provides important background to the new IRS Directive on FCA settlements.
Legal Background on Deductibility
Under Section 162(f) of the Internal Revenue Code, no deduction is allowed for "any fine or similar penalty paid to a government for the violation of any law." Fines and penalties are defined under Treasury regulations to include amounts paid "in settlement of . . . actual or potential liability" for a civil fine or penalty. In an IRS Technical Advice Memorandum ("TAM") issued in October of 2004, the IRS addressed the deductibility of a payment under an FCA settlement and concluded that it included both compensatory and penalty amounts. See TAM 171120-0 (slip op. at 12) (Oct. 26, 2004), available at http://www.irs.gov/pub/irs-wd/0502041.pdf . In that TAM, the IRS used the government's final pre-allocation spread sheet to apportion the payment between compensatory and penalty amounts, based on its assessment that this allocation was contemporaneous with the settlement and therefore presented the "best evidence" of the parties' intent.
Although the TAM merely represented the IRS's opinion on the issue and is not binding on a court, the notice accompanying the new Directive cites the TAM's conclusion that a portion of FCA settlements are nondeductible under Section 162(f) and notes that the purpose of the payment governs its deductibility. It also notes that the burden of establishing deductibility is on the taxpayer, citing Talley Indus., Inc. v. Commissioner, 116 F.3d 382, 285-86 (9th Cir. 1997).
Under existing law, obstacles to deductibility include:
- the IRS's insistence on evidence of the parties' intent regarding amounts paid under the settlement;
- the fact that the burden of proving that intent has been placed on the taxpayer; and
- the DOJ practice of inserting "tax neutrality" language in all FCA settlements.
As a result, taxpayers settling FCA allegations may have great difficulty prevailing in disputes over deductibility without contemporaneous statements demonstrating that amounts deducted represented compensatory payments to the government. Both litigation and tax practitioners will need to keep this in mind during negotiation of FCA settlements.
New Obstacles to Deductibility
Under the Directive, according to "mandatory procedures" agreed to by the IRS and DOJ, IRS agents are authorized to consult with government attorneys assigned to the FCA case from Main Justice or the U.S. Attorney's Office through a designated liaison--the "Health Care Technical Advisor" in healthcare fraud settlements, and the "Environmental Technical Advisor" in settlements with environmental penalties. A collaboration between the IRS and DOJ on the factual matters in FCA suits is apparently envisioned.
Specifically, the Directive provides that
0[a]ll field work can then be conducted through that [DOJ or AUSA] attorney, including interviews and the request for records relevant to each [taxpayer]. The examiner needs to discuss the settlement attorney's personal assessment of his/her case relative to the position of whether or not penalties were included in the total settlement amount.
Thus, conversations and documents giving the views of the government's advocates involved in a settlement are directly exchanged with the IRS agent. The Directive states that [i]t is important to understand that no issue is ever proposed to a [taxpayer] unless the existence of a penalty is fully supported by DOJ. The Service makes no attempt to interpret the application of the FCA. All interpretation of the FCA as it applies to each case is that of DOJ. In addition, no penalty amount is based on any computation made by IRS. All figures are those of DOJ. The entire issue is based on the facts, figures, documentary evidence and interpretation of DOJ.
The IRS's assurances to the side, the IRS/DOJ collaboration means that the IRS's initial determination of whether and how much of an FCA settlement payment is deductible will be based on the views of the taxpayers' adversary (the DOJ or the AUSA) in the underlying FCA dispute.
Finally, the new Directive provides guidance to IRS agents, who are required to examine FCA settlements of $10 million or greater. They are also required to apply risk analysis to determine whether settlements below this threshold should also be examined. In order to identify FCA settlements early on in the tax collection process, IRS agents are directed not only to use DOJ's website to research press releases on these settlements, but are also directed to the website of Taxpayers Against Fraud, a decidedly partisan relators' organization.
While existing obstacles to tax deductibility of FCA settlement payments make it somewhat more difficult for a company to properly plan on the tax consequences of any FCA settlement, these new procedures put forward in the IRS's Directive raise even more concern. Counsel for FCA defendants are now on notice that allegedly "confidential" settlement discussions are fair game for IRS auditors. This also means, however, that DOJ cannot hide behind privilege claims when the tax treatment of FCA settlements reaches the courts. See GAO Tax Administration Report at 31 (stating that the IRS considered that any protective "enforcement confidential and/or attorney-client" privilege associated with documents released to IRS would be waived). The IRS/DOJ collaboration may also mean that courts in tax disputes will be far less likely to give any deference to the IRS in those disputes.