In CCA 201619008, the IRS concluded that amounts paid for violating the US Foreign Corrupt Practices Act (FCPA) are not deductible. Specifically, the IRS indicated that Section 162(f) precludes a deduction for a payment representing a disgorgement of profits and paid by the Taxpayer to the Securities and Exchange Commission (SEC). Practitioners have asserted that the ILM incorrectly indicates that the disgorgement payment is not deductible, as discussed herein. This memorandum highlights the importance of carefully analyzing amounts paid, and applying correct legal principles, for purposes of determining whether or not Section 162(f) applies to preclude a deduction or, alternatively, whether the amounts at issue are fully or partly deductible.

Background

The FCPA contains both anti-bribery and accounting provisions, designed to prohibit corrupt payments to foreign officials to obtain or retain business. Enforcement is handled by the SEC.

The Taxpayer was accused of failing to maintain adequate internal controls sufficient to record the nature and purpose of payments, or to prevent improper payments, to government officials. Further, the 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 Taxpayer consented to a final judgment in a civil proceeding brought against it by the SEC. The Taxpayer agreed to pay disgorgement of the profits gained as a result of the conduct alleged in the action. The Taxpayer also agreed to institute the necessary procedures.

Law and analysis

Section 162(f) prohibits taxpayers from deducting any fines or penalties for any violation of law, even when incurred in carrying on a business. The IRS noted several court cases extrapolating on this issue, most notable in the area of civil fines.

The Taxpayer argued that an exception exists in order to encourage prompt compliance with the securities laws. The Taxpayer further argued that the payment was intended "as a compensatory or remedial measure" and not to "penalize or punish" it.

The IRS started with noting that Section 162(f) is not restricted to payments that are "punitive" in the narrow sense that they are imposed solely as retribution for past wrongdoing. Rather they may also be imposed to encourage future compliance.

The IRS continues in discussing Taxpayer's further argument that the deductibility of a payment turns on whether the payment goes to injured parties. The IRS disagrees and states that the characterization of a payment for purposes of Section 162(f) depends on the origin of the liability giving rise to it, not the ultimate use of the funds. Accordingly, the destination of a civil penalty payment does not change the status of the payment as a civil penalty.

Next, the IRS noted that 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. The IRS explained its view that nothing indicated that the purpose of the disgorgement payment was to compensate the Government or some non-governmental party for its specific losses caused by Taxpayer's violations of the FCPA. Consequently, the IRS regarded the disgorgement payment as not deductible under Section 162(f) because the payment was primarily punitive. Similarly, the IRS observed, a deduction for a loss under Section 165 is prohibited citing, generally, Revenue Ruling 77-126, 1977-1 C.B. 47 and Stephens v. Comm'r., 905 F.2d 667 (2nd Cir. 1990).

The IRS similarly rejected the Taxpayer's third argument that the payment is deductible because the Consent Agreement and final judgment in the SEC case "do not contain language prohibiting deductibility, which the SEC commonly uses when it seeks to punish wrongdoers." The IRS concluded that the absence of a provision prohibiting a deduction for disgorgement does not create a negative implication. In 2003, it noted, the SEC adopted a policy of requiring settlement agreements with civil penalties to include language stating that the settling parties would not deduct civil penalties for tax purposes. The IRS indicated that the SEC does not negotiate with settling parties about whether settlement amounts are tax deductible; also, the SEC does not consider any aspects of taxes when calculating a proposed settlement amount.

Implications

The CCA controversially concludes that the disgorgement payment is nondeductible. As noted, the IRS regarded the disgorgement payment as not deductible under Section 162(f) because the payment was primarily punitive, citing the Stephens case. Importantly, that Second Circuit decision did not address Section 162(f) and instead addressed deductibility solely under Section 165. Certain case law supports that civil disgorgement in the security law context is remedial (not punitive) in nature and serves to compel the offending party to remit the profits obtained from improper conduct.

While Section 162(f), when applicable, permanently disallows a deduction for fines or penalties paid to a government for violation of any law, there are many nuances to what constitutes a fine or penalty for purposes of Section 162(f). Careful attention should be paid to analyze relevant amounts paid, applying relevant legal principles, to ensure a deduction for amounts to which a taxpayer is entitled. Examples of relevant laws where Section 162(f) analysis may arise include, but are not limited to, the False Claims Act, FCPA, Federal Deposit Insurance Act, and environmental and hazardous waste laws.

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