In Altria Group, Inc. v. United States, the US District Court for the Eastern District of Virginia held that a tobacco company may deduct, as a business expense, a payment made to Oregon under a "split-recovery" statute. The case focuses on former IRC Section 162(f) (i.e., pre-Tax Cuts and Jobs Act (TCJA)). It is relevant for current law purposes, however, as it provides general guidance on how to assess the "origin of the liability" under the final IRC Section 162(f) regulations to determine whether an amount paid is a fine or penalty. For more information on the IRC Section 162(f) regulations, see Tax Alert 2021-0108.

Facts

Oregon has a split-recovery statute under which a portion of punitive damages awarded to a plaintiff are paid to the state to provide "money, medical treatment, counseling, and a host of other services required to help victims of crime deal with or recover from the crimes of which they are victims."

Jesse Williams died of lung cancer, and his estate sued Philip Morris USA, Inc. (PM USA) in 1997, asserting that Williams' death resulted from Philip Morris's negligence and fraudulent misrepresentation (see Williams v. Philip Morris Inc.). Williams's estate prevailed in part on its negligence claim for economic and non-economic (but not punitive) damages, as well as on its misrepresentation claim for which the jury awarded economic damages, non-economic damages and punitive damages.

Additionally, Oregon sued several cigarette manufacturers, including Philip Morris, in 1997. Oregon alleged that the manufacturers conducted unfair trade practices and violated Oregon's Racketeer Influenced and Corrupt Organizations (RICO) Act statute. Oregon settled its claims under a multi-state Master Settlement Agreement (MSA) that included Philip Morris. Under the MSA, Oregon released the tobacco companies from past and future claims relating to tobacco products.

Because of the MSA, Philip Morris sent a letter to Oregon's Attorney General stating that Oregon was not entitled a portion of the punitive damages awarded to the Williams estate. The case made it all the way to the Oregon Supreme Court, which held that the release of claims under the MSA did not include Oregon's interest in the punitive damages awarded to the Williams estate. Accordingly, Oregon was entitled to a portion of the punitive damages award.

After paying Oregon, Altria filed its 2012 tax return and deducted the entire portion of the punitive damages awarded to the Williams estate and the portion paid to Oregon, including interest, as a business expense under IRC Section 162(a). The IRS allowed the deduction for the portion paid to the Williams estate, but disallowed the deduction for the payment to Oregon. Citing IRC Section 162(f), the IRS asserted that the payment made by Altria to Oregon was a fine or similar penalty paid to a government for violating of a law. Altria paid the tax and interest resulting from the IRS's adjustments; in 2018, it filed Form 1120X, Amended US Corporation Income Tax Return, claiming a refund for the amount paid due to the adjustments. After the IRS disallowed the refund request, Altria filed suit seeking (1) the recovery of approximately $9.3 million it paid in federal income taxes for the 2012 tax year plus any interest allowed by law, (2) an award for the costs of the lawsuit and (3) any other relief deemed appropriate by the court.

Holding

IRC Section 162(f)

IRC Section 162(a) allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. IRC Section 162(f), as in effect in 2012, stated that a deduction was not allowed under IRC Section 162(a) for any fine or similar penalty paid to a government for violating a law. The 2012 regulations defined "fine or similar penalty" as an amount paid as a civil penalty imposed by federal, state or local law or an amount paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (criminal or civil). Compensatory damages paid to a government were not a fine or penalty.

The court looked to the ordinary meanings of penalty, similar, fine and offense to conclude that Altria's payment to Oregon did not resemble a penalty for an offense because "there is no defined offense for which the payment was required to be paid on account of the violation of some proscribed conduct." The court also considered the regulations in effect in 2012 as well as the legislative history of IRC Section 162(f). The Senate Finance Committee report states:

In approving the provisions dealing with fines and similar penalties in 1969 [when IRC Section 162(f) was enacted], it was the intention of the committee to disallow deductions for payments of sanctions which are imposed under civil statutes but which in general terms serve the same purpose as a fine exacted under a criminal statute.

S. Rep. No. 92-437 (1971), reprinted in 1971 U.S.C.C.A.N. 1918, 1980.

For additional guidance on IRC Section 162(f), the court looked to the final regulations issued to implement the modifications to IRC Section 162(f) as part of the TCJA. The final regulations clarify that IRC Section 162(f)(1) "does not apply to any amount paid or incurred by reason of any order or agreement in a suit in which no government or governmental entity is a party."

After considering the Senate Finance Committee report, the regulations and several court opinions, the court determined that "similar penalty" in IRC Section 162(f) is a penalty to prohibit conduct that a criminal statute prohibits. As a result, the court turned to why Altria made the payment to Oregon.

Oregon law

Or. Rev. Stat. Section 31.730 requires punitive damages to be proven by clear and convincing evidence that "the party against whom punitive damages are sought has acted with malice or has shown a reckless and outrageous indifference to a highly unreasonable risk of harm and has acted with a conscious indifference to the health, safety and welfare of others." As such, the court observed that Oregon's law on when punitive damages can be awarded focuses on state of mind, meaning a jury may award punitive damages if state of mind is shown in connection to the charged conduct. The court also noted that Oregon's punitive damage statutes do not "prohibit or proscribe specific conduct or define conduct that itself is an offense." Therefore, the court concluded that the punitive damages at issue are not awarded for violating a law and cannot be imposed unless the state of mind defined in the statute accompanies the conduct.

The court also found that punitive damages are not a "similar penalty" as set out in IRC Section 162(f). In addition, Oregon's punitive damages statute and the jury instructions in Williams v. Philip Morris Inc. do not mention Oregon's split recovery statute. Without Oregon's split-recovery statute, the court noted, the full amount of punitive damages awarded in Williams v. Philip Morris Inc. would have gone to the Williams estate.

Therefore, the court found that Oregon's split-recovery statute, not the jury's verdict in favor of the William's estate, is the origin of Philip Morris's liability to pay a portion of the punitive damages to Oregon. Accordingly, the court held that the payment made under the split-recovery statute is not a fine or similar penalty, and it is not paid for violating a law because the split-recovery statute's purpose is to fund a state-based fund for victims compensation.

As such, the court held that Altria is entitled to a refund of approximately $9.3 million for overstatements of income, unclaimed credits and overstatements of tax, plus interest.

Implications

The Altria case underscores the importance of a careful analysis as to the "origin of the liability," as well as pertinent facts, such as legislative intent related to an applicable statute, for purposes of determining whether an amount paid is a fine or penalty for purposes of IRC Section 162(f).

Under amended IRC Section 162(f)(1), taxpayers may not deduct amounts paid (whether by suit or agreement) to a government or governmental entity in relation to: (1) the violation of any law or (2) the investigation or inquiry by the government or entity into the potential violation of a law. IRC Section 162(f)(2) contains an exception to IRC Section 162(f)(1) under which a taxpayer may deduct an amount described in IRC Section 162(f)(1), provided the amount is otherwise deductible under the Code and the taxpayer establishes (i.e., the so-called "establishment requirement," addressed in the final regulations) that the amount paid or incurred:

• Constitutes restitution (including remediation of property) for damage or harm that was or may be caused by a violation of any law or the potential violation of the law
  or
• Is paid to come into compliance with any law that was violated or otherwise involved in the investigation or inquiry into the potential violation of any law (establishment requirement) and is identified as such in the court order or settlement agreement (identification requirement)

To meet the establishment requirement, the taxpayer must use documentary evidence to prove:

• Its legal obligation to pay the amount identified in the order or agreement as restitution, remediation or an amount paid to come into compliance with a law
• The amount paid or incurred
• The date the amount was paid or incurred
• "That, based on the origin of the liability and the nature and purpose of the amount paid or incurred," the amount was for restitution or remediation or to come into compliance with a law

Under this analysis, a taxpayer will need to consider not only the settlement agreement or order, for example, but also the underlying legal claim and statutory provisions giving rise to the liability, and determine whether the purpose of the claim is compensatory or related to compliance with the law or, alternatively, punitive in nature (or whether both aspects are involved in more complex controversies). Consideration of applicable laws is necessary and can be complicated in the context of class action settlements that involve multiple jurisdictions. Due to the necessary documentary evidence and the need for appropriate language in the agreement or order, taxpayers may want to confer with tax advisors early in the process.

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