The following article is reprinted from The M&A Tax Report, Vol. 11, No. 11, June 2003, Panel Publishers, New York, NY.


By Robert W. Wood

Few would argue with the notion that corporate America has been badly battered over the past year and a half. The initial thunderclap that was Enron (or "I am Enron, hear me roar") is even becoming a distant memory, as one scandal seems to morph into another. Recently, the $1.4 billion global securities industry settlement that had been in the works for some months was finalized. Under this so-called global settlement, finally announced at the end of April by the SEC and New York State Attorney General (plus various other federal and state securities regulators), ten investment banking and securities firms agreed to pay $487.5 million in penalties, $387.5 million in disgorgement, $432.5 million in defending for independent research, and $80 million to promote investor education.

Among some legislators (including Senate Finance Committee Chair Grassley, R-IA, and ranking minority member, Senator Baucus, D-MT), a curious kind of buyer's remorse was manifested early and often. The primary complaint of these fiscal watchdogs was evidently that this settlement was not generating enough money. Yet somehow, the focus of their complaints were tax rules, since on the surface, Section 162 would apparently allow deductions for all of the $1.4 billion except the $487.5 million denominated as "penalties."

Allowing a wrongdoer a tax deduction just doesn't seem American, and the Senators would need a strong pejorative spin on the situation. Since it was apparently no longer possible to negotiate upwards the global securities industry settlement, the Senators had to be content with negotiating (or forcing?) the after-tax effects of this kind of a deal. Indeed, they used this situation to attempt to address the problem with proposed legislation that would presumably have impact on a situation like this in the future. The proposed legislation would restrict a number of settlement payments that have traditionally been deductible, but if it is enacted, it may retroactively changed the law on this $1.4 billion settlement, too.

A New Type of GST?

Introduced by Senators Grassley and Baucus, S. 936, the Government Settlement Transparency Act of 2003 (which might be referred to as the "GST Act") would curtail a company's ability to deduct settlement payments, expanding the nondeductibility of fines and penalties. ("Government Settlement Transparency," who thinks up these names anyway?!) Section 162(f) would be amended to include other amounts, thus dramatically (although somewhat vaguely) cutting back on the availability of deductions.

Section 162(f) would preclude any deduction otherwise allowable if paid or incurred by suit, agreement "or otherwise" to a government (or at the direction of a government) in relation to the violation of any law or the investigation or inquiry into a potential violation of any law. The big exception to this pejorative treatment (although it appears to be a narrower exception than one might think) is for "any amount which the taxpayer establishes constitutes restitution for damage or harm caused by the violation of any law or the potential violation of any law." The proposed statute goes on to state that this exception would not apply to any amount paid or incurred as reimbursement to the government for the costs of any investigation or litigation, so those costs (which can be substantial) would apparently be nondeductible. Yowza.

The bill would also expand the scope of entities traditionally viewed as governmental entities. For purposes of these deduction restrictions, amounts paid or incurred to (or at the direction of) any of the following types of non-governmental entities would nonetheless be treated as amounts paid to (or at the direction of) a government:

This latter category, though requiring regulations to effect it, could conceivably be quite broad, particularly since "essential governmental function" seems a flexible category.

Pull Up the Ladder, Grandfather

If enacted in its current form, this bill would apply to amounts paid or incurred after April 27, 2003. However, amounts paid or incurred under any binding order or agreement entered into on or before April 27, 2003 (and, if requiring court approval, actually securing the court approval on or before April 27, 2003) are grandfathered.

I'm no expert on the vicissitudes of retroactivity. With tax legislation, it seems to often be the case that the effective date is not the date of enactment, but typically the much earlier date on which the sponsoring member of Congress first thought of the idea (perhaps in the shower). Ostensibly, such early "notice" dates are designed to prevent taxpayers from altering their behavior due to a tax statute which offers a limited window to take action before a newly-passed provision prevents it.

Despite the many months of discussion about the $1.4 billion securities industry settlement, however, the post-April 27, 2003 effective date of this law would, if enacted, apparently reach in full the securities industry settlement. New Section 162(f) would apply to all amounts paid or incurred after April 27, 2003, unless paid under a binding order or agreement entered into before that date. To be binding, the necessary court approval would also have to be obtained on or before April 27, 2003. This language would apparently cover those securities firms that are still in the process of negotiating their settlements with the SEC and other agencies. Moreover, as to the existing ten firms who are participating in the $1.4 billion settlement, even though these have been in the works for many months, they were evidently entered into on April 28, 2003.

Thus, it would appear that they would be fully caught within the ambit of the new bill. Plus, the settlement agreements themselves actually refer to tax treatment. The consent decrees are all roughly the same, but the numbers vary. Goldman Sachs, for example, agrees to pay (a) $25 million as a penalty; (b) $25 million as disgorgement of commissions and other monies; (c) $50 million for independent research; and (d) $10 million for investor education. The first $25 million is, of course, a "penalty." The $50 million independent research payment and the $10 million education payment are both explicitly stated to not constitute disgorgement or restitution and not to constitute payment for compensatory purposes.

Thus, the consent decree is pretty clear that of Goldman Sachs' $110 million payment, at least $85 million will be nondeductible. The settlement agreement does not specifically earmark this $25 million as deductible, though disgorgement payments traditionally are deductible. In fact, the only recognition that this is a deductible payment is the settlement agreement's statement that other payments (for example, the $60 million for independent research and investor education) are expressly not to be treated as disgorgement or restitution.

However, even though restitution payments are ordinarily deductible, the settlement agreement does not make this treatment explicit. To the contrary, if the legislation passes, it would seem that the "restitution" amounts may still not be treated as restitution. Why? The new law will require that an amount be treated as restitution only if the payment is required to be made to the specific persons or in relation to the specific property, actually harmed by the conduct of the taxpayer that resulted in the payment.

It is also not clear what tax treatment will apply in the event the new legislation does not pass, or does not pass in its current form. Presumably, only the amount identified as a penalty (in Goldman Sachs' case, $25 million).

Just Give It Back...

Restitution payments, quite appropriately, have traditionally been deductible. There are probably many theories why this is so. At least one of them is simply that the defendant will likely have included the payment in income in the first place. On giving it back, an offsetting deduction should be available. Even if the same party is not necessarily giving the payment back, compensatory or remedial payments have been deductible, even in the Service's own admission. How would this new statute apply? If this bill is passed, it will now be terribly important to determine what qualifies as "restitution." In the past, it was possible to treat payments as deductible business expenses even if they were denominated as "penalties" if it appeared that the purpose of the underlying statute was compensation or remediation, rather than the punishment of the payor. A good example of this dichotomy is presented by S. Clark Jenkens, et ux. v. Commissioner, T.C. Memo 1996-539 (1996). It seemed possible to police this line, and both the Service and the courts have been doing so.

In the landmark Allied-Signal, Inc. v. Commissioner, 54 F.3d 767 (3d Cir. 1995), the Third Circuit affirmed the Tax Court's denial of any deduction for an $8 million payment Allied-Signal made into an environmental trust. The court found that the payment was made with the virtual guarantee that a lower court would reduce a criminal fine by at least the amount previously levied against Allied-Signal. In fact, there is a long history of cases drawing the lines here between deductible payments and those that effectively represent fines or similar penalties.

Genesis of Restrictions

Section 162(f) only goes back to 1969, at which time Congress enacted Section 162(f) to codify what Congress then viewed as the general case law treatment of this subject. See Senate Report No. 552, 91st Congress, First Session (1969), reprinted at 1969-3 C.B. 423. Several years later, a Congressional Committee Report referenced Section 162(f), explaining that this deduction restriction applies to penalties "which are imposed under civil statutes, but which in general terms serve the same purpose as a fine exacted under a criminal statute." Senate Report No. 437, 92nd Congress, First Session, pp. 73-74 (1971), reprinted in U.S. Code Congressional and Administrative News, 1825, 1979-1980.

For its part, the Treasury in its regulations stated that a "fine or similar penalty" would include amounts paid:

The regulations are clear, though, that this definition is not all inclusive. At the same time, the regulations specifically exclude from the definition of a fine or similar penalty legal fees and related expenses that are incurred in defending a civil or criminal action arising from a violation of the law imposing the fine or penalty.

Since names often do not adequately describe precisely what a payment is, both the IRS and the courts have generally focused on the purposes of a payment. For example, in Huff v. Commissioner, 80 T.C. 804 (1983), the Tax Court held civil penalties not deductible under Section 162(f) because they were intended to penalize defendants for their illegal conduct, and not to compensate an injured party. Sometimes, a payment may both serve a law enforcement purpose (and thus be nondeductible) as well as a compensatory purpose (deductible). In such cases, it is appropriate to engage in line drawing to demonstrate or discern the purpose the payment was primarily designed to serve.

One of the most important cases is Allied-Signal, Inc. v. Commissioner, T.C. Memo 1992-204 (1992), aff'd, 54 F.3d 767 (3d Cir. 1995). That case involved a deduction which Allied-Signal claimed for restitution. Even though Allied-Signal paid $8 million into a nonprofit environmental fund, the Tax Court found the entire payment to be nondeductible since a quid pro quo was a reduction in the criminal fine to which the company was already subject. This kind of quid pro quo arrangement, regardless of whether denominated as restitution or something else, requires close analysis.

Even though restitution payments have traditionally been analogized by the IRS to penalties, restitution is often deductible. See Jon T. Stephens v. Commissioner, 93 T.C. 108, rev'd, 905 F.2d 667 (2d Cir. 1990). However, even where restitution is paid to a private party rather than the government, such payments may be nondeductible where the restitution arises out of a criminal action for fraud. See, for example, Jess Kraft, et ux. v. U.S., 991 F.2d 292 (6th Cir. 1993), cert. denied, 510 U.S. 976 (1993).

Why Paid?

Ultimately, this "purpose of the payment" analysis is exactly the kind of analysis that should be applied. The same concept arises in another application of Section 162(f) for late fees. A late fee is really designed to encourage prompt compliance with the law, and as such, has not been treated as a fine. Reg. §1.162-21(b)(2). See also Southern Pacific Transportation Co. v. Commissioner, 75 T.C. 497 (1980), supplemental opinion, 82 T.C. 122 (1984). The purpose of a payment, even if denominated a fine, should control. Thus, a "fine" that is essentially a reimbursement to the government for lost custom taxes is deductible. Middle Atlantic Distributors, Inc. v. Commissioner, 72 T.C. 1136 (1979), acq'd, 1980-2 C.B. 2.

Some quid pro quo payments, however, can still be deductible. Thus, a payment to the Clean Water Fund in order to avoid prosecution for water pollution was still held deductible as a compensatory payment in S&B Restaurant, Inc. v. Commissioner, 73 T.C. 1226 (1980). I find that the line between compensatory fines and noncompensatory ones is especially difficult to discern in this environmental area. The regulations suggest that civil environmental fines are nondeductible. Reg. §1.162-21(c), Examples (2) and (7). Of course, it may be difficult for the taxpayer to show that a fine is imposed with a compensatory motive.

Last Word?

Ultimately, whether a payment constitutes a fine or penalty paid to a governmental entity is probably not something that can be defined very easily, unless one wants to draw an extremely bright line based primarily on semantics. Relying purely on semantics, as we tax advisors know, is probably not a good idea. If semantics should not be the controlling test, then whether one views restitution payments is the only appropriate exception from non-deductibility is a question of policy for the legislature. It does concern me, though, that the proposed bill seems to draw a very narrow box around the notion of restitution. Identifying the specific persons harmed would seem to be required before a deduction is available.

To me, this seems unduly narrow, and a rule that, in at least some cases, will defeat the purpose Congress would presumably be trying to achieve with this bill: encouraging good taxpayer behavior. If a company is being asked to make restitution payments, it will want to secure some kind of assurance that the right people will receive the restitution, or a tax deduction (even under the new scheme) might be denied. Bear in mind too, that restitution isn't always paid willingly.

A good example was Waldman v. Commissioner, 88 T.C. 1384 (1987), affirmed in unpublished order, 850 F2d 611 (9th Cir. 1988). There, the Tax Court was faced with the appropriate tax treatment of restitution that was paid by the president of a loan brokerage company as a condition for the court to stay his prison sentence. The restitution was paid to the company's customers, who were the victims of conspiracy to commit grand theft. The Tax Court determined that the restitution was paid to a government within the meaning of Section 162(f), so that no deduction was appropriate.

The state, the Tax Court reasoned, exercised ultimate control over the disposition of the restitution payments. The Tax Court suggested that it was irrelevant whether the government actually got to keep the fine or penalty in order for the prohibition on a deduction to be applicable. In another case, Bailey v. Commissioner, 756 F2d 44 (6th Cir. 1985), the court concluded that a fine was non-deductible under Section 162(f) even though it was paid directly to third parties, not to a government.

Ultimately, of course, no one can stop Congress from tinkering with tax rules. In the wake of certain large settlements (Exxon Valdez some years ago, the securities industry settlement right now, and presumably others — perhaps even Enron — soon), this is not surprising. Still, it should be done carefully, and should be prospective.

New Bill Would Bar Settlement Deductions, Vol. 11, No. 11, The M&A Tax Report (June 2003), p. 1.