Few tax issues are more fact-intensive than determining the tax consequences to the payor of payments made under a settlement agreement with a governmental body when the agreement is silent as to the nature of the payments. In a legal advice memorandum, the IRS Office of Chief Counsel shed some light on the factors it thinks are important in such a situation. Whenever possible, of course, the taxpayer should seek to negotiate settlement agreement terms that would support the desired tax treatment.
Payments made pursuant to a settlement agreement or court judgment ordinarily will be characterized, from the payor's perspective, as a deductible expense, a capital expenditure, or a nondeductible, noncapital payment.
The origin and character of the claim with respect to which an expense was incurred determines its tax treatment. Generally, if a claim arises from acts performed by a taxpayer in the ordinary course of its business operations, settlement payments and payments made pursuant to court judgments related to the claim are deductible under section 162. For example, payments made to compensate a plaintiff for actual damages or harm caused by the defendant's action generally are deductible. However, some settlement payments or legal fees may be characterized as capital expenses if they are incurred in connection with the acquisition of a capital asset. For example, if a settlement agreement in patent litigation provides for payments both to compensate a plaintiff for past royalties and to acquire rights to the plaintiff's intellectual property, the portion of the payment allocable to the acquisition of intellectual property represents a capital expenditure.
Another notable exception to the notion that business payments ordinarily are deductible under section 162(a) is section 162(f), which prohibits the deduction of any "fine or other similar penalty paid to the government for the violation of any law."
IRS AM 2007-0015 describes the analytical steps the IRS will take to determine whether settlement payments made to compromise civil actions brought by, or on behalf of, the government are deductible by the payor. The memorandum states that the IRS first will look to the nature of the statute pursuant to which the settlement is being paid. If the statute allows only compensatory remedies, the inquiry ends, and the settlement payment is deductible in full. However, under section 162(f), no part of a settlement payment is deductible if the compromised action was brought pursuant to a civil statute having a wholly "punitive" purpose of enforcing the law and punishing the violator.
The memorandum acknowledges that discerning the purpose of settlement payments made to compromise an action under a statute that serves both compensatory and punitive purposes is a difficult task, requiring the IRS to analyze the settlement to determine the intent of the parties. Discerning that intent is an intensely factual inquiry, requiring close examination of the relevant facts and circumstances of the specific payment at issue and the manner in which it was calculated.
The False Claims Act (FCA) provides that either the Attorney General or a private citizen (the relator orqui tam plaintiff) may bring an action in the name of the government for a violation of the FCA. The FCA entitles the relator to a share of any amounts recovered.
Under the facts considered in the memorandum, the government intervened in a suit brought by a relator and eventually settled with the defendant. The settlement agreement provided that the defendant will pay a lump-sum amount to the government in settlement of all potential FCA claims. The settlement agreement also provided that a specified portion of the amount will be paid by the government to the relator in satisfaction of the statutory relator fees.
The memorandum concludes that the amount paid to the relator is deductible in full by the defendant-payor because reimbursement of relator fees has a compensatory -- not punitive -- purpose. The memorandum cites the Supreme Court's 2003 opinion in United States ex rel. Chandler for the proposition that damages paid in the context of an FCA settlement serve remedial as well as punitive purposes and that the portion of a settlement payment that is intended as recompense to the government for its obligation to pay the relator is not a nondeductible fine or penalty under section 162(f).
The memorandum notes that other courts, including the U.S. Tax Court, have concluded that relator fees are not penalties. For example, the Tax Court said in Rocco v. Commissioner , "The payment to a relator in a qui tam action is not a penalty imposed on the wrongdoer; instead, it is a financial incentive for a private person to provide information and prosecute claims relating to fraudulent activity."
The memorandum considers a situation in which the amount of the relator fee was specifically set forth in the settlement agreement. Accordingly, the IRS stated, it did not have to "engage in an analysis of whether the parties intended for this portion of the lump-sum payment to be compensation or a penalty, since they clearly intended it to be paid to the relator." At the same time, the fact that the relator fee amount was specified would not necessarily be determinative of the issue of deductibility. The reasoning of the memorandum and its reliance on United States ex rel. Chandler would seem to support the view that amounts properly allocable to relator fees, or any other reimbursement to compensate the government for its investigation costs, may be deductible under section 162 . Of course, the preferable approach is for the settlement agreement to state specifically what portion of the settlement payment reimburses the government for its costs.
Global Pharmaceutical and Life Sciences Advisory Leader, PwC United States
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Global Pharmaceutical and Life Sciences Assurance Leader, PwC Switzerland
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Global Pharmaceutical and Life Sciences Tax Leader, PwC United Kingdom
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