The Internal Revenue Code and FCPA Violations

We continue here with our discussion of tax consequences that may accrue when the U.S. federal government finds a company in violation of the Foreign Corrupt Practices Act (FCPA).

Tax-Related Responses to Illegal Payments Under the FCPA

If a company determines that an underlying improper payment was made to a foreign official under the FCPA, it should not deduct the payment. If the payment already has been deducted, quickly learning who knew of the improper nature of the payment, and when, should guide in-house counsel in determining the extent to which the corporation could be liable. In-house counsel should consider the applicable statute of limitations, including whether potential conspiracy charges or other factors might toll or extend the limitations period or otherwise affect legal exposure, as well as mitigating and aggravating factors regarding the primary FCPA violation and tax issues.

The steps related to tax compliance should be coordinated with the company's response to information it has learned about any FCPA violation itself, including the decision whether to self-report through an amended tax filing or otherwise. There is some question whether a taxpayer is legally obliged to file an amended return. See 26 C.F.R. ' 1.162-21 (“If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due.” See also Badaracco v. Comm'r, 464 U.S. 386, 393 (1984) (“[T]he Internal Revenue Code does not explicitly provide either for a taxpayer's filing, or for the Commissioner's acceptance, of an amended return.”). Irrespective of its legal obligation, however, a taxpayer may wish to amend an incorrect return to avoid or stanch potential interest charges and penalties on the original return, or for a host of non-tax reasons. Every case will be different, and in-house counsel and corporate compliance officers would do well to confer with both experienced tax counsel and experienced FCPA counsel to determine a corporation's exposure and next steps.

Deductibility of Payments To the Government to Resolve FCPA Matters

Deductibility of payments to government entities to resolve FCPA allegations and investigations will generally turn on whether the payments are penal or compensatory in nature. Section 162(f) of the Code provides that “[n]o deduction shall be allowed ' for any fine or similar penalty paid to a government for the violation of any law.” 26 U.S.C. ' 162(f). For purposes of this section, penalties include any amounts paid in settlement of actual or potential liability for a civil or criminal fine or penalty. (The U.S. Treasury Regulations define “fine or similar penalty” as an amount: 1) Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding; 2) Paid as a civil penalty imposed by Federal, State, or local law ' ; [or] 3) Paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal). 26 C.F.R. ' 1.162-21 (2012); Hawronsky v. Comm'r, 105 T.C. 94, at *97 (T.C. 1995).)

Payments to settle claims of restitution and disgorgement raise issues under these regulations. Compensatory and remedial payments are deductible. 26 C.F.R. ' 1.162-21(b)(2). (“Compensatory damages ' paid to a government do not constitute a fine or penalty.”). Therefore, the deductibility of restitution and disgorgement payments will turn on whether they can be characterized as compensatory or remedial, rather than penal in nature. Cavaretta v. Comm'r, No. 24823-07, 2010 WL 23331 at *4 (T.C. 2010). If the penalty is “imposed for purposes of enforcing the law and as punishment for the violation thereof,” the payment is not deductible. Fresenius Med. Care Holdings, Inc. v. United States, No. 08 Civ. 12118, 2010 WL 2595541, at *4 (D. Mass. June 24, 2010). See also Talley Indus. Inc. v. Comm'r, 116 F.3d 382, 385 (9th Cir. 1997) (quoting S. Pac. Transp. Co. v. Comm'r, 75 T.C. 497, 652'53 (T.C. 1980)); True v. United States, 894 F.2d 1197, 1204 (10th Cir. 1990). Remedial payments, in contrast, are “'imposed to encourage prompt compliance with the law, or as a remedial measure to compensate another party for expense incurred as a result of the violation.'” Fresenius, 2011 WL 2595541, at *4 (quoting S. Pac. Transp. Co, 75 T.C. at 652-53). The specific purpose of the payment is relevant. See Stephens v. Comm'r, 905 F.2d 667, 672-73 (2d Cir.
1990) (examining why a restitution payment was made to determine if it was punitive); see also R.W. Wood, “Tax Deductions for Damage Payments: What, Me Worry?” Tax Notes (Jan. 16, 2006). A court will also consider whether the payment was made to the government or a third party. Stephens, 905 F.2d at 673. This factor is not, however, dispositive. See Kraft v. United States, 991 F.2d 292, 298-99 (6th Cir. 1993) (restitution held to be nondeductible because it arose out of criminal proceedings). Finally, a court may consider “whether allowing the deductions severely frustrate[s] a sharply defined national policy or thwart[s] a State policy.” Bailey v. United States, No. 122-77, 1997 WL 759654, at *40 (Fed. Cl. Sept. 30, 1997).

These are fact-sensitive inquiries. If a specific payment is made in consideration of the government's forbearance from seeking a potential criminal penalty, courts generally conclude that the payment was punitive. See Allied Signal, Inc. v. Comm'r, T.C. Memo 1992-204, 1992 WL 67399 (T.C. 1992), aff'd 54 F.3d 767 (3d Cir. 1995). But see Spitz v. United States, 432 F. Supp. 148 (E.D. Wis. 1977) (allowing a deduction despite criminal sentence being conditioned on making restitution). Indeed, FCPA settlements with the DOJ typically bar deduction of a payment made by the settling corporation. See United States v. Smith & Nephew, Inc., No. 12-CR-00030, Deferred Prosecution Agreement at 5 (D.D.C. Feb. 1, 2012); United States v. Tyson Foods, Inc., No. 11-CR-037, Deferred Prosecution Agreement at 5 (Feb. 4, 2011). But cf. Jenkins v. Comm'r, 72 T.C.M (CCH) 1470, at *4 (T.C. 1996) (“some payments, although labeled 'penalties,' remain deductible if imposed to encourage prompt compliance with a requirement of the law, or as a remedial measure to compensate another party.”). Recent U.S. Securities and Exchange Commission FCPA resolutions have contained similar language prohibiting settling companies from deducting the penalty components of the dispositions, leaving the tax status of the disgorgement component unaddressed. See, e.g., In re Tenaris, Deferred Prosecution Agreement at 7 (May 17, 2011); SEC v. IBM Corp., No. 11-cv-0563, Consent of Defendant International Business Machine Corp. at 3 (D.D.C. Apr. 5, 2011). The tax court may split payments, determining that they are in part punitive and in part compensatory for federal tax purposes. Barnes v. Comm'r, T.C. Memo. 1997-25, 1997 WL 12138 at *5 (Jan. 15, 1997).

Conclusion

In an era of economic challenges that have put a spotlight on tax compliance, in-house counsel, financial and accounting departments, as well as corporate compliance personnel would do well to keep tax issues associated with FCPA compliance on the front burner. The importance of the issues warrants diligence in implementing compliance programs and swift, effective action when addressing specific evidence of misconduct.

Peter F.G. Schuur is a partner in the New York office of Debevoise & Plimpton LLP. He is a member of the firm's Tax Department. Bruce E. Yannett is a partner, Steven S. Michaels is a counsel, and John T. Pierpont is an associate in the firm's New York office; they are members of the Litigation Department and White Collar Litigation Practice Group. The authors may be reached at [email protected], [email protected], [email protected], and [email protected] respectively.

We continue here with our discussion of tax consequences that may accrue when the U.S. federal government finds a company in violation of the Foreign Corrupt Practices Act (FCPA).

Tax-Related Responses to Illegal Payments Under the FCPA

If a company determines that an underlying improper payment was made to a foreign official under the FCPA, it should not deduct the payment. If the payment already has been deducted, quickly learning who knew of the improper nature of the payment, and when, should guide in-house counsel in determining the extent to which the corporation could be liable. In-house counsel should consider the applicable statute of limitations, including whether potential conspiracy charges or other factors might toll or extend the limitations period or otherwise affect legal exposure, as well as mitigating and aggravating factors regarding the primary FCPA violation and tax issues.

The steps related to tax compliance should be coordinated with the company's response to information it has learned about any FCPA violation itself, including the decision whether to self-report through an amended tax filing or otherwise. There is some question whether a taxpayer is legally obliged to file an amended return. See 26 C.F.R. ' 1.162-21 (“If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due.” See also Badaracco v. Comm'r , 464 U.S. 386, 393 (1984) (“[T]he Internal Revenue Code does not explicitly provide either for a taxpayer's filing, or for the Commissioner's acceptance, of an amended return.”). Irrespective of its legal obligation, however, a taxpayer may wish to amend an incorrect return to avoid or stanch potential interest charges and penalties on the original return, or for a host of non-tax reasons. Every case will be different, and in-house counsel and corporate compliance officers would do well to confer with both experienced tax counsel and experienced FCPA counsel to determine a corporation's exposure and next steps.

Deductibility of Payments To the Government to Resolve FCPA Matters

Deductibility of payments to government entities to resolve FCPA allegations and investigations will generally turn on whether the payments are penal or compensatory in nature. Section 162(f) of the Code provides that “[n]o deduction shall be allowed ' for any fine or similar penalty paid to a government for the violation of any law.” 26 U.S.C. ' 162(f). For purposes of this section, penalties include any amounts paid in settlement of actual or potential liability for a civil or criminal fine or penalty. (The U.S. Treasury Regulations define “fine or similar penalty” as an amount: 1) Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding; 2) Paid as a civil penalty imposed by Federal, State, or local law ' ; [or] 3) Paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal). 26 C.F.R. ' 1.162-21 (2012); Hawronsky v. Comm'r , 105 T.C. 94, at *97 (T.C. 1995).)

Payments to settle claims of restitution and disgorgement raise issues under these regulations. Compensatory and remedial payments are deductible. 26 C.F.R. ' 1.162-21(b)(2). (“Compensatory damages ' paid to a government do not constitute a fine or penalty.”). Therefore, the deductibility of restitution and disgorgement payments will turn on whether they can be characterized as compensatory or remedial, rather than penal in nature. Cavaretta v. Comm'r, No. 24823-07, 2010 WL 23331 at *4 (T.C. 2010). If the penalty is “imposed for purposes of enforcing the law and as punishment for the violation thereof,” the payment is not deductible. Fresenius Med. Care Holdings, Inc. v. United States, No. 08 Civ. 12118, 2010 WL 2595541, at *4 (D. Mass. June 24, 2010). See also Talley Indus. Inc. v. Comm'r , 116 F.3d 382, 385 (9th Cir. 1997) (quoting S. Pac. Transp. Co. v. Comm'r , 75 T.C. 497, 652'53 (T.C. 1980)); True v. United States , 894 F.2d 1197, 1204 (10th Cir. 1990). Remedial payments, in contrast, are “'imposed to encourage prompt compliance with the law, or as a remedial measure to compensate another party for expense incurred as a result of the violation.'” Fresenius, 2011 WL 2595541, at *4 (quoting S. Pac. Transp. Co, 75 T.C. at 652-53). The specific purpose of the payment is relevant. See Stephens v. Comm'r , 905 F.2d 667, 672-73 (2d Cir.
1990) (examining why a restitution payment was made to determine if it was punitive); see also R.W. Wood, “Tax Deductions for Damage Payments: What, Me Worry?” Tax Notes (Jan. 16, 2006). A court will also consider whether the payment was made to the government or a third party. Stephens, 905 F.2d at 673. This factor is not, however, dispositive. See Kraft v. United States , 991 F.2d 292, 298-99 (6th Cir. 1993) (restitution held to be nondeductible because it arose out of criminal proceedings). Finally, a court may consider “whether allowing the deductions severely frustrate[s] a sharply defined national policy or thwart[s] a State policy.” Bailey v. United States, No. 122-77, 1997 WL 759654, at *40 (Fed. Cl. Sept. 30, 1997).

These are fact-sensitive inquiries. If a specific payment is made in consideration of the government's forbearance from seeking a potential criminal penalty, courts generally conclude that the payment was punitive. See Allied Signal, Inc. v. Comm'r, T.C. Memo 1992-204, 1992 WL 67399 (T.C. 1992), aff'd 54 F.3d 767 (3d Cir. 1995). B ut see Spitz v. United States , 432 F. Supp. 148 (E.D. Wis. 1977) (allowing a deduction despite criminal sentence being conditioned on making restitution). Indeed, FCPA settlements with the DOJ typically bar deduction of a payment made by the settling corporation. See United States v. Smith & Nephew, Inc., No. 12-CR-00030, Deferred Prosecution Agreement at 5 (D.D.C. Feb. 1, 2012); United States v. Tyson Foods, Inc., No. 11-CR-037, Deferred Prosecution Agreement at 5 (Feb. 4, 2011). But cf. Jenkins v. Comm'r, 72 T.C.M (CCH) 1470, at *4 (T.C. 1996) (“some payments, although labeled 'penalties,' remain deductible if imposed to encourage prompt compliance with a requirement of the law, or as a remedial measure to compensate another party.”). Recent U.S. Securities and Exchange Commission FCPA resolutions have contained similar language prohibiting settling companies from deducting the penalty components of the dispositions, leaving the tax status of the disgorgement component unaddressed. See, e.g., In re Tenaris, Deferred Prosecution Agreement at 7 (May 17, 2011); SEC v. IBM Corp., No. 11-cv-0563, Consent of Defendant International Business Machine Corp. at 3 (D.D.C. Apr. 5, 2011). The tax court may split payments, determining that they are in part punitive and in part compensatory for federal tax purposes. Barnes v. Comm'r, T.C. Memo. 1997-25, 1997 WL 12138 at *5 (Jan. 15, 1997).

Conclusion

In an era of economic challenges that have put a spotlight on tax compliance, in-house counsel, financial and accounting departments, as well as corporate compliance personnel would do well to keep tax issues associated with FCPA compliance on the front burner. The importance of the issues warrants diligence in implementing compliance programs and swift, effective action when addressing specific evidence of misconduct.

Peter F.G. Schuur is a partner in the New York office of Debevoise & Plimpton LLP. He is a member of the firm's Tax Department. Bruce E. Yannett is a partner, Steven S. Michaels is a counsel, and John T. Pierpont is an associate in the firm's New York office; they are members of the Litigation Department and White Collar Litigation Practice Group. The authors may be reached at [email protected], [email protected], [email protected], and [email protected] respectively.