The IRS recently released an internal Chief Counsel Advice Memorandum that said Section 162(f) of the Tax Code prohibited an FCPA defendant from deducting the disgorged amount.
According to the SEC complaint, a subsidiary of a U.S. taxpayer intentionally falsified its books and records, which were consolidated into the taxpayer’s books and records and reported in its financial statements. The Memorandum also notes that the taxpayer failed to implement adequate internal accounting and financial controls.
As part of the resolution of the ensuing enforcement action, the taxpayer entered into a consent agreement with the SEC, under which the taxpayer was required to “disgorge” a specified amount in ill-gotten gains attributable to the alleged misconduct while also paying a separate “civil penalty” relating to the same alleged misconduct.
The penalty amount could be reduced (dollar-for-dollar) for any amount the foreign entity was required to pay as a criminal penalty in a separate proceeding, and the consent agreement provided that the penalty amount was not deductible for tax purposes.
The consent agreement was silent with respect to whether the disgorgement amount was deductible.
In its analysis, the Memorandum explains that if “a payment serves both a non-deductible purpose and a deductible purpose, it is necessary to determine which purpose the payment primarily serves . . . . Thus, a payment imposed primarily for purposes of deterrence and punishment is not deductible under section 162(f).”
According to the Memorandum, disgorgement payments can be primarily compensatory or primarily punitive, depending on the facts. For example, if the amount of profit disgorged equals the victims’ losses or is used as a means to obtain compensation for harmed investors, then disgorgement can be primarily compensatory. On the other hand, if the disgorgement serves primarily to prevent the wrongdoer from profiting from the illegal conduct or is used as a direct substitute for a civil penalty, then it is primarily punitive.
In this case, the Memorandum found the absence of certain facts determinative — namely that the taxpayer presented “nothing” to indicate “that the purpose of the disgorgement payment was to compensate the United States government or some non-governmental party for its specific losses caused by Taxpayer’s violations of the FCPA.”
Concluding that the disgorgement payment was primarily punitive, the Memorandum advised that it was not deductible pursuant to Section 162(f).
The Memorandum is not precedential but may reflect the position that could be taken in audits of other taxpayers who have made disgorgement payments to resolve FCPA enforcement actions. If the Memorandum reflects a movement by the IRS to challenge deductions of disgorgement payments in FCPA cases, the question is largely a factual one. Taxpayers still have an advantage over the IRS for ensuring favorable facts are memorialized at the time the FCPA case is resolved.
Further, the Memorandum highlights a potential inconsistency in how the IRS and the SEC view disgorgement.
The SEC has historically viewed disgorgement as only an equitable remedy that may not be imposed if it is “punitive.” The Memorandum could be read as leaning in favor of finding any disgorgement as being punitive. A taxpayer potentially subject to disgorgement may argue to the SEC that disgorgement should not be imposed because, for tax purposes, disgorgement would be treated as “punitive.” If disgorgement was imposed, the taxpayer could argue to the Service that the amounts disgorged should be deductible because they are equitable, not “punitive,” in the eyes of the SEC.
Finally, according to the Memorandum, the taxpayer agreed to pay the disgorgement along with prejudgment interest. The Memorandum does not indicate whether prejudgment interest is deductible. But if the IRS extends its section 162(f) analysis to the interest, it would have serious financial implications for companies since prejudgment interest can be significant.
For additional information about the Memorandum, please see Miller & Chevalier’s recent article.
Natasha Goldvug is Counsel with Miller & Chevalier’s Tax department. Her practice focuses on the representation of taxpayers in all stages of federal tax controversies.