Defense Contractor Claims Entitlement to Full Deduction for Settlement Payment

Stencel Aero Engineering Corp., a subsidiary of Talley, manufactured ejection seats for military aircraft. The government concluded that it had been overcharged $1.56 million for the applicable years. In 1985 Stencel, Talley and the government entered into a settlement agreement in which the two companies agreed to pay $2.5 million. Stencel paid the agreed amount and Talley claimed a $2.5 million deduction under section 162 on its 1986 consolidated return.

The IRS disallowed the deduction, determining that the payment was not an ordinary and necessary business expense. The Tax Court granted Talley summary judgment, reasoning that the payment was to compensate the government for its losses. The court rejected the IRS's argument that $940,000 (the difference between the $2.5 million and the $1.56 million actual loss) was a nondeductible punishment. The IRS appealed as to the $940,000. (For a summary of the Tax Court memorandum opinion, see Tax Notes, Dec. 19, 1994, p. 1503; for the full text, see 94 TNT 244-9 .)

Reversing, the Ninth Circuit concluded that there was a genuine issue of material fact regarding the characterization of the $940,000 portion of the payment. (For a summary of that opinion, see Tax Notes, June 30, 1997, p. 1840; for the full text, see Doc 97-18539 (12 pages), 97 TNT 121-31 , or H&D, June 24, 1997, p. 4745.)

On remand, the Tax Court held that Talley was not entitled to deduct the $940,000, pointing out that the settlement agreement was silent as to whether a portion of the payment would constitute compensation to the government for its losses or a penalty against Stencel.(For a summary of that opinion, see Tax Notes, June 28, 1999, p. 1896; for the full text, see Doc 1999-21339 (19 pages) or 1999 TNT 118-94 .)

The company argues that the Tax Court erred in finding that the settlement was silent as to whether the $940,000 differential was compensation or a penalty. Talley asserts that it is well settled that a contractor's payment in satisfaction of the government's claims under the Truth in Negotiations Act is fully deductible as an ordinary and necessary business expense and that the $940,000 should therefore be deductible.

[1] Talley Industries, Inc., an appellant herein, is a wholly owned subsidiary of Carpenter Technology Corporation, which is a publicly traded corporation listed on the New York Stock Exchange. Otherwise, appellants have no parent, subsidiary or other affiliate that has issued stock to the public.

TABLE OF CONTENTS

STATEMENT OF ISSUE

[3] Did the Tax Court err in holding that, out of a total of $2.5 million paid by Stencel to the United States Government in settlement of various claims resulting from the mischarging of Stencel's labor costs under certain Navy Department contracts, the sum of $940,000 was a "fine or similar penalty paid to a government" within the meaning of section 162(f) of the Internal Revenue Code of 1954 (hereinafter the "Code") and, therefore, not properly deductible on Talley's consolidated income tax return as an ordinary and necessary business expense under section 162(a)?

JURISDICTIONAL STATEMENT

[4] Talley maintained its principal place of business in Phoenix, Arizona, at the time of the filing of its petition for redetermination with the Tax Court. The Tax Court entered its decision on October 14, 1999, and Talley filed its notice of appeal on January 13, 2000. C.R. 1, 112, 114. ¹ Accordingly, this Court has jurisdiction of this appeal pursuant to section 7482 of the Internal Revenue Code of 1986.

STATEMENT OF THE CASE

[5] This case is on appeal to this Court for the second time. The case was initially briefed and argued in the Tax Court on Talley's motion for summary judgment and the Commissioner's cross motion for partial summary judgment, each addressing the deductibility, as an ordinary and necessary business expense under section 162(a) of the Code, of the entire $2.5 million paid by Stencel (in three installments) to the United States Government in settlement of Stencel's civil liability with respect to the mischarging of labor costs under various procurement contracts between Stencel and the Department of the Navy. The Tax Court granted Talley's motion in major part and denied the Commissioner's cross motion (C.R. 45) on the basis of a memorandum opinion holding that, with the exception of $1,885, the payments in question were fully deductible notwithstanding section 162(f), which denies a deduction under section 162(a) for a "fine or similar penalty paid to a government for the violation of any law." C.R. 44 (reported at 68 T.C.M. (CCH) 1412 (1994)).

[6] While eventually conceding that the Tax Court had reached the correct result as to $1.56 million out of the total $2.5 million settlement payment, the Commissioner nevertheless appealed the Tax Court decision on the grounds that as to the remaining $940,000 the record presented a genuine issue of material fact necessitating a trial. This Court agreed with the Commissioner on this point and remanded the case to the Tax Court to resolve the factual question "as to the characterization and purpose of the $940,000 contested portion of the settlement." Talley Industries Inc. v. Commissioner, 116 F.3d 382, 388 (1997) (hereinafter cited as Talley I).

[7] The case was tried to the Tax Court on the basis of a 27- page Stipulation of Facts (C.R. 96) and the testimony of six witnesses, three called by Talley and three by the Commissioner (C.R. 98, 99, 100). At the conclusion of the trial the parties proposed to the court more than 100 findings of fact premised in whole or in part on the trial testimony of these six witnesses. C.R. 105, 106. Although it did not question either the credibility of any of the six witnesses or the relevance of their testimony, the court nevertheless failed to adopt any of these proposed findings, even those that were entirely undisputed. Instead, the court ruled that the $940,000 contested portion of Stencel's settlement payment is a section 162(f) "fine or similar penalty" largely because there is no evidence in the record that, either in negotiating or in documenting the settlement, Stencel and the Government ever reached any kind of formal agreement between themselves that the $940,000 was intended to compensate the Government for losses and damages not already included in the $1.56 million portion of the settlement which the Commissioner concedes is deductible. C.R. 110 (reported at 77 T.C.M. (CCH) 2191 (1999)). Consistent with its opinion in this regard, the Tax Court thereupon entered its decision determining an increase in Talley's consolidated federal income tax liability for the one taxable year in issue (1984) in the amount of $388,265. C.R. 112. Talley now appeals from this decision.

STATEMENT OF FACTS

[8] Stencel was at all relevant times a wholly owned subsidiary of Talley and a manufacturer of ejection seats for military aircraft. Stip. paragraphs 2, 22. As of February 25, 1985, Stencel had approximately 40 active procurement contracts with the United States Navy. Stip. paragraph 24.

[9] On December 20, 1984, the Defense Criminal Investigative Service (hereinafter "DCIS"), acting with the aid of a search warrant, seized a quantity of records in Stencel's possession at its headquarters in Arden, North Carolina, related to various invoices previously submitted by Stencel for payment under Stencel's Defense Department contracts. Stip. paragraph 27. Less than three months later, on March 8, 1985, Stencel was indicted by a federal grand jury in the Western District of North Carolina on 44 counts of fraudulent conduct in its dealings with the Government. Stip. paragraph 28. The first count, alleging a violation of 18 U.S.C. section 286, charged that Stencel and three of its officers, for some unknown period prior to December 1, 1984, had conspired to procure the payment of false and fraudulent claims under Stencel's defense contracts by causing the timecards of various Stencel employees to be altered and falsified so that time actually charged to certain fixed-price contracts would be reallocated for billing purposes either to cost- plus-fee contracts or to contracts for which the price had not yet been fully negotiated. The second count, under 18 U.S.C. section 287, accused Stencel of knowingly filing one fraudulent claim involving the reallocation of one employee's time under one particular contract. The remaining 42 counts alleged that Stencel and the three officers had made (or had aided and abetted the making of) false and fraudulent statements and representations to the Defense Department, in violation of 18 U.S.C. section 1001, by submitting a total of 42 altered or otherwise falsified timecards involving work performed by some two dozen Stencel employees, for the most part during the week of August 5, 1984. Stip. paragraphs 29-30, Jt. Exh. 5-E.

[10] Stencel eventually offered to plead guilty to ten of the 42 counts of the criminal indictment charging violations of 18 U.S.C. section 1001. Stip. paragraph 32. The federal district court accepted the plea and, on July 1, 1985, ordered Stencel to pay a fine of $10,000 on each of these ten counts, for a total fine of $100,000. Stip. paragraphs 34-36, Jt. Exh. 7-G. This was the maximum fine authorized by law for the specific offenses to which Stencel had pleaded guilty. 18 U.S.C. section 1001 (1982). The district court's Judgment and Probation Commitment Order also provided "that [Stencel] shall make full restitution for all losses, to be determined by the U.S. Navy at a later date." Stip. paragraphs 35-36, Jt. Exh. 7-G. Pursuant to the plea agreement between Stencel and the United States Attorney, and with the approval of the district court, the balance of the indictment against Stencel was dismissed. Stip. paragraphs 32-36, Jt. Exhs. 6-F, 7-G.

[11] On May 23, 1985, the Navy issued an order suspending Talley and all of its subsidiaries from contracting with any agency in the executive branch of the Government. Stip. paragraphs 38-41, Jt. Exhs. 9I, 10-J. Upon the conclusion of the criminal proceedings, the order was lifted with respect to Talley and all of its subsidiaries except Stencel. Stip. paragraphs 46, 48, Jt. Exh. 14-N. As to Stencel, the suspension order continued in effect pending a formal Navy contractor-debarment hearing and the company's efforts to negotiate a settlement of the Government's damage claims. Stip. paragraphs 42-45, Jt. Exhs. 11-K, 12-L, 13-M. In the course of the debarment proceedings, Stencel renewed its commitment to make full restitution to the Navy, while the Navy asked for nothing over and above compensatory damages. T.T. 56-60, 70-71, 185-87, 192, 292-93.

[12] Settlement negotiations began in earnest in the fall of 1985. Stip. paragraphs 54-55. Talley and Stencel were represented in these negotiations by Mark S. Dickerson, Secretary and General Counsel of Talley, and by two outside attorneys, William J. Kilberg and John Chierichella. Stip. paragraph 56. The Government was represented by Joyce R. Branda, a trial attorney in the Commercial Litigation Branch (Fraud Section) of the Civil Division of the United States Department of Justice (hereinafter the "DOJ). Stip. paragraph 57.

[13] In mid-November, the parties met in Asheville, North Carolina. At that meeting the Government provided Stencel and Talley with a preliminary schedule (hereinafter the "Asheville Damages Schedule") of the Navy's losses attributable to the specific billing irregularities described in the grand jury indictment as well as to other acts of labor-cost mischarging uncovered by DCIS and the Defense Contract Audit Agency (hereinafter "DCAA") in each of Stencel's four major operating departments. Stip. paragraphs 58-60, Jt. Exh. 17-Q. As set forth in the Asheville Damages Schedule, which dealt for the most part only with mischarging during 1984, the Government's losses for that year consisted of two components -- calculated losses and additional estimated or projected losses. On the basis of a direct comparison of employee timecards used in billing the Navy with other employee time and production records, DCAA had made an actual calculation of 1984 mischarging losses in the amount of $241,335. Then, extrapolating from the losses thus calculated in Stencel's Production Department, DCAA further projected that the Government had sustained additional 1984 mischarging losses of another $118,811 not included in calculated losses. The total 1984 mischarging losses, therefore, both calculated and projected, came to $360,146. Stip. paragraphs 59-64, Jt. Exh. 17-Q.

[14] Talley and the Commissioner are in agreement that this $360,146 figure did not represent all of the losses attributable to labor-cost mischarging at Stencel during 1984. Stip. paragraph 65. In particular, the Asheville Damages Schedule did not reflect any losses the Government sustained in the nature of incidental or consequential damages resulting from the overstatement of Stencel's labor costs. The Asheville Damages Schedule, for example, did not include the Government's costs in prosecuting the criminal case against Stencel and its co-defendants, in undertaking the further investigation which ultimately led to the Asheville meeting, or in conducting the debarment proceedings initiated by the Navy against Stencel and its affiliates. Stip. paragraph 67. It likewise covered none of the "downtime costs" the Navy incurred to the extent it had been forced to ground one or more of its aircraft for want of replacement ejection seats or spare parts which Stencel could not deliver while the suspension order was outstanding. Stip. paragraph 67; C.R. 97, Resp. Exh. Z, p. 4, n.4; T.T. 498.

[15] Furthermore, the Asheville Damages Schedule included nothing in the nature of an interest component to compensate the Government for the loss of the use of its funds insofar as the Navy had already paid Stencel's invoices based on the mischarged labor costs. Nor did the Asheville Damages Schedule take account of any of the Navy's derivative contract losses stemming not directly from the mischarging of labor costs to a particular contract which had been overbilled, but from the fact that employee time mischarged under one contract would have resulted in the overpricing of a later contract where the pricing of the second contract was dependent in part on labor and overhead rates determined with reference to billings under the earlier contract. Stip. paragraph 67. While the dollar value of these derivative contract losses was never quantified, the Navy did sustain some such losses, and in all probability in a significant amount. T.T. 87-91, 94-104, 154-57, 169-70, 218-21, 264, 315, 362-70, 408-12.

[16] The criminal investigation which ultimately led to Stencel's indictment and conviction had focused primarily on the mischarging of labor costs during 1984. Nevertheless, there was evidence that at least some Stencel employees had been mischarging time under various Navy contracts as early as 1979. Stip. paragraph 69. Even by January 1986, however, neither Stencel nor the Government had been able to analyze the billing data for the five years 1979 through 1983 to the extent necessary to determine the Government's losses for any of those earlier years without in some manner extrapolating backwards on the basis of the Government's loss calculations and projections for 1984. Stip. paragraph 70.

[17] The Navy was Stencel's largest customer and one of only three companies in the non-Communist world qualified to produce ejection seats for Navy aircraft. Accordingly, Stencel and the Government both recognized the urgency of reaching an agreement sufficient to permit the Navy to lift the contractor-suspension order still outstanding against Stencel. Stip. paragraph 71. Toward this end, on January 14, 1986, Stencel and the Navy executed an agreement (hereinafter the "Interim Agreement") wherein the Navy consented to the immediate withdrawal of the suspension order in return for Stencel's undertaking to pay the Navy $600,000 and to continue thereafter to negotiate in good faith with the DOJ in an effort to determine the full extent of Stencel's liability to the Government for whatever mischarging had in fact occurred. Stip. paragraphs 76- 78, Jt. Exh. 20-T.

[18] Although the Government could have proceeded against Stencel on common law theories as well, Stencel's primary concern was its exposure under two federal statutes: the False Claims Act (hereinafter the "FCA") and the Truth in Negotiations Act (hereinafter the "TINA"). T.T. 96-99, 101-03, 284-86, 430-31. As the FCA read at the time in question, Stencel was liable to the Government for twice the amount of the damages sustained by the Navy as a result of Stencel's fraudulent billing practices. ² The TINA, on the other hand, made no provision for damages as such. Instead, the TINA empowered the Navy, acting unilaterally on the basis of language included in the contract for this purpose, to adjust the price of any of its Stencel contracts by the amount "by which it may be determined . . . that such price was increased" because Stencel had "furnished cost or pricing data which . . . was inaccurate, incomplete or noncurrent" in connection with the awarding or pricing of the contract. ³ The FCA and the TINA are not mutually exclusive in terms of coverage, but as a practical matter Stencel's liability for double damages under the FCA involved those contracts to which employee labor costs actually had been mischarged, while its TINA exposure arose out of derivative losses under other contracts which had been priced with reference to the contracts where mischarging had occurred. T.T. 96-99, 285-86, 363-64.

[19] In November 1985, Ms. Branda, on behalf of the DOJ, made a settlement proposal based on the assumption that the Government's "singles" damages determined under the FCA had averaged $300,000 per year for each of the years 1979 through 1984. ⁴ She offered to settle for $3.6 million, or double the assumed "singles" damages of $1.8 million over the six-year period. Stip. paragraph 72. By way of a counter proposal, Stencel offered $750,000. Stip. paragraph 73.

[20] By late January 1986, Stencel and the Government had agreed, for purposes of their settlement discussions, to assume that the mischarging of employee time at Stencel had occurred during each of the years 1979 through 1984 at a constant rate in relation to Stencel's direct labor charges to its Navy contracts for the year in question. Stip. paragraph 79. On this basis, and using $300,000 as the estimated amount of the Government's "singles" damages for 1984 (roughly the midpoint between the $241,335 of calculated losses and the $360,146 of combined calculated and projected losses as shown on the Asheville Damages Schedule), the parties fixed the Government's aggregate "singles" damages for the entire six-year period at $1.56 million. Stip. paragraphs 79-81; T.T. 238.

[21] Once the parties had agreed upon the $1.56 million figure as a reasonable estimate of the Government's total "singles" losses for all years, the negotiations moved swiftly to their ultimate conclusion. On January 31, 1986, Mr. Kilberg wrote to Ms. Branda, offering on behalf of Stencel to settle the case for $2 million (including the $600,000 just paid to the Navy under the terms of the Interim Agreement). Stip. paragraphs 82, 85, Jt. Exh. 21-U. As part of this proposal, Stencel sought a release from the Government under the FCA with respect to any mischarging of labor costs prior to December 20, 1984 (the date on which DCIS executed its search warrant at Stencel's North Carolina plant). In addition, besides a commitment from the Government to pay Stencel's outstanding invoices, Stencel asked for a release under the TINA covering defective pricing based on labor-cost mischarging and involving any contract where the pricing had been finalized before December 20, 1984, or pertaining either to the later finalization of the pricing of contracts entered into before that date (where the mischarging also occurred before December 20) or to the finalization of Stencel's overhead rates for years prior to 1985. ⁵ Stip. paragraphs 84-85, Jt. Exh. 21-U; T.T. 132-36. Mr. Kilberg's letter stated that Stencel's $2 million offer was intended as "compensation for any and all restitution and damages that may be owing by Stencel to the United States for any possible labor mischarging that may have occurred prior to December 20, 1984. . . ." Stip. paragraph 85, Jt. Exh. 21-U, p.1.

[22] A week later, on February 7, Ms. Branda responded to Mr. Kilberg with a $2.5 million counteroffer, coupled with a demand that the language of his proposed TINA release be generally limited just to contracts as to which the pricing actually had been finalized prior to December 20, 1984. Stip. paragraphs 84, 86, 88, Jt. Exh. 22- V; T.T. 138-41. Like Mr. Kilberg's original proposal, Ms. Branda's counteroffer provided that Stencel would be paid on its outstanding invoices. Stip. paragraphs 85-88, Jt. Exhs. 21-U, 22-V. Ms. Branda did not expressly reject or otherwise comment on Mr. Kilberg's characterization of Stencel's earlier offer as "compensation for . . . restitution and damages. . . ," nor did she characterize her counteroffer as anything other than entirely compensatory.

[23] Stencel accepted Ms. Branda's counteroffer and, on February 18, 1986, the parties executed a definitive agreement (hereinafter the "Settlement Agreement") resolving the matter on terms substantially identical to those set forth in Ms. Branda's letter of February 7. Stip. paragraphs 88-93, 99-101, Jt. Exhs. 23-W, 24-X. Stencel thus agreed to pay the Government an additional $1.9 million (for a total of $2.5 million, including the $600,000 paid pursuant to the Interim Agreement) and to limit the coverage of the TINA release in the manner proposed by Ms. Branda. Under the terms of the Settlement Agreement, however, only $900,000 of the $1.9 million was due on the execution of the agreement, with the balance payable on or before February 18, 1987, and bearing simple interest "computed at the rate established, from time to time, by the Secretary of the Treasury pursuant to Public Law 92-41, 85 Stat. 97." Stip. paragraphs 91-92, 101, Jt. Exh. 24-X, pp. 2-3. Stencel did in fact defer payment of the $1 million balance until the first anniversary of the signing of the Settlement Agreement, at which time Stencel also paid almost $87,000 in interest determined in accordance with Public Law 92-41. ⁶ Stip. paragraph 103.

[24] Neither the Settlement Agreement itself nor any related correspondence purports to make any allocation of Stencel's $2.5 million settlement payment among the three principal elements of consideration received by Stencel under the terms of the settlement (e.g., the lifting of the Navy's contractor-suspension order, the FCA release and the TINA release). However, neither the Settlement Agreement nor the correspondence shows any intention on the part of either Stencel or the Government to characterize any portion of Stencel's $2.5 million payment as other than compensatory. Indeed, the possibility that Stencel might pay some amount in the nature of punitive damages had never been discussed during the course of either the debarment proceedings on the settlement negotiations. T.T. 107- 08, 121, 238-39, 245-46, 322, 330-31, 342-43. Nor was Stencel ever put on notice that the Government might be looking for something besides compensatory damages. T.T. 328-32, 342-43.

[25] Both Stencel and the Government were fully aware at the time of the settlement that, in addition to derivative contract losses of the kind recoverable under the TINA, the Government had sustained certain incidental and consequential losses not reflected in the agreed $1.56 million estimate of "singles" damages, including in particular the loss of the use of (or loss of earning power on) the $1.56 million itself. T.T. 175-77, 335-36, 462, 472-78. In fact, in a civil complaint that she prepared early in 1986 for filing in federal court in North Carolina if the settlement negotiations collapsed, Ms. Branda demanded prejudgment interest on whatever FCA damages she recovered (as well as on TINA damages for derivative contract losses). Stip. paragraph 104, Jt. Exh. 25-Y, pp. 11-12; T.T. 489. At the same time, Stencel and Ms. Branda both understood that as the courts had traditionally construed the double-damages provision of the FCA, apart from derivative losses separately cognizable under the TINA, the Government was unlikely to recover any incidental or consequential losses, including an interest factor on the $1.56 million, other than by the recovery of second-tier damages resulting from the automatic doubling of "singles" or first-tier damages. ⁷ T.T. 40-43, 171-77, 260-63, 266-67, 464-65. Talley and the Commissioner have stipulated that, computed under Public Law 92-41 and compounded annually, the interest accrued through the date of execution of the Settlement Agreement on the estimated $1.56 million of "singles" damages on which the agreement is based totalled $832,000. Stip. paragraph 97.

STANDARD OF REVIEW

[26] The Tax Court's findings of fact are reviewable for clear error, while its conclusions of law and interpretation of the Internal Revenue Code are subject to review de novo. Oregon State University Alumni Ass'n, Inc. v. Commissioner, 193 F.3d 1098 (9th Cir. 1999); Estate of Rapp v. Commissioner, 140 F.3d 1211 (9th Cir. 1998).

SUMMARY OF ARGUMENT

[27] This Court, in Talley I, instructed the Tax Court to determine what portion of the $940,000 in issue is allocable otherwise than to the Government's claim for damages under the FCA, and then to determine whether the remaining portion, if any, which is allocable to the Government's FCA claim was intended by the parties to the Settlement Agreement to compensate the Government for losses not included in the $1.56 million of agreed first-tier FCA damages or to punish Stencel for its misconduct. The Tax Court erred in both respects.

[28] First, even though it is undisputed that the Government had sustained losses that were not included in its FCA claim but were recoverable separately under the TINA, and even though the Settlement Agreement released Stencel from its TINA liability for these losses, the Tax Court found that the entire $940,000 is allocable solely to second-tier FCA damages. Second, although the Tax Court was instructed to look to the evidence to ascertain the intent of the parties, the court examined the evidence only to determine whether the parties had expressed their intentions to each other by way of an oral or written agreement. Finding no such agreement, the court concluded that appellants had failed to prove that the $940,000 was to any extent compensatory.

[29] Given the proper interpretation of the Court's instructions in Talley I, appellants did carry their burden of proof. The evidence is overwhelming that the Government sustained substantial losses, in addition to its TINA claims, in the nature of incidental and consequential damages not reflected in the Government's calculation of its first-tier FCA damages, including in particular the Government's loss of the use of the $1.56 million itself, and that both Stencel and the Government fully intended that whatever portion of the $940,000 might be allocable to second-tier FCA damages would compensate the Government for these losses.

ARGUMENT

[31] Talley and the Commissioner have stipulated that the $1.56 million estimate of first-tier FCA damages represents a mathematical extrapolation of the Government's calculated and projected "singles" losses, as summarized in the Asheville Damages Schedule. Stip. paragraphs 79-81. They have further stipulated that the Asheville Damages Schedule did not include or otherwise take into account any losses "attributable to overbilling to the Government resulting from the fact that time mischarged under one contract resulted in overpricing of another contract where the pricing of the second contract was dependent in part on labor and overhead rates determined on the basis of billings under the first contract" (in other words, derivative defective-pricing losses recoverable by the Government through the price-adjustment mechanism of the TINA). Stip. paragraph 67; T.T. 96-99, 221, 324-26, 362-64, 408-10.

[32] The testimonial record is equally clear that even though derivative contract losses were not reflected to any extent in the $1.56 million figure, they were definitely covered by the $2.5 million settlement payment, and thus as a matter of mathematical necessity included in the $940,000 differential between these two numbers. Mr. Chierichella, who represented Stencel in the settlement negotiations, testified that Stencel's TINA exposure for defective pricing was enough in and of itself to justify Stencel's paying $940,000 over and above the $1.56 million of estimated FCA "singles" damages, and that the Government's releasing Stencel from its potential TINA liability was essential to the settlement. T.T. 129- 30, 132-41, 148, 153-58. Ms. Branda, the lead negotiator for the Government, agreed that the $2.5 million figure included compensation to the Government with respect to Stencel's TINA liability for defective pricing and was intended to cover the Government's TINA losses. T.T. 450. So did Mr. Clarence E. Brooks, a DCAA auditor who assisted Ms. Branda in the settlement negotiations. He testified that defective pricing was an acknowledged element of the Government's losses not shown on the Asheville Damages Schedule but nevertheless taken into account for purposes of the settlement. T.T. 411-13. Likewise, the scope and wording of the TINA-liability release in the Settlement Agreement was the subject of detailed negotiation between Stencel and the Government. Stip. paragraphs 83-88, Jt. Exhs. 21-U, 22-V; T.T. 138-39. In short, the Tax Court's finding that the entire $940,000 in issue represents only second-tier or "double" FCA damages is directly contrary to all of the evidence -- Talley's and the Commissioner's -- in any way relevant to the question of the composition of the $940,000 figure.

[33] For this reason alone, the Tax Court decision must be reversed. The only question in this case is whether the $940,000 constitutes a "fine or similar penalty" for purposes of section 162(f) of the Code, and the Commissioner has never argued that any amount paid by Stencel to settle its derivative TINA liability for the defective pricing of subsequent contracts (as contrasted to its second-tier FCA liability for billing the Government its mischarged labor costs on earlier contracts) is caught by section 162(f). The law is settled, in fact, that a contractor's payment in satisfaction of the Government's claims under the TINA is fully deductible as an ordinary and necessary business expense in the same manner as a payment between private parties to resolve a commercial contract dispute. Sundstrand Corp. v. Commissioner, 17 F.3d 965 (7th Cir. 1994), affirming 98 T.C. 518 (1992). See Grossman & Sons, Inc. v. Commissioner, 48 T.C. 15, 27 (1967); Rev. Rul. 80-211, 1980-2 C.B. 57. The Tax Court said as much in its earlier opinion in this case, in response to the parties' cross motions for summary judgment, where it noted that insofar as Stencel's $2.5 million settlement payment is attributable to its potential TINA liability, the payment is wholly compensatory and for this reason beyond the coverage of section 162(f). C.R. 44, p. 21 (68 T.C.M. (CCH) at 1418). Unfortunately, after the trial of the case following the earlier appeal to this Court, the Tax Court rendered this very pertinent observation academic when it concluded, contrary to all of the evidence on the subject, that the entire $940,000 represents only second-tier FCA damages and that no portion is fairly allocable to the resolution of Stencel's TINA liability.

II.

[35] Section 162(f) precludes a deduction for what otherwise would be a deductible section 162(a) business expense where the amount in question is a "fine or SIMILAR penalty paid to a government for the violation of any law." (Emphasis added.) The word "similar" is critical to the proper interpretation of the statute; for while Congress certainly meant to deny a deduction for a criminal fine of every kind and description, it did not intend to limit the deductibility of an ordinary and necessary business expense which might well be a "penalty" in the colloquial sense, but where the essential purpose of the payment is to compensate some governmental entity for the actual damage it sustained on account of the taxpayer's violation of the law. Mason & Dixon Lines, Inc. v. United States, 708 F.2d 1043 (6th Cir. 1983) (deduction allowed for statutory damages assessed after taxpayer had been fined for exceeding state highway weight restrictions). Thus it is that the Commissioner, in his own regulations construing section 162(f), states unequivocally: "Compensatory damages . . . do not constitute a fine or penalty." Treas. Reg. section 1.162-21(b)(2).

[36] Recognizing the importance of the distinction between a "penalty" in general and a "penalty similar to a fine" in the statutory sense, the Court began its analysis in Talley I with a brief summary of the law on this point:

Whether a civil penalty is deductible depends upon "the

[37] Applying these principles to the record in this case as it stood at that point in time, and acknowledging the dual character of the double-damages provision of the FCA, the Court held that the Tax Court had erred in granting Talley's motion for summary judgment, because:

Stencel faced potential liability under the FCA, the TINA,

[38] This Court thus identified two distinct factual issues that the Tax Court would have to address on remand: First, to what extent is the $940,000 component of the settlement in excess of agreed FCA "singles" damages allocable to Stencel's TINA or common law contract liability? Second, if less than all of the $940,000 is allocable to TINA or other contract-based liability, was the residual amount, representing second-tier FCA damages, intended by Stencel and the Government, as the parties to the settlement, to compensate the Government for its losses or to punish or deter Stencel with respect to past or future conduct?

[39] The Tax Court answered the first question by finding that none of the $940,000 is allocable to Stencel's TINA liability but that the entire amount represents second-tier FCA damages. Supra note 8. As discussed in Part I above, the Tax Court's finding in this respect is clearly erroneous, and for this reason alone the decision below must be reversed.

[40] The Tax Court's resolution of the second issue also constitutes reversible error. Contrary to the instructions of this Court, the Tax Court sought not to determine the probable intent of Stencel and the Government with respect to any second-tier FCA damages component that may have been included in the $940,000, but only whether Stencel and the Government had expressed their intentions in this regard to each other in the form of some kind of oral or written agreement between them.

[41] The Tax Court correctly verbalized its instructions when it stated "the Court of Appeals indicated that the [question of] deductibility . . . would have to be resolved by determining the parties' intent" as to the compensatory or punitive and deterrent character of the settlement. ⁹ C.R. 110, p. 15 (77 T.C.M. (CCH) at 2195). Two paragraphs later, however, the Tax Court abandoned its broad mandate in favor of limiting the inquiry to the existence vel non of a contractual understanding between the parties with respect to the nature of the settlement. Although it had been clearly instructed by this Court to evaluate the evidence adduced at trial and to ascertain as best it could from that evidence the probable state of mind of the parties to the Settlement Agreement on the issue of the character of the settlement payment, the Tax Court apparently felt compelled to override this directive in the belief, premised in large part on a highly problematic suggestion of Justice Oliver Wendell Holmes, that evidence of the intentions of the parties would be meaningless unless the parties had actually communicated their intentions to each other in something at least approximating a contractual format. ¹⁰ C.R. 110, p. 16 (77 T.C.M. (CCH) at 2196).

[42] As this Court observed in Talley I, "[n]either the characterization nor purpose of the [settlement] payment is clarified by the settlement agreement." 116 F.3d 382, at 387. Having thus commented on the absence of a contractual understanding on these matters in the document where it is most likely that the parties would have recorded any such understanding, the Court certainly would have remanded the case for trial on only the very narrow question of the possible existence of some other contractual agreement if the Court had meant for a contractual agreement to be a prerequisite to the deductibility the $940,000.

[43] In Talley I, the Court sent this case back to the Tax Court to address and resolve what the Court described in unmistakable terms as a controlling question of fact with respect to the intentions of the parties to the Settlement Agreement. On remand, however, the Tax Court superimposed what is in effect its own point of statutory construction, holding that no portion of Stencel's settlement payment, at least insofar as allocable to the second-tier damages provisions of the FCA, is compensatory for purposes of section 162(f) unless Stencel and the Government actually agreed between themselves in the course of the settlement negotiations that it was compensatory. Since it failed in this regard to adhere to the mandate of this Court, the decision of the Tax Court must be reversed.

III.

[45] Counsel for both parties to the settlement negotiations were well aware that the $1.56 million figure had been derived from the Asheville Damages Schedule, that it represented only "singles" damages as this term is used with reference to the FCA, and that "singles" damages are strictly loss-of-bargain damages. ¹¹ Stip. paragraphs 67, 79-81; T.T. 40-41, 114-15, 238-40, 460-61. The parties also knew that, in addition to its "singles" damages, the Government had sustained substantial damages of an incidental or consequential nature, damages which it could recover only by holding out for a settlement in excess of the $1.56 million.

[46] Setting aside its TINA claim, the largest element of incidental and consequential damages sustained by the Government but not included in the $1.56 million of "singles" damages was undoubtedly the interim loss of the earning power of the $1.56 million itself, a loss typically compensated in contract litigation by the awarding of prejudgment interest on the amount eventually recovered as loss-of-bargain damages. The presettlement interest factor in this case was a sizable number for two reasons: the $1.56 million of agreed "singles" damages was predicated on the assumption that the mischarging of Stencel's labor costs had extended back to a point in time more than seven years prior to the settlement date, and during several of those years interest rates were higher than at any time in recent memory.

[47] Both Stencel and the Government were cognizant of the fact that lost earning power was a major component of the Government's total damages, and both were fully aware that the $940,000 in excess of the $1.56 million was the only sum available to compensate the Government in this respect. T.T. 171, 173, 218, 266-67, 462-66. It is true, as the Tax Court observed, that the parties did not negotiate an interest component as such in terms of a specific dollar amount. However, insofar as the Settlement Agreement permitted Stencel to defer payment of $1 million of the $2.5 million settlement until the first anniversary of the settlement date, the parties did agree to a stated interest rate, i.e., the rate prescribed under Public Law 92- 41. Applying the Public Law 92-41 rates in effect during the seven- plus years covered by the Settlement Agreement, the interest factor on the $1.56 million of first-tier damages, assuming annual compounding, came to more than $800,000. Stip. paragraph 97.

[48] Ms. Branda would prefer to leave the impression that although she understood that the Government had lost the earning power of the $1.56 million, she never consciously took account of an interest factor in negotiating the $2.5 million settlement. T.T. 462- 66. Questions of credibility, of course, are for the trial court. It is nonetheless highly indicative of Ms. Branda's true state of mind that at the same time she purports to have been oblivious to the recovery of an interest component as part of the negotiated settlement, she was in the midst of drafting a complaint for filing in federal district court in North Carolina demanding both $1.56 million of "singles" damages and prejudgment interest thereon. ¹² Stip. paragraph 104, Jt. Exh. 25-Y; T.T. 488-90. Ms. Branda also was very sensitive to interest rates while she was negotiating the settlement. In her words, the Public Law 92-41 rate built into the deferred-payment provision in the Settlement Agreement was "a high interest rate . . . in the government's favor, and that's why I negotiated the figure in connection with my settlement agreement." T.T. 465. It stretches credulity beyond the breaking point to suggest that the Government, in the person of Ms. Branda, fought to collect maximum interest on the one-year deferral of an amount equal to approximately two-thirds of its "singles" damages, but had no intention of recovering any interest on the seven-year deferral of all of its "singles" damages. This is particularly true when Ms. Branda herself testified that she rejected Stencel's $2 million settlement offer, transmitted by Mr. Kilberg's letter of January 31, 1986 (Stip. paragraph 85, R. Exh. 21-U), at least in part because it was insufficient to compensate the Government for its losses. ¹³ T.T. 443. In this respect, incidentally, Ms. Branda was in complete agreement with the Navy Department, the immediate victim of Stencel's misconduct, whose General Counsel a few weeks earlier had recommended a $2.5 million settlement as necessary to cover both "provable" and "possible" losses for 1984 and prior years. Stip. paragraph 75, Jt. Exh. 19-S.

[49] Although probably not as significant as the interest factor on the $1.56 million, the Government had substantial consequential damages in the nature of investigation and prosecution costs (including the costs of the Navy contractor-debarment proceedings), none of which was part of the $1.56 million of "singles" damages computed on the basis of the Asheville Damages Schedule. Stip. paragraph 67; T.T. 175-77. These costs, too, were very much on the minds of both parties in the course of the settlement negotiations. T.T. 175-77, 240-47, 472-75, 484-85. To conclude that the Government negotiator knew that her client had incurred these expenses but had no intention of recouping them through the settlement process is at odds both with common experience and with her own testimony that, not surprisingly, one of her paramount responsibilities as a DOJ attorney representing the Government in any contract dispute was to determine the nature and scope of the Government's losses and then to recover those losses, by settlement or litigation, to the maximum extent possible in the circumstances of the case. T.T. 458-59.

[50] Despite overwhelming evidence that the $940,000 was compensatory even to the extent it may have represented second-tier FCA damages (as distinguished from consideration for the release of Stencel from its potential TINA liability), the Tax Court still was not persuaded that appellants had carried their burden of proof. The court said in this regard:

We reject petitioner's contention that the disputed portion

[51] The Tax Court confused the facts of the case with the terminology of the Government's principal witness. To be sure, Ms. Branda did testify that from her perspective the $940,000 in excess of the $1.56 million was a "penalty." T.T. 441, 447-48. However, she also testified that, as she uses the word "penalty," ANY amount received in settlement of ANY FCA case over and above the Government's "singles" damages is ALWAYS a "penalty." T.T. 473-74. This follows because, by her definition, a "penalty" is simply the mathematical difference between the gross settlement amount and the Government's "singles" damages. ¹⁴ T.T. 473. For the Tax Court to accord controlling significance to Ms. Branda's personal characterization of the $940,000 in the face of clear and convincing evidence to the contrary defeats the very purpose of the factual inquiry required under Talley I -- an inquiry made necessary precisely because second-tier damages are not inherently punitive or penal as Ms. Branda's testimony would imply, but are designed in the first instance to serve as the vehicle for the Government to recover whatever incidental and consequential losses are not already included in the calculation of the Government's first-tier damages. United States ex rel. Marcus v. Hess, 317 U.S. 537 (1943); see United States v. McLeod, 721 F.2d 282 (9th Cir. 1983); Talley I, 116 F.3d at 387; see also United States v. Aerodex, 469 F.2d 1003 (5th. Cir. 1972).

[52] The practical effect of the Tax Court's finding that appellants did not meet their burden of proof because Ms. Branda defines any amount recovered in an FCA settlement in excess of "singles" damages as a "penalty" is to hold, notwithstanding the opinion of this Court in Talley I, that second-tier FCA damages are noncompensatory as a matter of law. The upshot is the incongruous result that even though Talley and the Commissioner have stipulated that the Government had to recover out of the $940,000 in question some $800,000 of interest alone in order to be fully compensated with respect to its $1.56 million of "singles" damages, not one dollar of the $940,000 can be considered compensatory for purposes of section 162(f).

CONCLUSION

[53] The finding of the Tax Court that the entire $940,000 in issue represents only second-tier FCA damages (as distinguished from compensation for the Government's derivative contract losses recoverable under the TINA) is inconsistent with the undisputed evidence in the record. In addition, the Tax Court disregarded the instructions of this Court, as set forth in Talley I, in determining the compensatory or punitive character of any portion of the $940,000 which might represent second-tier FCA damages. Finally, the Tax Court erred again in holding that appellants had not carried their burden of proof with respect to the characterization of any such portion of the $940,000. For these reasons the decision of the Tax Court must be reversed.

March 30, 2000

[54] Because of the significance of this case to the proper application of section 162(f) of the Internal Revenue Code, appellants request that their appeal be set for oral argument.

CERTIFICATE OF COMPLIANCE PURSUANT TO FED. R. APP. P. 32(a)(7)(C) AND CIRCUIT RULE 32-1 FOR CASE NO. 00-70080

I certify that:

[55] Counsel for appellants, Talley Industries, Inc., et al., state that to the best of their knowledge and belief there are no related cases pending in this Court.

ADDENDUM

I. CONTRACT DISPUTES ACT OF 1978

41 U.S.C. section 611. Interest

[56] Interest on amounts found due contractors on claims shall be paid to the contractor from the date the contracting officer receives the claim pursuant to section 6(a) from the contractor until payment thereof. The interest provided for in this section shall be paid at the rate established by the Secretary of the Treasury pursuant to Public Law 92-41 (85 Stat. 97) for the Renegotiation Board.

II. INTERNAL REVENUE CODE OF 1954

I, Gloria Polanco, hereby certify as follows:

[57] I am over the age of eighteen years and not a party to this action; my business address is 333 South Grand Avenue, Los Angeles, California 90071; I am employed in the office of James G. Phillipp, a member of the bar of this Court, and at his direction, on this date, I served two copies of the foregoing Appellants' Opening Brief and one copy of the Excerpts of Record on the opposing party in this action via overnight air courier by placing the stated number of true and correct copies in a courier-supplied shipping carton, with all shipping charges fully prepaid, addressed as follows:

Paula M. Junghans, Esq.

² The False Claims Act, 31 U.S.C. section 3729 et seq. (1982), provided in pertinent part at the time of the Stencel settlement negotiations:

A person not a member of an armed force of the United States is

³ The Truth in Negotiations Act, 10 U.S.C. section 2306(f) (1982), read in pertinent part during the period in issue:

(1) A prime contractor or any subcontractor shall be

⁵ By the end of 1985, the value of Stencel's invoices which the Navy had not yet paid because Stencel could no longer certify the accuracy of its labor charges had become a potentially significant problem in terms of Stencel's cash flow. T.T. 305-06. These so-called "backlogged invoices" included those invoices already submitted by Stencel but not yet paid at the time Stencel was indicted, as well as later invoices which, once the indictment had been returned, Stencel was unable to submit to the Navy because it could then no longer attest to the accuracy of the charges. Stip. paragraph 37, Jt. Exh. 8-H; T.T. 302-06.

⁶ Public Law 92-41, section 2(a)(3), 85 Stat. 97 (1971), amending the Renegotiation Act of 1951, directs the Secretary of the Treasury to determine, once every six months, an appropriate interest rate predicated on current commercial rates for new five-year loans. This rate is used for various purposes in connection with federal- contract matters, including the computation of interest owing to a contractor who recovers on a claim against the Government under the Contract Disputes Act of 1978. 41 U.S.C. section 601, at section 611 (1994); T.T. 144, 465-66.

⁷ See United States v. Aerodex, 469 F.2d 1003 (5th Cir. 1972); infra note 12. "Singles" damages are often described in this brief as "first-tier damages," while the incremental amount added to "singles" damages to produce double damages is generally referred to as "second-tier damages."

⁸ The court noted in the first instance only that "the parties intended the [$2.5 million] settlement to include double damages" under the FCA, but said nothing about the amount of the "double damages" component. C.R. 110, p. 14 (77 T.C.M. (CCH) at 2195). Two sentences later it becomes apparent that in fact the court actually found that the entire $940,000 in excess of the $1.56 million represents second-tier damages, for the court then says that its next task is to "consider whether the purpose of the $940,000 double damage payment was to compensate the Government for its losses or to deter or punish Stencel." C.R. 110, pp. 14-15 (77 T.C.M. (CCH) at 2195). (Emphasis added.)

⁹ In the one sense of the term, of course, the concept of "deterrence" does not entirely exclude the notion of compensation. See Stephens v. Commissioner, 905 F.2d 667 (2d Cir. 1990); Waldman v. Commissioner, 88 T.C. 1384 (1987). To the extent that a wrongdoer is required to reimburse his victim fully and completely (e.g., by turning over not only the stolen funds but also the earnings thereon while he had possession of the funds), the deterrent value of the exercise will be greater than if he is permitted to reimburse the victim for less than all of the victim's true monetary losses (e.g., if he is not required to make compensation for the victim's loss of the use of the funds by paying over the interim profits or their equivalent). Presumably, therefore, the Court in its prior opinion, in directing the Tax Court to find the intent of the parties, used the term "deterrence" in the more narrow sense of traditional punitive damages, which by their very nature are awarded in addition to whatever amount has already been determined to be necessary to fully compensate the plaintiff for his losses.

¹⁰ Responding to the conflicting views of Talley and the Commissioner about the correct characterization of the $940,000, the Tax Court quoted the following excerpt from O. Holmes, The Path of the Law, 10 Harv. L. Rev. 457, 464 (1897):

"the making of a contract depends not on the agreement of two

¹¹ Under the rule of United States v. Aerodex, Inc., supra note 7. See generally T.T. 41-42.

¹² The Circuits are split on the question whether in an FCA case the Government can recover prejudgment interest in addition to statutory second-tier damages. Compare United States v. McLeod, 721 F.2d 282 (9th Cir. 1983) and United States v. Foster Wheeler Corp., 447 F.2d 100 (2d Cir. 1971) with United States v. Cooperative Grain Supply Co., 476 F.2d 47 (8th Cir. 1973). Ms. Branda was generally familiar with the law on this point (T.T. 464) and presumably knew at the time she drafted the complaint that the Fourth Circuit, with appellate jurisdiction over the North Carolina court, had not yet addressed the issue.

¹³ See also infra note 14.

¹⁴ Mr. Kilberg's letter of January 31, 1986, offered $2 million as "compensation for any and all restitution and damages" related to the mischarging of labor costs at Stencel. Stip. paragraph 85, Jt. Exh. 21-U, p. 1. A few days later Ms. Branda rejected this offer and replied with a counter offer of her own, which made no mention of restitution or damages. Stip. paragraph 88, Jt. Exh. 22-V. The Tax Court viewed this omission from Ms. Branda's counteroffer -- and the fact her letter stated that the Government "cannot accept [Mr. Kilberg's] terms" -- as a further indication that Ms. Branda did not consider the $940,000 as compensatory. C.R. 110, p. 18 (77 T.C.M. at 2196).

The better interpretation is to the contrary. First, Mr. Kilberg's reference to "compensation for any and all restitution and damages" was not a "term" as such of Stencel's proposal, but rather Stencel's characterization of the payment. Second, under the Tax Court's interpretation the compensatory character of the entire settlement payment would be open to question, despite the fact that Ms. Branda concedes that even under her definition of a "penalty," all but $940,000 of the payment is compensatory. Finally, given the fact that Ms. Branda's counteroffer actually set forth alternative wording for those specific portions of Mr. Kilberg's letter which she found objectionable, the stronger inference, especially in light of her testimony about the inadequacy of the $2 million to cover the Government's losses (T.T. 443), is that she was in full agreement with the proposition that the total $2.5 million settlement was meant to constitute restitution for those losses was therefore compensatory in nature.