Trade Words for Concepts in Penalty Deduction Regs, Firm Says

July 9, 2020

Sharon Y. Horn
Attorney-Advisor
Internal Revenue Service, Dep't of the Treasury
Attn: 26 CFR Part 1 [REG-104591-18] IRS-2020-0008

Re: Comments on Notice of Proposed Rulemaking, REG-104594-18

Dear Ms. Horn:

We are writing in response to the request for comments in Notice of Proposed Rulemaking, REG-104594-18, IRS-2020-0008 (May 13, 2020), concerning the proposed regulations that provide guidance on the disallowance of an ordinary and necessary deduction for certain fines, penalties, and other amounts under section 162(f) of the Internal Revenue Code (“Code”) and the new reporting requirements in section 6050X, both as enacted by Public Law 115-97, commonly referred to as the 2017 Tax Cuts and Jobs Act (the “TCJA”). We submit these comments based on our experience attempting to apply new section 162(f) and we request that you take our comments into consideration when finalizing such proposed regulations.

Specifically, we recommend that the Internal Revenue Service (the “Service”) and the Department of Treasury (the “Treasury”) issue guidance:

I. Background

A. Old Law

Section 162(f) is a long-standing provision enacted with the purpose of codifying existing case law and the “frustration of public policy” doctrine.¹ Under this doctrine, ordinary and necessary deductions are prohibited when they would, if allowed, “frustrate sharply defined national or State policies proscribing the particular types of conduct evidenced by some governmental declaration thereof.”² Specifically, a deduction for amounts paid to the government for fines or penalties has long been recognized to “frustrate state policy in severe and direct fashion by reducing the 'sting' of the penalty prescribed by the state legislature.”³

Prior to the TCJA, section 162(f) explicitly stated that “no deduction shall be allowed . . . for any fine or similar penalty paid to a government for the violation of any law.”⁴ Section 1.162-21(a) of the 1975 Treasury Regulations defined the term “government” to mean either “(1) the government of the United States . . . (2) the government of a foreign country, or (3) . . . an entity serving as an agency or instrumentality of [the government].”⁵

Section 1.162-21(b)(1) of the 1975 regulations described the phrase “fine or similar penalty” as any amount “paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal),” including amounts paid as a civil penalty imposed by federal, state, or local law.⁶

Section 1.162-21(b)(2) further provided that compensatory damages paid to a government do not constitute a fine or penalty.⁷ Because the statutory language did not itself define the words “fine” or “similar penalty,” courts traditionally applied this provision by analyzing whether the nature of a payment was punitive, in which case the payment was non-deductible, or was compensatory, in which case the payment could be deductible.⁸ Thus, compensatory damages paid to the government (including damages pursuant to Section 4A of the Clayton Act) were deductible if they were otherwise qualified business expenses.⁹

B. New Law

1. In General

Section 13306(a)(1) of the TCJA amended and expanded section 162(f) to provide for a general prohibition on deductions otherwise allowable under chapter 1 of the Code (“chapter 1”) for any amounts paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government, governmental entity, or nongovernmental entity in connection with a violation of law or inquiry into a potential violation of law.¹⁰

Section 162(f)(2)(A) provides an exception to the general rule and allows a taxpayer to deduct certain amounts paid or incurred that are otherwise deductible under chapter 1 provided:

The statute clarifies that satisfying the Identification Requirement is not in and of itself sufficient to meet the Establishment Requirement,¹³ and that restitution, remediation, and amounts paid to come into compliance with a law do “not apply to any amounts paid or incurred as reimbursement to a government or governmental entity for the costs of any investigation or litigation.”¹⁴

Section 162(f) further provides that a deduction will not be disallowed for amounts paid or incurred (1) as restitution for failure to pay any tax if such amount would have been allowed as a deduction if it had been timely paid,¹⁵ (2) pursuant to any court order in a suit in which no government or governmental entity is a party,¹⁶ or (3) as taxes due.¹⁷

2. Scope of General Rule and Exclusion

Section 162(f) is a significant expansion of the prior provision as it no longer only disallows a deduction for fines or similar penalties but, rather, applies the disallowance rule in the first instance to all payments made to, or at the direction of, a government or government entity. Notably, the distinction between non-deductible punitive damages and deductible compensatory damages previously included in the regulations and supported by case law is removed from the language of the statutory general rule. In other words, the exception from the phrase “fine or similar penalty” is now explicit only with respect to restitution, remediation, or compliance payments and, accordingly, a deduction for payments of compensatory damages is not explicitly and clearly allowed by the statute.

3. Definition of Payee

Under the pre-TCJA version of section 162(f)(5), the term “government” included the U.S. government, the government of a foreign country, and their respective governmental entities.¹⁸ Under the TCJA, section 162(f)(5) now provides that certain nongovernmental entities are treated as governmental entities for purposes of section 162(f).¹⁹ Such nongovernmental entities include any nongovernmental entity that exercises self-regulatory powers (including imposing sanctions) either (1) in connection with a qualified board or exchange or (2) in order to perform an essential governmental function. Proposed section 1.162-21(a) incorporates this definition of nongovernmental entity as part of the general rule.²⁰

C. Reporting Obligations

In conjunction with the section 162(f) amendment, the TCJA enacted a reporting regime in new section 6050X. Under section 6050X(a), the “appropriate official” of the governmental entity, or nongovernmental entity treated as a governmental entity, that is involved in the relevant suit or settlement agreement is required to file an information return with the Service.²¹ The return must provide (1) the total amount to be paid as a result of the suit or agreement, (2) any amount to be paid for restitution or remediation of property, and (3) any amount to be paid to come into compliance with the law.²²

Proposed section 1.6050X-1 provides that such information reporting requirements will apply only to orders and agreements that become binding under applicable law on or after January 1, 2022.²³

II. Recommendations

A. Clarify that the Phrase “In Relation to the Violation of Any Law or the Investigation or Inquiry by such Government or Entity into the Potential Violation of Any Law” Does Not Include a Governmental Entity Asserting Legal Rights as a Private Party or On Behalf of a Private Party

The statutory language “in relation to the violation of any law” could be interpreted to apply to circumstances in which a governmental entity uses the law to enforce contracts or recover amounts through tort, contract, or other law in the same manner that a private party would do so. When a governmental entity enforces rights as a private party, or on behalf of a private party, such governmental entity is not acting as a regulator. Any damages recovered in these circumstances would be by reference to the rights of, or damages to, to the governmental entity or the private party on whose behalf the governmental entity is acting. The recovery would not be a fine or penalty set as an enforcement mechanism. Section 162(f) was intended to eliminate any tax benefit that would ameliorate the punitive effect of fines or penalties by effectively reducing the economic cost of such fines or penalties.²⁴ The revisions to section 162(f) were intended to improve the administration of the provision and to allow for its application to be more uniform and less subject to individual taxpayers' differing interpretations of the phrase “fines or penalties.”²⁵

However, neither the original provision nor the revisions in the TCJA are intended to impact the treatment of amounts paid to settle disputes solely because a governmental entity may be a party in the dispute. Proposed section 1.162-21(c) provide that the rules in section 162(f) do “not apply to any amount paid or incurred by reason of any order or agreement in a suit in which no government or governmental entity is a party.” The principle is that even though the order, the agreement, or the lawsuit may relate to the violation of law, the resolution is not a punitive measure if it instead relates to the enforcement of a private party's rights under the law. The same principle should apply when a governmental entity is acting as a private party or on behalf of a private party. If a government contractor is paid for work that is not completed for a governmental entity, and that governmental entity sues the government contractor to recover funds, an amount paid to settle that dispute should not be subject to the section 162(f) rules, even if the action to recover the funds invokes contract, tort, or other law

Similarly, in cases where the government “steps into the shoes” of a financially insolvent institution as a receiver for that institution, the government's exercise of rights on behalf of that institution, in which the result is the payment of funds, should not fall within the purview of the section 162(f) rules. For instance, in other legal contexts, the Federal Deposit Insurance Corporation (“FDIC”) has been recognized to act in two separate capacities: (1) as a regulator of depository institutions and an insurer of accounts at deposit institutions (“FDIC-C”) and (2) as a receiver of failed banks and thrifts (“FDIC-R”), which is treated as functionally and legally distinct from its corporate role.²⁶ Section 162(f) should not apply to amounts paid to the FDIC-R, as such amounts if paid to the private party before it failed (or had it not failed), would have been deductible and would not have been limited by section 162(f).²⁷

B. Clarify that the Establishment and Identification Requirements for “Restitution or Remediation” Can Be Satisfied Even if the Payor Does Not Admit Fault or Damage to the Payee

Controversies are often settled for a monetary sum without an admission of fault or damages. A defendant may be willing to pay an amount just to resolve a controversy. In such cases, if the underlying claim is a claim for restitution or compensatory damages, then the amounts paid to settle such claim should be deductible. As currently proposed, the Establishment Requirement requires a payment that “restores” a person, governmental entity, or property “harmed” by the violation or potential violation of law be supported by adequate evidence. This could be viewed as requiring an acknowledgement or presence of “harm” for a payment to be treated as restitution or remediation. In addition, the Identification Requirement could be read to preclude such a deduction because it requires an amount to be labeled specifically as “restitution or remediation.” A specific label could be understood as a requirement that the payor has to admit fault and/or damages.

Regardless of whether fault or damages are admitted, the origin of the claim that resulted in the payment in such circumstances should still be considered in a claim for restitution or remediation.²⁸ In fact, where the liability is incurred in connection with ordinary and routine business activities, settlement payments have traditionally been viewed as an acceptable means of defending the corporate business.²⁹ As a result, the payment has and should continue to be deductible.³⁰ To clarify this result, we recommend that the final regulations provide that an amount may be considered restitution or remediation even if no fault or damages are acknowledged, so long as the settlement agreement identifies a valid underlying claim that would have resulted in restitution or remediation.

C. Provide that the Use of Words that Describe a Payment to Restore in Whole, or in Part, a Person or Property that has been Harmed, or Allegedly Harmed, are Sufficient to Satisfy the Identification Requirement, Absent Evidence to the Contrary.

Proposed section 1.162-21(f)(3)(i) describes the Establishment Requirement for “restitution or remediation” conceptually and states:

An amount is paid or incurred for restitution or remediation pursuant to paragraph (b)(1) of this section if it restores, in whole or in part, the person, as defined in section 7701(a)(1); the government; the governmental entity; or property harmed by the violation or potential violation of a law described in paragraph (a)(3) of this section.

However, proposed section 1.162-21(b)(2)(ii) then states a very specific and narrow range of words that a settlement agreement must use to satisfy the Identification Requirement. The proposed regulations provide:

The identification requirement is presumed to be met if an order or agreement specifically states that the payment, and the amount of the payment, described in paragraph (b)(2)(i) of this section, constitutes restitution, remediation, or an amount paid to come into compliance with a law or if the order or agreement uses a different form of the required words, such as, “remediate” or “comply with a law.”

These required words are too narrow. For instance, terms such as “restitution,” “remediation,” and “remediate” can have different and specific meanings that may prevent their use in a settlement agreement, even when the settlement amount is being paid to restore the person or property harmed by the violation or potential violation of law. As pointed out by other commentators, “restitution” can mean the opposite of what is provided in the proposed regulations and instead refer to the return of unjust enrichment.³¹ For example, Dan B. Dobbs in Law of Remedies describes restitution as “a return or restoration of what the defendant has gained in a transaction.”³² Similarly, the Restatement (Third) of Restitution and Unjust Enrichment states that “[r]estitution identifies those circumstances in which a person is liable for benefits received (i.e., unjustly enriched) and the liability is measured by the extent of the benefit.”³³

Yet, the proposed regulations specifically exclude “forfeiture or disgorgement” from the scope of “restitution or remediation.” The preamble to the Proposed Regulations explains that this exclusion is appropriate because “[f]orfeiture³⁴ and disgorgement focus on the unjust enrichment of the wrongdoer, not the harm to the victim.” This reasoning is directly contradictory to the definitions of restitution cited above. This illustrates the problem created by relying too heaving on specific, narrow words to adequately identify the payments intended to be treated as deductible under section 162(f). Rather than focusing on the specific words “restitution,” “remediation,” and “remediate,” we recommend that the final regulations include a broader array of words that are sufficient, including a catchall description of words that conceptually indicate a payment is consistent with the definition of “restitution or remediation” in proposed section 1.162-21(f)(3)(i). We recommend the final regulations provide that the use of words, such as “compensatory damages,” “consequential damages,” “make whole,” or any other word that describes a payment to restore in whole or in part a person or property that has been harmed, or allegedly harmed, are sufficient to satisfy the Identification Requirement, absent evidence to the contrary.³⁵

III. Conclusion

There is significant risk that, without the adoption of certain clarifying rules as described above, section 162(f) may preclude taxpayers from being allowed a deduction for payments that should be deductible. Therefore, we recommend that the Service and the Treasury issue guidance:

Sincerely,

Philip R. West

Gregory N. Kidder

Aaron Hsieh

Steptoe & Johnson LLP
Washington, DC