Court Sheds Light on Deductibility of Civil FCA Payments
The recent decision in Fresenius Medical Care Holdings v. United States, 111 AFTR 2d 2013-1938 (D. Mass. May 9, 2013), is critically important for government contractors facing fraud accusations, because it is a rare case involving the tax treatment of payments made under the civil False Claims Act, which provides for treble damages and statutory penalties. The False Claims Act also provides that in cases brought by a whistleblower, also known as a "relator," the whistleblower is entitled to a percentage of any recovery and attorneys' fees and costs. Given the availability of "multiple" damages, penalties, and fees and costs under the FCA, the court was faced with determining to what extent Fresenius's payments were compensatory, and therefore deductible. First, the case confirmed that payments that are expressly earmarked for a relator are deductible. Second, the case illustrates that the IRS uses a Justice Department tracking form to characterize the amounts paid as deductible or not for tax purposes. Third, the court rejected arguments by both the taxpayer and the government that certain terms typically appearing in settlement agreements were determinative. Finally, the strategy to pursue a jury trial and its result for the taxpayer are very informative.
Fresenius Medical Care Holdings (FMCH) acquired a business that had been named as a defendant in several False Claims Act actions brought by whistleblowers, and that was also the subject of criminal and civil investigations conducted by the United States government. After negotiation with the government, FMCH agreed to a global settlement agreement that included the payment of $101 million in criminal fines. FMCH also agreed to pay $385 million to release the government's civil claims, $66 million of which was designated in the settlement agreements to be paid to the relators in the qui tam actions. The Justice Department, in an internal "Health Care Fraud Tracking Form" that was not shared with FMCH, allocated the civil payment as follows: Compensatory Damages, $192 million; Relator Fee, $66 million; Investigation Costs and Penalties, $127 million. On its tax returns, FMCH did not claim any deduction for the $101 million in criminal fines because IRC § 162(f) disallows any deduction for "any fine or similar penalty paid to a government for the violation of any law." However, FMCH deducted all of the $385 million it paid to settle the civil case. On audit, based on the DoJ Tracking Form, the IRS allowed a deduction for the $192 million in compensatory damages but disallowed the remainder on the basis that it constituted a "fine or similar penalty."1 FMCH filed a protest with the IRS Appeals Office, which additionally allowed a deduction for the $66 million relator payments but denied a deduction for the rest.2 Accordingly, the $127 million identified by the Justice Department as investigation costs and penalties remained at issue.
FMCH had a choice of forums. It could have gone to the Tax Court or filed suit in a refund forum (the relevant U.S. district court or the Court of Federal Claims). FMCH elected to make full payment of the tax, which committed it to a refund forum, even while its case was being considered by IRS Appeals. When it could not settle with IRS, FMCH chose to proceed in U.S. District Court for the District of Massachusetts and demanded a jury trial.
FMCH may have decided to proceed in the district court both to get before a jury and to avoid the Tax Court.3 Prior to Fresenius, the only real modern litigation on the tax treatment of FCA civil damages was Talley Industries v. Commissioner, 116 F.3d 382 (9th Cir. 1997), on remand, T.C. Memo. 1999-200 (1999), aff'd mem., 18 Fed. Appx. 661 (9th Cir. 2001). In Talley, the Ninth Circuit held that amounts paid in a settlement under the civil FCA above the government's "singles" damages (the base compensatory damages recovered under the civil FCA, before being multiplied) could potentially have either a compensatory purpose, allowing them to be deducted, or a punitive purpose, precluding deduction. The proper characterization would depend on the intent of the parties to the settlement. In its opinion on remand, the Tax Court held that the settlement agreement was ambiguous as to whether the parties had intended the amount in excess of singles damages to be compensatory or punitive. Moreover, the court found that Talley had not made a serious effort to quantify any actual damages the government might have suffered in addition to those accounted for as its singles damages. Since the burden of proof in tax cases is on the taxpayer, the court found that no part of the amount paid in excess of the amount the IRS conceded was singles damages was deductible.
In Fresenius, as in Talley, the court began its analysis by considering the terms of the settlement agreements. The court rejected arguments by both FMCH and the government that the terms of the settlement agreements necessarily controlled the outcome of the case. FMCH argued that language in each of the civil settlement agreements that FMCH and its subsidiaries "further agree that nothing in this Agreement is punitive in purpose or effect"4 conclusively established that the amounts paid were compensatory. However, the court held that this language simply addressed the Double Jeopardy and Excessive Fines Clauses, and that a different test applied for tax deductibility. In so holding, the court was influenced by the fact that DoJ clearly intended to avoid a characterization of the settlement payments for tax purposes in the agreements.
For its part, the government contended that, under Talley, the parties to a settlement had to agree on the amount to be treated as compensatory for the taxpayer to meet its burden of proof to claim a deduction. As is customary in civil FCA settlements, the Fresenius agreements explicitly disclaimed any characterization for tax purposes of the settlement payments. However, the court held that express agreement of the parties was not what Talley required. Rather the court stated that:
aspects of "make-whole" [i.e., compensatory] recovery can be proved independently of any express agreement or the lack of one, through proof of interest calculations, attorneys' billable hours, and expense records. While the parties' negotiations also may provide evidence of the compensation due to the government, these negotiations and the eventual settlement agreement will seldom be the sole evidence available to foresighted parties.
The court pointed out that there could be several additional costs to the government beyond its singles damages, including payment to a relator (already allowed by IRS in Fresenius), interest, and consequential damages, and that payment for any of these could serve a compensatory purpose. The court noted that the False Claims Act's treble damages provision was meant, in part, to compensate the government for some of these categories of costs.
In Fresenius, the court focused on pre-judgment interest. Especially damaging to the government's case was a letter in the civil FCA case from DoJ to FMCH seeking to justify treble damages in connection with some of the issues on the ground that pre-judgment interest owed to the government would exceed even that amount. On some other issues, the government sought multiple damages under the civil FCA, but not pre-judgment interest, while it sought only singles damages plus pre-judgment interest under other laws for which multiple damages were unavailable. The court held that a reasonable jury could infer from this that a substantial part of the multiple damages was in fact intended to compensate the government for the delay in payment.
In its verdict, the jury allowed FMCH to deduct $95 million of the $127 million at issue, about 75 percent. This appears to have been a reasonable result for FMCH, given the difficulty of bearing its burden of proof in the face of DoJ's refusal to characterize the payments for tax purposes. FMCH correctly gambled that going before a jury, it would get a reasonable result that the court would decline to disturb. The jury strategy had risk, in part because the businesses involved had admitted to defrauding the government, and therefore FMCH could be viewed as an unattractive plaintiff. The fact that the fraudulent conduct occurred before FMCH acquired the businesses, which were under new management, may have helped.
Fresenius is instructive on several counts. First, where possible, taxpayers should be sure that any relator payments are specified in the relevant settlement agreement. This should bring them within the scope of IRS internal guidance that they are deductible, though the taxpayer might still be able to show the compensatory nature of the relator payments even if the amount is not specified. Second, although DoJ insists on tax neutrality in the settlement agreement itself, opportunities abound to try to get the compensatory nature of amounts above singles damages into the record so as to meet the taxpayer's burden of proof. In Fresenius, DoJ helped the taxpayer in this regard by making the comparison between multiple damages and pre-judgment interest. In a different case, consequential damages rather than interest might be the key. Companies should keep this in mind during the negotiation process. Third, jury trials may be an interesting strategy, but one that will require full payment of the tax before litigating, which given the large amounts involved will often make them unavailable.
The government (or even FMCH) may appeal, in which case more light may be shed on these points by the First Circuit. Unfortunately, Fresenius illustrates how long these cases can take to resolve. The returns at issue were filed beginning in 2001; the trial court's judgment came in 2013, and if there is an appeal, the elapsed time will be even longer.
1 An IRS official is reported to have said that "The tracking statement is probably one of the last things" considered by the IRS in its deductibility analysis. "Tracking Document Is of Least Significance in Government Settlement Taxation, IRS Official Says," 2010 Tax Notes Today 186-7 (Sept. 27, 2010). However, it was determinative in Fresenius.
2 The IRS issued internal legal advice while FMCH's case was pending before Appeals, apparently to a different taxpayer, on this issue. The advice held that, at least where the settlement agreement identified the amount to be paid to the relator, such a payment should be treated as compensatory (defraying the government's cost of paying the relator) rather than punitive, and should be deductible. AM 2007-0015 (July 12, 2007). FMCH's settlement agreements similarly included a specific designation of $66 million to be paid to the relators. Fresenius Medical Care Holdings v. United States, 106 AFTR 2d 2010-5028 (D. Mass. June 24, 2010).
3 Regardless of whether FMCH chose the Tax Court or district court, the decision would be appealable to the First Circuit.
4 It is understood that this language was formerly standard but is no longer used by DoJ in civil FCA settlement agreements.
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