First Circuit Sustains the Tax Deductibility of Settlement Payments under the Civil False Claims Act in Fresenius
In Fresenius Medical Care Holdings, Inc. v. United States,1 the First Circuit upheld the tax deduction of civil False Claims Act payments in excess of the amount that the government deemed to be "single" damages. In so doing, the court rejected the longstanding position of the government that was based on its reading of the Ninth Circuit's decision in Talley Industries, Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 1997).
Briefly, Fresenius Medical Care Holdings (FMCH) acquired a company that had been named as a defendant in several civil False Claims Act actions, and that was also the subject of criminal and civil investigations conducted by the United States government. FMCH worked out a settlement with DoJ under which it paid a $101 million criminal fine and $385 million to secure the release of the civil claims. Following its practice in these matters, DoJ refused to characterize the tax treatment of the $385 million in the settlement agreements. However, in an internal document later shared with the IRS, DoJ classified the civil payment as $192 million in compensatory damages, $66 million to pay relators in the case, and $127 million for investigation costs and penalties.
The issue was how much of these payments FMCH could deduct. The Internal Revenue Code allows a deduction for compensatory payments, but not for "a fine or similar penalty."2 FMCH did not seek to deduct the criminal fine. The IRS allowed a deduction for the $192 million that DoJ had characterized as compensatory damages and the $66 million designated as payment to the relators. The IRS denied any deduction for the remaining $127 million on the grounds that it was a penalty.
FMCH paid its tax on the basis that the $127 million was not deductible and then filed a refund claim on the basis that it was. When the IRS did not pay the claim, FMCH filed suit in district court and demanded a jury trial. The jury allowed a deduction of $95 million, about 75% of the amount at issue, and the government appealed.
The government contended that it was entitled to judgment as a matter of law. Boiled down, the government's argument was essentially as follows:
- The taxpayer has the burden of proof of deductibility.
- That burden can be met only if the taxpayer can show that the parties to the settlement intended an amount to be compensatory and not punitive.
- DoJ refused to characterize the payments in the settlement agreements.
- Therefore, the taxpayer cannot prove the intent of the parties and cannot meet its burden of proof as to deductibility.
Under this line of reasoning, the taxpayer could never prevail, because DoJ always refuses to characterize civil False Claims Act payments in settlement agreements. The government's argument did not play well before the First Circuit, which stated: "Such an exclusive focus [on express characterization] would give the government a whip hand of unprecedented ferocity: it could always defeat deductibility by the simple expedient of refusing to agree – no matter how arbitrarily – to the tax characterization of a payment." Indeed, as the court also noted, "during the negotiations [between FMCH and DoJ] leading to the settlement, the government apparently refused to discuss tax consequences."
The court agreed that if an amount was characterized in the settlement agreement (which as a matter of practice never occurs in civil False Claims Act cases), that would ordinarily be dispositive. However, the court held that, in the absence of such a characterization, the taxpayer may meet its burden by showing that the economic substance of the payment was compensatory and not punitive. FMCH had made just such a showing at trial, largely on the basis that documents passed back and forth in negotiation of the settlement showed that much of the amount in dispute was intended to compensate the government for delay in payment of the "single" damages.
The government's argument was based on its reading of 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), previously the only modern authority on the tax treatment of civil False Claims Act payments. In Talley, the Ninth Circuit had held that deductibility of civil False Claims Act payments depended on the intent of the parties. On remand, the Tax Court found that the settlement agreement was silent on this point and that Talley had not made an effort to quantify what damages the government had suffered above what the IRS had already allowed as a deduction. Thus, Talley could not meet its burden of proof.
The First Circuit was not so sure that the government's reading of Talley – that the necessary intent could only be proved by the settlement agreement – was correct. The court observed that, unlike Talley, FMCH had introduced evidence extraneous to the settlement agreement as to the intent of the parties. The Talley result could be distinguished on the basis that there was no such evidence in that case. However, the First Circuit also held that even if Talley did stand for the principle espoused by the government, it declined to follow Talley. We believe that the First Circuit's reading that distinguishes Talley is the correct one. The First Circuit's articulation of its reading of the case is likely to undercut the ability of the government to rely on Talley in other cases as well. It is possible that even the Ninth Circuit will eventually clarify that intent may be demonstrated outside of the provisions of the settlement agreement.
The First Circuit left one important point open, because it did not have to reach it. The district court had, in essence, instructed the jury to find what amount was necessary to compensate the government; only the excess over that could be considered a fine or other penalty that would not be deductible. On appeal, the government objected to this. It argued that where the settlement payment was smaller than the original claims, both the punitive and compensatory elements should be reduced proportionately, rather than reducing the punitive element alone. The court described this argument as having "a patina of plausibility," but decided that it did not need to reach the issue because the government had failed to raise the point timely below. Possibly, that failure was part of a deliberate government strategy to rely exclusively on Talley and not to cloud its position with alternative arguments. It may be expected, however, that the government will pursue this line in future cases.
It is not known at present whether DoJ will seek a rehearing. Possibly, DoJ could seek certiorari based on an alleged conflict with Talley although, as discussed above, such a conflict is questionable at best.
1 No. 13-2144 (1st Cir. Aug. 13, 2014). We previously wrote about the district court's decision in this case. Please see http://www.crowell.com/newsevents/alertsnewsletters/all/court-sheds-light-on-deductibility-of-civil-fca-payments.
2 IRC § 162(f).
* Howard Weinman is admitted to practice only in the District of Columbia and before the Internal Revenue Service. Practice limited to matters before the Internal Revenue Service.
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