Your Government at Work: IRS and SEC Take Contrary Positions on Disgorgement
On May 6, 2016, the IRS released a Chief Counsel Advice (CCA)1 stating that disgorgement payments to the SEC in a corporate Foreign Corrupt Practices Act (FCPA) enforcement action are not tax deductible. The corporate taxpayer in the CCA allegedly violated the internal controls and books and records provisions of the FCPA. The taxpayer entered into a consent agreement with the SEC that required it to pay disgorgement for the profits gained as a result. The taxpayer also agreed to pay a penalty and agreed with the Department of Justice that the penalty would not be deductible for tax purposes.
The IRS determined in the CCA that the disgorgement payment was a nondeductible “fine or penalty” under Internal Revenue Code section 162(f). The taxpayer argued that the disgorgement payment is deductible because it was made to encourage prompt compliance with the securities laws, was intended as a compensatory or remedial measure, and because the consent agreement did not prohibit deductibility. The IRS rejected all of these arguments. Notably, the CCA does not take the position that all disgorgement payments are nondeductible under section 162(f), and in fact the IRS and Tax Court have previously allowed a deduction for disgorgement payments.2 Rather, the CCA argues that whether disgorgement is primarily compensatory (and deductible) or punitive (and nondeductible) depends on the facts of a particular case. The CCA determined that the taxpayer at issue could not establish that the disgorgement was intended to compensate the SEC for actual losses and therefore opined that the disgorgement was not tax deductible. In support of its position, the IRS noted that compensatory payments normally flow to the injured party, but here there was no allegation that the government was damaged by the company’s FCPA violations. Furthermore, there was no indication that the purpose of the disgorgement payment was to compensate the government or some other party for specific losses caused by the taxpayer. Therefore, the IRS concluded that the disgorgement payment was primarily punitive.
In contrast to the IRS’s view that disgorgement can be penal and therefore not tax deductible, the SEC maintains that disgorgement is never penal for the purposes of the five-year statute of limitations in civil enforcement actions. Section 3.1.2 of the SEC Enforcement Manual states that “certain claims are not subject to the five-year statute of limitations under [28 U.S.C. § 2462], including claims for injunctive relief and disgorgement.” Thus the Enforcement Manual characterizes disgorgement as an equitable remedy—not a penalty—to be considered by the SEC in assessing the societal interest when determining accountability. See, e.g., SEC Enforcement Manual § 6.1.1(c)(4). Punitive remedies, or penalties, on the other hand, are time-barred if they are not pursued within the statute of limitations. Gabelli v. SEC, 133 S. Ct. 1216 (2013).
Courts and administrative tribunals have generally agreed with the characterization of disgorgement paid to the SEC as an equitable remedy for the purposes of the five-year statute of limitations. Administrative Law Judge Cameron Elliott, in In re Matter of Timbervest, LLC, et. al., Release No. 658 (Aug. 20, 2014), found “[d]isgorgement is an equitable remedy that requires a violator to give up wrongfully obtained profits causally related to the proven wrongdoing.” (citing SEC v. First City Fin. Corp., 890 F.2d 1215, 1230-32 (D.C. Cir. 1989)). As annunciated in Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996), the five-year statute of limitations does not apply to disgorgement. However, as the United States Supreme Court held, the five-year statute of limitations does apply to civil monetary penalties because they are penal in nature. See Gabelli v. SEC, 133 S. Ct. 1216 (2013).
Thus, the recent CCA appears to conflict with the SEC’s position on disgorgement. The IRS position is that the disgorgement at issue is punitive rather than compensatory and therefore is a nondeductible “fine or penalty.” In contrast, the SEC characterizes disgorgement as equitable relief (i.e., not a penalty) and specifically relies on that characterization when arguing to the courts that disgorgement should not be subject to the five-year statute of limitations applicable to SEC penalties. The CCA also conflicts with previous guidance determining that disgorgement is not subject to the section 162(f) limitation. Can the government really have it both ways by saying disgorgement is a penalty when it comes to tax deductibility but not a penalty for purposes of the statute of limitations? We doubt it, and we suspect fair-minded jurists will agree when given the opportunity.
1A Chief Counsel Advice is nonprecedential guidance from the IRS Office of Chief Counsel.
2 See Wang v. Commissioner, T.C. Memo 1998-389, aff’d, 35 Fed. Appx. 643 (9th Cir. 2002); LAFA 20152103F (holding that disgorgement payment made as a result of alleged violations of the Federal Food, Drug, and Cosmetic Act was likely deductible and not subject to the section 162(f) limitation).
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