Regulators Look to End Tax Deductions on Fines

Regulators hit companies with a record amount of fines and penalties last year for everything from Foreign Corrupt Practices Act violations to money laundering. Not all of it, however, will take a toll on the bottom lines of perpetrators.

That's because some companies are exploiting a longstanding loophole used to claim tax deductions for punitive fines after they reach settlements with government agencies, such as the Securities and Exchange Commission or the Department of Justice. The SEC and the Justice Department are now looking to close such loopholes.  

A new study from U.S. Public Interest Research Group, a consumer advocacy organization, finds that American taxpayers are subsidizing a portion of the fines. The report, titled “Subsidizing Bad Behavior,” spotlights what it says is the “common practice” of companies claiming fines and penalties as tax-deductible business expenses by utilizing “ambiguities in the tax law to avoid paying a significant portion of such payments.”

For example, after BP settled with the government in 2010 to pay victims of the Deepwater Horizon disaster in the Gulf of Mexico, the oil giant claimed $10 billion in tax savings by writing off $37.2 billion put aside for expenses related to the oil spill.

Similar maneuvers date back further. Following the infamous Exxon Valdez oil spill in 1989, the government's $1.1 billion settlement ended up only costing the oil company slightly more than $524 million once deductions were carved away.

A 2005 report from the Government Accountability Office studied the practice of deducting a portion of government settlements; of the 34 it tracked that year, it found that 20 of the entities fined deducted a portion of their penalty. That same year, when insurance brokerage firm Marsh & McLennan negotiated an $850 million fine with New York Attorney General Eliot Spitzer to settle price-fixing fraud charges, it was able to wash away approximately $300 million via tax deductions.In 2006, Boeing agreed to a $615 million settlement with the Department of Justice over allegations it improperly used competitors' proprietary information to procure government contracts. Plans to deduct a portion of that settlement fueled such ire on Capitol Hill – notably from Sen. John McCain (R-Ariz.) – that it ultimately decided not to do so.

Earlier this month, Bank of America agreed to an $11.6 billion negotiated settlement with Fannie Mae to resolve charges that its Countrywide Financial subsidiary sold the agency mortgages obtained with improper underwriting and other practices. Separately, 10 banks also agreed to pay $8.5 billion in  benefits to homeowners for violating regulatory procedures and foreclosing on hundreds of thousands of properties. Phineas Baxandall , U.S. PIRGS's senior analyst for tax and budget policy, says these settlements also have the potential to be reduced through tax deductions.

Unless the Internal Revenue Service or other agencies take moves to explicitly forbid it, these banks could write off the cost of these settlements as ordinary business payments and “taxpayers will be forced to pick up a significant part of the tab,” Baxandall says, estimating it could be the “equivalent of giving a $4 billion tax subsidy to Bank of America and a $2.9 billion subsidy to the other banks.” Whether or not these banks take advantage of this, however, won't be known until they file taxes for the year.

The U.S. tax code clearly prohibits companies from deducting any portion of fines and penalties they agree to pay to U.S. government agencies, such as the SEC, as restitution for bad behavior. The rules are less clear, however, for government-negotiated settlements that include restitution paid to private parties. Baxandall explains that the banks could deduct the portion of these payments.

Moreover, settlements often fail to make clear what specific portion of a settlement should be regarded as punitive, U.S. PIRG says. Corporate tax attorneys take advantage of the ambiguity and deduct these expenses as a normal business expense.

They are aided in doing so because tax laws allow companies to deduct payments of “compensatory damages” for the results of business risk taking that are not specifically singled out for punishment. Also, in most cases, settlements from class-action lawsuits are deductible.

A large tax deduction from a settlement can prove very valuable, even if a company would not report taxable profits that year. They can “carry forward” their taxable losses to future years and eliminate future taxes. Likewise, they can also apply these losses backward to eliminate tax liability for up to two previous years.

“Unless the agency really provides specific instruction as to the tax treatment of the settlement payments, a corporation usually claims them as compensatory damages paid as some sort of restitution to an injured party,” says Ryan Pierannunzi, tax and budget associate with U.S. PIRG. “They say it is a normal cost of business they should be able to deduct just as they would with any other cost they incur.”

“There is plenty of power that federal agencies, both regulators and the IRS, have to improve their communication. If it is not stated clearly, corporations are going to deduct as much as they can.”

—Ryan Pierannunzi,

Tax and Budget Associate,

U.S. PIRG

The problem is nothing new, but past efforts to prevent it have failed to gain traction. In 1969, when the tax code was updated, language was added regarding payments made for liability or potential liability not being counted as being normal business expenses. “That's still on the books, but because there often doesn't seem to be a clear distinction between what is considered payments for potential liability or for an acceptable business expense that's where these problems occur,” Pierannunzi says.

Presidents Clinton, Bush, and Obama have all advocated making punitive damages to private parties non-deductible.

Numerous members of Congress have also tried to address the issue, including Senators Chuck Grassley (R-Iowa), John McCain (R-Ariz.) and Max Baucus (D-Mont.), who co-sponsored the Government Settlement Transparency Act of 2003 which would have ended deductibility for settlements. The Treasury department also addressed the issue with a proposal in 2009, as did a bill sponsored by Sen. Harry Reid (D–Nev.) in 2010.  These efforts, however, failed to gain needed support.

In a report by the Heritage Foundation, a conservative think tank, Hans Anatol von Spakovsky, a former member of the Federal Election Commission, detailed opposition to such a move. Increased liability risks and costs will “likely cause businesses to cut jobs, decrease investments in research and development, scale back expansion plans, and pass higher costs to consumers,” he wrote, adding that “eliminating the deductibility of punitive damages will encourage plaintiffs' lawyers to file even more lawsuits, further clogging dockets across the country and increasing the cost of litigation.”

Spakovsky says it would be an “unwise practice” to use the tax code to achieve public policy or social objectives and make it harder for regulators to negotiate settlements.

BAD BEHAVIOR

The following is an excerpt from the study “Subsidizing Bad Behavior” by U.S. PIRG.

A variety of members of Congress have also sought to ensure that settlement payments to government agencies not be deducted.

In 2003, Senators Chuck Grassley (R-IA), John McCain (R-AZ), and Max Baucus (D-MT) cosponsored the “Government Settlement Transparency Act of 2003,” which would have ended deductibility for settlements paid “in relation to the violation, or potential violation, of any law,” with the exception of restitution payments.

Introducing the legislation on the floor of the Senate, Senator Baucus stated that:

“Over the past several months, we have become increasingly concerned about the approval of various settlements that allow penalty payments made to the government in settlement of a violation or potential violation of the law to be tax deductible. This payment structure shifts the tax burden from the wrongdoer onto the backs of the American people. This is unacceptable...With these efforts to achieve greater accountability in the business community and ensure the integrity of our financial markets, it is important that the rules governing the appropriate tax treatment of settlements be clear and adhered to by taxpayers.”

In 2006, Senator John McCain criticized the Department of Justice for not explicitly ensuring in its negotiated settlement with the defense contractor Boeing that the payments would not be tax deductible:

“My other concerns relate to how the Justice Department handled the deductibility issue. In response to a letter I sent to the Justice Department, with Chairman Warner and Finance Committee Chairman Grassley, the Department explained that its policy was not to address deductibility in its fraud settlement agreements.

“While the Justice Department's policy may make sense in relatively low-quantum settlements, in high-quantum settlements, it might not. That's be- cause how the Government addresses corporate misconduct that gives rise to settlements of $100 million or more, has policy implications: if the settlor is permitted to recover what it pays to the Government from any third- party, that is, either the taxpayer or its insurers, the deterrence value and punitive effect of the settlement will be diluted. In defense procurement fraud and public corruption cases, like this one, deterrence value and punitive effect are everything.

“Therefore, in high-quantum corporate fraud settlements, the Department might want to revise its policy by specifically allocating the payments under a given settlement as either penalty or otherwise, and specifically prohibit the settlor from recovering penalty from any third-party. Particularly in defense procurement fraud cases, this could really make a difference.”

Source: U.S. PIRG.

In the absence of legislative action, some agencies are taking matters into their own hands. The SEC has now instituted a policy requiring that its settlements must include language that make it clear that penalty payments are not tax deductible. In keeping with that policy, it required that its $535 million civil penalty agreement with Goldman Sachs in 2010 would not be tax deductible. The agreement explicitly states that: “the civil penalty shall be treated as a penalty paid to the government for all purposes, including tax purposes.”

The Department of Justice has also taken a similar approach with recent settlements. When BP agreed to a $4.5 billion settlement with the Justice Department in November, for example, over the Deepwater Horizon oil spill in the Gulf of Mexico, it was expressly stipulated that none of that penalty could be used for a tax write-off.

At the Department of Justice press conference announcing the settlement, Lanny Breuer, assistant attorney general for its criminal division, took the extra step of addressing the tax issue: “The Attorney General was very clear that nothing in the criminal settlement could be tax deductible, nor could it be an offset to any further civil resolution, and that was the very explicit term of these agreements.”

The Department of Justice included similar language in the $500 million settlement with UBS AG last month over charges it manipulated the London interbank market interest rates. U.S. PIRG points out, however, that no such provision was included in the $700 million portion that will be paid to the Commodities Futures Trading Commission.

More can be done by federal agencies U.S. PIRG says. Its report offers a variety of recommendations:

The President should instruct federal regulatory bodies to assume full responsibility for determining the extent to which settlement payments are punitive and therefore nondeductible.

All federal agencies should be instructed to publicize the expected after-tax amounts of settlements, which would more accurately report the net penalty that will be paid by the corporation.

Congress should prohibit the tax deduction of punitive settlement payments to private parties.

Regulators should clearly define and distinguish between the agreed-upon punitive payments that will not be tax deductible and normal costs of doing business.

Any publicly traded corporations that deduct the whole settlement or just part of it with federal agencies should be required to provide brief justification for deducting such expenses on their annual filings with the SEC.

“There is plenty of power that federal agencies, both regulators and the IRS, have to improve their communication,” Pierannunzi says. “If it's not stated clearly, corporations are going to deduct as much as they can.”