Corporations may be facing stricter rules on how they report their deductible settlement payments under the recent tax law—unless the IRS opts to write more lenient guidance, as some tax professional are requesting.
The new reporting requirements in the 2017 tax act (Pub. L. No. 115-97) are meant to boost transparency in corporate settlements and make it easier for the IRS to keep track of how much of a settlement payment a company is—and should be—writing off.
”The vaguer the guidance is, the more opportunities corporations have” to find loopholes, Michelle Surka, director of the watchdog U.S. Public Interest Research Group’s Campaign for Budget Transparency, told Bloomberg Tax.
Some tax professionals have asked the IRS for more business-friendly guidance. They’ve requested that the agency not apply the new requirements to cases involving foreign governments, adopt “a rebuttable presumption” that stated deductible amounts are accurate in certain cases, and provide flexibility in how deductible payments are defined.
The IRS in March requested comments on the new rules, such as how to define certain terms and “any anticipated administrative difficulties in securing information needed to report” as required by an added code section. The agency has separately asked for input on how thoroughly it should investigate settlement agreements, as well as the kind of documentation it should use to substantiate them.
“The more closely the IRS can examine these agreements, the better,” Surka said. She cautioned, however, that IRS investigations of suspicious settlements are “easier said than done,” as “the IRS is obviously understaffed and underfunded.”
Tax code Section 162(f), before the new tax law, barred deductions for fines and penalties paid to governments for violations of the law. The tax act amended it to also apply to payments to or mandated by governments and similar entities for an investigation into a potential violation.
Even with these restrictions, companies can deduct portions of their settlements characterized as restitution for damage caused by the violation of a law, remediation of property, or compliance costs—money paid to come into compliance with any law that was broken or potentially violated. Companies can claim the deductions, tax professionals told Bloomberg Tax, as long as they can back it up with evidence and get those terms in the settlement agreement.
While the restitution and compliance amounts must now be listed in the settlement for the company to write off the expenses, that “alone shall not be sufficient” to establish deductibility, amended Section 162(f) states. The company, as always, must submit this information to the IRS, but the tax law’s new Section 6050X says that the government or similar entity in a case must do so as well.
John Moriarty, IRS deputy associate chief counsel (Income Tax and Accounting), suggested earlier this year that thorough examinations of these agreements may be rare, and the IRS has said it wants taxpayer input on how far it should go in exercising its right to scrutinize those agreements and what proof should be necessary.
The IRS “might, under different facts and circumstances, look behind and look for further evidence” beyond the settlement agreement, he said during a February American Bar Association tax section meeting in San Diego. However, he said, “it would surprise me if that happened often.”
Guidance on Sections 162(f) and 6050X is a priority for the IRS, as indicated by the most recent update to its 2017-2018 Priority Guidance Plan, in which those provisions made the shortlist of 2017 tax law measures given the most urgent attention.
What Taxpayers Want
The American Institute of CPAs wrote a June 13 letter to Moriarty and IRS Associate Chief Counsel (Income Tax & Accounting) Scott Dinwiddie asking the agency to make “a rebuttable presumption,” in certain circumstances, “in favor of a taxpayer” that the requirements of the section outlining exemptions for restitution and compliance “are satisfied.”
Absent such a presumption, the group said, “there is a concern about undermining the certainty” of amounts identified as deductible under the tax law, as the new rules could be “interpreted to place an additional burden on the taxpayer” by requiring them to thoroughly establish that the amount is in fact a restitution or compliance payment. The AICPA publicly released the letter on its website on June 18.
The law firm Skadden, Arps, Slate, Meagher & Flom LLP, in a June 11 letter to acting IRS Commissioner David Kautter released June 12 under the Freedom of Information Act, asked for guidance to allow some flexibility around the term “restitution.”
“Given the multiple meanings of ‘restitution,’ it will be difficult for parties to agree to use that term in settlement agreements” when the term is restricted to a single, specific definition, the firm said. “To avoid problems associated with forcing taxpayers to advocate for mislabeling of awards, the proposed regulations should allow for alternative identifying terms that will enable taxpayers to retain the deduction.”
Skadden also requested that the new rules “not apply to payments made to foreign governments.” But if the IRS does let them apply to foreign cases, and the government party to a settlement doesn’t follow the reporting requirement, “taxpayers should be given leniency” regarding the identification of deductible restitution or compliance payments in the agreement.
In cases brought by U.S.-based government entities, however, “we believe the government’s reporting obligation will help to facilitate negotiations between the parties with regard to identifying the portion of any payment made that constitutes restitution,” the firm wrote.
The amount a company plans to spend on working to comply with the law, which the amended code now mandates be stated in the agreement, may differ from what the company ultimately spends on compliance, the letter said. As long as the agreement lists some sort of plan of action the company must take to comply, the law’s requirement that deductible compliance expenses be listed in the agreement “should be treated as met,” it continued.
A Fair Question?
“Give me a break—of course it includes foreign governments. The old statute included foreign governments,” Steve Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, said in reaction to the letter from Skadden. “The short answer is: Don’t settle with a foreign government unless they give you that statement” establishing what are and aren’t deductible payments, he added.
As for the AICPA’s suggestion that the IRS adopt a “rebuttable presumption” in favor of taxpayers, Rosenthal said, “the facts are in the control of the taxpayer—they can arrange what they want to arrange. They shouldn’t get a rebuttable assumption.”
The IRS shouldn’t grant such leniency, he added. But, echoing other tax professionals, Rosenthal said the agency doesn’t have the resources to investigate those agreements, a problem the law was intended to fix by requiring stricter reporting standards.
Kat Saunders Gregor, a tax partner at Ropes & Gray LLP in Boston, said it was fair for Skadden to urge the IRS to disregard Section 6050X in cases brought by foreign governments, as most reporting requirements are established by intergovernmental agreements and treaties—not laws unilaterally passed by one country.
The AICPA’s circumstances for a rebuttable presumption, she added, “make sense.” Cases under the False Claims Act, for example, would encompass cases in which a company overcharged the government and has to pay the government back. The group’s request for a safe harbor limiting the application of the statute’s language, she said, was simply a rational plea for some definitional guidance on what many tax professionals describe as vague wording.