The Department of Justice’s $20.8 billion settlement with a BP Plc subsidiary over the Deepwater Horizon oil spill raised some eyebrows.
The oil giant could write $15.3 billion off its taxable income, the U.S. Public Interest Research Group, a watchdog organization, said at the time of the 2015 deal. (BP declined to comment for this article, but told the Wall Street Journal at the time that it “follows the U.S. tax code in accounting for expenses related to the accident.”)
The group urged the federal government to be more explicit in defining what’s deductible and what isn’t in settlement agreements with corporations, and said the DoJ “should go farther and make sure that the entirety of the settlement is non-deductible, regardless of how the money is spent.”
The 2017 tax act (Pub. L. No. 115-97) addressed the first recommendation, but may have given companies, in certain cases, the chance to deduct even more. The law, in jurisdictions where the company isn’t a taxpayer, created incentives for both parties negotiating a settlement agreement to inflate those amounts—and therefore what they can write off—tax professionals told Bloomberg Tax.
Cats, Mice, and Lipsticked Pigs
The tax overhaul defines categories of court-ordered expenses specifically eligible for deductions, providing corporations with certainty about how much they can deduct upfront.
Prior to the law’s changes, companies could deduct a court-ordered payment if they had proof it was compensatory to victims of the alleged law-breaking.
Under amended tax code Section 162(f), penalties or fines for a violation of the law, and now an investigation into a potential violation, aren’t deductible, but payments toward restitution, remediation, and coming into compliance with the law are now explicitly carved out for deductions.
With those exceptions, a company would likely “try to move as much to restitution as possible,” said Alan Feld, a professor at Boston University School of Law.
The law creates a new twist on an old cat-and-mouse game, said Richard Pomp, a professor at the University of Connecticut School of Law. Still, Pomp and others said, flagrant abuse won’t pass muster with the Internal Revenue Service.
“I would say this is probably an example of an old Wall Street adage: You make money as a bull, you make money as a bear, but you never make money as a pig,” Pomp said. As for companies that go too far in inflating their deductible restitution payments, he added, “The IRS may say, ‘You put lipstick on a pig.’”
U.S. PIRG Campaign for Budget Transparency Director Michelle Surka, who was quoted in the group’s response to the BP oil spill, praised the tax law’s changes.
“In the past it was really mired by uncertainty. Old 162(f) was super vague,” she said. Referring to certain portions of settlements, she added, “the IRS wasn’t equipped with the ability to determine whether or not it was actually deductible.”
Surka said, however, that “there is certainly room to take advantage of that system.”
‘More Incentivized to Play Ball’
When negotiating settlements, the companies or individuals accused of wrongdoing and the government entity bringing or building the case generally have diverging interests. The former wants to pay a little and deduct a lot; the latter wants the company to pay a lot and deduct as little as possible.
But in cases pitting a foreign, state, or local government against a U.S. company or person not based in that jurisdiction—and therefore not paying taxes to that government—those interests may instead dovetail.
A corporation may agree to a larger overall settlement as long as a substantial portion is classified as restitution or compliance payments, because those portions are deductible, tax professionals said. And cash-strapped state and local governments “may very well be willing” to allow the company to allocate a large sum to restitution if the full amount of the settlement can be larger, said Scott Levine, a partner at Jones Day in Washington.
“I suspect, all things being equal, they would be more incentivized to play ball, because they might be able to get a larger settlement,” he said.
In Foreign Courts
New tax code Section 6050X requires governments and similar entities to file with the IRS a form detailing payments under a settlement agreement.
The law’s “two-pronged approach”—filings from both sides of a settlement—should help ensure there’s no abuse by corporations, even in foreign courts. Also, it “will hopefully be easier for the IRS” to keep the rules from being exploited, said Rachel Partain, a member of Caplin & Drysdale, Chartered, in New York, whose practice focuses on tax controversy and litigation.
Even so, she said, “the taxpayer could say, ‘Hey, jurisdiction, this should be restitution and I’ll put a little more on.’” If a country’s government files the form mandated by 6050X and it matches with the defendant’s filing, Partain added, “taxpayers have every incentive to get that restitution up.”
The IRS, however, can’t compel foreign governments to report settlement amounts with U.S. taxpayers under 6050X.
Other problems may arise from differences in legal vocabulary between countries, as a “settlement” or “restitution” may go by other names in a foreign jurisdiction, said Kat Saunders Gregor, a tax partner at Ropes & Gray LLP in Boston.
Fortunately for companies, however, the defendant must only get the restitution and compliance amounts into the settlement agreement and, separately, prove that they are in fact restitution or compliance payments in order to get the amount deducted, she said. But they should calculate those figures carefully and reasonably, she added.
“I think it’s a weighing factor—people will want to identify the maximum amount as restitution, but there will have to be back-up for it,” Gregor said. “They can’t just arbitrarily pick a number.”
State and local governments should take caution when submitting their 6050X forms, she said, as it “could be a pretty scandalous outcome if a particular state agency were actually verifying to the IRS directly amounts that were not in fact restitution.”
Lack of Resources
The IRS said that while it reserves the right to take a closer look at those settlements, the extent to which it should do so, and how much documentation should be needed to approve the deduction, are still open questions. The agency asked for comments on the new deductibility rules in its March 27 Notice 2018-23.
The notice also gave government entities more time to send settlement information required under Section 6050X, as “programming and form changes” are still needed.
Any IRS audit of a suspicious settlement agreement would likely be “thorough,” and the decision to scrutinize a particular agreement will surely be more than “a superficial determination based purely on the parties’ allocation to restitution,” retired IRS special trial attorney John McDougal wrote in an email.
“However, the likelihood of an audit on this or any other issue that isn’t at the top of the IRS’ priority list is slim, because of the lack of resources,” he continued, citing declines in staffing levels over the last several decades.
The agency likely won’t funnel resources into investigating settlement reporting more generally, John Moriarty, IRS deputy associate chief counsel (Income Tax and Accounting), said during an American Bar Association tax section meeting in San Diego in February. In fact, he said during the event, “it would surprise me if that happened often.”