Over the past decade, the U.S. Securities and Exchange Commission (SEC) has increasingly applied a cocktail of "fines, penalties, and disgorgement" of profits when entering into negotiated settlements of enforcement actions brought under the U.S. Foreign Corrupt Practices Act (FCPA). The Securities and Exchange Act of 1934 authorizes the SEC to use disgorgement as an enforcement vehicle to prevent unjust enrichment and to deter violations of federal securities law. The SEC first began to impose disgorgement in the FCPA context in 2004. In the last three years alone, the SEC has extracted more than $940 million from companies in connection with FCPA-related dispositions, of which approximately $829 million has been disgorgement, $59 million has been civil fines and $53 million has been prejudgment interest.

Whether the fines, penalties or disgorgement paid to resolve enforcement actions involving the FCPA and other laws are deductible for federal income tax purposes is an area of keen interest for companies subject to such actions. To date, there has been limited guidance on whether disgorgement is tax deductible. Generally speaking, the tax law (Internal Revenue Code Section 162(f)¹) provides that no deduction shall be allowed for any fine or similar penalty paid to a government for the violation of any law. The policy behind this rule is that a taxpayer should not be permitted to enjoy a tax benefit from the payment of an amount intended to be punitive and to deter a particular type of behavior. In contrast, compensatory damages, which are intended to remedy a specific harm caused by the taxpayer, but are not intended to punish the taxpayer for causing the damages, are not considered fines and penalties and can be deducted. To determine whether a taxpayer's expenditures are remedial or punitive, courts apply a facts-and-circumstances test, including an examination of the intent of the judge or agency imposing the expenditure, the statute authorizing the expenditure and whether the substance of the expenditure is different from its form.

Recently, the Internal Revenue Service (Service) publicly released an internal memorandum that addressed the tax consequences of disgorgement paid by a particular taxpayer to the SEC.

Before we discuss the substance of this memorandum, it is important to note that this type of internal memorandum (referred to as Chief Counsel Advice or CCA) is not precedential and cannot be cited as authority. This CCA emanated from the Service's audit of a particular taxpayer and reflects the advice given to the audit team by an office within the National Office of the Service's Chief Counsel. While not precedential, this CCA may well reflect the position that could be taken in audits of other taxpayers who have made payments to resolve FCPA enforcement actions. The CCA could also reflect the beginning of the coordination of those audits by a group within the Service. In order to protect taxpayer confidentiality, the CCA is heavily redacted and uses generic terms (such as "Country"), which complicates deciphering the facts of the particular situation. Nevertheless, companies that have made (or may make) payments to resolve FCPA cases would be well advised to review the CCA to understand the positions the Service could be expected to take if a deduction were to be challenged in an audit by the Service.

The CCA concludes that section 162(f) prohibits this taxpayer, who, according to the SEC complaint, violated the accounting provisions of the FCPA, from deducting the disgorged amount. In this particular case, a subsidiary of a company incorporated and headquartered in the United States intentionally falsified its books and records. These falsifications were subsequently consolidated into the U.S. taxpayer's books and records and reported in its financial statements. The CCA also notes that the taxpayer failed to implement adequate internal accounting and financial controls. As part of the resolution of the ensuing enforcement action, the taxpayer entered into a consent agreement with the SEC. Under the consent agreement, the taxpayer was required to, among other things, "disgorge" a specified amount in ill-gotten gains attributable to the alleged misconduct while also paying a separate "civil penalty" relating to the same alleged misconduct. The penalty amount could be reduced (dollar-for-dollar) for any amount the foreign entity was required to pay as a criminal penalty in a separate proceeding, and the consent agreement specifically provided that the penalty amount was not deductible for tax purposes. The consent agreement was silent with respect to whether the disgorgement amount was deductible.

In its analysis, the CCA explains that courts "have held that section 162(f) prohibits a deduction for civil penalties 'imposed for purposes of enforcing the law and as punishment for the violation thereof,' and courts have also held that some payments, although labeled as 'civil penalties,' are deductible if 'imposed to encourage prompt compliance with a requirement of the law or as a remedial measure to compensate another party.'" The CCA also notes that if "a payment serves both a nondeductible purpose and a deductible purpose, it is necessary to determine which purpose the payment primarily serves. . . . Thus, a payment imposed primarily for purposes of deterrence and punishment is not deductible under section 162(f)." (citations omitted).

According to the CCA, disgorgement payments can be primarily compensatory or primarily punitive, depending on the facts. For example, if the amount of profit disgorged equals the victims' losses or is used as a means to obtain compensation for harmed investors, then disgorgement can be primarily compensatory for the purposes of section 162(f). On the other hand, if the disgorgement serves primarily to prevent the wrongdoer from profiting from the illegal conduct or is used as a direct substitute for a civil penalty, then it is primarily punitive and not deductible. The CCA's position that disgorgement payments can be primarily compensatory or primarily punitive is not clearly supported. The case cited by the CCA, SEC v. Contorinis, plainly states that, "disgorgement does not serve a punitive function." 743 F.3d 296, 301 (2d Cir. 2014).

In this case, the CCA found the absence of certain facts -- namely that the taxpayer presented "nothing" to indicate "that the purpose of the disgorgement payment was to compensate the United States Government or some non-governmental party for its specific losses caused by Taxpayer's violations of the FCPA" -- determinative. Concluding that the disgorgement payment is primarily punitive, the CCA advised that it is not deductible pursuant to section 162(f).

The CCA is notable for several reasons.

First, if the CCA indeed reflects a movement by the Service to more aggressively challenge deductions of disgorgement payments in FCPA cases, this question, as the CCA notes, is largely a factual one. Taxpayers have an inherent advantage over the Service in terms of the access to the facts and the prospect for ensuring favorable facts are appropriately memorialized at the time the FCPA case is resolved.

Second, the CCA highlights a potential inconsistency in how the Service and the SEC view disgorgement and, in particular, when each considers disgorgement to be "punitive." The CCA could be read as leaning in favor (perhaps heavily in favor) of finding any disgorgement as being punitive (and thus not deductible). The SEC has historically viewed disgorgement as only an equitable remedy that may not be imposed if it is "punitive." This view is consistent with the views of many courts, such as the Second Circuit in Contorinis, which is cited in the CCA even though arguably inconsistent with the memorandum's analysis, and the DC Circuit in SEC v. First City Fin. Corp., which states that although it may be key to the SEC's efforts to deter others from violating the securities laws, "disgorgement may not be used punitively." 890 F.2d 1215, 1230 (DC Cir. 1989).²

If the Service's view of disgorgement aligns with the SEC's view, there would be, in theory, no tax issue. There would be no punitive disgorgement by the SEC, so the issue addressed by the CCA would not arise. Under the analysis in the CCA, however, even disgorgement that the SEC deems to be equitable could be considered by the Service to in fact be punitive. If the views reflected in the CCA were adopted more broadly, the resulting non-deductibility would mean that the disgorgement of profits on which the company may already have paid taxes would not be deductible. If conflicting agency interpretations remain, a taxpayer potentially subject to disgorgement may well argue to the SEC that disgorgement should not be imposed because, for tax purposes, disgorgement would be treated as "punitive." If disgorgement was nonetheless imposed, the taxpayer could argue to the Service that the amounts disgorged should be deductible because they are equitable, not "punitive," in the eyes of the SEC.

Third, according to the CCA, the taxpayer agreed to pay the disgorgement along with prejudgment interest. The CCA does not indicate whether prejudgment interest is deductible. But if the Service extends its section 162(f) analysis to such interest, it would have serious financial implications for companies since prejudgment interest can be significant.

The implications of the anomaly of the potentially different views of disgorgement by the SEC and the Service could affect not just deductibility of disgorgement payments, but also whether disgorgement could be imposed after the statute of limitations has run or, even, the general characterization of disgorgement as a non-punitive sanction.  

1. Unless otherwise stated, all references to "Section" are to the Internal Revenue Code of 1986, as amended.
2. Of note, on May 26, 2016, the Eleventh Circuit issued an opinion on a related issue: whether the SEC was correct in arguing that disgorgement, as an equitable remedy, was not subject to the five-year statute of limitations in 28 U.S.C. § 2462, which applies to "any civil fine, penalty, or forfeiture." In Graham, the Eleventh Circuit avoided the question of whether disgorgement could be considered a "penalty," and instead found that the five-year statute of limitations applied because disgorgement fell within the broader definition of "forfeiture" under the statute. SEC v. Graham (No. 14-13562). 

For more information, please contact the following authors:

Kathryn Cameron Atkinson, katkinson@milchev.com, 202-626-5957

George A. Hani, ghani@milchev.com, 202-626-5953

Maria O'Toole Jones, mjones@milchev.com, 202-626-6057

Homer E. Moyer, Jr., hmoyer@milchev.com, 202-626-6020

Marc Alain Bohn*

Natasha Goldvug*

Irina Anta*

*Former Miller & Chevalier attorney

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