August 28, 2014

First Circuit Rules on Tax Deductibility of False Claims Act Settlements

By Jason Enzler

The First Circuit Court of Appeals issued a decision recently on a matter of first impression for the circuit: whether courts may consider factors outside of settlement agreements in False Claims Act cases in order to determine whether portions of a settlement can be deducted from a defendant’s tax liability. In ruling that courts can indeed look beyond the agreements, the First Circuit in Fresenius Medical Care Holdings, Inc. v. United States arguably has broken ranks and issued a holding at odds with a prior decision by the Ninth Circuit.

The case involved Fresenius Medical Care Holdings, a large operator of dialysis centers, and its decision to settle what the Court termed a “gallimaufry” of claims against the company, including False Claims Act allegations. Fresenius paid over $100 million in criminal fines and an additional $385 million to resolve the civil charges. Following a trend common among alleged fraudsters, Fresenius then sought to deduct the settlement payment from its tax liability.

U.S. law generally allows businesses to deduct damages or settlement payments as expenses, but does not allow deductions of payments to the government “for any fine or similar penalty” or to settle possible liability for such a fine or penalty. 26 U.S.C. § 162(f). Given the treble damages provision of the False Claims Act, a question arises as to what portion of a settlement is compensatory (therefore deductable) and what portion may be more punitive in nature (and not deductable).

The government and Fresenius agreed that the criminal fines were punitive and not deductable. The parties also agreed that roughly $192 million, an amount deemed to be equal to the single damages under the False Claims Act, and after some argument, another $65 million representing the amount paid to the qui tam relators, was deductable. In dispute was the status of a remaining balance of $126 million.

According to the government, a prior ruling by the Ninth Circuit in Talley Industries, Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 1997) created a rule making settlement amounts for False Claims Act cases “in excess of single damages” and “whistleblower fees” automatically non-deductable, unless the settlement agreement explicitly states otherwise. The First Circuit rejected this argument, holding that in the absence of such a tax characterization, courts could look beyond the agreement to the “economic reality” of the settlement. In this case, that resulted in an additional savings of $50 million for Fresenius.

While the government expressed several concerns with the possible outcomes of the tack the First Circuit has taken, the Court’s opinion also offers a solution. Instead of remaining silent about the tax characterization of settlement payments, the government can just start inserting provisions in its settlement agreements detailing how the payments will be treated. With the huge amounts of money at stake and businesses’ widespread practice of deducting damages and settlement payments, the potential for tax deductions is already part of the calculus when parties are considering settlement.

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