Investigations into potential violations of U.S. and non-U.S. securities laws are often resolved by a settlement requiring the business to make one or more large settlement payments. We have seen settlements paid to the DOJ, the SEC, other U.S. and non-U.S. regulators, and private plaintiffs. An important question is whether the payment will be deductible for tax purposes. Since 1969, the U.S. tax law has denied a deduction for “any fine or similar penalty paid to a government for the violation of any law.” This limitation was significantly changed by the U.S. tax reform law enacted in December of 2017 (known as the Tax Cuts & Jobs Act or “TCJA”). These changes, which had been proposed in Congress over 30 times since 2003 but not enacted until now, respond in part to disputes the IRS has had with taxpayers in the past.
Under the revised rule, which applies to settlement agreements and court orders finalized on or after December 22, a payment is non-deductible if
- it is paid to or “at the direction of”
- a government or governmental entity (or certain identified self-regulatory organizations),
- in relation to the violation of any law or an investigation or inquiry by such government or governmental entity into a potential violation of any law
subject to a narrow exception for certain payments of “restitution” or an amount paid to come into compliance with a law. See Section 162(f) of the Code, as amended by the TCJA (hereinafter “New Section 162(f)”). This exception is very narrow and will be met only if, among other things, the court order or settlement agreement specifies that the payment is restitution or an amount paid to come into compliance with the law.
This blog post will describe the new law in more detail and alert you to what you should be thinking about when negotiating resolutions of governmental and SRO investigations.
The Limitations on Deductions Under Section 162(f) Before the TCJA
Before the TCJA, the denial of the deduction applied if the amount was paid to a “government”, which included U.S. federal, state and foreign governments, political subdivisions thereof, and any entity serving as an agency or instrumentality of a government or political subdivision thereof. The IRS took the view that self-regulatory organizations such as FINRA or boards of exchanges constituted “agencies or instrumentalities” of a government under pre-TCJA Section 162(f). Pre-TCJA Section 162(f) was also interpreted to apply to amounts paid to non‑governmental victims if the origin of the liability giving rise to the payment was in the nature of a fine or penalty owed to a government and the government controlled or directed the payment, whereas a compensatory payment paid to a victim to restore the victim to its prior state was deductible.
The tax treatment of a disgorgement payment was a grey area: the IRS’s position was that a disgorgement payment was deductible if imposed for “primarily compensatory” purposes and not deductible if imposed primarily for deterrence and/or punishment purposes, and this would be a facts and circumstances determination in each case. The IRS modified its position in response to the June 2017 Supreme Court decision in Kokesh v. SEC, a securities law case, which held that a disgorgement payment in an SEC proceeding constituted a penalty for statute of limitation purposes. A few months later, in November 2017, IRS Chief Counsel formally took the position that, based on Kokesh, in securities laws, all disgorgement payments in relation to securities laws violations are penalties for purposes of Section 162(f) and therefore not deductible.
Changes Made by the TCJA
“Any Amount,” Not Limited to “Fine or Penalty.” The amendment enacted in December 2017 was written long before the Kokesh case (and indeed, a substantially identical amendment has been floated in Congress since 2003), and it does not directly address disgorgement payments. Instead, New Section 162(f) states a general rule that no deduction is allowed for “any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government in relation to the violation of any law or to the investigation or inquiry into the potential violation of any law.” Under the new law, whether a payment constitutes a fine or similar penalty is no longer controlling; a payment to a government relating to a violation (or investigation of a potential violation) of the law is not deductible unless an exception applies.
Expansions of Payees. As indicated above, the revisions respond in part to issues that had been the subject of disputes between the IRS and taxpayers. First, New Section 162(f) encompasses a payment made, not only to a government, but also a payment made at the direction of a government. Second, the definition of “governmental entity” is expanded to explicitly include non-governmental entities that exercise self-regulatory powers in connection with an exchange or board of trade governed by the SEC or the CFTC, and any self-regulatory agency exercising self-regulatory powers as part of performing an “essential government function” that has been explicitly identified as subject to this new rule in Treasury Regulations. This is significant because the IRS had taken the position that the prior law encompassed such self-regulatory entities, and now it has been made clear that only those specified in the New Section 162(f) or newly-issued Treasury Regulations are covered.
The Three Explicit Exceptions Under New Section 162(f). New Section 162(f) provides three exceptions where amounts paid to a government will be deductible.
The first is for amounts paid pursuant to a court order in a private lawsuit, a necessary clarification in light of the fact that New Section 162(f) applies to payments “at the direction of” a government, which could arguably encompass any payment pursuant to a court order.
The second is for amounts paid as taxes due. This exception is necessary because New Section 162(f) is not limited to fines and penalties; it applies to “any amounts” paid to a government which would pick up tax payments absent this exception.
The third exception, in New Section 162(f)(2), is for amounts that the taxpayer establishes constituted restitution or an amount paid to come into compliance with law. The taxpayer’s burden includes (but is not limited to) a requirement that the court order or settlement agreement explicitly state that the payment is restitution or an amount paid to come into compliance with the law. It is not clear what additional evidence or proof the taxpayer must provide to satisfy this burden.
The statutory language of New Section 162(f)(2) (requiring the taxpayer to demonstrate that the payment is restitution “for damage or harm” caused by the violation (or potential violation)) and the historical positions taken by the IRS suggest that the IRS will require taxpayers to prove that payments eligible for this exception are paid to the victims and are measured by the loss of the victims. As a result, SEC disgorgement amounts, to the extent they are measured by the wrongdoer’s unjust enrichment, will not be eligible for the exception.
What about disgorgement payments that are not measured by the wrongdoer’s gains? As explained above, in November 2017, before the new law was enacted, the IRS Chief Counsel adopted a new, bright line rule that all SEC disgorgement payments are penalties for purposes of Section 162(f). The IRS based this on the Supreme Court’s reasoning in its June 2017 Kokesh opinion.
In Kokesh, the Supreme Court held that an SEC disgorgement was a “penalty” in the context of applying the five-year statute of limitations in 28 U.S.C. § 2462. The Court reasoned that disgorgement is intended to deter future violations of the securities laws by depriving wrongdoers of their ill-gotten gains, which is inherently punitive. It also noted that since a district court has discretion to determine how and to whom the disgorgement payment will be distributed, such payments do not directly compensate victims. Relatedly, the Court reasoned that SEC disgorgement is imposed as a consequence of violations where the victim is the public at large, rather than an aggrieved individual. While Kokesh did leave some room for SEC disgorgement to be found to be an equitable remedy and not a “penalty,” the IRS Chief Counsel took a more rigid position that “all disgorgement” payments relating to the violation of a federal securities law are penalties and not compensatory. When interpreting the term “restitution” under New Section 162(f), the IRS is likely to rely on its previous analysis to conclude that an SEC disgorgement payment is not compensatory in nature (it is, instead, imposed as a penalty) and therefore cannot be characterized as “restitution for damage or harm caused by” the violation of law.
Government Reporting Obligations. The TCJA also imposes reporting requirements on governmental entities relating to New Section 162(f). Any government or governmental entity that is involved in a suit or agreement relating to a violation of a law over which the government or entity has authority must file a form setting forth (i) the total amounts required to be paid as a result of the suit or agreement which is within the scope of New Section 162(f) and (ii) any such amounts that are eligible for the restitution / coming into compliance with the law exception in New Section 162(f)(2).
This reporting requirement, along with the requirement that a court order or settlement must designate a payment as restitution or paid to come into compliance with the law in order to qualify for the exception in New Section 162(f)(2), may impact negotiations with the SEC or other governmental entities. Taxpayers should remember that reaching agreement with the payee will not guarantee that the IRS or a court will agree that the requirements of New Section 162(f) are met.
Implications and Opportunities
In general, New Section 162(f) may present an opportunity for companies to negotiate settlement agreements with a government in a manner that will satisfy the requirements for deductions; for instance, if a company agrees to distribute funds back to victims and key the settlement amounts to the amount of harm as opposed to the amount of unjust enrichment, the payments may be deductible. In the context of SEC enforcement actions, however, it will likely be difficult for defendants to characterize monetary payments in a way that satisfies the new tax law. Not only did the Supreme Court label disgorgement a “penalty” in Kokesh (rejecting the notion that it was primarily compensatory), the SEC only has authority to seek penalties and, in administrative proceedings only, disgorgement of ill-gotten gains; it does not have authority to seek restitution.
Companies should consider the potential advantage of settling civil class actions early and voluntarily repaying victims for their loss and then arguing that the repayment also satisfies any separate disgorgement obligation to a government. Payments made to settle lawsuits that do not involve a government fall outside the purview of New Section 162(f), as do payments made directly to victims as compensation. Both types of payments are generally deductible as business expenses under the normal U.S. tax rules.
The SEC has a well-settled practice of offsetting disgorgement by amounts repaid or distributed to investor-victims. The SEC’s offsetting practice is common when a defendant pays restitution to a victim in a parallel criminal proceeding, and when a defendant settles civil claims as well. Offsetting makes good sense: as one administrative law judge aptly stated, “it cannot be said that a respondent was unjustly enriched by amounts repaid to investors.” By compensating victims before an SEC settlement is reached, taxpayers can credibly argue to the SEC that a disgorgement order (calculated by ill-gotten gains) be offset by that amount. This puts a company in the best position to obtain favorable tax treatment of amounts ultimately repaid to victims and reduces the amount of non-deductible disgorgement payments.
Additionally, post-Kokesh, the SEC may be more willing to accept a defendant’s principled argument for limiting a disgorgement calculation. This is because of the uncertain future of the SEC’s ability to pursue disgorgement at all. In footnote 3 of the Kokesh opinion, the Supreme Court ostensibly invited a challenge as to whether disgorgement is available as an SEC remedy in enforcement actions:
Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context. The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to § 2462’s limitations period.
It is only a matter of time before a defendant presses the issue. And, if disgorgement is not an equitable remedy, which is what the Supreme Court concluded in Kokesh, then the SEC has no authority to seek disgorgement in district court proceedings. This could unravel the SEC’s ability (and eagerness) to seek disgorgement in administrative proceedings as well. As a result, the SEC may be more willing to limit disgorgement to an amount less than the total amount of ill-gotten gains, especially if presented with a reasoned argument, like an offset with amounts already paid to victims. Moreover, because civil penalties are limited by statute, the SEC will also be facing arguments that it cannot impose a penalty—including disgorgement—greater than the statutory limit. This too will put pressure on the SEC to limit disgorgement amounts.
While there may not be room for a business to argue that a disgorgement payment is restitution under New Section 162(f), businesses negotiating with the SEC should nevertheless evaluate the tax consequences of any payment before a settlement is finalized—and consider settling related private claims early.
 It has also denied a deduction for two-thirds of most anti-trust treble damages payments.
 Settlement agreements and court orders finalized before December 22 are subject to the old Section 162(f). See TCJA § 13306(a)(2).
 Treas. Reg. § 1.162-21(a).
 I.R.S. C.C.A. 201623006 (June 3, 2016).
 See, e.g., Allied-Signal, Inc. v. Comm’r, T.C. Memo. 1992-204, aff’d, 54 F.3d 767 (3d Cir. 1995); Waldman v. Comm’r, 88 T.C. 1384 (May 20, 1987).
 Treas. Reg. § 1.162-21(b)(2); C.C.A. 201619008 (Jan. 29, 2016).
 I.R.S. C.C.A. 201748008 (Nov. 17, 2017), published on Dec. 1, 2017.
 “New Section 162(f)” refers to Section 162(f) of the Code, as amended by the TCJA.
 New Section 162(f)(1).
 New Section 162(f)(5) provides that for purposes of New Section 162(f), “the following nongovernmental entities shall be treated as governmental entities: (A) any nongovernmental entity which exercises self-regulatory powers (including imposing sanctions) in connection with a qualified board or exchange (as defined in [26 U.S.C.] section 1256(g)(7)). (B) To the extent provided in regulations, any nongovernmental entity which exercises self‑regulatory powers (including imposing sanctions) as part of performing an essential governmental function.”
 New Section 162(f)(3) provides that the general rule barring deductions “shall not apply to any amount paid or incurred by reason of any order of a court in a suit in which no government or government entity is a party.”
 New Section 162(f)(4) provides that the general rule barring deductions “shall not apply to any amount paid or incurred as taxes due.”
 New Section 162(f)(2) provides that the general rule barring deductions “shall not apply to any amount that, (i) the taxpayer establishes—(I) constitutes restitution (including remediation of property) for damage or harm which was or may be caused by the violations of any law or the potential of any law; or (II) is paid to come into compliance with any law which was violated or otherwise involved in the investigation or inquiry described in paragraph (1)[.]”.
 New Section 162(f)(2)(A)(ii). See also New Section 162(f)(2)(A) (providing that “identification under clause (ii) alone shall not be sufficient to make the establishment required under clause (i)”).
 The new law explicitly disallows a restitution deduction for a reimbursement payment to a government for the costs of any investigation or litigation.
 Historically, the IRS allowed a deduction for payments as being “compensatory” (and not fines or penalties) only if they were paid to a victim and served to restore the victim to their prior state.
 I.R.S. C.C.A. 201748008 (Nov. 17, 2017).
 New Section 6050X.
 See 15 U.S.C. §§ 77h-1(e), 78u-2(e) (granting the SEC authority to require disgorgement in administrative proceedings); 15 U.S.C. §§ 77h-1(g), 78u-2(a) (granting the SEC authority to impose penalties in administrative proceedings); 15 U.S.C. §§ 77t(d), 78u(d) (granting district courts authority to impose civil penalties).
 By way of background, the SEC initially only had authority to obtain injunctive relief barring future violations of the securities laws; it had no authority to seek monetary remedies. But starting in the 1970s, and specifically in SEC v. Texas Gulf Sulfur, the SEC began petitioning district courts (with success) to order disgorgement as an exercise of their “inherent equity power to grant relief ancillary to an injunction.” SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 91 (S.D.N.Y 1970), aff’d in part and rev’d in part, 446 F.2d 1301 (2d Cir. 1971). Over time, the SEC’s ability to obtain disgorgement through the court’s equitable power became so routine that, in 1990, Congress explicitly authorized the SEC to seek disgorgement of ill-gotten gains in administrative proceedings and civil penalties in both district court and administrative proceedings. Today, the SEC’s authority to seek monetary penalties at all is limited to penalties and amounts constituting disgorgement. Additionally, there is no explicit statutory authority for the SEC to seek disgorgement in district court proceeding.
 See I.R.S. P.L.R. 200911002 (Mar. 13, 2009).
 SEC v. Palmisano, 135 F.3d 860, 863 (2d Cir. 1998) (“[t]o the extent he pays back the victims of his securities fraud as a result of the criminal restitution order, those payments should be credited towards the disgorgement award.”). See, e.g., SEC v. ETS Payphones, Inc., 408 F.3d 727, 735 (11th Cir. 2005) (“[T]he ‘power to order disgorgement extends only to the amount with interest by which the defendant profited from his wrongdoing. Any further sum would constitute a penalty assessment.’” (quoting SEC v. Blatt, 583 F.2d 1325, 1335 (5th Cir. 1978))); SEC v. Loomis, 17 F. Supp. 3d 1026, 1032 (E.D. Cal. 2014) (instructing the SEC to recalculate disgorgement figures accounting for funds repaid to investors); SEC v. Rockwell Energy of Tex., LLC, No. H-09-4080, 2012 WL 360191, at *3 (S.D. Tex. Feb. 1, 2012) (stating that defendants “must receive a set-off ‘for amounts repaid to investors’” (quoting SEC v. United Energy Partners, Inc., 88 F. App’x 744, 747 (5th Cir. 2004))); SEC v. Haligiannis, 470 F. Supp. 2d 373, 384 (S.D.N.Y. 2007) (“[C]ontributions may be considered ill-gotten gains as a result of the fraud, although distributions must be subtracted as they did not unjustly enrich defendant.”); SEC v. Monarch Funding Corp., No. 85-cv-7072, 1996 WL 348209, at *10 (S.D.N.Y. June 24, 1996) (“[I]t is axiomatic that disgorgement should be fashioned on the amount of ill-gotten gain currently realized by the defendant and not yet already repaid.”).
 In S.E.C. v. State St. Bank & Trust Co., the SEC credited the defendant for reimbursing investors more than $340 million through settlement of private actions. See Consent of Defendant State Street Bank & Trust Co., SEC v. State St. Bank & Trust Co., No. 1:10-cv-10172-DPW (D. Mass. Feb. 4, 2010); Consent Litigation Release No. 21408 (Feb. 4, 2010).
Similarly, in a 2012 enforcement action against Claymore Advisors, the IRS offset disgorgement in the amount the defendant voluntarily reimbursed shareholders for their loss. See; e.g., Claymore Advisors, LLC, Investment Company Act Release No. 30308, Admin. Proceeding 3-5139 (Dec. 19, 2012) (reporting that “the Commission is not imposing disgorgement, prejudgment interest, or a civil penalty based upon [the defendant’s] undertakings”. The undertakings included an agreement by the defendants to set up a fund to reimburse former shareholders for losses in excess of $45 million, “which represent[ed] 100% of the loss attributable” to the transactions at issue).
 Initial Decision on Default, Release No. 962, Admin. Pro. 3-15815, In the Matter of L&L Energy, Inc., and Dickson Lee, CPA, (Feb. 17, 2016).
This post comes to us from Cleary, Gottlieb, Steen & Hamilton LLP. It is based on the firm’s memorandum, “Settlement Payments Under the New Tax Reform Law,” dated February 21, 2018, and available here.