Author: Matt Huffman, Associate Member, University of Cincinnati Law Review
On August 13, 2014, the First Circuit addressed an issue of first impression in Fresinius Medical Care Holdings, Inc. v. United States, holding that a court may consider factors beyond a tax characterization agreement when determining the deductibility of a settlement payment under the False Claims Act (FCA). In so holding, the court rejected the government’s argument that the Ninth Circuit had appropriately adjudicated this issue in Talley Industries, Inc. v. Commissioner and that the only pertinent inquiry in determining the deductibility of an FCA settlement payment is whether a tax characterization agreement exists between the government and the settling parties. The court explained its disagreement with the Ninth Circuit: “[i]f Talley stands for the proposition asserted by the government, then Talley is incorrectly decided and does not deserve our allegiance.” In its decision, the First Circuit correctly parted from Talley and determined that the economic realities of a settlement agreement should be considered in the absence of a tax characterization agreement. Nonetheless, in adopting this test, the First Circuit should have gone further to hold that economic realities should not be ignored even in the presence of such an agreement. Considering that FCA settlements often involve hundreds of millions of dollars, the First Circuit’s decision will have significant tax consequences for companies settling FCA suits in the future.
The False Claims Act
The False Claims Act imposes liability if a person knowingly submits a false claim to the government or knowingly makes a false record or statement to have a false claim paid by the government. Additionally, what is known as “the reverse false claims” section imposes liability where one acts improperly in order to avoid having to pay money to the government. The statute provides that a liable individual must pay a civil penalty between $5,500 and $11,000 for each false claim, plus triple the amount of the government’s actual damages.
Whether a civil penalty like the FCA’s is deductible for federal income tax purposes depends on “the purpose which the statutory penalty is to serve.” If a civil penalty is punitive and therefore imposed to enforce a law, the payment is not deductible. However, if the penalty is compensatory and therefore imposed to encourage prompt compliance with a requirement of the law, or is imposed as a remedial measure to compensate another party for expenses incurred as a result of the violation, it is deductible.,
The Ninth Circuit’s Stance
In Talley, the Ninth Circuit considered the tax treatment of an FCA settlement over a defense contractor’s fraudulent conduct. The court started from the common understanding that FCA damages can serve both punitive and compensatory purposes. The court reasoned that, to the extent the settlement exceeded single damages to the government, the case presented a question “as to the characterization and the purpose of” that “excess” portion of the settlement. Because the settlement agreement in the case did not include detail regarding the tax characterization of the payment, the court remanded the case to the tax court with the direction to answer this question by determining “whether the parties intended the payment to compensate the government . . . or to punish” the taxpayer. The court also stressed that the taxpayer bore the burden of proving eligibility for deductions and would suffer the consequences of any lack of the parties’ intent. This decision has been interpreted to mean that any FCA civil settlement payment in excess of the government’s actual damages should be treated as punitive fines—and thus non-deductible—unless the parties have manifested a contrary intention, regardless of the economic reality of the settlement.
The First Circuit’s Stance
In Fresinius, the government relied on Talley for the proposition that only a tax characterization agreement between the government and the taxpayer can prove manifested intent regarding the tax characterization of a settlement payment. However, the First Circuit determined that a rule requiring a tax characterization agreement as a precondition to deductibility focuses “too single-mindedly on a parties’ manifested intent in determining the tax treatment of a particular payment.” The court reasoned that the government could simply refuse to agree to a tax characterization in every instance, therefore disallowing deductibility even when settlement payments were compensatory and not punitive. As a result, the court held that a tax characterization agreement is not a precondition to the deductibility of a settlement payment.
The court noted that, although the “holding may be at odds with the decision in Talley,” the court was “convinced that generally accepted principles of tax law compelled [the court] to part company with the Ninth Circuit.” But the First Circuit also noted that its intention was not to undermine the “intent” of settling parties. The court stated that if the government and a defendant settle an FCA claim and specifically agree as to how the settlement will be treated for tax purposes, the reviewing court should honor that agreement. However, in Fresinius the government and the taxpayer explicitly disagreed on the tax characterization of the settlement payment. Therefore, the court ruled it was appropriate to analyze the economically reality of the particular transaction to determine whether there was a compensatory purpose, and thus whether the payment was deductible. After analyzing the economic realities of the FCA settlement in Fresinius, the jury found that $95,000,000 of the $127,000,000 settlement payment should be considered “compensatory.” Thus, the court ordered tax refunds which, with accrued interest, totaled over $50,000,000.
What’s the Best Approach?
The First Circuit was correct in parting from the Ninth Circuit’s decision in Talley. The Talley decision effectively ruled that, if the parties did not explicitly agree on the tax characterization of a settlement payment, they had impliedly agreed that any payment in excess of single damages to the government should be considered punitive damages and non-deductible. This interpretation of Talley ensured that the government would receive the most favorable tax position in every single FCA settlement, regardless of the economic reality of the settlement payment. By holding that a tax characterization agreement was not a precondition to the deductibility of an FCA settlement payment, the First Circuit’s holding allows a taxpayer to have an equal bargaining position when settling an FCA case.
Creating an implied agreement where no explicit agreement exists would also be inconsistent with other areas of tax law. For example, when private parties are involved in a transaction challenged by the government, courts typically look to the substance of the transaction to determine tax characterization, regardless of any agreement the parties may have had in place. This same approach should apply to a settlement payment.
Should the First Circuit Have Gone Further?
In its holding in Fresinius, the First Circuit noted that, if a tax characterization agreement exists between parties in an FCA settlement, the court should honor that agreement. However, when an FCA case is litigated rather than settled, there is no tax characterization agreement. Nevertheless, some portion of the award beyond single damages may be determined to be compensatory, and thus deductible. A rule that, in the absence of an agreement, any damages beyond single damages are automatically considered punitive and not deductible would be in direct conflict with well-settled tax law. It does not follow that a tax characterization agreement in an FCA settlement should be binding despite the economic realities of the settlement, when no such agreement exists in a litigated FCA case. Generally, amounts paid or received in settlement should receive the same tax treatment, to the extent practicable, as would have applied had the dispute been litigated and reduced to judgment. In that sense, not only should a court be permitted to look at the economic reality of a settlement payment in the absence of a tax agreement, it should have the duty to look beyond the language even where a tax agreement exists.
Requiring courts to look at the substance of an FCA settlement even where a tax agreement exists would be in accordance with other areas of tax law previously discussed. Similar to considering transactions between private parties, a tax characterization agreement in an FCA settlement should be considered and generally followed, but where the substance of a settlement is clearly inconsistent with the tax characterization agreement, the economic reality of the settlement must rule.
The Future of FCA Settlement Payment Deductibility
Whether a settlement payment under the FCA is tax deductible can have huge monetary consequences. In Talley, the Ninth Circuit held that in order for settlement payments in excess of single damages to be considered “compensatory,” the parties must have manifested intent to categorize the excess payment as such. The Ninth Circuit determined that this manifested intent could only be demonstrated through a tax characterization agreement. The First Circuit correctly parted from Talley in Fresinius, holding that, in the absence of a tax characterization agreement, a court should consider the economic realities of a settlement to determine the allocation of the payment between compensatory and punitive and thus its deductibility. However, the First Circuit should have gone further. Even where a tax characterization agreement exists, courts often act as the watchdog over the tax treatment of transactions between private parties. It follows that the court should play a similar role in presiding over the tax characterization of settlement payments. Additionally, because settlement payments should result in the same tax treatment as adjudicated claims, the best rule would hold that, even where a tax characterization agreement exists, the economic realities of an FCA settlement payment should be considered in determining the deductibility of that payment.
 763 F.3d 64 (2014).
 Section 162(a) of the Internal Revenue Code allows a taxpayer to deduct all ordinary and necessary business expenses incurred by the taxpayer in carrying on any trade or business for United States federal income tax purposes. Section 162(f) provides an exception to this rule, prohibiting the deduction of fines or similar penalties paid to a government for the violation of any law. However, compensatory damages paid to a government are explicitly excluded from the definitions of fines and penalties. 26 C.F.R. § 1.162-21(b)(2). Therefore, a company may deduct the amount of a civil FCA settlement characterized as compensatory for tax purposes.
 31 U.S.C. §§ 3729-3733.
 Talley Industries, Inc. v. Comm’r, 116 F.3d 382 (9th Cir. 1997).
 Fresinius, 763 F.3d at 71.
 31 U.S.C. § 3729(a)(1)(A-B).
 31 U.S.C. § 3729(a)(1)(G).
 Southern Pac. Trans. Co. v. Comm’r, 75 T.C. 497, 653, 1980 WL 4591 (1980).
 Id.; see also Huff v. Comm’r, 80 T.C. 804, 824, 1983 WL 14824 (1983); Stephens v. Comm’r, 905 F.2d 667, 673 (2d Cir. 1990); True v. United States, 894 F.2d 1197, 1203-04 (10th Cir. 1990); Bailey v. Comm’r, 756 F.2d 44, 46-47 (6th Cir. 1985).
 Compensatory damages are deductible because they do not serve the same purpose as a criminal fine and are not “similar” to a fine within the meaning of 26 U.S.C. § 162(f).
 Irwin v. Comm’r, 131 F.3d 146 (9th Cir. 1997); Gragg v. United States, No. 12-CV-3813 YGR, 2014 WL 1319686, at *3 (N.D. Cal. Mar. 31, 2014); United States v. Helms, No. 08 CV 151 JLS NLS, 2010 WL 3384997, at *6 (S.D. Cal. Aug. 26, 2010). Each of these cases relies on Talley for the proposition that “if evidence to establish a deduction is lacking, the taxpayer, not the government, suffers the consequence.” In Fresinius, the government relied on this proposition to argue that, absent a manifested contrary intention, any settlement sums in excess of single damages should be treated as punitive fines, and are therefore nondeductible for the taxpayer. Fresinius at 69.
 Fresinius Medical Care Holdings, Inc. v. United States, 763 F.3d 64, 70 (1st Cit. 2014).
 Id. at 66.
 Id. at 70.
 Fresinius Medical Care Holdings, Inc. v. United States, 763 F.3d 64, 66 (1st Cit. 2014). The First Circuit affirmed the district court’s decision to instruct the jury to focus on the economic realities of a settlement in the absence of a tax characterization agreement. Fresinius involved nearly $127,000,000 paid to the government under an FCA settlement. The jury found that $95,000,000 was deductible. Accepting this finding, the court ordered tax refunds for Fresinius, which totaled more than $50,000,000.
 See, e.g., United States v. Eurodif S.A., 555 U.S. 305, 317–18 (2009); Boulware v. United States, 552 U.S. 421, 429–30 (2008).
 See Cook Cnty. v. United States ex rel. Chandler, 538 U.S. 119, 130–31 (2003); United States v. Bornstein, 423 U.S. 303, 315 (1976).
 See, e.g., Lyeth v. Hoey, 305 U.S. 188, 196 (1938).