First Circuit Affirms Deduction of Fraud Penalty Settlement By Government Contractor

This article appeared in accountingtoday

Boston (August 20, 2014)

By Roger Russell

The First Circuit, in a case of first impression and a split with the Ninth Circuit, has held that in determining the tax treatment of an FCA (False Claims Act) civil settlement, a court may consider factors beyond the mere presence or absence of a tax characterization agreement between the government and the settling party.

The case, Fresenius Medical Care Holdings, Inc. v. United States, involved the tax treatment of roughly $127 million paid to the government in partial settlement of what the court characterized as “a kaleidoscopic array of claims.” Fresenius is a major operator of dialysis centers in the U.S. and around the world. Between 1993 and 1997, a series of civil actions were brought against Fresenius by whistleblowers, resulting in investigations into Fresenius’s dealings with various federally funded health-care programs, and a complex of criminal plea and civil settlement agreements by Fresenius with the government.

The district court concluded that where the parties had abstained from any tax characterization, the critical consideration in determining deductibility was the extent to which the disputed payment was compensatory as opposed to punitive. Generally, no business expense deduction is allowed for fines paid for the violation of any law, but compensatory damages may be deductible since they are not considered to fines.

The First Circuit found that at trial, the court’s jury instructions followed this conclusion and directed the jury’s focus to the economic realities of the situation. According to the First Circuit, “The jury split the baby and found that a large chunk of the money ($95 million) was deductible. “

The government relied on the Ninth Circuit’s Talley decision, arguing that the FCA settlement context is special and that economic reality is irrelevant, insisting that the only pertinent inquiry is one that seeks to determine whether a tax characterization agreement exists between the government and the settling party. The First Circuit disagreed.

“We cannot accept the government’s rationale,” the court stated. “A rule that requires a tax characterization agreement as a precondition to deductibility focuses too single-mindedly on the parties’ manifested intent in determining the tax treatment of a particular payment. Such an exclusive focus would give the government a whip hand of unprecedented ferocity: it could always defeat deductibility by the simple expedient of refusing to agree – no matter how arbitrarily -- to the tax characterization of a payment.”