Tax Administration
Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments
Gao ID: GAO-05-747 September 15, 2005
Although some civil settlement payments are deductible, their deterrence factor could be lessened if companies can deduct certain settlement payments from their income taxes. GAO was asked to (1) identify federal agencies that negotiated some of the largest dollar civil settlements, (2) determine whether selected federal agencies take tax consequences into account when negotiating settlements and officials' views on whether they should address payment deductibility in settlement agreements, (3) determine whether companies with some of the largest civil settlement payments deducted any of the payments on their federal income taxes, and (4) determine what information the Internal Revenue Service (IRS) collects on civil settlements reached by federal agencies.
The Environmental Protection Agency (EPA), Securities and Exchange Commission (SEC), and Department of Justice (DOJ) negotiated civil settlements that were among the largest in the federal government in fiscal years 2001 and 2002. Also, the Department of Health and Human Services (HHS) was involved in negotiating some of the largest dollar False Claims Act (FCA) health-care civil settlements for which DOJ has primary responsibility. The largest civil settlements at these agencies ranged from about $870 thousand to over $1 billion. Officials in the four agencies we surveyed said that they do not negotiate with settling companies about whether settlement amounts are tax deductible. They said it was IRS's role to determine deductibility. In preparing to negotiate environmental settlements, EPA and DOJ may consider certain tax issues in calculating the amounts they propose to seek. This calculation estimates a company's economic benefit, that is, the financial gain from not complying with the law. Some DOJ environmental settlements with civil penalties have language stating that penalties are not deductible. DOJ officials said since the law is generally clear that civil penalties paid to a government are not deductible, stating so in the agreement was merely restating the law and is not necessary. The majority of companies responding to GAO's survey on how they treated civil settlement payments for federal income tax purposes deducted civil settlement payments when their settlement agreements did not label the payments as penalties. GAO received responses on 34 settlements totaling over $1 billion. For 20 settlements, companies reported deducting some portion or all of their settlement payments. IRS does not systematically receive civil settlement information from all four agencies. IRS officials said that a permanent system for agencies to provide information would be useful. IRS obtains information on a case-by-case basis from public sources and agencies. IRS also has two temporary compliance projects focusing on tax issues that affect settlement payment deductibility. In 2004, IRS introduced a tax schedule to provide information on a company's fines, penalties, and punitive damages.
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GAO-05-747, Tax Administration: Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
September 2005:
Tax Administration:
Systematic Information Sharing Would Help IRS Determine the
Deductibility of Civil Settlement Payments:
GAO-05-747:
GAO Highlights:
Highlights of GAO-05-747, a report to the Committee on Finance, U.S.
Senate:
Why GAO Did This Study:
Although some civil settlement payments are deductible, their
deterrence factor could be lessened if companies can deduct certain
settlement payments from their income taxes. GAO was asked to (1)
identify federal agencies that negotiated some of the largest dollar
civil settlements, (2) determine whether selected federal agencies take
tax consequences into account when negotiating settlements and
officials‘ views on whether they should address payment deductibility
in settlement agreements, (3) determine whether companies with some of
the largest civil settlement payments deducted any of the payments on
their federal income taxes, and (4) determine what information the
Internal Revenue Service (IRS) collects on civil settlements reached by
federal agencies.
What GAO Found:
The Environmental Protection Agency (EPA), Securities and Exchange
Commission (SEC), and Department of Justice (DOJ) negotiated civil
settlements that were among the largest in the federal government in
fiscal years 2001 and 2002. Also, the Department of Health and Human
Services (HHS) was involved in negotiating some of the largest dollar
False Claims Act (FCA) health-care civil settlements for which DOJ has
primary responsibility. The largest civil settlements at these agencies
ranged from about $870 thousand to over $1 billion.
Officials in the four agencies we surveyed said that they do not
negotiate with settling companies about whether settlement amounts are
tax deductible. They said it was IRS‘s role to determine deductibility.
In preparing to negotiate environmental settlements, EPA and DOJ may
consider certain tax issues in calculating the amounts they propose to
seek. This calculation estimates a company‘s economic benefit, that is,
the financial gain from not complying with the law. Some DOJ
environmental settlements with civil penalties have language stating
that penalties are not deductible. DOJ officials said since the law is
generally clear that civil penalties paid to a government are not
deductible, stating so in the agreement was merely restating the law
and is not necessary.
The majority of companies responding to GAO‘s survey on how they
treated civil settlement payments for federal income tax purposes
deducted civil settlement payments when their settlement agreements did
not label the payments as penalties. GAO received responses on 34
settlements totaling over $1 billion. For 20 settlements, companies
reported deducting some portion or all of their settlement payments.
IRS does not systematically receive civil settlement information from
all four agencies. IRS officials said that a permanent system for
agencies to provide information would be useful. IRS obtains
information on a case-by-case basis from public sources and agencies.
IRS also has two temporary compliance projects focusing on tax issues
that affect settlement payment deductibility. In 2004, IRS introduced a
tax schedule to provide information on a company‘s fines, penalties,
and punitive damages.
Approximate Ranges and Cumulative Values of the 20 Largest Civil
Settlement Agreements at the Four Agencies Contacted in Each Year for
Both Fiscal Years 2001 and 2002:
[See Table 1]
What GAO Recommends:
GAO recommends that IRS work with federal agencies to develop a cost-
effective means of systematically obtaining information on civil
settlements that would benefit IRS in ensuring the correct tax
treatment of settlement payments.
IRS agreed with the recommendation and will form an executive-led team
to implement it. EPA generally supported our recommendation and the
other agencies did not address the recommendation.
www.gao.gov/cgi-bin/getrpt?GAO-05-747.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Michael Brostek at (202)
512-9110 or brostekm@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Civil Settlements Negotiated by EPA, SEC, HHS, and DOJ Were among the
Largest in Fiscal Years 2001 and 2002:
The Four Agencies Do Not Negotiate the Tax Deductibility of Settlement
Amounts, but Two Agencies Consider Aspects of Taxes in Determining
Amounts for Negotiations:
A Majority of the Surveyed Companies Deducted Civil Settlement
Payments, Generally When Settlement Agreements Did Not Label Payments
as Civil Penalties:
No Permanent System Is in Place for Agencies to Routinely Inform IRS of
Civil Settlements or Provide Other Settlement Information That IRS
Would Find Useful:
Conclusions:
Recommendation for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Selected IRS Audit Results Information on Companies with
Civil Settlement Payments:
Appendix III: Comments from the Internal Revenue Service:
Appendix IV: Comments from the Environmental Protection Agency:
Appendix V: Comments from the Securities and Exchange Commission:
Appendix VI: Comments from the Department of Health and Human Services:
Appendix VII: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Approximate Ranges and Cumulative Values of the 20 Largest
Civil Settlement Agreements at the Four Agencies Contacted in Each Year
for Both Fiscal Years 2001 and 2002:
Table 2: Practices of Four Federal Agencies regarding Tax Issues They
Consider during Settlement Negotiations and in Settlement Agreements:
Table 3: Company Responses on Whether They Deducted Civil Settlement
Payments from Their Federal Income Taxes:
Table 4: Company Responses on Whether They Deducted Various Types of
Civil Settlement Payments:
United States Government Accountability Office:
Washington, DC 20548:
September 15, 2005:
The Honorable Charles E. Grassley:
Chairman:
The Honorable Max Baucus:
Ranking Minority Member:
Committee on Finance:
United States Senate:
The value of civil settlements that federal regulatory agencies
annually reach with those who violate laws or regulations can exceed
billions of dollars. Civil settlements,[Footnote 1] which can be used
to avoid litigation, are one of the enforcement tools some agencies can
use to correct violations and punish those who violate laws or
regulations by imposing penalties or other actions. Many civil
settlements with federal agencies may require that the entities
settling with the agencies make monetary payments. When negotiating
settlements, agencies consider many factors, which may include whether
payments are sufficient in size to deter the violator or others from
violating applicable laws or regulations in the future and mitigate any
economic benefit that the violator gained from not complying.
The deterrence effect of monetary payments could be lessened if
violators are able to deduct the civil settlement payments from their
income taxes since deductions reduce the amount of tax violators would
otherwise pay. In general, payments that are intended to punish
(punitive payments) a violator are not deductible and payments made to
compensate (compensatory payments) those who were harmed by a violation
are deductible under federal law. Nevertheless, it may not always be
clear which payments are deductible, in part because the Internal
Revenue Code (IRC)[Footnote 2] does not address the deductibility of
all types of payments that may be made pursuant to a civil settlement
and the statutes imposing the payments may be unclear regarding whether
they are punitive, compensatory, or both. Over the last several years,
concerns that some companies deducted, or planned to deduct, large
civil settlement payments from their federal income taxes have
heightened Congress's interest in this area.
Because of your interest in obtaining information on how agencies
address tax issues for civil settlements and how companies have treated
civil settlement payments on their federal income tax returns, you
asked us to review some of the largest settlement agreements and
determine how some companies have treated their civil settlement
payments for federal tax purposes. As agreed, the objectives of this
report are to (1) identify federal agencies that negotiated some of the
largest dollar civil settlements in recent years, (2) determine whether
the selected federal agencies having some of the largest civil
settlements take tax consequences into account when negotiating
settlements and officials' views on whether they should address the
deductibility of payments in the agreements, (3) determine whether the
companies that paid some of the largest civil settlement payments
deducted any of the payments on their federal income tax returns, and
(4) determine what information the Internal Revenue Service (IRS)
collects on civil settlements reached by federal agencies.
To identify federal agencies that negotiated the largest dollar civil
settlements in recent years, we analyzed information from various
sources, including agencies' Web sites, annual reports and enforcement
reports, and other available information. Based on our analysis of the
information, we concluded that the Environmental Protection Agency
(EPA), the Securities and Exchange Commission (SEC), and the Department
of Justice (DOJ) negotiated some of largest civil settlements in fiscal
years 2001 and 2002. We also included the Department of Health and
Human Services (HHS) because HHS was involved in negotiating some of
the largest dollar False Claims Act (FCA) health care civil settlements
that DOJ has primary responsibility to negotiate.[Footnote 3] We
selected this time frame since it would allow the settling companies
time to pay the settlements; determine the applicable tax treatments,
if any; and file federal income tax returns. We interviewed officials
in these agencies to identify and obtain copies of their largest civil
settlements.
To determine whether the four federal agencies having some of the
largest civil settlements take tax consequences into account when
negotiating civil settlements, we determined whether the agencies
negotiate with companies about whether civil settlement amounts are tax
deductible and whether the agencies considered any aspects of taxes
when internally deciding on what settlement amounts they should present
for the negotiations. In making these determinations, we reviewed the
underlying agreements and obtained information on the agencies' civil
settlement policies and procedures, including whether they address tax
issues, and interviewed officials. We also obtained agency officials'
views on whether they should address the deductibility of payments in
the agreements.
To determine whether the companies that paid some of the largest civil
settlement payments deducted any of the payments on their federal
income tax returns, we developed a questionnaire to survey the
companies. We did not independently verify the responses of the
surveyed companies.
To determine what information IRS collects on civil settlements reached
by federal agencies, we interviewed knowledgeable officials from IRS
and the four agencies and reviewed supporting documentation about what
information, if any, IRS obtains from the four selected agencies
regarding their civil settlement agreements.
You also asked us to provide information on whether corporate
taxpayers' deductions for settlement payments were being examined in
IRS audits and the outcome of the audits. To obtain this information,
we interviewed IRS officials concerning our work and requested
information on whether corporate taxpayers' deductions for settlement
payments were being examined in audits and the outcome of the audits.
Appendix II provides this information.
We assessed the reliability of the lists of the largest settlement
agreements identified by the agencies and found them to be sufficiently
reliable for the purposes of our reporting objectives. Our work was
conducted from February 2004 through June 2005 in accordance with
generally accepted government auditing standards. (See app. I for a
more detailed description of our scope and methodology.)
Results in Brief:
Four agencies--EPA, SEC, HHS[Footnote 4], and DOJ--negotiated civil
settlement agreements that were among the largest negotiated by the
federal government in fiscal years 2001 and 2002. The cumulative value
of their 160 largest settlements exceeded $9 billion. The settlements
ranged in size from just under $1 million to over $1 billion. For
example, the payments required under SEC's civil settlements ranged
from about $870 thousand to about $114 million, and the estimated value
of EPA's settlements ranged from about $1 million to over $1 billion
(see table 1 and the table notes).
Officials in the four agencies we surveyed said that they do not
negotiate with settling companies about whether settlement amounts are
tax deductible. Some officials said it was IRS's role to determine
deductibility. Before entering into a settlement with the settling
companies for environmental settlements, EPA and DOJ officials consider
tax issues in determining the economic benefit a settling company
gained from noncompliance. This takes into account whether a company
would have incurred tax deductible costs if it had complied with the
law, such as a one-time nondepreciable expenditure and applies the
violator's appropriate year-specific combined state and federal
marginal tax rates to the costs. Other than some settlements with civil
penalties containing language stating that the penalties are not
deductible, the settlement agreements we reviewed generally did not
specify the deductibility of settlement amounts, which was consistent
with what the agency officials told us. As an example of the
exceptions, we found that some DOJ environmental settlements with civil
penalties did include language in the agreement between DOJ and the
settling company that the penalties would not be deducted for federal
income tax purposes. DOJ officials said that including such language is
not standard practice and emphasized that since the law is generally
clear that civil penalties paid to a government are not deductible,
stating so in the settlement agreement is merely restating the law.
The majority of the companies responding to our survey on how companies
treated civil settlement payments for federal income tax purposes
deducted settlement payments when their settlement agreements did not
label the payments as penalties. We received responses on the
companies' tax treatment of 34 civil settlements with total amounts
exceeding $1 billion. The companies reported deducting some or their
entire civil settlement amount for 20 of the 34 settlements. In 2 of
these settlements, company representatives said they erred in deducting
the civil penalty payments totaling about $1.9 million and told us they
would file amended tax returns. For 3 of the 15 settlements for which
companies deducted some or all of their DOJ FCA settlement payments,
companies reported that language in their settlement agreements was a
rationale for the deductions, although DOJ told us that language did
not pertain to tax deductibility. The total amount of deductions taken
by these 5 companies exceeded $100 million. DOJ changed the language
for future FCA settlements based on our findings. Furthermore, three
companies that deducted FCA settlement payments reported that they did
so in whole or in part because their settlement agreements contained
language stating that the company denied wrongdoing. Their deductions
totaled about $15.5 million.
IRS does not generally receive civil settlement information in a
systematic manner from the four agencies we surveyed, although IRS
obtains some settlement information from those agencies on a case-by-
case basis to use in determining whether companies properly treated
settlement amounts for tax purposes. IRS officials told us that a
permanent system for agencies to provide IRS with timely civil
settlement information could help, for instance, in selecting firms to
audit. Officials of the four agencies in our review expressed
willingness to work with IRS to provide settlement information. IRS has
two temporary compliance projects that collect information on tax
issues that affect the deductibility of settlement amounts made
pursuant to FCA and environmental settlement agreements in part to help
IRS address improper deductions during examinations. In association
with one of the compliance projects, DOJ recently agreed to provide
information about large FCA settlements shortly after they are closed
and information on all FCA cases annually for the duration of the
project. In addition, in 2004, IRS introduced Schedule M-3, which could
also help IRS in identifying companies with civil settlements because
it captures some information on fines, penalties, and punitive damages
from companies with total assets of $10 million or more.
We are recommending that the Commissioner of Internal Revenue direct
the appropriate officials to work with federal agencies that reach
large civil settlements to develop a cost effective means of obtaining
information on settlement agreements that would be beneficial to IRS in
ensuring the correct tax treatment of the settlement amounts.
In commenting on a draft of this report (see app. III), the
Commissioner of Internal Revenue agreed with our recommendation and
will form an executive-led team to implement it. EPA also provided
comments and said they generally supported our recommendation (see app.
IV). SEC provided written comments but did not address our
recommendation (see app. V). HHS sent a letter stating they had no
comments but provided technical comments (see app. VI). DOJ also
provided technical comments. We made changes to our report to
incorporate the agencies' comments as appropriate.
Background:
Civil settlements are one of several enforcement tools used by some
federal agencies to help ensure that individuals and companies comply
with the laws and regulations they enforce. For purposes of this
report, civil settlements involve negotiations by federal agencies with
companies to resolve issues about their compliance with laws and
regulations. The negotiation process can involve discussions between
agency officials and a company about each party's proposals to address
the compliance problem and can end with a written agreement that
reflects the terms reached by the settling parties. In such cases, the
civil settlements generally require a company to agree to perform
certain activities or stop engaging in certain activities. Some
settlements also require that monetary payments be made to the
government and to others. When determining settlement amounts, agencies
consider various factors, including thresholds for fines and penalties
set by federal statutes for violations and the severity of the
violation.
While some agencies have administrative authority to enter into civil
settlements, some cases are required to be referred to DOJ for
resolution. For these cases, DOJ may settle with the defendant or take
the defendant to court. Of the four agencies we contacted, DOJ is
responsible for certain environmental settlements on behalf of EPA and
certain civil health care fraud cases on behalf of HHS.
Section 162 of the IRC provides a deduction for all ordinary and
necessary business expenses, including settlements and similar
payments. This provision is subject to an exception in IRC § 162(f)
that denies a deduction for any fine or similar penalty paid to the
government for the violation of any law.[Footnote 5] The definition of
"fine or similar" penalty includes an amount paid in the settlement of
the taxpayer's actual or potential liability for a fine or penalty
(civil or criminal).[Footnote 6] Furthermore, Treasury regulations
provide that payments made as compensatory damages paid to a government
do not constitute a fine or penalty.[Footnote 7] In general, IRS views
punitive payments as being nondeductible and compensatory payments as
being deductible.
Although the terms used to describe a payment required as part of a
civil settlement may provide an indication of whether the amount is
deductible or not, according to IRS, often it is necessary to look to
the intent of the law requiring the payment or the facts and
circumstances of the settlement to determine whether a payment is
deductible. Civil settlement agreements we reviewed use terms other
than "compensatory" or "punitive" to describe settlement payments. For
instance, some agencies use terms like restitution or disgorgement for
payments that are intended to compensate the government or
others.[Footnote 8] Even when a term used to describe a payment may
seem to indicate that a payment is not deductible, in fact, the
opposite may be the case. For example, a payment labeled as a civil
penalty[Footnote 9] and that seems not deductible may be deductible if
it is imposed as a remedial measure to compensate the government or
other party. Or, payments that will be used for remedial or
compensatory purposes and seem deductible may not be so if the law
requiring the payment indicates the payment is to have a punitive or
deterrent effect. IRS and courts look to the purpose of the statute,
including the legislative history and administrative and judicial
interpretation, to determine whether a payment serves a punitive or
compensatory purpose. If the law is unclear, or if the statute serves
both punitive and compensatory purposes, the facts and circumstances of
the specific settlement payment, including the terms of the settlement
agreement, often need to be examined to determine the purpose the
parties intended the payment to serve.
Until recently, IRS did not have a tax form that could be used to
identify whether a fine or penalty had been deducted for tax purposes.
Effective for any tax year ending on or after December 31, 2004,
corporations with consolidated assets of $10 million or more that are
required to file IRS Form 1120, the corporate income tax return, must
also file Schedule M-3. Schedule M-3 requires companies to reconcile
financial accounting net income (or loss) with taxable net income and
expense and deduction items. The 2004 Schedule M-3 line items for
reconciliation include fines, penalties, and punitive damages.
Civil Settlements Negotiated by EPA, SEC, HHS, and DOJ Were among the
Largest in Fiscal Years 2001 and 2002:
In fiscal years 2001 and 2002, EPA, SEC, HHS, and DOJ negotiated some
of the largest civil settlements in the federal government. The civil
settlements we examined ranged in size from about $870 thousand to over
$1 billion. (See table 1.) For example, a 2001 EPA judicial settlement
related to the Clean Air Act required a utility company to
significantly reduce harmful air pollution from its power plants at an
estimated cost of over $1 billion and pay a $3.5 million fine. The
cumulative value for the 20 largest settlements for fiscal year 2001
and the 20 largest settlements for fiscal year 2002 at the four
agencies--a total of 160 settlements--exceeded $9 billion.[Footnote 10]
Table 1: Approximate Ranges and Cumulative Values of the 20 Largest
Civil Settlement Agreements at the Four Agencies Contacted in Each Year
for Both Fiscal Years 2001 and 2002:
Agency: EPA[A];
Smallest: $1 million;
Largest: $1 billion;
Cumulative value: $4.1 billion.
Agency: SEC;
Smallest: $870 thousand;
Largest: $114 million;
Cumulative value: $607 million.
Agency: HHS[B];
Smallest: $3 million;
Largest: $790 million;
Cumulative value: $2 billion.
Agency: DOJ[C];
Smallest: $12 million;
Largest: $471 million;
Cumulative value: $3.3 billion.
Source: GAO analysis of EPA, SEC, HHS, and DOJ data.
Notes: For settlements identified by SEC, HHS, and DOJ, the total value
of settlements reflects payments payable to the U.S. government and
other recipients such as the relator, also known as the whistleblower.
For settlements identified by EPA, the total value of settlements
included payments payable to the U.S. government; the estimated cost of
any Supplemental Environmental Projects; and the estimated costs of
pollution controls, monitoring equipment, or other complying actions
that companies are required to take to come into compliance with
environmental laws. The penalty portion ranged from approximately
$500,000 to almost $10 million, and the cumulative value of the penalty
amount for these settlements was about $124.3 million.
[A] EPA settlements, including those for which DOJ led the
negotiations, are included under the EPA category.
[B] The settlements identified by HHS include only FCA settlements. HHS
officials told us FCA settlements, which DOJ negotiates, are the
largest of the agency's civil settlements.
[C] The list of settlements obtained from DOJ was of cases closed in
fiscal years 2001 and 2002. The dollar values of settlements provided
were net of relators' fees.
[End of table]
The Four Agencies Do Not Negotiate the Tax Deductibility of Settlement
Amounts, but Two Agencies Consider Aspects of Taxes in Determining
Amounts for Negotiations:
Officials in the four agencies said that they do not take tax
consequences into account during negotiations with settling parties,
that is, they do not negotiate with companies about the deductibility
of settlement amounts.[Footnote 11] They said they generally do not
have tax expertise and that determining deductibility of settlement
amounts is IRS's role. When negotiating, officials said they look to
the relevant laws and regulations and the facts and circumstances of
the case, including the severity of the violation and the strength of
the evidence against the violator to determine the settlement amount to
seek. In preparing for negotiations, two agencies--EPA and DOJ--
consider certain tax issues in calculating the amounts they propose to
seek in negotiating environmental settlements. This calculation
estimates a company's financial gain from not complying with the law,
that is, their economic benefit. The agencies factor in whether the
company would have incurred tax deductible expenses to stay in
compliance and apply the violator's year-specific combined state and
federal marginal tax rates to the costs of complying on time and
complying late. Except for some settlement agreements stating that
civil penalties are not deductible, the agencies' written civil
settlement agreements we reviewed generally did not specify the
deductibility of settlement amounts. As an exception to this general
practice, we found that some DOJ environmental settlements with civil
penalties included language indicating that the penalties would not be
deducted for federal income tax purposes. DOJ Environmental and Natural
Resources (ENR) Division officials explained that when a settlement
agreement includes civil penalties, their attorneys have discretion
about whether to include such language in an agreement. The officials
emphasized that the law is generally clear that civil penalties paid to
a government are not deductible and stating so in the agreement is
essentially restating the law and is not necessary. In addition, in
2003, subsequent to the time frame of the settlements we reviewed, SEC
adopted a policy of requiring settlement agreements with civil
penalties to include language stating that the settling parties would
not deduct civil penalties for tax purposes.
Table 2 describes the four agencies' practices regarding how they
consider tax issues during their settlement negotiation processes,
including drafting the terms of their settlement agreements. The
settlement agreements we reviewed were consistent with the practices
described to us by the agencies' officials. These practices are current
as of June 2005. Because each settlement agreement is unique,
settlements negotiated by these agencies can have some exceptions to
the practices listed in the table.
Table 2: Practices of Four Federal Agencies regarding Tax Issues They
Consider during Settlement Negotiations and in Settlement Agreements:
Agency: EPA;
Administrative environmental settlements;
Does the agency negotiate with settling parties about whether
settlement amounts are tax deductible? No;
Does the agency consider any aspects of taxes when calculating its
proposed settlement amount? Yes, if applicable to determine the
economic benefit portion of a civil penalty and if applicable as part
of valuing Supplemental Environmental Projects (SEP) a company agrees
to undertake as part of a settlement;
Does the written settlement agreement include specific information
about the deductibility of the settlement amount? Yes, when settlements
include civil penalties, some agreements state that civil penalties are
not deductible. Also when a company has said it will not deduct the
cost of a SEP, the government takes this into account when determining
the value of the SEP, and the agreement will specify that the company
will not deduct the costs of the SEP.
Agency: SEC settlements[A];
Does the agency negotiate with settling parties about whether
settlement amounts are tax deductible? No;
Does the agency consider any aspects of taxes when calculating its
proposed settlement amount? No;
Does the written settlement agreement include specific information
about the deductibility of the settlement amount? Yes, since 2003,
settlements that include civil penalties are to state that the civil
penalties are not deductible.
Agency: HHS settlements[B];
Does the agency negotiate with settling parties about whether
settlement amounts are tax deductible? No;
Does the agency consider any aspects of taxes when calculating its
proposed settlement amount? No;
Does the written settlement agreement include specific information
about the deductibility of the settlement amount? No.
Agency: DOJ: FCA settlements;
Does the agency negotiate with settling parties about whether
settlement amounts are tax deductible? No;
Does the agency consider any aspects of taxes when calculating its
proposed settlement amount? No;
Does the written settlement agreement include specific information
about the deductibility of the settlement amount? No.
Agency: DOJ: Judicial environmental settlements;
Does the agency negotiate with settling parties about whether
settlement amounts are tax deductible? No;
Does the agency consider any aspects of taxes when calculating its
proposed settlement amount? Yes, if applicable to determine the
economic benefit portion of a civil penalty and if applicable as part
of valuing SEPs a company agrees to undertake as part of a settlement;
Does the written settlement agreement include specific information
about the deductibility of the settlement amount? Yes, when settlements
include civil penalties, some agreements state that civil penalties are
not deductible. Also when a company has said it will not deduct the
cost of a SEP, the government takes this into account when determining
the value of the SEP, and the agreement will specify that the company
will not deduct the costs of the SEP.
Source: GAO analysis.
[A] In 2003, SEC implemented a policy that settlements with civil
penalties are to include language stating that the civil penalties
would not be deducted. Agreements negotiated before SEC implemented
this policy do not include such language.
[B] The HHS settlements we reviewed were FCA civil health care fraud
cases negotiated by DOJ.
[End of table]
As table 2 shows, the selected agencies do not negotiate with companies
about whether they can deduct any portion of their settlement from
their income taxes. In determining their negotiating position and any
changes to agree to during negotiations, officials generally look to
factors such as the relevant laws and regulations and the facts and
circumstances of the case, including the severity of the violation and
the strength of evidence against the violator. Officials in the four
agencies said that determining deductibility is IRS's role, and they
generally do not have the expertise to address the deductibility of
payments during negotiations or to specify the tax consequences of
amounts in the settlements. IRS staff agreed and said that if agencies
were to specify whether a settlement amount is deductible, there could
be a risk that the agencies might concede tax consequences in order to
reach a settlement.
The following information summarizes the policies, procedures, and
views of the agencies on taking taxes into account during negotiations
and specifying the tax deductibility of settlement payments in the
agreements.
EPA:
EPA's mission is to protect the environment and address related human
health impacts. EPA can reach civil administrative and judicial
enforcement settlements against violators of environmental laws, and
its priorities in negotiating settlements are to ensure that violators
come into compliance with the law, punish past violations and deter
future violations, obtain restoration of environmental damage resulting
from violations, and impose civil penalties sufficient to recover any
economic benefit gained as a result of the violator's noncompliance and
deter future violations. EPA negotiated the civil administrative
settlements under its own authority without a judicial process. Cases
that are brought and settled by DOJ on behalf of EPA are referred to as
civil judicial enforcement settlements. DOJ's policies, procedures, and
officials' views for these cases are discussed in the DOJ section of
this report.
All EPA civil settlements we reviewed included payments labeled as
civil penalties for violations of environmental laws or regulations. In
addition, the value of the settlements sometimes included estimated
amounts a company may incur to achieve and maintain compliance with the
environmental laws and regulations, such as installing a new pollution
control device to reduce air pollution or prevent emissions of a
pollutant. Also, some settlements included SEPs, which are projects a
company agrees to undertake in addition to complying actions. IRS is
currently reviewing the deductibility of SEPs.
Civil penalties in EPA settlements are generally composed of two parts:
economic benefit and gravity. Economic benefit represents the financial
gains that a violator accrues by delaying expenditures necessary to
comply with environmental regulations, avoiding them, or both. Under
EPA's civil penalty policy, the goal of recovering the economic benefit
of noncompliance is to place the violator in the same position as if
compliance had been achieved from the start. The amount EPA includes in
a civil penalty to account for the seriousness of the violation is
referred to as the gravity portion of the penalty. EPA includes the
gravity portion of the penalty to provide deterrence against future
noncompliance. When calculating the gravity portion of the initial
civil penalty amount, EPA adjusts the gravity-based penalty on various
case-specific factors, including the strength of evidence against the
company and the company's degree of cooperation and history of
noncompliance.
When calculating the economic benefit portion of civil penalties, EPA
uses an economic computer model to estimate any financial advantage a
company gained from not complying with environmental laws. EPA's
economic computer model takes into account whether a company would have
incurred tax deductible costs if it had complied with the law, such as
a one-time nondepreciable expenditure, in estimating the economic
benefit a company gained by not complying with environmental laws or
regulations. The computer model applies the appropriate year-specific
combined state and federal marginal tax rates of the violator in
calculating economic benefit along with standard financial cash flow
and net present value analysis techniques to calculate the costs of
complying on time and of complying late.
When calculating the gravity portion of civil penalties, EPA officials
consider the facts surrounding each violation, including factors such
as the actual or possible harm caused by the violation, the size of the
violation, and the goals of the specific environmental program. EPA
officials acknowledged that they negotiate with violators about the
size of the gravity portion of the penalty, but said in doing so they
consider factors such as the strength of their position and not whether
the violator may be able to claim a tax deduction.
When EPA settlements include civil penalty payments,[Footnote 12] EPA's
practice is to explicitly label these payments as civil penalties. In
some settlements with civil penalties, the settlement agreements also
reference IRC § 162(f), which states that penalties payable to a
government are nondeductible. Officials noted that including language
referencing IRC § 162(f) is not EPA's usual practice. EPA officials
said that they believe the law is clear that civil penalties payable to
a government are generally nondeductible, so they do not see inclusion
of such language in settlement agreements as necessary.
As part of some settlements, companies perform SEPs, which are projects
not required by law, that are voluntarily undertaken by a respondent in
exchange for possible penalty mitigation.[Footnote 13] EPA may mitigate
the civil penalty ultimately assessed as part of the settlement, when a
respondent agrees to undertake a SEP. EPA still collects a civil
penalty as part of the settlement in accordance with its 1998 SEP
policy, which calls for collecting the greater of 25 percent of the
gravity component of the penalty, or 10 percent of the gravity, plus
economic benefit. To determine the value of SEPs, EPA uses an economic
computer model, and if a company tells EPA that it plans to deduct the
SEP costs, EPA factors the company's decision into valuing the SEP
through the model. EPA officials said that they are not involved in a
violator's decision to deduct the SEP costs and that they take the
violator's decision at face value.
SEC:
SEC is responsible for administering and enforcing federal securities
laws and regulations and fostering fair and efficient markets for the
trading of securities. SEC enforcement officials told us that in
enforcing the securities laws, they aim to protect investors and punish
violators. In performing its enforcement role, SEC may, among other
actions, negotiate civil settlements with those who violate securities
laws. When appropriate, SEC provides that violators make monetary
payments that generally include amounts for civil penalties and
disgorgement. The SEC settlement agreements we reviewed included
penalties for violations of the securities laws. These settlements also
included disgorgement, in which SEC attempts to ensure that violators
of securities laws or regulations do not profit from their illegal
activity, and when appropriate, these disgorged profits are returned to
investors.
The IRC does not specifically address the deductibility of
disgorgement. Although IRS looks at the individual facts and
circumstances of a case to determine deductibility, it has generally
regarded disgorgement payments as compensatory, and therefore tax
deductible. As previously discussed, Treasury regulations provide that
in civil actions, compensatory damages paid to a government do not
constitute a fine or a penalty.[Footnote 14]
SEC's Chief Counsel for Enforcement emphasized that SEC's decision on
how much of a settlement payment is penalty versus disgorgement is
based solely on the facts and circumstances of the case, including the
law violated, the degree of harm, and the seriousness of the violation.
However, the official further said that although SEC does not negotiate
with settling parties about the deductibility of settlement payments,
settling parties may initiate negotiations with SEC about how the
settlement payment is to be allocated between penalty and disgorgement.
Although settling parties may seek a larger disgorgement amount because
it is generally tax deductible, SEC staff make recommendations for
disgorgement and penalties based on their analysis.
In 2003, SEC implemented a policy requiring all civil settlement
agreements with penalties to include language that expressly prohibits
the settling party from taking a tax deduction or seeking to recover
from an insurance carrier the penalty portions of the settlement
payment. SEC adopted standardized language prohibiting deductions as a
result of the Global Research settlement, in which 10 Wall Street
companies settled for a combined $875 million in civil penalties and
disgorgement. There were reports that some of the settling companies
were planning to take deductions for the civil penalty portion of the
settlement payments that would be placed into funds for investors who
were harmed by the companies' violations. The Sarbanes-Oxley Act of
2002 allows SEC, in appropriate cases, to add penalties to the
disgorgement fund for the benefit of harmed investors, pursuant to the
"fair fund" provisions of the act.[Footnote 15] SEC provides in its
standardized settlement language that such amounts are to be treated as
penalties for tax purposes. SEC's settlement agreements are silent on
the tax deductibility of disgorgement. Senior SEC officials noted that
in their view, decisions about the deductibility of disgorgement should
be left to IRS.
HHS:
HHS is the principal federal agency responsible for protecting the
health of American citizens and providing essential human services.
HHS's largest civil settlements are generally FCA cases relating to
civil health care fraud. FCA generally provides that anyone who
knowingly submits false claims to the government is liable for damages
up to three times the amount of the damages sustained by the government
plus penalties from $5,500 to $11,000 for each false claim submitted.
Although many FCA cases involve civil health care fraud against the
Medicare and Medicaid programs that HHS administers, the act is also
used in settling other types of fraud perpetrated against the federal
government, such as defense contractor fraud. A civil health care FCA
case, for example, could involve a health care provider who grossly
overcharged for medical services rendered and then filed claims for
reimbursement at the overcharged rates. Usually, civil health care
fraud cases are based on referrals from federal and state investigative
agencies and private persons.[Footnote 16]
DOJ is responsible for representing the United States in FCA cases and
therefore negotiates the FCA settlements. DOJ's Civil Division carries
out those responsibilities along with U.S. Attorneys' Offices located
across the country. Accordingly, DOJ sets the overall policy for civil
health care fraud FCA settlements. For health care settlements, HHS's
Office of Inspector General (OIG) provides DOJ assistance in several
ways, including investigating individuals and companies that may have
abused the HHS health care programs, and sometimes works with DOJ to
determine the amount of single damages, that is, the amount of loss
sustained by the government due to the violator's actions.
DOJ:
DOJ negotiates settlement agreements on behalf of other federal
agencies, including some cases involving HHS and EPA. The DOJ
settlement agreements we reviewed were limited to FCA settlements
negotiated by DOJ's Civil Division and judicial environmental
settlements negotiated by DOJ's ENR Division. The FCA cases negotiated
by DOJ that we reviewed contained a single payment labeled as a
settlement amount, which does not characterize the extent to which
payments are for single or multiple damages or civil penalties. All of
the DOJ-led environmental settlement agreements that we reviewed
included amounts labeled as penalties and some included SEPs.
In negotiating FCA civil settlement agreements, DOJ Civil Division
officials said that they do not consider or discuss any aspects of
taxes. In calculating the settlement amount for FCA cases, DOJ first
assesses the amount of damages the violation cost the government and
seeks to recover the full amount. It also considers the severity of the
violation in determining whether the settling company should pay a
multiple of the assessed damages and civil penalties.
DOJ Civil Division officials stated that they do not include language
on the deductibility of payments in their written FCA settlement
agreements. In fact, according to the officials, all FCA settlements
contain DOJ's standard settlement agreement language, which states that
nothing in the agreement characterizes the payments for federal income
tax purposes. DOJ Civil Division officials said that this language
supports the agency's policy of not addressing the tax treatment of
settlement payments in settlements agreements.
DOJ Civil Division and IRS officials told us that the agencies came to
a mutual agreement that DOJ's tax-neutral practices on the
deductibility of civil settlement payments are appropriate.
Furthermore, officials added that the settlement agreements refer to
the payments as a settlement amount because the negotiations with the
settling party usually involved agreeing on a lump sum amount without
characterizing the payment into categories such as single, double, or
treble damages and civil penalties. Officials said they do not
categorize the payments more specifically because doing so would add
complexity to the negotiation process by adding additional factors on
which to obtain agreement between the parties. Thus, the agreement does
not characterize the extent to which the settlement payment is punitive
or compensatory. According to IRS staff, single damages are generally
considered compensatory and therefore tax deductible, and any multiple
damages and civil penalties are generally considered punitive and
therefore nondeductible.
Officials in DOJ's Civil Division and HHS's OIG said that even though
FCA allows for the assessment of penalties in addition to multiple
damages, penalties are not always sought. The HHS officials said that
penalties are not generally sought in FCA settlements because
collecting a multiplier of damages is sufficient to compensate the
government and provide a deterrence.
DOJ also negotiates environmental cases on behalf of EPA. EPA refers to
cases it sends to DOJ to settle as judicial cases since they are not
resolved under EPA's administrative authority. EPA staff assist DOJ
staff in building these cases and EPA's civil penalty policies
generally apply to DOJ environmental settlements. However, DOJ--not
EPA--has primary settlement authority for these cases, and DOJ is not
bound by EPA's penalty policies.
Like EPA, in preparing for negotiations and determining the amount to
seek at settlement, DOJ considers aspects of taxes in calculating the
economic benefit a violator received from not complying with
environmental laws. However, DOJ ENR Division officials told us that
their position is to be neutral on tax issues. DOJ sometimes uses the
EPA economic benefit computer model to calculate economic benefit
amounts but may also obtain outside experts. Similar to EPA's
administrative settlements, some DOJ-negotiated environmental
settlements may involve SEPs, which can be used to offset a portion of
the civil penalty that DOJ would otherwise seek. The officials
reiterated that they do not negotiate with the violator about the
deductibility of the SEP costs, but would factor in the violator's
stated intentions about deducting the SEP costs in establishing its
value as part of the settlement.
As with EPA civil administrative settlements, when DOJ-negotiated
environmental settlements include civil penalties, the practice is to
explicitly label these payments as civil penalties. Also, in some
settlements with civil penalties, DOJ-negotiated environmental
settlement agreements reference IRC § 162(f), which states that fines
or similar penalties payable to a government are nondeductible. DOJ ENR
Division officials said that having settlement agreements reference IRC
§ 162(f) is not standard practice and would be at the discretion of
officials involved in the settlement negotiations. According to these
officials, the law is generally clear that civil penalties payable to
the government are nondeductible and stating so in agreements is merely
restating the law. The officials said they do not negotiate with the
settling companies about whether the amounts are deductible.
We observed that one large settlement agreement negotiated by DOJ's ENR
Division contained language stating that the settling company was not
allowed to take a deduction for funding of remediation work and that
its chief financial officer must submit a certification that deductions
were not taken. DOJ's ENR Division officials told us that a case such
as this one likely involved particular negotiating circumstances and
strategies. They emphasized that this was an exception rather than
their usual practice of not specifying the tax treatment of settlement
amounts in the settlement agreement.
A Majority of the Surveyed Companies Deducted Civil Settlement
Payments, Generally When Settlement Agreements Did Not Label Payments
as Civil Penalties:
In responding to our survey,[Footnote 17] companies that paid some of
the largest civil settlement payments at the four agencies we reviewed
generally reported that they deducted civil settlement payments when
the settlement agreements did not label the payments as penalties.
Conversely, when the settlement agreements labeled the payments as
penalties, the companies generally reported that they did not deduct
the payments. Overall, for 20 of the 34 settlements for which we
received survey responses, companies stated that they deducted some or
all of their civil settlement payments.[Footnote 18] The total value of
settlement amounts of the 34 settlements for which we received
responses was over $1 billion. Table 3 summarizes the overall responses
from the companies, and table 4 provides survey results on deductions
categorized according to how the settlement agreements labeled the
settlement payments.
Table 3: Company Responses on Whether They Deducted Civil Settlement
Payments from Their Federal Income Taxes:
Agency: SEC settlements;
Company deducted some or all: 1;
Company deducted none[A]: 2.
Agency: DOJ environmental settlements[B];
Company deducted some or all: 4;
Company deducted none[A]: 11.
Agency: DOJ FCA settlements;
Company deducted some or all: 15;
Company deducted none[A]: 1.
Total;
Company deducted some or all: 20;
Company deducted none[A]: 14.
Source: GAO.
Note: We did not verify the companies' responses with IRS.
[A] Because some companies with SEPs did not report whether they
deducted the SEPs, the number of settlements listed for which companies
did not make any deduction may be overstated.
[B] In table 1, environmental cases handled by DOJ are reported under
EPA cases. In this table, they are reported as "DOJ environmental
settlements." To the extent that any of these settlements contained
estimates of compliance costs, those were not among the costs included
in our survey.
[End of table]
Table 4: Company Responses on Whether They Deducted Various Types of
Civil Settlement Payments:
Classifications of settlement payments in settlement agreements:
Agency: SEC;
Civil penalty: Deducted: 1;
Civil penalty: Not deducted: 2;
Settlement amount[A]: Deducted: N/A;
Settlement amount[A]: Not deducted: N/A;
SEP[B]: Deducted: N/A;
SEP[B]: Not deducted: N/A;
Disgorgement: Deducted: 1;
Disgorgement: Not deducted: 0.
Agency: DOJ environmental[C];
Civil penalty: Deducted: 2;
Civil penalty: Not deducted: 13;
Settlement amount[A]: Deducted: N/A;
Settlement amount[A]: Not deducted: N/A;
SEP[B]: Deducted: 2;
SEP[B]: Not deducted: 2;
Disgorgement: Deducted: N/A;
Disgorgement: Not deducted: N/A.
Agency: DOJ FCA;
Civil penalty: Deducted: 0;
Civil penalty: Not deducted: 0;
Settlement amount[A]: Deducted: 15;
Settlement amount[A]: Not deducted: 1;
SEP[B]: Deducted: N/A;
SEP[B]: Not deducted: N/A;
Disgorgement: Deducted: N/A;
Disgorgement: Not deducted: N/A.
Total;
Civil penalty: Deducted: 3;
Civil penalty: Not deducted: 15;
Settlement amount[A]: Deducted: 15;
Settlement amount[A]: Not deducted: 1;
SEP[B]: Deducted: 2;
SEP[B]: Not deducted: 2;
Disgorgement: Deducted: 1;
Disgorgement: Not deducted: 0.
Source: GAO.
Note: Totals in this table do not add up to 34 because the following
settlement agreements contain more than one classification of
settlement payment: one SEC settlement contains both a civil penalty
and disgorgement and 10 DOJ-led EPA settlements contain both civil
penalties and SEPs.
[A] Settlement amount includes only those settlements in which the
entire settlement payment was labeled as a settlement amount and was
the only payment in the settlement.
[B] For six of the survey responses for settlements with SEPs, the
companies did not respond as to whether they had deducted SEPs
associated with the settlement.
[C] In table 1, environmental cases handled by DOJ are reported under
EPA cases. In this table, they are reported as "DOJ environmental." To
the extent that any of these settlements contained estimates of
compliance costs, those were not among the costs included in our
survey.
[End of table]
As shown in table 4, for 15 of the 16 DOJ FCA settlements, companies
reported deducting their payments. Of these 15 settlements, 12 survey
responses showed that companies deducted the full amount of the
payment, while 3 responses showed they deducted a percentage of the
full amount--ranging from 43 to 89 percent. Consistent with DOJ's usual
practice for FCA civil settlements, these FCA settlement agreements
referred to the settlement payment as the settlement amount, which does
not characterize whether the settlement amount included a penalty or
was punitive or compensatory in nature.
In addition, of the 15 settlements for which companies settled DOJ FCA
cases and deducted payments, companies in 7 settlements told us that
they deducted payments because, in their view, the settlement amounts
were restitution or compensatory in nature. However, minutes of a
healthcare fraud settlements meeting between IRS and DOJ show that IRS
believes FCA settlement payments usually include a punitive portion to
punish violators and to deter future violations. Also, according to
DOJ's technical comments on the draft of this report, in most FCA
settlements (apart from those that recover strictly penalties), some of
the amounts paid are in the nature of compensatory reimbursement and
may be deductible.[Footnote 19]
Five companies we surveyed reported that a sentence in their FCA
settlement agreements indicating that the settlement was not punitive
in purpose or effect was a basis for them taking deductions. The
settlement amounts deducted by these five companies totaled over $100
million. According to a director in DOJ's Civil Division, DOJ does not
intend for the language in FCA settlement agreements that the companies
mentioned to refer to tax treatment. The DOJ official said that this
sentence is not intended to imply that the settlement amounts are
compensatory for tax purposes, but rather to ensure that the amounts
are not punitive for double jeopardy purposes or prohibitions on
excessive fines.[Footnote 20] The DOJ official added that a subsequent
statement that is standard in all FCA settlement agreements articulates
DOJ's position on deductibility, that is, that the agreement does not
characterize the payment for federal income tax purposes. Based on our
discussions with DOJ and our survey evidence showing that some
companies cited this sentence in support of their tax deductions, DOJ
revised the relevant portions of the FCA settlement agreement model
language. Effective June 2005, the new language removes references to
the settlement not being punitive in purpose or effect.
Furthermore, three companies that deducted FCA settlement payments
reported that they did so in whole or in part because their settlement
agreements contained language stating that the company denied
wrongdoing. Their deductions totaled about $15.5 million. Two of these
three companies also cited the sentence discussed in the prior
paragraph as another reason for deducting the amounts.
Also, as shown in table 4, three other companies reported deducting
settlement payments even though they were labeled as civil penalties.
Two of these companies reported that our survey made them aware that
their deductions were improperly taken, and they plan to file amended
tax returns. These deductions totaled about $1.9 million. The other
company reported that it deducted the civil penalty because it was paid
to a self-regulatory organization, which the company believed was not a
government agency. This settlement agreement contained language
indicating that the self-regulatory organization settled with the
company on behalf of a federal agency.
Ten companies that responded to our survey had environmental settlement
agreements negotiated by DOJ that contained SEPs.[Footnote 21] Our
analysis of the settlement agreements for the 10 companies showed that
four agreements contained language stating that the SEP costs are not
deductible. Two companies with settlements that contained this language
reported to us that they did not deduct the costs, and the other 2
companies did not respond to the survey question. Of the 6 companies
with SEPs for which the settlement agreements did not state whether the
costs were deductible, 2 companies reported deducting the SEP costs and
the other 4 companies did not indicate whether they deducted SEP costs.
Some of the companies that reported not deducting any settlement
payments gave us varying reasons for not taking deductions. The reasons
included references to IRC § 162(f), which states, in part, that
penalties paid to a government are not deductible, and provisions in
their settlement agreements specifying that they would not deduct the
settlement payments.
No Permanent System Is in Place for Agencies to Routinely Inform IRS of
Civil Settlements or Provide Other Settlement Information That IRS
Would Find Useful:
The four federal agencies do not systematically provide IRS with civil
settlement information that would be useful to IRS for compliance
purposes, although the agencies do provide such information on a case-
by-case basis at IRS's request, such as for audits of companies with
settlement agreements. The agencies told us they were willing to work
with IRS to develop a permanent system for routinely providing
appropriate information. DOJ Civil Division and EPA have established
means for providing IRS with information on civil settlement agreements
as part of IRS's temporary compliance research projects. In 2004, IRS
introduced Schedule M-3, which could potentially help IRS identify
corporations with some settlements because it captures information on
fines, penalties, and punitive damages from companies with assets of
$10 million or more.
Settlement Information from Agencies Could Help IRS with Its Audit
Strategy and Facilitate Pre-filing Agreements:
In general, the four federal agencies do not routinely notify IRS when
a civil settlement has been reached or provide other settlement-related
information that IRS would find useful, although they provide IRS with
settlement information on a case-by-case basis. To identify settlements
that have been reached, IRS officials search agency Web sites and press
releases. DOJ ENR Division, EPA, and SEC officials said that their Web
sites generally post most of their civil settlement agreements. IRS
usually contacts the agencies on a case-by-case basis to obtain
information to use during audits in assessing whether companies
properly treated their settlement payments on their income tax returns.
For example, to determine the facts and circumstances of a settlement,
IRS contacts DOJ officials to obtain information on FCA settlements,
including written exchanges between the agency and the company and the
tracking forms that are used by DOJ to allocate settlement amounts to
various government accounts. According to IRS staff, the tracking form
and the other information it obtains from DOJ about a settlement can
provide leads for determining nondeductible punitive damages in FCA
cases.[Footnote 22]
The agencies have expressed willingness to notify IRS when a settlement
has been reached and to work with IRS on providing other appropriate
information. Some steps in this direction have already been taken. For
example, EPA has designated staff to work with IRS to provide specific
settlement information.
IRS officials said that it would help IRS's compliance efforts if
agencies systematically notified IRS that a settlement has been reached
and provided additional information, such as their intent regarding the
breakdown of the settlement payment by category (i.e., punitive versus
compensatory). According to an IRS Director in the Large and Mid-Size
Business Division, such information could play a role in determining
which firms to audit and, when an audit occurs, whether a settlement
should be covered. Further, the IRS Director said that in some cases
IRS would like to offer pre-filing agreements to settling
companies,[Footnote 23] which would resolve the tax treatment of
settlement payments before tax returns are filed. The Director focused
on large settlements for which IRS enforcement action was more likely
than on smaller settlements.
DOJ and EPA Are Providing IRS Settlement Information as Part of IRS's
Temporary Compliance Research Projects:
IRS is collecting information on certain settlements through two
compliance projects. IRS uses compliance projects to collect
information and conduct research in order to target audits in
particular issue areas. It intends to use the project results on the
degree to which companies incorrectly deduct civil settlement payments
to make data-driven business decisions on how to correct the
noncompliance.
In 2003, IRS initiated a fraud settlements compliance project focusing
on the deductibility of payments made in the settlements involving
fraud, primarily FCA settlements. The fraud settlements compliance
project targets multimillion-dollar settlements where at least part of
the settlement payment may be punitive although the agreements may not
specify punitive damages. During February 2005 discussions between IRS
and DOJ, DOJ officials agreed to notify IRS promptly of FCA settlements
they reach of $10 million and more and provide a list of smaller dollar
FCA settlement agreements annually for the duration of the project. DOJ
officials told us they would be willing to continue providing IRS with
this information after the completion of this compliance project. IRS
officials said that this information would be useful to them in
targeting and conducting audits. According to the compliance project
description, IRS staff have found that for settlements involving
Medicare fraud, companies are claiming deductions for the full amount
of the settlement. However, IRS staff told us that these settlement
payments generally contain a punitive portion. This compliance project
is scheduled to be completed in 2006.
In 2004, IRS initiated an environmental settlements compliance project,
which focuses on four components of environmental settlements that may
result in an income tax issue--civil penalties; SEP costs; complying
actions; and other payments and requirements, which may include
punitive sanctions. For the project, IRS says it needs access to
negotiating files, court documents, settlement documents, databases,
personnel, and attorneys at the relevant settling agencies. EPA has
agreed to provide IRS with certain case-specific information. To obtain
an initial sample of approximately 30 recently negotiated significant
environmental settlements, IRS staff searched agency press releases and
Web sites and contacted EPA and DOJ staff for settlement information on
a case-by-case basis. The initial review of this sample suggests that
companies may be noncompliant when deducting, capitalizing, amortizing,
or depreciating SEP costs. The compliance initiative description also
said that some IRS staff have questioned the appropriateness of
deducting SEP costs if SEP costs are payments in lieu of a penalty
because it appears that such costs are not deductible under IRC §
162(f).[Footnote 24] IRS officials said that IRS's National Office
plans to issue a technical advice memorandum (TAM) that will address
SEP deductibility and capitalization issues. The compliance project
staff told us that this compliance project is scheduled to be completed
in late 2005, although it may be extended.
According to IRS's fraud settlements compliance project description,
the compliance projects also provide IRS with the necessary information
to evaluate the potential for negotiating pre-filing agreements with
settling companies. Under pre-filing agreements, IRS and companies
resolve whether all or a portion of a settlement payment can be
deducted before the companies file their tax returns. The project
description says that for those cases for which a pre-filing agreement
is not executed, IRS examiners can more timely develop the facts and
reach a position on deductibility, which can reduce examination time on
this issue while enhancing IRS compliance results. IRS officials told
us they are in discussions with one company that reached a civil
settlement regarding a pre-filing agreement and are offering pre-filing
agreements to other settling companies.
Schedule M-3 Provides IRS with Some Settlement Information from
Companies:
IRS has a new source of information that could help it identify
companies with settlements. In 2004, IRS introduced Schedule M-3, which
is designed to reconcile differences in financial accounting and
taxable income (or loss). The schedule is being used by corporations
with assets of $10 million or more and is to be phased in for use by
other corporations in 2005 and 2006. Because Schedule M-3 collects
information on fines, penalties, and punitive damages, it may help IRS
identify settlements that should be considered if a company is audited.
Schedule M-3 as currently designed may not capture settlement payments
that were not labeled as fines, penalties, or punitive damages in the
written settlement agreement. Based on our discussions, IRS officials
responsible for Schedule M-3 said that they were considering options to
address this situation.
Conclusions:
When settlement agreements specify civil penalties, the law is
generally clear that they are nondeductible. However, when the
settlements do not contain penalties, deductibility may be less clear
because the IRC and the statutes imposing the payments may be silent
regarding whether the payments are punitive or compensatory in nature.
Moreover, many settlement agreements do not contain language addressing
the tax deductibility of settlement payments. To determine the
deductibility of settlement payments during audits or in reaching pre-
filing agreements, IRS examines settlement information that would
provide the relevant facts and circumstances in a particular case.
Given this situation, one way to help IRS better ensure that companies
are properly treating settlement payments for tax purposes is to have
agencies systematically notify IRS when they have reached a settlement
that requires significant dollar payments and provide information that
IRS may find useful. With such information, IRS can better determine
which companies to examine and whether settlement payments should be
part of the examination. In addition, with a regular flow of
information on settlements as they are reached, IRS would be able to
contact companies when appropriate to obtain pre-filing agreements on
how the settlement payments should be treated on their tax returns.
This may be especially useful in cases such as the DOJ FCA settlement
agreements, which may not contain useful information for the settling
company and IRS to determine the tax treatment of the settlement
amounts.
Recommendation for Executive Action:
We recommend that the Commissioner of Internal Revenue direct the
appropriate officials to work with federal agencies that reach large
civil settlements to develop a cost effective permanent mechanism to
notify IRS when such settlements have been completed and to provide IRS
with other settlement information that it deems useful in ensuring the
proper tax treatment of settlement payments.
Agency Comments and Our Evaluation:
We sent a draft of this report to IRS, EPA, SEC, HHS, and DOJ for
comment. We received written comments from IRS, EPA, SEC, and HHS. DOJ
provided written technical comments.
In his August 26, 2005, letter, the Commissioner of Internal Revenue
(see app. III) said that he agreed with our recommendation and said
that it would be beneficial for IRS to work with federal agencies to
develop a systematic method for obtaining information on civil
settlements contemporaneous with those settlements. He said that IRS
will form an executive led team to work with each agency with
significant civil settlements to reach agreement on what information
will be provided, the format of the information, and the frequency of
delivery. IRS also provided technical comments which we incorporated in
our report.
EPA's Assistant Administrator, Office of Enforcement and Compliance
Assurance stated in an August 26, 2005, letter (see app. IV) that EPA
generally supports our recommendation and believes that EPA already has
mechanisms to provide IRS with settlement information useful in
determining the proper tax treatment of settlement amounts. The
Assistant Administrator said that EPA's publicly available Web site
contains 3 years of information on concluded enforcement settlements
and other EPA online enforcement databases with settlement information
could be made available to IRS. EPA believes that these mechanisms are
more cost effective than developing a specific notification process for
IRS. While we agree that EPA has mechanisms in place to provide IRS a
means to access its settlement information, we believe that it would be
useful if EPA notified IRS directly of its significant settlements
contemporaneously so IRS could ensure that it is aware of all
significant settlements and be better positioned to contact companies
sooner to initiate pre-filing agreements with them. Regarding our
reference to IRS officials needing access to information such as
negotiating files and documents to help determine the proper tax
treatment of settlement payments, the Assistant Administrator expressed
concern that making such information available to IRS could result in a
waiver of any protective privilege associated with such information and
might jeopardize pending settlements and ongoing enforcement actions.
This issue was not within the scope of our study and in our view is
among the type of issues that can be addressed as IRS and agency
officials work together to establish information sharing arrangements
regarding significant settlement agreements.
The Assistant Administrator also commented on how we characterized the
value of EPA settlements and, in particular, stated that our comparison
of EPA settlement values to those of the other agencies we surveyed is
dissimilar. The Assistant Administrator said that we should only
include monetary payments for EPA civil penalties in valuing EPA
settlements to make them comparable to the value of settlements in the
other agencies. In our view, and as consistently reflected in our
report, the value of an agency's settlements includes all components
that are reflected in settlement agreements. This was also consistent
with how the agencies we surveyed valued their settlements. We believe
it would be misleading to show the value of settlements based on civil
penalties alone when the negotiated settlement agreement clearly
included other components. Further, some settlements we reviewed, such
as DOJ FCA settlements, did not contain penalties. EPA also made some
technical comments which we have incorporated into the report to
clarify and more fully present certain information.
In a letter dated September 1, 2005, an SEC Enforcement Division
director did not specifically comment on our recommendation but said
that the Commission takes seriously the importance of meaningful
sanctions in its enforcement program (see app. V). HHS provided a
letter stating they had no comment on the draft but sent technical
comments which we incorporated into our report (see app. VI). DOJ
provided some technical comments which we included in our report to
more accurately reflect information about their settlements.
As agreed with your offices, unless you publicly release its contents
earlier we plan no further distribution of this report until 30 days
from its date. At that time, we will send copies to interested
congressional committees, the Secretary of the Treasury, the
Commissioner of Internal Revenue, and other interested parties. We will
also make copies available to others on request. In addition, the
report will be available at no charge on the GAO Web site at
http://www.gao.gov.
If you or your staff have any questions about this report, please
contact me at (202) 512-9110 or brostekm@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. GAO staff who made major contributions
to this report are listed in appendix VII.
Signed by:
Michael Brostek:
Director, Tax Issues Strategic Issues:
[End of section]
Appendix I: Scope and Methodology:
The objectives of this report were to (1) identify federal agencies
that negotiated some of the largest dollar civil settlements in recent
years, (2) determine whether the selected federal agencies having some
of the largest civil settlements take the tax consequences of the
companies into account when negotiating civil settlements and
officials' views on whether they should address the deductibility of
payments in the agreements, (3) determine whether the companies that
paid some of the largest civil settlement payments deducted any of the
payments on their federal income tax returns, and (4) determine what
information the Internal Revenue Service (IRS) collects on companies
with civil settlements reached by federal agencies. In addition, we
sought to identify whether companies' deductions for settlement
payments were being examined in audits and the outcome of the audits.
To identify federal agencies that negotiated civil settlements
involving companies with some of the largest civil settlement payments,
we analyzed information on settlements reached by various federal
agencies because we were unable to identify any single, reliably
searchable, comprehensive source or database that was known to contain
such information governmentwide. We limited our scope to settlements
that were negotiated in fiscal years 2001 and 2002 involving companies
that file IRS Form 1120, U.S. Federal Corporate Tax Return.[Footnote
25] We selected this time frame since it would allow the settling
companies time to pay the settlements; determine applicable tax
treatments, if any; and file federal income tax returns.
As a starting point to identify agencies with large settlements in
those years, we used information in the 1998 Federal Financial
Management Status Report and Five-Year Plan that summarized assessments
and collections of civil monetary penalties by federal agencies for
fiscal year 1997.[Footnote 26] The information in the report was based
on data compiled from 76 federal agencies and showed which of those
agencies were responsible for the majority of the civil monetary
penalty assessments and collections in fiscal year 1997. Consolidated
information on federal agency assessments of civil penalties was not
available for subsequent years because the Federal Reports Elimination
Act of 1998[Footnote 27] eliminated the annual requirements for federal
agencies to report this information.
Generally, we then sought to determine if the same agencies that were
responsible for the majority of the civil monetary assessments and
collections in fiscal year 1997 were likely to have some of the largest
settlement amounts in fiscal years 2001 and 2002. We did this by
reviewing such material as agency press releases on settlement
agreements, annual reports, enforcement reports, and other data on
agency Web sites. In addition, we also performed more general searches
of commercially available databases that contain archived content from
newspapers, magazines, legal documents, and other printed sources and
other federal Web sites that provided information about corporate civil
settlements to help us gauge whether the settlements we were
identifying at these agencies were among the largest being reported
from various publication sources.
As part of our analysis of this information, we comparatively assessed,
to the extent possible, whether agencies tended to have relatively
fewer individual settlements with typically large-dollar assessments
(millions of dollars per individual settlement) or more numerous
individual settlements of relatively low-dollar amounts. We chose those
agencies that appeared to have a larger settlement amount per case.
We did not include IRS in the agencies we analyzed since tax
settlements are not tax deductible. We also excluded the Federal
Reserve System from consideration because its reported total settlement
amounts could incorporate settlements by multiple agencies.
By comparing and analyzing such information across the leading agencies
for overall civil assessments in 1997, we selected the Environmental
Protection Agency (EPA), the Securities and Exchange Commission (SEC),
and the Department of Justice (DOJ) for further review after concluding
that they were among those agencies responsible for negotiating the
largest individual civil settlements in fiscal years 2001 and 2002 that
we could identify. Also, during these 2 fiscal years, we determined
that the Department of Health and Human Services (HHS) was involved in
negotiating some of the largest dollar False Claims Act health-care-
related civil settlements that DOJ has primary responsibility for
negotiating.
We contacted each of the four agencies and requested information on its
largest civil settlements, that is, cases in which the largest dollar
amounts were to be paid to the federal government or others. In
discussing our request for lists of settlements, agency officials
advised that lists of cases based on largest settlements would likely
include cases of entities not required to file IRS Form 1120. (See
table 1 in the body of this report for information received from the
four agencies on their 20 largest civil settlements for fiscal years
2001 and 2002, which includes settlements with some entities not
required to file IRS Form 1120.)
We took several steps to assess the reliability of the agencies'
automated systems that provided the lists of settlement agreements. We
interviewed agency officials who were knowledgeable about compiling,
entering, and checking the data in the databases used to provide the
lists; reviewed related documentation about the quality and accuracy of
the data and the systems that produced them; and to the extent
possible, cross-checked the lists with other sources. For example, we
compared selected information, such as settlement amount from copies of
the actual settlement agreements with the amount shown on the list
obtained from the agencies. We also asked the companies to confirm this
information. Likewise, the companies confirmed whether they had paid
the settlement. We determined that the lists of largest settlements and
associated settlement amount information were sufficiently reliable for
the purposes of this report.
To determine whether the federal agencies take the tax consequences of
the companies into account when negotiating civil settlements and their
views on whether they should address the deductibility of payments in
settlement agreements, we interviewed officials in each of the four
agencies about their settlement policies and negotiation processes. We
obtained and reviewed the underlying agreements and documentation on
the agencies' policies, procedures, and processes for negotiating and
structuring civil settlements with monetary payments.
We also interviewed officials in the four agencies to determine if
their settlement policies and procedures were different now than they
were during fiscal years 2001 and 2002. We obtained documentation
supporting any major policy or procedural changes that addressed how
settlement payments are treated for tax purposes.
To determine whether the companies that paid some of the largest civil
settlement payments deducted any of their payments on their federal
income tax returns, we developed a data collection instrument (DCI) to
collect the information. We collected information from the four
agencies on their largest dollar civil settlements, that is, cases that
included payments to the federal government or others. Agency officials
advised us that the lists of the largest settlements would likely
include some settlements with entities that were not required to file
IRS Form 1120. When such a settlement was among the 20 largest, we
selected additional settlements that otherwise met our
criteria.[Footnote 28] In contrast to SEC, HHS, and DOJ, from which we
obtained information on the largest civil settlements payable to the
federal government and other parties such as relators, EPA settlement
amounts included costs incurred for companies to comply with
environmental laws and regulations. We selected the largest EPA
settlements that had a civil penalty because our focus was on how
payments were treated for tax purposes. We requested copies of
settlement agreements for the cases appearing on the lists from the
agencies.[Footnote 29]
We sent the DCI we developed to 44 companies for which we were able to
obtain copies of the settlement agreements and find cognizant
representatives who were familiar with the settlements and the tax
treatment of the settlement payments and who agreed to participate in
our survey. These 44 companies were required to file IRS Form 1120. In
the end, we received DCI responses from 31 companies concerning 34 of
the settlements. We told companies that we would only report
information we collected in summary form so company names are not
specifically identified.
We examined the settlement agreements for the 34 settlements reached by
companies that responded to our DCI to determine if they contained
specific language that addressed how civil settlement payments are to
be treated for federal income tax purposes.[Footnote 30] In those
instances where we found specific language that addressed how civil
settlement payments are to be treated for federal income tax purposes,
we followed up with agency officials to corroborate how this treatment
related to the specific agencies' policies and procedures.
The settlement agreements we examined are not a representative sample
of settlements for these agencies in these fiscal years, and the
results of our examination cannot be generalized to other settlement
agreements. Likewise, the information we obtained through our DCI
represents the responses of each company that voluntarily completed the
instrument with regard to a specific settlement. Their responses cannot
be generalized to any other population of settlements. Other than
verifying the settlement amount and that the amount was paid by the
companies when possible, we did not verify the other company responses
to our survey questions.
To determine what information IRS collects on companies with civil
settlements reached by federal agencies, we interviewed knowledgeable
officials from IRS and the four agencies and reviewed supporting
documentation about what information, if any, IRS obtains from the four
selected agencies regarding their civil settlement agreements.
To determine the results of IRS's audits of companies concerning the
tax treatment of settlement payments, we obtained information from
knowledgeable IRS auditing staff.[Footnote 31] An IRS technical advisor
(TA) manager provided us readily available information on IRS's
industry groups in its Large and Mid-Size Business Division on the
results of corporate audits where the deductibility of civil settlement
payments was an issue.[Footnote 32]
We conducted our work at EPA, SEC, HHS, DOJ, and IRS regional and
headquarters offices, from February 2004 through June 2005 in
accordance with generally accepted government auditing standards.
[End of section]
Appendix II: Selected IRS Audit Results Information on Companies with
Civil Settlement Payments:
According to selected information IRS provided on 46 companies that
claimed settlement payment deductions on their income tax returns, IRS
adjusted or proposed adjustments for approximately half of these
companies. The 46 companies settled with varying agencies, including
EPA, HHS, and DOJ. In the 24 cases for which IRS adjusted or proposed
adjustments to the amount deducted as settlement payments on the tax
return, the adjustments ranged from "not substantial" to 100 percent,
according to the IRS examiners' notes for the cases.
According to IRS staff, only a portion of the amount listed as a
settlement payment would be nondeductible. Because these portions would
be deemed to be penalties, the balance would be a deductible
compensatory expense. IRS collected this information under compliance
research projects and from additional information from staff familiar
with audits of companies in which the deductibility of settlement
payments was an issue.
This information, which covers multiple years, is limited to these
particular companies. As IRS staff selected the 46 companies for audit
or research because of potential noncompliance, these audit results
cannot be projected to other companies with civil settlements.
[End of section]
Appendix III: Comments from the Internal Revenue Service:
DEPARTMENT OF THE TREASURY:
INTERNAL REVENUE SERVICE:
WASHINGTON, D.C. 20224:
COMMISSIONER:
August 26, 2005:
Mr. Michael Brostek:
Director, Tax Issues:
United States Government Accountability Office:
Washington, D.C. 20548:
Dear Mr. Brostek:
Thank you for giving us the opportunity to review and provide comments
on your draft report titled, "Tax Administration: Systemic Information
Sharing Would Help IRS Determine the Deductibility of Civil Settlement
Payments" (GAO-05-747). Your audit report is comprehensive and provides
a balanced picture of settlement negotiations and agreements at Federal
regulatory agencies, and the IRS' efforts with respect to civil
settlements. We are pleased that the four Federal agencies you
interviewed during the course of the audit are willing to work with the
IRS on a permanent basis to routinely inform us about civil settlements
and provide related documents that would help us determine the
deductibility of large settlements, improve our audit strategies, and
facilitate pre-filing agreements with companies settling civil cases.
As mentioned in your report, section 162 of the Internal Revenue Code
(IRC) provides a deduction for all ordinary and necessary business
expenses, including settlements and similar payments. However, this
provision is subject to an exception in IRC § 162(f) that denies a
deduction for any fine or penalty paid to a government for the
violation of any law. It is often necessary to look at the pertinent
statute that underlies the settlement payment and the facts and
circumstances of the settlement to determine deductibility. Moreover,
the IRS' most difficult obstacle in this area is, and will continue to
be, the ability to determine the amount of the penalty on a case-by-
case basis. Therefore, we will continue to explore options for making
penalty determinations more readily ascertainable.
We agree with your recommendation that it would be beneficial for the
IRS to work with Federal agencies to develop a systematic method for
obtaining information on civil settlements contemporaneous with those
settlements. The IRS will follow your recommendation to create better
interagency information sharing. As mentioned in your report, the IRS
has been working with some government agencies on a case-by-case basis
to request information on civil settlements in connection with taxpayer
examinations and for temporary compliance research projects. We will
continue to do so until a permanent program is put in place to receive
civil settlement information. The following is our planned corrective
action in response to your audit recommendation.
Corrective Action:
The IRS will form an executive-led team to work with each agency with
significant civil settlements to reach agreement as to 1) what
information will be provided, 2) the format of the information, and 3)
the frequency of delivery.
Implementation Date:
June 30, 2006:
Responsible Official:
Director, Pre-filing and Technical Guidance (Large and Mid-Size
Business Division):
If you have any questions, please call me or Kathy Petronchak,
Director, Pre-filing and Technical Guidance at (202) 283-8280.
Sincerely,
Signed for:
Mark W. Everson:
[End of section]
Appendix IV: Comments from the Environmental Protection Agency:
Note: GAO comments supplementing those in the report text appear at the
end of this appendix.
UNITED STATES ENVIRONMENTAL PROTECTION AGENCY:
OFFICE OF ENFORCEMENT AND COMPLIANCE ASSURANCE:
WASHINGTON, D.C. 20460
AUG 26 2005:
Via Federal Express and Facsimile:
Mr. Charlie Daniel:
Assistant Director, Tax Issues:
Strategic Issues Team:
Rm 2C38:
U.S. Government Accountability Office:
441 G Street, N.W.
Washington, DC 20548:
Re: EPA Comments on the U.S. Government Accountability Office's Draft
Report, "Tax Administration: Systematic Information Sharing Would Help
IRS Determine the Deductibility of Civil Settlement Payments," GAO-05-
747:
Dear Mr. Daniel:
Thank you for the opportunity to comment on the Government
Accountability Office's (GAO's) above-titled draft report. Because your
report discusses enforcement settlement agreements reached by the
Environmental Protection Agency (EPA or Agency), the Administrator
referred the draft to the Office of Enforcement and Compliance
Assurance (OECA) for review and comment. We appreciate GAO's efforts
throughout the development of this draft report to seek EPA input on
our civil enforcement settlements. [NOTE 1]
EPA generally supports GAO's recommendation that EPA work with the
Internal Revenue Service (IRS) to develop a cost-effective means of
sharing information on civil enforcement settlements. Indeed, as
explained in further detail below, EPA believes that it already has
systems in place to provide the IRS with the information it needs to
evaluate the tax consequences of EPA settlements. In addition, we have
several other comments we would like to be considered as GAO prepares
its final report.
NOTE:
[1] As previously noted in our May 2005 informal comments, EPA's
comments will only apply to administrative enforcement settlements; any
comments regarding judicial settlements would be provided by the U.S.
Department of Justice (DOJ).
I. Recommendation to Share Settlement Information with the IRS:
GAO recommends that the IRS Commissioner "direct the appropriate
officials to work with federal agencies .. to develop a cost-effective
permanent mechanism to notify IRS when such settlements have been
completed and to provide IRS with other settlement information that it
deems useful in ensuring the proper tax treatment of settlement
payments." (See Draft Report at page 38). On page 35, the draft
provides that the "IRS says that it needs access to negotiating files,
court documents, settlement documents, personnel, and attorneys at the
relevant settling agencies." [NOTE 2]
As we have discussed with both GAO and the IRS, EPA believes that the
Agency already has systems in place to provide the IRS with the
enforcement settlement information it needs to evaluate the tax
implications of environmental enforcement settlements. While GAO's
draft report recommends that EPA develop a system to notify the IRS
when settlements are completed, EPA believes that its current
enforcement data systems are far more cost-effective than developing a
specific notification process for the IRS. Because the IRS can access
this data at any time, coupled with the fact that this data is updated
regularly, it is EPA's view that it would be an unnecessary expenditure
of resources to create a separate system for notifying the IRS whenever
EPA settles an enforcement case.
Specifically, EPA's publicly available website, the Enforcement and
Compliance History Online (ECHO) found at www.epa.gov/echo, contains
three years of information on concluded enforcement settlements,
including penalties, the estimated costs of injunctive relief and the
value of supplemental environmental projects (SEPs). In addition, EPA
has informed the IRS that it may access EPA's Online Tracking
Information System (OTIS), that provides multiple data on EPA cases and
regulated facilities. OTIS is only available to EPA's state and tribal
partners, as well as to other federal agencies that have received
approval from EPA for access. [NOTE 3] The information contained in
OTIS goes back more than three years. It provides, via an easy to use
website, details on settlements, including information on the amount of
penalties assessed and the estimated costs to be incurred as a result
of the respondent/defendant performing complying actions i.e.
injunctive relief), and SEPs, where applicable. At least one IRS staff
person has been granted access to OTIS, and EPA would welcome the
opportunity to provide access and training on OTIS to more IRS staff.
NOTES:
[2] In addition, IRS officials have indicated that receiving
information from agencies that shows the intent regarding the breakdown
of the settlement payment into what is considered "punitive" and
"compensatory" would be helpful to IRS in making tax determinations.
See Draft Report at page 33.)
[3] For example, the Securities and Exchange Commission (SEC) recently
received training on OTIS and now has access to the system.
With regard to GAO's reference to IRS's stated need for access to
documents such as negotiating files and settlement documents, EPA is
concerned that releasing such privileged information to the IRS could
result in a waiver of any protective privilege associated with such
documents, including those designated as enforcement confidential
and/or attorney-client privileged. As noted in GAO's draft report, in
2004, the IRS sought specific settlement information on approximately
thirty environmental enforcement settlements as part of the IRS's
temporary compliance project. EPA discussed the request with IRS
counsel, who advised EPA that the IRS would consider any privilege
associated with such documents to be waived, even if documents were
designated as enforcement confidential and/or attorney-client
privileged. As such, EPA is concerned that releasing privileged
information would jeopardize pending enforcement settlements and/or
ongoing enforcement actions with other respondents.
EPA believes that providing the IRS with access to EPA's data systems
will balance EPA's need to protect enforcement sensitive and privileged
settlement information from public disclosure with the IRS's need to
receive information on settlements to ensure that settlement payments
are treated appropriately for tax purposes.
II. EPA Settlement Components and Characterization as "Settlement
Payments" or "Payment Amounts"
Throughout the draft report, GAO refers to EPA civil settlements as
including "payment amounts" or "settlement payments." Although it is
not clear from the draft report, it appears that the terms "payment
amounts" and "settlement payments" include costs to be incurred by a
respondent as a result of an enforcement settlement, in addition to
civil penalties assessed pursuant to a civil settlement. To clarify any
ambiguity, we recommend that the text of the report distinguish between
monetary payments made directly to a governmental entity (L.& civil
penalties) and costs to be incurred by a defendant/respondent as a
consequence of performing the actions required under the civil
settlement agreement. Because GAO's draft report defines "civil
settlements" as "formal legal agreements between an agency and an
alleged violator to resolve a lawsuit or potential lawsuit see Draft
Report at page 1, footnote I and page 8), monetary payments made to
governmental entities pursuant to EPA enforcement settlements are
limited to civil penalties, generally payable to the U.S. Treasury.
[NOTE 4] In addition, many EPA settlements include injunctive relief
provisions - actions required to be taken by the respondent to come
into compliance, or to clean up environmental contamination. Finally,
some EPA settlements include SEPs. A SEP is not performed "in lieu of a
penalty," as stated at page 35 of the draft report. Rather, a SEP is a
project voluntarily undertaken by a respondent as part of a settlement
with EPA. In exchange for undertaking a SEP, EPA may mitigate the
ultimate civil penalty assessed.
NOTE:
[4] Pursuant to section 107 of the Comprehensive Environmental
Response, Compensation, and Liability Act (CERCLA), 42 U.S. C. § 9607,
EPA may recover all costs of removal or remedial action incurred by the
U. S. government not inconsistent with the National Contingency Plan.
Settlements resolving liability pursuant to CERCLA § 107 are not civil
settlements to resolve alleged noncompliance and are hence outside the
scope of GAO's draft report.
III. Statements Regarding EPA's Consideration of Taxes in Assessing a
Respondent's Economic Benefit of Non-Compliance:
The draft report includes several statements that are misleading with
respect to EPA's consideration of taxes when assessing a respondent's
economic benefit of noncompliance. Specifically, the document states
that the Agency "considers the aspects of the tax situation of the
settling company when calculating amounts they propose to seek in
negotiating environmental settlements. For example, they consider the
economic benefit a settling company gained from noncompliance and, in
doing so, they estimate a company's financial gain from not complying
with the law including the effects on the company's tax liabilities."
It appears that GAO has misunderstood EPA's activities with respect to
the development of the economic benefit and tax consequences. On pages
3 and 12, the draft states that EPA takes into account the violator's
tax liability. The tax liability is the money owed to the U.S. Treasury
on a year-to-year basis. We almost never consider a violator's tax
liabilities. In calculating the economic benefit of noncompliance, we
do assume that the violator is deducting/depreciating the cost of
compliance. We also assume the maximum marginal tax rate for settlement
purposes. If the violator insists on a corporate specific rate, we look
at their taxes and apply that rate, although this is rather unusual.
IV. H.R. 3, 109th Cong. § 5509 (2005):
GAO references a proposed provision in H.R. 3, 109th Cong. § 5509
(2005), that would modify Internal Revenue Code § 162(f), to disallow
certain deductions from taxes. (See Draft Report at page 9, footnote
3.) Specifically the bill provides that amounts paid or incurred
(whether by suit, agreement or otherwise) to or at the direction of a
government in relation to a violation of law, or the investigation or
inquiry into the potential violation of any law are nondeductible.
Based on recent conversations with GAO staff, and our review of the
Conference Report on H.R. 3, it is our understanding that this
provision was not included in the bill recently signed by the
President. [NOTE 5] Accordingly, we request that this footnote be
deleted or clarified to reflect that this was not included in the
enacted legislation.
NOTE:
[5] See House Report No. 109-203 at 1166-1168 and 1179.
V. Valuation of EPA Settlements in the Charts:
On the summary page and in Table 1 at page 11, the draft report
purports to summarize the approximate ranges and cumulative values of
the twenty largest civil settlement agreements for each of the four
agencies reviewed, including EPA, for fiscal years 2001 and 2002. While
the other agencies' settlements appear to include only payments made to
the U.S. government or other recipients (e.g., whistle blowers), the
value of EPA settlements reflected in the chart includes civil
penalties plus the estimated costs incurred by a respondent under the
terms of the settlement agreement e(., the estimated cost of installing
pollution control equipment). That is, the value of EPA civil
settlements summarized in the charts include the estimated dollar value
of the injunctive relief as well as the dollar value of any SEPs that
the respondent may have agreed to undertake as part of the settlement.
EPA is concerned that because the chart is not comparing like
"payments," the cumulative value of EPA's settlements is misleading. As
currently arrayed, the chart compares monetary payments under
settlements with the SEC, the Department of Health and Human Services,
and the Department of Justice with monetary payments (i.e., civil
penalties) plus estimated costs to be incurred by respondent in
performing injunctive relief and SEPs, where applicable, pursuant to
EPA settlements. To make these amounts comparable, we strongly urge GAO
to revise the chart in Table 1 to include only monetary payments made
pursuant to EPA settlements (i.e., civil penalties). We would be happy
to provide GAO with information on the twenty largest civil settlement
agreements that require the payment of civil penalties and were
concluded in FY01 and FY02.
VI. Conclusion:
Thank you once again for the opportunity to review and provide input on
GAO's draft report. In addition to the foregoing comments, we are
enclosing for GAO's consideration technical comments on the draft
report. In the event that you have questions or concerns regarding any
of our comments, please do not hesitate to contact Susan O'Keefe of my
staff at (202) 564-4021. Susan is the Associate Director of the Special
Litigation and Projects Division, within OECA's Office of Civil
Enforcement.
Sincerely,
Signed by:
Granta Y. Nakayama:
Assistant Administrator:
Attachment:
GAO Comments:
1. We reviewed the text in our draft report and believe that it
adequately distinguishes between monetary payments made directly to a
governmental entity and costs to be incurred by a defendant as a
consequence of performing actions required under a civil settlement
agreement. To illustrate, a note to table 1 in our draft report stated
that "For settlements identified by EPA, the total value of settlements
included payments payable to the U.S. government; the estimated cost of
any Supplemental Environmental Projects; and the estimated costs of
pollution controls, monitoring equipment, or other complying actions
that companies are required to take to come into compliance with
environmental laws."
2. As the Assistant Administrator suggested, we have revised our report
to show that a proposed legislative provision mentioned in a footnote
to disallow tax deductions for amounts paid to or at the direction of a
government in relation to a violation was not included in the bill
signed into law. However, our report shows that a new provision has
since been introduced.
[End of section]
Appendix V: Comments from the Securities and Exchange Commission:
UNITED STATES:
SECURITIES AND EXCHANGE COMMISSION:
DIVISION OF ENFORCEMENT:
WASHINGTON, D.C. 20548:
September 1, 2005:
Michael Brostek:
Director, Tax Issues:
Strategic Issues Team:
U.S. Government Accountability Office:
Washington, DC 20548:
Dear Mr. Brostek:
Thank you for the opportunity to review and comment upon the draft rep
art primarily concerning tax administration and the deductibility of
civil settlement payments. The report discusses how the Internal
Revenue Service identifies and evaluates returns from taxpayers who
have paid money pursuant to civil settlements with governmental
agencies. The report includes an analysis of certain settlements
reached by four federal agencies, including the Securities and Exchange
Commission, and further discusses whether and to what extent each of
these agencies takes into account tax considerations in negotiating
settlements.
We note that the concluding recommendation in the draft report is not
specifically directed towards the Commission. Nevertheless, please be
assured that the Commission takes seriously the importance of
meaningful sanctions in our enforcement program, and we are constantly
evaluating the best means to effectuate the Commission's goal of
investor protection.
We appreciate the courtesy that the GAO has extended to the Commission
in connection with the preparation and fiinalization of this report and
its recommendation. if we can be of further assistance, please feel
free to contact me at (202) 551-48941 or Joan McKown at (202) 551-4933.
Yours Truly,
Signed by:
Linda Chatman Thomsen:
cc: Charlie W. Daniel:
DanielC@gao.gov:
[End of section]
Appendix VI: Comments from the Department of Health and Human Services:
DEPARTMENT OF HEALTH & HUMAN SERVICES:
Office of Inspector General:
Washington, D.C. 20201:
AUG 22 2005:
Mr. Michael Brostek:
Director, Tax Issues:
Strategic Issues Team:
U.S. Government Accountability Office:
Washington, DC 20548:
Dear Mr. Brostek:
The Department has reviewed your draft report entitled, "TAX
ADMINISTRATION: Systematic Information Sharing Would Help IRS Determine
the Deductibility of Civil Settlement Payments" (GAO-05-747), and has
no comments at this time.
The Department provided technical comments directly to your staff.
The Department appreciates the opportunity to comment on this draft
report before its publication.
Sincerely,
Signed by Larry J. Goldberg for:
Daniel R. Levinson:
Inspector General:
The Office of Inspector General (OIG) is transmitting the Department's
response to this draft report in our capacity as the Department's
designated focal point and coordinator for U.S. Government
Accountability Office reports. OIG has not conducted an independent
assessment of these comments and therefore expresses no opinion on
them.
[End of section]
Appendix VII: GAO Contact and Staff Acknowledgments:
GAO Contact:
Michael Brostek (202) 512-9110:
Acknowledgments:
In addition to the contact named above, Thomas Beall, Danielle Bosquet,
Charlie Daniel, Keira Dembowski, Jeanine Lavender, Cheryl Peterson,
Michael Rose, Amy Rosewarne, and Jennifer Wong made key contributions
to this report.
FOOTNOTES
[1] In this report, civil settlements are formal legal agreements
between agencies and alleged violators to resolve a lawsuit or
potential lawsuit. The terms agencies use to refer to civil settlement
agreements may vary.
[2] 26 U.S.C. et seq.
[3] HHS's role in these negotiations includes recommending an
appropriate settlement amount to DOJ.
[4] HHS settlements were for FCA cases for which DOJ had primary
responsibility.
[5] Recently, several legislative proposals have been introduced, but
not enacted, to modify the rules for deducting fines or similar
penalties paid to the government for the violation of any law.
Currently, a proposed provision in S. 1565, 109th Cong. § 207 (2005),
would provide that amounts 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 the investigation or inquiry
into the potential violation of any law are nondeductible. The bill
contains an exception for restitution. Amounts paid to certain self-
regulatory entities that impose sanctions, such as the National
Association of Securities Dealers, are treated similarly for purposes
of the proposal.
[6] Treas. Reg. § 1.162-21(b)(1)(iii).
[7] Treas. Reg. § 1.162-21(b)(2).
[8] Restitution is the return or restoration of some specific thing to
its rightful owner or status. Disgorgement is the act of giving up
something (such as profits illegally obtained) on demand or by legal
compulsion.
[9] A civil penalty is a fine assessed for violation of a statute or
regulation.
[10] This total differs from the sum of the agency cumulative value in
table 1 because we excluded 7 of the FCA settlements identified by HHS
that were also included in DOJ's list of the 20 largest civil
settlements for fiscal year 2001 and the 20 largest civil settlements
for fiscal year 2002.
[11] Although DOJ has lead responsibility for negotiating FCA cases on
behalf of HHS, HHS is involved in the negotiations process, including
recommending settlement amounts to DOJ.
[12] In some cases, such as when the settlement only requires a company
to come into compliance, a settlement does not include a civil penalty
payment.
[13] In B-247155 (July 7, 1992) we concluded that EPA lacked authority
to settle certain EPA actions by entering into SEPs. Further, in B-
247155.2 (Mar. 1, 1993) we concluded that the Miscellaneous Receipts
Act, 21 U.S.C. § 3302, which requires all federal agencies to remit all
penalties to the U.S. Treasury, was circumvented when alleged violators
were allowed to make payments to an institution other than the federal
government. According to EPA officials, subsequent to our decisions,
EPA made substantial changes to its SEP policy to address our concerns.
We did not assess the changes to EPA's SEP policy.
[14] Treas. Reg. § 1.162-21(b)(2).
[15] Pub. L. No. 107-204, § 308, 116 Stat. 745 (2002).
[16] Private persons, known as relators, can bring actions for
violations of FCA. 31 U.S.C. § 3730.
[17] We sent surveys on 47 civil settlements to companies in which we
identified a representative who could address our survey questions. Our
results are limited to the 34 settlements for which we received
responses. Three of the companies we surveyed responded for 2
settlements each. See app. I for more details on our methodology.
[18] One surveyed company stated that it planned to take a deduction
for the SEP portion of its civil settlement payment, but had not yet
done so at the time of our survey. For purposes of this report, we
categorized this company's response as deducted.
[19] DOJ cited Cook County, Illinois v. U.S. ex rel. Chandler, 538 U.S.
119 (2003).
[20] The Double Jeopardy Clause in the U.S. Constitution prohibits
anyone from being prosecuted twice for substantially the same crime.
U.S. Const. amend. V. The Excessive Fines Clause of the U.S.
Constitution prohibits the imposition of excessive fines. U.S. Const.
amend. VIII.
[21] In settlement agreements for the surveyed companies, some SEPs are
referred to as Beneficial Environmental Projects or Environmental
Beneficial Projects.
[22] IRS recently issued a technical advice memorandum, TAM 200502041
(Jan. 14, 2005), that concluded that the tracking form was not relevant
"since the proper allocation [between punitive and compensatory aspects
of a FCA recovery] depends on intent at the time the settlement was
reached, not on events occurring after that time." A TAM is a written
response to a technical or procedural question on the interpretation
and proper application of tax authority to a specific set of facts. A
taxpayer may not rely on a TAM issued to another taxpayer.
[23] IRS's Pre-filing Agreement Program encourages taxpayers to request
consideration of an issue before the tax return is filed and thus
resolve potential disputes and controversy earlier in the examination
process. IRS intends such agreements to reduce the cost and burden
associated with post-filing examinations, to provide companies a level
of certainty regarding a transaction, and to make better use of
taxpayer and IRS resources.
[24] According to EPA, SEPs are projects, not already required by law,
undertaken voluntarily by a respondent/defendant in an enforcement
action. A respondent/defendant's agreement to perform a SEP may be
taken into account as a mitigating factor in assessing the ultimate
civil penalty in a particular case. To calculate the value of an SEP,
EPA's economic model considers, among other things, the entity's tax
status, the penalty payment date, the estimated project costs, the
project's operation date, the combined state and federal tax rate, and
the tax deductibility of onetime nondepreciable expenditures.
[25] We excluded flow-through entities, such as partnerships that do
not file IRS Form 1120. We also excluded individuals, governments, and
not-for-profit entities.
[26] This document was jointly written by the Chief Financial Officers
Council and the Office of Management and Budget.
[27] Pub. L. No. 105-362, § 1301(a), 112 Stat. 3280 (1998).
[28] We selected to survey companies on 5 settlements outside of the 20
largest for 4 DOJ-led HHS False Claims Act settlements and 1 DOJ-led
EPA settlement --for reasons including the following: we were not
always able to identify a cognizant representative or obtain a
settlement agreement for each of the 20 largest for each fiscal year.
[29] In some instances, we did not need to request copies of the EPA
settlement agreements because EPA posted the agreements on its Web
site.
[30] We did not examine SEC settlement agreements to determine if they
contained specific language addressing federal tax treatment of
payments because SEC officials told us that the agency did not include
language addressing tax consequences in settlement agreements prior to
2003.
[31] Because IRS databases do not have indicators to track audit cases
with settlements, a systematically identified set of cases involving
settlements was not available for us to examine.
[32] According to an IRS TA Manager, IRS examiners are likely to
consult TAs and TA managers in examining such issues as deduction of
settlement amounts. TAs are nationwide experts who ensure consistent
treatment of all taxpayers' issues within their specific industries or
issue areas.
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