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From Health Law Daily, August 14, 2014

Government can’t dictate tax treatment of FCA settlement payments

By Michelle L. Oxman, JD, LLM

The government’s refusal to agree on the deductibility of settlement proceeds has no effect on the tax treatment of the payments, a federal appeals court has ruled. Rather, settlement agreements under the False Claims Act (FCA) are treated like settlements of litigation between private parties. If the parties do not agree on the tax consequences of payments, the IRS or a court must make the determination based on the “economic realities” of the transaction. The trial court’s decision was affirmed (Fresenius Medical Care Holdings, Inc. v United States, August 13, 2014, Selya, B).

The settlement. Fresenius Medical Care Holdings, Inc. and its predecessor in interest (Fresenius) operated a chain of dialysis centers. Between 1993 and 1997, several whistleblowers in different locations brought qui tam actions under the FCA, 31 USC sec. 3729et seq. Government agencies then began their own investigations and intervened in the qui tam suits. Ultimately, Fresenius entered into a global settlement with the government covering a variety of claims, including those under the FCA, under which it paid more than $464 million to the government. Of this amount, about $101 million was earmarked as criminal fines; the remaining $385 million constituted civil damages. The settlement agreement specifically disclaimed any commitment as to the tax treatment of the civil damages.

Deductibility. Because 26 USC sec. 162(f) provides that no deduction is allowed for fines or penalties, Fresenius claimed no deduction on its tax return for the criminal penalties. In negotiations, Fresenius and the government agreed that the single damages under the FCA, about $193 million, were deductible as compensatory damages. The tax treatment of the remainder, about $193 million, at least some of which was attributable to the treble damages available to the government under the FCA, was disputed.

The litigation. Fresenius paid the taxes on the disputed amount under protest and pursued an administrative appeal, in which the government conceded that the payments to the relators also were deductible. Fresenius then filed a lawsuit for a refund of the tax it had paid on the remaining amount, about $127 million. The government relied on Talley Industries Inc. v Commissioner, 116 F.3d 382 (9th Cir. 1997) for the proposition that all amounts in excess of the single damage award were punitive unless the settlement agreement provided otherwise. It argued that no part of the disputed amount was deductible because the settlement agreement explicitly took no position on the tax consequences of the civil damages.

The trial court ruled that the agreement was only one factor to be considered and that the economic consequences of the transaction controlled because the agreement was silent. Therefore, it denied the government’s motion for judgment as a matter of law. Fresenius presented evidence of the compensatory nature of the payments, and the trial court instructed the jury to determine the amount necessary to place the government in the position it would have been in if the unlawful conduct had not occurred. The jury determined that $95 million was paid to make the government whole.

The appeal. The First Circuit rejected the government’s interpretation of the Talley decision. In that case, the settlement agreement addressed the deductibility issue but was not clear, and the parties had not developed a factual record as to the economic consequences of the payments. It noted that other decisions established that payments under the FCA in excess of the single damage amount may compensate the government for the expenses of litigation, interest on the amount due, or other costs.

The appeals court also ruled that the government’s position was inconsistent with two general principles of tax law: (1) the economic realities of a transaction, not a designation in an agreement between the parties, determine the tax consequences; and (2) payments under a settlement agreement should be treated as they would be after a trial and entry of judgment. Both principles required that the court consider factors other than the parties’ agreement in determining the deductibility of the payment.

The court declined to consider the government’s argument that the trial court’s instruction to the jury on how to determine the amount of the penalty was incorrect because the government had not raised that specific objection below.

The case number is 13-2144.

Attorneys: James F. Bennett (Dowd Bennett LLP), Thomas C. Borders (McDermott Will & Emery LLP), and Maria R. Durant (Collora LLP) for Fresenius Medical Care Holdings, Inc. Tamara W. Ashford, U.S. Department of Justice, for United States.

Companies: Fresenius Medical Care Holdings, Inc.; United States

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