Under existing court precedent and IRS guidance, payments made under the False Claims Act pursuant to a court order or a settlement agreement are treated as deductible to the extent that they are compensatory or remedial in nature. See Fresenius Medical Care Holdings, Inc. v. United States, 763 F.3d 64 (1st Cir. 2014). The ruling in Fresenius was based on Section 162(a) of the Internal Revenue Code, under which compensatory payments are deductible as ordinary and necessary business expenses. Fines and penalties are not deductible under section 162(f) of the Code. For this purpose, Treasury regulations define a "fine or similar penalty" to include amounts "[p]aid as a civil penalty imposed by Federal, State, or local law" and amounts "paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal)." 26 C.F.R. § 1.162–21(b)(1). However, "[c]ompensatory damages ... paid to a government do not constitute a fine or penalty." 26 C.F.R. § 1.162–21(b)(2).

Under these provisions, so-called "single damages" amounts that are inherently compensatory under the False Claims Act are deductible. On the other hand, the tax treatment of statutory penalties or the "multiple" damages imposed in excess of the single damages amount, which may serve both compensatory and punitive purposes, depends upon the particular facts and circumstances of the individual case. In this regard, amounts paid to the relator, prejudgment interest, and governmental investigatory expenses may be considered compensatory and therefore deductible in some situations. See Fresenius, 763 F.3d at 68-69. The burden of proving that the payments are compensatory is on the taxpayer. Id. at 68.

If enacted and signed by the President, the new law would provide that False Claims Act payments are generally not deductible except to the extent that the payment constitutes restitution for damage or harm caused by the violation or potential violation of any law, or is paid to come into compliance with any law which was violated, and the payment is identified as such in the court order or settlement agreement. Moreover, even if an amount is identified as restitution in a court order or settlement agreement, that identification "shall not be sufficient" to establish deductibility. In other words, the IRS would be free to challenge deductibility, and the taxpayer would have the burden of establishing that any amount paid actually constitutes restitution.

Furthermore, amounts paid as reimbursement for governmental investigatory expenses would not be deductible. The new law does not specifically discuss the deductibility of amounts paid to relators, but the disallowance of the deductibility of investigatory expenses raises concerns about the deductibility of amounts paid to relators.

The new law would apply to amounts paid or incurred on or after the enactment date, except that it would not apply to amounts paid or incurred under any binding order or agreement entered into before such date. This exception does not apply to an order or agreement requiring court approval unless the approval was obtained before such date.

Two other provisions in the proposed legislation deserve close scrutiny: One section in the proposed Conference bill provides that the non-deductibility language "shall not apply to any amount paid or incurred by reason of any order of a court in a suit in which no government or governmental entity is a party." That may give defendants broader leeway to argue for deductibility in cases filed under the qui tam provisions of the False Claims Act in which the United States declines to intervene as a party.

Another provision would require government agencies (or entities treated as such) to file information returns with the IRS setting forth the amount of each settlement agreement or order entered into (with exceptions for certain de minimis amounts), and identify separately any amounts that are for restitution or remediation of property, or correction of noncompliance.

The implications of these changes are potentially significant for defendants in pending False Claims Act litigation, or companies that are the subject of a False Claims Act investigation by the Department of Justice. Historically, the Department has insisted upon a "standard" provision in its settlement agreements in which the parties stipulate that the agreement does not characterize the settlement amount for purposes of the Internal Revenue Code. The Fresenius court held that this "non-characterization" provision was not binding on a court considering the deductibility of the settlement amount. Instead, the economic realities (or the agreement of the parties) would determine what part of a settlement was compensatory and therefore deductible. Fresenius, 763 F.3d at 70-71. Under the language proposed in the Tax Cut and Jobs Act, that rule would change. Defendants would be able to treat as tax-deductible payments under the False Claims Act only to the extent that they are able to get the Department of Justice expressly to agree that part of the payment is restitution.