While the legal debate over the definition of disgorgement is far from over, the basis for its tax deductibility has again drawn attention to the use of "net profit" as a possible base for calculating the gain. It will be interesting to see how the story unfolds. The success, however, as with so many great stories, will depend on who is sitting in the director’s chair.
Updated on 15 December, 2020
Earlier this month, the US Congress approved the National Defense Authorization Act for Fiscal Year 2021 (“NDAA”). Buried deep in the 4,000-plus pages of the NDAA is an amendment to the Securities Exchange Act of 1934 which gives the Securities and Exchange Commission (“SEC”) statutory authority to seek disgorgement of any unjust enrichment resulting from violation of a securities law and establishes a 10-year statute of limitations for disgorgement and equitable remedies. As we know, the SEC frequently seeks to disgorge illicit profits in Foreign Corrupt Practices Act resolutions, and this new legislation provides the SEC with the clarity and explicit approval to pursue ill-gotten gains in federal court.
As discussed in the article below, after the 2017 Supreme Court ruling in Kokesh v SEC, which deemed the disgorgement of ill-gotten gains to be a penalty and therefore subject to the five-year statute of limitations period, the SEC found itself in the potentially unenviable position of being unable to recover funds for victims simply because the fraudulent scheme commenced more than five years earlier. Furthermore, the Kokesh ruling did not opine on whether the SEC had the explicit authority to seek disgorgement in the first place. This setback was partially addressed in Liu v SEC before the Supreme Court earlier this year, when the Court ruled that the SEC did indeed have the power to seek disgorgement in federal court, but limited the recoverable amount to the net profit obtained from the unlawful conduct.
The amendments to the Securities Exchange Act included in the NDAA will be applicable not just to future cases but also to those still pending at the time the NDAA is enacted, at a stroke increasing the potential size of the disgorgement sought by the SEC through federal courts. For those cases where illicit profits have been ‘earned’ by wrongdoers over many years, the return of ten years’ worth of ill-gotten gains could well result in a significant increase to the size of payments being made by the targets of SEC disgorgement actions.
So the story continues…
If you have been following the development of disgorgement and what implications the recent changes may have had on companies, then you may have noticed the latest US Internal Revenue Service (IRS) publication, proposing changes that will prevent companies from deducting disgorgement and forfeiture payments from future taxable profit.
Act One: Setting the Scene
To understand how it is we have gotten to this point, we need to go back to the beginning. Similar to most other tax jurisdictions, the IRS does not allow a taxpayer to deduct from the calculation of taxable income any fines and penalties paid. Generally, whether a disgorgement payment was tax-deductible or not depended on whether the IRS deemed the payment as a form of “compensation” to the victim or punishment. This would depend on the facts of the particular case as the IRS interpreted it and was largely uninfluenced by any of the terms negotiated with enforcement agencies. Therefore, the IRS’s decision of whether a settlement payment qualified for deductibility was largely left to them.
Act Two: Enter Kokesh
The ruling from Kokesh v SEC during 2017 pleased most audiences, holding that claims by the SEC for disgorgement are subject to the five-year statute of limitations. This was seen by many as a win against “the man.” However, it was another section of the ruling that caught the attention of the IRS, that being “[t]he primary purpose of disgorgement orders is to deter violations of the securities laws by depriving violators of their ill-gotten gains.” It seems that it was this part of the ruling that in essence likened (to the IRS, at least) disgorgement payments to that of a fine or penalty and in all likelihood prompted the changes to tax regulation.
Act Three: Enter IRS and the publishing of new regulations
On May 13, 2020, the IRS proposed new rules, potentially denying the deductibility of disgorgement from future taxable profits. Some legal pundits are even arguing that, in its current state, it would appear to deny a deduction for any payment categorized as “disgorgement,” even if paid to restore or compensate an injured party. If disgorgement were to be denied its tax deductibility status entirely, it would tear away at the concept of disgorgement; that it is meant to restore the offender to its economic position before having committed the wrong.
Considering that, where a wrongdoer paid tax on profits earned and is subsequently asked to disgorge the gross amount of profit in full, the company is essentially still “out of pocket” for an amount equal to the tax paid; tax that the company paid on profit it was adjudged not to have earned. Being able to claim back the tax, in the form of deducting the disgorgement from future taxable income, would restore the balance. Regulators, like the SEC and DOJ, have other mechanisms for penalizing the wrongdoer, over and above the disgorgement.
The ruling in Kokesh likely opened the door for the IRS to suggest the changes and enable them to hang onto to the tax collected, changes that arguably would have seen less resistance from the public, that is, until Liu v Sec.
Act Four: Enter protagonist Liu
The Liu v. SEC ruling in July 2020 is thought to muddy the waters a bit and perhaps argues to restore the balance, to leave the wrongdoer in the position it was in had it not transgressed. The Court held that a disgorgement is a form of equitable relief and should not exceed a wrongdoer’s net profits and one can observe the terms “disgorgement” and “restitution” often used interchangeably. While this legal debate over the definition of disgorgement is far from over, the basis for its tax deductibility has again drawn attention to the use of “net profit” as base for calculating the gain. A possible solution might be for the company to negotiate with the regulating agency to include taxes paid on the gain, as part of the legitimate business expenditure. The tax will be deducted from the gain amount in determining the final amount of the disgorgement and ultimately come to a closer “net profit view,” as suggested by Liu. In this scenario, it would make sense for the IRS to refuse the disgorged amount as a tax deduction as the company would have received this benefit already when it negotiated its disgorgement settlement with the relevant regulator.
We know this not to be the Final Act
The narrative might be paused for now, but the story is far from over. Even after the IRS considers the input from the public and promulgates the final changes into effect, we know that some section of it will eventually be challenged. Perhaps only once courts have additional opportunity to weigh in, will we see exactly how far companies will be penalized. The yardstick seems to be unstuck at the moment.
There should be no reason for companies to be penalized further by paying tax on profits deemed not to have earned. This is not “tax,” rather a new or additional penalty which will have to be decided on in society’s search to restore a wrongdoer to a fair economic position it was in before having committed the wrongdoing.
 Source: Kokesh v. SEC, 137 S. Ct. 1635 (2017).