The global settlement and tax deductibility of fines and penalties.

• Author: Beck, Allen M.

On April 28, 2003, the Securities Exchange Commission (SEC), New York Stock Exchange (NYSE), National Association of Securities Dealers (NASD), North American Securities Administrators Association and New York State Attorney General announced the "Global Settlement of Conflicts of Interest Between Research and Investment Banking" (Global Settlement), finalizing an agreement reached in principle in December 2002. The Global Settlement followed joint investigations by regulators into alleged conflicts of interest between investment banking and securities research at brokerage firms. As a result of the investigation, 10 of the nation's top investment firms agreed to pay a total of approximately $1.4 billion; see www.nasd.com/global_settlement.asp.

The $1.4 billion settlement comprised $487.5 million in penalties, $387.5 million in disgorgement, $432.5 million to fund independent research and $80 million to fund and promote investor education. The Global Settlement, as well as recent agreements reached by MCI and others, have brought attention to uncertainties as to the tax treatment of settlement payments. The possibility of the firms obtaining sizable tax benefits from deducting the payments raised a political outcry and prompted proposed legislation to expand the definition of nondeductible fines or penalties.

Generally, no deduction is allowed if the payments are classified as a "fine or penalty payable to a government." However, it is not always clear when a payment is a penalty; payments called penalties may still be deductible if classified as compensation for damages. The tax treatment of fines and penalties is discussed below.

The Code

Sec. 162(f) disallows a deduction for "any fine or similar penalty paid to a government for the violation of any law." The history of Sec. 162(f)'s enactment in the Tax Reform Act of 1969 reveals that Congress intended to codify the general court position disallowing the deduction of fines and penalties.

The Supreme Court had addressed the issue in Tank Truck Rentals, Inc., 356 US 30 (1958), and Hoover Motor Express Co., Inc., 356 US 38 (1958), and declared in both cases that no deduction was allowable for a fine or penalty if the deduction would severely frustrate a sharply defined national or state policy. The goal was to prevent favorable tax treatment from "blunting the sting" of a validly imposed penalty. In H.A. True, Jr., 894 F2d 1197 (1990), the Tenth Circuit noted that committee comments and...