IRS has privately ruled that an investment services company could deduct as a Code Sec. 162 business expense its payments to settle a class action lawsuit related to its placement of clients' money in a fund that went bankrupt due to the criminal actions of its manager. It used the origin of claim doctrine to conclude that the settlement payments were made in the ordinary conduct of the taxpayer's trade or business.
Background. Under Code Sec. 162(a), a taxpayer can deduct all the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. However, no deduction is available for personal expenditures, capital expenditures, or fines or similar penalties paid to a government for the violation of any law. Generally, amounts paid to settle lawsuits are currently deductible if the acts which gave rise to the litigation were performed in the ordinary conduct of the taxpayer's business.
The origin of the claim test, first set forth by the Supreme Court in U.S. v. Gilmore, (S Ct 1963) 11 AFTR 2d 758, 372 U.S. 39, controls how to distinguish deductible business expenses from personal or capital expenditures. Under this test, the substance of the underlying claim or transaction out of which the expenditure in controversy arose governs whether an item is deductible, regardless of the motives of the payor making the payment or the consequences that may result from the failure to defeat the claim.
Under Code Sec. 461(h) and, an accrual method taxpayer incurs a liability in the tax year in which all events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
Under Code Sec. 263(a), no deduction is allowed for the cost of permanent improvements or betterments made to increase the value of any property. Instead, such costs must be capitalized.
Facts. ABX Corp., an accrual method taxpayer, is owned by Foreign Parent, a bank. Foreign Parent provides a full range of banking services to a diverse client base. Individual customer services include private banking services for high net worth individuals. ABX is part of Foreign Parent's private banking division, and services high net worth individuals of a specific geographic area. In addition to traditional banking services, ABX also provided asset management and investment advisory services. In connection with its private banking business, ABX made available to some of its clients the opportunity to invest in shares of several investment funds. In Year 1, criminal actions were commenced against the manager of one of these funds for his role in a fraud that resulted in the placement of the fund into bankruptcy. Clients of ABX who were invested in this fund consequently suffered losses as a result of the criminally fraudulent activities of the fund's manager. As a result of these losses, four class action lawsuits were filed in Year 2 naming ABX as a defendant, among others. The claims alleged the following causes of action: (a) violation of §10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 of the SEC; (b) negligent misrepresentation; (c) breach of fiduciary duty; (d) gross negligence; and (e) unjust enrichment.
On Date 1, Foreign Parent announced that it would offer a Settlement to its clients who had invested in the fund and were therefore affected by the fraud. The structure of the settlement was conceived to satisfy ABX's regulatory requirements as well as its clients. ABX participated in the Settlement via a contribution to Foreign Subsidiary 1, a wholly owned subsidiary of Foreign Parent. Foreign Subsidiary 1 in turn issued its own preferred securities directly to ABX's clients who accepted the terms of the Settlement. The preferred securities entitle the holder, subject to certain conditions, to a fixed percentage, non-cumulative annual cash distribution and have a perpetual term (meaning that the shares can never be redeemed). Annual distributions, as well as liquidation and redemption payments, are guaranteed by Foreign Parent. The preferred securities are redeemable at the option of Foreign Subsidiary 1, in whole but not in part, on any distribution date occurring on or after Final Date.
The Settlement in turn required ABX's clients to transfer legal title to the shares in the ABX funds (including any causes of actions those funds may have against Fund, its manager, and/or any other third party) to Foreign Subsidiary 2, which are held in a Foreign Subsidiary 2 account. In addition, ABX's clients were required to forgo any legal actions against Foreign Parent and related subsidiaries included ABX, for the clients' investments in Fund. At the time of the Settlement, ABX did not obtain compensation from Foreign Subsidiary 2 in connection with the funds' securities because their value was doubtful. ABX represented that it did not stand to obtain any compensation in the future in connection with the Fund. ABX did not receive any reimbursement from an insurance company, or similar compensation, as a result of its payment in connection with the Settlement.
Observation: The terms of the settlement in PLR 201117007 are very similar to those offered by Banco Santander, a large Spanish bank, to clients that it placed into a Bernard Madoff-run fund.
On Date 2, Year 2 Foreign Subsidiary 1 issued preferred securities directly to ABX's clients who accepted the Settlement. ABX did not hold in its own account or name any of the preferred securities for future settlements. ABX did not hold the preferred securities for any period of time after issuance during which the value of the preferred securities could have fluctuated. Based on the number of ABX's clients who accepted the Settlement, and the principal amount of their investment in the funds, ABX made an undisclosed cash contribution to Foreign Subsidiary 1. ABX also represented that the preferred shares are the equivalent of cash. ABX received an undisclosed capital contribution from Foreign Parent in connection with ABX's contribution to Foreign Subsidiary 1.
Favorable rulings. IRS responded favorably to each of the ruling requests made by ABX:
... Payments are deductible under Code Sec. 162 ABX, as a trusted financial advisor, adopted the Settlement to protect its reputation in the marketplace and maintain its current level of business. The Settlement was reasonable given the alleged damages sought in the class action lawsuits, and resulted in a payment of value to ABX's clients. As a result, the payment for the release of potential liability under the Settlement was an ordinary and necessary expense of ABX's trade or business.
... Liability was fixed at time of payment. In Year 2, ABX entered into a Settlement agreement with its clients who accepted the Settlement. Also in Year 2, it made a contribution to Foreign Subsidiary 1 and on the same date Foreign Subsidiary 1 issued preferred securities directly to ABX's clients who accepted the Settlement. ABX's liability was fixed by the Settlement agreement, the amount of the liability was determinable with reasonable accuracy, and economic performance occurred when the Foreign Subsidiary 1 preferred securities were issued to ABX's clients to the extent of the fair market value of those shares. As a result, ABX's liability under the Settlement was incurred in Year 2.
... None of the payments are capitalized. ABX's payment of preferred stock to its settling clients for the release of liabilities and to maintain good business relations with its clients did not create a separate and distinct asset, a financial interest, or a significant future benefit. As a result, the payments to ABX's clients aren't capitalized under Code Sec. 263(a).
References: For origin of the claim doctrine, see FTC 2d/FIN ¶L-2501; TaxDesk ¶305,001; TG ¶16161.