After a four-year court battle, MasterCard Inc. announced on June 25, that it had reached an agreement to settle its outstanding litigation with American Express. The lawsuit, filed in federal court in 2004, alleged that MasterCard, Visa, and some of their member banks blocked Amex from the bank-issued card business in the United States.
The settlement calls for 12 quarterly payments by MasterCard, beginning in the third quarter of 2008, each of $150 million. The payments are contingent on the performance of Amex’s U.S. Global Network Services business. According to the MasterCard press statement, “On a tax-affected net present value basis, the settlement payments are estimated to be, in the aggregate, approximately $1 billion. MasterCard will take a charge for the settlement in the current quarter. The maximum nominal amount of the settlement is $1.8 billion”
There is a question, however, as to whether MasterCard is entitled to a tax deductible for the payments it makes; and if so, when will the deduction arise? Although there is limited information with which to work, we believe we can come up with an accurate assessment of the issues.
Ordinary and Necessary Business Expenses
Regarding whether the settlement payouts are taxable, Section 162 of the Internal Revenue Code says that in carrying on any trade or business, a deduction is allowed for all of the ordinary and necessary expenses paid or incurred during the taxable year. There is no “moral” component to this rule. Indeed, a 1980 IRS ruling ( Revenue Rule 80-211, 1980-2 C.B. 57) provides an example of a corporation that deducts a payment identified as punitive damages as an ordinary and necessary business expense.
The ruling explains that the corporation’s obligation to make the payment arose out of a civil lawsuit. In the suit, the company, called Chi Corp for this purpose, was sued by Upsilon Inc. for both breach of contract and fraud in connection with the “ordinary conduct” of its business activities. Judgment was rendered against Chi by the court in which the lawsuit had been filed.
The ruling concludes that payment of the judgment by Chi — including those amounts identified as punitive damages — is an ordinary and necessary “cost of doing business”, and is therefore, deductible for federal income tax purposes. The ruling notes that both the courts and the IRS recognize that payments made in settlement of lawsuits are deductible if the acts which gave rise to the litigation were performed in the ordinary conduct of the taxpayer’s business.
However, there is a caveat. When Section 162 was amended by the Tax Reform Act of 1969, Congress included a list of expenditures for which a deduction would be disallowed. That list was intended to be “all-inclusive,” and not merely illustrative. Therefore, if the settlement payout relates to an activity not specifically enumerated in Section 162(c) — and the limitations set forth in other parts of Section 162 are not implicated — the outlays ought to be tax-deductible regardless of the fact that they stem from an activity which offends the sensibilities of most observers.