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.
In the current case, we know that the settlement announced by MasterCards pertains to litigation which alleged violations of certain anti-trust provisions. Accordingly, it is possible that Section 162(g) might limit MasterCard’s deduction for the settlement amounts. That section applies in cases in which: there is a criminal proceeding; the taxpayer is convicted of a violation of the antitrust laws; or the plea of guilty or nolo contendre to an indictment or information charging such a violation is entered or accepted in the proceeding.
In fact, under Section 4 of the Clayton Act such violations disallow deductions for two-thirds of amounts paid or incurred on any judgment for damages entered against the taxpayer. Deductions are also disallowed for settlement of any action brought under the Clayton Act on account of such violation.
But that doesn’t appear to be the case with MasterCard. The tax status of the payments has not been judged to be adversely affected by the provisions of Section 162(g). The fact that the discounted and “tax affected” settlement amount ($1 billion) represents only 55 percent of the gross settlement amount ($1.8 billion) suggests that MasterCard will be taking a tax deduction — under the authority of Revenue Ruling 80-211— for the full amount, not merely one-third thereof, of the payment.
Timing of Deductions
Under the accrual method of accounting, a liability is incurred, and generally taken into account for federal income tax purposes, in the taxable year when: (1) all events have occurred that establish the fact of the liability; (2) the amount of the liability can be determined with “reasonable accuracy”; and (3) so-called “economic performance” has occurred. This rule is known as the “all events” test. (See Regulation Section 1.461-1(a)(2).)
In the MasterCard case, the first two conditions of the all events test are each satisfied in 2008. And pending the evaluation of the economic performance condition, the amount to be paid out by MasterCard over the period of the agreement would be deductible in 2008. However, in our view, the economic performance prong of the test will defer MasterCard’s deduction.
To be sure, the economic performance of some liabilities occurs only when payment is made to the person to whom the liability is owed. For example, the rule applies to any workers’ compensation act, or arises out of any tort, breach of contract, or violation of law. That includes a liability arising out of the settlement of a dispute in which such a tort, breach of contract, or violation, respectively, is merely alleged. (See Reg. Sec. 1.461-4(g)(2).)
It appears that the liability incurred by MasterCard in connection with the Amex settlement fits this description. That means it is likely that MasterCard’s tax deductions related to the Amex payments will only arise in the years in which the payments are actually made. The fact that the charge will, for financial accounting purposes, be taken in 2008 has no bearing on the tax consequences of the settlement. For that purpose, under the all events test, the tax deductions should be available only as and when the payments are actually remitted to A.*
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
There is little doubt that the payments will be accounted for as ordinary income by American Express. Under the “origin of the claim” rule, it is well-settled that damages received in lieu of “lost profits” are taxed. In the MasterCard case, the amounts to be derived from the settlement might have to be taken into account in the year 2008, in which the settlement terms are hammered out. Under the accrual method, income can be included in gross income when (1) all the events have occurred which fix the right to receive such income, and (2) the amount can be determined with reasonable accuracy. (See Regulation Section 1.451-1(a).) There is not, as there is on the deduction side, an economic performance prong that must be satisfied for the accrual of income to take place. Accordingly, even though MasterCard’s deductions will likely be spread out over the period in which it makes the payments to Amex, the latter may well be required to account for the gross settlement amount in the taxable year in which the settlement agreement is entered into.