Last month, the U.S. Court of Appeals for the First Circuit affirmed the award of a $50 million tax refund to Fresenius Medical Care Holdings, Inc. The court agreed with Fresenius that certain payments in settlement of alleged False Claims Act violations were tax-deductible. The case is Fresenius Medical Care Holdings, Inc. v. United States, No. 13-2144 (1st Cir. Aug. 13, 2014).

Fresenius operates dialysis centers within the United States and abroad, and in the mid-1990s its predecessor company faced an array of FCA whistleblower suits and related government investigations. Fresenius eventually settled both criminal and civil matters with the Government, agreeing to pay $385,147,334 to resolve the civil matters.

Fresenius claimed a tax refund based on the amount it paid to settle civil FCA claims. Civil FCA violations normally result in treble damages and a statutory penalty per false claim. Although the Government agreed that Fresenius could deduct an amount equal to single damages ($192,550,517) plus that amount owed to the whistleblowers ($65,800,555), Fresenius sued in the District of Massachusetts to seek a tax refund based on the remaining $126,796,262. A jury concluded that $95,000,000 of the remaining $126,796,262 was “compensatory” in nature and hence deductible, which resulted in a $50,420,512.34 tax refund for Fresenius.

The Government appealed, arguing that amounts paid in settlement of civil FCA claims—other than single damages and whistleblower payments—are nondeductible unless the parties enter into a tax characterization agreement indicating a mutual intent that those sums be deductible. The Government relied on a Ninth Circuit case, Talley Industries Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 1997), in support. Because there was no tax characterization agreement in this case, the Government reasoned, Fresenius was owed no refund.

The First Circuit found the Government’s position unpersuasive in light of “generally accepted principles of tax law” to the contrary. Fresenius’s ability to deduct civil FCA settlement payments did not turn exclusively on the presence or absence of a tax characterization agreement. Instead, the district court had correctly instructed the jury to consider what portion of the settlement was compensatory, rather than punitive, “in terms of the economic realities of make-whole remediation.” Under well-settled rules of tax law, the compensatory portion was deductible.

The First Circuit identified a number of rationales for its conclusion. For one thing, exclusive reliance on the existence of a tax characterization agreement would give the Government case-by-case veto power over deductibility by refusing to engage in an agreement. Moreover, such exclusive reliance “would be an anomaly in tax law,” as “courts that are required to make tax characterizations typically look to substance—that is, the economic reality of the particular transaction, objectively viewed—rather than to the form chosen by the parties.” Of course, if a tax characterization agreement existed in a particular case, a court should “honor that agreement,” but the absence of one should not doom settlement payments as nondeductible.

Contrary to the Government’s reading of Talley, the First Circuit’s decision in Fresenius does not actually create a clear circuit split. Talley does not hold that a tax characterization agreement is the sine qua non of deductibility, and its implications to that effect are at best unclear. Although the First Circuit acknowledged that Fresenius potentially departs from the Ninth Circuit’s approach, it expressed skepticism that Talley indeed stands for the categorical proposition that the Government had ascribed to it.

Fresenius is the First Circuit’s contribution to the long-running judicial dialogue regarding the nature of FCA damages as punitive and/or compensatory—and one that carries significant financial consequences for both the Government and FCA defendants. The case may be interpreted as the inevitable result of an FCA regime that not infrequently leads to massive damages awards, as well as “the sometimes hazy line that separates the compensatory from the punitive.”

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Photo of Alan Pemberton Alan Pemberton

Alan Pemberton has practiced in the government contracts area since 1982, and chaired or co-chaired Covington’s government contracts practice from 2000 to 2016. His practice includes the full range of government contracts matters, including bid protest and other procurement litigation before GAO, agency…

Alan Pemberton has practiced in the government contracts area since 1982, and chaired or co-chaired Covington’s government contracts practice from 2000 to 2016. His practice includes the full range of government contracts matters, including bid protest and other procurement litigation before GAO, agency boards, and federal and state courts and ADR tribunals. He advises large and small contractors and grantees about the full range of government proposal, performance, compliance, regulatory, suspension and debarment, transactional and legislative issues. He also directs the firm’s pro bono program as co-chair of the Public Service Committee.

Photo of Kayleigh Scalzo Kayleigh Scalzo

Kayleigh Scalzo represents government contractors in high-stakes litigation matters with the government and other private parties. She has litigated bid protests in a wide variety of forums, including the Government Accountability Office, U.S. Court of Federal Claims, U.S. Court of Appeals for the…

Kayleigh Scalzo represents government contractors in high-stakes litigation matters with the government and other private parties. She has litigated bid protests in a wide variety of forums, including the Government Accountability Office, U.S. Court of Federal Claims, U.S. Court of Appeals for the Federal Circuit, FAA Office of Dispute Resolution for Acquisition, Port Authority of New York and New Jersey, federal and state agencies, and state courts. She is also a co-head of the firm’s Claims, Disputes, and Other Litigation Affinity Group within the Government Contracts practice.

Kayleigh has particular experience navigating state and local procurement matters at both ends of the contract lifecycle, including bid protests and termination matters. In recent years, she has advised and represented clients in connection with procurements in Alaska, Arizona, California, the District of Columbia, Illinois, Indiana, Kansas, New Jersey, New York, Pennsylvania, Tennessee, Texas, and Virginia.

Kayleigh is a frequent speaker on bid protest issues, including the unique challenges of protests in state and local jurisdictions.