Crime doesn’t pay — and may be taxable under Subpart F

By Nelson Yates, J.D., LL.M., Chicago

Editor: Alex J. Brosseau, CPA

One seldom discussed but potentially important component of Subpart F income under Sec. 952(a)(4) is illegal bribes, kickbacks, or other payments made by or on behalf of a controlled foreign corporation (CFC) to a foreign government official, employee, or agent. For this purpose, "payments" narrowly means "payments which would have been unlawful under the Foreign Corrupt Practices Act of 1977 [FCPA] if the payor were a United States person" instead of a CFC (Foreign Corrupt Practices Act of 1977, P.L. 95-213, 91 Stat. 1494 (1977)). This definition of "payments" for purposes of Sec. 952(a)(4) is necessary because, in general, the provisions of the FCPA do not apply to a CFC of a U.S. corporation. Sec. 952(a) imposes the hypothetical "if the payor were a United States person" to determine whether the CFC's payment would have violated the FCPA, and if so, it is recharacterized as Subpart F income.

Sec. 952(a)(4) and the flush language of Sec. 952(a) serve to penalize the U.S. parent of a CFC where the CFC paid a bribe to a government official and, had that bribe been paid directly by the U.S. parent,the payment would have violated the FCPA. The "penalty" is that Sec. 952(a)(4) causes the payment to be immediately taxable to the U.S. parent.

Tax departments should be particularly concerned if a company has signed a nonprosecution agreement (NPA) with the U.S. Department of Justice (DOJ) and the company must recognize Subpart F income because of Sec. 952(a)(4). The amounts classified as Subpart F income because of Sec. 952(a)(4) must match the amounts disclosed as illegal payments made by the company's CFC(s) to foreign officials or governments. Therefore, efforts to mitigate the Subpart F pickup, for example through bifurcation discussed below, must be considered at the time of the negotiation of the NPA, not after its execution.

Overview of the FCPA

In simple terms, the FCPA criminalizes the bribery of foreign and U.S. government officials by companies subject to its provisions. The FCPA uses "criminal sanctions to discourage corporations from paying bribes to secure business or favorable treatment from foreign government officials" (see Lord, "Note: Stapled Stock and I.R.C. Section 269B: Ill-Conceived Change in the Rules of International Tax Jurisdiction," 71 Cornell L. Rev. 1066, 1072, n. 34 (July 1986)).

The section of the FCPA known as the anti-bribery provisions makes it a violation of U.S. law if certain U.S. persons (and a select group of foreign companies) make an "offer, payment, promise to pay, or authorization of the payment of any money, or offer, gift, promise to give, or authorization of the giving of anything of value to" a foreign official or agent thereof to influence an official decision of the foreign official in his or her capacity as such (see 15 U.S.C. §78dd-1(a) (§30A of the Securities Exchange Act of 1934, P.L. 73-291)). The DOJ's website explains the reach of the FCPA's anti-bribery provisions:

Since 1977, the anti-bribery provisions of the FCPA have applied to all U.S. persons and certain foreign issuers of securities. With the enactment of certain amendments in 1998, the anti-bribery provisions of the FCPA now also apply to foreign firms and persons who cause, directly or through agents, an act in furtherance of such a corrupt payment to take place within the territory of the United States.

A violation of the anti-bribery provisions of the FCPA can result in substantial fines to businesses and, for individuals, imprisonment for up to five years and fines of up to $100,000 (see 15 U.S.C. §78dd-2(g)). The provisions of the FCPA apply to both U.S. corporations as well as certain foreign corporations (e.g., those that have stock traded on U.S. exchanges), as well as officers, employees, directors, and agents of either.

In addition to the regulatory and criminal framework designed to punish the criminality of the act itself, there are negative tax consequences to such illegal payments.

Tax 'cost' of violating the FCPA

In general, a U.S. corporation and its CFC cannot deduct the amounts paid as (illegal) bribes, even thoughthe bribe often is an expense incurred in the pursuit of the company's trade or business. Broadly, Sec. 162(c) denies any deduction under Sec. 162(a) for any payment made in violation of U.S. law. Relevant for this discussion, Sec. 162(c)(1) denies any deduction under Sec. 162(a) — deductions for ordinary and necessary trade or business expenses — for the amount of such payments to government agents, officials, and/or employees. Specifically, Sec. 162(c)(1) reads:

Illegal payments to government officials or employees — ... any payment made, directly or indirectly, to an official or employee of any government, or of any agency or instrumentality of any government, if the payment constitutes an illegal bribe or kickback or, if the payment is to an official or employee of a foreign government, the payment is unlawful under the Foreign Corrupt Practices Act of 1977.

This reflects the language of Sec. 162(c)(1) after the passing of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248, which added the final phrase regarding the FCPA (cf. Tax Reform Act of 1969, P.L. 91-172, §902(c)).

Sec. 162(c)(1) prevents such payments that violate the FCPA from reducing taxable income of a CFC or U.S. corporation (see, e.g., Rev. Rul. 77-442, which provides that Sec. 162(c) contributions to foreign political parties and payments to foreign government officials that are made before Nov. 4, 1976, reduce the earnings and profits of a CFC even though they are not deductible). Sec. 964(a) prevents payments that would have violated the FCPA had the payer been a U.S. person and not a CFC, from reducing the earnings and profits of the CFC.

Sec. 964(a) flatly states that for the purposes of determining the earnings and profits of a foreign corporation:

the amount of any illegal bribe, kickback, or other payment (within the meaning of section 162(c)) shall not be taken into account to decrease such earnings and profits or to increase such deficit. The payments referred to in the preceding sentence are payments which would be unlawful under the Foreign Corrupt Practices Act of 1977 if the payor were a United States person.

As a result of Secs. 162(c)(1) and 964(a), a CFC cannot deduct from (1) the CFC's taxable income or (2) the CFC's earnings and profits the amounts the CFC paid that would have violated the FCPA had the CFC been a U.S. person. These two sections deny deductibility of those foreign bribes and work hand-in-hand with Sec. 952(a)(4), which converts the amount denied into taxable income to the U.S. parent of the CFC payer.

Congress's purpose behind these provisions was to discourage the use of foreign bribes as a means of doing business overseas. Initially, in 1976 the U.S. Senate proposed denying deferral on any income generated from such foreign bribes, creating a new class of Subpart F income titled "foreign bribe-produced income" (see S. Rep't No. 94-938, 94th Cong., 2d Sess., §1065 (1976)). The agreement reached in conference committee "subjects to current taxation as a deemed dividend an amount equal to the amount of any bribe paid by a foreign subsidiary or a [domestic international sales corporation] of a U.S. company. In addition, the earnings and profits of any corporation paying a foreign bribe is not to be reduced by that amount paid" (see H.R. Conf. Rep't No. 94-1515, 94th Cong., 2d Sess., §1065 (1976)). However, when Secs. 162(c)(1), 952(a)(4), and 964(a) were introduced, the "legality" standard imposed for each at that time was not the FCPA.

The FCPA as the 'standard'

As a result of the FCPA's becoming the uniform standard for Secs. 162(c)(1), 952(a)(4), and 964(a), some bribes and other payments denied deductibility under Secs. 162(c)(2) and 162(c)(3) are not Subpart F income pursuant to Sec. 952(a)(4). It was not until TEFRA that the FCPA became the legal standard for Secs. 162(c)(1), 952(a)(4), and 964(a) (P.L. 97-248, §288 (1982)). Prior to TEFRA, Sec. 162(c)(1) read:

No deduction shall be allowed under subsection (a) for any payment made, directly or indirectly, to an official or employee of any government, or of any agency or instrumentality of any government, if the payment constitutes an illegal bribe or kickback or, if the payment is to an official or employee of a foreign government, the payment would be unlawful under the laws of the United States if such laws were applicable to such payment and to such official or employee. [Sec. 952(c)(4), as enacted by P.L. 91-172, §902(c)(1) (Dec. 30, 1969)]

TEFRA substituted the phrase "is unlawful under the Foreign Corrupt Practices Act of 1977" within the pre-TEFRA language immediately above and added similar language to Secs. 952(a)(4) and 964(a). The Senate stated that the purpose behind that uniformity was:

that a single standard of legality for payments to foreign government personnel is appropriate for both the Foreign Corrupt Practices Act and the Internal Revenue Code. In some cases, the current tax law test may be overly hard. Moreover, the current tax law test, which requires a hypothetical determination of U.S. law, may need clarification. [S Rep't No. 97-494, 97th Cong., 2d Sess., Vol. 1, p. 164 (July 12, 1982)]

Prior to TEFRA and the single standard of the FCPA, the "illegal bribes, kickbacks, or other payments (within the meaning of section 162(c))" referred to in Sec. 952(a)(4) were not limited only to payments "which would be unlawful under the Foreign Corrupt Practices Act of 1977 if the payor were a United States person."

The IRS confirmed this narrow application of Sec. 952(a)(4) in a Field Service Advice (FSA) Memorandum dated Dec. 4, 1995:

Under section 162(c)(1), illegal payments made directly or indirectly to officials, employees, or agents in fact of a government are nondeductible. As you note, section 162(c)(2) disallows a deduction for other illegal payments made to non-governmental persons. You ask whether such payment made by or on behalf of a CFC also should give rise to subpart F income under section 952(a)(4). After reviewing your request, we have concluded that bribes paid to non-government persons do not give rise to subpart F income under section 952(a)(4). [1995 FSA 461]

In that 1995 memorandum, the IRS analyzed the legislative history of Secs. 952(a)(4) and 162(c) and concluded "[i]t appears virtually certain that Congress in 1976 knowingly restricted the scope of section 952(a)(4) to payments to government officials, even though at the time section 162(c) denied deductions for certain bribes to non-governmental officials" (id.). The IRS further stated that with the passing of TEFRA:

Congress again declined to extend the scope of section 952(a)(4) treatment to bribes paid to private (non-government related) persons. Regulations under section 952(a)(4) mirror the provision as amended in 1982 and confine its scope to payments that are illegal under the FCPA. [Id.]

Thus, it appears that while Secs. 162(c) and 964(a) continued to deny the deductibility of a bribe — even one that would not violate the FCPA had the payer been a U.S. person instead of a CFC — Sec. 952(a)(4) is only triggered if that payment would have violated the FCPA had the payer been a U.S. person.

Risk of mitigating Sec. 952(a)(4)

When a tax department is made aware that its company's foreign subsidiaries have been making illegal payments to a foreign government, often the company has self-reported and it is negotiating or has entered into an agreement with a U.S. agency (e.g., SEC, DOJ). Tax departments may find themselves having to understand and possibly mitigate the adverse tax consequences resulting from such business actions.

If the company's foreign subsidiaries used a foreign agent to make the illegal payments and that foreign agent also provided some other service, such as local market intelligence, a tax practitioner may attempt to bifurcate the payments as: (1) payments subject to recharacterization under Sec. 952(a)(4); and (2) payments made for otherservices the foreign agent provided. But before any sort of post hoc effort to bifurcate those payments is made, any settlement agreements between the company and the U.S. government (or one of its regulatory bodies) should be carefully reviewed.

For example, a U.S. multinational may enter into an NPA with the DOJ. Often in the NPA, the amount of the illegal payments is the gross amount paid to the foreign agent. This means that during negotiations between the parties, the illegal payments made to the foreign agent (to be made to a foreign government on behalf of the U.S. multinational) were not distinguished from any amounts paid to the foreign agent for other, legitimate services. This lack of bifurcation may make sense from a business and legal perspective, as tax risk is not the company's primary driver in such negotiations. But failure to consider the tax consequences during the NPA negotiation can significantly limit a tax department's ability to mitigate the application of Sec. 952(a)(4). Language such as the following clause may be included in the NPA:

The Company expressly agrees that it shall not, through present or future attorneys, officers, directors, employees, agents, or any other persons authorized to speak for the Company make any public statement, in litigation or otherwise, contradicting the acceptance of responsibility by the Company set forth above or the facts described in the Statement of Facts.

The final clause immediately above seems to put the filing of a tax return that reports an amount as Subpart F income because of Sec. 952(a)(4) as anything different from the amount of the illegal payments in the NPA squarely in violation of such language. Prior to entering into an NPA negotiation, it is advisable to understand the tax implications of that agreement, and whether or not bifurcating illegal from non-illegal payments in the agreement language is possible.

One of the unplanned effects of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, is the need for closer integration between a U.S. multinational's business and legal teams and its tax department. (This is particularly true in the case of compliance with certain new provisions introduced by the TCJA, such as foreign-derived intangible income, where how a commercial transaction is contracted and documented can determine whether a benefit is available.) This integration may pave the way for earlier involvement of in-house (and if needed, outside) tax advice during settlement discussions with the U.S. government. Early consultation with the tax function may help U.S. multinationals mitigate any adverse tax consequences of such a settlement.


Alex J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.

For additional information about these items, contact Mr. Brosseau at 202-661-4532 or

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

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