Par. 2. Section 1.162-21 is revised to read as follows:
(a) Deduction Disallowed. Except as otherwise provided in this section, no deduction is allowed under chapter 1 of the Internal Revenue Code (Code) for any amount that is paid or incurred—
(1) By suit, settlement agreement (agreement), or otherwise;
(2) To or at the direction of a government or governmental entity, as defined in paragraph (f)(1) of this section, or a nongovernmental entity, as defined in paragraph (f)(2) of this section; and
(3) In relation to the violation, or investigation or inquiry into the potential violation, of any civil or criminal law.
(b) Exception for restitution, remediation, and amounts paid to come into compliance with a law —(1) In general. Paragraph (a) of this section does not apply to amounts paid or incurred for restitution, remediation, or to come into compliance with a law, as defined in paragraph (f)(3) of this section, provided that both the identification and the establishment requirements of paragraphs (b)(2) and (b)(3) of this section are met.
(2) Identification requirement —(i) In general. A court order (order) or an agreement identifies a payment by stating the nature of, or purpose for, each payment each taxpayer is obligated to pay and the amount of each payment identified.
(ii) Meeting the identification requirement. The identification requirement is presumed to be met if an order or agreement specifically states that the payment, and the amount of the payment, described in paragraph (b)(2)(i) of this section, constitutes restitution, remediation, or an amount paid to come into compliance with a law or if the order or agreement uses a different form of the required words, such as, “remediate” or “comply with a law.” Meeting the establishment requirement of paragraph (b)(3) of this section alone is not sufficient to meet the identification requirement of paragraph (b)(2) of this section.
(iii) Payment amount not identified. If the order or agreement identifies a payment as restitution, remediation, or to come into compliance with a law but does not identify some or all of the aggregate amount the taxpayer must pay, the identification requirement may be met, with respect to any payment amount not identified, if the order or agreement describes the damage done, harm suffered, or manner of noncompliance with a law, and describes the action required of the taxpayer, such as paying or incurring costs to provide services or to provide property.
(iv) Challenge by the IRS. The IRS may challenge the characterization of an amount identified under paragraph (b)(2) of this section. To rebut the presumption described in paragraph (b)(2)(ii) of this section, the IRS must develop sufficient contrary evidence that the amount paid or incurred was not for the purpose identified in the order or agreement.
(3) Establishment requirement —(i) Meeting the establishment requirement. The establishment requirement is met if the taxpayer substantiates, with documentary evidence, the taxpayer's legal obligation, pursuant to the order or agreement, to pay the amount identified as restitution, remediation, or to come into compliance with a law, the amount paid, and the date the amount was paid or incurred. Meeting the identification requirement of paragraph (b)(2) of this section alone is not sufficient to meet the establishment requirement of paragraph (b)(3) of this section.
(ii) Substantiating the establishment requirement. The documentary evidence described in paragraph (b)(3)(i) of this section includes, but is not limited to, receipts; the legal or regulatory provision related to the violation or potential violation of a law; documents issued by the government or governmental entity relating to the investigation or inquiry; documents describing how the amount to be paid was determined; and correspondence exchanged between the taxpayer and the government or governmental entity before the order or agreement became binding under applicable law.
(c) Other Exceptions —(1) Suits between private parties. Paragraph (a) of this section does not apply to any amount paid or incurred by reason of any order or agreement in a suit in which no government or governmental entity is a party.
(2) Taxes and related interest. Paragraph (a) of this section does not apply to amounts paid or incurred as otherwise deductible taxes or related interest. However, if penalties are imposed with respect to these taxes, paragraph (a) of this section applies to disallow a deduction for any interest payments related to the penalties imposed.
(3) Failure to pay Title 26 tax. In the case of any amount paid or incurred as restitution for failure to pay tax imposed under Title 26 of the United States Code, paragraph (a) of this section does not disallow a deduction for Title 26 taxes which is otherwise allowed under chapter 1 of the Code.
(d) Application of general principles of Federal income tax law —(1) Taxable year of deduction. If, under paragraph (b) or (c) of this section, the taxpayer is allowed a deduction for the amount paid or incurred pursuant to an order or agreement, the deduction is taken into account under the rules of section 461 and the related regulations, or under a provision specifically applicable to the allowed deduction, such as § 1.468B-3(c).
(2) Tax benefit rule applies. If the deduction allowed under paragraphs (b) or (c) of this section results in a tax benefit to the taxpayer, the taxpayer must include in income, under sections 61 and 111, the recovery of any amount deducted in a prior taxable year to the extent the prior year's deduction reduced the taxpayer's tax liability.
(i) A tax benefit to the taxpayer includes a reduction in the taxpayer's tax liability for that year or the creation of a net operating loss carryback or carryover.
(ii) A taxpayer's recovery of any amount deducted in a prior taxable year includes, but is not limited to—
(A) Receiving a refund, recoupment, rebate, reimbursement, or otherwise recovering some or all of the amount the taxpayer paid or incurred, or
(B) Being relieved of some or all of the payment liability under the order or agreement.
(e) Material change to order or agreement —(1) In general. If the parties to an order or agreement, entered before December 22, 2017, make a material change to the terms of that order or agreement on or after the applicability date in paragraph (h) of this section, paragraph (a) of this section applies to any amounts paid or incurred, or any obligation to provide property or services, after the date of the material change.
(2) Material change. A material change to the terms of an order or agreement under paragraph (e)(1) of this section may include: Changing the nature or purpose of a payment obligation; or changing, adding to, or removing a payment obligation, an obligation to provide services, or an obligation to provide property. A material change does not include changing a payment date or changing the address of a party to the order or agreement.
(f) Definitions. For purposes of section 162(f) and § 1.162-21, the following definitions apply:
(1) Government or governmental entity. A government or governmental entity means—
(i) The government of the United States, a State, or the District of Columbia;
(ii) The government of a territory of the United States, including American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the U.S. Virgin Islands;
(iii) The government of a foreign country;
(iv) An Indian tribal government, as defined in section 7701(a)(40), or a subdivision of an Indian tribal government, as determined in accordance with section 7871(d); or
(v) A political subdivision of (i), (ii), or (iii), or a corporation or other entity serving as an agency or instrumentality of any of paragraph (f)(1)(i)-(f)(iv) of this section.
(2) Nongovernmental entity treated as a governmental entity. (i) A nongovernmental entity described in paragraph (f)(2)(ii) of this section is treated as a governmental entity.
(ii) A nongovernmental entity treated as governmental entity is an entity that—
(A) Exercises self-regulatory powers (including imposing sanctions) in connection with a qualified board or exchange (as defined in section 1256(g)(7)); or
(B) Exercises self-regulatory powers, including adopting; administering; or enforcing laws and imposing sanctions, as part of performing an essential governmental function.
(3) Restitution, remediation of property, and amounts paid to come into compliance with a law. (i) An amount is paid or incurred for restitution or remediation pursuant to paragraph (b)(1) of this section if it restores, in whole or in part, the person, as defined in section 7701(a)(1); the government; the governmental entity; or property harmed by the violation or potential violation of a law described in paragraph (a)(3) of this section.
(ii) An amount is paid or incurred to come into compliance with a law that the taxpayer has violated, or is alleged to have violated, by performing services; taking action, such as modifying equipment; providing property; or doing any combination thereof.
(iii) Regardless of whether the order or agreement identifies them as such, restitution, remediation, and amounts paid to come into compliance with a law do not include any amount paid or incurred—
(A) To reimburse the government or governmental entity for investigation costs or litigation costs;
(B) At the payor's election, in lieu of a fine or penalty;
(C) As forfeiture or disgorgement; or
(D) To the extent the payment or contribution does not meet the requirements of paragraph (f)(3)(i) or (ii) of this section, to an entity; fund, including a restitution, remediation, or other fund; group; government or governmental entity.
(4) Suit, agreement, or otherwise. A suit, agreement, or otherwise includes, but is not limited to, settlement agreements, non-prosecution agreements, deferred prosecution agreements, judicial proceedings, administrative adjudications, decisions issued by officials, committees, commissions, boards of a government or governmental entity, and any legal actions or hearings which impose a liability on the taxpayer or pursuant to which the taxpayer assumes liability.
(g) Examples. The application of this section may be illustrated by the following examples.
(1) Example 1. Identification and establishment requirements —(i) Facts. Corp. A enters into an agreement with State Y's environmental enforcement agency (Agency) for violating state environmental laws. Under the terms of the agreement, Corp. A must pay $40,000 to the Agency in civil penalties, $80,000 in restitution for environmental harm, $50,000 for remediation of contaminated sites, and $60,000 to conduct comprehensive upgrades to Corp. A's operations to come into compliance with the state environmental laws.
(ii) Analysis. The identification requirement is satisfied for those amounts the agreement identifies as restitution, remediation, or to come into compliance with a law. If Corp. A establishes, as provided in paragraph (b)(3) of this section, that the amounts it paid or incurred are for restitution, remediation, and to come into compliance with state environmental laws, paragraph (a) of this section does not preclude Corp. A from deducting $190,000. Under paragraph (a) of this section, Corp. A may not deduct the $40,000 in civil penalties. Section 162(f) and § 1.162-21(a) will not disallow Corp. A's deduction for the $60,000 paid to come into compliance with the state environmental laws. However, Corp. A may deduct the $60,000 paid only if, under the facts and circumstances, the payment would be otherwise deductible under chapter 1 of the Code. See section 161, concerning items allowed as deductions, and section 261, concerning items for which no deduction is allowed, and the regulations related to sections 161 and 261.
(2) Example 2. Restitution —(i) Facts. Corp. A enters into an agreement with State T's securities agency (Agency) for violating a securities law by inducing B to make a $100,000 investment in Corp. C stock, which B lost when the Corp. C stock became worthless. As part of the agreement, Corp. A agrees to pay $100,000 to B as restitution for B's investment loss, incurred as a result of Corp. A's actions. The agreement specifically states that the $100,000 payment by Corp. A to B is restitution. The agreement also requires Corp. A to pay a $40,000 fine to the Agency as a result of Corp. A's misconduct.
(ii) Analysis. Corp. A's $100,000 payment to B is identified in the agreement as restitution. If Corp. A establishes, as provided in paragraph (b)(3) of this section, that the amount paid was for that purpose, Corp. A may deduct the $100,000 payment. Paragraph (a) of this section precludes Corp. A from deducting its payment of $40,000 to the Agency because the payment of a fine is not treated as restitution, remediation, or as paid to come into compliance with a law.
(3) Example 3. Amount paid to come into compliance with a law— (i) Facts. Corp. B, an accrual method taxpayer, is under investigation by State X's environmental enforcement agency for a potential violation of State X's law governing emissions standards. Corp. B enters into an agreement with State X under which it agrees to upgrade the engines in a fleet of vehicles that Corp. B operates to come into compliance with State X's law. Although the agreement does not provide the specific amount Corp. B will incur to upgrade the engines to come into compliance with State X's law, it identifies that Corp. B must upgrade existing engines to lower certain emissions. Under the agreement, Corp. B also agrees to bring certain machinery, already in compliance with State X law, up to a standard higher than that which the law requires, and to construct a nature center in a local park for the benefit of the community. Corp. B presents evidence, as described in paragraph (b)(3)(ii) of this section, to substantiate that the expenses Corp. B will incur to upgrade the engines will be amounts paid to come into compliance with State X's law.
(ii) Analysis. Because the agreement describes the specific action Corp. B must take to come into compliance with State X's law, and Corp. B presents invoices to establish that the agreement obligates it to incur costs to come into compliance with a law, paragraph (a) of this section would not preclude a deduction for the amounts Corp. B incurs to come into compliance. However, Corp. B may not deduct the amounts paid to bring its machinery up to a higher standard than required by State X's law or to construct the nature center because no facts exist to establish that either amount was paid to come into compliance with a law or as restitution or remediation.
(4) Example 4. At the direction of a government —(i) Facts. Corp. D enters into an agreement with governmental entity, Consumer Board, for violating consumer protection laws by failing to provide debt-relief services it promised its customers. The agreement requires Corp. D to pay $60,000 as restitution to the customers harmed by Corp. D's violation of the law.
(ii) Analysis. At the direction of Consumer Board, Corp. D must pay $60,000 to its customers as a result of its violation of the law. The agreement identifies the $60,000 as restitution. Provided Corp. D establishes, under paragraph (b)(3) of this section, that the $60,000 constitutes restitution, paragraph (a) does not apply.
(h) Applicability date. The rules of this section are proposed to apply to taxable years beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations is published in the Federal Register , except that such rules do not apply to amounts paid or incurred under any order or agreement that became binding under applicable law before such date. Until that date, taxpayers may rely on these proposed rules for any order or agreement, but only if the taxpayers apply the rules in their entirety and in a consistent manner.