PLR 200716013: Required escrow deposits qualify as deductible settlement fund payments

Plain-English summary

A product manufacturer that was not a defendant in an industry lawsuit had to make annual deposits into escrow accounts under laws adopted by government claimants. The IRS ruled that each account was a qualified settlement fund from its establishment, even though no formal complaint had been filed against the company. The accounts were government approved, held segregated assets, and addressed asserted claims arising from the company's business. The IRS also ruled that the deposits were ordinary and necessary business expenses deductible in the year transferred, subject to the stated facts about the claims and any potential reversion. The IRS declined to rule on two alternative plans because it would not issue rulings on alternative plans of a proposed transaction.

Ruling snapshot

• Question: Were the required escrow accounts qualified settlement funds, and when could the company deduct its deposits?
• Outcome: Mixed; the main requested treatment was approved, while rulings on two alternative plans were declined.
• Key authorities: IRC §§ 162, 461, 468B; Treas. Reg. §§ 1.468B-1, 1.468B-3.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200716013
Third Party Communication: Congressional;
Release Date: 4/20/2007
Government
Index Number: 162.00-00, 461.00-00,
Dates of Communication: February 6, 2006;
468B.00-00
March 30, 2006; May 2, 2006; August 16, 2006
Person To Contact:
------------------------
--------------------------, ID No. ------------
------------------------------------------- Telephone Number:
-------------------------
--------------------
----------------------------------
Refer Reply To:
---------------------------
CC:ITA:B07
PLR-146027-05
Date:
-
January 11, 2007

Legend:

Company = -------------------------------------------------
A = ----------------------------------------
B = ---------------------
C = --------------------------------------------------------------------------------------------
D = --------------------------------------------------------------------------------------------------------
------------------------------
F = -------------
G = -----------
H = --------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------
I = --------------------------
J = ------------------------------
L = ----------------------------------
M = ------------------------------------------------------
N = ----------------------------------------------
O = --------------------------------------------
P = ----------------------------------------------------------------------------------------------------
Year 1 = -------
Year 2 = -------
Date 1 = --------------------------
Date 2 = ------------------
Number = -----------
$X = ----------------

PLR-146027-05
2

Dear ----------:

This is in response to your ruling request on behalf of Company dated August 11, 2005, as amended on October 19, 2005, and on July 19, 2006, and supplemented by correspondence dated December 20, 2005, June 28, 2006, July 19, 2006, August 31, 2006, September 7, 2006, September 29, 2006 (two letters), October 17, 2006 (two letters), and November 1, 2006. You requested the following rulings concerning the tax treatment of certain escrow accounts required by and established pursuant to law:

(1) that the escrow accounts are qualified settlement funds within the meaning of section 1.468B-1 of the Income Tax Regulations and payments made by Company to these escrow accounts are fully deductible; or

(2) that upon irrevocable assignment to J or L, respectively, of the Company’s reversionary interest in the escrow accounts established by Company with the B pursuant to a D relating to G product sales in J and in L, the escrow accounts are qualified settlement funds within the meaning of section 1.468B-1 of the Income Tax Regulations and payments made by Company to these escrow accounts are fully deductible; or

(3) that upon irrevocable assignment to J or L, respectively, of the Company’s reversionary interest in the escrow accounts established by Company with the B pursuant to a D relating to G product sales in J or in L, payments made by the Company to these escrow accounts are ordinary and necessary business expenses and under sections162 and 461of the Code are fully deductible.

A taxpayer conference of right was held on September 27, 2006.

FACTS

Company is a corporation engaged in the manufacture and wholesale distribution only of I brands of F, a type of G product. Company uses an accrual method of accounting.

The Cs brought a consolidated suit against the major manufacturers and sellers (manufacturers) of G, including F, products. The suit asserted various claims for monetary, equitable and injunctive relief, including consumer protection and/or antitrust laws. Company was not a party defendant in the suit brought by the Cs against the major manufacturers of G products.

On Date 1, the Cs entered into a settlement agreement, A, to resolve litigation against the major manufacturers of G products. Under the A, the party defendant

PLR-146027-05
3

manufacturers of G products are required to establish escrow accounts and make annual payments (in perpetuity) into escrow for the benefit of the Cs. The A provides that all payments are in settlement of H. The party defendants’ ongoing payments to the escrow accounts are determined by a formula based on their F sales. In exchange for these payments, the defendant manufacturers of G products are “absolutely and unconditionally released and forever discharged from all claims that the Cs directly, indirectly, derivatively or in any other capacity ever had, now have, or hereafter can, shall or may have” against the defendant manufacturers from liability relating to past, present and certain future claims stemming from the use, sale, distribution, manufacture, development, advertising, or marketing of F. Under the A, these escrow accounts are expressly intended to be treated as qualified settlement funds for federal income tax purposes.

The party defendant manufacturers believed that the manufacturers of G products not named as party defendants in litigation also contributed to the harms, e.g., relating to P, alleged by the Cs. Consequently, the party defendant manufacturers of G products demanded as a condition of the settlement that nonparty manufacturers of G products be required to share the financial burdens and make deposits into escrows as well. The Cs (of which J and L are parties) agreed. In relevant part, the A directs the Cs to require that certain nonparty manufacturers, of which Company is one, establish escrow accounts. Further, to accomplish this, each C is required to have O, i.e., a “D.” A model D was incorporated into and made an integral part of the A approved by the court having jurisdiction. Each C has a D.

The objective of the D is to force nonparty manufacturers who refuse to opt into the A to assume a share of the financial burdens, i.e., the C-borne costs, created by the use of F (a type of G products). The D applies to any nonparty manufacturer of G products selling F within a C. The amount of any manufacturer’s annual deposits into the escrow accounts required by the D is based on the manufacturer’s sales of F during the year in question. Any escrow accounts set up for this purpose must be approved by one of the Cs.

Company has not opted into the A. Therefore, as a nonparty manufacturer of G products selling F within a C, Company is required to establish escrow accounts under each C’s D.

The Cs advised Company of its duty to deposit funds in accordance with the above and have made written demands for the deposits. In Year 1, Company established the escrow accounts and began making annual deposits to the escrow accounts. On Date 2, Company transferred the escrow accounts to B institution. To date, Company has deposited a total of $ X in accordance with the above. As long as Company remains a G product manufacturer selling F within a C, it will continue to be required to make annual deposits into such escrow accounts, based on its F sales, either at B or similar financial institutions. The escrow accounts exist to satisfy C claims

PLR-146027-05
4

brought against Company within Number after the date such funds are placed into escrow. Company may not access the funds for any purpose other than satisfying C claims during the Number period. Under the model D, any remainder will revert to Company (reversionary interest) after those periods lapse.

Company expects that claims for reimbursement for the costs of identical harms alleged by the Cs and settled under the terms of the A, will be made against all the contributed funds. If successful, the funds will be used to satisfy the C’s claims, and nothing will remain to revert to Company.

In Year 2, J and L (both of which are members of the Cs) each O permitting a nonparty manufacturer of G to irrevocably assign its reversionary interest in the escrow accounts to J or to L, respectively, and providing that immediately upon the irrevocable assignment of the reversionary interest in the escrow account, the monies in the escrow account may be used to resolve or satisfy claims relating to the harm caused by the manufacture and the sale of F. See M and N.

On October 19, 2005, Company amended its submission by requesting ruling number 3 and on July 19, 2006, Company amended its submission by requesting ruling number 1. At its conference of right held on September 27, 2006, and in its post-conference submission, Company indicated its preference for requested ruling number 1.

REQUESTED RULING 1

Escrow Account Classification

Section 468B(g) of the Code provides, in part, that nothing in any provision of law shall be construed as providing that an escrow account, settlement fund, or similar fund is not subject to current income tax. Pursuant to the authority of section 468B(g), the Secretary has published sections 1.468B-1 through 1.468B-5 of the regulations regarding qualified settlement funds.

Section 1.468B-1(a) provides that a qualified settlement fund is a fund, account, or trust that satisfies all three requirements of section 1.468B-1(c). First, section 1.468B-1(c)(1) requires that the fund, account, or trust is established pursuant to an order of, or it is approved by, the United States, any state (including the District of Columbia), territory, possession, or political subdivision thereof, or any agency or instrumentality (including a court of law) of any of the foregoing and is subject to the continued jurisdiction of that governmental authority. Second, section 1.468B-1(c)(2) requires that the fund, account, or trust is established to resolve or satisfy one or more contested or uncontested claims that have resulted or may result from an event (or related series of events) that has occurred and that has given rise to at least one claim asserting liability (i) under the Comprehensive Environmental Response, Compensation

PLR-146027-05
5

and Liability Act of 1980; (ii) arising out of a tort, breach of contract, or violation of law; or (iii) designated by the Commissioner in a revenue ruling or revenue procedure. Third, section 1.468B-1(c)(3) provides that the fund, account, or trust must be a trust under applicable state law, or its assets must be otherwise segregated from other assets of the transferor (and related persons).

Section 1.468B-1(j)(1) provides that if a fund, account or trust is established to resolve or satisfy claims described in section 1.468B-1(c)(2), the assets of the fund, account, or trust are treated as owned by the transferor of those assets until the fund, account, or trust also meets the requirements of sections 1.468B-1(c)(1) and (c)(3). On the date the fund, account, or trust satisfies all the requirements of section 1.468B-1(c), the transferor is treated as transferring the assets to a qualified settlement fund.

Section 1.468B-2(k)(2) provides that a qualified settlement fund is in existence for the period that (i) begins on the first date on which the fund is treated as a qualified settlement fund under section 1.468B-1; and (ii) ends on the earlier of the date the fund (A) no longer satisfies the requirements of section 1.468B-1; or (B) no longer has any assets and will not receive any more transfers.

Based on the facts represented, in Year 1 the escrow accounts established by Company satisfied all three requirements of section 1.468B-1(c), and therefore are treated as qualified settlement funds as of the date established. First, with respect to section 1.468B-1(c)(1), the Cs are governmental authorities as the term is used in that context. Under the D provisions, each escrow account established by Company must be approved by the C for which the account is established. The appropriate official of each C has the authority to monitor and pursue in court charges against Company to enforce annual compliance with the D.

Second, with respect to section 1.468B-1(c)(2), under all these facts and circumstances, we are persuaded that Company established the escrow accounts to resolve or satisfy contested or uncontested claims that have resulted or may result from a related series of events that has occurred and that has given rise to at least one claim asserting liability arising out of a violation of law. In this case, no formal complaint has been legally filed against Company by any of the Cs. However, the absence of a formal complaint is not fatal to a determination that (1) the Cs have established the existence of the requisite claim or claims and asserted liability against Company, and (2) the Company has established the escrow accounts to resolve or satisfy said claim or claims.

With respect to (1), the event (or related series of events) that has already occurred is the development, manufacture, advertising, marketing, use, sale, and distribution of F (the only G product which Company sells). The claim that has already arisen is that a manufacturer of F is financially liable to reimburse the Cs for the costs associated with the harms related to the sale of F. Although Company has not been

PLR-146027-05
6

named a party defendant to a suit filed by the Cs, the requirement of a suit asserting liability is not what the regulation requires. The regulation requires only that at least one “claim” asserting liability has resulted or may result. Each of the Cs has already made at least one claim asserting liability against each non-party manufacturer of F by means of having O that is a D and by means of making a written demand for deposits against Company.

With respect to (2), it is also clear that Company established and funded the escrow accounts to resolve or satisfy the claims (whether eventually contested or uncontested) and written demand made by the Cs. The objective of the D is to force nonparty manufacturers who refuse to opt into the A to assume a share of the financial burdens created by the harms allegedly caused by the use of F. Each C has a D, which applies to any nonparty manufacturer of G products selling F within a C. The amount of a manufacturer’s annual deposits into the escrow accounts are based on a manufacturer’s sales of F during the year in question. Company is such a manufacturer and the amounts of its legally-obligated deposits are calculated on said basis. Therefore, even in the absence of a formally-filed legal complaint, the second prong under the regulation is satisfied.

Note that the facts in this case are distinguishable from Example 7 in section 1.468B-1(k) regarding a landfill operator. There a corporation owned and operated a landfill in a state that required the corporation to transfer money to a trust annually based on the total tonnage of material placed in the landfill during the year. Under the law, the corporation is required to perform (either itself or through contractors) specified closure activities when the landfill is full, and the trust assets would be used to reimburse the corporation for these closure costs. The trust in that example is not a qualified settlement fund because it is established to secure the liability of the corporation to perform such closure activities. The instant case does not involve a performance liability. The funds transferred to the escrow accounts under a D are not used to secure the future performance of Company. To the contrary, the funds will be used to satisfy the Cs claims based on the past conduct of Company; conduct that is related to known harm stemming from the use of F and that has given rise to known liabilities (e.g., increase in financial burdens on the Cs).

Third, with respect to section 1.468B-1(c)(3), the assets in the escrow accounts are otherwise segregated from other assets of Company (and related persons). Beginning in Year 1, Company established separate escrow accounts with several leading financial institutions, including accounts at B. Under the regulations, a separate bank account is sufficient to satisfy this requirement. See section 1.468B-1(h)(1).

Deduction of Payments

PLR-146027-05
7

Section 162(a) of the Code provides the general rule that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. See also section 1.162-1(a).

Section 461(a) provides, in part, that the amount of any deduction shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

Section 1.461-1(a)(2) provides, in part, that under an accrual method of accounting, a liability is incurred, and generally taken into account for federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

Section 461(f) provides that if (1) the taxpayer contests an asserted liability, (2) the taxpayer transfers money or other property to provide for the satisfaction of the asserted liability, (3) the contest with respect to the asserted liability exists after the time of the transfer, and (4) but for the fact that the asserted liability is contested, a deduction would be allowed for the taxable year of the transfer (or for an earlier taxable year) determined after application of section 461(h), then the deduction shall be allowed for the taxable year of the transfer.

Section 461(h)(1) provides, in part, that in determining whether an amount has been incurred with respect to any item during the taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.

Section 461(h)(4) provides that the all events test is met with respect to any item if all events have occurred which determine the fact of the liability and the amount of such liability can be determined with reasonable accuracy.

Section 1.468B-3(c)(1) provides that for purposes of section 461(h), economic performance occurs with respect to a liability described in section 1.468B-1(c)(2) to the extent the transferor makes a transfer to a qualified settlement fund to resolve or satisfy the liability.

Section 1.468B-3(c)(2) provides that economic performance does not occur to the extent (A) the transferor (or a related person) has a right to a refund or reversion of a transfer if that right is exercisable currently and without the agreement of an unrelated person that is independent or has an adverse interest (e.g., the court or agency that approved the fund, or the fund claimants), or (B) money or property is transferred under conditions that allow its refund or reversion by reason of the occurrence of an event that is certain to occur, such as the passage of time, or if restrictions on its refund or reversion are illusory.

PLR-146027-05
8

Section 1.468B-3(f)(1) provides that a transferor must include in gross income any distribution it receives from a qualified settlement fund.

Section 1.468B-3(f)(3) provides that a distribution described in section 1.468B- 3(f)(1) or (f)(2) is excluded from the gross income of a transferor to the extent provided by section 111(a) (regarding the recovery of tax benefit items).

Based on the above, the amounts transferred into escrow accounts will be used to pay money damages to the Cs for liabilities that arose as a result of Company’s principal business activity, that is, the manufacture and sale of F. Thus, such amounts are deductible under section 162(a) as ordinary and necessary business expenses. To the extent that the all events tests under section 1.461-1(a)(2), including economic performance, are met, the amounts transferred into the escrow accounts would be deductible in the taxable year transferred. In this case, the first prong of the all events test, i.e., all the events have occurred that establish the fact of the liability, is met because this is a contested liability within the meaning of section 461(f). Likewise, the second prong, i.e., the amount of the liability can be determined with reasonable accuracy, is met because the amount of the liability can be readily ascertained based on the formula prescribed by the D. Finally, under section 1.468B-3(c), transfers to a qualified settlement fund to resolve or satisfy claims for which it is established constitute economic performance. Therefore, transfers to the escrow accounts are deductible in the taxable year Company makes the transfers to the qualified settlement funds.

The fact that the model D provides for a reversion of monies if any remain after Number from the date of the transfers does not prevent economic performance from occurring under the facts represented. The model D provides that the monies transferred into the escrow accounts revert to Company after Number from the date of the transfers if the Cs have not filed and prevailed on claims either by obtaining a judgment against, or a settlement with, Company. The funds exist to satisfy C claims brought against Company within Number after the date monies are transferred into the funds. Company may not access the funds for any purpose other than satisfying C claims during the Number period. Company expects that claims will be made against all the assets of the funds and, if successful, the funds will be used to satisfy C claims and that nothing will remain to revert to Company. There is no guarantee and little likelihood that any amounts will revert to Company after Number. The reversion in this case requires not only the passage of time, but also the successful defense against claims brought by the Cs before anything reverts to Company. Although the passage of time (i.e., Number) is certain to occur, it is clearly uncertain whether the Cs will neither file nor prevail on claims against Company. Thus, the payments are not transferred under conditions that allow its refund or reversion by reason of the occurrence of an event that is certain to occur. Finally, Company does not have a currently exercisable right to a refund or reversion. However, to the extent Company receives any distributions from

PLR-146027-05
9

the escrow accounts, e.g., overpayments, refunds, interest or other appreciation on the funds, Company must include such amounts in its gross income.

REQUESTED RULINGS 2 and 3

We decline to rule on requested rulings 2 and 3, which are alternative plans to the transaction the Company proposed in requested ruling 1. Section 6.12 of Rev. Proc. 2006-1, 2006-1 I.R.B. 1, provides, in relevant part, that the Internal Revenue Service will not issue a letter ruling on alternative plans of proposed transactions.

CONCLUSIONS

Based solely on the information provided and the representations made, we conclude that each of the escrow accounts established with B or similar institutions, as mandated by the Cs each having O that is a D, is treated as a qualified settlement fund within the meaning of section 1.468B-1 of the regulations as of the date of the establishment of the respective escrow fund, and that a deductible payment was made to a qualified settlement fund on the first date and each subsequent date that Company transferred funds to the respective escrow fund.

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. This ruling is directed only to Company who requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Powers of Attorney on file with this office, a copy of this letter is being sent to Company’s authorized representatives. A copy of this letter must be attached to any income tax return to which it is relevant.

The rulings contained in this letter are based upon information and representations submitted by the Company and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

Sincerely,

George Baker, Branch Chief
Office of Associate Chief Counsel
(Income Tax and Accounting)