The Deductibility of Bp’s Payments Made Under Consent Decree

Smart & Smarter, CPAs

444 Main Street

Richardson, TX 75080

Date        :  October 29, 2015

To        :  Senior Partner

From        :  Ziyin Li

Subject:  The Deductibility of BP’s Payments Made under Consent Decree

FACTS

In 2010, there was an explosion of BP’s Deepwater Horizon oil rig in the Gulf of Mexico, followed by an oil spill disaster. Due to human error, this explosion not only destroyed many buildings around that area, but also hurt and killed some people and animals near the gulf. After five years, BP and the Department of Justice finally reached an agreement on the terms of the Consent Decree to define and resolve BP’s total liability of $20.8B.

ISSUE(S)

Excluding the explicitly non-deductible $5.5B civil penalty, how should BP deduct the remaining $15.3B payments?

LAW AND ANALYSIS

There are basically four regulations and codes related to this issue. To begin with, IRC § 162(f)^[1] provides that “any fine or similar penalty” paid for violation of laws is not deductible. Conversely, Reg. § 1.162-21(b)(2)^[2] presents that “Compensatory damages (including damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) paid to a government do not constitute a fine or penalty.”

Here, the key point turns out to be whether the remaining payments are “fines or similar penalties” or “compensatory damages.”

It is necessary to know the purpose and to examine the nature of each payment. Notice that there are mainly four types of payments in both the BP Consent Decree and the separate agreement:

∙ $5.5B for civil penalties, which are not deductible

∙ $8.8B total for natural resource damages, which will be used to restore destroyed natural

   resources, and deal with unknown situations and adaptive management

∙ $0.6B to reimburse future assessment, removal, and investigation costs and lost royalties

∙ $5.9B total for the economic damages to the five Gulf States and local governments  

In the case of BP, only the $5.5B is explicitly in punitive damages for human error, however, the remaining $15.3B is used to restore and compensate the regions that had been affected. There is nothing stated on the Consent Decree that the $15.3B is for a punitive purpose. In contrast, Attorney General Loretta Lynch said BP “is providing critical compensation for the injuries it caused to the environment and the economy of the gulf region’’ (The Wall Street Journal, 2015)^[3]. The remaining $15.3B has its own practical uses: to rebuild, clean, and manage the explosion areas. It is indeed a remedy in nature and hence it is a deductible “ordinary and necessary” cost under IRC § 162(a)^[4].