In more detail

In general, section 162(a) allows the deduction of "all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Section 162(f), however, forecloses any deduction for amounts paid or incurred by a taxpayer, to or at the direction of a governmental entity, for a violation of law. Section 162(f) was amended in 2017 to provide, among other things, guidance on exceptions to the general rule of nondeductibility. Under the current version of section 162(f)(3), one such exception is that the general rule does not apply to any amount paid or incurred pursuant to an order in a suit in which no government or governmental entity is a party. The 2012 version of section 162(f), however, did not include this exception. Furthermore, neither the 2012 version nor the current version of section 162(f) defines what constitutes a fine or similar penalty for the violation of any law. In interpreting the statute, courts have instead found that it is necessary to characterize the reason for a payment to a government and that the characterization of a payment for purposes of section 162(f) turns on the origin of the liability giving rise to it. Courts have also held that a civil penalty is not deductible if the penalty is imposed for purposes of enforcing law and as punishment for violation thereof, yet it is deductible if the penalty is imposed to encourage prompt compliance with the requirements of the law, or as a remedial measure to compensate another party for expenses incurred as a result of the violation. Furthermore, courts generally look to the economic reality (i.e., public policy) of the particular transaction, rather than the form chosen by the parties, when required to make tax characterizations.

The punitive damages award in question arose from litigation where the federal government argued that Altria's alleged misrepresentation caused the plaintiff's death from lung cancer, and Oregon's direct lawsuits against Altria. The federal government further asserted that the amount of the punitive award paid to Oregon was nondeductible because it was a fine or similar penalty paid to a government under section 162(f). The court disagreed because the payment to Oregon originated from the split-recovery statute, not from the jury's verdict in favor of the plaintiff's estate. Judge Robert E. Payne stated in his opinion that, "[i]n sum, Oregon's split-recovery statute acts as a default payment scheme to allow the state to help finance a fund to be used to compensate victims of crime" and "[t]he split-recovery statute, in and of itself, does not act to punish the party against whom the punitive damage award was made."

As the parties stipulated that the amount was paid to a government, the main issue of the case relied on whether the portion of the punitive damages award that was paid to Oregon was a fine or similar penalty for the violation of any law. In determining that the portion of the award that was paid to Oregon under the split-recovery statute did not constitute "any fine or similar penalty paid to a government for the violation of any law," the court mainly focused on the origin of the liability for payment to Oregon.

Altria argued that the split-recovery statute simply redirected a portion of the punitive damages payment to Oregon and therefore the payment was not a "fine or similar penalty" paid to a government "for the violation of any law." On the other hand, the Government argued that the origin of the liability for the payment made to Oregon was the punitive damages award itself because the punitive damages awarded against Altria acted as a punishment and resulted in a payment "to a government", and that Altria's alleged misrepresentation constituted a "violation of any law." The federal government further disagreed with Altria's argument that the split-recovery statute served as the origin of Altria's obligation to pay Oregon because a "fine or similar penalty" under section 162(f) turns on whether the award was imposed as punishment. The court determined that although the punitive damages awarded to the plaintiff's estate were in fact a punishment, the award did not act as the basis in law or fact for the payment that Altria made to "a government." The court reasoned that, without the statute, the award would have gone entirely to the plaintiff's estate, and, therefore, the payment to Oregon originated from the split-recovery statute, not from the jury's verdict in favor of the plaintiff's estate.

To further support its conclusion, the court looked to section 162(f)'s regulatory and legislative history, the purpose of the payment required by the split-recovery statute, and the public policy doctrine codified by section 162(f).

Based on section 162(f)'s regulatory and legislative history, the court noted that the current text of section 162(f)(3) and the regulations thereunder confirm that the deduction is precluded only as to amounts that are paid to the government or a government entity when the government is a party to the litigation. The court further stated that the "fine or similar penalty paid to a government for violation of any law" refers to cases where the government exacts the fine or similar penalty when it is a party to the case, and, therefore, the payment to an individual's estate, which a government later lays claim to part of under a separate statute, cannot constitute a fine or similar penalty paid to a government for purposes of section 162(f).

Furthermore, the court stated that even if the 2012 version of section 162(f) is not interpreted in that way, the payment made under the Oregon split-recovery statute cannot constitute a fine or similar penalty or as payable for a violation of law because its purpose is not to enforce law or to punish a violation of law. Instead, the court noted that the general purpose of the split-recovery statute is to support a state-based crime victim fund that allows the state to compensate victims of crime, not to enforce a law or to punish a violation of law, and therefore, the portion of the award that was paid to Oregon under the split-recovery statute was deductible under section 162(f).

Lastly, the court also considered the public policy underlying the Oregon split-recovery statute and section 162(f). The court stated that its conclusion did not undermine the public policy because allowing the deduction would not frustrate the public policy of Oregon because the state still recovered a portion of the punitive damages and Altria still had to pay the plaintiff's estate its part of the award. According to the court, the public policy and laws of the State of Oregon have been fulfilled because allowing the deduction would not "encourage" noncompliance with state laws and still allows the full "sting of the penalty" as prescribed by the state legislature.

For the reasons set forth above, the court held that the payment under the split recovery statute was not "for any fine or similar penalty paid to a government for this violation of any law," and therefore, Altria was entitled to a refund in the amount of  USD 9,274,072.