By Peter Goodrich, Tax Services
The Volkswagen emissions scandal settlement agreement is stirring perhaps one of the greatest accounting debates in the history of the automotive industry. While this might not sound as exciting to any casual observer, the results could benefit Volkswagen dealers astronomically as far as tax outcomes are concerned. While the determination of the settlement amount’s taxable nature is currently undefined, there is a much stronger case now for capital gains tax treatment (20% tax rate) as opposed to ordinary income tax treatment (39.6% tax rate) based on the culmination of various tax minds at work and based on multitudes of tax research being done. Not to be overlooked is the ability to offset capital gains with capital losses, another potentially significant benefit of capital gains treatment. If we look at the numbers, we are talking about approximately $364,000 in tax savings on average which would be significant to the dealers. With a bulk 50% settlement payout on the horizon in late 2016 or early 2017, it is important to determine the respective tax implications ahead of time for tax planning purposes.
The capital gains tax treatment argument has now become more favorable due to a few variables involving settlement agreement semantics, case law and supplementary materials. The starting point for determining the tax treatment of a settlement payout is predicated on the origin of claim doctrine, or the reason for the legal claim. In the case of the Volkswagen settlement agreement, it explicitly states that the compensatory payments to the dealers are “for alleged diminution in value of franchise dealers’ capital and goodwill.” It would be tough however to postulate capital gains tax treatment solely based on the origin of claim doctrine because there exists within the Internal Revenue Code a sale or exchange requirement of property in order to establish capital gains tax treatment.
Our biggest concern is that the Internal Revenue Service may contest the position of capital gains tax treatment on the VW payouts positing the argument that the sale or exchange attribute is not present in these transactions. Evidentially, there exists corroborating case law where the courts have ruled and converted capital gains to ordinary income tax treatment solely based on this lack of sale or exchange attribute even when the origin of claim in those cases were capital in nature. There is some good news though despite this seemingly steep uphill battle for capital gains tax treatment of the VW payouts. There simultaneously exists case law where capital gains tax treatment was successfully asserted and the courts’ reasoning showed a complete disregard for the sale or exchange requirement. Additionally, there are even memoranda on cases published by the IRS themselves where they too demonstrated a logic that failed to refer to the sale or exchange requirement. It will be through the exposure of such court decisions and IRS administrative positions that a case for capital gains tax treatment can be fortified.
It is important to mention that the VW settlement agreement itself is not carved in stone and is subject to change. There is still a lot of current discussion and uncertainty on the subject matter yielding no consensus. Also, there is no direct court precedent related to this type of settlement agreement or official published IRS interpretation on these VW settlement payouts. It is only a matter of time before these issues are addressed and it is currently up to you and your tax advisor to determine how you will handle the pending settlement proceeds and their taxable nature should no position be established in the near future.