                         T.C. Memo. 1999-200



                       UNITED STATES TAX COURT



      TALLEY INDUSTRIES, INC. AND CONSOLIDATED SUBSIDIARIES,
   Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent*



     Docket No. 27826-92.               Filed June 18, 1999.



     James G. Phillipp and Dora Arash, for petitioner.

     Daniel M. Whitley and Bradley T. Stanek, for respondent.



         SUPPLEMENTAL MEMORANDUM FINDINGS OF FACT AND OPINION


     FAY, Judge:    This case was assigned to Chief Special Trial

Judge Peter J. Panuthos pursuant to the provisions of section

7443A(b)(4) and Rules 180, 181, and 183.1      The Court agrees with


     *
          Supplementing T.C. Memo. 1994-608.
     1
          All section references are to the Internal Revenue Code
                                                     (continued...)
                              - 2 -

and adopts the opinion of the Special Trial Judge, which is set

forth below.

               OPINION OF THE SPECIAL TRIAL JUDGE

     PANUTHOS, Chief Special Trial Judge:   This matter is before

the Court on remand from the Court of Appeals for the Ninth Circuit.

See Talley Indus., Inc. & Consol. Subs. v. Commissioner, 116 F.3d 382

(9th Cir. 1997), revg. and remanding T.C. Memo. 1994-608.    In Talley

Indus., Inc. & Consol. Subs. v. Commissioner, T.C. Memo. 1994-608, we

granted petitioner's motion for summary judgment in part--holding

that petitioner was entitled to a deduction of $2.5 million (less

$1,885 which was characterized as a "fine" pursuant to criminal

charges) reflecting the amount that petitioner paid to the

Government to settle its civil liability for submitting false claims

under certain Federal contracts.   The Court of Appeals reversed and

remanded the case on the ground that "a genuine issue of material

fact exists as to the characterization and the purpose of the

$940,000 portion of the settlement."   Talley Indus., Inc. & Consol.

Subs. v. Commissioner, 116 F.3d at 387.   The Court of Appeals

summarized the matters to be decided on remand as follows:

     If the $940,000 represents compensation to the
     government for its losses, the sum is deductible. If,
     however, the $940,000 represents a payment of double
     damages [under the False Claims Act], it may not be


     1
      (...continued)
in effect for the year in issue, unless otherwise indicated.     All
Rule references are to the Tax Court Rules of Practice and
Procedure.
                                 - 3 -

      deductible. If the $940,000 represents a payment of
      double damages, a further genuine issue of fact exists
      as to whether the parties intended the payment to
      compensate the government for its losses (deductible)
      or to punish or deter Talley and Stencel
      (nondeductible). [Citation omitted.]

Id.
                         FINDINGS OF FACT

      Stencel Aero Engineering Corp. (Stencel), a wholly owned

subsidiary of Talley Industries, Inc. (Talley or petitioner),

manufactured ejection seats for military aircraft.    During the

early 1980's, Stencel's primary customer was the U.S. Department

of the Navy (Navy Department).    Stencel's work for the Navy

Department involved both the production of ejection seats and

research and development projects (R&D projects).

      Stencel's employees generally were required to maintain

daily timecards showing the number of hours devoted to specific

production contracts or R&D projects.    Stencel used the data from

these records to determine its costs under a particular

production contract or R&D project, and, in the case of all

contracts with the Navy Department, those data were incorporated,

directly or indirectly, in the invoices or requests for progress

payments that Stencel submitted to the Navy Department.

      On December 20, 1984, the Defense Criminal Investigative

Service executed a search warrant at Stencel's plant in Arden,

North Carolina, and seized certain of Stencel's records,

including certain employee timecards.    On March 8, 1985, a
                               - 4 -

Federal grand jury sitting in the Western District of North

Carolina returned a criminal indictment against Stencel and three

of its senior employees.   Stencel was charged in the indictment

with one count of violating 18 U.S.C. section 287 (filing a false

claim for payment with the Federal Government), one count of

violating 18 U.S.C. section 286 (conspiracy to file a false claim

for payment with the Federal Government), and 42 counts of

violating 18 U.S.C. section 1001 (submission of a false claim in

writing to an agency of the Federal Government) or 18 U.S.C.

section 2 (aiding and abetting in the commission of such an

offense).

     On May 23, 1985, the Navy Department suspended Talley and

Stencel from further Government contract work by placing the two

companies on the Consolidated List of Debarred, Suspended and

Ineligible Contractors.

     On June 12, 1985, Stencel entered into a plea agreement with

the Government under which Stencel agreed to plead guilty to 10

counts of making false statements to the Government in violation

of 18 U.S.C. section 1001.   In exchange, the Government agreed

not to prosecute certain of Stencel's officers and to dismiss the

remaining counts against Stencel.   The plea agreement was

accepted by the U.S. District Court for the Western District of

North Carolina and, on July 8, 1985, the court entered a Judgment

and Probation Commitment Order against Stencel.   The Judgment and
                               - 5 -

Probation Commitment Order stated in pertinent part that Stencel

would pay a fine of $100,000 ($10,000 for each of the 10 agreed

counts) and that Stencel shall "make full restitution for all

losses, to be determined by the U.S. Navy at a later date".

     On July 12, 1985, the Navy Department lifted the suspension

order against Talley and all of its subsidiaries, with the

exception of Stencel.   During the time that Stencel remained in

suspended status, the Navy Department generally was prohibited

from purchasing either new ejection seats or replacement parts

for ejection seats from Stencel.

     In September 1985, Joyce R. Branda (Ms. Branda), a trial

attorney with the Fraud Section, Commercial Litigation Branch,

Civil Division, U.S. Department of Justice, was assigned to

represent the Government in the Stencel matter.   Upon assignment

to the case, Ms. Branda received evidence that all four of

Stencel's major departments--production, engineering, inspection,

and quality assurance--had engaged in labor mischarging, and that

mischarging may have occurred as early as 1979.

     As a result of the alleged mischarging, Talley and Stencel

faced potential civil liability under the False Claims Act (FCA),

31 U.S.C. section 3729 (1982),2 the Truth in Negotiation Act


     2
        At the time of Stencel's indictment, 31 U.S.C. sec. 3729
(1982) provided in pertinent part:

          A person not a member of an armed force of the
                                                   (continued...)
                              - 6 -

(TINA), 10 U.S.C. section 2306(f) (1982),3 and common law



     2
      (...continued)
     United States is liable to the United States Government
     for a civil penalty of $2,000, an amount equal to 2
     times the amount of damages the Government sustains
     because of the act of that person, and costs of the
     civil action, if the person--

            (1) knowingly presents, or causes to be
     presented, to an officer or employee of the Government
     or a member of an armed force a false or fraudulent
     claim for payment or approval;

            (2) knowingly makes, uses, or causes to be made
     or used, a false record or statement to get a false or
     fraudulent claim paid or approved * * *
     3
        At the time of Stencel's indictment, 10 U.S.C. sec.
2306(f) (1982) provided in pertinent part:

          (1) A prime contractor or any subcontractor shall
     be required to submit cost or pricing data under the
     circumstances listed below, and shall be required to
     certify that, to the best of his knowledge and belief,
     the cost or pricing data he submitted was accurate,
     complete and current--

            (A) prior to the award of any negotiated prime
     contract under this title where the price is expected
     to exceed $500,000; * * *

          (2) Any prime contract or change or modification
     thereto under which such certificate is required shall
     contain a provision that the price to the Government,
     including profit or fee, shall be adjusted to exclude
     any significant sums by which it may be determined by
     the head of the agency [as defined in section 2302 to
     include the Secretary of the Navy] that such price was
     increased because the contractor or any subcontractor
     required to furnish such a certificate, furnished cost
     or pricing data which, as of a date agreed upon between
     the parties (which date shall be as close to the date
     of agreement on the negotiated price as is
     practicable), was inaccurate, incomplete, or noncurrent
     * * *.
                               - 7 -

contract claims.

     Talley and Stencel were represented by, among others,

private attorneys William J. Kilberg (Mr. Kilberg) and John

Chierichella, and by Mark S. Dickerson, Talley's secretary and

general counsel.

     During a November 18, 1985, meeting in Asheville, North

Carolina, the Government provided Talley and Stencel with a

schedule (the Asheville damages schedule) summarizing the

Government's estimate of its damages during 1984 attributable to

the specific acts of labor mischarging described in the

indictment as well as the additional labor mischarging that the

Government suspected in Stencel's four major departments.    The

Asheville damages schedule included an estimate of total damages

for 1984 of $205,699 and an estimate of forfeitures under the FCA

of $850,000 (425 alleged acts of labor mischarging multiplied by

$2,000).   The Asheville damages schedule did not include an

estimate of the Government's incidental damages, such as the

costs associated with the investigation, the suspension and

debarment proceedings, the grounding of any Navy aircraft for

lack of replacement parts, or the Government's loss of use of

funds improperly paid to Stencel.

     Although the Government believed that labor mischarging had

occurred as early as 1979, neither party examined or analyzed

Stencel's billing data or other records for the years 1979 to
                                 - 8 -

1983 to the extent necessary to calculate the Government's actual

losses for any of those years.

     Because the Navy Department was Stencel's largest customer,

and since Stencel was one of only a few companies in the world

qualified to produce ejection seats for Navy Department aircraft,

the Government and Stencel both recognized the urgency of

reaching an agreement sufficient to permit the Navy Department to

lift Stencel's suspension.

     In November 1985, Ms. Branda offered to settle the

Government's claims against Talley and Stencel for $3.6 million.

Ms. Branda arrived at the $3.6 million figure by assuming an

average of $300,000 in "singles" damages per year for the 6-year

period 1979 through 1984 for total "singles" damages of $1.8

million, and then doubling that amount.    "Singles" damages is a

term of art under the FCA, which provides for an award of double

the Government's actual damages.

     On or about December 9, 1985, Talley and Stencel countered

Ms. Branda's $3.6 million settlement offer by offering to settle

the Government's claims for $750,000.    Talley and Stencel

calculated the Government's total damages for labor mischarging

for 1983 and 1984 at $191,899.    In addition, although Talley and

Stencel denied liability for labor mischarging before 1983, their

settlement offer included amounts for alleged labor mischarging

in Stencel's production department from 1979 to 1984. Talley and
                               - 9 -

Stencel arrived at the $750,000 figure by doubling the amount

that they believed represented the Government's actual losses.

     On December 24, 1985, Walter T. Skallerup, Jr., General

Counsel of the Navy, responded as follows to Ms. Branda's request

for a recommendation of the minimum settlement value of the

Government's claims against Talley and Stencel:

          The investigation leading to the guilty plea
     focused primarily on evidence of mischarging during
     1984. There is reason to believe, however, that
     mischarging began in 1979 and continued throughout the
     period from 1979 to 1984. The amount of such
     mischarging cannot now be quantified. Nevertheless, we
     believe that any settlement offer should include an
     amount for the full False Claims Act liability for the
     provable losses in 1984 and a substantial amount for
     the possible liability for losses in prior years, or a
     total of $2.5 million.

     On January 7, 1986, Ms. Branda submitted a memorandum to the

Assistant Attorney General, Civil Division, in which she proposed

to reject the pending $750,000 settlement offer and suggested

that the case should be settled in the range of $2 million to

$2.5 million.   Ms. Branda summarized her position as follows:

          Thus, we think that the singles figure of $1.56
     million adequately compensates the government for its
     losses based upon a fair and defensible projection. We
     also believe that here, where Stencel has pled guilty
     to related criminal charges and where civil proceedings
     have not begun, it is premature to accept only an
     estimate of our single losses and that assessment of a
     "penalty" (as a portion of our double damages and/or
     forfeitures) is appropriate. A settlement of $2 - 2.5
     million represents compensation for an estimate of
     losses, plus assessment of a penalty.
                              - 10 -

On January 13, 1986, Ms. Branda was given authorization to reject

the pending $750,000 settlement offer and to make a counteroffer

of $2.5 million.

     On January 14, 1986, Talley, Stencel, and the Navy

Department executed an interim agreement under which the Navy

Department agreed to end Stencel's suspension and Stencel agreed,

in turn, to pay the Navy Department $600,000 and to continue

negotiating in good faith to settle the potential liability.

     By late January 1986, Talley, Stencel, and the Government

had agreed to assume, solely for purposes of settlement

discussions, that Stencel's labor mischarging had occurred in

each of the years 1979 through 1984 at a constant rate in

relation to Stencel's direct labor charges for such years.    They

further agreed that the Navy Department's total losses of the

type described in the Asheville damages schedule for 1979 through

1984 were $1,560,000.

     By letter dated January 31, 1986, Mr. Kilberg made a new

offer to settle the Government's claims against Talley and

Stencel for $2 million (with an offset of the $600,000 that

Stencel had paid earlier).   Mr. Kilberg's letter stated in

pertinent part:

          Stencel has offered the United States a total of
     two million dollars, inclusive of the $600,000
     previously paid pursuant to agreement with the
     Department of the Navy. This sum shall be compensation
     for any and all restitution and damages that may be
     owing by Stencel to the United States for any possible
                              - 11 -

     labor mischarging that may have occurred prior to
     December 20, 1984 and shall release Stencel from any
     liability to the United States for:

                (1) any and all possible violations of
           the False Claims Act * * *;

                (2) any and all possible violations of
           the Truth in Negotiations Act * * *;
           [Emphasis added.]

Mr. Kilberg's letter included a third numbered paragraph

describing the releases of liability set forth in the first and

second numbered paragraphs.   Mr. Kilberg's letter also included a

statement that the offer was intended to represent double

damages.

     By letter dated February 7, 1986, Ms. Branda rejected Mr.

Kilberg's $2 million settlement offer but made a counteroffer to

settle the matter for $2.5 million (with an offset for the

$600,000 that Stencel had already paid under the interim

agreement).   Ms. Branda's letter stated in pertinent part:

          Stencel's offer has been carefully considered by
     this office, the Navy's Office of General Counsel, the
     Defense Contract Audit Agency, and Defense Contract
     Administration Services in Atlanta. While we believe
     that the offer is made in good faith, we cannot accept
     its terms. However, I am prepared to make the
     following counter offer, subject to final Department
     approval:

                1. Stencel agrees to pay to the United
           States the sum of $2,500,000, inclusive of
           the $600,000 paid to the Navy pursuant to the
           agreement dated January 14, 1986; [Emphasis
           added.]
                              - 12 -

In extending her counteroffer, Ms. Branda expressly adopted the

first and second numbered paragraphs in Mr. Kilberg's January 31,

1986, letter (quoted above) and partially adopted and modified

the third numbered paragraph therein.   Ms. Branda did not

specifically characterize the settlement payment, or any part

thereof, as either compensation for the Government's losses or as

a penalty.

     On February 18, 1986, the parties executed a settlement

agreement that was consistent with Ms. Branda's February 7, 1986,

counteroffer.   The settlement agreement provided that Talley and

Stencel would pay the Government $1.9 million ($2.5 million less

an offset of $600,000), that Talley and Stencel would pay

$900,000 upon execution of the agreement, and that Talley and

Stencel would pay the remaining $1 million no later than February

18, 1987, with simple interest computed at the rate established

by the Secretary of the Treasury pursuant to the Renegotiation

Act Amendments, Pub. L. 92-41, sec. 2, 85 Stat. 97 (1971).     The

settlement agreement provided that Talley and Stencel were

relieved of liability under the FCA and the TINA, and that the

settlement satisfied Stencel's obligation to provide restitution

under the Judgment and Probation Commitment Order entered on July

8, 1985.   The settlement agreement did not characterize the

payment as either compensation to the Government for its losses

or as a penalty.
                              - 13 -

     Talley reported the $2.5 million payment as an ordinary and

necessary business expense on its consolidated Federal income tax

return for the taxable year 1986.   Upon examining the return,

respondent disallowed the deduction and determined a deficiency

in petitioner's Federal income tax for 1986 in the amount of

$853,042.   Petitioner invoked the Court's jurisdiction by filing

a petition for redetermination.   At the time the petition was

filed, petitioner's principal place of business was located in

Phoenix, Arizona.

                              OPINION

     Section 162(a) provides the general rule that a taxpayer is

allowed a deduction for all ordinary and necessary expenses paid

or incurred by the taxpayer in carrying on a trade or business.

Section 162(f), however, proscribes a deduction under section

162(a) for "any fine or similar penalty paid to a Government for

the violation of any law."   The phrase "fine or similar penalty"

is defined in section 1.162-21(b), Income Tax Regs., as follows:

          (b) Definition. (1) For purposes of this section
     a fine or similar penalty includes an amount--

            (i) Paid pursuant to conviction or a plea of
     guilty or nolo contendere for a crime (felony or
     misdemeanor) in a criminal proceeding;

            (ii) Paid as a civil penalty imposed by Federal,
     State, or local law, * * *;

            (iii) Paid in settlement of the taxpayer's
     actual or potential liability for a fine or penalty
     (civil or criminal); * * *
                                - 14 -

Section 1.162-21(b)(2), Income Tax Regs., provides that

compensatory damages paid to a Government do not constitute a

fine or penalty.

     Deductions are a matter of legislative grace, and the

taxpayer must show that he comes squarely within the terms of the

law conferring the benefit sought.       See Rule 142(a); INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice

Co. v. Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering,

290 U.S. 111, 115 (1933).   Applying this principle in the instant

case, petitioner bears the burden of proving that, in settling

the Stencel matter, the parties intended for the entire $2.5

million payment (including the $940,000 portion of the payment

that exceeded the Government's $1.56 million "singles" damages)

to represent compensation to the Government for its losses.

     The first issue to be resolved is whether the parties

intended the Stencel settlement to include double damages under

the FCA.   Although the settlement agreement does not characterize

the $2.5 million payment, or any part thereof, as double damages,

we conclude that the parties intended the settlement to include

double damages under the FCA.    In short, the parties' various

offers and counteroffers repeatedly referred to the settlement as

including double damages.

     Next, we must consider whether the purpose of the $940,000

double damage payment was to compensate the Government for its
                                  - 15 -

losses or to deter or punish Stencel.      The Court of Appeals

stated:

            The double damages provision of the FCA has both
       compensatory and deterrence purposes. See United
       States v. McLeod, 721 F.2d 282, 285 (9th Cir. 1983);
       see also Mortgages, Inc. v. United States Dist. Court,
       934 F.2d 209, 213 (9th Cir. 1991); United States v.
       Northrop Corp., 59 F.3d 953, 965 (9th Cir. 1995).
       "[T]he double damages provision of the [FCA] is meant
       not only to compensate the government fully but also to
       deter fraudulent claims from being filed against it."
       McLeod, 721 F.2d at 285. Congress chose the double
       damage provision "'to make sure that the government
       would be made completely whole.'" Id. (quoting United
       States v. Hess, 317 U.S. 537, 551-52, 63 S.Ct. 379,
       388, 87 L.Ed. 443 (1943)). At the same time, however,
       the double damage provision "'maximizes the deterrent
       impact ....'" McLeod, 721 F.2d at 285 (quoting United
       States v. Bornstein, 423 U.S. 303, 317, 96 S.Ct. 523,
       531, 46 L.Ed.2d 514 (1976)).

Talley Indus., Inc. & Consol. Subs. v. Commissioner, 116 F.3d at

387.

       The settlement agreement does not characterize the $2.5

million payment, or any portion thereof, as either compensation

for the Government's losses or as a penalty.      In light of this

ambiguity, the Court of Appeals indicated that the deductibility

of the $940,000 amount would have to be resolved by determining

the parties' intent.    See id.

       Petitioner contends that no portion of the $940,000 in

dispute can be considered a penalty because the Government's

actual losses--including its incidental losses, such as the costs

associated with the investigation, the suspension and debarment

proceedings, the grounding of Navy aircraft for lack of
                              - 16 -

replacement parts, and the Government's loss of use of funds

improperly paid to Stencel--exceeded the $2.5 million that

petitioner paid under the settlement agreement.    Petitioner

further contends that its representatives and attorneys always

intended for the entire settlement to represent compensation to

the Government for its losses.

     Respondent counters that, regardless of the amount of the

Government's actual losses, the Government intended that the

disputed portion of the settlement payment would serve as a

penalty to deter Stencel and other Government contractors from

submitting false claims.

     The parties present opposing positions respecting the

correct characterization of the disputed portion of the

settlement payment.   Justice Oliver Wendell Holmes stated that

"the making of a contract depends not on the agreement of two

minds in one intention, but on the agreement of two sets of

external signs,--not on the parties' having meant the same thing,

but on their having said the same thing."     Holmes, "The Path of

the Law", 10 Harv. L. Rev. 457, 464 (1897).

     We reject petitioner's contention that the disputed portion

of the settlement agreement cannot be considered a penalty

because the Government's actual losses purportedly exceeded the

entire $2.5 million settlement payment.   Neither party made a

serious effort to quantify the Government's actual losses in
                              - 17 -

excess of its "singles" damages of $1.56 million.   Moreover, the

settlement, by its very nature, reflects a compromise influenced

by a number of factors including the hazards of litigation, the

need for an expedited settlement, and possibly the character of

the payment.   To accept petitioner's position, we would have to

ignore evidence that the Government was willing to accept the

settlement on the belief that a portion of the settlement in

excess of its "singles" damages would amount to a penalty.     It

follows that we must proceed to consider the parties' intent, as

mandated by the Court of Appeals.   See Talley Indus., Inc. &

Consol. Subs. v. Commissioner, 116 F.3d at 387-388.

     A settlement agreement is treated like any other contract

for purposes of interpretation.   See United Commercial Ins.

Serv., Inc. v. Paymaster Corp., 962 F.2d 853, 856 (9th Cir.

1992); see also Saigh v. Commissioner, 26 T.C. 171, 177

(1956); Fisher v. Commissioner, T.C. Memo. 1994-434.   In the

case of an ambiguous contract, the Court may consider extrinsic

evidence, such as evidence of the parties' prior negotiations and

communications, in order to ascertain the parties' intent.     See

California Pac. Bank v. SBA, 557 F.2d 218, 222 (9th Cir. 1977); 2

Restatement, Contracts 2d, sec. 214(c) (1981); see also United

Commercial Ins. Serv., Inc. v. Paymaster Corp., supra at 856;

Interpublic Group of Cos. v. On Mark Engg. Co., 381 F.2d 29, 32-

33 (9th Cir. 1967).
                              - 18 -

     The record shows that, in negotiations leading up to the

settlement agreement, petitioner took the position that its

settlement offer would serve to compensate the Government for its

losses.   In this regard, Mr. Kilberg's January 31, 1986, letter

stated:   "This sum shall be compensation for any and all

restitution and damages that may be owing by Stencel to the

United States for any possible labor mischarging that may have

occurred prior to December 20, 1984".

     However, Ms. Branda rejected Mr. Kilberg's January 31, 1986,

settlement offer.   In particular, by letter to Mr. Kilberg dated

February 7, 1986, Ms. Branda stated:    "While we believe that the

offer is made in good faith, we cannot accept its terms."    Ms.

Branda went on to present a counteroffer in which she expressly

adopted specific portions of Mr. Kilberg's earlier offer.    Ms.

Branda did not adopt Mr. Kilberg's characterization of the

settlement payment as compensation.    In fact, although Ms. Branda

had characterized a portion of the settlement as a penalty in her

in-house communications, Ms. Branda did not characterize the

settlement payment at all in her counteroffer to Mr. Kilberg.

     Petitioner did not clarify the matter.   The parties executed

a settlement agreement that is silent on the subject of the

characterization of the settlement payment.

     The Court of Appeals emphasized that petitioner "suffers the

consequence" if evidence to establish entitlement to the disputed
                              - 19 -

deduction is lacking.   Talley Indus., Inc. & Consol. Subs. v.

Commissioner, 116 F.3d at 387-388.     The record shows that the

parties did not agree whether the portion of the settlement in

excess of the Government's "singles" damages would constitute

compensation to the Government for its losses or a penalty

against Stencel.   It thus follows that petitioner has failed to

establish entitlement to a deduction for the disputed portion of

the settlement.

     Consistent with the foregoing,

                                      Decision will be entered

                               under Rule 155.
