Lessons Learned from New York’s Largest Ever False Claims Act Tax Settlement

Insight can be hard to gain from publicly announced settlements, mostly because litigation is typically settled due to the cost of defense and overall frustration with litigating. But the recently announced settlement of a False Claims Act case in New York, based on state income tax, is an exception.

A Harbinger for More to Come

On April 18, the New York Attorney General announced what he touted as the largest settlement of a New York whistleblower lawsuit brought under the state’s False Claims Act to recover New York state income taxes alleged to have been unpaid (AG Announcement). The defendant in that suit, Alabama-based investment firm Harbert Management Corp. (“Harbert”), agreed to a $40 million settlement with New York over state income taxes that Harbert paid to its home state of Alabama, instead of paying in the higher taxing rate state of New York.

Expect more states to look into including state income tax as a basis within their False Claims Acts, the dollars are too big to ignore.

Based on the public settlement documentation (Settlement Agreement), Harbert was alleged to have earned hundreds of millions of dollars through an office in New York from 2004 – 2009, for which it paid no income tax to New York. While Harbert did pay Alabama taxes for all of its income, the New York Attorney General alleged that state law requires taxes to be paid on any income derived from New York activities.

Anonymous Whistleblower (Likely Ex-Employee) to “Earn” Nearly $9 Million

According to the Attorney General, Harbert organized Harbinger Capital Partners Offshore Managers LLC, a $26 billion hedge fund run out of an office at 555 Madison Avenue in Manhattan. During the years at issue, Harbinger would either allocate zero percent of its earnings to New York or not file a state tax return. Harbinger’s position was that it had no nexus in New York state and had no income derived from New York sources. But Harbinger made hundreds of millions of dollars by shorting the subprime mortgage market in 2007.

Harbert states that its $40 million settlement was a business decision made “to avoid protracted, distracting and expensive litigation.” Through counsel, Harbert stated that its decision to pay tax on all of its taxable income to Alabama was “based on tax advice from multiple outside tax professionals,” and that the detailed facts would have demonstrated Harbert’s good faith if it had progressed through litigation. The whistleblower, who remains anonymous and is assumed to be a disgruntled ex-employee, will receive around $8.8 million of the settlement under the 2013 New York False Claims Act.

The Attorney General counters that Harbinger’s investment group conducted substantive activities in New York, including developing investment strategy, due diligence efforts and interacting with people in the distressed investment industry. The Attorney General also alleges that in 2005, Harbinger received advice from outside accounting professionals that some New York tax would be due. The settlement agreement also reflects that Harbinger’s office continued to grow in size with its ongoing successes.

A Little Good Faith Can Go A Long Way: 3 Takeaways From This Record Setting FCA Settlement

1. The dollars are too big to ignore. Expect more states to look into including state income tax as a basis within their False Claims Acts. Out of 31 states with a False Claims statute, only 15 currently allow a claim based on state income tax. It’s only a matter of revising the law, as New York did in 2013.
2. Document and follow good-faith efforts. Even where a nexus issue seems clear to you, or to your client, extra steps should be taken for big-ticket items to document a good-faith review of your position, reflect the basis for that decision, and then follow the advice, for best protection from a fraud claim down the road.
3. The face of the enemy has changed. No longer is it just the Department of Revenue who needs to be considered for potential audit and discovery of incorrect state tax filings?interpreting tax laws and policy has been taken from the taxing authorities and placed in the hands of individual whistleblowers and state courts.