COST OF INDEPENDENT SPENT FUEL STORAGE INSTALLATION MUST BE CAPITALIZED.

UIL Number(s) 0162.09-17, 0263.01-00, 0263A.00-00, 0468A.00-00

                                             Date: May 31, 1996

[1] Whether the costs of constructing an Independent Spent Fuel Storage Installation ("ISFSI") may be deducted as ordinary and necessary business expenses under section 162 of the Internal Revenue Code, as an abandonment loss under section 165, or as nuclear decommissioning costs under section 468A.

FACTS:

[2] In Year 1, Taxpayer, DEF Company, and the predecessor to Government Agency entered into an agreement to build the ABC Nuclear powered Electric Generation Station (the "ABC Station"). Pursuant to that agreement, Government Agency was required to designate a facility for the temporary storage and reprocessing of the ABC Station's spent nuclear fuel segments (subject to the availability of appropriations to Government Agency). Pursuant to two subsequent agreements, Government Agency in turn designated the State B National Engineering Laboratory (the "State B NEL") to receive and temporarily store this material. In addition to its contractual obligation to provide for the temporary storage and processing of the spent nuclear fuel segments, federal law required that Government Agency provide a repository for the permanent storage and disposal of the spent nuclear fuel beginning in Year 9. As of Year 2, however, Government Agency had no such facility nor had it any plans to complete construction of such a facility prior to Year 11 at the earliest.

[3] In Year 2, Taxpayer decided to begin phasing out the operational use of its ABC Station. The initial plan was to gradually phase out the operation of the nuclear facility through Year 10, decommission the ABC Station, and then convert the usable portion of the facility to a natural gas-powered generation station. Consequently, Taxpayer entered into an agreement (the "Year 2 Agreement") with the State A Public Utilities Commission (the "State A PUC"), DEF Company, and other parties involved in litigation and administrative proceedings regarding the operation of the ABC Station. Pursuant to the Year 2 Agreement, Taxpayer had requested and received approval from the State A PUC to write down a significant portion of the investment in the ABC Station. As a result, Taxpayer's investment in the ABC Station was removed from the rate base and Taxpayer recognized a large abandonment loss for the remaining book value of the investment. ¹

[4] The initial plan was to decommission the ABC Station using the SAFSTOR decommissioning method, under which most of the dismantlement work would be accomplished after a 50 plus year decontamination and waiting period. Under the SAFSTOR method, the estimated cost of decommissioning the ABC Station in Year 2 dollars was $b. Part of the abandonment loss recorded on Taxpayer's books was this initial decommissioning reserve of $b. This amount was adjusted periodically through the end of Year 6 assuming the SAFSTOR method would be used.

[5] In Year 4, Taxpayer realized that it would have to incur very expensive repair work to continue operating the ABC Station, even at a reduced capacity. Therefore, Taxpayer decided it would shut down the ABC Station ahead of the shut down scheduled to occur in Year 10.

[6] Once the decision was made to shut the plant down and begin the defueling process, Taxpayer became aware that State B had problems with the shipment of spent nuclear fuel into State B. The Governor of State B had serious concerns about the environmental impact that the spent nuclear fuel would have on State B. Initially, Taxpayer was able to ship some fuel to the State B NEL. However, in Year 6, Government Agency was enjoined from receiving spent nuclear fuel at the State B NEL. The Taxpayer initiated legal action challenging on constitutional grounds State B's refusal to permit Government Agency to accept spent nuclear fuel segments in State B. Although the injunction was subsequently set aside, the Taxpayer represents that Government Agency has determined that it must prepare an Environmental Impact Statement (EIS) relative to the receipt and storage of spent fuel at the State B NEL before it will accept any more fuel shipments. Consequently, no shipments of fuel have been received at the State B NEL since late in Year 6.

[7] Several other parties also had concerns about the shipment of spent nuclear fuel into State B, including a local State B indian tribe whose reservation was located near the State B NEL. The tribe banned the shipment of spent nuclear fuel across the tribal reservation pursuant to a tribal resolution. The Taxpayer initiated legal action to enjoin the indian tribe from interfering with the shipment of spent nuclear fuel to the State B NEL. Although the court ordered the tribe to permit the shipment of spent nuclear fuel acrosS the reservation, the tribe subsequently passed a new resolution that attempts to regulate -- rather than ban -- shipments of spent nuclear fuel within the reservation's boundaries. The Taxpayer and the indian tribe are currently litigating the validity of this new resolution.

[8] In Year 6, Taxpayer decided to convert from the SAFSTOR decommissioning method to the DECON decommissioning method. Under the DECON method, all dismantlement work is accomplished within four years, thus requiring no extended decontamination and waiting period. The Taxpayer believed that use of the DECON method was preferable because it would reduce the overall cost of decommissioning and eliminate considerable uncertainty associated with the SAFSTOR method. Moreover, under the DECON method, Taxpayer would be able to repower the ABC Station for natural gas generation by Year 9, and could use $c of existing equipment.

[9] With the delay in permitting shipments to the State B NEL, Taxpayer constructed an ISFSI for the temporary storage of spent nuclear fuel segments. Taxpayer completed design work and began fabrication on the ISFSI on or about Date 1, when the construction contract was awarded. The facility was completed and turned over to the Taxpayer on or about Date 2. Thereafter, Taxpayer was able to proceed with its decommissioning plans and avoid further delays. The total cost of construction of the ISFSI was $d. Defueling from the ABC station reactor to the ISFSI began on Date 3 and was completed on Date 4.

[10] The total $e in additional costs incurred in decommissioning the ABC Station through the end of Year 7 -- which includes $d attributable to construction of the ISFSI -- were accounted for by charging those costs against Taxpayer's decommissioning reserve. For tax purposes, these costs were charged against taxable income in the year incurred.

[11] Taxpayer continues to pursue all available legal remedies to enable it to ship the spent fuel to State B. However, Taxpayer may have to store the spent fuel in the ISFSI until Year 11 (which Taxpayer assumes is the earliest date that a Federal repository would be able to accept the fuel). If Taxpayer is required to store the spent fuel until Year 11, it will be required to recognize substantial additional costs for storing the fuel.

[12] In Date 5, after the Taxpayer was unable to ship its spent fuel to State B, the Taxpayer filed a claim for breach of contract with Government Agency. Among the damages claimed, amounting to over $g, were costs for the design and construction of the ISFSI. The Taxpayer filed suit against Government Agency sometime in Year 8. In Date 6, the Taxpayer and Government Agency reached an agreement in principle under which Government Agency will take title to the spent fuel, and, eventually, to the ISFSI itself, with Government Agency paying the Taxpayer $f of the costs of the ISFSI (plus annual payments pending transfer of the facility to Government Agency).

[13] The revenue agent assigned to this matter has represented as a factual matter that the Taxpayer never abandoned or waived its right to a claim for damages from Government Agency or State B, and, moreover, the Taxpayer did not have any reasonable basis for believing that such claims should be abandoned.

LAW AND ANALYSIS:

WHETHER THE COSTS OF CONSTRUCTING THE ISFSI ARE DEDUCTIBLE NUCLEAR DECOMMISSIONING COSTS WITHIN THE MEANING OF SECTION 468A(c)(2) OF THE CODE.

[14] Section 468A(a) of the Code provides that a taxpayer may elect to deduct for any taxable year the amount of payments made to a Nuclear Decommissioning Reserve Fund (the "Fund") during the taxable year. Section 468A(c)(2) provides that, in addition to any deduction under section 468A(a), there shall be allowable as a deduction for any taxable year the amount of the nuclear decommissioning costs with respect to which economic performance (within the meaning of section 461(h)(2)) occurs during such taxable year.

[15] Section 1.468A-1(b)(5) of the Income Tax Regulations defines the term "nuclear decommissioning costs" or "decommissioning costs" to mean all otherwise deductible expenses to be incurred in connection with the entombment, decontamination, dismantlement, removal and disposal of the structures, systems, and components of a nuclear power plant that has permanently ceased the production of electric energy. Such term includes all otherwise deductible expenses to be incurred in connection with the preparation for decommissioning, such as engineering and other planning expenses, and all otherwise deductible expenses to be incurred with respect to the plant after the actual decommissioning occurs, such as physical security and radiation monitoring expenses. Such term does not include otherwise deductible expenses to be incurred in connection with the disposal of spent nuclear fuel under the Nuclear Waste Policy Act of 1982 (Pub. L. 97-425). An expense is otherwise deductible for purposes of section 1.468A-1(b)(5) if it would be deductible under chapter 1 of the Code without regard to section 280B.

[16] The Taxpayer argues that the costs of constructing the ISFSI are an integral part of the decommissioning process of the ABC Station and that these costs are decommissioning costs within the meaning of section 468A(c)(2) of the Code and section 1.468A-1(b)(5) of the regulations. As such, when economic performance occurs under section 461(h)(2), the costs are currently deductible. Economic performance presumably occurred when the ISFSI was constructed.

[17] "Nuclear decommissioning costs1, are broadly defined in section 1.468A-1(b)(5) of the regulations to include expenses incurred before, during, and after the actual decommissioning process for the nuclear power plant unit that has ceased operations. This broad definition is consistent with Congress' recognition in enacting section 468A of the Code in 1984 that "the establishment of segregated reserve funds for paying future nuclear decommissioning costs was of sufficient national importance that a tax deduction, subject to limitations, should be provided for amounts contributed to qualified funds." Joint Committee on Taxation Staff, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 270 (1984).

[18] The costs of constructing the ISFSI are incurred in connection with the dismantlement of the ABC Station. Due to the Government Agency's inability to store the spent fuel, the Taxpayer constructed the ISFSI so that the Taxpayer could proceed with decommissioning the ABC Station. However, whether the costs of constructing the ISFSI are "otherwise deductible" would be determined under other provisions of the Code (e.g., below) Costs that meet the definition of nuclear decommissioning costs under section 468A are not automatically deductible. The costs are deductible when economic performance occurs under section 461(h)(2) if the costs are deductible under section 162 (or are otherwise deductible under another provision of chapter 1 of the Code).

[19] Accordingly, the fact that the costs of constructing the ISFSI are nuclear decommissioning costs within the meaning of section 468A(c)(2) of the Code and section 1.468A-1(b)(5) of the regulations does not preclude the costs from being characterized as nondeductible capital expenditures under section 263.

WHETHER THE COSTS OF CONSTRUCTING THE ISFSI ARE DEDUCTIBLE UNDER SECTION 162 OF THE CODE OR WHETHER SUCH COSTS ARE CAPITAL EXPENDITURES UNDER SECTION 263 AND 263A.

[20] Section 162 of the Code generally allows a deduction for the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 263 generally prohibits deductions for capital expenditures. Section 263(a)(1) provides that no deduction shall be allowed for any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property. Section 263(a)(2) provides that no deduction shall be allowed for any amount expended in restoring property or in making good the exhaustion thereof for which an allowance has been made in the form of a deduction for depreciation, amortization, or depletion.

[21] Section 1.263(a)-1(b) of the regulations provides that capital expenditures include amounts paid or incurred (1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use. Section 1.263(a)-2(a) provides that capital expenditures include the costs to acquire, construct, or erect buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life extending substantially beyond the taxable year.

[22] Section 263A provides that direct costs and indirect costs properly allocable to real or tangible personal property produced by the taxpayer shall be capitalized. Section 263A(g)(1) provides that, for purposes of section 263A, the term produce includes construct, build, install, manufacture, develop, or improve.

[23] Section 1.263A-1T(a)(1) of the temporary Income Tax Regulations ² states, in part, that, except as otherwise provided, all costs that are incurred with respect to real or tangible personal property that is produced, or property that is acquired for resale, are to be capitalized with respect to such property.

[24] Section 1.263A-1T(a)(5)(ii) defines the term "produce" to include construct, build, install, manufacture, develop, improve, create, raise, or grow. Property produced for the taxpayer under a contract with the taxpayer is treated as property produced by the taxpayer to the extent that the taxpayer makes payments or otherwise incurs costs with respect to such property.

[25] The Supreme Court in INDOPCO Inc. v. Commissioner, 503 U.S. 79 (1992), has noted the "familiar rule" that income tax deductions are "a matter of legislative grace" and that the taxpayer bears the "burden of clearly showing the right to the claimed deduction. . . ." Id. at 83. Section 161 of the Code clarifies the relationship between deductions allowable under section 162 and capital expenditures under section 263. Section 161 provides that the deductions allowed in Part VI, including section 162, are subject to the exceptions set forth in Part IX, including section 263. Thus, the capitalization rules of section 263 take precedence over the rules for deductions under section 162.

[26] The costs of constructing the ISFSI are capital expenditures under section 263 of the Code. Section 263 generally prohibits deductions for capital expenditures. Section 1.263(a)-2(a) of the regulations provides in relevant part that capital expenditures include the costs to construct fixtures and similar property having a useful life extending substantially beyond the taxable year. The fact that a capital expenditure has a finite life does not convert a nondeductible capital expenditure into a deductible expense. See Vest v. Commissioner, T.C. Memo 1993-243 (requiring capitalization of costs of temporary building constructed to house piece of high-tech medical equipment pending completion of construction of permanent medical clinic). Contrary to the Taxpayer's position, these capitalization rules are not altered in this case by the fact that the Taxpayer incurred the costs to construct the ISFSI in connection with its shutdown of the ABC Station. Sections 162 and 263 and the regulations thereunder do not provide for the deductibility of otherwise capital expenditures when those costs are incurred in connection with the winding up of a trade or business.

WHETHER THE COSTS OF CONSTRUCTING THE ISFSI ARE DEDUCTIBLE UNDER SECTION 165 OF THE CODE AS AN ABANDONMENT LOSS.

[27] Section 165(a) of the Code provides that there shall be allowed as a deduction any loss sustained during the tax year and not compensated for by insurance or otherwise. Section 1.165-1(b) of the regulations provides that, to be allowable as a deduction under section 165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the tax year.

[28] Under section 1.165-1(d)(2)(i), if an event occurs that may result in a loss and, in the year of the event, there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained until it can be ascertained with reasonable certainty whether or not such reimbursement will be received. Whether a reasonable prospect of recovery exists is a question of fact to be determined on an examination of all facts and circumstances.

[29] Notwithstanding that the costs of constructing the ISFSI are capital expenditures under sections 263 and 263A of the Code, the Taxpayer may still be entitled to an abandonment loss deduction under section 165. If the Taxpayer did not have a reasonable prospect of recovering on its claim against Government Agency, the Taxpayer would be entitled to an abandonment loss deduction. Conversely, if the Taxpayer did have a reasonable prospect of recovering on its claim, it would not be entitled to an abandonment loss deduction. The agent has stated that the Taxpayer did have a reasonable prospect of recovery. The Taxpayer stated at conference that it did not have a reasonable prospect of recovery and would provide memoranda and corporate minutes to support its position. The Taxpayer did not provide this evidence. Typically, the national office bases its technical advice on the facts provided by the agent when there is disagreement between the agent and the Taxpayer. See Rev. Proc. 96-2, 1996-1 I.R.B. 60, 67. However, because of the importance of this factual issue and the clear legal conclusions outlined above that follow from the factual determination, we are not reaching a conclusion on this issue.

CONCLUSIONS:

[30] The costs of constructing the ISFSI are not deductible as ordinary and necessary business expenses under section 162 of the Code or as nuclear decommissioning costs under section 468A. Such costs are to be treated as capital expenditures under sections 263 and 263A. These costs would be deductible under section 165 as an abandonment loss if the Taxpayer did not have a reasonable prospect of recovering on its claim against Government Agency for the years at issue.

[31] A copy of this technical advice memorandum is to be given to the Taxpayer. Section 6110(j)(3) of the Code provides that it shall not be used or cited as precedent.

² The temporary regulations applied to the tax years during which the costs of constructing the ISFSI were incurred.