Attorneys Brand Guidance on Capitalization of Environmental Remediation Costs as 'Bad Tax Policy'

[1] On February 6, 2004, the Internal Revenue Service (the "Service") released Revenue Ruling 2004-18, which holds that environmental remediation costs are subject to capitalization under section 263A of the Internal Revenue Code (the "Code"). The facts of the ruling involve a manufacturer that, to comply with applicable laws, incurs costs to remediate soil and groundwater contaminated by hazardous waste produced in its manufacturing process. The ruling concludes that the taxpayer's remediation costs are incurred by reason of the taxpayer's production activities and thus are properly allocable to property produced by the taxpayer that is inventory in the taxpayer's hands under Treas. Reg. § 1.263A-1(e)(3)(i).

[2] For the reasons outlined below, we respectfully submit that this result is bad tax policy and request that this result be rectified either through legislation or administrative guidance.

[4] By holding that environmental remediation costs are capitalizable under section 263A, Rev. Rul. 2004-18 now denies a current deduction (in favor of basis recovery) to virtually all taxpayers that typically incur such costs, i.e., producers of real or tangible property. Under Rev. Rul. 2004-18, remediation costs will now be allocable to basis in inventory or self constructed assets and will be recovered against income only in the year or years in which the basis in the assets to which such environmental costs are allocated produced assets are to be allocated these environmental remediation costs. Are items in current inventory production or currently produced capital assets to be encumbered with these environmental costs, or will such costs be allocated to inventory or assets still on hand that were produced in the year the environmental damage occurred? What happens to such costs if no such inventory or assets are still on hand? Rev. Rul. 94-38 avoided the allocation issue that was ducked in Rev. Rul. 2004-18 because that earlier ruling more properly determined that environmental remediation expenses incurred years after the environmental damage has occurred are really not production costs. They certainly have no nexus to current production, and there is a real question as to whether the Code and Treasury Regulations require such costs incurred many years after the environmental damage has been done to be treated as a cost of prior production. In any event, the administrative burden of attempting to allocate these costs to prior-years' production outweighs any technical reading of section 263A that might require capitalization of these costs, and, for this reason, the decision in Rev. Rul. 94-38 to allow a current deduction was obviously premised on interpreting the tax provisions of the Code and Regulations in a manner that is consistent with the Service's own stated policy of providing practical rules which make tax compliance efficient and understandable.

[5] This about-face by the Service also significantly undermines the important public policy goal of encouraging environmental remediation. Congress has, in the past, specifically sought to provide incentives for taxpayers to engage in environmental remediation through the Tax Code. A prime example is section 198 (the so-called "brownfields" provision), which was added to the Code as part of the Taxpayer Relief Act of 1997 and expired on December 31, 2003. Section 198 provided a current deduction for certain environmental cleanup costs that otherwise would be subject to capitalization. In this regard, the legislative history of that section provided, "To encourage the cleanup of contaminated sites, as well as to eliminate uncertainty regarding the appropriate treatment of environmental remediation expenditures for Federal tax law purposes, the Committee believes that it is appropriate to provide clear and consistent rules regarding the Federal tax treatment of certain environmental remediation expenses." S. Rep. No. 33, 105th Cong., 1st Sess., at 110.

[6] This policy objective was recently reiterated in the President's 2005 Budget, which proposed a permanent extension of section 198. In this regard, Treasury's Bluebook states, "The Administration believes that encouraging environmental remediation is an important national goal. The brownfields provision encourages the cleanup of contaminated brownfields, thereby enabling them to be brought back into productive use in the economy and mitigating potential harms to public health. Extending the special treatment accorded to brownfields on a permanent basis would remove doubt among taxpayers as to the deductibility of remediation expenditures and would promote the goal of encouraging environmental remediation." Department of the Treasury, General Explanations of the Administration's Fiscal Year 2005 Revenue Proposals (Feb. 2004).

[7] We find it curious that the Service would, almost simultaneously with publication of the President's Budget, issue a revenue ruling at odds with what the President's Budget identifies as an "important national goal."

[9] Similarly, the holding of Rev. Rul. 2004-18 calls into question the treatment of payments to qualified settlement funds ("QSFs") established under section 468B of the Code. QSFs frequently are set up to satisfy liabilities under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. See Treas. Reg. § 1.468B-1(c)(2)(i). Treas. Reg. § 1.468B-3(c)(1) provides that with respect to such liabilities, for purposes of section 461(h), economic performance occurs to the extent a taxpayer makes a transfer to a QSF to resolve or satisfy such liabilities. In the past, taxpayers have been allowed current deductions under section 162 for transfers to QSFs established to satisfy environmental liabilities based on Rev. Rul. 94-38. See, e.g., PLRs 9852037, 9852038 (Sept. 29, 1998). Insofar as Rev. Rul. 2004-18 requires costs previously deducted pursuant to Rev. Rul. 94-38 to be subject to capitalization under section 263A, it would appear that taxpayers might be denied current deductions for transfers to a QSFs, significantly undercutting the tax policy considerations that resulted in the adoption of the QSF provisions.