January 30, 2006
Mr. Eric Solomon Mr. Donald Korb
Acting Deputy Assistant Secretary (Tax Policy) Chief Counsel
Department of Treasury Internal Revenue Service
1500 Pennsylvania Avenue, N.W.1111 Constitution Avenue, N.W.
Washington, DC 20220Washington, DC 20044
Mr. Thomas Barthold
Acting Chief of Staff
Joint Committee on Taxation
1015 Longworth
Washington, DC 20515
Re: Rev. Rul. 2005-42Capitalization of Environmental Remediation Expenditures
Dear Messrs. Solomon, Korb and Barthold:
The American Institute of Certified Public Accountants (AICPA) offers the attached comments to highlight our significant tax policy and administrative concerns regarding Rev. Rul. 2005-42, which generally requires capitalization of environmental remediation expenditures under section 263A. These comments were developed by the AICPA’s Tax Accounting Technical Resource Panel and approved by the Tax Executive Committee.
The AICPA believes that environmental remediation costs should not be capitalized under section 263A. If capitalization is used, Rev. Rul. 2005-42’s analogy of remediation costs to repair expenses is incorrect. Finally, even if this analogy is correct, some fact patterns in Rev. Rul. 2005-42 treat remediation costs inconsistently with repairs. We are also concerned that the procedural rules for filing accounting method change applications to conform to this ruling using a cut-off method do not provide adequate time for taxpayers to respond.
We appreciate your consideration of these comments. If you have any questions, please contact me at ; Christine Turgeon, Chair, AICPA Tax Accounting Technical Resource Panel, at ; or George White, AICPA Technical Manager, at .
Sincerely,
Thomas J. Purcell III
Chair, AICPA Tax Executive Committee
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Revenue Ruling 2005-42
Requiring Capitalization of Environmental Remediation Expenditures
Developed by the
Rev. Rul. 2005-42 Task Force
Les Schneider
Jan Skelton
Barry Tovig
Christine Turgeon
George White, AICPA Technical Manager
January 30, 2006
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Revenue Ruling 2005-42 Requiring Capitalization of Environmental Remediation Expenditures
In Rev. Rul. 2004-18, 2004-1 C.B. 509, the Internal Revenue Service and Treasury Department determined that costs incurred to clean up land that a taxpayer contaminated with hazardous waste by operation of the taxpayer’s manufacturing activities on that site are includible in inventory costs under section 263A. In Rev. Rul. 2005-42, 2005-28 I.R.B. 67, the IRS and Treasury further concluded that such environmental remediation costs are properly allocable under section 263A to the inventory produced during the taxable year in which the costs are incurred. Importantly, the IRS reached the same conclusion in all five fact patterns of this ruling where the taxpayer (1) currently manufactures the same product at the contaminated site; (2) currently manufactures a different product at the site than it produced at the time of the contamination; (3) temporarily idles the site during the remediation; (4) permanently ceases manufacturing activities at the contaminated site; or (5) contaminates a remote third-party site no longer used to dispose waste from its manufacturing activities. Both rulings provide procedural rules for filing an application to change a taxpayer’s method of accounting to comply with the conclusions in the rulings.
As explained in the following comments, it is the position of the AICPA that treating environmental remediation costs as subject to capitalization under section 263A is an unwise policy decision and a specific exclusion should be provided for such costs. Moreover, even if it is concluded that subjecting environmental remediation costs to section 263A is appropriate as a policy matter, we believe it is incorrect to analogize environmental remediation costs to repair expenses as done in Rev. Rul. 2005-42. In addition, even if the government were to determine that all (or certain types of) environmental remediation costs should properly be treated in the same manner as repair costs for purposes of section 263A, we question whether the treatment of environmental remediation costs in certain of the facts patterns in Rev. Rul. 2005-42 is consistent with the treatment of repairs. Finally, the AICPA also is concerned that the procedural rules provided in Rev. Rul. 2005-42 for filing accounting method change applications to conform to the rulings and to effect a change using a cut-off method did not provide adequate time for taxpayers to respond.
1.Substantive Issues
A.Requiring capitalization of environmental remediation costs under section 263A is an unwise policy decision.
We believe that the rationale for capitalizing environmental remediation costs has previously been considered by the IRS and Treasury and such capitalization has been rejected as unwise as a policy matter. For example, the conclusion that environmental remediation costs must be capitalized under section 263A is inconsistent with the policy decision articulated in Rev. Rul. 94-38, 1994-1 C.B. 35, that such costs are deductible as ordinary and necessary business expenses under section 162. In Rev. Rul. 94-38, the IRS and Treasury Department concluded that costs a taxpayer incurred to remediate soil and to treat groundwater that it contaminated with hazardous waste from its business were deductible section 162 expenses. In reaching its conclusion with respect to the soil remediation and groundwater treatment costs, the IRS and Treasury Department noted that the Internal Revenue Code “generally endeavors to match expenses with the revenues of the taxable period to which the expenses are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes.” The IRS and Treasury Department found that the soil remediation and groundwater treatment expenses did not permanently improve the taxpayer’s land, nor did they provide significant future benefits. Instead, the IRS and Treasury Department found that the expenditures were “appropriate and helpful in carrying on the taxpayer’s trade or business and were commonly and frequently required” in the taxpayer’s particular business.
Rev. Rul. 94-38, confirming the current deductibility of environmental remediation costs, was published shortly after several revenue raising measures were proposed and considered by the House of Representatives Ways and Means Committee in the early 1990s. One such proposal included a “clarification” of the treatment of environmental remediation expenditures, including a requirement that all environmental remediation expenditures be subject to capitalization under section 263(a) and amortized over a specified period. Hearings were held before the Subcommittee on Select Revenue Measures, Committee on Ways and Means, in the summer of 1993. Leslie Samuels, then Assistant Secretary (Tax Policy) at the Department of Treasury, testified that the proposal to require capitalization of environmental remediation costs was “under study,” and that the Treasury was considering “appropriate ways to reduce the potentially large costs likely to be incurred by the IRS and taxpayers in resolving disputes over the proper treatment of these costs.”[1]
Several coalitions of taxpayers, representing a variety of industries, also testified at the hearings and urged the Subcommittee that, if the treatment of environmental remediation expenditures were to be clarified, any such clarification should confirm that the costs are currently deductible under current law, and should remain deductible. The testimony consistently noted that requiring capitalization of environmental remediation costs would not result in a clear reflection of income because it would result in associating costs incurred for past activities with future income. In fact, as one party testified, “[e]nvironmental remediation costs as a general matter relate only to prior activities of the taxpayer or a previous property holder and do not provide an ongoing benefit beyond that associated with the general welfare of the environment.”[2] Similarly, another party noted that “most environmental cleanup costs are ‘backward looking’ – they relate to past events, and to income that was generated in the past, not to income that will be produced in the future.”[3] The testimony collectively emphasized that environmental remediation expenditures, are by their very nature, costs incurred to eradicate damage caused to the environment in the past. The testimony concluded that a deduction in the taxable year in which the costs are incurred clearly reflects income because there is no benefit to which the costs will relate in the future. The Subcommittee, through its comments during the testimony, seemed to recognize that current law at the time provided appropriate treatment of environmental remediation expenses (i.e., that current law provided for a determination of which costs were currently deductible and which required capitalization), and that further legislative action was not needed.[4]
In addition to its inconsistency with the matching concept, the conclusion in Rev. Rul. 2004-18 and Rev. Rul. 2005-42 that environmental remediation costs are subject to IRC 263A is inconsistent with many provisions of the Code that are intended to encourage environmental cleanup, including sections 172(f), 198 and 468B. For example, section 172(f) allows a 10-year carryback of net operating losses attributable to amounts allowable as a deduction in satisfaction of a liability under Federal or State law requiring the remediation of environmental contamination. To be eligible for the 10-year carryback, the expenditure must be a currently deductible expense. If environmental remediation costs are capitalized under section 263A, such costs will no longer be currently deductible. Instead, the costs will be recovered through costs of goods sold for inventory or through depreciation for self-constructed assets. The conclusions in Rev. Ruls. 2004-18 and 2005-42 effectively preclude taxpayers from applying section 172(f) to environmental remediation costs. As a result, the rulings have the effect of writing this aspect of section 172(f) out of the Code.
Section 198 allows a current deduction for qualified environmental remediation expenditures, which generally are expenditures that otherwise would be chargeable to a capital account that are paid in connection with the abatement or control of hazardous substances at a qualified contamination site. Rev. Rul. 2005-42 avoided any literal inconsistency with section 198 by stipulating as a factual matter that none of the expenditures at issue in the ruling qualify under section 198. As a result, it is unclear whether the analysis and conclusion in Rev. Rul. 2005-42 would apply to require capitalization of qualified environmental remediation expenditures under section 263A to the extent the expenditures relate to the taxpayer’s production activities, thereby circumventing Congressional intent to allow an immediate deduction for such expenditures under section 198.
Section 468B provides a deduction for payments to qualified settlement funds (QSF). Under section 468B, economic performance is satisfied in the taxable year in which a taxpayer makes a transfer to a QSF in satisfaction of a liability. Taxpayers frequently establish QSFs to satisfy environmental liabilities. Taxpayers have previously been allowed current deductions under section 162 for transfers to QSFs established to satisfy environmental liabilities based on the IRS and Treasury Department’s conclusion in Rev. Rul. 94-38 that remediation costs were currently deductible. The conclusions in Rev. Rul. 2004-18 and Rev. Rul. 2005-42 now call the current deduction permitted by section 468B into question.
In summary, we believe that the decision to require capitalization of environmental remediation costs by subjecting them to section 263A represents unwise tax policy. Therefore, we recommend that the Treasury Department use its regulatory authority under section 263A to specifically exclude all environmental remediation costs from the scope of section 263A similar to the regulatory exclusion provided for product liability and warranty costs, and then withdraw Rev. Rul. 2004-18 and Rev. Rul. 2005-42.[5] Alternatively, to the extent the government feels it is bound by section 263A to require capitalization of these costs, the AICPA recommends that legislation be passed to exclude environmental remediation costs from section 263A to ensure the proper tax policy result as discussed above is achieved.
B.Environmental remediation expenditures should not be viewed as repairs.
The centerpiece of the rationale in Rev. Rul. 2004-18 and Rev. Rul. 2005-42 that environmental remediation expenditures should be treated as section 263A costs is that they are analogous to repairs. However, this analogy is flawed. The reason that repair costs are treated as section 263A costs is that the repairs are necessary to keep production machinery functioning so that additional inventory may be produced in the current period in which the repairs take place. This reasoning is not applicable to most environmental remediation costs. Most environmental remediation costs are designed to correct pollution that occurred in the past as a result of production in the past of goods that are sold by the time that the remediation occurs. This type of environmental remediation is just like the expense a taxpayer incurs in repairing a defective product that the taxpayer previously produced and sold. Under the existing UNICAP regulations, such warranty expenses are not treated as section 263A costs.[6]
Thus, the major flaw in Rev. Rul. 2004-18 and Rev. Rul. 2005-42 in our view is that the rulings fail to differentiate between two major types of environmental remediation – remediation designed to correct for prior pollution and having no impact on current and future production and remediation incurred to enable a manufacturing plant to continue producing in the future. We argue that the former type of remediation should be treated as a non-production cost excludible from section 263A, but agree that the latter type of remediation is analogous to repairs and, absent a specific exclusion for such costs, should be treated consistently with repairs for purposes of section 263A. However, we do not believe that most environmental remediation falls into this category. Moreover, we do not see such a distinction being drawn in the examples in Rev. Rul. 2005-42. On the contrary, Situations 1, 2 and 3 of Rev. Rul. 2005-42 do not provide that capitalization is required only to the extent that the remediation is necessary to continue operating the manufacturing plant at the contaminated site. Similarly, Situations 4 and 5 in Rev. Rul. 2005-42 specifically require capitalization of costs incurred to cleanup environmental contamination at a closed plant and a third party landfill, respectively, even though neither remediation could possibly benefit current production.
C.Treating environmental remediation as a production cost of the period in which they are incurred is improper.
Even if the government determines that all (or certain types of) environmental remediation costs are properly treated as analogous to repairs, we do not believe that treatment means that all such remediation costs should be allocated to inventory produced in the period in which they are incurred. A fundamental underpinning of section 263A is activity-based costing, under which indirect costs are traced to the activity to which they relate in order to determine the pool of inventoriable costs that are then allocated between ending inventory and cost of goods sold.[7] Environmental remediation costs are not like general overhead costs that cannot be traced to particular activities. On the contrary, environmental remediation costs are capable of being traced to production at the plant to which the remediation relates. Thus, for example, costs incurred to remediate one plant do not benefit inventory that is produced at another plant (contrary to the conclusion reached in Situation 4 of Rev. Rul. 2005-42). Moreover, remediation costs incurred at a plant where nothing further will be produced because the plant is closed (a not uncommon situation) should not be allocated to inventory produced at a different plant which is not being remediated (contrary to the conclusion reached in Situation 4 of Rev. Rul. 2005-42). Finally, costs incurred to remediate a third party landfill no longer used by a taxpayer do not benefit inventory produced at the taxpayer’s manufacturing plant (contrary to the conclusion reached in Situation 5). Recognizing that tracing costs in the foregoing cases may only be permissible for taxpayers using a facts-and-circumstances type of allocation method under section 263A, we believe that the remediation costs in the foregoing circumstances should simply be classified as non-production costs.
You will note that nowhere in this analysis are we advocating that environmental remediation costs be treated as “retrospective production costs” similar to the floor stock costs at issue in Rev. Rul. 2001-8, 2001-3 C.B. 726. After much consideration of this alternative, we believe that environmental remediation costs are different from retrospective production costs. We believe that the category of costs classified as retrospective production costs should be reserved for costs that are economically incurred during the production process, but are not treated as incurred for tax purposes under the “all-events” testand/or the economic performance requirement until a later taxable year, such as post-employment benefits. In addition, corrections in the current year of production costs incurred in a prior year and retrospective adjustments of the cost of prior production, such as the case in Rev. Rul. 2001-8, warrant such treatment. In contrast, most environmental remediation costs incurred at a particular plant generally were not known at the time of production and thus cannot be traced to, or be related to, specific goods produced at that plant in prior periods. Accordingly, we do not believe that environmental remediation costs should be treated as retrospective production costs. Rather, as explained above, we believe environmental remediation costs simply should be treated as non-production costs.
II.Procedural Issue
Rev. Rul. 2005-42, issued on June 20, 2005, effectively required taxpayers to implement a method change pursuant to the automatic consent procedures in Rev. Proc. 2002-9 for their first taxable year ending after February 6, 2004, if they wished to use a cut-off transition method. Many taxpayers had already filed a tax return for such year before Rev. Rul. 2005-42 was issued. Moreover, many other taxpayers had planned to file or did file their 2004 tax return shortly after Rev. Rul. 2005-42 was issued. These taxpayers had inadequate time to make the computations necessary to effectuate the required change for their 2004 taxable year. Alternatively, a taxpayer could implement the change on a cutoff basis using a two-step approach, under which Rev. Rul. 2004-18 is implemented for 2004 and Rev. Rul. 2005-42 is implemented for 2005, but generally only if action was taken within 30 days (i.e., by July 20, 2005), a time which had expired long before many taxpayers (especially smaller, less-sophisticated taxpayers) knew that Rev. Rul. 2005-42 was issued. Rev. Rul. 2005-42 simply provided inadequate notice to make a cutoff change in a timely fashion. Accordingly, we strongly request that taxpayers be permitted to implement the change for their 2005 taxable year and still be eligible for the cut-off transition method.