Deductibility of environmental remediation costs.

In Letter Ruling(TAM) 9952075, the IRS held that the costs of remediating post-acquisition contamination are currently deductible under Rev. Rul. 94-38. However, environmental remediation costs are capitalizable under Secs. 263 and 263A to the extent they are for pre-acquisition contamination. At issue was the treatment of the costs to remediate land containing both pre- and post-acquisition contamination in preparing for new construction, which led the examining agent to conclude the costs were capital and, therefore, distinguishable from Rev. Rul. 94-38.

Background

Rev. Rul. 94-38 involved a manufacturer that owned and operated a manufacturing plant built on land on which the taxpayer buried hazardous waste discharged from its manufacturing operations. The land was not contaminated by hazardous waste when the taxpayer purchased it. To comply with Federal, state and local environmental requirements, the taxpayer decided to remediate the contaminated soil and groundwater, and establish a continuous monitoring system. The taxpayer also constructed groundwater treatment facilities that would remain in operation for approximately 10 years. During this time, the taxpayer would continue to monitor the groundwater to ensure compliance with applicable environmental laws. During and after the remediation and treatment, the taxpayer continued to use the land and operate the plant in the same manner as it did prior to remediation, except that new hazardous waste discharges were disposed of in accordance with applicable environmental laws.

Rev. Rul. 94-38 held that the soil remediation and groundwater treatment costs could be deducted currently; however, the costs of constructing the groundwater treatment facilities had to be capitalized and depreciated. The Service concluded that neither the soil remediation nor the ongoing groundwater treatment costs (other than those to construct the facility) produced a permanent improvement to the taxpayer's land or otherwise provided a significant future benefit. The IRS further concluded that the appropriate test for determining whether expenditures increase the value of property was to compare the status of the asset after the expenditures with the status before the condition arose that necessitated the expenditures (i.e., before the land was contaminated), citing Plainfield-Union Water Co., 39 TC 333 (1962), nonacq. on other grounds, 1964-2 CB 8. Under the facts in Rev. Rul. 94-38, the soil remediation and ongoing groundwater treatment expenditures did not result in improvements that increased the value of the taxpayer's property; the taxpayer merely restored its soil and groundwater to their approximate condition before they were contaminated by its manufacturing operations.

TAM 9952075

The taxpayer purchased property containing manufactured gas plants, which had been in operation for several years. The manufactured gas plants yielded large quantities of by-products, which were often disposed of on-site in unlined pits. The taxpayer continued to operate the plants, but then switched to supplying natural gas. In preparing the site to construct a new operations facility, the taxpayer incurred environmental remediation costs on the site for both pre- and post-acquisition contamination.

Discussion

The examining agent determined that the environmental remediation costs were distinguishable from those in Rev. Rul. 94-38 and, as such, were capital expenditures. He proposed multiple rationales to support a finding requiring the capitalization of the environmental remediation costs:

1. The expenditures had to be capitalized under Secs. 263 and 263A, because they were incurred to adapt the property to a new or different use under Regs. Sec. 1.263(a)-1(b).

2. The expenditures had to be characterized as part of the costs of constructing the taxpayer's new operations facility and, therefore, had to be capitalized under Regs. Sec. 1.263(a)-2(a), as costs incurred for the construction of an asset with a useful life extending substantially beyond the tax year.

3. The expenditures had to be characterized as part of a general plan of rehabilitation under Norwest, 108 TC 265 (1997), in which the taxpayer incurred costs to remove and replace asbestos insulation in the process of completely renovating and remodeling its building.

Post-Acquisition Environmental Remediation Costs

The Service noted that, "[w]hile Rev. Rul. 94-38 does anticipate that the taxpayer will continue to use the property in the same manner that it did prior to the cleanup, [it] do[es] not believe that [a taxpayer's] intent to build a new building on the site would change the tax treatment of cleanup costs to which Rev. Rul. 94-38 would otherwise apply." The IRS further reiterated that, because the post-acquisition remediation costs merely are restorative in nature, they do not adapt the property to a new or different use. Therefore, the remediation costs alone do not adapt the site to a new or different use; rather, they merely restore the site to the condition that existed at the time the taxpayer acquired the property. For the same reasons, the Service also found that the post-acquisition remediation costs need not be capitalized as land preparation costs as part of the construction of the operations facility.

Additionally, the IRS concluded that this situation is distinguishable from Norwest, as well as from other cases in which the "plan of rehabilitation" doctrine has been applied, because the environmental remediation costs were not directly related to the construction of the operations facility. Unlike the asbestos removal costs in Norwest (which were directly related to the renovation of the building), the costs in Rev. Rul. 94-38 are for restoration of an asset separate and apart from the new operations facility--the land. Because the environmental remediation costs are for land restoration, the Service held that such costs should not be considered part of a plan of rehabilitation or improvements to its building. This distinction, that the costs be "directly related to the renovation of the building" is very important, because it could be interpreted as a narrowing of the IRS's position on capitalization of costs related to self-constructed property. However, it is certain that the Service recognized the sensitive policy implications of the treatment of environmental remediation costs and, accordingly, was more inclined to permit the current deduction of such costs.

Finally, the IRS concluded that the taxpayer's remediation costs pertaining to the post-acquisition contamination are not allocable to the production of real or tangible personal property under Sec. 263A, because such costs relate to the restoration of the land and not to the construction of the operations facility.

Pre-Acquisition Environmental Remediation Costs

Not surprisingly, the Service concluded that, to the extent the remediation costs pertain to environmental contamination present when the taxpayer acquired the site, that portion of the overall cost may not be deducted under Sec. 162. Rev. Rul. 94-38 clearly required that, to qualify for a current deduction, the taxpayer must be both the property's owner and the party that contaminated the property with hazardous waste from its business. Accordingly, as the remediation of pre-existing contamination does more than restore the site to the condition that existed at the time of the taxpayer's purchase, such costs constitute an improvement or betterment and are capital in nature.

Observation: The fact that a taxpayer had to request technical advice from the IRS National Office on the issue of environmental remediation costs indicates that Service examining agents still have not accepted the National Office's position on the breadth of INDOPCO. Further, while recent rulings in this area provide welcome relief (e.g., Rev. Rul. 2000-4), this TAM clearly demonstrates the need for additional guidance from the Service in this area--both for practitioners and for IRS examining agents.

(Author's note: The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP.)

FROM PAUL K. GIBBS, CPA, WASHINGTON, DC