Tax treatment of asbestos abatement costs: November 6, 1996.

The Department of the Treasury and the Internal Revenue Service have been reviewing whether asbestos abatement expenditures may be deducted currently or must be capitalized. The current guidance on this important issue is contradictory, with revenue agents aggressively citing the IRS's private ruling position - as reflected in Technical Advice Memorandum 9411002 (Nov. 19, 1993) (hereinafter the TAM) - to require capitalization of such costs, while taxpayers generally deduct such costs, citing section 162 of the Internal Revenue Code on the treatment of ordinary and necessary business expenses. As important, the only published guidance on the treatment of environmental clean-up costs, Rev. Rul. 94-38,(1) permits an ordinary and necessary deduction for the costs of removing environmentally hazardous PCBs in soil and groundwater clean-ups. TEI is pleased to submit these comments in respect of this important issue.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works - one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proper treatment of asbestos remediation expenditures.

Treatment of Asbestos

Abatement Costs in TAM 

9411002

In Technical Advice Memorandum 9411002, the taxpayer acquired a warehouse and boiler house for use in the taxpayer's business of providing warehouse space and related services. The principal function of the boiler house was to provide heat for the warehouse. Both the warehouse and the boiler house contained asbestos as an insulating material. As a condition to securing a bank loan to expand its facility, the taxpayer in the TAM was required to (i) remove the asbestos from the boiler house and (ii) encapsulate the asbestos contained in pipe insulation in the warehouse. As part of the expansion of the business facility and removal of the asbestos material, the taxpayer converted space in the boiler house to a garage and office. The conversion was funded in part by the bank loan.

The TAM permits the taxpayer to deduct the asbestos encapsulation costs but requires capitalization of the costs incurred in removing asbestos from the boiler house. This latter decision was reached, the TAM provides, because "these expenditure add to the value of the taxpayer's property and adapt such property to a new and different use." In so concluding, the TAM distinguished Plainfield-Union Water Co. v. Commissioner,(2) in which the Tax Court permitted the taxpayer to deduct the cost of removing a tar lining from water pipes in order to install a concrete lining thereby permitting the pipe to continue its principal function of carrying water. Plainfield-Union holds that, for purposes of determining whether an expenditure increases the value of property and therefore must be capitalized, the proper comparison is between the value of the property after the expenditure and the value of that property immediately before the condition requiring the expenditure. Under the facts in Plainfield-Union, the Tax Court concluded that the expenditures did not increase the value of the property.

The TAM concludes that, unlike the costs at issue in Plainfield-Union, the costs incurred by the taxpayer in removing the asbestos "increased the value, use and capacity of the taxpayer's property as compared to the status of its property in its original asbestos-containing condition." In particular, the taxpayer's expenditures (i) permanently eliminated a health risk, resulting in better operating conditions and preventing further contamination, (ii) made the property "significantly more attractive to potential buyers, investors, lenders and customers," and (iii) "enhanced the usefulness and capacity of the taxpayer's property by enabling the taxpayer to provide office space and a garage in the space made available by the elimination of the asbestos hazard." The TAM further observes:

Thus, unlike the costs incurred in Plainfield-Union, the costs incurred to remove asbestos from the taxpayer's boiler house did not return the property to the state that it was in before the condition necessitating the expenditure arose. Under these facts, the condition necessitating the expenditure was the original condition of the property when the taxpayer acquired it. Thus, the asbestos removal costs increased the value, use and capacity of the taxpayer's facility as compared to its original asbestos-containing condition.

By contrast, the TAM concludes that the taxpayer's encapsulation expenses did not appreciably increase the value of the warehouse, did not substantially increase its useful life, and did not adapt the property to a new or different use. The environmental hazard of asbestos was reduced rather than eliminated. Consequently, the encapsulation expenditures "did not enable the taxpayer to operate on a changed, more efficient, or larger scale." The TAM also emphasizes that, unlike asbestos removal costs, encapsulation had only a temporary effect. Finally, the TAM concludes that the repair properly was considered "incidental" within the meaning of Treas. Reg. [section] 1.162-4 because only damaged or punctured portions of the pipe insulation were encapsulated and those portions represented less than 25 percent of the pipes in the warehouse.

Treatment of Environmental

Clean-up Costs in Rev. Rul.

94-38

In Rev. Rul. 94-38, the taxpayer purchased uncontaminated land on which it built a manufacturing plant that discharged hazardous waste, which the taxpayer subsequently buried on portions of the land. In order to comply with new environmental protection requirements, the taxpayer (i) removed contaminated soil, (ii) replaced it with uncontaminated soil, and (iii) constructed groundwater treatment facilities to extract, treat, and monitor contaminated groundwater.(3) Ongoing monitoring activities also were undertaken to ensure that the remediation efforts were successful. The soil remediation efforts were intended to restore the land to its uncontaminated condition. The ruling concludes that the costs of soil remediation and ongoing groundwater treatment (other than construction of the treatment facilities) are usually deductible:

Under these facts, X's soil remediation expenditures and ongoing groundwater treatment expenditures (i.e., the groundwater treatment expenditures other than the expenditures to construct the groundwater treatment facilities) do not produce permanent improvements to X's land within the scope of [sections] 263(a)(1) or improvements to X's land within the scope of [sections] 263(a)(1) or otherwise provide significant future benefits. Under the facts of this ruling, the appropriate test for determining whether the expenditures increase the value of property is to compare the status of the asset after the expenditure with the status of that asset before the condition arose that necessitated the expenditure (i.e., before the land was contaminated by X's hazardous waste) .... X's soil remediation and ongoing groundwater treatment expenditures do not result in improvements that increase the value of X's property because X has merely restored its soil and groundwater to their approximate condition before they were contaminated by X's manufacturing operations.

[Citation to Plainfield-Union omitted.]

The IRS also concluded that such expenditures do not prolong the life of the land or adapt it to a new or different use.(4)

Although the taxpayer continued to use the plant for the manufacturing activity that engendered the hazardous waste, the ruling permits the taxpayer to deduct the cost of the soil remediation and on-going monitoring expenses regardless whether the property continued to be used for that activity. The water treatment facilities, on the other hand, have a useful life substantially beyond the taxable year of construction. Consequently, the costs associated with those facilities were found to be capital in nature.

Effect of Rev. Rul. 94-38 on

the Analysis in TAM 9411002

A. Overview

TEI submits that there is no meaningful distinction between (i) expenditures incurred to remove contaminated soil and replace it with uncontaminated soil and (ii) expenditures incurred to remove asbestos from property and replace it with nonhazardous materials. In either case, the general rule should be that such expenditures are deductible. Concededly, an exception to the general rule of deductibility should (and does) apply where the expenditures adapt property to a new or different use - but the limits of the exception to the deductibility of repair expenses should also be recognized. In this respect, the facts of TAM 9411002 are clearly distinguishable from both Rev. Rul. 94-38 and typical asbestos remediation situations. In the TAM, the asbestos removal expenditures were incurred as a part of an overall reconstruction pursuant to which the boiler house was converted to an entirely new use as a garage and office. Consequently, capitalization arguably is appropriate under the specific facts of the TAM on the grounds that the expenditures were incurred "to adapt property to a new or different use."(5) This, however, is not generally the case for taxpayers removing asbestos from existing buildings. In most cases, the expenditure is incurred in order to permit the taxpayer to use its property in the same manner as before the expenditure.

B. Plainfield-Union

TAM 9411002 attempts to distinguish Plainfield-Union on three separate grounds. As discussed below, two of the purported distinctions cannot be harmonized with the holding in Rev. Rul. 94-38. The third, while meritorious in concept, should not generally apply since the facts of the TAM materially differ from those in Rev. Rul. 94-38 and more typical asbestos remediation efforts.

1. Permanent" Repairs

The TAM declares that asbestos removal expenditures provide a permanent solution to the problem. While the concrete lining installed by the taxpayer in Plainfield-Union did not provide a "permanent" resolution of the tuberculation problem caused by acidic river water, the expenditures provided a long-term solution.(6) Moreover, a fair reading of the Plainfield-Union decision shows that "permanency" did not play an important role in Tax Court's analysis.(7) In particular, the court cited several cases in which repairs were held to be deductible even though the expenditures constituted a permanent solution to the particular problem.(8) More important, the removal and replacement of asbestos in the TAM were no less permanent than the soil removal and replacement activities in Rev. Rul. 94-38, which cites Plainfield-Union to support the deduction of such costs. In both the TAM and Rev. Rul. 94-38, the contaminant was completely removed from the property.(9)

The TAM avers that "section 263 disallows a deduction for costs incurred for permanent improvements or betterments." This statement, however, omits critical qualifying language in section 263(a)(1), which denies a deduction "for permanent improvements or betterment made to increase the value of any property or estate." In our view, Rev. Rul. 94-38 applies the rule of section 263(a)(1) correctly, holding that soil removal expenditures are not permanent improvements" within the meaning of section 263 because they do not increase the value of property as compared to the value before the contamination that causes a loss of value. Put simply, the permanency of a repair alone is not sufficient to require capitalization under section 263. An expenditure must also increase the value of the property as compared to the value before the defect arose necessitating the repair.(10)

Determining when a repair increases the value of the property is the crux of both Rev. Rul. 94-38 and Plainfield-Union. Obviously, any proper repair increases the value of property as compared to its status when such property has a known (and unrepaired) defect. Hence, if the increase-in-value test is applied by comparing the property's value while burdened with a known defect, no repair would ever be deductible. Consequently, the court in Plainfield-Union rejected that view and held that the proper comparison is to the value of the property "prior to the condition necessitating the expenditure," i.e., prior to the time that the defect had a deleterious effect on the property's value.(11)

According to the TAM, the "condition necessitating the expenditure" (within the meaning of Plainfield-Union analysis) was the original condition of the property when the taxpayer acquired it." Based on this conclusion, the removal of the asbestos from the boiler house increased its value. The TAM's conclusion, however, is wrong. The value of property constructed with asbestos should be compared to the value of property without asbestos before the potential health hazards of asbestos were known.(12) The value of the property at that earlier point in time could not have been reduced as a result of the asbestos problem. Consequently, asbestos removal and replacement could not increase the value of the property as compared to its value at that prior point in time.(13) Stated differently, the value of a building subsequent to the abatement of asbestos is not different from the value of a building before asbestos was found to be hazardous.

2. Repairs that Make

Property More "Attractive"

The TAM concludes that, unlike the repairs in Plainfield-Union, the asbestos removal and replacement expenditures made the property more attractive to potential buyers and others. We see no basis for distinguishing the TAM from either Plainfield-Union or Rev. Rul. 94-38 in this respect. In all three cases, the disputed expenditures made the property more attractive to all concerned. Indeed, any properly executed repair makes the property more "attractive" than it was before the repair.

3. Repairs that Adapt

Property to a New Use

The TAM distinguishes Plainfield-Union on the grounds that the expenditures at issue "enhanced the usefulness and capacity of the... property by enabling the taxpayer to provide office space and a garage in the space made available by the elimination of the asbestos hazard." This fact usefully distinguishes the TAM from both Plainfield-Union and Rev. Rul. 94-38. To the extent expenditures are incurred to convert property to a new or different use, we agree that they must be capitalized. The critical issue, however, is that the TAM is atypical in this respect. In most asbestos remediation cases, taxpayers will continue to use property for the same purposes as before the remediation expenditures. The only difference in the remediated property is the substitution of generally inferior, but safer, insulation.

"Incidental Repairs"

The deductibility of the encapsulation expenses in the TAM turned on the conclusion that the repairs were "incidental in relation to the taxpayer's overall operations." The ruling notes that only damaged or punctured portions of the pipe insulation were treated, and that a "large portion of the asbestos-containing pipe insulation was not affected by the work performed."(14) Although Plainfield- Union involved repairs on only a small percentage of the taxpayer's pipes, the Tax Court did not even suggest that this was an important consideration. Indeed, one of the cases cited with approval in Plainfield-Union, Buckland v. United States,(15) involved deductible expenditures amounting to 35 percent of the cost of the repaired building.(16) Finally, Rev. Rul. 94-38 accorded no independent significance to the concept of "incidental" repairs. While the soil removal and replacement activities in that ruling appeared to be quite extensive, there is no indication of their significance relative to "the taxpayer's overall operations," nor was there any indication that such factual inquiry was important to the legal analysis.

Interplay Between Asbestos

Hazards and the Factual

Status of Property

Some commentators contend that asbestos remediation activities cannot constitute a "repair" since the property is fully functional prior to remediation of the asbestos. In that view, removing a potential health hazard has no connection with improving the functions of the building.

We disagree and find it curious that the status of a building or machinery as fully functional can be determined without regard to whether such property presents a potentially life threatening hazard to the persons who occupy it. Assuming that an expenditure does not materially add to the value of the property, appreciably prolong its life, or adapt it to a new or different use, an expenditure that causes property to be safe to people is no less deserving of the status of a deductible repair (indeed, such an expenditure is probably more deserving) than an expenditure that ensures the efficient mechanical operation of the property.

Rev. Rul. 94-38 certainly does not rely on such a theory. The ruling contains no indication that removing the soil and groundwater contamination affected in any manner the efficient operation of the manufacturing facility. Hence, we reject the notion that asbestos abatement cannot per se constitute a repair.

Conclusion

In promulgating additional guidance on asbestos abatement expenditures, the IRS should look to Plainfield-Union and Rev. Rul. 94-38 to provide the necessary touchstones. Just as Rev. Rul. 94- 38 does not address all factual permutations of PCB-cleanup expenditures, so it is unnecessary in the context of guidance on asbestos abatement to address all conceivable fact patterns. Any concerns that such guidance might permit deductions for expenditures that should be capitalized under existing legal doctrines (e.g., expenditures adapting property to a new or different use, or expenditures incurred as part of an overall plan of rehabilitation that results in the creation of a new asset) can be addressed by stating that such limitations will continue to apply and will preclude current deductions for asbestos abatement expenditures in certain cases.

TEI appreciates this opportunity to comment on the deductibility of asbestos abatement expenditures. These comments were prepared under the aegis of the Institute's Federal Tax Committee whose chair is David L. Klausman of Westinghouse Electric Corporation. If you should have any questions concerning the Institute's comments they should be directed to Mr. Klausman at [phone] or to Jeffery P. Rasmussen of the Institute's professional staff at [phone]. (1) 1994-1 C.B. 35.

(2) 37 T.C. 333 (1962), nonacq. 1964-2 C.B. 8.

(3) The soil removal and replacement project was initiated in 1993 and was expected to be completed in 1995. Construction of the groundwater treatment facility began in 1993 and was to be operational until 2005.

(4) Rev. Rul. 94-38 further states that "since the land is not subject to an allowance for depreciation, amortization, or depletion, the amounts expended to restore the land to its original condition are not subject to capitalization under section 263(a)(2)." Treas. Reg. [sections] 1.263(a)-i(b) confirms that section 263(a)(2) does not apply to expenditures for repairs and maintenance that are deductible under section 162 and Treas. Reg. [sections] 1.162-4. (5) Treas. Reg. [sections] 1.263(a)-1(a).

(6) In its findings, the Tax Court stated that while the cement lining "will wash out eventually ... "[c]leaning and cement lining usually eliminate the problems of tuberculation and the necessity of periodic cleaning for as long as the cement lining lasts." 39 T.C. at 336.

(7) The TAM also cites American Bemberg Corp. v. Commissioner, 10 T.C. 361, 377 (1948), nonacq. 1948-2 C.B. 5, aff'd, 177 F.2d 200 (6th Cir. 1949). While the Tax Court in that pre-Plainfield-Union decision emphasized that the expenditure there did not cure the geological defect requiring the expenditure, the Bemberg decision turned principally on the analysis of the Board of Tax Appeals in Illinois Merchants Trust Co., Executor, 4 B.T.A. 103 (1926), acq. 1926- 2 C.B. 2. In Illinois Merchants, the Board distinguished between the expenditures that "restore to a sound state or ... mend," which are deductible, and expenditures "for replacements, alterations, improvements, or additions which prolong the life of the property, increases its value, or make it adaptable to a different use," which must be capitalized. Id. at 106. Unlike the expenditures in Illinois Merchant, American Bemberg, and the portion of Rev. Rul. 94-38 addressing permanent groundwater treatment facilities, typical asbestos remediation expenditures do not add value, prolong life, or adapt property to a different use.

(8) For example, the Plainfield-Union court cited Regenstein v. Edwards, 121 F. Supp. 952 (M.D. Ga. 1954), where steel columns and steel crossbeams were installed in order to permanently cure the defect." 37 T.C. at 339 (emphasis added). (In Regenstein, expenditures incurred to shore up a sagging floor were held to be deductible.) The court in Plainfield-Union also cited Midland Empire Packing Company v. Commissioner, 14 T.C. 635 (1950), acq. 1950-2 C.B. 3, where a concrete lining added to a basement in order to seal out oil was held to be deductible even though the lining was arguably a permanent solution to the problem. Moreover, the Plainfield-Union decision cites Illinois Merchants Trust Co., where expenditures incurred to cut off pilings below the water level and replace the removed portions with concrete supports were determined to be deductible notwithstanding that the expenditures also constitute a permanent solution to the dry rot problem. 37 T.C. at 339.

(9) While continued manufacturing activities conceivably could have caused the replacement soil in Rev. Rul. 94-38 to become contaminated, the ruling clearly does not consider this a bar to a deduction. Significantly, the ruling states that its holding will apply even if the taxpayer ceases operations on the property. In that case, the new soil represents a permanent solution.

(10) See also Treas. Reg. [sections] 1.162-4, which states that repairs in the nature of a replacement must be capitalized "to the extent that they arrest deterioration and appreciably prolong the life of property." (Emphasis added.) The phrase "arrest deterioration' suggests a permanent fix. Hence, a permanent replacement having the effect of "arresting deterioration" nonetheless is deductible so long as it does not also appreciably prolong the life of the property. (11) 39 T.C. at 338. (12) Moreover, the reasoning in Plainfield-Union - indeed, the case law generally addressing deductions for repairs and maintenance - does not limit the deductibility of repairs solely to elimination of conditions or defects arising from physical deterioration or physical changes in the status of the asset. The proper comparison is between the "status of the asset prior to the condition necessitating the expenditure" and the status of the property after the repair. A change in the status of the property does not require a physical deterioration. In the case of assets containing asbestos, the status of the assets is not changed by the presence or absence of the asbestos. Rather, it is the discovery of asbestos as a hazardous substance and the discovery of its presence in a taxpayer's asset that impel the abatement expenditure that restores the asset's value to its pre-contamination status. (13) The TAM avers that "the condition necessitating the expenditure was the original condition of the property when the taxpayer acquired it." The TAM concludes from this that the "removal costs increased the value, use and capacity of the taxpayer's facility as compared to its original asbestos-containing condition." The TAM's logic is defective because if one cannot measure the original value of the property without the asbestos, one also cannot conclude that a repair to the property materially increased the property's value. (14) In support of its position on "incidental" repairs, the TAM cites Mountain Fuel Supply Co. v. United States, 449 F.2d 816, 822 (10th Cir. 1971), cert. denied, 405 U.S. 989 (1972), and Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1, 17 (1979). These cases, however, do not support the TAM's proposition that the term "incidental" represents an independent legal requirement. In Mountain Fuel, the critical factor was that the expenditure enabled "the pipeline to begin a new period of expected life," a factor that places the expenditures clearly in the capital improvement category." 449 F.2d at 821. Similarly, the expenditures in Wolfsen were so substantial that they constituted a "replacement" of the previously existing asset. 72 T.C. at 18. (15) 66 F. Supp. 681 (D. Conn. 1946). (16) See also Hensler v. Commissioner, 73 T.C. 168 (1979), acq. in result in part, like 1980-2 C.B. 1 (repair costs amounting to B percent of the cost of the equipment held deductible), and American Bemberg, supra frepair costs amounting to 15 percent of the cost of recently acquired property held