New tech advice on asbestos removal: a wolf in sheep's clothing.
In Technical Advice Memorandum 9411002 (November 9, 1993), the Internal Revenue Service ruled that costs of asbestos removal must be capitalized, but that costs of asbestos encapsulation may be deducted currently. Superficially, there is much about this technical advice memorandum (TAM) that appears favorable, but scrutiny yields a less satisfying reaction. Although the result will probably not provoke cries of outrage, the IRS's analysis and reasoning will, in the long run, be troublesome in different factual situations. Moreover, to the extent the TAM reflects an IRS policy to allow current deductibility only when the source of contamination continues to pose a health hazard, such a policy is, at best, highly questionable. The ruling, which focuses on the specific factual circumstances, is discussed in this article.
II. Description of the TAM
The TAM addresses the tax treatment of costs incurred to abate asbestos contamination. The TAM addresses two factual circumstances involving a warehouse and an adjoining boiler house. The property, which was purchased in year 1, contained asbestos insulation at the time of purchase. The use of the boiler house to heat the warehouse was abandoned in year 2. In a subsequent, unspecified year, the taxpayer was required by its lender to abate the asbestos in both facilities "in order to secure a bank loan for expansion of its facilities." The asbestos was removed from the boiler house, and the boiler house was converted to two-truck garage and office space. The office space was rented to a related party. Portions of the asbestos insulation in the warehouse were encapsulated. The use of the warehouse in the taxpayer's business was unchanged. The TAM holds that the removal costs must be capitalized but the encapsulation costs may be deducted currently.
B. Asbestos Removal
The TAM concludes that expenditures for removing asbestos from the boiler house must be capitalized for two reasons. First, the removal "increased the value, use and capacity of the taxpayer's property." Second, the expenditures "adapt[ed] such property to a new and different use."
In support of its conclusion that the removal increased the value, use, and capacity of the property, the TAM recites the following factors as determinative:
* "The expenditures permanently eliminated the
health risks posed by the presence of asbestos....
Therefore, the expenditures created better operating
conditions and prevented any further contamination
of employees or lessees."
* "The expenditures made the property significantly
more attractive to potential buyers, investors, lenders,
* "The expenditures 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
In support of its determination that the property, after the asbestos removal, was adapted for a new or different use, the IRS reasoned that the expenditures "allowed the taxpayer to establish a new and expanded use for a space that was previously unusable because of the presence of asbestos-containing materials .... By removing the asbestos, the taxpayer permanently eliminated the defect in its boiler house."
C. Asbestos Encapsulation
The determination that the encapsulation costs may be currently deducted under section 162 is supported primarily by a number of negative factual determinations:
* The costs "neither appreciably increased the value
of the ... property nor substantially prolonged its
* The "encapsulation expenditures did not increase
the value or prolong the useful life of the ... property
beyond what it was before the asbestos became
* The "effects of the encapsulation are temporary...
The taxpayer's encapsulation expenditures did not
eliminate the asbestos from the area.... Thus, to
the extent that the ... asbestos ... posed a threat to
the efficient operation of the ... warehouse ... this
problem continues to exist."
Addressing the "incidental repairs" language of Treas. Reg. [sections] 1.162-4 and treating it as a separate, independent requirement of deductibility, the TAM concludes that the expenditures were "incidental repairs." This conclusion seems founded on the rather modest scope of the encapsulation effort--less than 25 percent of the total pipes in the warehouse. "The taxpayer in this case only performed encapsulation activities on damaged or punctured areas .... [A] large portion of the asbestos-containing pipe insulation was not affected by the work performed."
There are four aspects of TAM 9411002 that are troubling.
First, the TAM makes clear that the IRS views the "incidental repairs" language of Treas. Reg. [sections] 1. 162-4 as an independent, stand-alone requirement for current deductibility. Because the IRS definition of "incidental repairs" is completely subjective, the standard is not likely to facilitate the analysis of the deductibility of environmental remediation expenditures nor is it likely to assist in the resolution of cases by Exam or Appeals.
Second, in discussing the proper tax characterization of the expenditures, there is insufficient analysis of the taxpayer's having bought contaminated property. The precise circumstances of any such purchase are often pivotal to proper analysis. The TAM ignores these facts entirely. Its failure to do so materially impairs the analytical value of the TAM.
Third, in focusing intensely on the remediation efforts, the TAM is almost cavalier in its treatment of the taxpayer's converting an idle boiler room to rentable office space and a garage that were then used in the taxpayer's business. Absent highly unusual circumstances, in the complete absence of any environmental remediation expenditures, such a conversion would require capitalization. Centering the analysis on the environmental remediation expenditures and concluding that all costs must be capitalized conjures up the image of a sorcerer who utters an unintelligible incantation and then claims credit for a subsequent solar eclipse.
Finally, in discussing adaptation for a new use, the TAM seemingly concludes that remediation expenditures are not currently deductible unless a hazardous condition continues to exist after the expenditures have been made. Concededly, sound tax policy should not be debased by irrelevant, non-tax policy concerns. But even from this perspective!, if IRS policy requires the continued presence of hazardous conditions as a prerequisite to deductibility, such a policy is, at best, questionable. The deductibility of repairing a sidewalk is not dependent upon the retention of a hazard to pedestrians. The same should be true for environmental remediation.
B. The "Incidental Repairs " Standard Is Too Subjective
Treating the "incidental repairs" language of Treas. Reg. [sections] 1.162-4 as an independent, stand-alone requirement is troublesome because, as articulated by this TAM, this requirement is entirely subjective. The TAM expresses the view that there are four requirements for current deductibility. Specifically, the TAM states unequivocally that in order to be deductible currently an expenditure must be (1) an incidental repair and (2) not add material value, (3) not substantially prolong useful life, and (4) not adapt property for a new and different use. The subjective nature of the first requirement is highlighted by this sentence from the TAM:
Whether an expenditure is more in the nature of a
capital expenditure or an incidental repair expense
turns on the taxpayer's particular facts and circumstances. Thus, any expenditure that, in the eyes of a revenue agent, is "more in the nature of a capital expenditure" must be capitalized even if it can be objectively demonstrated that the expenditure does not add value, does not prolong life, and does not adapt property for a new or different use. Such a test can only lead to continuous disputes between the IRS and taxpayers.
C. The TAM Accords Inadequate Consideration To The Prior Purchase
Of Contaminated Property
The failure of the TAM to address the consequences of the taxpayer's purchase of contaminated property is also a cause for concern. Unfortunately, the TAM does not reveal the time period between the taxpayer's purchase and its remediation of the contaminated property. But if the taxpayer knowingly purchased contaminated property and then embarked upon remediation, perhaps all the remediation expenditures, including encapsulation, should have been capitalized. Conversely, if the property was purchased before contamination was discovered, a strong argument can be made that none of the remediation expenditures, as such, should be capitalized because removing the contamination simply restores the property to uncontaminated value and does not add value. The omission of any analysis of the purchase and its attendant consequences renders this TAM analytically impotent in many important aspects.
D. The TAM Fails To Adequately Consider The Conversion Of The Boiler Room To A New
And Different Use
Regardless of the circumstances of the original purchase, the costs of converting an idle boiler room to rentable office space and a garage for use in the business would seem to be capital in nature. Such a result would seem routine: The costs associated with the boiler room conversion would be capitalized, and the costs associated with warehouse asbestos encapsulation could be deducted.
Why, then, did the IRS apparently go out of its way to ignore the obvious and address an unnecessary issue? One answer is that the IRS may be trying to lay the groundwork for other rulings requiring capitalization. By taking a very easy case for capitalization (the conversion of the boiler room) and clothing it with largely irrelevant environmental remediation facts, the IRS has produced a ruling in which the conclusion is probably right--the costs of the conversion should be capitalized. In the future, however, the TAM may be cited as an example of "environmental remediation expenditures" that required capitalization. But the truth of the matter is that most, if not all, of the environmental remediation "facts" affecting the boiler room conversion are irrelevant to the TAM's capitalization conclusion.
E. A Per Se Rule Requiring Capitalization Of All Expenditures That Eliminate Environmental
Hazards Is Highly Questionable
Finally, the TAM seems to reflect a policy that remediation Expenditures are deductible only if a hazardous condition remains. Such a policy--which is implied by the TAM's contrasting statements describing the effects of "removal" with the effects of "encapsulation"--is not only troubling from a tax policy perspective but is highly questionable from every other non-tax policy perspective.
Accordinly to the TAM, the removal expenditures "permanently eliminated the health risks," but the encapsulation expenditures "did not eliminate the threat of exposure." The asbestos removal "permanently eliminated the defect in the boiler house," but after encapsulation "to the extent that the existence of asbestos in the warehouse posed a threat ... this problem continues to exist for the future." Since the removal expenditures must be capitalized and the encapsulation expenditures may be deducted, a reasonable inference is that to qualify for deductibility, a hazardous condition must remain in existence.
There is, of course, no apparent tax policy justification for drawing this line of demarcation. Precedent is plentiful in support of the position that a "repair" can eliminate the condition necessitating the repair. E.g., Southern Ford Tractor Corp. v. Commissioner, 29 T.C. 833 (1958)(grading eliminating inadequate drainage); Munroe Land Co. v. Commissioner, 25 T.C.M. (CCH) 3 (1954)(new insulation eliminating leakage). Similar precedent also exists in closely analogous factual situations in which unsafe or unhealthy conditions necessitate a repair and the repair eliminates the unhealthy or unsafe condition. E.g., Midland Empire Packing Co. v. Commissioner, 14 T.C. 635 (1950)(cement lining eliminating oil seepage causing unhealthy fumes and fire hazard).
If the IRS believes (1) there is an inherent difference between the health hazards posed by environmental contamination and other hazardous conditions and (2) that difference per se requires capitalization when the source of environmental contamination is eliminated from a site, the burden should be on the IRS to justify that position from a tax policy perspective. It is not sufficient to conclude summarily, as does this TAM, that all expenditures that eliminate contamination are "in the nature of" capital expenditures. This only begs the question.
Absent a clear and compelling tax policy justification for the position that all expenditures which eliminate environmental contamination must be capitalized, the conclusion articulated by this TAM is not only unnecessary, it is indefensible. The conclusion is unnecessary because the IRS's analysis is compromised by its disregarding of the circumstances of the acquisition and not considering the conversion of the boiler room to a new and different use. The thinly disguised effort to elevate the post-remediation existence of a safer work environment to the status of a separate asset, the creation of which requires capitalization is also without any clear precedential support. This policy espoused by the TAM is indefensible because, without justification, it will materially increase the after- tax costs of any remediation effort that eliminates a source of environmental contamination.
From every other non-tax policy perspective, the elimination of the health hazards posed by environmental contamination is a national priority. Not only should hazardous sites be remediated, but every possible incentive should be provided to encourage prompt remediation. The projected costs of such remediation are enormous. While tax policy should not be distorted to accommodate such remediation efforts, neither should tax policy be stretched to create barriers to effecting remediation. This TAM regrettably creates such barriers.
TAM 9411002 is the first pronouncement from the IRS on environmental remediation expenditures since the IRS's self-imposed moratorium was lifted in late 1993. That the TAM did not contain a broad endorsement of the current deductibility of such expenditures is not surprising. But the lack of greater factual and analytical definition is disappointing.
Given the acknowledged importance of the issue and the establishing of a Join IRS-treasury Department Working Group to formulate policy in this area, even private letter rulings should be expected to help focus the debate and clarify the issues. Unfortunately, the most recent asbestos removal TAM may serve only to obfuscate.
McGEE GRIGSBY practices tax law wtih Latham & Watkins in Washington, D.C. He is chairman of the firm's D.C. Tax Department. He received his L.L.M. from Harvard Law School. Mr. Grigsby specializes in tax controversy practice.
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|Date:||May 1, 1994|
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