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The proper income tax treatment of environmental remediation expenditures.

On June 15, 1993, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning the proper income tax treatment of environmental remediation expenses. The Institute's submission was prepared under the aegis of TEI's Federal Tax Committee, whose chair is David F. Nitschke of Amerada Hess Corporation. Preparation of the comments was coordinated by David Freedman of CSX Corporation, who headed a special task force of TEI members to prepare the comments.

I. Introduction

Nearly every business enterprise is affected by federal, state, and local laws designed to protect the environment and promote the conservation of natural resources. Businesses have incurred substantial costs in remedying the consequences of historical; manufacturing and disposal practices and ensuring that current practices are consistent with all applicable standards. Concern over the proper federal income tax consequences of environmental mental remediation expenditures has been raised by the recent release by the Internal Revenue Service of technical advice memoranda requiring the capitalization of the costs of asbestos removal and the cleanup of polychlorinated biphenyl (PCB) discharges. The IRS has publicly requested assistance in understanding the remediation costs being incurred by taxpayers and the complex economic, legal, and tax accounting issues that surround those expenses.(1)

In response to that request, Tax Executives Institute has prepared this analysis of the proper treatment of remediation efforts. As the principal association of business tax executives in North America, TEI 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 the government alike. TEI's nearly 4,900 members 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 training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proper treatment of environmental remediation expenses.

II. Summary of Analysis

Although it has been more than two decades since the enactment of federal legislation authorizing the creation of the Environmental Protection Agency (EPA), the proper income tax treatment of remediation expenditures is only now emerging as an issue for the IRS. Businesses, meanwhile, have generally considered remediation expenditures deductible when incurred. Thus, it is proper for the IRS to provide immediate guidance to quell the incipient uncertainty concerning the proper income tax treatment of remediation expenditures engendered by recently issued technical advice memoranda that conclude otherwise.

TEI believes that a thorough analysis of existing tax rules demonstrates that most remediation expenses are currently deductible as repairs. TEI's analysis begins with a summary of the principal federal statutes governing environmental liability and proceeds with an analysis of the theoretical underpinning of the distinction between capital expenditures and deductible repairs: proper matching of income with the related expenses. In distinguishing capital expenditures from periodic expenses, similar criteria are employed for both tax and financial accounting - particularly the concept of matching expenses with the income to which it relates. The overarching purpose of each is the accurate computation of net income. Under both financial and tax accounting principles, the costs of cleaning up environmental contamination on a company's own property should generally be treated as an expense because only rarely will cleanup expenditures result in a future, revenue-generating benefit to a business. Capitalizing remediation expenditures would distort net income because such costs extinguish a liability arising from the past activities of the taxpayer.

Although there is no specific statutory provision governing the federal income tax treatment of environmental clean-up costs, guidance may be found in the treatment of repair and maintenance costs under section 162 of the Code. Under Treas. Reg. [section] 1.162-4, the costs of incidental repairs that neither materially add to the value of property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition are currently deductible. Environmental clean-up costs are both ordinary and necessary under section 162 because they are both common and appropriate and helpful because they satisfy a liability of the business.

Section 263 and Treas. Reg. [section] 1.263(a)-1(b) limit repair deductions by providing that expenditures are capital where they materially increase the value or substantially prolong the useful life of property owned by the taxpayer or are incurred to adapt the property to a new or different use. Performing repairs on property that is in need of repair will always add value or extend the life of the property where measurement of the increase in value is the condition of the property that exists immediately before the repair is undertaken. The courts, however, have wisely rejected this test for measuring whether a repair increases value or prolongs useful life. The issue was specifically addressed in Plainfield-Union Water Co. v. Commissioner. Applying the, Plainfield-Union test in the context of environmental contamination, the "condition necessitating the expenditure" is the discovery of the contamination. If the value of the property prior to discovery of the condition is compared with the value after removal of the contamination, the cost of the cleanup generally will not contribute to an increase in the value of the property. Absent the creation of a separate capital asset (e.g., tanks or filtration plants), the remediation of contaminated property generally does not result in the creation of any significant future benefits or enhanced value. Environmental remediation of contaminated property merely restores the property to its previous state prior to the "condition necessitating the expenditure."

Under the second prong of the capitalization test, expenditures that substantially prolong an asset's expected useful life must be capitalized. But environmental clean-up activities generally will rarely extend the expected life of the affected asset. Rather, expenditures for this purpose will simply permit taxpayers to continue to use the property over its expected useful life.

Under the third prong of the test for capitalization, expenditures made to adapt property to a new or different use must be capitalized. When applying this standard to property subject to repair or remediation, consideration must be given to the property's original intended use. Expenses incurred to remediate environmental damage will not adapt the property to a new use or substantially increase a property's value for use in the taxpayer's business; rather, the expense will generally permit the taxpayer only to continue or maintain use of the property for its original purposes.

Environmental remediation may be undertaken voluntarily or in response to specific government-mandated requirements. Compulsory payments are not in and of themselves capital expenditures under section 263(a) of the Code. Thus, courts have had no difficulty confirming the deductible nature of compulsory repairs because the correct test for capitalization is whether the amounts spent extend the property's life, adapt it to a new use, or make it more valuable for use in the taxpayer's business as compared to its previous condition. To be capitalized, a repair expenditure must meet one of the three prongs of the test of capitalization set forth in Treas. Reg. [section] 1.263(a)-1(b).

Finally, the IRS cannot ignore the very real possibility that remediation efforts may be impaired unnecessarily because of the uncertainty (and increased cost) engendered by aggressive IRS enforcement tactics that emphasize capitalization in the absence of unequivocal National Office guidance. A revenue maximizing course of action would hence not only be at odds with tax law principles but would also be counter-productive for environmental policy and anti-competitive for U.S.-based manufacturers. In the two recent technical advice memoranda, the rationales proffered for the conclusions that the environmental remediation expenditures should be capitalized are strained. TEI urges the IRS to reconsider the results in the technical advice memoranda and to confirm through public guidance that environmental remediation expenditures are generally in the nature of deductible repairs.

III. Overview of Pertinent

Federal Income Tax Rules

The federal income tax treatment of environmental remediation costs affects nearly every taxpayer engaged in manufacturing, natural-resource extraction, transportation, and related industries. Although it has been more than two decades since the enactment of federal legislation authorizing the creation of the Environmental Protection Agency (EPA), the proper income tax treatment of remediation expenditures is only now emerging as an issue for the IRS. Businesses, meanwhile, have generally considered remediation expenditures deductible when incurred, and the IRS should provide immediate guidance to quell the incipient uncertainty concerning the proper income tax treatment of remediation expenditures engendered by the recently issued technical advice memoranda.(2)

This position paper sets forth TEI's approach to the resolution of the environmental clean-up issues most commonly encountered in the ordinary course of a taxpayer's trade or business - i.e., whether an expenditure qualifies as an ordinary and necessary expense deductible under section 162 of the Code or must be capitalized under section 263.(3) The proper resolution of the income tax treatment of remediation expenses must, of course, be integrated into the tax system as a whole. TEI believes that a thorough analysis demonstrates that most remediation expenses are currently deductible as repairs. In certain limited circumstances, however, the costs should be properly capitalized. In a very few cases, an analysis of all the factors involved in distinguishing deductible repairs from capital expenditures may lead to an inconclusive result. In such "hard cases" (the ones that make "bad law"), a balance must be struck between the fundamental principles of tax interpretation and the societal goal of cleaning up the environment.

Moreover, the IRS must not make its policy decisions in a tax-only vacuum. Slavish adherence either to protecting the fisc or to what one may believe constitutes a theoretically pure tax result should be tempered by decent respect for what is practicable and legitimate concern for encouraging companies to clean up environmental hazards. Rulings and regulations that permit the deduction of expenditures to clean and protect our environment should be interpreted reasonably to promote the social policy of environmental protection. The IRS cannot ignore the very real possibility that remediation efforts may be delayed unnecessarily because of the uncertainty (and increased cost) engendered by aggressive IRS enforcement tactics that emphasize capitalization. A revenue maximizing course of action would be both counter-productive for environmental policy and anti-competitive for U.S.-based manufacturers.(4)

To provide additional analysis, we have crafted a set of examples concerning (1) the ownership of the affected property; (2) the purchase of contaminated property before or after discovery of the contaminants; (3) the creation of new or additional property in connection with a clean-up effort; (4) the effect of federal or state environmental regulations; and (5) the extent and degree of future benefits, if any, arising from a clean-up. The examples, which are set forth in an appendix, address fundamental questions such as (1) who is legally liable for what and when, (2) what is the proper financial accounting treatment of the transaction, and (3) what factors affect the proper tax treatment. Although by no means exhaustive, the examples do serve to illustrate the tax principles that must be addressed and applied when considering the proper tax treatment of remediation expenditures.

IV. The Scope of Environmental

Remediation Activities

Environmental remediation costs generally relate to cleaning up the natural by-products or waste-stream from manufacturing, extraction, or other past activities.(5) The disposal of hazardous and non-hazardous wastes alike has generally been consistent with the most commonly accepted and prudent means legally and technologically available at the time. Indeed, as scientific knowledge evolves, the potential ill effects of various disposal practices are continually re-examined and new standards devised. Furthermore, increased public awareness of environmental consequences has led businesses to adopt more ecologically sound practices as a matter of good corporate citizenship and prudent business practice.

Taxpayers face a plethora of costs to comply with a myriad of current environmental laws imposed by federal, state, and local authorities. Costs are incurred to clean up problems associated with past business operations, to minimize contamination from present operations, and to forestall future environmental problems. Occasionally, taxpayers will purchase property with pre-existing conditions that necessitate clean-up expenditures. Finally, taxpayers may incur liabilities for clean-up costs owing to activities of unrelated parties - for example, as a lessor of property to third parties or as one of many parties jointly and severally liable for cleaning up a multi-party disposal site.

When a taxpayer determines that a potential clean-up liability exists, a number of steps may be undertaken to investigate the scope and magnitude of the problem. Those steps include reviewing a site's history; conducting a site inspection and soil, air, or water testing; analyzing test results; performing research to develop an appropriate remedy; obtaining bids (or scheduling work crews) for clean-up work; evaluating bids for the cleanup; awarding clean-up contracts; supervising site remediation work to ensure compliance with the contract and governmental mandates; and coordinating compliance with regulatory agency requirements.

For any particular remediation project, the expenditures may include engineering consulting fees for the development of a remediation plan, site clean-up expenses (including disposal costs), costs of monitoring a site after the initial cleanup, costs related to obtaining certification of remediation, government assessments relating to the problem, and legal fees. Finally, site clean-up expenses may include repair or removal of underground storage tanks, bio-remediation of water and soil, installation of protective liners, burning of contaminated soil, construction of water-treatment or storage facilities, or encapsulation of the problem area.

There are a number of overlapping federal, state, and local statutes that impose liability for cleaning up the environment. State and local statutes are often patterned after federal environmental provisions and thus will rarely provoke tax issues different from those arising under federal legislation. The principal federal statutes imposing environmental clean-up liability on taxpayers are the following:

* Federal Water Pollution

Control Act (Clean Water

Act);(6)

* Oil Pollution Control Act of

1990;(7)

* Resource Conservation and

Recovery Act of 1976

(RCRA);(8)

* Toxic Substance Control Act

(TSCA);(9)

* Comprehensive Environmental

Response, Compensation,

and Liability Act of

1980, as amended (CERC-LA);(10)

and

* Occupational Safety and

Health Act (OSHA).(11)

Although the reach of all these statutes is not coextensive, a brief discussion of CERCLA highlights the potentially broad scope of a company's liability under the whole panoply of federal environmental protection statutes. CERCLA permits federal authorities to enter and clean up properties where hazardous substances are found, establishes a fund to finance the cleanup costs (Superfund), and generally provides the power for oversight and enforcement of all clean-up activities. CERCLA imposes liability on private parties - denominated "Potentially Responsible Parties" (PRPs) - who are identified as having contributed to the release of hazardous substances. The liability imposed under CERCLA is strict, joint and several, and retroactive. Consequently, PRPs may be held responsible for all clean-up costs even though a particular party's actions were legal and reasonable at the time, and even though the company may have disposed of only a small amount of hazardous substances at a particular site. PRPs include the current property owner, previous owners, parties that generated substances disposed of at the site, and transporters of hazardous substances as determined by the EPA in each case. Although remedial action at a site may be undertaken by either the federal government or PRPs, many PRPs choose to oversee the clean-up work directly based on the belief that they will be better able to manage the amount and timing of expenditures by strict oversight of the contractor.

The expansive, all-encompassing nature of the liability imposed by the applicable federal environmental protection statutes (as well as numerous state and local counterparts) is keyed to the use to which a taxpayer puts the property and the accompanying environmental damage that may arise from that business use. A proper accrual of the liability arises contemporaneously with the income generated from the business activity, creating the condition, even though the condition goes undiscovered or does not require remediation under then existing environmental standards. The treatment of environmental remediation expenses for financial accounting purposes is instructive of the proper time and manner for accrual of the expense liability.

V. Significance of Financial

Accounting Rules and

the Matching Principle

A. Financial Accounting

Treatment

Section 446(a) of the Internal Revenue Code generally provides that taxpayers should calculate taxable income under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books."(12) Complying with generally accepted accounting practices (GAAP) does not assure that a method of accounting "clearly reflects income," particularly where the method conflicts with a requirement set forth in the Code or regulations."(13) Where the taxpayer's method is otherwise permitted by the regulations, however, conformity with GAAP should ordinarily be strong evidence that the method of accounting for an item clearly reflects income.(14) The reason is plain: GAAP and section 446(a) seek to measure the same economic events. Indeed, in distinguishing capital expenditures from periodic,expenses, similar criteria are employed for both tax and financial accounting - particularly the concept of matching expenses with the income to which it relates. The overarching purpose of each is the accurate computation of net income.(15)

The Financial Accounting Standards Board (FASB), through its Emerging Issues Task Force (EITF), addressed the proper treatment of environmental remediation costs for financial statement purposes in EITF Abstract No. 90-8.(16) The EITF categorized environmental clean-up costs, as follows:

* Costs incurred by a company

to remove, contain, or

neutralize (clean up) existing

environmental contaminations

of its property. (For

example, the cleanup of contamination

resulting from

the leaking of underground

tanks of gasoline stations.)

* Costs incurred by a company

to clean up environmental

contamination of property

owned by others. (For

example, the cleanup of

shoreline contamination resulting

from spills by oil

tankers.)

* Costs incurred to mitigate

or prevent environmental

contamination that has yet

to occur and that otherwise

may result from future operations

or activities. (For

example, pollution control

equipment that forestalls

further air pollution.)

* Costs incurred to prepare

property for sale.

The EITF concluded that generally remediation costs should be an item of expense. In certain limited circumstances, however, the EITF recognized that the costs may properly be capitalized. Specifically, capitalization would be permitted under GAAP only where such costs are recoverable in the future and one of the following criteria is met:

* the costs extend the life, increase

the capacity, or improve

the safety or efficiency

of property owned;

* the costs prevent or mitigate

environmental contamination

from future operations

and activities; or

* the costs are incurred in

preparing for sale property

that is currently held for

sale.

The EITF also concluded that, in order to satisfy the first or second criterion, the condition of the property after the costs are incurred must be improved as compared with the condition of the property when originally constructed or, if later, acquired.(17)

The EITF concluded that the costs of cleaning up environmental contamination on a company's own property should be treated as an expense. The reasoning is that such cleanup does not increase the capacity or improve the safety or efficiency of the property relative to its condition when built or acquired. Rather, the cleanup only restores the property to its former uncontaminated state and is not a betterment of the property. The EITF also concluded that a cleanup does not create an asset but merely extinguishes a liability created when the contamination occurred. Likewise, costs incurred to clean up environmental contamination of property owned by others should be expensed, since these costs cannot possibly create an asset owned by the company incurring the cost of a clean-up.

Finally, the EITF concluded that costs incurred to mitigate or prevent environmental contamination that has yet to occur (or that may result from future operations or activities) should be capitalized because they create an asset enhancing future operations by preventing pollution that would result from future operations. Costs to clean up environmental contamination made to prepare property for sale that is currently held for sale are capitalized provided those costs are realizable.

The standards set forth by the EITF for the analysis of the financial statement treatment of environmental remediation costs are cogent and persuasive because they clearly comport with the economic reality of the underlying transactions.

B. Matching of Income

with Related Expenses

The theoretical underpinning of capitalization for both financial and tax accounting principles is that the period in which expenses are deducted should match the period in which the income generating those expenses was earned.(18) Expenditures that provide a benefit for a future period are capitalized and recovered from the income for the period to which the expenses are attributable. In many instances, environmental clean-up expenses directly relate to activities that generated income in prior periods, perhaps as long as decades ago. The legal constraints governing the revenue-producing activities, in all likelihood, did not require that the taxpayer take remediation action in the prior period because the environmental damage caused by prior practices was uncovered only as a result of recent scientific and technological advances.

Environmental legislation recognizes that historical practices were deficient by establishing a current liability for past practices. Remediation expenditures are not being made to compensate for normal, deferred maintenance. Indeed, in many cases current clean-up and repair costs could not have been incurred because the taxpayer was unaware of the need for any action or was not required under then-existing law. This clearly distinguishes environmental remediation expenses from the type of expenses capitalized in Wolfsen Land and Cattle Co. v. Commissioner,(19) where the taxpayer deferred normal maintenance expenditures until the drainage ditches were dysfunctional. Moreover, environmental remediation expenses will rarely give rise to future income, but rather extinguish a liability arising from the past activities of the taxpayer. This again distinguishes such expenses from the deferred maintenance expenses in Wolfsen where the drainage ditches were critical to the production of future income.

To match clean-up expenses with income in the proper period, taxpayers have three choices: (1) expenses could be carried back for deduction in the period in which the taxable income giving rise to the expenditure was earned; (2) the expenses could be deducted in the period in which a payment is made or accruable; or, (3) the expenses could be capitalized and deducted in a future period.

Carrying deductions back to prior periods would generally match remediation expenditures to the period in which the polluting activity occurred. Except under the conditions prescribed in section 172, however, carryback treatment is generally not permitted. In the absence of a net operating loss - under either the general rule of section 172(b) or under the special rule of section 172(f) for losses arising as a result of expenses incurred to comply with federal or state laws - a carryback of remediation expenses would be impermissible.

Capitalizing remediation expenditures, on the other hand, would distort current period net income and future period net income because there is no relationship between the income-producing activity and discharging the liability for the clean-up expenditure. The clean-up activity is causally related to prior-period activity. The current discovery of the harmful impact of a past activity does not thereby cause a future benefit to arise. Complying with applicable environmental regulations similarly does not create a future benefit. Capitalizing remediation costs, then, would violate the clear reflection of income doctrine because (1) the need for remediation is attributable to prior-year operations, (2) the environmental clean-up liability is imposed on a retrospective basis, and (3) there is no significant future benefit arising from the costs.

In contrast, proper matching will permit a current deduction at the time a remediation expense is paid or accrued. Although the period in which an expenditure is incurred may differ from the period of the activity creating the liability, permitting a current deduction is consistent with the requirement that taxable income be computed based upon the taxpayer's books and records because, for book purposes, these expenditures are generally expensed. It is also consistent with the concept of economic performance prescribed by section 461(h). To deny a deduction for expenses actually incurred when the related income is known and previously reported would result in a gross mismatching of income and expense thereby distorting the computation of taxable income.(20)

VI. Federal Income

Tax Treatment of

Remediation Expenses

Remediation costs are generally incurred to restore property to its ordinary, pre-contamination condition. Although there is no statutory provision specifically governing the federal income tax treatment of environmental clean-up costs, guidance may be found in the treatment of repair and maintenance costs under section 162 of the Code. Costs that fall outside of the scope of the repair and maintenance provisions may be subject to capitalization under section 263.

A. Ordinary and Necessary

Expenses

Section 162(a) of the Code provides that a taxpayer may claim a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. In order to be deductible, an expenditure must (1) be paid or incurred during the taxable year, (2) be for the purpose of carrying on any trade or business, (3) be an expense, (4) be a necessary expense, and (5) be an ordinary expense.(21)

In this context, "necessary" imposes only the minimal requirement that the expense be appropriate and helpful for the development of the taxpayer's business. To be "ordinary," an expense must relate to a transaction of common or frequent occurrence in the taxpayer's trade or business. The common interpretation of "ordinary" was set forth by the Supreme Court in Welch v. Helvering:(22)

Ordinary in this context does

not mean that the payments

must be habitual or normal in

the sense that the same taxpayer

will have to make them

often. A lawsuit affecting the

safety of a business may happen

once in a lifetime. The

counsel fees may be so heavy

that repetition is unlikely.

Nonetheless, the expense is

an ordinary one because we

know from experience that

payments for such a purpose,

whether the amount is large

or small, are the common and

accepted means of defense

against attack.(23)

Environmental clean-up costs are both ordinary and necessary under section 162 because they are both (1) common and (2) appropriate and helpful because they satisfy a liability of the business. This is the case irrespective of whether the remediation expenses are incurred in connection with a one-time, single-site cleanup or, alternatively, as a frequently recurring item at the same or different clean-up sites.(24)

B. Repair or Capital

Expenditure

1. General

Treas. Reg. [section] 1. 162-4 provides that the costs of incidental repairs that neither materially add to the value of property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition are currently deductible. The regulation adds, however, that repairs in the nature of replacements, to the extent they arrest deterioration and appreciably prolong the life of the property, are not currently deductible.

Section 263(a)(1) limits the scope of section 162 by prohibiting a deduction for amounts paid out for permanent improvements or betterments to increase the value of property. Treas. Reg. [section] 1.263(a)-1(b) elaborates on the statutory limitation by providing that expenditures are capital where they materially increase the value or substantially prolong the useful life of property owned by the taxpayer or are incurred to adapt the property to a new or different use. The regulation continues that "amounts paid or incurred for repairs and maintenance are not capital expenditures." In addition, the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year is specifically defined as capital in nature by Treas. Reg. [section] 1.263(a)-2(a).

Notwithstanding the charge of the regulations, the distinction between what is capital and what is expense is not easily discerned. The principles of the regulations, however, have been refined through judicial interpretation. For example, in the seminal case of Illinois Merchants Trust Co.,(25) the Board of Tax Appeals stated:

To repair is to restore to a

sound state or to mend, while

a replacement connotes a substitution.

A repair is an expenditure

for the purpose of

keeping the property in an ordinarily

efficient operating

condition. It does not add to

the value of the property, nor

does it appreciably prolong its

life. It merely keeps the property

in an operating condition

over its probable useful life

for the uses for which it was

acquired. Expenditures for

that purpose are distinguishable

from those for replacements,

alterations, improvements

or additions which prolong

the life of the property,

increase its value, or make it

adaptable to a different use.(26)

This summary of a "repair" is incorporated in the section 263 regulations, but neither the Illinois Merchants decision nor the regulations address how, and from what point - temporally and qualitatively - changes in value, use, or life should be measured.

2. When Is the Proper Time

to Measure Increases in

Value, Life, or Changes

in Use?

Where the taxpayer is aware that damage or deterioration to property has occurred, ascertaining the value of property prior to the condition necessitating the repairs is generally not difficult. Where the taxpayer is unaware that a condition exists (or is developing), however, the measurement of value ante quo is problematic. The valuation process is further complicated where environmental standards are tightened - whether as a result of increasing scientific knowledge of potential harms, development of economically efficient environmental remediation techniques, or changes in societal norms and expectations.

Performing repairs on property in need of repairs will always add value or extend the life of the property where the point of measurement is the condition of the property that exists immediately before the repair is undertaken. The courts, however, have wisely rejected this test for measuring an increase in value. The issue was specifically addressed in Plainfield-Union Water Co. v. Commissioner,(27) where the Tax Court stated:

. . . any properly performed

repair adds value as compared

with the situation existing

immediately prior to the repair.

The proper test is whether

the expenditure materially

enhances the value, use, life

expectancy, strength, or capacity

as compared with the

status of the asset prior to the

condition necessitating the expenditure.(28)

In the context of most environmental remediation expenses - including, for example, asbestos removal - TEI submits that the useful life, value, or use of the remediated property prior to the discovery of contamination should be compared with the useful life, value, or use of the restored property. Arguably, the value of property is not diminished unless or until an adverse environmental condition is known or reasonably discoverable.(29) The events triggering the deterioration in the value of property are (1) the identification of the deleterious effects of the contamination and promulgation of a governmental standard regulating its discharge, disposal, or emission, and (2) the taxpayer's discovery or knowledge of the presence of contamination in excess of the prescribed limits. Applying the Plainfield-Union test in the context of environmental contamination, then, the "condition necessitating the expenditure" is the discovery of the contamination. If the value of the property prior to discovery of the condition is compared with the value after removal of the contamination, the cost of the cleanup generally will not contribute to an increase in the value of the property.

Despite the IRS's nonacquiescence in the Plainfield-Union case, the Tax Court's decision has been commonly cited in determining when the value of property has increased.(30) In Technical Advice Memorandum 9240004 (hereinafter, "the asbestos ruling") and Technical Advice Memorandum 9315004 (hereinafter, "the PCB ruling" or "the soil remediation ruling"), the IRS went to great lengths to distinguish Plainfield-Union. Despite the IRS's efforts, the case remains important to determine when to apply the test of a material increase in value.(31)

3. Enhanced Value-how

Is It Measured?

Expenditures that result in the creation of a significant future benefit or separate asset (with a useful life of greater than one year) must be capitalized. In INDOPCO, Inc. v. Commissioner,(32) the Supreme Court ruled that certain corporate takeover expenditures should be capitalized because the taxpayer received significant longterm benefits as a result of a merger transaction:

[A]lthough the mere presence

of an incidental future benefit - some

future aspect - may

not warrant capitalization, a

taxpayer's realization of benefits

beyond the year in which

the expenditure is incurred is

undeniably important in determining

whether the appropriate

tax treatment is immediate

deduction or capitalization.(33)

Similarly, in Woolrich Woolen Mills v. United States,(34) the Third Circuit applied a one-year rule-of-thumb to expenditures incurred to remediate water polluted by the taxpayer's textile mill. The taxpayer erected a waste-water treatment facility to comply with certain environmental regulations. Although the water filtration system was not an integral part of the taxpayer's manufacturing operations, the court found that the item was capital. In pertinent part, the court explained:

While it might be considered

"divorced" in a sense of not

being a productive part of taxpayer's

manufacturing process,

it is nonetheless an integral

part of the total property

which taxpayer devotes to its

business. In this sense, it is

no less "divorced" than a

fence, Russell Box Co. v. Commissioner,

208 F.2d 452 (1st

Cir. 1953); safety devices installed

in a factory, consisting

of railings and shields, George

Haiss Mfg. Co., supra; a sprinkler

system, Hotel Sulgrave,

Inc., supra; fire exits, RKO

Theatres, Inc. v. United

States, supra; Trenton-New

Brunswick Theatres Co., supra;

or safety devices in an

elevator, International Bldg.

Co., supra, all of which were

held to constitute capital expenditures. . . .

In essence taxpayer's contention

is that the filtration plant

did not enhance the value of

its property. We cannot subscribe

to this contention. It is

inconsistent with the finding

of the District Court that "the

waste plant is a permanent

addition to the . . . [taxpayer's]

mill property . . . having

a life extending beyond the

year in which construction

thereon was completed." In

our opinion, this fact-finding

required the District Court to

hold that the cost of construction

of the waste plant constituted

a non-deductible capital

expenditure within the

meaning of Section 24(a) (2)

of the Internal Revenue Code

of 1939 and it erred in failing

to do so.(35)

Case law hence confirms the creation of a significant long-term future benefit or a separate asset with a useful life of greater than one year is evidence of enhanced value where the production of future income will be increased. Additionally, the courts have affirmed that enhanced value must be measured by comparing the restored property to its previously unimpaired status.(36)

When applying the value test to conditions requiring environmental remediation, the "condition necessitating the expenditure" is properly viewed as the discovery that a certain substance or condition is present on the taxpayer's property and that its presence represents an environmental hazard. Absent the creation of a separate capital asset (e.g., tanks or filtration plants), the remediation of contaminated property generally does not result in the creation of any significant future benefits or enhanced value. Prior to discovery, there is no known risk of unsafe working conditions or liability for employee safety - and, hence, no measurable decline in the property's value. Environmental remediation of contaminated property merely restores the property to its previous state prior to the "condition necessitating the expenditure."

In the asbestos ruling, the IRS attempted to distinguish the objective measurement of increased value in Plainfield-Union. Specifically, the IRS said the value of the property increased as a result of subjective factors (e.g., safer working conditions for employees and increased marketability because property without asbestos is "inherently more valuable" than property with asbestos insulation), which are not compatible with the objective valuation approach in Plainfield-Union. Quite plainly, making any repair will increase the "safety" of property or make the property "inherently more valuable" when compared with an unrepaired condition. Costs that improve the operational safety of assets (without the addition of additional equipment, components, or units of property) are incurred to maintain the property in an ordinarily efficient operating condition. Indeed, the IRS has recognized this view in characterizing the cost of scraping lead-based paint from areas accessible to children as a deductible maintenance repair.(37)

4. Extended Life

Expenditures that substantially prolong an asset's expected useful life must be capitalized. This standard, however, must be applied in the context of the type of property being remediated. For example, in Illinois Merchants Trust, the replacement of rotted wooden pilings with cement pilings was held to be a deductible repair because the cement pilings did not extend the expected useful life of the supported building.(38) In Midland Empire Packing Co. v. Commissioner,(39) expenditures incurred to line a basement with cement to prevent oil seep-age were held to be deductible repairs because the lining did not extend the expected useful life of the related building. The evidence in the case established that "the expenditure did not . . . prolong the expected useful life of the property over what they were before the event occurred which made the repairs necessary."(40)

Similarly, environmental clean-up activities generally will not extend the expected life of the affected asset. Rather, expenditures for this purpose will simply permit taxpayers to maintain or continue the use of the property over its expected useful life.

5. New or Different Use

Expenditures made to adapt property to a new or different use must be capitalized. When applying this standard to property subject to repair or remediation, consideration must be given to the property's original intended use. Furthermore, the degree of the change in use is relevant to the determination of the tax treatment of an expenditure. In cases where the change in use is not material, expense treatment has been permitted. For example, in Plainfield-Union the taxpayer relined its tar-lined water pipes with cement. The repair was made necessary by the change from the use of well water to more acidic river water, which had caused tuberculation. In holding that the expenditures were deductible repairs, the court explained that the cement lining did not qualify the pipe for a new use, but rather permitted the taxpayer to use the pipe for its intended purpose - carrying water.(41)

When determining whether expenditures adapt property to a new use, the courts look to the taxpayer's intent in making the expenditure. In J.H. Collingwood v. Commissioner,(42) the taxpayer graded farm land to form terraces in order to control soil erosion. The expenditures were held to be deductible repairs because they did not add to the productivity of the land nor make it suitable for new uses. The court recognized that the grading was performed for the sole purpose of preventing topsoil erosion to retard or prevent the deterioration of the farm lands. The court focused on the intent of the taxpayer to maintain the original use of the property as farmland. In a similar fashion, expenses incurred to remediate environmental damage will not adapt the property to a new use or substantially increase a property's value for use in the taxpayer's business; rather, the expense will generally permit the taxpayer to continue its historic use of the property.

6. Only Incidental Repairs

are Deductible

In the PCB ruling, the IRS asserted that repairs are deductible only where they are "incidental." "Incidental" in the context of the repair regulations has been defined by the Tax Court as meaning "necessary to some other action."(43) Under this interpretation, repairs incidental to maintaining business property or keeping property in an ordinarily efficient operating condition are deductible; repairs incidental to capital expenditures must be capitalized. Any attempt to read incidental as "minor" or de minimis is wrong. As the PCB ruling acknowledges, courts analyzing work performed on tangible assets that was costly in relation to the cost of the assets nonetheless have found the expenditures deductible based on the nature of the work performed.(44) Thus, the magnitude of expenditures spent on environmental remediation is merely an item to consider in determining whether an expenditure enhances the value of the property, prolongs the life of the property, or adapts it to a new use. Unless the expenditure meets one of these three prongs of section 263, the magnitude of the expenditure is irrelevant. The soil remediation ruling attempts to elevate "incidental" to become a separate test for current deductibility. The ruling is at odds with the body of case law.

7. Knowledge/ Intent/

Diligence

When analyzing changes in a property's value, life, or use, the courts have looked to the knowledge, intent, and diligence of the taxpayer relative to the event triggering the expenditure. In American Bemberg Corp. v. Commissioner,(45) the taxpayer constructed its manufacturing facility on bedrock pocketed with geological faults. The soil in the faults shifted, causing cave-ins of the factory floors and machinery. In holding that the expenditures incurred to remedy the damage were deductible repairs, the court relied on the fact that -

Neither the existence nor the

nature nor the extent of any

abnormality in the subsurface

conditions affecting petitioner's

plant was discoverable in

the exercise of the diligence

and prudence appropriate to

the circumstances at any earlier

date than they were actually

discovered.(46)

By contrast, in Mt. Morris Drive-in Theatre v. Commissioner,(47) the taxpayer constructed a drive-in theater without a drainage system. When the system was subsequently installed pursuant to a legal settlement, the court held the expenditures to be capital because "it was obvious at the time when the drive-in theater was constructed, that a drainage system would be required to properly dispose of the natural precipitation normally to be expected, and that until this was accomplished, petitioner's capital investment was incomplete."(48) Thus, expenditures made to cure defects or remedy situations that, by the exercise of diligence and prudence appropriate to the circumstances would not have been discovered at the time of acquisition, should be accorded expense treatment (assuming all the other appropriate criteria are met). Expenditures that could have been reasonably anticipated by the taxpayer may require capitalization.

8. Plan-of-rehabilitation

Doctrine

An additional consideration in distinguishing capital expenditures from ordinary repairs is the judicially created plan-of-rehabilitation doctrine. As stated in Wehrli v. United States:(49)

The courts have superimposed

upon the criteria in the repair

regulation an overriding precept

that an expenditure

made for an item which is part

of a "general plan" of rehabilitation,

modernization, and

improvement of the property,

must be capitalized, even

though, standing alone, the

item may appropriately be

classified as one of "repair."(50)

. . . Whether [a] plan exists

and whether a particular item

is part of it are usually questions

of fact . . . [that depend

upon] a realistic appraisal of

all the surrounding facts and

circumstances, including, but

not limited to, the purpose,

nature, extent, and value of

the work done. . . .(51)

The statement that the courts have "superimposed" the plan of rehabilitation doctrine as an "overriding precept" on the repair regulations, TEI believes, is an overstatement. We believe that a series of related repairs must also have the effect of increasing the value, extending the life, or adapting the property to a new use before the doctrine is invoked, and the expenditures therefore become capital improvements. In other words, a series of repairs do not rise to the level of a "plan of rehabilitation" unless one of the three tests for capitalization is otherwise satisfied.(52)

The plan-of-rehabilitation doctrine distinguishes an expense incurred to "keep" an asset in operating condition (i.e., a repair) from an expense incurred to "put" an asset in operating condition. The mere existence of a detailed work-plan for repairs, however, should not by itself trigger the plan-of-rehabilitation doctrine. The creation of a detailed work-plan for an environmental remediation project, for example, is simply sound business practice.(54)

In Jones v. Commissioner,(55) the taxpayer acquired property that had been determined to be unfit for habitation by the state fire marshall. The taxpayer originally intended to demolish the structure and construct a new one in its place. When the demolition was prohibited, the taxpayer under-took a plan to put the property into a condition that would allow it to again be used. The costs incurred were held to be capital expenditures because ". . . the taxpayer rebuilt the structure without having demolished it."(56) Stated differently, expenditures made to "put" the property into a condition suitable for the taxpayer's use must be capitalized.

In Home News Publishing Co.,(57) the taxpayer owned property that, at the time of its acquisition, had second and third floors that had collapsed from being overloaded. The building had been used in the taxpayer's business for a number of years, despite its hazardous condition. Following an inspection, a city building inspector required that new steel girders be installed in the building. Concurrent with the girder installation, the taxpayer performed other work on the building that ordinarily would have been classified as deductible repair expense. Nonetheless, all the expenditures were required to be capitalized because they were made pursuant to a general plan of reconditioning - one that improved the property as a whole and made it suitable for the taxpayer's purposes.(58)

Implicit in the plan-of-rehabilitation doctrine is the notion that the classification of an expenditure as a deductible repair or a capital improvement depends on the context in which the expenditure is made. When both substantial capital improvements and repairs are made to the same asset pursuant to the same plan, the distinction between the capital improvements and the repairs disappears because in combination the expenditures change the asset's use, increase its value, or prolong its life. Because one of the criteria for capitalization specified in Treas. Reg. [section] 1.263(a)-1 is satisfied, the expense must be capitalized. The doctrine does not change the test for capitalization; rather, it subsumes normally deductible repairs within the capital expenditures.

Under Treas. Reg. [section] 1.263(a)-1, plan-of-rehabilitation expenditures must relate to the enhancement of the life, value, or use of the same asset. Thus, capital improvements made to one asset do not change the character of expenditures made to a different asset, even if made pursuant to the same general plan.(59)

9. The Wolfsen Decision

In the soil remediation ruling, the IRS relies upon an extremely unusual case to require capitalization of "deferred maintenance" costs. In Wolfsen v. Commissioner,(60) the taxpayer owned a cattle ranch. An integral part of the ranch was an irrigation system. Over time, the irrigation system became unworkable because of many factors. Proper maintenance of the irrigation system, however, was essential to the operation of the ranch. Periodic maintenance of the system was very expensive - approximately equal to the cost of constructing a new system. Because of the extraordinary expense, the taxpayer allowed the system (or portions of it) to deteriorate to where it could no longer provide an adequate water supply. As the Tax Court explained, "[al]though petitioner performs spot or emergency repairs on the system, it does not have a plan of normal repair and maintenance. Rather, petitioner has adopted a plan whereby it delays repair until a particular stretch of ditch or levee absolutely requires draglining to avoid dysfunction."(61) After the maintenance, the system would remain operational for approximately 10 years, at which time the maintenance would be required again.

As a business strategy, the taxpayer in Wolfsen intentionally permitted the property to deteriorate to a completely dysfunctional state. The expenditures had the effect of restoring the system to its original capacity. As a result, the system (or portion thereof) had reached the end of its original useful life and the expenditure substantially prolonged that life. That the court upheld the capitalization (and corresponding amortization) treatment advocated by the taxpayer in this case is unremarkable.(62) What is remarkable is that, although the court in Wolfsen cited Plainfield-Union with approval, the soil remediation ruling goes to great lengths to argue that Wolfsen somehow limited Plainfield-Union. The ruling simply proves too much.(63) The factual pattern in Wolfsen is significantly different from the typical case of environmental remediation. Environmental remediation expenditures generally relate to cleaning up the waste streams from historical income-producing activities. This waste was either spilled accidentally or disposed of legally on the taxpayer's property or in licensed disposal sites. Unlike Wolfsen, then, environmental clean-up costs are not purposely deferred annual maintenance. In most cases, neither the government nor the taxpayer is aware that an environmental hazard exists when the polluting activity occurs. When a taxpayer incurs clean-up costs, it is providing a remedy for pollution generated by its past income-producing activity; any relationship between the remediation costs and future activities is insignificant. In Wolfsen, incurring the expenditures was essential to the production of future income from the farming activity. It will be a very unusual case where remediation expenditures will relate directly to the production of future income.

Furthermore, while environmental remediation will generally be performed pursuant to a "plan," the expenditures generally do not produce a separate item of value. Rather, the value of an existing asset is merely restored to its pre-contamination state. Environmental clean-up costs rarely produce future benefits. The costs relate to the past activities of the taxpayer in the production of prior years' income. Consequently, the expenditures are properly matched with income from the prior periods through a current deduction. With few exceptions, the clean-up activities, once completed, will not be performed on the same property or site again. The clean-up costs simply discharge a liability incurred by the taxpayer.

C. Expenditures Mandated

by Law

Expenditures mandated by law may or may not be capital in nature. As stated in Commissioner v. Lincoln Savings and Loan Association,(64) "the fact that a payment is imposed compulsorily upon a taxpayer does not in and of itself make that payment an ordinary and necessary expense within the meaning of section 162(a) of the 1954 Code."(65)

Conversely, compulsory payments are not in and of themselves capital expenditures under section 263(a). Courts have had no difficulty confirming the deductible nature of compulsory repairs. For example, in Midland Empire Packing Co., oil leaked from a nearby refinery and seeped underneath the taxpayer's meat-packing plant, creating an unsanitary condition. Pursuant to an order by federal meat inspectors, Midland added a concrete lining to the walls and floor to prevent further oil seepage. These expenditures were held to be deductible because the property was neither enlarged nor adapted for a different use. The expenditures did not enhance the value or prolong the expected life of the property. The repairs merely served to keep the property in an operating condition over its probable useful life for the purpose for which it was intended.(66) The IRS's acquiescence in Midland underscores that measures taken in response to regulatory action do not automatically put the expenditures beyond the pale of deductibility.

Concededly, certain mandatory payments made to comply with a law have been found to be capital items.(67) All these cases, however, involved the creation of a separate, distinct, and improved asset with a useful life of greater than one year that will contribute to the production of future income. For example, in Hotel Sulgrave Inc. v. Commissioner,(68) the taxpayer installed a sprinkler system in an apartment building where none had previously existed. In RKO Theatres Inc. v. United States,(69) the taxpayer installed new exit facilities and fire escapes. In these cases, the expenditures did more than bring the property into compliance with the law by repairing or restoring existing facilities. They added new capacity or new assets to already existing facilities. Thus, the creation of new assets served to materially enhance the property's value and resulted in capitalization.

In Teitelbaum v. Commissioner,(70) the court stated that a city ordinance requiring the conversion of a building's electrical system from direct to alternating current rendered "the property more valuable for the taxpayer's use by bringing the property into compliance with applicable regulations."(71) Despite the courts flawed embrace of the city ordinance as dispositive, TEI believes the court may have reached the proper result because the conversion appears to have adapted the building to a new and different use. Specifically, a building wired for alternating current can be used for different purposes from a building wired for direct current because there are many electrical devices and lights that require alternating current for proper operation. As a result, the building was more valuable after the repairs than before because tenants would be able to operate updated electrical equipment.(72) In determining whether the expenditure should be capitalized, the majority in Teitelbaum compared the impaired value before the conversion to the restored value of the property. Under the teaching of Plainfield-Union, this is an improper basis for comparing changes in value and, hence, capitalization of repair type expenses. Teitelbaum can be reconciled with Plainfield-Union, however, by recognizing that the Seventh Circuit explicitly disagreed with a finding of the Tax Court that the building was more valuable after the expenditures than before. The increase in value, however, was not attributable to the taxpayer's compliance with the city ordinance; rather, the functionality of the building changed dramatically with the introduction of a more modern, A.C.-based electrical system.(73) Expenditures to put the property into compliance with environmental law merely restore its pre-impairment value. The correct test for capitalization is whether the amounts spent extend the property's life, adapt it to a new use, or make it more valuable for use in the taxpayer's business as compared to its previous condition.

The closest analogy of the effect of government-mandated remediation expenditures are expenses incurred by mining companies to restore strip-mined land to its original state. Many states require mining companies to restore land to its original, pre-strip-mined condition. Should a mine operator fail to reclaim the land in the prescribed manner, the state has the right to perform the needed work and bill the mine operator. Violators also face possible civil and criminal penalties.

State provisions relating to land reclamation are similar in effect to many of the state and federal laws concerning environmental remediation. Taxpayers are required to refill, re-soil, and grade land; plant trees and grass; file reports; and monitor clean-up efforts. State and federal agencies have the right to inspect and impose civil and criminal penalties. They also have the right to perform the remediation work and bill the responsible parties. The underlying purpose of strip-mining legislation and environmental laws are the same: to restore the property to the condition it was in prior to the event that created the problem.

The IRS has challenged deductions for mine reclamation costs by challenging whether the costs met the "all events test" for a proper accrual. The courts have consistently determined that the expenses may be currently deducted.(74) Indeed, the rules modifying the time for deduction of accrued expenses contained in section 461(h) were adopted by Congress in 1984 in part over a concern that - although the fact of the liability for reclamation was established under the applicable laws - the expenses were being deducted in advance of the time when the economic performance occurs. In connection with the enactment of sections 461(h) and 468, however, Congress evinced no intent to alter the fundamental rules for distinguishing deductible expenses from capital expenditures - even where the expenditures are mandated by federal, state, or municipal law. Indeed, TEI believes that the policy that underlies the continued deductibility of mining reclamation and solid-waste disposal site costs (subject to the deferral of the deduction under section 461(h) or 468) supports the proposition that expenses incurred by a taxpayer to refill, grade, and restore property to its pre-remediation state are deductible currently regardless of whether the expenditures are mandated by law.

D. Summmary

TEI believes that ordinarily environmental, remediation expenditures should be deductible as repairs. Only in rare cases will such expenditures add materially to the value of property, extend the useful life of the property, or adapt the property to a new use. In the two recent instances where the IRS has faced directly the issue of the proper income tax treatment of environmental clean-up costs, the rationales proffered for the conclusions that the environmental remediation expenditures should be capitalized are strained and result in an erroneous application of the law. TEI urges the IRS to reconsider the rationale and the results in the technical advice memoranda and to clarify and confirm through public guidance that environmental remediation: expenditures are generally in the nature of deductible repairs.

VII. Conclusion

TEI appreciates the opportunity to contribute to the continuing dialogue concerning the proper treatment of environmental clean-up costs. The Institute's comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is David F. Nitschke of Amerada Heas Corporation. Preparation of the comments was coordinated by David Freedman of CSX Corporation, who headed a special task force of TEI members to prepare the comments. If you should have any questions concerning the comments please do not hesitate to contact Mr. Nitschke at (908) 750-6782, Mr. Freedman at (904) 279-6189, or Jeffery P. Rasmussen of the Institute's legal staff at (202) 638-5601.

Appendix

Examples of the Analysis of the Treatment of Environmental Remediation Expenditures

* Example 1 Waste-Water Discharges

Facts

"A" has been engaged in manufacturing for many years along the banks of X river. A's manufacturing process requires it to draw water from x river and subsequently discharge that water back in to the river following treatment. When it was initially impelmented, the treatment process employed by A was state-of-the-art. Despite its best efforts to maintain the water-treatment facility, A has been required by the EPA to undertake further actions to eliminate the discharge of dioxin into the water. In order to comply with an EPA directive, A undertakes to construct a new water filtration systems. The new system will bring A's plant into compliance with the standards set forth in the Clean Water Act. A's manufacturing process is unaffected by the new filter system.

Although the new system has no effect on A's manufacturing process, A must comply with the Clean Water Act and, as the owner of facility responsible for discharging illegal substances into the water, is liable for its cleanup.

Financial Statement Analysis

For financial accounting purposes, the cost of the new water filtration system installed by A should be capitalized because it will prevent or mitigate environmental contamination from future operations and because a new, separately identifiable asset is created.

Income Tax Analysis

For tax purposes, the cost of the new water filtration system should be capitalized because a separate capital asset with a determinable useful life extending beyond the end of the taxable year gas been created. Treas. Reg. [section] 1.263(a)-1(a)(1) and Woolrich Woolen Mills v United States, 289 F.2d 444(3d. Cir. 1961).

* Example 2 PCB Discharges

Facts

As part of its manufacturing operations, "B" operates and maintains an integrated electrical distribution system. Power for the system is provided by outside electric companies and from turbine generator at a mil operated by B. As a result of routine maintenance checks conducted by B, PCB leaks were discovered in a number of transformers. The PCBs were discharged into the air and the ground. As the owner of the equipment that was the source of the PCBs discharged, B is liable under the Toxic Substance Control Act for cleaning up the spill.

B incurs costs to (1) remediate the contaminated soil by excavating, transporting, and disposing the contaminated soil, (2) monitor the level of PCBs in the workplace and near the manufacturing operation for a period of years, and (3) repair various pieces of leaking equipment with a series of spot welds to seal the leaks. The cleanup and restoration of the plant and the affected areas may require up to five years to complete.

Financial Statement Treatment

The costs incurred by B to remediate the contaminated soil, monitor the level of PSBs, and repair the leaking equipment do not increase or improve the safety or efficiency of the land or equipment relative to its conditions before the discovery of the leaks. Therefore, they should be expensed on B's financial statements.

Income Tax Analysis

The costs incurred to remediate the contaminated soil including excavation, transportation, and disposal of the soil should be expensed. The soil remediation expenditures are incidental repairs that neither materially add to the value of the property, nor appreciably prolong its life, but merely restore the property to its original, pre-contaminated condition.

The expenses incurred to monitor the PCB levels are ordinary and necessary expenses under section 162(a). The continuous nature of the monitoring demonstrates that the expenditures relate to "transactions of common or frequent occurrence in the taxpayer's trade or business." Furthermore, no separate assets is created by the monitoring activity that will contribute to the production of future income.

The expenditures incurred to repair the leaking equipment are expenses because they do not increase the value, extend the expected life, or adapt the use of the property when compared with the condition of the condition of the property prior to the event requiring the expenditures. Treas. Reg. [section] 1.162-4.

* Example 3 Leaking Underground Fuel Tanks

Facts

In order to operate its manufacturing equipment, "C" stores No.6 fuel oil in several storage tanks on its premises. The storage tanks and related pipes were installed and maintained in accordance with prevailing industry practice and government regulations. Fuel oil from these tanks accidently leaked from these underground storage tanks and contaminated the soil both at C's manufacturing operations and on three adjacent residential properties owned by other individuals. As the owner of the leaking fuel oils tanks, C bears the costs of the cleanup and repair. C is required to remove the storage tanks and remediate the soil surrounding the leaking tanks pursuant to the Solid Waste Disposal Act and the Resource Conservation Recovery Act.

The costs to repair the leaking underground storage tanks and the costs to treat the soil, both at C's operations and the adjacent properties, will be borne by C. There is a remote possibility that C may be able to recover some of the clean-up costs from an insurer. The clean-up costs will be incurred over a number of years.

Financial Accounting Treatment

The cleanup of oil on C's property does not constitute a betterment because the action merely restores the property to its pre-contaminated state. The cost should therefore be expensed for financial accounting purposes. Likewise, costs incurred to clean up the oil from the adjoining properties does not create a separate asset and thus should be an expense under the EITF guidelines.

Income Tax Analysis

The costs of repairing a leaking underground storage tank and the soil remediation expenditures on both C's and the adjoining properties should be expensed. The repair of the leaking storage tank and the soil remediation expenditures do not increase the value or significantly extend the life of the assets, but merely keep them in an ordinarily efficient operating condition for their original intended use.

The costs of remediating the adjoining properties are ordinary and necessary business expenses deductible under section 162(a). These costs extinguish a liability of C's, which arose from the ordinary conduct of its business.

* Example 4 Multi-Party Dump Site Cleanup Under CERCLA

Facts

"D" us engaged in various mining operations in state A. Until five years age, hazardous and nonhazardous waste materials generated from D's operations were legally disposed of at Site Y, which was owned by another private party. Other corporations and individuals also disposed of waste at Site Y until it was filled to capacity. Based upon a review of Y by the EPA,and pursuant to EPA's authority under the Comprehensive Environmental Response. Compensation, and Liability Act of 1980 (CERCLA), site Y was selected for cleanup of the hazardous waste deposited there. D is identified as one of scores of Potentially Responsible Parties (PRPs). Based upon a consent decree negotiated with the EPA, all of the PRPs have agreed to pay a certain amount of remedies Site. The payment will be used for te remediation acitivities and no amounts will be paid for, or in lieu of, fines or penalties imposed under CERCLA or any other state or federal law. Once the amounts have been paid, D will be considered as having discharged its liabilities with respect to site Y.

Financial Accounting Treatment

For financial accounting purposes, payments made under an EPA consent degree related to Site Y should be treated as an expenses because (1) the property is not owned by D and (2) the payment settles a liability without creating an asset.

Income Tax Analysis

Remediation of the site will not directly or indirectly benefit any current assets or operations of D. The operations at Site X have been closed, and its remediation does not result in the creation of any assets of any assets owned by D.D.'s CERCLA. liability arose from prior acts undertaken in the ordinary conduct of its business. The settlement payments are ordinary and necessary business expenses deductible under section 162(a) because they extinguish D's ordinary business liability.

Amounts paid in settlement of a lawsuit are deductible if the acts giving rise to the litigation were performed in the ordinary conduct of the taxpayer's business. See Rev. Rul. 80-2011, 1980-2 C.B. 57; Rev. Rul. 78-210, 1987-1 C.B. 38; and Kornhaunser v. United States, 276 U.S. 145 (1928). D may indirectly enhance its corporate image by performing the remediation, however, an expenditure must provide more than in an direct or remote future benefit before capitalization is required. INDOPCO,Inc. v. Commissioner, 112 S. Ct. 1039 (1992); Rev. Rul. 92-80, 1992-39 I.R.B. 7.

* Example 5 Discovery of Nascent Conditions

Facts

"E" owns and operates various hotel and resort properties. In 1970, E purchased Property P and operated it as part of its hotel business. In 1992, as part of a routine maintenance inspection, E discovered that same of the machines purchased with the property were lined wit asbetos. E was unaware of the abestors in the machines at the time of purchase. As the current owner of the equipment, E is liable for asbestos removal under CERCLA, regardless of whether E had knowledge of the problem at the time of the purchase.

E considered two options to abate the asbetos. The first option involves the continuous monotoring of the airborne levels of asbestos fibers followed by encapsulation of the fibers should the emissions exceed prescribed guidelines. The second option consist of removing the asbestos from the machines and replacing it with other insulating materials. After analyzing the affected assets and the potential dangers of each option and based upon input from both state and federal agencies, E uses a combination of both methods. Under either alternative the assets would (1) serve the same purpose, (2) have the same expected useful life, and (3) not be more valuable in E's hands. Indeed, in each case where the asbestos was removed and replaced, the asset was less efficient than before.

Financial Accounting Treatment.

Where E was aware of asbestos in the machines at the time of their purchase, costs incurred within a reasonable period of time after acquisition should be capitalized as part of the costs of the acquired property subject to an impairment. EITF Abstract 89-13. Where the taxpayers was not aware of the asbestos problem at the time of acquisition, the costs would be capitalized only were betterment criteria is met - i.e., do the costs extend the life, increase the capacity, or improve the safety or efficiency of the property with its condition when originally acquired? Since neither the monitoring and encapsulation nor he removal of the asbestos meets these criteria, the costs should be expenses for financial statement purposes.

Income Tax Analysis

Removal of the asbestos and replacement with another insulating material should be treated as a repair to the property under Treas. Reg. [section] 1.162-4. The insulation does not increase the value of the property compared with its value prior to the discovery of the asbestos. Replacing the insulation material merely maintains the property in an ordinarily efficient operating condition suitable for its original purpose. Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962), nonacq. 1964-2 C.B. 8.

Assuming E exercised an appropriate level of diligence in determining the existence of asbestos at the time of its acquisition, the discovery of the asbestos is the event that triggers the decline in the value of the property. See American Bemberg Corp. v. Commissioner, 10 T.C. 361 (1948). The asbestos replacement restores the property to its original value. Therefore, the asbestos removal "keeps" the property in an ordinarily efficient operating condition.

Similarly, the monitoring and encapsulation of the asbestos does not increase the value, extend the life nor adapt the property to a new use and costs, therefore, should be allowed as an ordinary and necessary deduction under section 162(a).

NOTES

(1) See, e.g., Remarks by Stuart L. Brown, IRS Associate Chief Counsel (Domestic), to the Federal Bar Association as reported in BNA's Daily Tax Report, No. 45, at G-11 (March 10, 1993). See also Proposed 1993 Internal Revenue Service and Treasury Department Business Plan ("assess the need for guidance on the treatment of environmental clean-up expenditures"). (2) The uncertainty has been exacerbated by the technical advice memoranda's citation of the Supreme Court's decision in INDOPCO, Inc. v. Commissioner, 112 S. Ct. 1039 (1992) - especially the Court's dictum that "deductions are exceptions to the norm of capitalization." Because officials of the National Office have repeatedly assured taxpayers that the IRS views INDOPCO as not fundamentally changing the law of capitalization - they regard it as a "sheild" and not a "sword" - we have not focused our analysis on the decision. Rather, this paper focuses on how traditional tax law principles, including the matching principle that the Court invoked in INDOPCO, apply to environmental remediation expenses. (3) Thus, excluded from the analysis are the special circumstances that arise under section 468A (nuclear decommissioning costs) and section 468B (qualified settlements funds), which may be one means of funding clean-up expenditures). Also excluded are the tax issues associated with the purchase and sale of business assets with contingent liabilities for environmental clean-up costs. In addition, this paper does not address losses that qualify for an ordinary deduction under section 165. (4) Without question, there will be transitory tension between industrial or economic policy and environmental protection. All other things being equal, countries that assign a higher priority to employment than to environmental protection will attract greater manufacturing investment than countries that invert the priorities. Denying companies that benefit of tax deductions for environmental protection will attract greater manufacturing investment than countries that invert the priorities. Denying companies that benefit of tax deductions for environmental clean-up expenditures cannot help but exacervate the costs difference of doing business in the United States vis-a-vis foreign countries. (5) "Remediation" expenditures generally relate to cleaning up the incidents of past activities, whereas pollution from current ongoing acitivities are "abated" or "controlled." (6) 33 U.S.C. [sub section] 1251 - 1387. The Clean Water Act governs the discharge of oil and other pollutants into navigable waters and adjoining shorelines. Under the Act, owners and operators of vessels discharging pollutants are liable for clean-up costs and the resulting damage to natural resources. (7) 33 U.S.C. [sub section] 2623 -2761. The Oil Pollution Act of 1990 expands liability under the Clean Water Act to owners and operators of onshore facilities, pipelines, or offshore facilities exercising a right of use over a spill area. Thus, as amended by the 1990 legislation, the Clean Water Act requires parties to incur costs to clean up land and water owned or controlled by others. (8) 42 U.S.C. [sub section] 6901 - 6992k. The RCRA, enacted in 1976, gives the Environmental Protection Agency authority to take legal action to force the cleanup or other corrective action at active hazardous waste facilities irrespective of whether the facilities were in compliance with the law before the enactment of RCRA. RCRA controls the transportation, storage, treatment, and disposal of hazardous waste and regulates the use of landfulls. It also impose liability upon waste generators using the disposal sites. (9) 15 U.S.C. [sub section] 2601 - 2671. The TSCA requires owners of equipment, facilities, and other sources of PCBs to clean up spills or releases of materials containing certain concentrations of PCBs. It also requires local educational agencies (e.g., school boards) to remove material containing asbestos under certain conditions. (10) 42 U.S.C. [sub section] 9601 - 9675. CERCLA is a national decree to investigate and clean up current and abandoned hazardous waste disposal sites, and to curtail future disposal of hazardous substances at unauthorized locations. CERCLA also authorized the Superfund program. The power to enforce CERCLA is suffused among various federal agencies including the federal Emergency Management Agency and the Department of Interior. The EPA, however, has the broadest responsibility for enforcing CERCLA. (11) 29 U.S.C. [sub section] 651 - 678. (12) I.R.C. [section] 446(a) and Treas. Reg. [section] 1.446-(1(a)(1). (13) Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979). (14) Treas. Reg. [section] 1.446-1(a)(2). (15) "[T]he Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculations of net income of tax purposes." INDOPCO, Inc. v. Commissioner, 112 S. Ct. 1039, 1043 (1992), citing Commissioner v. Idaho Power Co. 418 U.S. 1 (1974). (16) Under SEC disclosure rules, public companies must adhere to the pronouncements of the FASB. In addition, companies issuing certified financial statements must comply with GAAP as prescribed by the FASB. (17) The EITF rule bears a resemblance to the Plainfield-Union rule discussed in Part VI.P.2. (18) See I.R.C. [section] 446; INDOPCO, Inc. v. Commissioner, 112 S. Ct. 1039 (1992); Commissioner v. Idaho Power Co., 418 U.S. 1, 16 (1974). (19) 72 T.C. 1 (1979). (20) See Southeastern Mail Transport, Inc. v. Commissioner, T.C. Memo. 1992-252. (21) Lincoln Savings & Loan v. Commissioner, 403 U.S. 345, 352 (1971). (22) 290 U.S. 111 (1933). (23) Id. at 114. (24) An ordinary expense means "normal, usual or "customary." Deputy v. DuPont, 308 U.S. 488, 495 (1940). A one-time expenditure in the life of a taxpayer qualifies as ordinary for purpose of section 162 provided the "transaction which gives rise to it. . . [is] . . . of common of frequent occurrence in the type of business involved." Id. (25) 4 B.T.A. 103 (1926). (26) Id. at 106. (27) 39 T.C. 333 (1962), nonacq. 1964-2 C.B. 8. (28) Id.at 338 (emphasis added). (29) In American Bemberg Corp. v. Commissioner, 10 T.C. 361 (1948), nonacq. 1948-2 C.B. 5, aff'd, 177 F.2d 200 (6th Cir. 1949), the taxpayer's plant was built over a fault in the bedrock. The taxpayer expended $734,000 in 1941 and $199,000 in 1942 in drilling and filing the void with grout. The court determined that, although the condition may have existed for years, the taxpayer as unable to discover the abnormal sub-surface conditions at any earlier date. It therefore permitted the taxpayer to deduct as repairs expenditures that were substantial in relation to the cost of the building. (30) See, e.g., Oberman v. Commissioner, 47 T.C. 471 (1967); Hudlow v. Commissioner, 30 T.C.M. 894 (1971); Mennuto v. Commissioner, 56 T.C. 910 (1971). (31) The soil remediation ruling contains the astounding reductio ad absurdum that any replacement would be deductible under the Plainfield-Union formulation of the increase-in-value test. Obversely, should the IRS be successful in consigning Plainfield-Union to the dustbin of history, all repairs would become capital. (32) 112 S. Ct. 1039 (1992). (33) Id. at 1044-1045. (34) 289 F.2d 444 (3d Cir. 1961). (35) Id. at 448-449. (36) See Plainfield-Union Water Co. v. Commissioner, 39 T.C. at 338. (37) G.C.M. 36828 (September 1, 1976). See Rev. Rul. 79-66, 1979-1 C.B. 114 (the cost of removing lead-based paint from areas accessible to children in their homes is deductible as a personal medical expense, regardless of the potential increase in the value of the residence). (38) "The evidence shows that these expendistures did not add value of prolong the expected life of the property over what they were before the event which made the repairs necessary occurred." 4 B.T.A. 103, 107 (1926) (emphasis added). (39) 14 T.C. 635 (1950), acq. 1950-2 C.B. 3. (40) Id. at 641 (emphasis added). (41) 39 T.C. at 341. (42) 20 T.C. 937 (1953) (43) Bloomfield Steamship Co. v. Commissioner, 33 T.C. 75, 83 (1959), aff'd, 285 F.2d 431 (5th Cir. 1961). (44) See, e.g., R.R. Hensler v. Commissioner, 73 T.C. 168 (1979) ($1.4 million spent to repair equipment costing $2.4 million held deductible), acq. 1980-2 C.B. 1; American Bemberg Corp. v. Commissioner, 10 T.C. 361 (1948) (approximately $900,000 expended over two years to fill void beneath a $7 million building held deductible), aff'd, 177 F.2d 200 (6th Cir. 1949); and Buckland v. United States, 66 F. Supp. 681 (D. Conn. 1946) (expenditures to stop leaks in a factory building held deductible despite total cost of 35 percent of the building cost). (45) 10 T.C. 361 (1948), aff'd, 177 F.2d 200 (6th Cir. 1949). (46) Id at 370 (emphasis added). (47) 25 T.C. 272 (1955), aff'd 238 F.2d 85 (6th Cir. 1956). (48) Id. at 275. (49) 400 F.2d 686 (10th Cir. 1968). (50) Id. at 689. (51) Id. at 690. (52) The doctrine is generally invoked in cases involving a series of extensive repairs to rehabilitate dilapidated buildings. In Mountain Fuel Supply Co. v. United States, 449 F.2d 816 (10th Cir. 1971), the Tenth Circuit applied the doctrine to a taxpayer that dug up 40 miles of a gas pipeline for straightening, cleaning, and spot-welding. A significant portion of the opinion, however, delves into the factual record that established that the reconditioned pipe would have a substantially new period of expected life and an improved pressure capacity. In other words, the expenditures met at least two of the three prongs for capitalization. Mountain Fuel Supply should be contrasted with Niagara Mohawk Power Corp. v. United States, 558 F.2d 1380 (Ct. Cl. 1977) where a taxpayer undertook to repair leaks to approximately six percent of the joints on the pipeline. The Claims Court permitted the taxpayer to deduct the costs incurred as repairs. (53) Estate of Walling v. Commissioner, 373 F.2d 190 (1967). (54) Likewise, entering into a consent decree to settle an environmental liability does not create a "plan of rehabilitation." A consent decree simply memorializes the agreement of the parties and the work to be performed. (55) 24 T.C. 563 (1955), aff'd, 242 F.2d 616 (5th Cir. 1957). (56) Id. at 620. (57) 18 B.T.A. 1008 (1930). (58) Id. 1010. (59). See e.g., Moss v. Commissioner, 831 F.2d 833 (9th Cir. 1987); Kaonis v. Commissioner, 37 T.C.M. 792 (1978), aff'd mem., 639 F.2d 788 (9th Cir. 1981); and Keller Street Development Co. v. Commissioner,47 T.C. 559 (1961), acq. 1962-2 C.B. 5, aff'd in part rev'd in part on other grounds, 323 F.2d 166 (9th Cir. 1963). (60) 72 T.C. 1 (1979). (61) Id. at 8. (62) The court accepted that taxpayer's contention that capitalization (and amortization) was proper because:

The subject expenditures are part of a

systematic plan under which most of

the earthworks on the ranch will be

draglined. Thus, the dragline expenditures

have a significant impact on the

value of the system. . . . We also believe

that to the extent the expenditures have

the effect of replacing the previously

waste intangible created by the last

draglining of the subject ditch or levee,

they have a subtantial impact on the

value of the system, as well as producting

a separate item of value. . . .

Secondly, we consider important the

fact that the expenditures in issue produce

an item of value which is not used

up by the end of the taxable year in

which made. Indeed, many of these expenditures

produce value which is used

up only gradually over the course of up

to 30 years. Thirdly, these expenditures

will affect the ranch's production of income

for up to 109 years. Finally, we

note that the item of value produced

wastes over a predetermined useful life.

. . . In summary, these expenditures are

more than merely "incidental." They

are, rather, in the nature of capital "replacement"

expenditures which must be

capitalized and amortized over its appropriate

useful lives." Id. at 17. (63) Wolfsen is an aberrant case from an number of perspectives. First, the taxpayer did not argue for a deduction in the case. Indeed, it stipulated to capitalization and sought instead to establish an appropriate period for depreciation or amortization of the costs. Second, the government's theory in the case is unclear, but it appears that it argued that the improvements should have been deducted when incurred. The unusual features of the case perhaps explain why subsequent cases rarely cite Wolfsen, particularly for distinguishing between repairs and capital expenditures. (64) 403 U.S. 345 (1971). (65) Id. at 359. The Supreme Court in INDOPCO narrowed other aspects of the Lincoln Savings decision. Lincoln Savings, however, remains unchanged for the proposition that payments mandated by law are not per se capital expenditures. (66) 14 T.C. 635 (1950), acq. 1950-2 C.B. 3. (67) See, e.g., Teitelbaum v. Commissioner, 294 F.2d 541 (7th Cir. 1962), cert. denied, 368 U.S. 987 (1965); Hotel Sulgrave, Inc. v. Commissioner, 21 T.C. 619 (1954); RKO Theatres, Inc. v. United Staes, 163 F. Supp. 598 (Ct. Cl. 1958). (68) 21 T.C. 619 (1954). (69) 163 F. Supp. 598 (Ct. Cl. 1958). (70) 294 F.2d 541 (7th Cir. 1962), cert denied, 368 U.S. 987 (1965). (71) Id. at 544. (72) The Teitelbaum case is anamalous for another reason. Even though (as the dissenting opinion pointed out) the Tax Court had found that the payments had not increased the value of the buildings, prolonged its life, or adapted it to a different use, the majority of the 7th Circuit found that the modifications made the property "more valuable." 294 F.2d at 544. (73) Arguably, the more modern A.C.-based electrical system would increase the demand for the building and the future rental income. (74) See, e.g., Ohio River Collieries Co. v. Commissioner, 77 T.C. 1369 (1981); Denise Coal Co. v. Commissioner, 271 F.2d 930 (3d Cir. 1959); Harrold v. Commissioner, 192 F.2d 1002 (4th Cir. 1951).
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Date:Jul 1, 1993
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