January 30, 2006
Mr. Eric Solomon
Acting Deputy Assistant Secretary (Tax Policy)
Department of Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220
Mr. Donald Korb
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20044
Mr. Thomas Barthold
Acting Chief of Staff
Joint Committee on Taxation
1015 Longworth
Washington, DC 20515
Re: Rev. Rul. 2005-42 Capitalization of Environmental Remediation Expenditures
Dear Messrs. Solomon, Korb and Barthold:
The American Institute of Certified Public Accountants (AICPA) offers the attached comments
to highlight our significant tax policy and administrative concerns regarding Rev. Rul. 2005-42,
which generally requires capitalization of environmental remediation expenditures under section
263A. These comments were developed by the AICPA’s Tax Accounting Technical Resource
Panel and approved by the Tax Executive Committee.
The AICPA believes that environmental remediation costs should not be capitalized under
section 263A. If capitalization is used, Rev. Rul. 2005-42’s analogy of remediation costs to
repair expenses is incorrect. Finally, even if this analogy is correct, some fact patterns in Rev.
Rul. 2005-42 treat remediation costs inconsistently with repairs. We are also concerned that the
procedural rules for filing accounting method change applications to conform to this ruling using
a cut-off method do not provide adequate time for taxpayers to respond.
We appreciate your consideration of these comments. If you have any questions, please contact
me at tpurcell@creighton.edu; Christine Turgeon, Chair, AICPA Tax Accounting Technical
Resource Panel, at christine.turgeon@us.pwc.com; or George White, AICPA Technical
Manager, at gwhite@aicpa.org.
Sincerely,
Thomas J. Purcell III
Chair, AICPA Tax Executive Committee
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Revenue Ruling 2005-42
Requiring Capitalization of Environmental Remediation Expenditures
Developed by the
Rev. Rul. 2005-42 Task Force
Les Schneider
Jan Skelton
Barry Tovig
Christine Turgeon
George White, AICPA Technical Manager
January 30, 2006
2
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Revenue Ruling 2005-42 Requiring Capitalization of Environmental
Remediation Expenditures
In Rev. Rul. 2004-18, 2004-1 C.B. 509, the Internal Revenue Service and Treasury Department
determined that costs incurred to clean up land that a taxpayer contaminated with hazardous
waste by operation of the taxpayer’s manufacturing activities on that site are includible in
inventory costs under section 263A. In Rev. Rul. 2005-42, 2005-28 I.R.B. 67, the IRS and
Treasury further concluded that such environmental remediation costs are properly allocable
under section 263A to the inventory produced during the taxable year in which the costs are
incurred. Importantly, the IRS reached the same conclusion in all five fact patterns of this ruling
where the taxpayer (1) currently manufactures the same product at the contaminated site; (2)
currently manufactures a different product at the site than it produced at the time of the
contamination; (3) temporarily idles the site during the remediation; (4) permanently ceases
manufacturing activities at the contaminated site; or (5) contaminates a remote third-party site no
longer used to dispose waste from its manufacturing activities. Both rulings provide procedural
rules for filing an application to change a taxpayer’s method of accounting to comply with the
conclusions in the rulings.
As explained in the following comments, it is the position of the AICPA that treating
environmental remediation costs as subject to capitalization under section 263A is an unwise
policy decision and a specific exclusion should be provided for such costs. Moreover, even if it
is concluded that subjecting environmental remediation costs to section 263A is appropriate as a
policy matter, we believe it is incorrect to analogize environmental remediation costs to repair
expenses as done in Rev. Rul. 2005-42. In addition, even if the government were to determine
that all (or certain types of) environmental remediation costs should properly be treated in the
same manner as repair costs for purposes of section 263A, we question whether the treatment of
environmental remediation costs in certain of the facts patterns in Rev. Rul. 2005-42 is consistent
with the treatment of repairs. Finally, the AICPA also is concerned that the procedural rules
provided in Rev. Rul. 2005-42 for filing accounting method change applications to conform to
the rulings and to effect a change using a cut-off method did not provide adequate time for
taxpayers to respond.
1.
Substantive Issues
A. Requiring capitalization of environmental remediation costs under section 263A is
an unwise policy decision.
We believe that the rationale for capitalizing environmental remediation costs has previously
been considered by the IRS and Treasury and such capitalization has been rejected as unwise as a
policy matter. For example, the conclusion that environmental remediation costs must be
capitalized under section 263A is inconsistent with the policy decision articulated in Rev. Rul.
94-38, 1994-1 C.B. 35, that such costs are deductible as ordinary and necessary business
expenses under section 162. In Rev. Rul. 94-38, the IRS and Treasury Department concluded
3
that costs a taxpayer incurred to remediate soil and to treat groundwater that it contaminated with
hazardous waste from its business were deductible section 162 expenses. In reaching its
conclusion with respect to the soil remediation and groundwater treatment costs, the IRS and
Treasury Department noted that the Internal Revenue Code “generally endeavors to match
expenses with the revenues of the taxable period to which the expenses are properly attributable,
thereby resulting in a more accurate calculation of net income for tax purposes.” The IRS and
Treasury Department found that the soil remediation and groundwater treatment expenses did not
permanently improve the taxpayer’s land, nor did they provide significant future benefits.
Instead, the IRS and Treasury Department found that the expenditures were “appropriate and
helpful in carrying on the taxpayer’s trade or business and were commonly and frequently
required” in the taxpayer’s particular business.
Rev. Rul. 94-38, confirming the current deductibility of environmental remediation costs, was
published shortly after several revenue raising measures were proposed and considered by the
House of Representatives Ways and Means Committee in the early 1990s. One such proposal
included a “clarification” of the treatment of environmental remediation expenditures, including
a requirement that all environmental remediation expenditures be subject to capitalization under
section 263(a) and amortized over a specified period. Hearings were held before the
Subcommittee on Select Revenue Measures, Committee on Ways and Means, in the summer of
1993. Leslie Samuels, then Assistant Secretary (Tax Policy) at the Department of Treasury,
testified that the proposal to require capitalization of environmental remediation costs was
“under study,” and that the Treasury was considering “appropriate ways to reduce the potentially
large costs likely to be incurred by the IRS and taxpayers in resolving disputes over the proper
treatment of these costs.”1
Several coalitions of taxpayers, representing a variety of industries, also testified at the hearings
and urged the Subcommittee that, if the treatment of environmental remediation expenditures
were to be clarified, any such clarification should confirm that the costs are currently deductible
under current law, and should remain deductible. The testimony consistently noted that
requiring capitalization of environmental remediation costs would not result in a clear reflection
of income because it would result in associating costs incurred for past activities with future
income. In fact, as one party testified, “[e]nvironmental remediation costs as a general matter
relate only to prior activities of the taxpayer or a previous property holder and do not provide an
ongoing benefit beyond that associated with the general welfare of the environment.”2 Similarly,
another party noted that “most environmental cleanup costs are ‘backward looking’ – they relate
to past events, and to income that was generated in the past, not to income that will be produced
in the future.”3 The testimony collectively emphasized that environmental remediation
1
Statement of Leslie B. Samuels, Assistant Secretary (Tax Policy), Department of Treasury, before the
Subcommittee on Select Revenue Measures, Committee on Ways and Means, September 21, 1993.
2
Statement of Roy H. Hock on behalf of The Coalition to Preserve the Current Deductibility of Environmental
Remediation Costs Regarding Proposals to Clarify the Treatment of Environmental Remediation Costs before
the Subcommittee on Select Revenue Measures, Committee on Ways and Means, U.S. House of
Representatives, September 23, 1993.
3
Statement of Wayne Robinson on behalf of The Coalition for the Fair Treatment of Environmental Cleanup
Costs Regarding Proposals to Clarify the Treatment of Environmental Remediation Costs, September 23, 1993.
4
expenditures, are by their very nature, costs incurred to eradicate damage caused to the
environment in the past. The testimony concluded that a deduction in the taxable year in which
the costs are incurred clearly reflects income because there is no benefit to which the costs will
relate in the future. The Subcommittee, through its comments during the testimony, seemed to
recognize that current law at the time provided appropriate treatment of environmental
remediation expenses (i.e., that current law provided for a determination of which costs were
currently deductible and which required capitalization), and that further legislative action was
not needed.4
In addition to its inconsistency with the matching concept, the conclusion in Rev. Rul. 2004-18
and Rev. Rul. 2005-42 that environmental remediation costs are subject to IRC 263A is
inconsistent with many provisions of the Code that are intended to encourage environmental
cleanup, including sections 172(f), 198 and 468B. For example, section 172(f) allows a 10-year
carryback of net operating losses attributable to amounts allowable as a deduction in satisfaction
of a liability under Federal or State law requiring the remediation of environmental
contamination. To be eligible for the 10-year carryback, the expenditure must be a currently
deductible expense. If environmental remediation costs are capitalized under section 263A, such
costs will no longer be currently deductible. Instead, the costs will be recovered through costs of
goods sold for inventory or through depreciation for self-constructed assets. The conclusions in
Rev. Ruls. 2004-18 and 2005-42 effectively preclude taxpayers from applying section 172(f) to
environmental remediation costs. As a result, the rulings have the effect of writing this aspect of
section 172(f) out of the Code.
Section 198 allows a current deduction for qualified environmental remediation expenditures,
which generally are expenditures that otherwise would be chargeable to a capital account that are
paid in connection with the abatement or control of hazardous substances at a qualified
contamination site. Rev. Rul. 2005-42 avoided any literal inconsistency with section 198 by
stipulating as a factual matter that none of the expenditures at issue in the ruling qualify under
section 198. As a result, it is unclear whether the analysis and conclusion in Rev. Rul. 2005-42
would apply to require capitalization of qualified environmental remediation expenditures under
section 263A to the extent the expenditures relate to the taxpayer’s production activities, thereby
circumventing Congressional intent to allow an immediate deduction for such expenditures
under section 198.
Section 468B provides a deduction for payments to qualified settlement funds (QSF). Under
section 468B, economic performance is satisfied in the taxable year in which a taxpayer makes a
transfer to a QSF in satisfaction of a liability. Taxpayers frequently establish QSFs to satisfy
environmental liabilities. Taxpayers have previously been allowed current deductions under
section 162 for transfers to QSFs established to satisfy environmental liabilities based on the IRS
and Treasury Department’s conclusion in Rev. Rul. 94-38 that remediation costs were currently
deductible. The conclusions in Rev. Rul. 2004-18 and Rev. Rul. 2005-42 now call the current
deduction permitted by section 468B into question.
4
Hearing before the Subcommittee on Select Revenue Measures, Committee on Ways and Means, September
21, 1993.
5
In summary, we believe that the decision to require capitalization of environmental remediation
costs by subjecting them to section 263A represents unwise tax policy. Therefore, we
recommend that the Treasury Department use its regulatory authority under section 263A to
specifically exclude all environmental remediation costs from the scope of section 263A similar
to the regulatory exclusion provided for product liability and warranty costs, and then withdraw
Rev. Rul. 2004-18 and Rev. Rul. 2005-42.5 Alternatively, to the extent the government feels it is
bound by section 263A to require capitalization of these costs, the AICPA recommends that
legislation be passed to exclude environmental remediation costs from section 263A to ensure
the proper tax policy result as discussed above is achieved.
B. Environmental remediation expenditures should not be viewed as repairs.
The centerpiece of the rationale in Rev. Rul. 2004-18 and Rev. Rul. 2005-42 that environmental
remediation expenditures should be treated as section 263A costs is that they are analogous to
repairs. However, this analogy is flawed. The reason that repair costs are treated as section
263A costs is that the repairs are necessary to keep production machinery functioning so that
additional inventory may be produced in the current period in which the repairs take place. This
reasoning is not applicable to most environmental remediation costs. Most environmental
remediation costs are designed to correct pollution that occurred in the past as a result of
production in the past of goods that are sold by the time that the remediation occurs. This type
of environmental remediation is just like the expense a taxpayer incurs in repairing a defective
product that the taxpayer previously produced and sold. Under the existing UNICAP
regulations, such warranty expenses are not treated as section 263A costs.6
Thus, the major flaw in Rev. Rul. 2004-18 and Rev. Rul. 2005-42 in our view is that the rulings
fail to differentiate between two major types of environmental remediation – remediation
designed to correct for prior pollution and having no impact on current and future production and
remediation incurred to enable a manufacturing plant to continue producing in the future. We
argue that the former type of remediation should be treated as a non-production cost excludible
from section 263A, but agree that the latter type of remediation is analogous to repairs and,
absent a specific exclusion for such costs, should be treated consistently with repairs for
purposes of section 263A. However, we do not believe that most environmental remediation
falls into this category. Moreover, we do not see such a distinction being drawn in the examples
in Rev. Rul. 2005-42. On the contrary, Situations 1, 2 and 3 of Rev. Rul. 2005-42 do not provide
that capitalization is required only to the extent that the remediation is necessary to continue
operating the manufacturing plant at the contaminated site. Similarly, Situations 4 and 5 in Rev.
Rul. 2005-42 specifically require capitalization of costs incurred to cleanup environmental
contamination at a closed plant and a third party landfill, respectively, even though neither
remediation could possibly benefit current production.
5
Reg. section 1.263A-1(e)(3)(iii)(H). Presumably product liability and warranty costs are specifically excluded
from section 263A because they more properly relate to goods that have been sold in prior years, similar to
environmental remediation costs.
6
See reg. section 1.263A-1(e)(3)(iii)(H).
6
C. Treating environmental remediation as a production cost of the period in which
they are incurred is improper.
Even if the government determines that all (or certain types of) environmental remediation costs
are properly treated as analogous to repairs, we do not believe that treatment means that all such
remediation costs should be allocated to inventory produced in the period in which they are
incurred. A fundamental underpinning of section 263A is activity-based costing, under which
indirect costs are traced to the activity to which they relate in order to determine the pool of
inventoriable costs that are then allocated between ending inventory and cost of goods sold.7
Environmental remediation costs are not like general overhead costs that cannot be traced to
particular activities. On the contrary, environmental remediation costs are capable of being
traced to production at the plant to which the remediation relates. Thus, for example, costs
incurred to remediate one plant do not benefit inventory that is produced at another plant
(contrary to the conclusion reached in Situation 4 of Rev. Rul. 2005-42). Moreover, remediation
costs incurred at a plant where nothing further will be produced because the plant is closed (a not
uncommon situation) should not be allocated to inventory produced at a different plant which is
not being remediated (contrary to the conclusion reached in Situation 4 of Rev. Rul. 2005-42).
Finally, costs incurred to remediate a third party landfill no longer used by a taxpayer do not
benefit inventory produced at the taxpayer’s manufacturing plant (contrary to the conclusion
reached in Situation 5). Recognizing that tracing costs in the foregoing cases may only be
permissible for taxpayers using a facts-and-circumstances type of allocation method under
section 263A, we believe that the remediation costs in the foregoing circumstances should
simply be classified as non-production costs.
You will note that nowhere in this analysis are we advocating that environmental remediation
costs be treated as “retrospective production costs” similar to the floor stock costs at issue in
Rev. Rul. 2001-8, 2001-3 C.B. 726. After much consideration of this alternative, we believe that
environmental remediation costs are different from retrospective production costs. We believe
that the category of costs classified as retrospective production costs should be reserved for costs
that are economically incurred during the production process, but are not treated as incurred for
tax purposes under the “all-events” test and/or the economic performance requirement until a
later taxable year, such as post-employment benefits. In addition, corrections in the current year
of production costs incurred in a prior year and retrospective adjustments of the cost of prior
production, such as the case in Rev. Rul. 2001-8, warrant such treatment. In contrast, most
environmental remediation costs incurred at a particular plant generally were not known at the
time of production and thus cannot be traced to, or be related to, specific goods produced at that
plant in prior periods. Accordingly, we do not believe that environmental remediation costs
should be treated as retrospective production costs. Rather, as explained above, we believe
environmental remediation costs simply should be treated as non-production costs.
7
See reg. section 1.263A-1(c) and reg. section 1.263A-1(g)(3).
7
II.
Procedural Issue
Rev. Rul. 2005-42, issued on June 20, 2005, effectively required taxpayers to implement a
method change pursuant to the automatic consent procedures in Rev. Proc. 2002-9 for their first
taxable year ending after February 6, 2004, if they wished to use a cut-off transition method.
Many taxpayers had already filed a tax return for such year before Rev. Rul. 2005-42 was issued.
Moreover, many other taxpayers had planned to file or did file their 2004 tax return shortly after
Rev. Rul. 2005-42 was issued. These taxpayers had inadequate time to make the computations
necessary to effectuate the required change for their 2004 taxable year. Alternatively, a taxpayer
could implement the change on a cutoff basis using a two-step approach, under which Rev. Rul.
2004-18 is implemented for 2004 and Rev. Rul. 2005-42 is implemented for 2005, but generally
only if action was taken within 30 days (i.e., by July 20, 2005), a time which had expired long
before many taxpayers (especially smaller, less-sophisticated taxpayers) knew that Rev. Rul.
2005-42 was issued. Rev. Rul. 2005-42 simply provided inadequate notice to make a cutoff
change in a timely fashion. Accordingly, we strongly request that taxpayers be permitted to
implement the change for their 2005 taxable year and still be eligible for the cut-off transition
method.
We understand that the IRS response to the foregoing argument is that taxpayers had adequate
notice of what was required as a result of the issuance of Rev. Rul. 2004-18. However, it has
been our experience that virtually no taxpayer took action, or planned to take action, for their
2004 taxable year because it was publicly announced that the IRS was reconsidering Rev. Rul.
2004-18, and it was unclear to taxpayers whether the IRS would clarify it, change it or revoke it.8
In addition, the situations in Rev. Rul. 2005-42 in which capitalization of environmental
remediation costs was required, and the manner in which such costs were required to be
capitalized, was well beyond what many taxpayers expected in interpreting the limited
conclusion in Rev. Rul. 2004-18.
In view of the foregoing circumstances, we recommend (if the ruling is not revoked or modified
as suggested in this letter) that the IRS and Treasury should permit taxpayers to file a Form 3115
to comply with Rev. Ruls. 2004-18 and 2005-42 with a choice of section 481 or cut-off method
for the first taxable year ending after June 20, 2005.
8
This understanding was based on public comments of government officials that Rev. Rul. 2004-18 left
unresolved the issue of whether environmental remediation costs are to be included in the cost of goods
produced in the year the expenditures are incurred or whether they should be associated with the cost of goods
produced in the year the waste was discharged (and thus generally deducted in the year incurred). Moreover,
the IRS and Treasury Priority Guidance Plan included a project to address Rev. Rul. 2004-18 titled “Guidance
regarding the treatment of post-production costs under section 263A.”
8