On July 3, 2008, the Internal Revenue Service (“IRS”) announced its current legal theory regarding costs incurred or amounts paid for the performance of Supplemental (Beneficial) Environmental Projects (“SEPs”) or similar environmentally-beneficial projects under federal or state law that involve the acquisition or construction of property to be owned by the taxpayer (“SEP-related costs”). Using a public policy argument, the IRS has concluded that these SEP-related costs are analogous to nondeductible fines and penalties and, therefore, the costs cannot be added to the tax basis of the asset produced. In other words, the IRS is denying a corporation the right to recover certain SEP-related costs either through a current deduction, through annual depreciation deductions, or upon ultimate disposition of the property.
Overview of SEPs
In settling environmental enforcement cases, the U.S. Environmental Protection Agency (“EPA”) requires the alleged violators to achieve compliance with Federal environmental laws and regulations and, in many cases, to pay a monetary penalty in order to deter noncompliance. To further the goals of protecting and enhancing public health and the environment, the EPA encourages the use of SEPs as part of settlements and, if a SEP is performed, EPA may reduce the proposed monetary penalty. However, the SEP must be consistent with EPA’s SEP Policy (eff. May 1, 1998). The SEP Policy provides that the SEP must be voluntary. In other words, the SEP must be in addition to what the alleged violator is required to do to return to compliance and must not be otherwise required by federal, state or local law or regulation. Also, the SEP must be undertaken as part of the settlement; projects that have already begun or that the alleged violator had previously committed to perform are not eligible for consideration. Further, while the EPA usually provides oversight over the SEP to ensure that the project is fully implemented, EPA may not receive, manage, or control any funds set aside for the SEP and may not manage or administer the SEP. Last, there must be some relationship between the underlying violation being settled and the health or environmental benefit that will result from the SEP.
The EPA recognizes seven categories of projects that can be acceptable SEPs: pollution prevention, pollution reduction, public health, environmental restoration and protection, environmental audits, environmental compliance training, and emergency planning and preparedness. Examples of pollution prevention and reduction SEPs include modifications to production processes and the replacement, improvement, or addition of pollution control technologies. Environmental restoration and protection SEPs may include, among other things, purchasing property for conservation purposes or restoring damaged habitat.
IRS’ Classification of SEP-Related Costs as a Tier 1 Issue
Many state environmental agencies have adopted policies and procedures similar to EPA’s SEP Policy and allow for SEPs as part of the settlement of a state environmental enforcement action. The tax treatment of SEP-related costs has been classified by the IRS as a “Tier I” issue as part of its initiative to identify, prioritize, and resolve what it believes to be significant compliance issues. Tier I issues (as opposed to Tier II or Tier III issues) are considered to be of the highest strategic importance and to have a significant impact on one or more industries. Typically, an issue is classified as a Tier I issue because it may affect a large number of taxpayers, it represents a significant dollar risk, there is a substantial compliance risk, and the issue is highly visible.
Because the IRS believes that the resolution of a Tier I issue is of critical compliance importance, all audits of SEP-related costs will be conducted under the oversight and control of an Issue Management Team and all audit teams are required to address the SEP issue in accordance with established guidance and strategies. In July 2008, the IRS issued this guidance in the form of a “coordinated issue paper,” which sets forth the IRS’ current legal position and which is intended to ensure uniform application of this position by the audit teams to all SEP-related costs.
IRS’ Current Position Regarding the Taxation of SEP-Related Costs
Under the most basic tax principles, a corporation is entitled to take a current deduction for expenses incurred in the ordinary course of its trade or business. I.R.C. § 162. However, in lieu of a current deduction, a corporation must capitalize the costs incurred for new buildings or permanent improvements and the direct and certain indirect costs of producing property. I.R.C. §§ 263 and 263A. These capitalized costs are added to the tax basis of the property and recovered either through amortization or depreciation deductions over time or upon the ultimate disposition of the property.
Where a corporation has incurred costs to construct an environmental project, such costs should qualify as capital expenditures under I.R.C. §§ 263 and 263A. The IRS, however, takes the position that the SEP-related costs cannot be added to the tax basis of the property because of an exception in I.R.C. § 263A. Under this exception,
any cost which (but for section 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale under section 263A and the regulations thereunder. Thus, for example, if a business meal deduction is limited by section 274(n) to 80 percent of the cost of the meal, the amount properly allocable to property produced or acquired for resale under section 263A is also limited to 80 percent of the cost of the meal.
Treas. Reg. § 263A-1(c)(2); see also I.R.C. § 263A(a)(2). According to the IRS, the Internal Revenue Code provision that precludes SEP-related costs from being considered in the computation of taxable income is I.R.C. § 162(f), which provides that there is no deduction for “any fine or similar penalty paid to a government for the violation of any law.” The IRS, however, concedes that I.R.C. § 162(f) applies only to current deductions and not to capital expenditures such as SEP-related costs and, by its own terms, cannot apply to deny a tax benefit for these costs.
As a result of this concession, the IRS position hinges on two presumptions: (i) SEP-related costs are “analogous” to nondeductible fines and penalties under I.R.C. § 162(f) and (ii) an analogy is a sufficient basis for applying the statutory exception to deny a corporation’s right to recover its costs. As to the first presumption, the costs at issue are not paid to the government as required under I.R.C. § 162(f). Indeed, under EPA’s SEP Policy, a project that provides funding or resources to EPA or another federal agency is not eligible for consideration as a SEP. More importantly, the IRS’ position ignores the fact that the SEP Policy states that the purpose of monetary penalties is to “deter noncompliance” and that the legislative history of I.R.C. § 162(f) states that payments made to ensure compliance are deductible. As to the second presumption, the clear statutory language of I.R.C. § 263A(a)(2) is not satisfied and this provision does not otherwise include or rely on a public policy based argument. As a result, the merits of the IRS’ current position are not well established, and no court has agreed with this position.
Corporations that are engaging in SEPs or have engaged in SEPs should be aware that the IRS is likely to challenge the tax treatment of the SEP-related costs upon audit of the applicable tax returns. In either instance, corporations should consult with counsel to discuss the IRS’ position and any developments in the tax law.