Environmental Remediation Denied Sec. 1341 Relief Again

A’s manufacturing operations generate waste byproducts that are disposed of in the ordinary course of business. From 1940–1987, A included its waste disposal costs in computing its costs of goods sold for both financial accounting and Federal income tax purposes. During 1993, it was required by state and Federal authorities to conduct environmental remediation activities for waste byproducts generated in the 1940–1987 tax years. It was entitled to deduct a significant portion of those costs.

A contends that if it treats the environmental remediation costs as deductible in 1993, rather than allocable to 1940–1987, it will not receive the full tax benefit because of the tax rate differences during the relevant years.

Analysis

A argues that Sec. 1341 allows it to claim a deduction in 1993 at the same tax rate as it paid on the underlying gross income it reported in the years 1940–1987. It argues that the holding in Pennzoil-Quaker State Co., 62 Fed. Cl. 689 (2004), is exactly on point and should control the outcome of this case.

Sec. 1341 provides that if:

(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;

(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and

(3) the amount of such deduction exceeds $3,000, then the tax imposed by this chapter for the taxable years shall be the lesser of the following:

(4) the tax for the taxable year computed with such deduction; or

(5) an amount equal to

(A) the tax for the taxable year computed without such deduction, minus

(B) the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).

Under an “inventory exception,” Sec. 1341(a) does not apply to any deduction for an item that was included in gross income by reason of the sale or other disposition of stock in trade, inventory or property held by the taxpayer primarily for sale to customers; see Sec. 1341(b)(2).

This is an issue of first impression in the Third Circuit. However, the Pennsylvania District Court was persuaded by the logic and reasoning of Reynolds Metals Company, 389 FSupp2d 692 (ED VA 2005). That case concluded that later-incurred environmental remediation costs could not be deducted for past sales under Sec. 1341, which was the identical issue presented in the instant litigation.

The facts, issues and arguments in Reynolds are virtually identical to those in this case. In 1999, Reynolds filed refund claims for 1992–1995 totaling $22.3 million, in an attempt to recoup taxes paid during the years 1940–1987. It argued that, from 1940 through 1987, it used waste disposal practices in connection with its aluminum manufacturing operations that met prevailing standards. In the years 1992 through 1995, Reynolds incurred substantial environmental remediation costs in an effort to remediate contaminated areas, which resulted from its prior waste disposal practices. The Reynolds court determined, however, that its claim was “fundamentally at odds with what a taxpayer should expect to gain from section 1341 because Reynolds did not restore or repay an item previously included in gross income when it incurred environmental remediation costs from 1992 to 1995” (Reynolds, 389 F Supp2d at 704). The court did not “need to reach the issue of whether the inventory exception bars Reynolds’ claim because Reynolds has not demonstrated that it is entitled to relief under subsection (a) of section 1341” (Id. at 703).

The Pennsylvania District Court agreed with the Reynolds decision and adopted it as its own. Thus, it held that A could not establish that the 1993 environmental remediation costs were an allowable deduction for an item of income over which A appeared to have an unrestricted right as required by Sec. 1341(a).

Alcoa, Inc., WD PA, No. 203CV0626, 12/23/05

REFLECTIONS:: Last year, in Rev. Rul. 2004-17, the IRS similarly ruled that current-year costs for remediation of prior-year contamination did not qualify for Sec. 1341 treatment. In Pennzoil, a subsequent case relied on by A, the Federal Claims Court allowed a coal-mining company Sec. 1341 treatment of current-year price-fixing settlement payments for previously reported oil sales income.