rr-04-18.pdf

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Part I

Section 263A.BCapitalization and Inclusion in Inventory Costs of Certain Expenses

26 CFR 1.263A-1: Uniform capitalization of costs.
(Also ' 162.)

Rev. Rul. 2004-18

ISSUE

Are costs incurred to clean up land that a taxpayer contaminated with hazardous
waste by the operation of the taxpayer=s manufacturing plant includible in inventory
costs under ' 263A of the Internal Revenue Code?

FACTS

X, a corporation using an accrual method of accounting, owns and operates a
manufacturing plant that produces property that is inventory in X=s hands. X's
manufacturing operations discharge hazardous waste. In the past, X buried this waste
on portions of X=s land. The land was not contaminated by hazardous waste when
purchased by X.

In order to comply with applicable federal, state, and local environmental
requirements, X incurs costs (within the meaning of ' 461(h)) to remediate the soil and
groundwater that had been contaminated by the hazardous waste, and to establish an
appropriate system for the continued monitoring of the groundwater to ensure that the
remediation removes all hazardous waste. The costs X incurs are not research and
experimental expenditures within the meaning of ' 174 or environmental management
policy costs. The soil remediation and groundwater treatment restores X's land to
essentially the same physical condition that existed prior to the contamination. During
and after the remediation and treatment, X continues to use the land and operate the
plant in the same manner as X did prior to the cleanup except that X disposes of any
hazardous waste in compliance with environmental requirements.

LAW

Section 263A(a) provides that the direct costs and indirect costs properly allocable to
property that is inventory in the hands of the taxpayer shall be included in inventory
costs.

Section 1.263A-1(a)(3)(ii) of the Income Tax Regulations provides, in part, that
taxpayers that produce tangible personal property must capitalize (1) all direct costs of
producing the property, and (2) the property=s allocable share of indirect costs.

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Section 1.263A-1(e)(3)(i) provides, in part, that indirect costs are properly allocable
to property produced when the costs directly benefit or are incurred by reason of the
performance of production activities. Cost recovery, production facility repair and
maintenance costs, and scrap and spoilage costs, such as waste removal costs, are
examples of indirect costs that must be capitalized to the extent the costs are properly
allocable to produced property. See ' 1.263A-1(e)(3)(ii) (I), (O) and (Q).

Section 1.263A-1(e)(4)(iv)(I) provides that costs incurred for environmental
management policy generally are not allocated to production or resale activities (except
to the extent that the costs of any system or procedure benefit a particular production or
resale activity).

Section 1.263A-1(c)(2)(ii) provides that the amount of any cost required to be
capitalized under ' 263A may not be included in inventory or charged to capital account
or basis before the taxable year during which the amount is incurred within the meaning
of ' 1.446-1(c)(1)(ii). Pursuant to ' 461(h), in determining whether an accrual method
taxpayer has incurred an amount for any item during the taxable year, the all events test
shall not be treated as met any earlier than when economic performance occurs.

Section 1.263A-2(a)(3)(i) provides that any cost required to be capitalized by ' 263A
must be capitalized regardless of whether the cost was incurred before, during, or after
production.

Rev. Rul. 94-38, 1994-1 C.B. 35, analyzes whether costs incurred to clean up land
and to treat groundwater that a taxpayer contaminated with hazardous waste from the
taxpayer=s manufacturing business are capital expenditures. The ruling holds that the
costs to clean up land used in the taxpayer=s manufacturing process and to treat
groundwater are not capital expenditures because these costs do not prolong the useful
life of the land or adapt the land to a new or different use. Therefore, costs incurred to
clean up land and to treat groundwater that a taxpayer contaminated with hazardous
waste from the taxpayer=s business are deductible by the taxpayer as business
expenses under ' 162. Costs properly allocable to constructing groundwater treatment
facilities, however, are capital expenditures under ' 263.

Rev. Rul. 98-25, 1998-1 C.B. 998, holds that costs incurred to replace underground
storage tanks containing waste by-products under the circumstances in the ruling are
not capital expenditures under ' 263, but are ordinary and necessary expenses under '
162.

ANALYSIS

The discussion in Rev. Rul. 94-38 of Plainfield-Union Water Co. v. Commissioner, 39
T.C. 333 (1962), nonacq., 1964-2 C.B. 8, demonstrates that the revenue ruling was

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intended to address whether the costs to clean up the land and to treat the groundwater
are capital expenditures that must be capitalized into the basis of the land under
' 263(a) or whether the costs are ordinary and necessary repair expenses under ' 162.
Rev. Rul. 94-38 does not address the treatment of these costs as inventory costs under
' 263A. Similarly, Rev. Rul. 98-25 does not address whether amounts incurred to
replace underground storage tanks must be included in inventory costs under ' 263A.

The holding of Rev. Rul. 94-38 that the costs to construct a groundwater treatment
facility must be capitalized under '' 263(a) and 263A rather than deducted under ' 162
demonstrates the distinction between capital expenditures and costs that are more in
the nature of repairs than capital improvements. As with other types of deductible
business costs, such as labor costs, taxes, rent, and supplies, once repair costs are
determined to be deductible under ' 162, a taxpayer with inventories must still apply the
rules of ' 263A to determine whether the repair costs must be included in inventory.
Section 1.263A-1(e)(3). In addition, if repair costs must be capitalized under '' 263(a)
and 263A to a depreciable asset, a taxpayer with inventories must still apply the rules of
' 263A to determine whether the depreciation expense must be included in inventory.
Section 1.263A-1(e)(3)(ii)(I).

In this situation, X incurs environmental remediation costs to clean up land that was
contaminated as part of the ordinary business operations of X=s manufacturing of
inventory. X=s environmental remediation costs are incurred by reason of X=s production
activities within the meaning of ' 1.263A-1(e)(3)(i). The costs are properly allocable to
property produced by X that is inventory in X=s hands under ' 1.263A-1(e)(3)(i).
Accordingly, X must capitalize the otherwise deductible environmental remediation costs
by including the costs in inventory costs in accordance with ' 1.263A-1(c)(3). Similarly,
costs incurred to replace underground storage tanks and depreciation cost recoveries of
the groundwater treatment facility must be included in inventory costs to the extent
properly allocable to inventory.

HOLDING

Environmental remediation costs are subject to capitalization under ' 263A.
Therefore, costs incurred (within the meaning of ' 461(h) and ' 1.263A-1(c)(2)(ii)) to
clean up land that a taxpayer contaminated with hazardous waste by the operation of
the taxpayer=s manufacturing plant must be included in inventory costs under ' 263A.

TRANSITION RULE

This paragraph applies to costs that would have been properly deducted in the
taxable year but for the requirement to capitalize the costs to inventory under § 263A,
and for which the taxpayer’s method of accounting was to deduct the costs. The
Internal Revenue Service will not challenge the treatment of environmental remediation
costs to which this paragraph applies as deductible expenses rather than as costs

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properly capitalized to inventory under § 263A in any taxable year ending on or before
February 6, 2004. Therefore, the treatment of environmental remediation costs to which
this paragraph applies as amounts properly capitalized to inventory under § 263A will
not be raised as an issue in any taxable year ending on or before February 6, 2004,
and, if the treatment of such environmental remediation costs as deductible expenses
rather than as amounts properly capitalized to inventory under § 263A has already been
raised as an issue in examination or before Appeals or the Tax Court in a taxable year
ending on or before February 6, 2004, the issue will not be further pursued. The
Service will not impose penalties on taxpayers or preparers for treating environmental
remediation costs to which this paragraph applies as deductible expenses rather than
as costs properly capitalized to inventory under § 263A in taxable years ending on or
before February 6, 2004.

CHANGE IN METHOD OF ACCOUNTING

A taxpayer using a method of accounting that does not comply with this revenue
ruling is using an impermissible method of accounting. Any change in a taxpayer's
treatment of environmental remediation costs to conform with this revenue ruling is a
change in method of accounting to which the provisions of '' 446 and 481 and the
regulations thereunder apply. A taxpayer changing its method of accounting to comply
with this revenue ruling must file a Form 3115 in accordance with the automatic change
in method of accounting provisions of Rev. Proc. 2002-9, 2002-1 C.B. 327, as amplified,
clarified and modified by Rev. Proc. 2002-54, 2002-2 C.B. 432, and Rev. Proc. 2002-19,
2002-1 C.B. 696, with the following modifications: (1) the scope limitations in section
4.02 of Rev. Proc. 2002-9 do not apply to a taxpayer that wants to make the change for
its first taxable year ending after February 6, 2004; and (2) a taxpayer that files a Form
3115 in accordance with this revenue ruling to make the change in method of
accounting for its first taxable year ending after February 6, 2004, may effect the
change using either a ' 481(a) adjustment as provided in sections 5.03 and 5.04 of Rev.
Proc. 2002-9 or a cut-off method. For purposes of Line 1a of Form 3115 (revised
December 2003), the designated number for the automatic accounting method change
authorized by this revenue ruling is "77." A taxpayer making the automatic change in
method of accounting authorized by this revenue ruling and another automatic change
in method of accounting under § 263A for the same taxable year may file one Form
3115 to make both changes, but must comply with the ordering rules of § 1.263A-
7(b)(2) and must enter the automatic accounting method change numbers for both
changes on Line 1a of Form 3115 (revised December 2003).

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 98-25 and Rev. Rul. 94-38 are clarified by providing that the otherwise
deductible amounts at issue in Rev. Rul. 98-25 and Rev. Rul. 94-38 are subject to
capitalization to inventory under ' 263A.

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Rev. Proc. 2002-9 is modified and amplified to include in the APPENDIX the
automatic change provided in this revenue ruling.

DRAFTING INFORMATION

The principal author of this revenue ruling is John Moriarty of the Office of Associate
Chief Counsel (Income Tax & Accounting). For further information regarding this
revenue ruling, contact Mr. Moriarty at 202-622-4930 (not a toll-free call).