The IRS recently released a private letter ruling (PLR 202129001) concluding that certain environmental mitigation payments made by a taxpayer were deductible under Section 162 in the year of payment.
The taxpayer that requested the advice owned two facilities located at an energy generation station. The taxpayer obtained the right to construct a third facility; however, the state later mandated that the taxpayer transfer such right to another party. Thereafter, the taxpayer entered into a joint development agreement (JDA), among other contractual agreements, with two other parties and transferred its right to develop, finance, construct and own the facility to Party A. Although the JDA provides that Party A must satisfy the environmental conditions associated with the transfer, Party A and taxpayer entered into an implementing agreement (IA) which obligated the taxpayer to share in the costs of mitigation. As part of the required mitigation activities, Party A purchased certain water rights needed to mitigate ground water drawdown. The IA required the taxpayer to compensate Party A for taxpayer’s share of such water rights. The taxpayer sought advice on the deductibility of this payment.
Section 162(a) provides that a deduction is allowed for all ordinary and necessary expenses paid or incurred during the taxable year in the carrying on of a trade or business. However, pursuant to Section 161, capital treatment under Section 263 takes precedence over expenses otherwise currently deductible under Section 162. Therefore, the taxpayer’s water right payment is subject to an analysis as to whether the expense is capitalizable to either tangible or intangible assets prior to determining current deductibility under Section 162.
Treas. Reg. Sec. 1.263(a)-3(d) provides that taxpayers are required to capitalize amounts paid to improve tangible property. Property is improved when there is a betterment of the property, a restoration of the property, or an adaption of the property to a new or different use. The IRS concluded that the payments in question were merely for mitigating environmental damage caused by the operation of the facility and not for the improvement of any tangible property. Thus, the payment was not required to be capitalized as a tangible asset.
Treas. Reg. Sec. 1.263(a)-4 provides rules for applying Section 263(a) to amounts paid to acquire or create intangibles. Treas. Reg. Sec. 1.263(a)-4(b)(1) provides that a taxpayer must generally capitalize an amount paid in the following instances:
- Acquisition of an intangible: The taxpayer did not acquire any asset from Party A.
- Creation of an intangible (including certain contract rights): Although the JDA created certain contract rights, the taxpayer’s payment under the IA was not paid to create or modify the existing contracts. Rather, the payment was made pursuant to the terms of the contracts in order to carry out taxpayer’s responsibilities.
- Creation of a separate and distinct intangible asset (property of measurable value, protected under applicable law and capable of being sold separate from the related business): The right to use the water for environmental mitigation had no value outside operation of the business as the water right could only be used at the facility. Accordingly, this right had no value outside of the business and was incapable of being sold separate from the business.
- Creation of a future benefit identified in published guidance: No future benefit was created.
- Facilitation of the acquisition or creation of an intangible: The taxpayer’s payment under the IA was not a cost of creating (or pursuing the creation of) the contacts. Further, the taxpayer’s liability arose after the creation of the IA.
Based on the foregoing, the IRS determined that the taxpayer’s payment was not required to be capitalized as an intangible asset.
The IRS concluded that the taxpayer’s payment was an ordinary and necessary business expense under Section 162 as the payment was made in carrying on the taxpayer’s business with an expectation of reducing future operating costs. Furthermore, the IRS determined that the payment was deductible in the year paid. Section 461 requires accrual method taxpayers to deduct liability amounts in the taxable year when the fact of the liability is established, the amount of the liability determined with reasonable accuracy and economic performance occurs. The IRS stated that the taxpayer met the requirements of Section 461 in the year that the environmental mitigation payments were made to Party A. Accordingly, the taxpayer was entitled to a deduction in the year of payment.
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