Coordinated Issue - All Industries - Supplemental (Beneficial) Environmental Projects (SEPs)
Effective Date: July 3, 2008
Supplemental (Beneficial) Environmental Projects (SEPs)
UILs: 162.21-18 (Environmental Fraud/DOJ Settled Cases & False Claims)
162.21-22 (Settlements with EPA)
162.21-01 (Cases not covered by either of the above UILs)
1) Whether any portion of the costs incurred or amounts paid by a taxpayer for the performance of a Supplemental Environmental Project (SEP) or similar project under federal or state law is an amount analogous to a nondeductible fine or similar penalty as defined under § 162(f) of the Internal Revenue Code.
2) Whether a taxpayer may include in the basis of assets it produces under § 263A, or as the basis of property under § 1012, any portion of the SEP costs that is an amount analogous to a fine or similar penalty.
1) A portion of the costs incurred or amounts paid by a taxpayer for the performance of a SEP or similar project under federal or state law may be analogous to a non-deductible fine or similar penalty defined under § 162(f).
2) A taxpayer may not include in the basis of assets it produces under § 263A, or as the basis of property under § 1012 the portion of SEP cost that is an amount analogous to a fine or similar penalty.
BACKGROUND AND FACTS
Most administrative or judicial actions brought by an environmental governmental agency against a violator result in a negotiated settlement in lieu of litigation. Subject to the environmental agency’s discretion, as part of the settlement, an alleged violator may voluntarily agree to perform an environmentally beneficial project in exchange for mitigation of some or all of the proposed penalty. These beneficial projects, generally called Supplemental Environmental Projects (SEPs), are only utilized as part of a governmental environmental law enforcement settlement. Some examples of SEPs include the purchase and donations of land for conservation purposes, the restoration of damaged habitat, and the implementation of public health projects such as mobile asthma clinics. In addition, violators have been required to add pollution control equipment to their plants, to build water treatment plants and to construct other types of real or personal property as part of a SEP. To be eligible as a SEP, a project must not be otherwise required under federal, state or local law, and cannot serve as a substitute for a violator’s compliance and/or remediation obligations.
The Environmental Protection Agency (EPA), as well as most other governmental environmental agencies, may utilize a formula approach to calculate the extent to which the proposed penalty may be mitigated in consideration of an alleged violator’s agreement to perform a SEP. However, agencies typically use their enforcement discretion when considering penalty mitigation, therefore making it difficult to speak in absolutes. As a general rule, a violator who agrees to perform a SEP will pay a smaller penalty than a violator who does not agree to perform a SEP. In determining whether and to what extent a proposed penalty may be mitigated, the environmental agency will consider the unique facts and circumstances of each case, including but not limited to the nature and extent of the violation, the economic benefit gained by the violator as a result of delayed or avoided compliance, the violator’s history of compliance, and the type and quality of the SEP.
Any settlement between the parties is memorialized to writing in a consent decree/order. The SEP will be described in the consent along with other elements, such as the civil penalty assessed, what the violator must do to come into compliance, and other injunctive relief. The SEP then becomes an enforceable component of the settlement instrument. Although each consent decree and consent order is unique, the mitigated penalty amount for agreeing to perform a SEP usually will not be ascertainable from the language in the body of the consent decree/consent order. Consequently, full factual development of the negotiation history of the settlement may be warranted to determine the extent to which the proposed penalty was mitigated.
LAW AND ANALYSIS
1) Whether any portion of the costs incurred or amounts paid by a Taxpayer for the performance of a SEP or similar project under federal or state law is an amount analogous to a nondeductible fine or similar penalty as defined under § 162(f) of the Internal Revenue Code.
Generally, taxpayers are taxed on net income and may deduct under § 162(a) all ordinary and necessary expenses paid or incurred in carrying on a trade or business, including judgments, settlements, and similar payments. Prior to 1969, courts used public policy grounds to deny deductions for business expenses if allowing the deduction would frustrate a sharply defined national or state policy. See, e.g., Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30 (1958). The Tank Truck Rentals case involved the issue of whether a trucking company could claim a business expense deduction for payment of fines imposed for the violation of state motor vehicle weight limit laws. The Court examined the state laws at issue and concluded that the fines were imposed for punitive and deterrent purposes. The Court held that the IRS had been correct to disallow the deduction of a business expense on public policy grounds because allowing the deduction would frustrate “sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.” Id. at 33-34. In Tank Truck Rentals, the “sharply defined state policy” was the state's interest in punishing those who violate weight limit laws on its highways (thereby causing excess damage to the roadways) and deterring such unlawful conduct in the future. Id. The purpose of this public policy doctrine is to prevent favorable tax treatment from “blunting the sting” of a validly imposed penalty by allowing the taxpayer a deduction for federal income tax purposes. Atzingen-Whitehouse Dairy, Inc. v. Commissioner, 36 T.C. 173, 183 (1961).
In 1969, Congress enacted § 162(c) (illegal bribes, kickbacks, and other payments), § 162(f) (fines and penalties), and § 162(g) (treble damage payments under antitrust laws), effectively codifying the extent to which deductions under § 162(a) would be disallowed on public policy grounds. Section 162(f) provides that no deduction shall be allowed under § 162(a) for any fine or similar penalty paid to a government for the violation of any law. Section 1.162-21(b)(1) of the Income Tax Regulations provides that a fine or similar penalty includes an amount paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal).
Section 263(a) denies a deduction for any capital expenditures. Section 263(a) provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments to increase the value of any property or estate. In addition, § 263A requires a taxpayer to capitalize direct and certain indirect costs of producing property.
When the amounts paid out by a taxpayer for the construction of the SEP constitute capital expenditures under §§ 263(a) and 263A, these amounts cannot be deducted under § 162(a). Consequently, § 162(f), which only prohibits deductions under § 162(a), does not, by its own terms, apply to deny a tax benefit for SEPs that involve the acquisition or construction of property to be owned by the taxpayer. Nevertheless, because § 162(f) represents a codification of the public policy doctrine, the analyses used by the courts and the Service in determining whether certain expenses meet the definition of a fine or similar penalty for purposes of § 162(f) are relevant for determining whether any expenditure, or a portion thereof, constitutes a fine or penalty whose allowance as a tax benefit would frustrate public policy. Thus, if any portion of a taxpayer’s expenditures as part of its settlement agreement, including capital expenditures, is analogous to the type of fines or penalties that have been disallowed under § 162(f), then there is a compelling basis to disallow such expenditure under a public policy rationale.
In order to evaluate the deductibility of a settlement payment, the courts and the Service have looked to the origin and character of the liability giving rise to the claim, not the taxpayer's motive for making the payment or the effect of the payment on the taxpayer's situation at the time the payment is made. See, e.g., Ostrom v. Commissioner, 77 T.C. 608 (1981). See also United States v. Gilmore, 372 U.S. 39, 48-49 (1963); Bailey v. Commissioner, 756 F.2d 44, 47 (6th Cir. 1985). Therefore, in order to determine whether any of the amounts incurred for the SEP constitute payments in settlement of a non-deductible fine or penalty, the analysis must focus on the nature of the liabilities that resulted in the SEP, and not the taxpayer's motives for proposing or accepting the SEP or the benefits of the SEP to other parties.
In addition, for purposes of § 162(f), the courts and the Service distinguish between punitive and remedial payments labeled civil penalties or settlements of those penalties (the punitive vs. remedial test). Under the punitive vs. remedial test, a payment imposed for purposes of enforcing the law or as punishment for its violation is not deductible, while a payment imposed as a remedial measure or to compensate the government or another party is deductible, even if it is labeled as a fine or penalty. See, e.g., Talley Indus., Inc. v. Commissioner, 116 F.3d 382, 385-86 (9th Cir. 1997); Mason and Dixon Lines, Inc. v. United States, 708 F.2d 1043, 1047 (6th Cir. 1983). In order to determine the purpose of a payment under the punitive v. remedial test, courts first look to legislative intent, including the language of the statute or ordinance in question, its legislative history, and other court decisions construing the statute or ordinance. Mason and Dixon Lines, Inc. v. United States, 708 F.2d 1043, 1047 (6th Cir. 1983); Huff v. Commissioner, 80 T.C. 804, 824 (1983). Where a payment ultimately serves each of these purposes, the court looks to the purpose that the payment was designed to serve. Talley Indus., Inc. v. Commissioner, 116 F.3d at 385-86; S & B Restaurant, Inc. v. Commissioner, 73 T.C. 1226, 1232 (1980); Middle Atlantic Distributors v. Commissioner, 72 T.C. 1136, 1145 (1979).
To evaluate the nature of a taxpayer's settlement, and thereby determine whether any amounts paid for a SEP are similar to non-deductible fines or penalties, an examiner must first consider the origin of the government’s underlying claims, which are generally violations of environmental laws and regulations in either federal or state statutes. An underlying purpose of the civil penalties imposed under certain environmental enforcement acts, for example the Clean Air Act, is to punish violators and to deter future violations. See, e.g., Colt Industries, Inc. v. United States, 11 Cl. Ct. 140 (1986)(“Pollution controls in this case are imposed for the general welfare by the exercise of sovereign powers. Civil penalties are to protect those interests, not to compensate for injuries to proprietary interests in business or property.”), aff'd on other grounds, 880 F.2d 1311 (10th Cir. 1989). Typically, the notice of violation in an enforcement action will outline numerous alleged statutory violations and state that the government may seek injunctive relief (requiring the taxpayer to bring its systems into compliance with environmental laws and regulations) or civil penalties, or both. In addition, the federal and state laws or regulations may set out the rationale or purpose for imposing civil penalties or the factors to be considered in determining whether a civil penalty will be assessed. In many cases, these factors can help demonstrate that the civil penalties are imposed to punish the taxpayer and deter future violations and that the penalties were not intended to provide remediation or compensatory damages. The fact that a taxpayer performs a SEP (e.g., by constructing an environmentally beneficial project or by contributing to an environmental endowment) in settlement of potential civil penalties does not change the nature of the penalties from punitive to compensatory.
A taxpayer may claim that § 162(f) is inapplicable where a settlement agreement requires a taxpayer to incur the costs to construct an asset or contribute to an environmental endowment fund, rather than to pay a cash penalty to the government. However, the courts have interpreted § 162(f) more broadly. For example, several cases support the proposition that payments made to parties other than the government may constitute nondeductible fines or similar penalties within the meaning of § 162(f). See, e.g., Bailey v. Commissioner, 756 F.2d 44 (6th Cir. 1985) (civil penalty imposed for violating a Federal Trade Commission consent order was not deductible even though taxpayer was permitted to apply the penalty toward the settlement of his liabilities in a class-action lawsuit); Waldman v. Commissioner, 88 T.C. 1384 (1987), aff'd without published opinion, 850 F.2d 611 (9th Cir. 1988)(criminal restitution payments made directly to victims was a non-deductible penalty); Allied-Signal, Inc. v. Commissioner, T.C. Memo. 1992-204, aff'd in unpublished opinion, 54 F.3d 767 (3d Cir. 1995). In Allied-Signal, the taxpayer had been convicted of environmental crimes and was sentenced to a fine in excess of $13 million. The taxpayer contributed $8 million to an environmental endowment fund with the understanding from the court that the proposed $13 million criminal fine would be reduced by the same $8 million. The Tax Court held that the payment was, “in substance,” a fine or similar penalty under § 162(f), reasoning that it was an involuntary payment ordered or directed by a court, that any compensatory or remedial purposes the payment served was minimal, and that it was imposed for punishment and deterrence. Id.
Although these cases all involve cash payments, not the construction of assets, the same rationale of prohibiting a tax benefit for amounts paid to punish or deter unlawful conduct applies whether the penalty is paid in cash or for the construction of an asset . Therefore, if a taxpayer settles (in whole or in part) a civil penalty, which is punitive in nature, by incurring costs to perform an environmental beneficial project or by contributing amounts to an environmental endowment or similar fund, the portion of such payments attributable to the civil penalty should be treated as non-deductible fines or penalties under § 162(f).
Having concluded that a portion of the cost of the SEP may be characterized as an amount analogous to a nondeductible fine or similar penalty as defined under § 162(f), the next issue is computing the portion of SEP costs that constitute the penalty amount. In order to make this determination, the courts and the Service have examined the facts and circumstances of each case to ascertain evidence of the parties' intent at the time of the settlement. Talley Indus., Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 1997); Rev. Rul. 75-230, 1975-1 C.B. 93. Generally, a taxpayer seeking to deduct a lump-sum settlement payment has the burden of establishing entitlement to a deduction. Talley Indus., 116 F.3d at 387. Thus, the taxpayer has the burden of proving what portion, if any, of the SEP costs was not intended to be characterized as a fine or similar penalty.
2) Whether a taxpayer may include in the basis of assets it produces under § 263A, or as the basis of property under § 1012, any portion of the SEP costs that is an amount analogous to a fine or similar penalty.
Because amounts paid for the construction of a beneficial environmental project constitute capital expenditures under §§ 263(a) and 263A, these amounts cannot be deducted under § 162(a) and § 162(f) does not apply. Therefore, the next issue that must be considered is whether a taxpayer may capitalize under §§ 263(a) and 263A amounts incurred for the construction of the SEP where these amounts are analogous to fines and similar penalties under § 162(f). For the reasons described below, a taxpayer may not include in the basis of assets it produces under § 263A any portion of the SEP costs that represents an amount analogous to a fine or similar penalty.
Sections 263(a) and 263A require a taxpayer to capitalize certain amounts in connection with the construction of the property. In particular, § 263(a) denies a deduction for capital expenditures by providing that taxpayers cannot deduct any amount paid out for new buildings or for permanent improvements or betterments to increase the value of any property or estate. See also § 1.263(a)-1(a). Section 1.263(a)-1(b) directs taxpayers to use § 263A and the regulations thereunder for cost capitalization rules for amounts paid for the production of self-constructed assets. Under § 263A(a)(2), a taxpayer must capitalize its direct costs of producing property together with such property's proper share of those indirect costs, part or all of which are allocable to such property.
The description of direct and indirect costs that must be capitalized under § 263A(a) is very broad and, without more, could potentially include costs that are not otherwise deductible under the Code. However, § 263A(a)(2) specifically provides that “any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.” That is, an amount may not be capitalized under § 263A if it cannot otherwise be taken into account in computing taxable income. The regulations under § 263A clarify this by stating:
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.
§ 1.263A-1(c) (2). Pursuant to this regulation, in order for a taxpayer to include a cost under § 263A, the cost must be eligible to be taken into account in computing taxable income by virtue of a Code section other than § 263A. Otherwise, taxpayers with property subject to § 263A (self-constructed assets or property acquired for resale) would be allowed to capitalize and take into account (via amortization, depreciation deductions, or increased basis recovery upon disposition) costs that may not be taken into account by taxpayers without § 263A property. The Service has consistently adhered to an interpretation of § 263A that does not allow for disparity in calculating taxable income between taxpayers with § 263A property and those without such property.
This interpretation of § 263A is consistent with the legislative history of § 263A(a)(2), which indicates that the flush language of § 263A(a)(2) was added to clarify “that a cost is subject to capitalization…only to the extent it would otherwise be taken into account in computing taxable income.” H. R. Rep. No. 100-795, at 98 (1988). Indeed, the legislative history of § 263A(a)(2) clarifies that an amount that is not otherwise allowable in determining taxable income may not be capitalized and recovered through depreciation or amortization deductions, as a cost of sales, or in any other manner. Id. This reasoning would prohibit a taxpayer from including in the basis of assets it produces under § 263A any portion of the SEP costs that represents an amount analogous to a fine or similar penalty, the deduction of which is prohibited by § 162(f).
By contrast, some have interpreted the parenthetical to the flush language in § 263A (a)(2) - “but for this subsection”-- as incorporating prior law into the scope of costs that a taxpayer may capitalize under § 263A. Under such an interpretation, the flush language applies only to costs that a taxpayer could not capitalize under another provision of the Code, such as § 263(a), prior to the enactment of § 263A. In other words, if a cost could have been capitalized under § 263(a) prior to the enactment of § 263A, that cost may still be capitalized to property that is subject to § 263A. For the reasons discussed below, this view is not correct.
First, the language of § 263A and the regulations thereunder cover all direct and indirect costs allocable to property produced by a taxpayer; the language is not limited to additional costs required to be capitalized after the effective date of § 263A. Section 263A, by its own terms, applies to direct costs as well as indirect costs allocable to property produced by the taxpayer. Likewise, the regulations under § 263A provide rules for both direct and all indirect costs. Direct costs and many indirect costs were, in fact, capitalized under prior law. Moreover, the regulations under other cost capitalization and cost recovery provisions, most notably § 263(a), refer to § 263A and the regulations thereunder for cost capitalization rules applicable to real or tangible personal property produced by a taxpayer. See, e.g., § 1.263(a)-1(b); § 1.162-12(a); § 1.174-2(a)(5). Neither the Code nor the regulations refers to the potential application of other capitalization provisions with respect to property subject to § 263A. The Code and regulations are structured as if § 263A contains the exclusive capitalization rules applicable to real or tangible personal property produced by the taxpayer.
Second, Congress intended for § 263A to be a single, comprehensive set of capitalization rules for property produced by a taxpayer or acquired for resale. Prior to the enactment of § 263A, cost capitalization requirements varied between types of property and among industries. Congress believed that “a single, comprehensive set of rules should govern the capitalization of costs of producing, acquiring, and holding property….” S. Rep. No. 99-313, at 140 (1986). To that end, § 263A was enacted. Section 263A is often referred to as the “uniform capitalization rules” because the intent and effect is to apply a single, comprehensive set of rules to (1) property produced by the taxpayer and (2) property acquired for resale.“ The Act applies a single set of capitalization rules to all costs incurred in manufacturing and constructing property.” Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, at 503 (Comm. Print. 1987). Thus, looking to another provision of the Code or prior case law would yield inconsistent capitalization rules and requirements for different types of property and in different industries, undermining the Congress's intent to establish uniform capitalization rules for all real or tangible personal property produced by the taxpayer. Likewise, looking to another provision of the Code or prior case law undermines congressional intent to establish a single, comprehensive set of rules for property acquired for resale.
Finally, Congress believed that a single, comprehensive set of capitalization rules would make the income tax more neutral in its effect on business decisions. Thus, taxpayers would not be able to shop for different cost capitalization rules in deciding whether and what type of property to produce and in which business to invest. This congressional policy is supported by the flush language of § 263A(a)(2). If otherwise non-deductible costs were allowed to be capitalized under § 263A, taxpayers that produce property for use in their business would have an income tax advantage over taxpayers that purchase property for use in their business (as well as taxpayers engaged in service businesses).
These three reasons demonstrate that the flush language in § 263A(a)(2) should not be interpreted as incorporating prior law into the scope of costs that a taxpayer can capitalize under § 263A. Accordingly, in order for a taxpayer to capitalize an amount under § 263A, the taxpayer must otherwise be able to take that amount into account in determining taxable income. Absent the capitalization provisions of §§ 263(a) and 263A, the cost of a SEP would fall under § 162(a) as an ordinary and necessary expense paid or incurred during the taxable year in carrying on a trade or business. As discussed above, however, § 162(f) would prohibit a § 162(a) deduction for the portion of the cost that is an amount analogous to a fine or similar penalty. Therefore, because a taxpayer could not deduct the portion of the cost that is analogous to a fine or penalty under § 162 if it were not incurred by reason of a production activity, it may not capitalize that portion under § 263A(a). See § 263A(a)(2) and § 1.263A-1(c)(2).
Even if the flush language of § 263A(a)(2) did not, by its terms, prevent a taxpayer from claiming basis for that portion of the cost of the SEP that was analogous to a fine or similar penalty, the public policy doctrine would still preclude a taxpayer from claiming basis under § 1012 for such amount.
As discussed above, the public policy doctrine is a common law rule that disallows deductions when “allowance would frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.” Tank Truck Rentals, 356 U.S. at 34. The Supreme Court has noted that deduction of fines and penalties uniformly has been held to frustrate state policy in severe and direct fashion by reducing the ‘sting’ of the penalty prescribed by the state legislature.” Id. Thus, fines and penalties and amounts analogous to fines and penalties in particular are subject to disallowance under the public policy doctrine.
While the doctrine has been codified (and its scope limited) in the text of § 162 and certain regulatory provisions, the public policy doctrine, as a common law rule of federal income tax law, limits tax benefits even in the absence of any statute or regulation providing for disallowance.
For example, Rev. Rul. 77-126, 1977-1 C.B. 47, addresses whether the forfeiture of illegal gambling devices for nonpayment of taxes results in losses deductible by the taxpayer under § 165. The ruling holds that although Congress codified and limited the public policy doctrine in the case of ordinary and necessary business expenses by amending § 162(c) and enacting §§ 162(f) and (g), the rules for disallowing a deduction under § 165 on the grounds of public policy are not so limited. The ruling disallows the § 165 deduction because allowing the taxpayer to deduct the losses would frustrate sharply defined public policy by “softening the sting” of the forfeiture.
In addition, Rev. Rul. 82-74, 1982-1 C.B. 110, addresses the federal income tax consequences that follow when taxpayer pays an arsonist to burn down an office building and collects, but is subsequently required to return, insurance proceeds. The ruling concludes that gain from collection of the proceeds is ordinary income and that repayment of the proceeds entitles taxpayer to a loss deduction equal to the amount of gain previously reported. Further, taxpayer's basis in the building is reduced to zero because taxpayer's loss is nondeductible. Even though § 1.165-3(b) would ordinarily increase the adjusted basis of the taxpayer's building by the net cost incurred with respect to the destruction of the property, the ruling holds that the basis adjustment is precluded on public policy grounds because the allowance of an upward basis adjustment for the payment to the arsonist would severely and immediately frustrate the statutory scheme regarding arson and insurance fraud.
Courts likewise have employed the public policy doctrine to disallow various tax benefits that would be inconsistent with articulated public policy. For example, courts have held that a loss deduction will be denied when to allow the deduction would frustrate a sharply defined Federal or State policy. E.g., Smith v. Commissioner, 34 T.C. 1100 (1960), aff'd per curiam, 294 F.2d 957 (5th Cir. 1961) (disallowing § 165 loss or § 166 bad debt deduction for a tax penalty, in part, because the deterrent impact of the tax penalty would be softened, and violations of statutory duty would be encouraged). See also Blackman v. Commissioner, 88 T.C. 677 (1987), aff'd, 867 F.2d 605 (1st Cir. 1988) (disallowance of deduction for a casualty loss for destruction of home resulting from taxpayer lighting his wife's clothes on fire); and Hackworth v. Commissioner, T.C. Memo. 2004-173 (disallowance of loss deduction under § 165 for forfeiture of proceeds from illegal gambling operation). Cf. Turnipseed v. Commissioner, 27 T.C. 758 (1957) (public policy doctrine applied to disallow a personal exemption for a woman illegally cohabitating with the taxpayer; later codified as § 152(b)(5)); Green v. Connally, 330 F. Supp. 1150 (D.D.C. 1971), aff'd per curiam sub nom., Coit v. Green, 404 U.S. 997 (1971) (private schools maintaining racially discriminatory admissions policies that clearly violate Federal policy denied qualification under § 501(c)(3)). Allowing a taxpayer basis for expenditures that are analogous to a fine or penalty would permit a taxpayer to derive a tax benefit that would “soften the sting” of the intended penalty. A taxpayer should not be able to derive a tax benefit from such expenditures, either in the form of increases to cost of goods sold resulting from inclusion of depreciation in inventory, or in the form of a basis offset in the event there is a disposition of the SEP.
In fact, whether the costs in issue may be included in cost of goods sold is addressed directly by regulation. Section 1.61-3(a) provides that in the case of a manufacturing business, gross income is determined “without subtraction of … amounts which are of a type for which a deduction would be disallowed under § 162(c), (f), or (g) in the case of a business expense.” See also § 1.471-3(d) (providing that in valuing inventories cost does not include such amounts). These regulations are consistent with, and promote, the policy expressed in Tank Truck Rentals -- to not permit tax benefits to “frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.” 356 U.S. at 34. Moreover, that policy is fully applicable when determining whether costs analogous to a fine or penalty should be included in basis for purposes other than calculating cost of goods sold, such as when determining gain or loss. The public policy doctrine is implicated regardless of whether taxpayer pays a fine, incurs a cost otherwise included in cost of goods sold, incurs a cost otherwise included in the § 1012 basis of an asset or pays monies that would otherwise be deductible as a charitable contribution under § 170, and there is no justification for disparate treatment of these four situations.
Thus, in accordance with § 263A(a)(2), § 1.61-3 of the regulations, and the public policy doctrine enunciated in Tank Truck Rentals, 356 U.S. at 34, a taxpayer may not include in the basis of assets it produces under § 263A or in the basis of property under § 1012, the portion of the SEP costs that represents an amount analogous to a nondeductible fine or penalty under § 162(f). Further, under § 162(f), a taxpayer may not deduct cash payments to an environmental endowment or similar fund, when such payments are made in lieu of paying a fine or similar penalty to the environmental agency itself. As the court noted in Allied-Signal, “[w]hile the form of the payment does not necessarily fit within the letter of section 162(f), in substance petitioner paid a criminal fine. . . .To allow petitioner a deduction in this case ‘would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose’.” T.C. Memo 1992-204 (quoting Gregory v. Helvering, 293 U.S. 465, 470 (1935)).
CONTACTS AND ASSISTANCE WITH THIS ISSUE
An Industry Director Directive was issued on this issue on May 30, 2007, titled Tier I Issue: Government Settlements Directive #1. It included Attachment II., Audit Guidelines on Government Settlements. For assistance with this issue, contact should be made with the Environmental Issue Technical Advisor.
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