Coordinated Issue - Petroleum and Retail Industries - Leaking Underground Storage Tank Remediation Reimbursement Program (February 5, 2009)

LMSB4-1108-054
EFFECTIVE DATE: FEBRUARY 5, 2009

LEAKING UNDERGROUND STORAGE TANK REMEDIATION REIMBURSEMENT PROGRAM
UILs:  61.40-00
        118.01-02

ISSUE

Whether payments received by corporate owners or operators of underground storage tanks from state financial assurance and compensation programs (“financial assurance funds”), or other state or local underground storage tank cleanup reimbursement programs, should be characterized as nonshareholder contributions to capital under section 118(a) of the Internal Revenue Code. 

FACTS

An underground storage tank (UST) system is a tank and any underground piping connected to the tank that has at least 10 percent of its combined volume underground.  USTs are primarily owned or leased by marketers who sell gasoline to the public (such as service stations and convenience stores) and non-marketers who use the tanks solely for their own needs (such as fleet service operators and government agencies).  In 1984, there were approximately 2.1 million USTs in the U.S., including abandoned tanks.  Nearly all of these tanks contained petroleum products, and many caused site contamination or were in serious threat of leaking.

In order to strengthen the ability of the nation to deal with USTs, as well as other hazardous waste concerns, Congress adopted the Hazardous and Solid Waste Amendments of 1984 (42 U.S.C. 6991b, as amended).  This legislation directed the Environmental Protection Agency (EPA) to promulgate regulations (contained at 40 CFR Part 280) as may be necessary to protect human health and the environment.  The regulations are applicable to all owners and operators of USTs and address issues such as release detection, prevention, and correction.

In addition, Congress created the Leaking Underground Storage Tank Trust Fund in 1986 (26 U.S.C. 9508, as amended) to enforce and oversee corrective actions at contaminated UST sites and to provide money for cleanups at UST sites where the owner or operator is unknown, unwilling, or unable to respond, or which require emergency action.  With EPA's approval, states may administer and enforce their own UST regulatory programs, but the state program must be no less stringent than the federal program (see 42 U.S.C. 6991c). 

Congress also directed the EPA to develop financial responsibility regulations for owners and operators of underground storage tanks (42 U.S.C. 6991b(d)).  Congress wanted UST owners and operators to maintain evidence of their financial ability to take corrective action and compensate third parties for bodily injury and property damage caused by sudden and non-sudden accidental releases arising from operating USTs. Owners and operators satisfy their financial responsibility requirements by establishing any one or more of the following financial mechanisms:  insurance, guarantee, surety bond, letter of credit, qualification as a self-insurer as well as any other method satisfactory to the EPA.

Authorization for financial responsibility corrective action programs administered by state and local agencies is contained in 42 U.S.C. 6991c(c), which allows states to establish financial assurance funds.  These programs help reduce the hardship of compliance by UST owners and operators with financial responsibility requirements and serve as the primary means for businesses to comply with the requirements.  In addition, section 6991c(c) authorizes state and local compensation programs, which provide revenue for the state cleanup of abandoned sites and act as mechanisms to compensate owners and operators for costs incurred in environmental remediation following releases.  As of January 2008, approximately 40 states have UST cleanup funds.  These state programs pay for most UST cleanups separate and apart from the federal Leaking Underground Storage Tank Trust Fund.

State financial assurance funds frequently have the following characteristics:  (1) financial assurance funds are created by state legislation and must be submitted to EPA for approval before they can be used as compliance mechanisms; (2) in most cases, states generate money for the funds with tank registration or petroleum fees; (3) legislatures delegate authority for the fund to a state agency addressing health, environmental, or insurance issues; (4) some state assurance funds include eligibility requirements, including maintaining proper records and demonstrating that facilities are in compliance with technical standards, such as leak detection; and (5) most state funds provide for some deductible amount of the remediation costs that the owner or operator is responsible for paying.  State financial assurance fund programs that do not have EPA approval cannot be used to demonstrate tank owner financial responsibility for federal purposes, but the funds from such programs can be used for UST cleanups. 

Many USTs have released or will release petroleum products into the environment through spills, overfills, or failures in the tank and piping system.  If a release occurs, a number of options are available to the owners or operators to evaluate and clean up the contamination.  For example, monitoring wells may be installed to evaluate the contamination, a water filtration and treatment system can treat the water, and contaminated soil can be excavated for treatment or disposal.  UST owners or operators at retail operations, such as gasoline service stations, typically claim ordinary deductions under section 162 for the costs incurred to remediate the contamination resulting from leaking USTs, as well as deducting any third party liability payments.  In addition, taxpayers may be allowed to claim deductions for the removal, cleaning and disposal costs associated with old tanks, as addressed in Rev. Rul. 94-38, 1994-1 C.B. 35.  See Coordinated Issue Paper, Petroleum Industry, “Replacement of Underground Storage Tanks at Retail Gasoline Stations” (Revision Date: July 10, 2002).  Taxpayers can file claims against state financial assurance funds, if available, and receive reimbursements for costs incurred and previously deducted in cleaning up contaminated UST sites, as well as for related third party liability.  In some cases, corporate taxpayers have claimed that state financial assurance reimbursements are contributions to the corporations’ capital accounts.  Consequently, they have not included the reimbursements in gross income, relying on section 118(a) to exclude the payments. 

LAW

Under section 61(a), except as otherwise provided in Subtitle A, gross income includes all income from whatever source derived.

Section 118(a) provides that, in the case of a corporation, gross income does not include any contribution to the capital of the taxpayer. 

Section 1.118-1 of the Income Tax Regulations provides, in part, that section 118 applies to contributions to capital made by persons other than shareholders.  For example, the exclusion applies to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities.  However, the exclusion does not apply to any money or property transferred to the corporation in consideration for goods or services rendered, or to subsidies paid for the purpose of inducing the taxpayer to limit production (emphasis added).

The legislative history to section 118 indicates that the exclusion from gross income for nonshareholder contributions to capital of a corporation was intended to apply to those contributions that are neither gifts, because the contributor expects to derive indirect benefits, nor payments for future services, because the anticipated future benefits are too intangible.  The legislative history also indicates that the provision was intended to codify the existing law that had developed through administrative and court decisions on the subject.  H.R. Rep. No. 1337, 83d Cong., 2d Sess. 17 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 18-19 (1954).

The legislative history of section 118 provides, in part, as follows:

This [section 118] in effect places in the Code the court decisions on the subject.  It deals with cases where a contribution is made to a corporation by a governmental unit, chamber of commerce, or other association of individuals having no proprietary interest in the corporation.  In many such cases because the contributor expects to derive indirect benefits, the contribution cannot be called a gift; yet the anticipated future benefits may also be so intangible as to not warrant treating the contribution as a payment for future services.

S. Rep. No. 1622, 83d Cong., 2d Sess. 18-19 (1954).

In Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943), the Court held that payments by prospective customers to an electric utility company to cover the cost of extending the utility’s facilities to their homes, were part of the price of service rather than contributions to capital.  The case concerned customers’ payments to a utility company for the estimated cost of constructing service facilities (primary power lines) that the utility company otherwise was not obligated to provide.  The customers intended no contribution to the company’s capital.

Later, in Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950), the Court held that money and property contributions by community groups to induce a shoe company to locate or expand its factory operations in the contributing communities were nonshareholder contributions to capital.  The Court reasoned that when the motivation of the contributors is to benefit the community at large and the contributors do not anticipate any direct benefit from their contributions, the contributions are nonshareholder contributions to capital.  Id. at 591.

In United States v. Chicago, Burlington & Quincy Railroad Co., 412 U.S. 401 (1973), the Court, in determining whether a taxpayer was entitled to depreciate the cost of certain facilities that had been funded by the federal government, held that the governmental subsidies were not contributions to the taxpayer’s capital.  The court recognized that the holding in Detroit Edison Co. had been qualified by its decision in Brown Shoe Co.  The Court in Chicago, Burlington & Quincy Railroad Co. found that the distinguishing characteristic between those two cases was the differing purpose motivating the respective transfers.  The Court stated that:

It seems fair to say that neither in Detroit Edison nor in Brown Shoe did the Court focus upon the use to which the assets transferred were applied, or upon the economic and business consequences for the transferee corporation.  Instead, the Court stressed the intent or motive of the transferor and determined the tax character of the transaction by that intent or motive.  Thus, the decisional distinction between Detroit Edison and Brown Shoe rested upon the nature of the benefit to the transferor, rather than to the transferee, and upon whether that benefit was direct or indirect, specific or general, certain or speculative.  These factors, of course, are simply indicia of the transferor’s intent or motive. (footnote omitted).

Id. at 411.

The Court reconciled Detroit Edison and Brown Shoe on the ground that in the former the transferor intended no contribution to the transferee’s capital, whereas in the latter the transferors did have that intent.  Furthermore, in considering the precedents of Detroit Edison and Brown Shoe, the Court identified the characteristics of a nonshareholder contribution to capital under the Internal Revenue Codes of 1939 and 1954:

1. It must become a permanent part of the transferee's working capital structure;
2. It may not be compensation, such as a direct payment for a specific,     quantifiable service provided for the transferor by the transferee;
3. It must be bargained for;
4. The asset transferred must foreseeably result in benefit to the transferee in an amount commensurate with its value; and
5. The assets ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.

Id. at 412-413.

In a recent district court decision, United States v. Coastal Utilities, Inc., 483 F. Supp. 2d 1232 (S.D. Ga. 2007), aff’d, 514 F.3d 1184 (11th Cir. 2008), the court held that universal service fund (USF) payments by the federal and state governments to a telecommunications provider, for the reimbursement of telecommunication services provided in high cost areas, constituted income and not capital contributions under section 118(a).  The court reasoned the payments constituted supplements to general revenue, rather than specific capital contributions.  The court focused primarily on the motivation of the government entities in making the subsidies.  Specifically, the court distinguished payments made as an incentive for providing a rate of return on the taxpayer’s investment (income) versus an investment in infrastructure (capital).  Instead of furnishing the payments directly for capital investment, the USF payments provide an enhanced return on investment to the telecommunication providers, taking into consideration actual investment, a range of expenses, and the allowable rate of return.  Thus, the court concluded that USF payments constitute income subsidies, not contributions to capital. 

The court also rejected Coastal Utilities' argument that the subsidies are capital contributions because they serve a public purpose. The court reasoned: 

At the highest level of generality, all government spending should, theoretically, and at least indirectly, be for the purpose of benefiting the community.  To decide a case such as this based on the most generalized expressed purpose of Congress would make virtually all government subsidies contributions to capital, except where the government received specific goods and services in return for the payments.

Id. at 1245-1246.

ANALYSIS

In the case of state UST cleanup reimbursements, some taxpayers contend that UST payments are contributions to capital and assert the following arguments:
(1) the motive underlying state payments is to benefit the public good by performing environmental cleanup and thus promoting health and safety in the state; and (2) the state is not the recipient of environmental remediation services, and, therefore, section 118(a) capital contribution treatment is appropriate.

The motivation of the states in making UST payments is to help owners and operators with the cost of environmental remediation.  The states do not intend to make capital contributions to UST owners and operators.  The state programs are designed to reduce the economic hardship of compliance by UST owners and operators with their financial responsibility requirements, namely, the ability to take corrective action and compensate injured parties.  The state programs are subsidies that enable owners and operators to pay for environmental remediation.

Despite the existence of a public benefit derived from such subsidy payments, a compelling public purpose does not negate the fundamental principle under sections 118(a) and 1.118-1 that governmental subsidy payments designed to subsidize business operations constitute income, not capital contributions.  As noted specifically in Coastal Utilities, government payments furnished as revenue supplements or subsidies to operating income constitute gross income, not capital contributions.   

Additionally, the cleanup reimbursement payments do not satisfy the characteristics of a nonshareholder contribution to capital as set forth in Chicago, Burlington & Quincy R.R., supra.  As discussed, (1) the reimbursement payments do not become a permanent part of the UST owner or operator’s working capital because the payments are not restricted to the acquisition of capital assets; UST cleanup reimbursements may be used to pay for any expense or distribution and act as operating subsidy payments.  (2) Reimbursements are made for specific, quantifiable costs incurred in the cleanup of petroleum contaminates caused by leaking USTs.  (3) Reimbursement payments are not bargained for; the payments are prescribed unilaterally by the state governments.  The owner or operator must perform its cleanup obligation and file its claims following all rules and procedures as mandated by each state UST cleanup fund program.  (4) The asset transferred in these situations, cash, is commensurate with its value, but this characteristic can never be controlling; a cash payment will always be commensurate with its value.  (5) Finally, UST payments do not generate additional income for the UST owner or operator because the UST payments are not restricted to the acquisition of capital assets that would generate such additional income; the reimbursements can be used to pay any expense or make any distribution.

CONCLUSION

Payments received by corporate owners or operators of underground storage tanks, in the form of payments from state financial assurance funds or other state underground storage tank cleanup reimbursement programs, are not nonshareholder contributions to capital under section 118(a) of the Internal Revenue Code. Therefore, amounts from state financial assurance funds or other reimbursement programs are included in gross income under Internal Revenue Code section 61(a). 

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