rr-05-42.pdf

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing.

This collection currently includes the publisher’s available advance-release directory. Historical bulletin renditions are discovered separately; an advance-release record alone does not certify the collection archive complete.

Part I

Section 263A Capitalization and Inclusion in Inventory Costs of Certain Expenses

26 CFR 1.263A-1: Uniform capitalization of costs.

Rev. Rul. 2005-42

ISSUE
Are environmental remediation costs incurred to clean up land that a taxpayer
contaminated with hazardous waste by the operation of the taxpayer’s manufacturing
activities properly allocable under § 263A of the Internal Revenue Code to the inventory
produced during the taxable year the costs are incurred?
FACTS
Situation 1. N, a corporation using an accrual method of accounting, owns land and
operates a manufacturing plant on Site X that N uses to produce stoves. Stoves are the
only property produced by N and are inventory in N’s hands. N’s manufacturing
activities discharge hazardous waste. In the past, N buried this waste on portions of
Site X in accordance with then applicable law. Site X was not contaminated by
hazardous waste when purchased by N.
In order to comply with federal, state, and local environmental requirements, N
incurs costs in 2005 to remediate the contaminated soil and groundwater at Site X. The
costs N incurs are not research and experimental expenditures within the meaning of

2

§ 174, qualified environmental remediation expenditures within the meaning of § 198(b),
or environmental management policy costs. The soil remediation and groundwater
treatment restores Site X to essentially the same physical condition that existed prior to
the contamination. The soil remediation and groundwater treatment does not materially
add to the value of Site X, appreciably prolong its life, or adapt it to a new or different
use. During and after the remediation, N continues to manufacture stoves at Site X.
Situation 2. The facts are the same as in Situation 1, except that N manufactures
clothes washers at Site X and no longer manufactures stoves. Clothes washers are the
only property produced by N and are inventory in N’s hands.
Situation 3. The facts are the same as in Situation 1, except that N temporarily
ceases its manufacturing activities at Site X during a part of 2005 while it remediates the
contaminated soil and groundwater.
Situation 4. The facts are the same as in Situation 1, except that N has permanently
ceased its manufacturing activities at Site X and manufactures stoves at another site.
Situation 5. The facts are the same as in Situation 1, except that in the past N
buried the waste on portions of Site Y, a remote dump site that N did not own or
otherwise use in its manufacturing activities. N was not obligated to clean up the site
when N buried the waste. In order to comply with federal, state, and local
environmental requirements, N incurs costs in 2005 to remediate the contaminated soil
and groundwater at Site Y. The soil remediation and groundwater treatment restores
Site Y to essentially the same physical condition that existed prior to the contamination.
The soil remediation and groundwater treatment does not materially add to the value of
any of N’s property, appreciably prolong its life, or adapt it to a new or different use.

3

During and after the remediation, N continues to manufacture stoves at Site X, but has
permanently stopped using Site Y to bury waste.
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 are 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 properly allocable share of indirect costs.
Section 1.263A-1(c)(1) provides that to determine these capitalizable costs,
taxpayers must allocate or apportion costs to various activities, including production
activities. Section 1.263A-1(c)(1) further provides that after § 263A costs are allocated
to the appropriate production activities, these costs generally are allocated to the items
of property produced during the taxable year and capitalized to the items that remain on
hand at the end of the taxable year. As a result, costs incurred during the taxable year
are either included in the cost of goods sold during the taxable year or are capitalized to
the items that remain on hand at the end of the taxable year using a method permitted
under § 1.263A-1(f).
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
accounts or basis any earlier than the taxable year during which the amount is incurred
within the meaning of § 1.446-1(c)(1)(ii).
Section 1.263A-1(c)(3) provides that capitalize means, in the case of property that is
inventory in the hands of a taxpayer, to include in inventory costs.

4

Section 1.263A-1(c)(4) provides that costs that are capitalized under § 263A are
recovered through depreciation, amortization, cost of goods sold, or by an adjustment to
basis at the time the property is used, sold, placed in service, or otherwise disposed of
by the taxpayer.
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. Generally, producers must capitalize direct and
indirect costs properly allocable to property produced under § 263A, without regard to
whether those costs are incurred before, during, or after production. See § 1.263A-
2(a)(3)(i).
Section 1.263A-1(e)(3)(ii) provides examples of indirect costs that must be
capitalized to the extent they are properly allocable to property produced. Indirect costs
required to be capitalized include the costs of repairing and maintaining production
equipment or facilities. See § 1.263A-1(e)(3)(ii)(O). In addition, costs related to
temporarily idle production equipment or facilities, other than depreciation, amortization
and cost recovery allowances, are indirect costs that are required to be capitalized. See
§ 1.263A-1(e)(3)(iii)(E).
Rev. Rul. 94-38, 1994-1 C.B. 35, holds that costs incurred to clean up land and to
treat groundwater contaminated with hazardous waste from the taxpayer’s business are
not capital expenditures under § 263 because these costs do not materially add value to
the land, prolong the useful life of the land or adapt the land to a new or different use
and, therefore, such costs are deductible by the taxpayer as business expenses under
§ 162. Costs incurred for constructing groundwater treatment facilities, however, are

5

capital expenditures under § 263.
Rev. Rul. 2004-18, 2004-1 C.B. 509, considers whether costs incurred to clean up
land that a taxpayer contaminated with hazardous waste by the operation of the
taxpayer’s manufacturing activities are includible in inventory costs under § 263A. Rev.
Rul. 2004-18 states that 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 still must apply the rules of ' 263A to determine whether the repair costs
must be included in inventory. Rev. Rul. 2004-18 concludes, therefore, that
environmental remediation costs similarly are subject to capitalization under § 263A and
are required to be included in inventory costs under the facts of that ruling.
ANALYSIS
Environmental remediation costs incurred to clean up land and to treat groundwater
that a taxpayer contaminated with hazardous waste from its production activities do not
materially add to the value of the land, appreciably prolong its life, or adapt it to a new or
different use. Rev. Rul. 94-38. Thus, these costs are more in the nature of repairs than
capital improvements and, under § 263A, are indirect costs that must be included in
inventory costs to the extent allocable to inventory. Rev. Rul. 2004-18. Generally,
repair costs incurred to keep equipment or facilities used in production activities in an
ordinarily efficient operating condition directly benefit or are incurred by reason of the

6

performance of the production activities and, therefore, are properly allocable to
inventory, without regard to whether those costs are incurred before, during, or after
production. See §§ 1.263A-1(e)(3)(i), 1.263A-1(e)(3)(ii)(O) and 1.263A-2(a)(3)(i).
Under §§ 1.263A-1(c)(1) and 1.263A-1(c)(2), these repair costs are allocable to the
property produced during the taxable year in which the costs are incurred, even though
the repairs may have been necessitated by the use of the equipment or facilities in the
production of property in prior taxable periods.
Like repair costs, environmental remediation costs incurred by a taxpayer to clean
up land and to treat groundwater that the taxpayer contaminated with hazardous waste
from its production activities are costs that directly benefit or are incurred by reason of
the performance of the production activities even if the condition that necessitated the
remediation arose during prior taxable periods. See § 1.263A-2(a)(3)(i). As with repair
costs, environmental remediation costs are properly allocable to inventory without
regard to whether those costs are incurred before, during, or after production. See
§ 1.263A-1(c)(2). Likewise, remediation costs are allocable under § 1.263A-1(c)(1) to
the property produced during the taxable year in which the costs are incurred.
In Situation 1, during 2005, N manufactures stoves at Site X. The costs N incurs in
2005 to clean up Site X are incurred by reason of N’s production activities, within the
meaning of § 1.263A-1(e)(3)(i). Because the environmental remediation costs to clean
up Site X are incurred in 2005, they are properly allocable to the inventory produced by
N in 2005, in accordance with §§ 1.263A-1(c)(1) and 1.263A-1(c)(2). Therefore, the
environmental remediation costs are allocable to the stoves produced by N during 2005,
using an allocation method permitted under § 1.263A-1(f).

7

In Situation 2, during 2005, N manufactures clothes washers at Site X. The costs N
incurs in 2005 to clean up Site X are incurred by reason of N’s production activities,
within the meaning of § 1.263A-1(e)(3)(i). Because the environmental remediation
costs to clean up Site X are incurred in 2005, they are properly allocable to the
inventory produced by N in 2005, in accordance with §§ 1.263A-1(c)(1) and 1.263A-
1(c)(2). Therefore, the environmental remediation costs are allocable to the clothes
washers produced by N during 2005, using an allocation method permitted under
§ 1.263A-1(f).
In Situation 3, during a part of 2005, Site X is temporarily idle. Nevertheless, the
costs N incurs in 2005 to clean up Site X are incurred by reason of N’s production
activities, within the meaning of § 1.263A-1(e)(3)(i). See § 1.263A-2(a)(3)(i). Because
the environmental remediation costs to clean up Site X are incurred in 2005, they are
properly allocable to the inventory produced by N in 2005, in accordance with
§§ 1.263A-1(c)(1) and 1.263A-1(c)(2). Therefore, the environmental remediation costs
are allocable to the stoves produced by N during 2005, using an allocation method
permitted under § 1.263A-1(f).
In Situation 4, N has permanently ceased its manufacturing activities at Site X.
Nevertheless, the costs N incurs in 2005 to clean up Site X are incurred by reason of
N’s production activities, within the meaning of § 1.263A-1(e)(3)(i). See § 1.263A-
2(a)(3)(i). Because the environmental remediation costs to clean up Site X are incurred
in 2005, they are properly allocable to the inventory produced by N in 2005, in
accordance with §§ 1.263A-1(c)(1) and 1.263A-1(c)(2). Therefore, the environmental
remediation costs are allocable to the stoves produced by N during 2005, using an

8

allocation method permitted under § 1.263A-1(f).
In Situation 5, N has permanently ceased burying waste from its manufacturing
activities on Site Y. Nevertheless, the costs N incurs in 2005 to clean up Site Y are
incurred by reason of N’s production activities, within the meaning of § 1.263A-1(e)(3)(i).
See § 1.263A-2(a)(3)(i). Because the environmental remediation costs to clean up Site
Y are incurred in 2005, they are properly allocable to the inventory produced by N in
2005, in accordance with §§ 1.263A-1(c)(1) and 1.263A-1(c)(2). Therefore, the
environmental remediation costs are allocable to the stoves produced by N during 2005,
using an allocation method permitted under § 1.263A-1(f).
HOLDING
Environmental remediation costs that are incurred to clean up land that a taxpayer
contaminated with hazardous waste by the operation of the taxpayer’s manufacturing
activities are incurred by reason of the taxpayer’s production activities and are properly
allocable under § 263A to the inventory produced during the taxable year the costs are
incurred.
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

9

provisions of Rev. Proc. 2002-9, 2002-1 C.B. 327, as modified and clarified by
Announcement 2002-17, 2002-1 C.B. 561, modified and amplified by Rev. Proc. 2002-
19, 2002-1 C.B. 696, and amplified, clarified, and modified by Rev. Proc. 2002- 54,
2002-2 C.B. 432, except that the scope limitations in section 4.02 of Rev. Proc. 2002-9
do not apply to a taxpayer that makes the change for its first or second taxable year
ending after February 6, 2004. A taxpayer that files Form 3115 to comply with Rev. Rul.
2004-18 and this revenue ruling 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. See Rev. Rul. 2004-18.
Additionally, a taxpayer that (1) files a Form 3115 on or before July 20, 2005, to comply
with Rev. Rul. 2004-18 for its first taxable year ending after February 6, 2004, or was
not required to change its method of accounting to comply with Rev. Rul. 2004-18, and
(2) files Form 3115 to comply with this revenue ruling for its first taxable year ending
after June 20, 2005, may effect the change using either a ' 481(a) adjustment 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 "92." 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).

10

EFFECT ON OTHER DOCUMENTS
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 Roman Faron of the Office of
Associate Chief Counsel (Income Tax & Accounting). For further information regarding
this revenue ruling, contact Mr. Faron at 202-622-4930 (not a toll-free call).