Proposed Regulations that Impact Environmental Enforcement Aim to Clarify 2017 Tax Act
As described in two previous Holland & Knight Energy and Natural Resources Blog posts, "Recent Changes Expected to Impact Environmental Enforcement" and "Tax Changes Impacting Government Enforcement: Comments Due November 13, 2018," the Tax Cuts and Jobs Act (TCJA) of 2017, P.L. 115-97 (Dec. 22, 2017), made changes to the long-standing rule precluding deductibility of "any fine or similar penalty paid to a government for the violation of any law." This blanket prohibition was changed by Section 13306, which revised 26 U.S.C. § 162(f) to state that "no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law" except in two circumstances when established by the taxpayer through the establishment requirement. The two exceptions are "for amounts constituting restitution or paid to come into compliance with law." Restitution includes remediation of property for damage or harm which was or may be caused by the violation of any law or the potential violation of any law. Amounts "paid to come into compliance" include costs "otherwise involved in the investigation or inquiry" as well, but shall not include "any amount paid or incurred as reimbursement to the government or entity for the costs of any investigation or litigation."
In addition, under § 162(f)(2)(A)(ii), the amounts must be "identified" as restitution or as an amount paid to come into compliance, as the case may be, in the court order or settlement agreement. This "identification requirement" was effective as of the date of passage (Dec. 22, 2017) and applies to amounts paid or incurred under any binding order or agreement entered into as of that date. Relatedly, the TCJA also added Section 6050X to the tax code, which obligates the governmental entity involved in the enforcement proceeding to file an information return for all cases in excess of $600 and specifies the amounts which fall into the two exceptions as specifically described in the settlement agreement or order. Form 1098-F (Fines, Penalties and Other Amounts), the form to be used by governmental entities to report environmental settlements, was finalized as of Dec. 31, 2019. However, the Internal Revenue Service (IRS) Transitional Guidance (Notice 2018-23) issued April 9, 2018, delayed the requirement for filing the informational return until at least the date of publication of proposed regulations. It further stated that "until proposed regulations under § 162(f) are issued, the identification requirement in § 162(f)(2)(A)(ii) is treated as satisfied for an amount if the settlement agreement or court order specifically states on its face that the amount is restitution, remediation, or for coming into compliance with the law." Form 1098-F will be required to be filed for each agreement by the relevant "appropriate official" of the governmental entity for the tax year when the agreement is executed along with Form 1096 (Annual Summary and Transmittal of U.S. Information Returns).
On May 13, 2020, the IRS published a Notice of Proposed Rulemaking, including proposed regulations, in the Federal Register (with minor corrections published on June 11). The proposed regulations address the requirements for fulfilling the establishment requirement and the identification requirement, as well as the governmental reporting requirements. In addition, the proposed regulations increase the threshold requirement for reporting to $50,000 (from $600 identified in the TCJA) and set the effective date for reporting "only to orders and agreements that become binding under applicable law on or after January 1, 2022" (85 Fed. Reg. 28538-39).
Under the proposed regulations, the identification requirement found in § 162(f)(2)(A)(ii) is described in § 1.162-21(b)(2) and includes a presumption that the identification requirement is met if the "order or agreement specifically states that the payment, and the amount of the payment, … constitutes restitution, remediation, or an amount paid to come into compliance with a law or if the order or agreement uses a different form of the required words, such as 'remediate' or 'comply with law.'" In addition, if the amount the taxpayer will incur or pay for restitution, remediation or to come into compliance is not identified in the order or agreement, the identification requirement may still be met if the order or agreement "describes the damage done, harm suffered, or manner of noncompliance with a law, and describes the action required of the taxpayer." Accordingly, it is important to review the language of any enforcement order or settlement agreement carefully, and if possible, include as much detail as possible, including specific amounts if available, in order to avail oneself of the presumption.
With respect to the establishment requirement, the proposed regulations require the taxpayer to substantiate with documentary evidence, "the taxpayer's legal obligation, pursuant to the order or agreement, to pay the amount identified as restitution, remediation, or to come into compliance with a law, the amount paid, and the date the amount was paid or incurred." Among the documents identified to meet this requirement are the following:
- the legal or regulatory provision related to the violation or potential violation of a law
- documents issued by the government or governmental entity relating to the investigation or inquiry
- documents describing how the amount to be paid was determined
- correspondence exchanged between the taxpayer and the governmental entity before the order or agreement became binding under applicable law
Hypothetical examples are provided in § 1.162-21(g).
The comment period closed July 13, 2020. Approximately 30 public comments were filed, which are available in the docket (IRS-2020-00008). Most of the comments came from representatives of governments, tax professionals and industry trade associations. Several items were identified by commenters as problematic for placing an undue burden on governmental officials obligated to file information returns, especially if the agreement or order does not specify clearly the various amounts needed to complete Form 1098-F or otherwise include sufficient information. In addition, questions arose where remediation is required as a result of strict liability and not necessarily a violation of applicable law, as may be the case under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA). It remains to be seen whether further accommodations to governmental reporting obligations will be made, but in the meantime, given the statutory requirements, care should be exercised when finalizing negotiations on environmental enforcement to be sure settlement agreements contain sufficient information and description to fall within the presumption for deductibility.
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