Utility deducts shared environmental mitigation payment

Plain-English summary

A utility paid its agreed share of another entity's cost to acquire water used solely to mitigate groundwater drawdown caused by a jointly developed generating facility. The IRS found the payment ordinary and necessary because it was made in carrying on the utility's business under an agreement expected to reduce future operating costs. Under the utility's accrual method, the liability was fixed, its amount was reasonably determinable, and economic performance occurred when payment was made. The payment did not improve the utility's tangible property and did not acquire or create a separate intangible, create contract rights, provide an identified future benefit, or facilitate creation of an intangible. The IRS therefore allowed a Section 162 deduction in the payment year and did not reach the taxpayer's alternative amortization requests under Sections 167 and 197.

Ruling snapshot

• Question: Could the utility deduct its contractual share of environmental mitigation costs in the year paid?
• Outcome: Approved; the payment was deductible under Section 162 in the payment year.
• Key authorities: IRC §§ 162, 263, and 461; Treas. Reg. §§ 1.162-1, 1.263(a)-3, 1.263(a)-4, and 1.461-4(g)(7); Rev. Rul. 95-32

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202129001 Third Party Communication: None
Release Date: 7/23/2021 Date of Communication: Not Applicable
Index Number: 162.00-00, 263.00-00
Person To Contact:
-------------------------------------------- ------------------, ID No. -----------------
----------------------------------- Telephone Number:
------------------------ --------------------
Refer Reply To:
--------------------------------- CC:ITA:B03
------------------------------------------------------ PLR-130345-18
Date:
---------------------------------------------------- April 21, 2021

LEGEND:

Taxpayer = ---------------------------------------------------------------------
Entity A = ---------------------------------------------------------------
-----------------------
Entity B = --------------------------------------------------------------------------
Entity C = ------------------------------------------------
Payment = -----------------------------------------------------------------------------
-----------------------------------------------------------------------------
-------------------------------------
x = -----------------------------------------------------------------------------
-----------------------------------------------
State = ----------
State Commission = ----------------------------------------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
n1 = -------------

PLR-130345-18 2

Dear -------------------:

This letter responds to your private letter ruling request and supplemental
correspondence, submitted on behalf of Taxpayer. That letter requested several rulings
concerning the tax treatment of the Payment by Taxpayer to Entity A under sections
162, 263, 167, and 197 of the Internal Revenue Code.

                            RULINGS REQUESTED

(1) The Payment is deductible as an ordinary and necessary business expense under
section 162(a) in the year of payment.
(2) Alternatively, if the Payment must be capitalized under section 263(a), the amount of
the Payment is amortizable under section 167 and § 1.167(a)-3 of the Income Tax
Regulations over a period of 15 years.
(3) Alternatively, if the Payment must be capitalized under section 263(a) and the
amount of the Payment is amortizable under section 167 and § 1.167(a)-3, but the
amortization period is not 15 years, the amortization period ends on December 31,
2050.
(4) Alternatively, if the Payment must be capitalized under section 263(a) and the
amount of the Payment is not amortizable under section 167 and § 1.167(a)-3, the
amount of the Payment is amortizable under section 197.

                                      FACTS

Taxpayer represents that the facts are as follows:
Taxpayer is a corporation headquartered in State and engaged in the business of x.
Taxpayer owns two facilities (Unit 1 and Unit 2) located at an energy generating station
(Station) in State. An unrelated entity, Entity B, owns a third facility (Unit 3) at Station.
In Year 1, State Commission issued a certificate (Certificate) granting Taxpayer the right
to construct a fourth facility (Unit 4) at Station. This right was subject to Taxpayer’s
satisfaction of certain environmental conditions and to the requirement that Taxpayer
obtain an order from State Commission confirming that the construction of Unit 4 was
necessary for Taxpayer to provide property and services to its customers.
However, State Commission later mandated that Taxpayer transfer its right to construct
Unit 4. Consequently, Taxpayer, Entity A, and Entity B entered into an amended joint
development agreement (JDA) in Year 2 regarding the development of Unit 4. Pursuant
to the JDA, Taxpayer transferred its rights to develop, finance, construct, and own Unit
4 to Entity A. Taxpayer and Entity A also entered into contracts under which: (1)
Taxpayer would lease to Entity A the real property upon which Facility was to be built;
(2) Entity A would pay Taxpayer to operate Unit 4; and (3) Entity A would pay Taxpayer

PLR-130345-18 3

for the right to use or benefit from certain facilities located at Units 1 and 2 and would
reimburse Taxpayer for certain costs incurred at Units 1 and 2 (collectively, the
Contracts).
Also pursuant to the JDA, Taxpayer transferred Certificate to Entity A. Entity A became
fully responsible for the satisfaction of the associated environmental conditions upon
this transfer. Nevertheless, as set forth in the JDA, Taxpayer, Entity A, and Entity B
entered into an agreement (Implementing Agreement) concerning these environmental
conditions. The Implementing Agreement provides that Entity A will propose mitigation
activities for acceptance, rejection, or modification by a committee composed of
representatives of each of Taxpayer, Entity A, and Entity B. The Implementing
Agreement also provides that the parties will share the costs of these mitigation
activities according to a set ratio.
Unit 4 began operations in Year 3. Subsequently, as mitigation activities, Taxpayer,
Entity A, and Entity B, each purchased individual undivided interests in two real
properties (Properties). Entity A also purchased a large amount of water flow from
Entity C to aid in mitigation. Under State law, Entity A is the sole owner of this water.
Under an agreement between Taxpayer, Entity A, and Entity B, the water can only be
used at the Properties to mitigate groundwater drawdown that occurs through the
operation of Unit 4. In Year 4, Taxpayer paid Entity A $n1 (the Payment) for its
allocable share of the costs of Entity A’s acquisition of the water right, in accordance
with the Implementing Agreement.
LAW

Section 162

Section 162(a) provides that there shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any trade or
business. See also § 1.162-1(a). In order to be deductible under section 162, an
expenditure must be (i) paid or incurred during the taxable year; (ii) sustained in
carrying on a trade or business; (iii) an expense; (iv) a necessary expense; and (v) an
ordinary expense. Commissioner v. Lincoln Savings and Loan Association, 403 U.S.
345, 352 (1971).

The term “ordinary” refers to an expenditure that is normal, usual, or customary. Deputy
v. du Pont, 308 U.S. 488, 495, 60 S. Ct. 363, 84 L. Ed. 416, 1940-1 C.B. 118 (1940).
An expenditure may be ordinary if it is commonly and frequently incurred in the type of
business involved. Id. (citing Welch v. Helvering, 290 U.S. 111, 114, 54 S. Ct. 8, 78 L.
Ed. 212, 1933-2 C.B. 112 (1933)).

The term “necessary” means appropriate and helpful to the development of the
taxpayer's business. Commissioner v. Tellier, 383 U.S. 687, 689, 86 S. Ct. 1118, 16 L.
Ed. 2d 185 (1966) (quoting Welch, 290 U.S. at 113); Commissioner v. Heininger, 320
U.S. 467, 471, 64 S. Ct. 249, 88 L. Ed. 171, 1944 C.B. 484 (1943).

PLR-130345-18 4

In Rev. Rul. 95-32, 1995-16 I.R.B. 8, the Service ruled that payments by a public utility
as part of programs to promote energy conservation and energy efficiency were
business expenses that are deductible under section 162. These programs were aimed
at reducing electrical costs to the taxpayer's customers, as well as addressing
environmental and societal concerns with the adverse environmental effects of
increased electrical generation. These programs also enabled the taxpayer to reduce
its future operating and capital costs.

Section 461(a) provides that a deduction shall be taken for the taxable year that is the
proper taxable year under the method of accounting used in computing taxable income.

Section 1.461-1(a)(2) provides that under an accrual method of accounting a liability is
incurred, and generally is taken into account for Federal income tax purposes, in the
taxable year in which all the events have occurred that establish the fact of the liability,
the amount of the liability can be determined with reasonable accuracy, and economic
performance has occurred with respect to the liability.

Section 461(h)(1) provides that in determining whether an amount has been incurred
with respect to any item during any taxable year, the all events test shall not he treated
as met any earlier than when economic performance with respect to the item occurs.

Section 461(h)(4) provides that the all events test is met with respect to any item if all
events have occurred which determine the fact of the liability and the amount of such
liability can be determined with reasonable accuracy.

Section 1.461-4(g)(7) provides guidance for certain liabilities for which payment is
economic performance. In the case of a liability for which specific economic
performance rules are not provided, economic performance occurs as payment is made
to the person to whom the liability is owed under § 1.461-4(g)(7).

Based on the information submitted, we conclude that the Payment is an ordinary and
necessary business expense under section 162. Taxpayer made the Payment in Year
4 in carrying on its business. Furthermore, Taxpayer made the Payment pursuant to an
agreement that Taxpayer expected would reduce its future operating costs.
Specifically, the JDA provided for an agreement between Taxpayer and Entity A
whereby Entity A would pay Taxpayer for the use of certain facilities and reimburse
Taxpayer for costs incurred at these facilities. Taxpayer anticipated significant cost-
savings as a result of this agreement. The Payment was therefore appropriate and
helpful to Taxpayer’s business.

Furthermore, we conclude that Taxpayer may deduct the Payment in Year 4, the year in
which it made the Payment pursuant to the Implementing Agreement. All events that
establish the fact of Taxpayer’s liability for the Payment occurred by Year 4. The
amount of the Payment was also determinable with reasonable accuracy in Year 4. In
addition, the regulations do not provide specific economic performance rules for the

PLR-130345-18 5

treatment of contractual obligations like Taxpayer’s contractual cost-sharing obligations
to Entity A. As a result, economic performance occurred with respect to Taxpayer’s
liability for the Payment when Taxpayer made this payment in accordance with § 1.461-
4(g)(7).

                              LAW AND ANALYSIS

Section 263

Under section 161 of the Internal Revenue Code, if a cost is a capital expenditure, the
capitalization rules of section 263 take precedence over the deduction rules of section

162. Commissioner v. Idaho Power Co., 418 U.S. 1, 17, 94 S. Ct. 2757, 41 L. Ed. 2d
     535 (1974). Therefore, a capital expenditure cannot be deducted under section 162,
     regardless of whether the expenditure is ordinary and necessary in carrying on a trade
     or business.

Section 263(a) generally prohibits deductions for capital expenditures. In this case, the
Payment presents issues that must be analyzed under §§ 1.263(a)-3 and 1.263(a)-4 of
the Income Tax Regulations.

Section 1.263(a)-3(d) provides that, except as otherwise provided in that section, a
taxpayer must capitalize amounts paid to improve a unit of tangible property. Section
1.263(a)-3(d) further provides that a unit of property is improved if amounts paid for
activities performed after the taxpayer places the property in service: (i) are for a
betterment to a unit of property; (ii) restore a unit of property; or (iii) adapt a unit of
property to a new or different use.

Based on the representations made, including additional information submitted, we
conclude that § 1.263(a)-3 does not require Taxpayer to capitalize the Payment as an
improvement to tangible property. Under the Implementing Agreement, Taxpayer is
required to reimburse Entity A for an allocable share of the costs of Entity A’s
environmental mitigation activities. To comply with its environmental mitigation
obligations, Entity A purchased a water right from Entity B to mitigate groundwater
drawdown that occurs at the Properties due to the operation of Unit 4. Although
Taxpayer owns an interest in the Properties where the water is used, the Payment is not
for the betterment of the Properties, is not paid to restore the Properties, and is not paid
to adapt the Properties to a new or different use as defined under § 1.263(a)-3. Rather,
the Payment to Entity A is for mitigating environmental damage that occurs during
operations at Unit 4. As such, the Payment is not for the improvement of Taxpayer’s
tangible property under § 1.263(a)-3.

Section 1.263(a)-4 provides rules for applying section 263(a) to amounts paid to acquire
or create intangibles. Section 1.263(a)-4(b)(1) provides that except as otherwise
provided in § 1.263(a)-4, a taxpayer must capitalize an amount paid to: (i) acquire an
intangible (see § 1.263(a)-4(c)); (ii) create an intangible described in § 1.263(a)-4(d); (iii)

PLR-130345-18 6

create or enhance a separate and distinct intangible asset within the meaning of §
1.263(a)-4(b)(3); (iv) create or enhance a future benefit identified in the Federal Register
or the Internal Revenue Bulletin as an intangible for which capitalization is required; and
(v) facilitate (as defined in § 1.263(a)-4(e)(1)) the acquisition or creation of an intangible.

Based on the representations and additional information submitted, we conclude that §
1.263(a)-4 does not require Taxpayer to capitalize the Payment. With respect to §
1.263(a)-4(c), Taxpayer has not acquired any asset from Entity A in a purchase or
similar transaction. With respect to amounts paid to create an intangible, only section §
1.263(a)-4(d)(6) potentially applies. This section requires taxpayers to capitalize
amounts paid to create certain contract rights. Under the present facts, the JDA created
certain contract rights for Taxpayer. However, Taxpayer’s payment of environmental
mitigation costs under the Implementing Agreement was not an amount paid to create,
originate, enter into, renew, or renegotiate the Contracts. Rather, the Payment is better
categorized as an amount paid pursuant to the terms of the Contracts in order to carry
out Taxpayer’s responsibilities under the Contracts. Accordingly, § 1.263(a)-4(d)(6)
does not apply to the Payment.

With respect to amounts paid to create a separate and distinct intangible asset, §
1.263(a)-4(d)(3)(i) defines a separate and distinct intangible asset as a property interest
of ascertainable and measurable value in money's worth that is subject to protection
under applicable state, federal or foreign law and the possession and control of which is
intrinsically capable of being sold, transferred or pledged separate and apart from a
trade or business. In this case, the water provided under Entity A’s water right can only
be used at the Properties to mitigate groundwater drawdown caused by operations at
Unit 4. Entity A’s right to use this water for environmental mitigation therefore has no
value outside of the operation of Unit 4. Accordingly, this right is intrinsically incapable
of being sold, transferred, or pledged separate and apart from the business. Section
1.263(a)-3(b)(1)(iii) therefore does not apply. In addition, the Payment does not create
or enhance a “future benefit” identified in published guidance.

Lastly, with respect to amounts paid to facilitate the acquisition or creation of an
intangible, § 1.263(a)-4(e)(1)(i) provides that, except as otherwise provided in §
1.263(a)-4, an amount is paid to facilitate the acquisition or creation of an intangible (the
transaction) if the amount is paid in the process of investigating or otherwise pursuing
the transaction. As discussed, Taxpayer’s payment for its allocable share of
environmental mitigation costs is not an amount paid to acquire an intangible from
another party or an amount paid to create a separate and distinct intangible. Although
Taxpayer and Entity A did enter into the Contracts pursuant to the JDA, Taxpayer’s
payment of its allocable share of environmental mitigation costs under the Implementing
Agreement was not a cost of creating the Contacts nor a cost paid in the process of
investigating or pursuing the creation of the Contracts. Further, Taxpayer’s liability for
the Payment arose after the creation of the Contracts under the terms of the
Implementing Agreement. Accordingly, the Payment could not have facilitated the
creation of the Contracts, and § 1.263(a)-4(e) therefore does not apply.

PLR-130345-18 7

                                  CONCLUSION

We conclude that Taxpayer may deduct the Payment as an ordinary and necessary
business expense under section 162 in Year 4. Consequently, we need not reach
rulings (2) through (4).

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this ruling.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides that
it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representatives.

A copy of this letter must be attached to any Federal income tax return to which it is
relevant. Alternatively, Taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                  Sincerely,



                                  Brinton T. Warren
                                  Chief, Branch 3
                                  (Income Tax & Accounting)

cc: