Rev. Rul. 88-46

1988-1 C.B. 76, 1988-24 I.R.B. 5.

                       Internal Revenue Service

                                 Revenue Ruling

                     BUSINESS EXPENSES; FINES AND PENALTIES

                            Published: June 13, 1988

Section 162. - Trade or Business Expense  26 CFR 1.162-21: Fines and penalties.

  Business expenses; fines and penalties. A nonconformance penalty assessed by the Environmental Protection Agency is not a 'fine or similar penalty' under section 162(f) of the Code and is, therefore, deductible as a business expense under section 162(a).

ISSUE

  If a taxpayer pays a nonconformance penalty (NCP) assessed by the Environmental Protection Agency (EPA) under section 206(g)(1) of the Clean Air Act (Act), 42 U.S.C. section 7525(g)(1), is that NCP a nondeductible 'fine or similar penalty' for purposes of section 162(f) of the Internal Revenue Code?

FACTS

  The taxpayer, a manufacturer of heavy-duty trucks and truck engines, has vehicles and engines that fail to conform to certain emission standards imposed under the Act. Section 206(g)(1) of the Act requires the EPA to issue a certificate of conformity for any class or category of heavy-duty vehicles or engines that exceeds the set emission standard but does not exceed an upper limit associated with that standard, if the manufacturer pays an NCP. Manufacturers that sell or introduce into commerce heavy-duty vehicles or engines not covered by certificates of conformity are subject to a civil penalty of not more than $10,000 for each violation of the Act. Because the taxpayer's heavy-duty vehicles and engines did not conform to the established emission standards, the taxpayer paid NCPs so that it could obtain the necessary certificates of conformity for its vehicles and engines.

LAW AND ANALYSIS

  Section 162(a) of the Code 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.

  Section 162(f) of the Code and the regulations thereunder provide that no deduction shall be allowed under section 162(a) for any fine or similar penalty paid to a government for the violation of any law.

  Section 1.162-21(b) of the regulations provides, in part, that the term 'fine or similar penalty' includes an amount paid as a civil penalty imposed by federal, state, or local law.

  Section 206(g)(1) of the Act states that, in the case of any class or category of heavy-duty vehicles or engines to which an emission of air pollutants standard applies, a certificate of conformity shall be issued and shall not be suspended or revoked for such vehicles or engines manufactured by a manufacturer notwithstanding the failure of such vehicles or engines to meet such standard if such manufacturer pays an NCP as provided under regulations promulgated by the EPA Administrator.

  Under section 205 of the Act, 42 U.S.C. section 7524, any person who violates the Act by selling or offering for sale any vehicle or vehicle engine that is not covered by a certificate of conformity shall be subject to a civil penalty of not more than $10,000 per truck or engine illegally sold.

  Pursuant to the authority under section 206(g)(3) of the Act (See also 40 C.F.R. section 86.1113-87 (1986)), the EPA Administrator has promulgated a formula, NCP = PR x EE x AAF, for calculating each NCP where:

NCP = penalty per vehicle or engine;

PR  = penalty rate, which is based on the amount that a

    conforming manufacturer would likely spend to meet the

    emission standard, per unit of pollutant;

EE  = units of pollutant by which a vehicle or engine exceeds

    emission standards;

AAF = annual adjustment factor, which increases the penalty

    based on the inflation rate and the extent of the industry

    usage of NCPs, to provide an incentive for compliance.

  The House Report regarding section 206(g)(3) of the Act states that in order to assure the achievement of the maximum emission reduction that is reasonably projected to be technologically available, while at the same time not ruling the nonconforming manufacturer out of the market, the Committee permitted certain nonconforming vehicles or engines to be certified conditionally upon payment of a nonconforming technology penalty. H.R. Rep. No. 294, 95th Cong., 1st Sess. 275 (1977). Footnote 17 of H.R. Rep. No. 294, at 275, states that this is a performance penalty, irrespective of fault. The report further states that, in connection with adopting these technology-forcing emission standards, the EPA Administrator is required to prescribe an allowable range of nonconformity that will allow any engine or vehicle that fails to meet the revised emission standards, but that nonetheless falls within this range, to be certified and sold provided the NCP is paid. The Conference Report states that the NCPs are to be set at a level that will eliminate the competitive advantage, if any, for the manufacturer of a nonconforming vehicle or engine. H.R. Conf. Rep. No. 564, 95th Cong., 1st Sess. 163 (1977).

  The Act and the legislative history indicate that the NCP formula is primarily designed as a permissive and equalizing formula to eliminate the competitive economic advantage that a nonconforming producer might otherwise have over a conforming producer. Congress envisaged an alternative allowable range of nonconformity that would allow a vehicle or engine to be covered by a certificate of conformity upon payment of an NCP. The NCP mechanism grants the EPA permission to conditionally certify nonconformity. This permissive characterization of the NCP mechanism in the legislative history, and the flexibility that mechanism was to provide with respect to Congress' setting of high technological emission standards, are inconsistent with a conclusion that, under section 162(f) of the Code, an NCP is a penalty paid 'for the violation of any law.' The legislative history of the NCP shows that it is not punitive in nature. Rather, the paying of an NCP provides one of two lawful alternative methods for receiving a certificate of conformity. The other is to simply conform to the established emission standard. Mere nonconformity within the allowable range of nonconformity is not a violation of the Act if there is a payment of the NCP. A taxpayer that pays the NCP and thus receives a certificate of conformity does not fall within section 205 of the Act, which imposes a penalty of not more than $10,000, per vehicle or engine, on manufacturers selling, or introducing into commerce, vehicles or engines not covered by certificates of conformity.

HOLDING

  The NCP that was assessed by the EPA is not a 'fine or similar penalty' for purposes of section 162(f) of the Code, and, therefore, section 162(f) does not preclude deduction of the NCP as a business expense under section 162(a).

DRAFTING INFORMATION

  The principal author of this revenue ruling is Sheldon Iskow of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Iskow on (202) 566-3417 (not a toll-free call).

Rev. Rul. 88-46, 1988-1 C.B. 76, 1988-24 I.R.B. 5.