Deepwater Horizon and Sec. 162

Editor: Michael D. Koppel, CPA, MSA, MBA, PFS, CITP

Expenses & Deductions

On April 20, 2010, the explosion and subsequent sinking of the Deepwater Horizon drilling rig in the Gulf of Mexico commenced the largest U.S. oceanic oil spill in history. The immense amount of cleanup and related expenses incurred by the oil company BP are expected to total in the billions.

The Congressional Research Service (CRS) recently published a report titled “Tax Deductible Expenses: The BP Case” (August 11, 2010), which concluded that BP will be able to reduce its tax liability by $10 billion, the “result of standard business expense deductions and the general ability of taxpayers to claim refunds for previously paid taxes when realizing a net operating loss (NOL) or carrying the loss forward to offset future tax liabilities.” Under current law, this amount is the estimated tax benefit from oil-spill-related expenses of approximately $32 billion.

Fines and penalties paid to governmental entities have long been nondeductible (Sec. 162(f)). “Involuntary” payments, including putative donations, to restore a region to pre-catastrophe levels and rehabilitating image are also nondeductible (Allied-Signal Inc., 54 F.3d 767 (3d Cir. 1995), aff’g T.C. Memo. 1992-204). In Allied-Signal, the Third Circuit, affirming the Tax Court, reasoned that a voluntary payment must be one that is made without the expectation of a quid pro quo from the government entity. Furthermore, amounts paid because of conviction or a plea of guilty or nolo contendere for a crime, whether felony or misdemeanor, in a criminal proceeding are nondeductible, as are civil penalties and settlements of actual or potential liabilities for a civil or criminal fine or penalty (Regs. Sec. 1.162-21(b)(1)).

Legal fees, court costs, and related expenses incurred in the defense of a prosecution or civil action are deductible if they are business related, ordinary, and necessary (Sec. 162(a); Regs. Sec. 1.162-21(b)(2)). This applies even in the event of an unsuccessful defense against criminal prosecution (Tellier, 383 U.S. 687 (1966)). In addition, compensatory damages (including remedial damages and damages under Section 4A of the Clayton Act (15 U.S.C. §15a), as amended) paid to a government do not constitute a nondeductible fine or a penalty (Regs. Sec. 1.162-21(b)(2)).

Less clear is the deductibility of expenses incurred in an industry fraught with inherent risk. Are these risks reasonable, ordinary, and necessary? According to BP’s second-quarter 2010 report, released on July 27, 2010,

[t]here are risks of technical integrity failure as well as risk of natural disasters and other adverse conditions in many of the areas in which we operate which could lead to loss of containment of hydrocarbons and other hazardous material, as well as the risk of fires, explosions or other incidents. . . . Our operations are often conducted in difficult or environmentally sensitive locations in which the consequences of a spill, explosion, fire or other incident could be greater than in other locations. [BP p.l.c., Group Results, Second Quarter and Half Year 2010 37–38 (July 27, 2010)]

Payments made by BP to date have been reported to be voluntary. BP’s claims team has paid approximately $400 million to individuals and businesses since the commencement of claims processing (May 3, 2010) (BP claims webpage). The second-quarter report explains that the company and U.S. government authorities have been conducting “unprecedented oil spill response activities,” including

the deployment of approximately 40,000 people across five states to protect and clean the shoreline. It includes assessment teams and the use of specialized equipment deployed to respond to oiling. Specialized marsh-cleaning experts have been employed and we are working closely with experts to minimize the impact on wildlife. [BP, Group Results, Second Quarter 3]

Following are a few of the preemptive commitments that BP has made or plans to make, according to the report:

• $10 million to the National Fish and Wildlife Foundation;
• $500 million for a 10-year research program studying the impact of the oil spill on the marine and shoreline environment of the Gulf of Mexico;
• $360 million to fund the cost of six berms in the Louisiana barrier islands project; and
• $100 million to compensate oil rig workers in the Gulf of Mexico who have lost wages as a result of the six-month moratorium on offshore drilling activities imposed by the Obama administration.

BP has also agreed to establish a $20 billion escrow account to be funded over the next three and a half years. The second-quarter report states that the escrow account will be available to satisfy

legitimate claims adjudicated by the [Gulf Coast Claims Facility], final judgments in litigation and litigation settlements, state and local response costs, and natural resource damages and related costs. Fines and penalties will be paid separately and not from the escrow account. [BP, Group Results, Second Quarter 3]

The report also mentions that numerous legal proceedings and investigations have been brought against BP to date by U.S. government agencies, including the Department of Justice, the Presidential Commission, the Coast Guard, the Bureau of Ocean Energy Management, Regulation and Enforcement (formerly Minerals Management Service), the Securities and Exchange Commission, the Chemical Safety and Hazard Investigation Board, and Congress. BP has also been named as a defendant in more than 300 private civil lawsuits as well as various class action lawsuits. Claims include those for personal injury, commercial or economic injury, breach of contract, breach of fiduciary duty, gross mismanagement, abuse of control, and securities fraud. BP estimates that many of these cases will not be resolved for years to come.

As mentioned earlier, penalties and fines paid to the government, civil penalties, and payments considered to be involuntary are nondeductible. However, the expenses paid to date by BP are not the result of court proceedings or judgments. The inherent risks of the oil industry make BP and other oil companies susceptible to accidents and various unforeseen circumstances. Restoration expenses in the billions may be unreasonable, unnecessary, and not ordinary in other industries, but in this case the expenses paid to date appear to have met the deductibility rules.

This event has been a politically charged issue. U.S. Rep. James Oberstar (D-MN), chair of the House Committee on Transportation and Infrastructure, expressed disdain at BP’s decision to deduct oil-spill related expenses.

BP’s decision to claim a nearly $10 billion tax credit stemming from costs it incurred during the oil spill cleanup is nothing short of reprehensible. At a time when the Gulf Coast is reeling from this catastrophic economic and environmental disaster, the last thing the region needs is for BP to substantially offset the amount it is paying to meet its responsibilities for cleanup and compensating victims. [Britt, “BP Taking $10 Billion Tax Credit from Gulf Spill,” MarketWatch (July 27, 2010)]

Time will tell if BP will be able to fully deduct these expenses, and the courts will ultimately decide if wrongdoing was an issue in this case. But for now, BP and its shareholders will deduct these costs under Sec. 162 and well-established precedents that allow the deduction of environmental cleanup costs for events that occur on their watch.

EditorNotes

Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.