IRS Taking Firm Approach to Ozone-Depleting Chemical Excise Tax Compliance

Under Sec. 4681, federal excise tax is imposed on certain imported products that contain or use in their manufacture ozone-depleting chemicals (ODCs). This tax may apply not only to goods containing electronic components but also to goods such as furniture, medical devices, automobiles, and appliances if ODCs were used in their manufacture. Companies importing products potentially containing ODCs may be caught unaware or unprepared by this taxing regime.

The IRS has recently reinvigorated its examination of the Sec. 4681 tax, adopted a strict interpretation of the regulations, and instituted a laboratory testing program to detect ODCs in printed circuit boards. The challenges posed by the current IRS approach call for diligent preparation and documentation by taxpayers. An item in the June Tax Clinic reviewed the current IRS approach to ODC compliance (see Karet and Hoffman, “Are You Properly Paying the Ozone-Depleting Chemicals Excise Tax?” 41 The Tax Adviser 377 (June 2010)). This item looks at the IRS’s ODC testing protocol and suggests strategies for taxpayers.

Background

The Sec. 4681 tax falls on any “imported taxable product” containing ODCs or manufactured using ODCs. To determine which imported products are taxable, businesses should follow the table of products found in Regs. Sec. 52.4682-3, which is organized according to U.S. International Trade Commission Harmonized Tariff Schedule (HTS) number.

An imported taxable product containing or manufactured using ODCs listed in Sec. 4682(a)(2) is subject to excise tax if it enters the United States for consumption, use, or warehousing. The tax is based on the weight of the ODCs used in manufacturing the product, including ODCs (1) incorporated into the product, (2) released into the atmosphere in the process of manufacturing, or (3) otherwise used in the manufacture of the product.

This provision was enacted in 1990, partly in response to international concern over depletion of the atmospheric ozone layer. Sec. 4681 forms part of the compliance regime of the United States, which was a 1990 signatory of the Montreal Protocol on Substances That Deplete the Ozone Layer, September 16, 1987, Treaty Doc. 100-10, 1987 1522 U.N.T.S. 2 (Montreal Protocol). That international compact seeks to protect the ozone layer by phasing out the production of substances believed to be responsible for ozone depletion, in order to reduce ODCs with the goal of eventual elimination. Since that time, the use of ODCs has been phased out in most countries under the Montreal Protocol, but ODCs remain in use in some developing nations.

Determining ODC Weight

There are two primary methods for determining the ODC weight in an imported product: the exact method or the table method. To use the exact method, the taxpayer, often through the assistance of the manufacturer, determines the weight of each ODC used as a material in the manufacture of an imported taxable product. A determination may be made that no ODCs were used in the manufacture, resulting in a weight of zero. To use the table method, the weight of the ODCs is established solely by using the tables in the Treasury regulations (see Regs. Sec. 52.4682-3(f)(6)). These tables, which were based on U.S. industry-wide usage and processes in the early 1990s, set predetermined weights of ODCs for various taxable products without consideration of any specific product’s recent manufacturing or technological advances in substituting other chemicals for ODCs.

Under the exact method, the regulation contemplates the taxpayer obtaining a letter from the foreign manufacturer of the product to establish the ODC usage in manufacturing. While the regulations set forth minimal standards for such letters, the IRS imposed eight criteria in its most recent ODC Audit Technique Guide (ATG), published in September 2007.

Among other requirements, the ATG requires that the letters list the major cost components of the product and their manufacturer, describe the environmental policy of the foreign manufacturer’s country regarding the Montreal Protocol, and describe the alternative substances or replacement technology used instead of ODCs, including the date such technology was placed in service and the name of the company providing it. However, revenue agents may not accept documentation as meeting these criteria.

In order to acquire empirical verification of ODC content, the IRS has developed an analytical testing procedure to detect trace levels of residual ODCs remaining from the manufacture of certain electronic components. The test protocol focuses solely on ODC detection at a threshold level; no exact ODC weight is determined. If ODCs are detected at levels above the IRS-mandated threshold, the IRS will use the table method to determine the weight to calculate the excise tax.

This laboratory test is used to support the IRS’s assertion of federal excise tax liability against taxpayers and to question manufacturers’ letters that are furnished by taxpayers to declare zero ODC content. More generally, the availability of testing and the results found to date appear to be the foundation for increased IRS skepticism toward imported goods that are declared free of ODCs.

Observation: It appears likely that the IRS will maintain its renewed enforcement activity in this area for the foreseeable future. The IRS has invested significant time and resources in the development and implementation of testing and training its examiners to identify and examine this issue. The IRS is unlikely to halt the use of the testing protocol unless it is scientifically discredited or guidance or court decisions limit its use or impact.

Strategies

Before audit: The federal excise tax on ODCs straddles areas of both federal tax law and import and customs law. As a result, companies that import products potentially subject to the tax should involve staff or outside advisers with proficiency in both areas.

The first step in addressing this issue should be to review a company’s imports, categorized by HTS numbers, to determine if there are matches to the IRS table, indicating possible ODC tax liability. The company can then estimate potential tax liabilities if ODCs are present. The next step is to contact the foreign manufacturers of all imported products that match the HTS numbers in the IRS table to request appropriate letters concerning ODC content of their products. Foreign manufacturers of components in a product’s supply chain should be part of this exercise.

While the IRS has adopted a skeptical stance toward such letters, they are necessary documentation to have for any potential Appeals protests or litigation. In addition, the IRS has begun to work with taxpayers, on both an individual and an industry-specific basis, in creating a uniform format that it will accept for letters from foreign manufacturers regarding ODC content.

Finally, if obtaining satisfactory foreign manufacturers’ letters is not possible, taxpayers may gather secondary information—e.g., ISO 14000 information, chemical purchase invoices, environmental policies—or test their own products. The IRS testing protocol is publicly available, and private laboratories may use it. In addition, other testing methods may provide more detail on ODC content than the IRS tests.

During audit: Once under IRS audit on this issue, the taxpayer may pursue other approaches. The IRS drafted the table containing HTS numbers for affected product categories in the early 1990s. Since that time, the HTS has been revised significantly, resulting in a mismatch between some products as they appear in the table and how they currently are identified upon import. Such mismatches can result in the overinclusion of products identified as subject to the ODC excise tax.

In addition, given the technological developments and manufacturing advances that have occurred since the early 1990s, the HTS product descriptions and the assumed ODC weights in the IRS table may no longer be appropriate. Once such mismatches are raised with IRS excise tax agents on exams, the agents may be willing to move products to more appropriate or descriptive HTS headings, thereby reducing or eliminating the proposed adjustments.

Editor: Annette B. Smith, CPA

EditorNotes

Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.

For additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.