Reynolds Metals Co. v. U.S.

• Decision Date: 22 August 2005
• Docket Number: No. Civ.A. 3:02CV670-JRS.,Civ.A. 3:02CV670-JRS.
• Citation: 389 F.Supp.2d 692
• Parties: REYNOLDS METALS COMPANY, et al., Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.
• Court: U.S. District Court — Eastern District of Virginia

389 F.Supp.2d 692

REYNOLDS METALS COMPANY, et al., Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.

No. Civ.A. 3:02CV670-JRS.

United States District Court, E.D. Virginia, Richmond Division.

August 22, 2005.

Thomas Arthur Clare, Kirkland & Ellis, Washington, DC, Natalie Hoyer Keller, Kirkland & Ellis, Chicago, IL, for Plaintiffs.

Michael J. Martineau, Trial Attorney, Tax Division, U.S. Dept. of Justice, Washington, DC, Robert P. McIntosh, United States Attorney's Office, Richmond, VA, for Defendant.

MEMORANDUM OPINION

SPENCER, District Judge.

THIS MATTER is before the Court on the parties' cross motions for partial summary judgment.¹ Reynolds Metals Co. ("Reynolds") is seeking a total tax refund of $22,271,747.00 which it claims resulted from the overstatement of its gross income from 1940 through 1987.

"Summary judgment is appropriate only if the pleadings, depositions, answers to interrogatories and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact." Smith v. Continental Casualty Co., 369 F.3d 412, 417 (4th Cir.2004) (citing Fed.R.Civ.P. 56(c) and Celotex Corp. v. Catrett, 477 U.S. 317, 322, 106 S.Ct. 2548, 91 L.Ed.2d 265 (1986)). "When faced with cross-motions for summary judgment, the court must review each motion separately on its own merits to determine whether either of the parties deserves judgment as a matter of law. When considering each individual motion, the court must take care to resolve all factual disputes and any competing, rational inferences in the light most favorable to the party opposing that motion." Rossignol v. Voorhaar, 316 F.3d 516, 523 (4th Cir.2003) (internal quotations and citations omitted).

(i) The Complaint

Reynolds and its subsidiaries seek recovery of income taxes and applicable interest for the taxable years 1992 through 1995. According to Reynolds, the amounts at issue are as follows: $7,023,004.00 in 1992; $2,603,965.00 in 1993; $5,935,322.00 for 1994 and $6,709,456.00 in 1995. This Court has jurisdiction over this matter because it involves a "civil action against the United States for the recovery of [an] internal-revenue tax ... erroneously or illegally assessed or collected." 28 U.S.C. § 1346(a)(1). The parties agree that Reynolds exhausted its administrative remedies and that this case is properly before the Court.

According to the Complaint, Reynolds' manufacturing operations generate waste byproducts. Reynolds claims that between 1940 and 1987, it utilized waste disposal practices in accordance with industry standards and federal regulations. During the nearly five decades, Reynolds claims that it included the disposal costs in the computation of its gross income for income tax purposes. In subsequent years, Reynolds learned that its waste disposal practices were inadequate when it incurred liability under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. 42 U.S.C. § 9601 et seq. As a result, during the years 1992 to 1995, Reynolds incurred substantial environmental remediation costs to re-dispose of the waste byproducts and to remediate contaminated areas.²

Reynolds contends that the environmental remediation costs borne during the 1992 to 1995 taxable years are allocable to revenue reported by Reynolds in the years 1940 to 1987. Therefore, Reynolds insists that it understated the waste disposal costs for those five decades. This understatement, according to Reynolds, caused its cost of goods sold to be understated and, consequently, caused it to overstate its gross income for the years 1940 to 1987. Reynolds sought a refund of the excess taxes paid during those years but the IRS has refused its claims.

According to Reynolds, if it treats the environmental remediation costs as deductible in the years 1992 through 1995 rather than allocable to the years 1940 to 1987, Reynolds would not receive the full tax benefit of its costs as a result of the differences in tax rates during the relevant years. The corporate tax rates for the years 1940 through 1987 were substantially higher than the tax rates from 1992 to 1995.

Reynolds insists that the Internal Revenue Code, and specifically 26 U.S.C. § 1341, provides a remedy for this contingency caused by the timing differences in the tax rates. According to Reynolds, § 1341 applies when a taxpayer recognized gross income in a prior year because the taxpayer had an unrestricted right to such income, only to discover later that it did not have such a right. Section 1341 provides that the affected taxpayer may (i) claim a deduction in the later year to offset the overstatement in the prior year or (ii) reduce its tax for the later year by the decrease in tax for the prior year that would have resulted if the taxpayer reported the correct amount of gross income in the prior year. Simply stated, the taxpayer is permitted to recover his tax overpayment. Applying these principles would result in the refunds mentioned above.

(ii) Reynolds Motion for Partial Summary Judgment

Reynolds's Motion for Partial Summary Judgment seeks a determination of whether it is entitled to relief under § 1341. After Congress passed extensive environmental legislation in the 1980s, Reynolds expended over $110 million remediating the sites of its prior operations.³ Between the years 1940 and 1987, Reynolds' manufacturing operations generated taxable income from the production of aluminum products. During those years, Reynolds' tax rate was usually 46% or higher. In 1987, Reynolds' tax rate dropped to 35%. As a result of the increased environmental clean-up costs and the lowered tax rate, Reynolds insists that it is entitled to a refund because it overstated its gross income for the years 1940 through 1987 due to the understated environmental costs.

Reynolds' motion asks the Court to decide three issues: (1) whether Reynolds had an unrestricted right to an item included in gross income for tax years 1940 through 1987; (2) whether Reynolds is entitled to a deduction for tax years 1992 through 1995 because Reynolds did not have an unrestricted right to the earlier item of gross income; and (3) whether the "inventory exception" applies to deny Reynolds relief.

According to Reynolds, the waste disposal costs were inventoriable costs included in the computation of Reynolds' cost of goods sold for the relevant tax years.⁴ During the tax years 1992 through 1995, Reynolds conducted environmental remediation activities related to waste byproducts generated in prior years. For federal income tax purposes, Reynolds treated the costs of these clean-up activities as either (i) ordinary and necessary business expenses deductible under § 162 (itemized deductions for trade or business expenses) or (ii) capitalized expenditures under § 263 (items not deductible; capital expenditures) which Reynolds amortized over a period of years.

(iii) Title 26, U.S.Code § 1341

According to Reynolds, § 1341 remedies inequities caused by the "claim of right" doctrine. Under the claim of right doctrine, a taxpayer must report taxable income in the year it is received. See United States v. Lewis, 340 U.S. 590, 591, 71 S.Ct. 522, 95 L.Ed. 560 (1951). If, during a subsequent tax year, a taxpayer discovered that he was not entitled to the previously claimed income, his only option was to claim a deduction in the year of repayment; the taxpayer was not permitted to recalculate his previous income and tax liability. An inequity resulted to the taxpayer when the deduction at a later year is taken at a lower tax rate.⁵

To rectify the inequity, Congress enacted § 1341 in 1954 as part of a massive revision to the tax code, see Public Law No. 83-591, 68A Stat. 348. Generally, § 1341 treats the change in tax rate as a tax neutral event by permitting the taxpayer to take a deduction at the same tax rate at which the relevant income was taxed. Reynolds insists that it is entitled to be placed in a tax neutral position through the application of § 1341. Reynolds argues that if it incurred the increased environmental clean-up costs during the years when the goods associated with the waste disposal were sold, its cost of goods would have been higher which would have reduced its gross income and lowered its tax bill.

Reynolds argues that it could take a deduction associated with the remediation costs in the tax years 1992 through 1995, but the lower tax rates do not place it in a tax neutral position relative to the tax liability it incurred from 1940 to 1987. Reynolds insists that the holding in Pennzoil-Quaker State Co. v. United States, 62 Fed. Cl. 689 (2004), is exactly on point and should control the outcome of this case.

Code section 1341 provides that if

(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;

(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and

(3) the amount of such deduction exceeds $3,000, then the tax imposed by this chapter for the taxable years shall be the lesser of the following:

(4) the tax for the taxable year computed with such deduction; or

(5) an amount equal to —

(A) the tax for the taxable year computed without such deduction, minus

(B) the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).

26 U.S.C. § 1341(a) (1995). Section 1341 also contains the "inventory exception" to the general rule. According to the inventory exception, section 1341

does not apply to any deduction allowable with respect to an item which was included in gross income by reason...