Environmental Business Alert: Navigating the IRS Green Trap

Date: Apr 28, 2009

The IRS zeroes in on products manufactured with some ozone-depleting chemicals.

According to the U.S. Internal Revenue Service ("IRS"), companies that import electronic components or products containing printed circuits, transistors, or similar components are subject to a U.S. excise tax for ozone depleting chemicals ("ODCs"). Apparently, many U.S. importers have either been unaware of the tax or mistakenly assumed their products were not manufactured with or contain covered ODCs. In its recent audits of various companies, the IRS has taken a hard line and assumed that in the absence of suitable substantiation, taxable ODCs are used in the manufacture of electronic products and components.

Background on ODC Excise Tax

Promulgated in 1989, after U.S. ratification of the 1987 Montreal Protocol on Substances that Deplete the Ozone Layer, the excise tax is intended to incentivize the use of substances that do not deplete the ozone layer. The ODC tax is imposed on imported products containing or manufactured with various chlorofluorocarbons (CFCs), as well as halons, carbon tetrachloride, or methyl chloroform. Importantly, hydrochlorofluorocarbons ("HCFCs") are not subject to the ODC tax.

Many products imported under Harmonized Tariff Schedule ("HTS") classification 84, 85, 87, 88, and 90 (among others) are subject to the ODC excise tax. A product is subject to tax if it enters into the U.S. for consumption, use, or warehousing and is listed in the Imported Products Table under Section 52.4682-3(f)(1) of the Internal Revenue Code.

The specific categories of products listed in the Table include refrigerators, freezers, and other products in which ODCs are used for purposes of refrigeration or air conditioning. The Table also lists products from the less obvious ODC use for "manufacturing electronic components." For example, imported printed circuit boards that were cleaned with ODC-based solvents during the manufacturing process to get rid of solder residue would be taxed. As a result, the ODC excise tax can apply to a broad array of products containing electronic components, including:

Computer products such as laptops, notebooks, printer units, and pocket computers;

  • Electronics like digital cameras, cell phones, and high definition televisions;
  • Kitchen appliances like coffee makers and microwaves; and
  • Personal care appliances, such as electric shavers, hair dryers and curlers.

Certain products are specifically excluded from the ODC excise tax, so it is important to review the table closely.

IRS Substantiation Requirements

Many U.S. companies rely on vendor assurance letters that taxable ODCs are not used in the manufacture of electronic component and products. According to the IRS, such reliance is based on the misconception that ODCs are no longer in use due to the Montreal Protocol. In reality, the Protocol did not institute an immediate ban on ODCs, but implemented a gradual phase-out over several decades, with developing countries allowed more time to phase out those chemicals with the highest ozone-depleting potential. While developed countries such as the United States and the European Union members committed to phasing out ODCs more quickly, developing countries (known as Article 5 countries), such as India and China can legally produce and use CFCs until 2010.

During recent audits, the IRS has presumed that ODCs are in fact used to manufacture electronic components made outside the U.S. unless suitable substantiation can be provided. Where a company is claiming to use no ODCs or non-taxable ODCs, such as HCFC-based solvents, for example, the IRS is requiring the level of substantiation set out in its ODC Excise Tax Audit Techniques Guide.[1]

A letter from the foreign manufacturer must be obtained for every component and subcomponent of the imported product. This required documentation through the supply chain is staggering. Furthermore, The IRS requires eight specific elements for each foreign manufacturer letter, as listed in the ODC Excise Tax Audit Techniques Guide. For importers claiming that their products and manufacturing processes use no taxable ODCs, the letters from the foreign manufacturers must describe the alternative ODC-free manufacturing technology, the type of equipment involved, where that equipment was purchased, and when it was placed into service. Common industry compliance techniques, such as simple self-certifications or sworn affidavits that no ODs are used, are not likely to be sufficient. Foreign manufacturer letters that meet the IRS' requirements must be available.

Absent the requisite substantiation, businesses should be prepared to face potential tax liability. The IRS regulations and Audit Guide set forth three methods for calculating the excise tax.[2] Companies may not only need tax advice but advice on ODC regulations to appropriately respond to inquiries by the IRS. A discovery by the IRS that a company's products contain ODCs could mean substantial back taxes, statutory interest and penalties for failure to file a return when due. Developing the type of documentation the IRS is requiring will pose a potentially enormous burden on affected companies.

Taxation as an environmental policy tool was controversial when it was first enacted by Congress. In the current environment, with a focus on reducing global warming and promoting sustainable development objectives and energy independence, environmental taxes could become a more important issue in the future.

For more information, please contact Sheila A. Millar at (202) 434-4143 or millar@khlaw.com or J.C. Walker at (202) 434-4181) or walker@khlaw.com.

[1] http://www.irs.gov/businesses/small/article/0,,id=186588,00.html.

[2] 26 C.F.R. § 52.4682-3.

Downloadable Files:
Navigating the IRS Green Trap