The Case for 'Reverse Depreciation' of Reclamation Costs

Taxpayers in certain industries, such as mining and waste disposal, are legally obligated to reclaim land or other property that is damaged or contaminated in the course of their business activities. The reclamation typically occurs after the underlying site has closed and the taxpayer is no longer carrying on business on the site. This article discusses the income tax treatment of these reclamation obligations, and in particular, the treatment of amounts set aside or invested for the purpose of funding the payment of reclamation costs. For example, taxpayers will often be required to provide financial assurance in respect of their reclamation obligations, which can include the posting of bonds, cash, letters of credit, or contributions to a reclamation trust. Under common law principles, reclamation costs are recognized for income tax purposes in the taxation year in which they are incurred, which normally means the year in which the reclamation is carried out. Taxpayers in the affected industries have argued that reclamation costs should be recognized for income tax purposes in taxation years prior to reclamation, once the obligation to reclaim (albeit in the future) has been imposed. In response to the industries' concerns, the federal government enacted statutory rules to allow a deduction for contributions made to a qualifying trust used to fund future reclamation. In general terms, under this system, a taxpayer's contributions to the trust are deductible in the year in which they are made and the trust is taxed annually on the investment income earned on the contributions. Withdrawals of the contributions and the investment income are included in the taxpayer's income upon withdrawal, and such amounts are deductible under general principles as they are spent on reclamation. Interestingly, although the statutory rules allow an earlier deduction on account of reclamation costs relative to the common law position, on an after-tax basis and after accounting for the time value of money, a taxpayer's liability to pay reclamation costs will generally be the same whether it is governed by the statutory system or by the common law rules. In other words, in economic terms, little has changed from the common law position. In this article, the author argues that reclamation costs that reflect negative salvage value (that is, where the reclamation does not add significant value that can be realized or consumed after the reclamation) should be subject to a depreciation Under the reverse depreciation approach, reclamation costs would be deducted or depreciated before the time of reclamation, during the taxpayer's income-earning process, to coincide with the taxpayer's loss in wealth represented by its liability to pay the costs. Under this approach, amounts invested to fund the future reclamation would be deductible on a current basis, and imputed interest expense thereon would be deductible up to the time of reclamation. The imputed interest expense deduction would serve to offset the inclusion of the income earned by investing such amounts. (Alternatively, the income could simply be exempt from taxation.) Thus, in contrast to the common law and statutory rules, the reverse depreciation approach would exempt from taxation the income earned for the purpose of funding the reclamation. The reverse depreciation approach would be analogous to an environmental registered retirement savings plan approach. In the case of reclamation costs that generate positive salvage value, the common law and statutory system will often be appropriate. However, even in the positive salvage value cases, it is argued that reverse depreciation may be more appropriate if the reclaimed site depreciated in value during the taxpayer's income-earning process but was not subject to a depreciation deduction during that period of time. Under these circumstances, the reverse depreciation of the reclamation costs could act as a remedial measure, meant to compensate for the lack of a regular depreciation deduction in the years in which the site actually depreciated in value owing to the taxpayer's contaminating business activities. For example, to the extent that the reclamation is performed on land (where regular depreciation is not available), reverse depreciation of the reclamation costs could be justified even if the reclamation generates positive salvage value.

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