In recent years, the number of IRS audits on the Ozone-Depleting Chemicals Excise Tax (“ODC tax”) targeting importers of electronics has increased dramatically. Multi-million-dollar audit assessments on the ODC tax are not rare. This article will discuss recent trends of the IRS audits on the ODC tax and how to get prepared for a possible IRS audit.
An excise tax is a federal tax on the use or consumption of goods or services. Tax on certain goods such as gasoline, cigarettes and alcohol, and tax on services such as telecommunication and air transportation are examples of the excise tax.
The ozone layer is a layer in the stratosphere that lies 9 to 20 miles above the surface. The ozone layer is vital for human life as the ozone layer absorbs harmful ultraviolet rays (“UVs”), which may cause skin cancer and other skin diseases. Chemicals that deplete the ozone layer are called ozone-depleting chemicals (“ODCs”). In Japan, they are often referred to as Freon or Freon gas. As ODCs are stable, inflammable and non-toxic, they were widely used in industries as refrigerants for air conditioners, solvents for printed circuit boards, and propellants for hair sprays.
In the early 1980’s, scientists discovered a hole in the ozone layer over the South Pole. Further research revealed that the ozone hole was created by a chemical reaction caused by chemicals such as chlorofluorocarbon (“CFC”), which were emitted in the air by industries. The Montreal Protocol, an international agreement to restrict the depletion of ozone layer by industrial activities, was signed in 1987. The protocol banned production of ODCs after 1995 and restricted the use of existing ODCs. However, the protocol gave additional time to eliminate ODCs to developing countries until 2009 or later depending on the type of ODCs.
The U.S. chose to implement the Montreal Protocol by imposing an excise tax with respect to ODCs. The ODC tax, which was effective January 1, 1990, was designed to increase the cost of products manufactured using the ODCs in order to facilitate implementation of alternative non-ODC technologies. IRC section 4682(a)(2) lists twenty chemicals such as CFCs and Halon as ODCs subject to the ODC tax.
The ODC tax consists of three taxes: 1) tax on sale or use by the manufacturer or importer of ODCs, 2) tax on inventory of ODCs, and 3) tax on sale or use by the importer of imported products manufactured using ODCs. Among the three, the tax on imported products is the most relevant to Japanese companies operating in the U.S as almost all of the recent IRS audits have been focusing on the tax on imports. Accordingly, this article focuses on the tax on importeds.
Products entered into the U.S. for consumption, use, or warehousing are subject to the ODC tax if they meet both of the following two conditions:
- ODCs are used in the manufacture or production; and
- The product is listed on the current Imported Products Table in the regulations
Consequently, products manufactured or produced without use of ODCs, or products not listed on the imported taxable table, are not subject to the ODC tax. Further, products that are warehoused or repackaged after the entry and then exported without being sold or used in the U.S. are not subject to the ODC tax.
As mentioned above, any imported products for which ODCs are used in the manufacturing process are subject to the ODC tax if the products are listed on the imported products table. However, the IRS has been focusing specifically on the electronics industry in recent years. This is because, in general, electronic products contain printed circuit boards. Before the Montreal Protocol, the ODCs were used to wash the printed circuit boards to remove solder residue. After the Montreal Protocol went in effect, improved solder no longer requiring the washing process and non-ODC solvents were developed . However, ODCs still may be used to wash the printed circuit boards in developing countries because the Montreal Protocol did not restrict the use of the ODCs entirely in developing countries and also because the new technologies may be more expensive to implement. Since many of the electronic products imported into the U.S. are manufactured in developing areas such as China and South East Asia, the IRS is focusing on these products.
The imported products table lists various types of industrial products and is organized by the Harmonized Tariff Schedule (HTS) Number. The table also states the ODC and the weight of that ODC used to manufacture each product listed on the table. The table is comprehensive and lists almost all electronic products. And, in fact, electronic products that are not specifically listed on the table fall under a category of “other electronic products.” Therefore, imported electronic products are generally subject to the ODC tax unless the taxpayer establishes that no ODCs were in fact used in the manufacturing process.
The ODC tax liability is generally calculated as follows:
Tax = (Tax Rate for the year) x (Ozone-Depletion Factor for the ODC) x (ODC Weight in lbs. for the product)
The tax rate in 2010 is $12.10 per pound of the ODC used. As the tax rate is increased by 45 cents each year, the tax rate in 2011 will be $12.55 per pound.
The ozone-depletion factor is a factor assigned to each of the twenty ODCs subject to the ODC tax to account for the degree of the effect of each ODC to the ozone layer. The ozone-depletion factor assigned to Halon, for example, is three to ten times higher than the factor assigned to other ODCs since Halon depletes the ozone layer more than other ODCs.
The ODC weight is generally determined based on the exact weight of the ODC used (“Exact method”) or weight listed on the imported products table (“Table method”). If the exact weight of the ODC used cannot be determined and the ODC weight is not specified in the imported products table, the ODC tax liability is one percent of the entry value reported to the U.S. Customs (“Value method”).
In order to use the exact method, an importer of a product must obtain one or more letters, which state the type of the ODCs used and the exact weight of the ODCs used, from the manufacturers of the product (“Manufacturer’s Letter”). In cases where no ODCs are used in the product’s manufacture, the ODC tax liability is zero under the exact method if an importer obtains the letters stating that the exact weight of the ODCs used is zero. In contrast to the exact method, the ODC tax liability never becomes zero under the table method because the ODC weight listed on the imported products table is used without regard to the actual non-usage of ODCs. The ODC tax liability under the value method also never becomes zero regardless of non-usage of ODCs because the ODC tax liability is computed as one percent of the entry value. Consequently, the only way for an importer to avoid being subject to the ODC tax is to have the IRS accept the application of the exact method by obtaining a complete manufacturer’s letter.
The IRS has an agreement with U.S. Customs to receive information for ODC tax purposes. The IRS usually begins an ODC tax audit by reviewing the U.S. Customs import records to identify importers of products potentially subject to the ODC tax. Once an ODC tax audit is started, the IRS examiners conduct the audit based on an assumption that the imported products are manufactured using ODCs. The examiners normally assess ODC tax based on either the table method or the value method if the importer cannot establish non-use of ODCs since the burden to establish non-use of ODCs is on the importer. Based on the current regulations, a letter from a manufacturer of the imported products that states non-use of ODCs should be sufficient to apply the exact method. However, the IRS recently changed its ODC tax examination policy due to the fact that letters stating non-use of ODCs were used by manufacturers that previously used ODCs and because the IRS believes the manufacturer letters are self serving and questions the truthfulness of the letters. Under the revised policy, IRS examiners now require a manufacturer’s letter to include extensive additional information such as foreign government official’s seal, detailed explanation of non-ODC alternative technology including the type of the equipment used, the date the alternative technology was placed in service, the name of the supplier of the alternative technology, and a copy of the invoice for the alternative technology. Further, the IRS examiners require submission of a letter from a manufacturer of printed circuit boards included in imported products in addition to a letter from the last assembler of the products.
There are several hurdles for an importer to obtain a manufacturer’s letter that satisfies all the requirements mentioned above. In most cases, it takes a long time to gather required information. An importer often finds that the manufacturer has been out of business when an IRS audit is started. Also, because the non-ODC alternative technologies were often implemented in the early 1990’s, gathering the detailed information on the alternative technologies often requires a search for old records. Since the IRS examiners always set a due date for submission of the manufacturer’s letters, an importer may not have enough time to obtain manufacturer’s letters from all manufacturers. Therefore, it is essential to obtain a letter in advance not only from a manufacturer of the imported products but also from a producer of the printed circuit boards included in the imported products for each imported product type. It is ideal to obtain a letter every time a new product is imported.
During an IRS audit, IRS examiners may propose laboratory testing, based upon methods developed by the IRS, instead of submission of detailed manufacturer’s letters. The IRS says the laboratory testing detects ODCs from a product to determine if ODCs were used in the product’s manufacturing process. The IRS may ask for the importer’s consent to conduct the laboratory testing. However, we generally do not recommend consenting to the testing because this laboratory testing has several problems. First, the technical and statistical information on the laboratory testing is not disclosed by the IRS and the IRS does not provide information such as the number of tests conducted and the percentage of tests which detected the ODCs. Second, although the ODCs used in packaging materials are not subject to the ODC tax, the laboratory testing technically cannot distinguish the permissible ODC use from the taxable ODC use. Third, once ODCs are detected by the laboratory testing, it is extremely difficult to avoid an ODC tax assessment because of the evidence allegedly established by the testing.
Also, our clients often ask us if it is possible to test their own products at a private laboratory as a precaution against a possible IRS audit. While it may seem to be a good protection for importers, such self-testing is not recommended either. The IRS examiners always request the results of self-testing if such testing has been conducted. An importer must provide the result even if the result was unfavorable. While the IRS examiners may assess ODC tax based on such unfavorable result, the IRS examiners may not necessarily accept the results of self-testing if the results are negative (i.e., no ODCs were detected). In addition, the testing is usually expensive as it requires special facilities.
An importer can go to IRS Appeals to protest the IRS examiner’s proposed assessment. Appeals is an organization within the IRS, but it is designed to review the result of an IRS audit from an independent and neutral point of view. Although the IRS field examiners often try to aggressively impose a significant amount of tax, the assessments are usually reduced in Appeals. It is not rare to see the Appeals officers reduce excessive assessments drastically. In some cases, the assessments proposed by the field agents are entirely eliminated as the Appeals officers accept manufacturer’s letters, which were previously rejected by the field examiners. While the Appeals process usually takes about a year, it may take longer if the Appeals officers request additional information.
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.