On April 12, 2010, Governor Arnold Schwarzenegger signed legislation that will exempt from California taxation escrow accounts that contain settlement funds used to perform cleanup actions pursuant to the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA). The bill, entitled the Conformity Act of 2010, brings California in line with the federal government in making tax free the income on certain escrow accounts and settlement funds created for the purpose of remediating CERCLA hazardous waste sites.
CERCLA Settlement Funds and Federal Law
Private parties who perform cleanup actions at CERCLA hazardous waste sites often use escrow accounts to manage third party settlements and other funds that are used to pay for the cleanup action. Traditionally, these accounts were subject to federal and state income tax and there was no effective way to generate a fair return that would avoid the federal and state tax on the income from such accounts. As a result, the funds available to perform the clean up were reduced.
Congress addressed this issue at the federal level when it passed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). TIPRA amended Section 468B(g) of the Internal Revenue Code (IRC) to provide that an escrow account, settlement fund or similar fund created after May 17, 2006, is to be treated as beneficially owned by the United States and exempt from taxation under the IRC if the settlement fund: (1) was established pursuant to a consent decree entered by a judge of a United States District Court; (2) was created for the receipt of settlement payments for the sole purpose of resolving claims under CERCLA; (3) is controlled (in terms of expenditures of contributions and earnings) by the government or its agency or instrumentality; and (4) provides that upon termination, any remaining funds will be disbursed to such government entity and used in accordance with applicable law. The TIPRA amendment reflects Congress’ concern that the usual rule — subjecting such settlement funds to income taxation — might prevent parties from entering into prompt settlements with the Environmental Protection Agency for the cleanup of Superfund sites and reduce the ultimate amount of funds available for the sites’ cleanup. In short, the tax-exempt status of CERCLA settlement funds is aimed at encouraging dispute resolution.
California Now Conforms to Federal Law
With the passage of the Conformity Act of 2010, the California Revenue and Taxation Code has been amended to incorporate the TIPRA amendment to 468B(g) of the IRC. The result is that most CERCLA settlement funds are now exempt from California in addition to federal tax.
Practical Details and Implications
Only CERCLA settlement funds that are exempt from federal tax will be exempt from California tax, and the California exemption applies only for tax years beginning on or after January 1, 2010. Estimated state tax payments due for 2010 need not be made and, if already made, should be refunded upon filing of the California tax return with respect to the CERCLA settlement fund. For those parties contributing to or considering creating a CERCLA settlement fund, the new legislation may result in significant tax savings, further encourage settlement, simplify tax preparation and ease compliance with tax regulations, to the overall benefit of CERCLA settlement fund contributors.
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This article was originally published by Bingham McCutchen LLP.