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18A-RP1-2018-DEQ · Department of Environmental Quality · 2018-07-02

IN THE OFFICE OF ADMINISTRATIVE HEARINGS

In the Matter of: No. 18A-RP1-2018-DEQ

Osborn Products Inc., ADMINISTRATIVE LAW JUDGE DECISION Appellant.

HEARING: May 14, 2018, at 9:00 a.m.; the record was held open until June 22, 2018, to allow the parties to submit written closing memoranda. APPEARANCES: Osborn Products Inc. (“Osborn”) was represented by Joseph A. Drazek, Esq., Quarles & Brady LLP; the Arizona Department of Environmental Quality (“ADEQ”) was represented by Shilpa Hunter-Patel, Esq., Assistant Attorney General. ADMINISTRATIVE LAW JUDGE: Diane Mihalsky _____________________________________________________________________ FINDINGS OF FACT BACKGROUND 1. On or about August 16, 2017, Osborn filed a Qualified Business Settlement (“QBS”) application with ADEQ pursuant to A.R.S. § 49-292.01 to settle its potential liability under the Water Quality Assurance Revolving Fund (“WQARF”).1 With the application, Osborn submitted copies of its U.S. Corporation Income Tax Returns for tax years 2014 and 2015. 2. On or about November 16, 2017, Osborn amended its QBS application to submit copies of Osborn’s tax returns for tax years 1986 and 1987.2 3. The years 1985 and 1986 were the two years preceding ADEQ’s investigation into Osborn’s potential liability. The amounts set forth on Osborn’s tax returns for income from all sources, including gross receipts or sales, were $2,851,792 in 1985 and $2,431,662.00 in 1986. Osborn claimed an offset for the cost of goods sold and/or operations of $1,277,995.00 on the 1985 return and $1,697,709.00 on the 1986 return.3

See Osborn’s Exhibit 2. See Osborn’s Exhibit 4. See Osborn’s Exhibit 4 at OSBQBS0140 and OSBQBS0158.

Office of Administrative Hearings 1740 West Adams Street, Lower Level Phoenix, Arizona 85007 (602) 542-9826 4. The years 2014 and 2015 were the two years preceding the filing of Osborn’s application for a QBS with ADEQ. The amounts set forth on Osborn’s tax returns for income from all sources, including gross receipts or sales, were $1,742,995 in 2014 and $1,727,328 in 2015. Osborn claimed an offset for the cost of goods sold and/or operations of $1,252,192 on the 2014 return and $1,104,511 on the 2015 return.4 5. Because ADEQ failed to approve Osborn’s QBS application within ninety days of the November 16, 2017 amendment, the application was deemed denied under A.R.S. § 49-292.01(E). Osborn filed an appeal of the denial. 6. ADEQ referred the matter to the Office of Administrative Hearings, an independent state agency, for an evidentiary hearing. On April 3, 2018, ADEQ issued a Notice of Hearing on the following two issues: 1. Does A.R.S. § 49-292.01(J) require ADEQ when determining whether an applicant is a qualified business to apply the definition of “gross income” contained in the IRS Code (26 U.S.C. §61/I.R.C. §61)?

2. Was ADEQ correct in not granting Osborn Products’ application for a qualified business settlement which calculated gross income based on the IRS Rules (26 C.F.R. § 1.61-3) rather than the IRS Code (26 U.S.C. §61/I.R.C. §61)?

7. A hearing was held on May 14, 2018. Osborn submitted nine exhibits and

presented the testimony of three witnesses: (1) Bruce Osborn, its president; (2) Laura Malone, ADEQ’s Director of its Waste Programs Division, who testified as a hostile witness; and (3) Donald Frost, CPA, a professor at Arizona State University, who testified as Osborn’s tax and accounting expert. ADEQ submitted three exhibits. APPLICABLE STATUTES A.R.S. § 49-292.01 provides in relevant part as follows: A. The director shall enter into a settlement under this article and section 107 of [the federal Comprehensive Environmental Response, Compensation, and Liability Act, as amended (“CERCLA”)] with a person that qualifies pursuant to this section without regard to the extent of its liability . . . . See Osborn’s Exhibit 1 at OSBQBS0038 and OSBQBS0087. B. An applicant seeking settlement under this section shall have identifiable gross income as defined in section 61 of the internal revenue code greater than one dollar in each of the two years prior to the application and in each of the two years preceding the year that an investigation of the applicant's share was initiated by either the department or the United States environmental protection agency. The applicant shall submit a letter to the director requesting a qualified business settlement on a form provided by the director. The request letter shall include the applicant's tax returns for the time periods provided in subsection J of this section. . . . .... J. For the purposes of this section, "qualified business" means an applicant who meets both of the following conditions:

1. The applicant's gross income as defined by section 61 of the internal revenue service code is less than two million dollars per year and greater than one dollar per year. 2. The applicant complies with the definition for the average of the two years preceding the year that an investigation of the applicant's share was initiated by either the department or the United States environmental protection agency, and for each of the two years preceding the year that a request was submitted by the applicant pursuant to subsection B of this section. (Emphasis added.) Section 61 of the Internal Revenue Code, 26 U.S.C. § 61(a), I.R.C. § 61, provides in relevant part as follows: General definition. Except as otherwise provided in this subtitle [26 U.S.C. §§ 1 et seq.], gross income means all income from whatever source derived, including (but not limited to) the following items:

(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;

(2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents;

(6) Royalties; (7) Dividends; (8) Annuities;

(9) Income from life insurance and endowment contracts; (10) Pensions; (11) Income from discharge of indebtedness;

(12) Distributive share of partnership gross income;

(13) Income in respect of a decedent; and (14) Income from an interest in an estate or trust.

(Emphasis added.)

HEARING EVIDENCE

8. Mr. Osborn testified that Osborn is a family-run business that manufactures

high-quality precision machined parts. Osborn was started by Mr. Osborn’s father in

1956 and has been in business continuously for 62 years. Osborn currently employs 26 people who, on average, have worked for Osborn for 20 or 25 years, with some employees having worked for Osborn for more than 30 or 40 years. Mr. Osborn testified that if ADEQ does not enter into a QBS settlement, Osborn will go bankrupt. Osborn’s long-term employees will lose their jobs and their health insurance. Due to these employees’ ages, it will not be easy for them to find new employment. 9. Osborn submitted evidence to establish that since April 29, 1997, when A.R.S. § 49-292.01 became effective,5 ADEQ has approved at least three QBS applications to resolve a regulated entity’s liability under CERCLA and WQARF, including the following: (1) On or about September 17, 1997, a QBS with regulated

See Laws 1997, Ch. 287, § 4. persons Arcadia Drycleaning & Laundry, Inc., Meadowbrook Cleaners, L.L.C., Mark J. and Janet M. Witt, and the Witt Revocable Trust (collectively, “Arcadia Drycleaning”);6 (2) On or about May 13, 2015, a QBS with Houston International, Ltd. (“Houston International”);7 and (3) On or about March 24, 2017, a QBS with Layke Incorporated.8 10. ADEQ agreed in a QBS with Arcadia Drycleaning to accept 10% of its average annual gross income for the two years preceding its application, or approximately $9,989.00 based on its total average annual gross income of $99,893.00, to resolve its liability under CERCLA and WQARF.9 The record does not reflect whether ADEQ allowed any offset against Arcadia’s gross income or whether the offset affected Arcadia’s eligibility to receive a QBS under A.R.S. § 49-292.01(B) and (J). 11. The Stipulation for Entry of Consent Decree/QBS resolving Arcadia Drycleaning’s liability under CERCLA and WQARF discussed the legislative history of A.R.S. § 49-291.01, in relevant part as follows: In enacting A.R.S. § 49-292.01, the Legislature made the decision that the public good was best satisfied by allowing small “mom-and-pop” businesses to escape from the onerous financial burdens of CERCLA and WQARF by settling with the government using a simple formula. The legislature heard a great deal of testimony regarding the need for reducing the WQARF and CERCLA liability of small businesses, and was very concerned about addressing their problems. See generally Minutes from the House Committee on the Environment at 12, 14, 15, 16 (March 20, 1997), (some small businesses have been involved in the CERCLA and WQARF process for years; settlements for small businesses are needed); Minutes from the Senate Committee on Appropriations at 35, 36 (February 26, 1997), (small business settlement takes people out of the process who have caused environmental damage [for cash payments]; definition of small business debated); Minutes from the Senate Committee on Natural Resources, Agriculture and Environment at 26, 27, 28 (February 12, 1997), (small business settlement program allows businesses to settle with ADEQ; small business definition should reflect ability to pay with a sliding scale and allow See Osborn’s Exhibit 6. See Osborn’s Exhibit 8. See Osborn’s Exhibit 13. See Osborn Exhibit 6. businesses to get out of CERCLA and WQARF investigations and litigation). After considering this testimony, the Legislature enacted the qualified business settlement, A.R.S. § 49- 292.01, which allows a small business to quickly settle its WQARF and CERCLA liability. House Bill Summary For The Committee On The Environment For S.B. 1452, at 5 (March 20, 1997) (settlement summarized); Senate Research Staff Memo, at 13 (March 3, 1997) (earlier bill had provision for ADEQ “to adopt rules for implementation of the small business settlement program” which was removed in the House and replaced with the Qualified Business Settlement provision). Giving the financial relief to small businesses is an essential part of the act, Senate Bill 1452, which created A.R.S. § 49-292.01. This legislative intent is clearly stated:

“Legislative intent . . . B. This act contains the following essential elements: . . . 3. Relief for parties that cannot afford to pay their share of cleanup costs. . . 1997 Ariz. Sess. Laws. Ch. 287, Section 1.

The formula contained in A.R.S. § 49-292.01 represents a simple and efficient method for calculating the ability to pay for a small business. The Legislature recognized that while this formula may not always be a precise measurement of the ability to pay, it is a rational basis for determining settlement amounts and it avoids the expenses associated with an exhaustive investigation.

Most importantly, the Legislature provided funding to make up the difference between what a qualified business pays, and the amount for which it may be liable under WQARF. This difference is defined as an “orphan share”. “Orphan shares means the cost of a remedial action that are allocated to an identified person who is determined to be a responsible party and that are not paid or otherwise satisfied by that responsible party due to any of the following: . . .(b) The party has entered into a [QBS] pursuant to this article. . .” A.R.S. § 49-282(E), 1997 Ariz. Sess. Laws. Ch. 287, Section 24. ....

Settlements under A.R.S. § 49-292.01 enable the State to recover some remediation costs, without having to incur further costs by spending money on extensive investigation and litigation. The unfortunate reality is that many small [Potentially Responsible Parties (“PRPs”)] do not have the money to pay their full allocated share, and all the investigation and litigation in the world cannot recover money which does not exist. The Legislature’s decision to provide some relief to small businesses facing financial disaster is obviously a legitimate solution to the problem, and the settlement is substantively fair.10

12. ADEQ agreed in a QBS to accept $5,805.55, or 10% of Houston

International’s average annual gross income as set forth on line 11 of its tax returns for

two years preceding its application, to resolve its liability under CERCLA and WQARF11

Line 11 on the federal corporate income tax Form 1120 is for “Total Income” after a

deduction for the “Cost of goods sold.”12 The record does not reflect whether the

deduction affected Houston International’s eligibility to receive a QBS under A.R.S. §

49-292.01(B) and (J).

13. On October 16, 2016, Layke Incorporated’s attorney demanded a QBS in

the amount of $27,895.00, based on 10% of its average annual gross income for the two years preceding the QBS application to resolve Layke Incorporated’s liability under CERCLA and WQARF. Layke International’s attorney stated in a footnote in the demand letter that “[t]he Internal Revenue Service defines gross income derived from a manufacturing business to mean ‘the total sales less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources.’ See IRS Regulation ¶ 5511, § 1.61-3.”13 The record does not reflect whether the deduction

Osborn’s Exhibit 6 at 6, l. 25 – 9, l. 6. See Osborn’s Exhibit 8. See Osborn’s Exhibit 2 at OSBQBS0038. Osborn’s Exhibit 13 at OSBQBS0456. for the cost of goods sold affected Layke Incorporated’s eligibility to receive a QBS under A.R.S. § 49-292.01(B) and (J). 14. On or about March 24, 2017, Ms. Malone sent a letter to Layke Incorporated’s attorney, stating that based on the information that he had provided, ADEQ agreed to a QBS settlement in the amount of $27,895.00.14 Ms. Malone testified that the QBS for Layke Incorporated was consistent with prior correspondence. 15. Osborn submitted an email chain showing that, on February 26, 2018, Tina LePage, ADEQ’s Remedial Projects Section Manager, Ana I. Vargas, ADEQ’s Deputy Director, Waste Programs Division, and Ms. Malone discussed Osborn’s QBS application. ADEQ’s employees made the following remarks in the email chain: [Ms. LePage (at 3:48 p.m.)]: I just wanted to be sure of the path forward. The original QBS was for about $55,000 [site is within WCP – North Canal Plume].

This is the site where we had the question about the calculation of gross income and how, if the Internal Revenue Code definition was applied, [Osborn’s] settlement would be substantially more. Currently, without any settlements, [Osborn’s] share is about $500,000. Agreeing to this settlement amount more than likely will increase the State’s orphan share associated with WCP unnecessarily.

Let me know if Christina should draft the QBS Acceptance Letter for Laura. .... [Ms. Vargas (at 3:55 p.m.)]: I am copying Laura on this. Yes, the discussion with Christina was to accept the offer as is. Until we have an opportunity to review a new proposed process, vet it and . . . agree to it, we will continue with the current process. Laura, please add any additional information. .... [Ms. Malone (at 5:58 p.m.]: Okay, we need to talk about this. I was not aware that accepting this offer was far below what See id. at OSBQBS0462. they are on the hook for and would increase our orphan share. I understand that we are having issues with the AGO and HGL and the AGO wanting a new process but I need to better understand what we are agreeing to before I’ll sign. I’ll have Lolee get something on the calendar ASAP. Thanks.15 Ms. Malone testified that “AGO” was the Attorney General’s Office and “HGL” was the contractor for identifying potential responsible parties. 16. Ms. Malone testified that the Houston International and Layke Incorporated settlements had been done incorrectly. Ms. Malone testified that if ADEQ has made mistakes in the past in processing QBS applications, it is not acceptable for ADEQ not to correct the mistakes in future or current applications. 17. Ms. Malone testified that Ms. Vargas was confused and was referring to something other than the QBS process or eligibility. Ms. Malone testified that she did not address Ms. Vargas’ confusion in the email, but that she meant to meet with staff as soon as possible. Ms. Malone testified that she wanted to talk to her staff about Ms. LePage’s concern about whether A.R.S. § 49-292.01 was being followed. 18. Ms. Malone testified that she was not aware that the ninetieth day after Osborn’s QBS was complete was February 22, 2018. The issue of Osborn’s eligibility for a QBS had been raised at the last minute, after the time had run out for ADEQ to issue a decision on its application. 19. ADEQ acknowledged that Mr. Frost is a tax and accounting expert. Mr. Frost noted that A.R.S. § 49-292.01(B) requires a QBS applicant to submit its tax returns on which the first line provided the entity’s gross receipts for the year. Mr. Frost testified that gross receipts are not the same as gross income in most cases. Mr. Frost testified that to calculate the income for a manufacturer such as Osborn, the costs of production, returns, and allowances must be deducted. Mr. Frost testified that the IRS’s regulations are part of the Internal Revenue Code and that the regulations provide for a deduction for the costs of goods sold. 20. Mr. Frost acknowledged that the cost of production would not need to be deducted from a consultant’s or service provider’s gross receipts to calculate its gross Osborn’s Exhibit 7. income. Mr. Frost acknowledged that Congress frequently provides special rules for a class of taxpayers, such as farmers, that A.R.S. § 49-292.01 does not refer to any special kind of business and that section 61 of the Internal Revenue Code does not require that the nature of the business be considered to determine gross income. Mr. Frost acknowledged that § 61 of the Internal Revenue Code applies to all taxpayers, but that the Code of Federal Regulations provides different deductions for different taxpayers based on the nature of their businesses. 21. Ms. Malone testified that ADEQ treats all QBS applicants the same, regardless of the nature of their businesses. A QBS applicant may be a farmer, a transporter, a service provider, or a manufacturer. Ms. Malone testified that she and her staff are familiar with the items included in gross income in Section 61 of the Internal Revenue Code, but that they are not familiar with the voluminous Code of Federal Regulations that set forth income deductions for various businesses. If ADEQ deducted an expense from a QBS applicant’s income that was not available to other applicants due to the nature of their businesses, it would not be fair. Ms. Malone testified that deducting the cost of goods sold from regulated manufacturers’ gross income to determine QBS eligibility would disparately impact other regulated businesses because the offset would not be available to these other businesses.16 CONCLUSIONS OF LAW 1. This matter lies within ADEQ’s jurisdiction. 2. Osborn bears the burden of proof to establish that it is qualified to enter into a QBS under A.R.S. § 49-292.01 by a preponderance of the evidence.17 3. “A preponderance of the evidence is such proof as convinces the trier of fact that the contention is more probably true than not.”18 However, because the facts were not disputed and Osborn’s appeal presents a pure legal issue of statutory interpretation, the Administrative Law Judge, ADEQ, and any reviewing court may review de novo the issue and the parties’ arguments under common-law canons of statutory construction without regard to the burden or standard of proof.

16 See ADEQ’s Exhibit 8. See A.A.C. R2-19-119; see also Vazanno v. Superior Court, 74 Ariz. 369, 372, 249 P.2d 837 (1952). Morris K. Udall, ARIZONA LAW OF EVIDENCE § 5 (1960). 4. When construing a statute, the primary goal is to ascertain the legislature's intent. If the statutory language is clear, we must ascribe plain meaning to the statute’s terms.19 5. Osborn also argues that in cases that apply the internal revenue code to determine a taxpayer’s liability for federal income taxes, federal regulations that the IRS has promulgated are “deemed to have received Congressional approval and have the effect of law.”20 The issue in this case, however, is Osborn’s eligibility for a QBS, not its tax liability. 6. Osborn also argues that the Legislature’s use of the phrases, “section 61 of the internal revenue code” in A.R.S. § 49-292.01(B) and “section 61 of the internal revenue service code” in A.R.S. § 49-292.01(J) creates an ambiguity that requires ADEQ to consider regulations, such as 26 C.F.R. § 1.61-3, that the Internal Revenue Service has promulgated to set forth the deduction for cost of goods sold to calculate gross income under A.R.S. § 49-292.01(J)(1). 7. But that is not what A.R.S. § 49-292.01 says. As noted by ADEQ, the Arizona legislature incorporated the Code of Federal Regulations into numerous statutes in Title 49, but not in A.R.S. § 49-292.01.21 The statute says “gross income as defined in section 61 of the internal revenue code,” not taxable income, gross profit, or total income. Allowing an offset for the Osborn for the costs of goods sold would treat other regulated entities who are not manufacturers unfairly. 8. The Administrative Law Judge will not speculate about why the word “service” was included in A.R.S. § 49-292.01(J). Courts have noted that “[l]egislation is not always expressed with perfect clarity. The goal of statutory construction is to give statutes the meaning the legislature intended and strict rules of grammar will be ignored where they are inconsistent with the statute’s general meaning and object.”22 9. The Legislature intended in A.R.S. §49-292.01(J) to make a simple formula define an eligible small business by providing a simple and efficient method for

19 See State ex rel. Brannan v. Williams, 217 Ariz. 207, 171 P.3d 1248 (App. 2007) (citations omitted). Cottage Savings Association v. Commissioner, 4999 U.S. 554, 561, (1991). See ADEQ’s Closing Statement at 5-6 n. 1. State ex rel. Arizona Department of Revenue v. Phoenix Lodge No. 798, 187 Ariz. 242, 248, 928 P.2d 666, 672 (App. 1996) (citation omitted). calculating a regulated entity’s ability to pay to allow ADEQ to identify small businesses with whom ADEQ is required by A.R.S. § 49-292.01(A) to enter into a QBS. As a state agency, ADEQ must follow the requirements as set forth in the governing statute.23 A regulated entity’s qualification as a small business that is entitled to make a QBS with ADEQ for its liability under WQARF and CERCLA has nothing to do with the entity’s liability for federal income taxes. Requiring ADEQ to consider the vagaries of the Code of Federal Regulations to calculate income deductions available to various businesses is not required by the clear language of A.R.S. § 49-292.01(J) and would complicate the simple rule that the legislature intended to define a small business that is entitled to a QBS from ADEQ. 10. Because Osborn’s gross income as defined in 26 U.S.C. § 61(a), I.R.C. § 61 exceeded two million dollars in 1985 and 1986, the two years preceding ADEQ’s investigation of its liability under WQARF and CERCLA, Osborn does not qualify for a QBS. RECOMMENDED ORDER Based on the foregoing, IT IS ORDERED that Appellant Osborn Products, Inc. appeal is denied. In the event of certification of the Administrative Law Judge Decision by the Director of the Office of Administrative Hearings, the effective date of the Order is the date of the certification by the Director of the Office of Administrative Hearings. Done this day, July 2, 2018. /s/ Diane Mihalsky Administrative Law Judge Transmitted electronically to:

Misael Cabrera, PE, Director Department of Environmental Quality

23 See A.R.S. § 41-1030(B) (“An agency shall not base a licensing decision in whole or in part on a licensing requirement or condition that is not specifically authorized by statute . . . .”) and A.R.S. § 41- 1001(12) and (13) (defining agency licensing decisions); see also Arizona Dept. of Water Resources v. McClennen, 238 Ariz. 371, 374, 360 P.3d 1023, 2016 (2015) (finding that agency was prohibited from basing a licensing decision on requirements that are not specifically authorized by statute).