Associated-Property Rule Regulation Held Invalid

By James A. Beavers, J.D., LL.M., CPA, CGMA

Interest Income & Expense

The Federal Circuit held that for purposes of determining the interest that a taxpayer must capitalize with respect to an improvement to property, the associated­-property rule in Regs. Sec. 1.263A-11(e)(1)(ii)(B) was invalid as applied to property temporarily withdrawn from service.

Background

Dominion Resources (Dominion) provides electric power and natural gas to individuals and businesses. In 1996, it replaced coal burners in two of its plants. When making those improvements, it temporarily removed the units from service—one unit for two months, the other for three months. During that time, Dominion incurred interest on debt unrelated to the improvements. Although there was a great difference in the adjusted basis of the units (approximately $10 million for one and $131 million for the other), the amount of the improvement costs to each unit was similar ($5.3 million and $6.7 million).

On its corporate tax returns, Dominion deducted some of that interest from its taxable income and capitalized the rest. The IRS disagreed with Dominion’s computation under Regs. Sec. 1.263A-11(e)(1)(ii)(B) and asserted that Dominion could deduct only a smaller amount of interest. Under a settlement, the IRS allowed Dominion to deduct 50% and to capitalize 50% of the disputed amount.

Still asserting that the entire disputed amount was deductible, Dominion filed suit in the Court of Federal Claims seeking a refund of $297,699 in corporate income tax, claiming that Regs. Sec. 1.263A-11(e)(1)(ii)(B) was invalid. The Court of Federal Claims denied Dominion’s claim, holding that the regulation was a permissible construction of Sec. 263A (Dominion Resources, Inc., 97 Fed. Cl. 239 (2011)). Dominion appealed the court’s decision to the Federal Circuit.

Allocation of Interest to Property Produced by a Taxpayer

Under Sec. 263A, a taxpayer is required to capitalize certain costs incurred in improving real property, instead of deducting the costs. In broad terms, interest is a cost covered by the capitalization requirement. Under Sec. 263A(f)(1), a taxpayer is required to capitalize interest when it is “allocable” to the property being improved. Under Sec. 263A(f)(2), interest is allocable “to the extent that the taxpayer’s interest costs could have been reduced if production expenditures . . . had not been incurred.” This is known as the avoided-cost rule.

The general formula to determine the amount of interest that a taxpayer must capitalize is the amount of “production expenditures” multiplied by the weighted-average interest rate on the debt during the time the production occurs. In other words, the production expenditures represent the base amount, and some fraction of that amount represents the interest that the taxpayer must capitalize. A larger base will lead to more interest capitalized.

In Regs. Sec. 1.263A-11(e)(1), the IRS defines what is included in production expenditures with respect to improvements that constitute the production of property by the taxpayer. The regulation sets out an “associated property” rule, stating:

accumulated production expenditures with respect to the improvement consist of (i) All direct and indirect costs required to be capitalized with respect to the improvement, (ii) In the case of an improvement to a unit of real property (A) An allocable portion of the cost of land, and (B) For any measurement period, the adjusted basis of any existing structure, common feature, or other property that is not placed in service or must be temporarily withdrawn from service to complete the improvement (associated property) during any part of the measurement period if the associated property directly benefits the property being improved, the associated property directly benefits from the improvement, or the improvement was incurred by reason of the associated property.

In the case of Dominion’s coal-burner units, Dominion and the IRS agreed that under the definition in Regs. Sec. 1.263A-11(e)(1), production expenditures include not only the amount spent on the improvement but also the adjusted basis of the entire unit being improved. Because the cost of the units were greater than the costs of the improvements to them, including those costs greatly increased the amount of the production expenditures associated with the improvements, resulting in the taxpayer’s having to capitalize a much larger amount of interest than if only the costs of the improvements were included. Dominion, in both the Court of Federal Claims and the Federal Circuit, argued that Regs. Sec. 1.263A-11(e)(1), as applied to property temporarily withdrawn from service, was invalid because it was not a reasonable interpretation of the statute.

The Federal Circuit’s Decision

The Federal Circuit reversed the Court of Federal Claims. The court held that the associated-property rule in Regs. Sec. 1.263A-11(e)(1)(ii)(B) as applied to property temporarily withdrawn from service was not a reasonable interpretation of Sec. 263A.

The court applied the two-step Chevron analysis to the regulation to determine if the regulation was valid (Chevron, U.S.A., Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984)). In that analysis, a court first determines whether a statute is ambiguous and thus subject to agency interpretation. If the statute is ambiguous, the court then determines whether the agency’s interpretation is based on a permissible construction of the statute. With regard to the first test, the court found that Sec. 263A contained only a circular definition of production expenditures and was therefore ambiguous on that point. Accordingly, the definition was subject to interpretation in regulations by the IRS.

However, the court further found that as applied to property temporarily withdrawn from service, the IRS was unreasonable in defining production expenditures in Regs. Sec. 1.263A-11(e)(1)(ii)(B) to include the adjusted basis of the entire unit of property, because doing so directly contradicted the avoided-cost rule that Congress intended to implement. The avoided-cost rule recognizes that if the improvement had not been made, those funds (equal to the cost of the improvement) could have been used to pay down the debt and therefore reduce interest that accrued on the debt. The court reasoned that the cost of the adjusted basis of the unit would not be available to pay down debt at the time of the improvement because the funds to purchase the unit were expended at the time of acquisition. Consequently, they are not available to pay down debt if the improvement is not made, thus making their inclusion inconsistent with the avoided-cost rule.

The court also stated that the regulation leads to absurd results. Because the adjusted basis amount of the property in question can have almost no relation to the cost of the improvement, the production expenditures and therefore the interest cost the taxpayer is required to capitalize could vary drastically for similar improvements done to different units of property with different adjusted bases. As the court pointed out, this occurred in Dominion’s case, where there was a huge difference in the adjusted bases of the two units at issue. According to the court, the law did not intend such a result.

Finally, the court acknowledged that an amount equal to the adjusted basis could potentially satisfy the avoided-cost method by assuming that the property owner would have sold the unit and used the sale proceeds to pay down the debt. However, in the case of property removed from service for improvement, this assumption was totally divorced from reality because the property is being improved to be put back into service. The court therefore rejected the use of this rationale for including adjusted basis in production expenditures.

Reflections

Both the Court of Federal Claims and the Federal Circuit also considered the case Motor Vehicles Manufacturers Ass’n of the United States, Inc. v. State Farm Mutual Automobile Insurance Co. , 463 U.S. 29 (1983), in which the Supreme Court set out the requirement that an agency, when promulgating a regulation, must “articulate a satisfactory explanation for its action, including a rational connection between the facts found and the choice made.” The Court of Federal Claims found that the requirement was met because, although the IRS had not cogently explained its actions with respect to the regulation, it had alerted taxpayers to the existence of the issue, and the path that it had taken in the rulemaking process could be discerned “albeit somewhat murkily.” However, the Federal Circuit, noting that the IRS had not explained how the use of an adjusted basis implements the avoided-cost rule in the preamble to the regulations or otherwise, held that the IRS had failed to meet the State Farm requirement. Given that the IRS frequently provides little explanation of the rationale for the positions it takes in regulations, this requirement, if it is followed by other courts, could provide a useful weapon for attacking the validity of regulations.

Dominion Resources Inc. , No. 2011-5087 (Fed. Cir. 5/31/12)

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