Appeals Court Invalidates Associated Property Rule in Capitalization Regulations

In a case of first impression, the Court of Appeals for the Federal Circuit (reversing the Court of Federal Claims) held that the “associated property” rule requiring capitalization of interest expense under Sec. 263A was invalid insofar as it applies to property temporarily withdrawn from service (Dominion Resources, Inc., No. 2011-5087 (Fed. Cir. 5/31/12), rev’g 97 Fed. Cl. 239 (2011)). The question of the validity of the portion of the regulation that applies to property that is not placed in service was not addressed.

As the court explained, Sec. 263A generally requires the capitalization of certain costs incurred in improving real property, rather than a current income tax deduction. Interest expense is covered by these rules as an indirect cost that is allocable to the property. The difficulty arises in determining what is properly allocable interest expense and therefore not currently deductible.

Dominion Resources, which provides electricity and natural gas to its customers, replaced coal burners in two of its plants, temporarily removing the units from service while making these improvements. At the same time, it incurred interest on debt not related to those improvements and deducted a large part of the interest on its tax returns.

The IRS applied the associated property rule of Regs. Sec. 1.263A-11(e)(1)(ii)(B), which requires the amount allocable to nondeductible amounts under Sec. 263A to be calculated by including the adjusted basis of any structure that is not placed in service or must be temporarily withdrawn from service to complete the improvement, to require Dominion to capitalize $3.3 million of the interest expense.

Dominion challenged the validity of the regulation as it applied to property temporarily withdrawn from service (it did not challenge its validity as applied to property not placed in service). The Federal Circuit analyzed the regulation under the two-step test from Chevron, U.S.A., Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984). Under that test, the court first determines whether Congress has spoken to the precise question at issue and then, if the statute is silent or ambiguous, determines whether the regulation is based on a permissible construction of the statute.

For Chevron step one, the court examined Sec. 263A(f)(2) and decided it is ambiguous, describing it as “opaque” and “circular.” For step two, the court determined that the regulation was not a reasonable interpretation of the avoided-cost rule in Sec. 263A(f)(2)(A)(ii), which requires interest expense to be capitalized if the interest expense could have been reduced or avoided if the production expenditures had not been incurred. This rule requires some interest to be capitalized to reflect the amount of interest expense that could have been avoided if funds had not been expended for construction. However, the court concluded that requiring the inclusion of the entire basis of the property was an impermissible construction of the statute, and it declared the regulation invalid.

The court also held that the IRS had violated the requirement that it provide a reasoned explanation for adopting a regulation (Motor Vehicles Manufacturers Ass’n v. State Farm Mutual Automobile Insurance Co. , 463 U.S. 29 (1983)). Notice 88-99, which announced that the associated property rule would be forthcoming, did not mention that basis would be part of the interest capitalization method. The preamble to the proposed regulation in which the rule was issued did not give a rationale for the rule, nor did the final regulations.

A concurring opinion in the case argued that the court could have decided the case on narrower grounds by merely concluding that the holding in State Farm should invalidate the regulation.