The U.S. Court of Federal Claims upheld regulations requiring imputed interest on the basis of business property temporarily removed from service to be included in capitalized costs of property improvements.
Virginia electric and natural gas utility Dominion Resources Inc. replaced coal burners in two of its electric generating plants, which it temporarily took offline. The taxpayer and the IRS agreed that the direct costs related to the burners had to be capitalized under IRC § 263A and associated regulations, the uniform capitalization, or “unicap” rules. They also agreed that debt directly related to the replacement had to be included in that capitalization. They disagreed, however, on the amount of interest on other debt that had to be allocated to associated boilers and generating equipment and capitalized as an indirect cost of taking them out of service (the “associated-property” rule).
IRC § 263A requires capitalization of the direct and allocable indirect costs of real or tangible personal property constructed, installed, produced or improved by the taxpayer and used in the taxpayer’s trade or business or for-profit activity. Under Treas. Reg. § 1.263A-9 (the “avoided-cost” method), such capitalized costs must include interest paid or incurred with respect to the property produced (“traced debt”). They also must include other interest to the extent it could have been avoided if the costs of producing or improving the property (“accumulated production expenditures”) had instead been used to repay loans. Under Treas. Reg. § 1.263A-11(e)(1)(ii)(B), accumulated production expenditures include the adjusted basis of any existing property that is removed from service during the improvement. In other words, when taking property out of service to replace it, after capitalizing interest on debt directly related to the replacement, a taxpayer that pays or incurs interest on other debt must also capitalize interest on that debt, up to an amount of debt equal to the adjusted basis of the property taken out of service. The taxpayer argued that this requirement conflicts with IRC § 263A and is unreasonable.
The court applied the two-step test of Chevron U.S.A. Inc. v. Nat. Res. Def. Council Inc. (467 U.S. 837 (1984)). Under step one, the court has to determine if Congress directly addressed the issue in the Code and, if so, whether the regulation is consistent with the law. If the Code is silent or ambiguous on the issue, then under step two the court determines if the regulation is reasonable—that is, not arbitrary or capricious, procedurally defective or manifestly contrary to the statute. Under step one the taxpayer argued that production expenditures under the avoided-cost method should not include the existing property’s basis, since it is not added to that of the improvement for purposes of depreciation, but rather remains subject to the depreciation method already being used. The court agreed that the use of “unit of property” in Treas. Reg. § 1.263A-11 to refer to the improvement alone, minus the associated property, appeared inconsistent with using the associated property’s basis to calculate interest imputed to the improvement.
Dominion also argued that the associated-property rule violated the definition of “production expenditure” in IRC § 263A(f)(4)(C): “costs (whether or not incurred during the production period) required to be capitalized under subsection (a) with respect to the property.” The court acknowledged that production expenditures could include economic costs related to replacement of property but said the statute did not address, nor had the government satisfactorily explained, why the basis of associated property was their proper measure. The court found that the government’s rationale that the associated property could be used to pay down debt if sold was “a fiction” in this case, given the size and permanence of electrical generating equipment. However, the court further noted that the statute itself is “tautological,” as it encompasses both the potential savings that might have been realized if the expenditures had not been incurred and the effect of those hypothetical savings on the actual expenditures. Thus, the court said, it could not conclude the associated-property rule contradicts the statute.
Under step two, the court found the regulatory history of the associated-property rule “sparse” and its stated rationale “not very satisfying.” The rule provides “at best a very rough approximation” of lost revenue and appears to be a disincentive to improving manufacturing property, the court said. However, although Dominion’s challenge was “strong,” in such a “close case,” “the court cannot say that Treasury overstepped the latitude granted by the statute.”
The court went on to examine whether the Treasury Department followed the rules of the Administrative Procedure Act—that is, whether it adopted the associated-property rule in an arbitrary or capricious fashion, abused its discretion or adopted it otherwise not in accordance with the law. Dominion, citing Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co. (463 U.S. 29 (1983)), argued that the Treasury Department failed to explain its reasoning for the rule. The court noted that State Farm would also allow a regulation of “less than ideal clarity” to be upheld “if the agency’s path may reasonably be discerned.” In this case, the court said, “it is a stretch” to say the Treasury cogently explained its reasoning, but its path “can be ‘discerned,’ albeit somewhat murkily.”
Dominion Resources appealed the decision to the Federal Circuit, where the case remained pending as of late May.
Dominion Resources Inc. v. U.S., docket no. 08-195T (Fed. Cl. 2/25/2011)
By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.
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