Appeals Court invalidates associated-property regs.

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requiring capitalization of interest expense under Sec. 263A was invalid insofar as it applies to property temporarily withdrawn from service. The question of the validity of the portion of the regulation that applies to property that is not placed in service was not addressed. For previous Tax Matters coverage of the case, Dominion Resources, Inc., at the trial court level, see “‘Associated-Property’ Regs Survive ‘Strong’ Challenge,” July 2011, page 66.

As the Federal Circuit explained, Sec. 263A generally requires a taxpayer to capitalize certain costs incurred in improving real property, rather than take a current income tax deduction. These rules cover interest expense as an indirect cost that is allocable to the property. The difficulty arises in determining what amount of interest expense is allocable to the property 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 for improvements to be calculated by including in accumulated production expenditures with respect to the improvement the adjusted basis of any structure that is not placed in service or must be temporarily withdrawn from service to complete the improvement, to require Dominion to capitalize $3.3 million of the interest expense.

Dominion challenged the validity of the regulation as it applied to property temporarily withdrawn from service. 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 step one of the Chevron analysis, the court examined Sec. 263A(f)(2) and decided it was 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 being improved in production expenditures in the calculation of the interest to be capitalized 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 Vehicle 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.

Dominion Resources Inc., No. 2011-5087 (Fed. Cir. 5/31/12), rev’g 97 Fed. Cl. 239 (2011)