By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Dominion Resources, Inc. v. U.S, 97 Fed. Cl. 239 (Fed. Cir. 2012), the Federal Circuit invalidated Regs. §1.263A-11(e)(1)(B), which provides special rules for the allocation of interest to property produced by a taxpayer. Under Chevron v. NRDC, 467 U.S. 837, 842-43 (1984), the Federal Circuit held that the regulation as it applied to property "temporarily withdrawn from service" was not a reasonable interpretation of §263A. Further, the Federal Circuit found that the Treasury Department failed to comply with the Administrative Procedure Act, which requires a reasoned explanation when regulations are promulgated.
Taxpayer provided electric power and natural gas to individuals and businesses. In 1996, it replaced coal burners in two of its plants. While making those improvements, Taxpayer temporarily removed the coal burners from service - one unit for two months, the other for three months. During this period, Taxpayer incurred interest on debt unrelated to the improvements. On its corporate tax returns, Taxpayer deducted some of that interest from its taxable income. The IRS disagreed with Taxpayer's treatment of the interest. Instead, the IRS argued that, under Regs. §1.263A-11(e)(1)(ii)(B), the interest should be capitalized not deducted. Under a settlement, the IRS allowed Taxpayer to deduct 50% and capitalize 50% of the disputed amount. Thereafter, still asserting that the entire disputed amount was deductible, Taxpayer filed this suit seeking to invalidate Regs. §1.263A-11(e)(1)(ii)(B) as it applied to property "temporarily withdrawn from service" and requesting a refund of $297,699 in corporate income tax.
As a general rule, §263A requires capitalization, instead of deduction, of certain costs incurred in improving real property. Deductions are taken in the current tax year, whereas a capitalization occurs over time. Under §263A(f)(1), interest is a cost requiring capitalization when that cost is "allocable" to the property. To determine what costs are "allocable" to the property, §263A(f)(2) provides that interest is allocable "to the extent that the taxpayer's interest costs could have been reduced if production expenditures … had not been incurred." In determining the amount of interest required to be capitalized, under §263A(f)(2), interest on any other indebtedness is assigned to real property to the extent that the taxpayer's interest costs could have been reduced if production expenditures had not been incurred. This provision is generally referred to as the "avoided-cost rule." Under Regs. §1.263A-11(e)(1), production expenditures subject to capitalization include not only the amount spent on the improvement but also the adjusted basis of the entire unit being improved that is temporarily withdrawn from service (so-called "associated property"). By including the adjusted basis amount, the regulation increases the amount of interest to be capitalized.
Under Mayo Foundation for Medical Education and Research v. U.S., 131 S. Ct. 704 (2011), the validity of a Treasury regulation must be analyzed under the Chevron two-step test. Step one requires a determination of whether Congress has directly spoken to the precise question at issue. If the statute is silent or ambiguous, then step two requires a determination of whether the agency's interpretation is based on a permissible construction of the statute. Under Chevron step one, the Federal Circuit reviewed the language of §263A(f)(2) and concluded that it was ambiguous, describing it as "opaque" and "circular." Accordingly, the Federal Circuit turned to the Chevron step two.
Under step two, the Federal Circuit concluded that the regulation directly contradicted the avoided-cost rule that Congress intended the statute to implement.1 The Federal Circuit reasoned that adjusted basis does not represent such an "avoided" amount because a property owner does not expend funds in an amount equal to the adjusted basis when making the improvement. Moreover, the Federal Circuit noted that the statute uses the term production "expenditures," the plain meaning of which is an amount actually expended or spent on the improvement. The Federal Circuit reasoned that the only way that an amount equal to the adjusted basis could potentially satisfy the avoided-cost method is by assuming that the property owner would have sold the unit and used the sale proceeds to pay down the debt. However, the Federal Circuit stated that there was no reasonable explanation for the assumption that a property owner would have sold the same unit that it removed from service for the sole purpose of improving, since selling the unit obviates the very reason for the improvement. Accordingly, the Federal Court concluded that the regulation unreasonably linked the interest capitalized when making an improvement to the adjusted basis.
Accordingly, the Federal Circuit held that the associated-property rule in Regs. §1.263A-11(e)(1)(ii)(B) as applied to property temporarily withdrawn from service was not a reasonable interpretation of §263A(f)(2)(A)(ii) since it contradicted the avoided-cost rule that the law implemented. Therefore, the Federal Circuit held that the regulation was invalid.
The Federal Circuit also concluded that the associated-property rule violated §706(2) of the Administrative Procedure Act because it failed to satisfy the requirement under Motor Vehicles Mfrs. Ass'n of the U.S., Inc. v. State Farm Mut. Auto. Ins. Co, (463 U.S. 29, 43 (1983), that Treasury "articulate a satisfactory explanation" for adopting a regulation, "including a rational connection between the facts found and the choice made." The Federal Circuit noted that the notice of proposed rulemaking provided no rationale for including the adjusted basis in the calculation other than the general statement that the regulations are intended to implement the avoided-cost method, and, similarly, the IRS provided no rationale in the final regulations.
This decision, taken together with the Supreme Court's recent decision in U.S. v. Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012), aff'g 634 F.3d 249 (4th Cir. 2011), demonstrate that the practical effect of Mayo, as many commentator feared, was not to give the Treasury department almost unfettered authority to legislate by regulation.
For more information, in the Tax Management Portfolios, see Garrett and Connor, 576 T.M., Uniform Capitalization Rules: Inventory; Self-Constructed Assets; Real Estate, and in Tax Practice Series, see ¶3570, Uniform Capitalization Rules.
1 S. Rep. No. 99-313, at 140, 144 (1986); H.R. Rep. No. 99-426, at 625, 628 (1985); Joint Committee on Taxation, JCS-10-87, 1987 WL 1364655 (1987).
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