Section 263A Regulation Falters Under the Chevron Two-Step and Administrative Procedure Act

By Robin L. Greenhouse, Esq.  

McDermott Will & Emery, Washington, DC

It's not often that Treasury regulations are invalidated under a Chevron (Chevron, U.S.A. Inc. v. NRDC, 467 U.S. 837, 842-43 (1984), analysis, but taxpayers have scored two recent wins. In Home Concrete Supply LLC v. U.S., 80 U.S.L.W. 3078 (2012), the U.S. Supreme Court held that the six-year statute of limitations for omissions was not triggered by an overstated basis, and invalidated Treasury regulations under §6501(e)(1)(A). In Dominion Resources, Inc. v. U.S., No. 2011-5087 (Fed. Cir. 5/31/12), the Federal Circuit invalidated Regs. §1.263A-11(e)(1)(ii)(B), finding that it was not a reasonable interpretation of §263A. Additionally, the Federal Circuit concluded the Treasury Department had acted contrary to §706(2) of the Administrative Procedure Act (APA) (5 USC §706(2)) because it failed to provide a reasoned explanation when it promulgated the regulation.

In Dominion Resources, the utility company replaced coal burners in two of its plants. When making those improvements, it temporarily removed units from service-one unit for two months, the other for three months. During that time, the company incurred interest on debt unrelated to the improvements.  The parties agreed that a certain amount of the construction-period interest should be capitalized under §263A, but disagreed as to the extent of that capitalization requirement.

Section 263A generally requires capitalization of certain costs incurred in improving real property. Interest is a cost covered by the capitalization requirement. Section 263A(f) provides special rules for allocation of interest to property produced by the taxpayer. Specifically, §263A(f)(1) states the general rule that interest is a cost requiring capitalization when the 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 calculated … (ii) interest on any other indebtedness shall be assigned to such property to the extent that the taxpayer's interest costs could have been reduced if production expenditures (not attributable to indebtedness described in clause (i)) had not been incurred." This is referred to as the "avoided-cost rule."

Regs. §1.263A-11(e)(1)(B) plainly defines production expenditures to include not only the amount spent on the improvement but also the adjusted basis of the entire unit being improved-the "associated-property rule." Because the regulation requires a larger base amount (by including the adjusted basis) it results in a larger amount of interest to be capitalized.


Dominion challenged the validity of the regulation only as it applied to property "temporarily withdrawn from service" and not as applied to property that "is not placed in service." Here the two improvements made at the plant had similar costs of $5.3 million and $6.7 million, but because the adjusted bases of the two units were drastically different, under the regulation the "production expenditures" for the improvements were $15 million and $138 million, respectively.

The Federal Circuit reversed the lower court and held that the regulation as it applied to property "temporarily withdrawn from service" was invalid because it is not a reasonable interpretation of §263A(f)(2)(A)(ii), and the regulation fails to provide a reasoned explanation for adopting the associated-property rule.

The Federal Circuit analyzed the regulation under the Chevron two-step analysis. The first step determines whether Congress has directly spoken to the precise question at issue. If the statute is silent or ambiguous, then step two determines whether the agency's answer is based on a permissible construction of the statute.

Here, the majority on the three-judge panel concluded that the associated-property rule in the regulation did not violate the terms of the statute because the statute (which is circular in nature) is ambiguous. However, moving to the second step, the majority found that the regulation is not a reasonable interpretation of the avoided-cost rule set out in §263A(f)(2)(A)(ii). The regulation directly contradicts the avoided-cost rule that Congress intended the statute to implement and leads to absurd results.

The Federal Circuit was unanimous in its holding that the associated-property rule violated §706(2) of the APA because it failed to meet the provision in Motor Vehicles Mfrs. Ass'n of the United States Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983), that requires the Treasury Department provide a reasoned explanation for adopting a rule. State Farm provides that under the APA a government agency must "articulate a satisfactory explanation for its action, including a rational connection between the facts found and the choice made." In this case, the Federal Circuit concluded that neither Notice 88-99 (which provided guidance on the upcoming regulations) nor the proposed rule provide an explanation for the way that use of an adjusted basis implements the avoided-cost rule.

The concurring opinion maintains that the majority has gone too far in deciding the Chevron question, and would instead offer Treasury Department a "do-over" to re-promulgate the regulation with an explanation for its rationale.  However, the concurring opinion appears to recognize this is no longer an option in view of the majority's Chevron analysis. 

The IRS may seek to continue its legal fight by asking for reconsideration en banc or filing a petition for certiorari to the Supreme Court. Alternatively, the Treasury Department may decide to issue a revised regulation that is responsive to the Federal Circuit's criticism. In any event, we should expect see more robust explanations in the preambles of all future regulations. 

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 Maule, 505 T.M., Trade or Business Expenses and For-Profit Activity Deductions,  and in Tax Practice Series, see ¶3570, Uniform Capitalization Rules, and ¶2200, Repairs of Tangible Property Used in a Trade or Business..

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