Federal Circuit Invalidates Section 263A Avoided-Cost Reg Because It Leads to "Absurd" Results (Parker Tax Publishing June 8, 2012)

In determining the amount of interest required to be capitalized under the uniform capitalization rules of Code Sec. 263A, Congress implemented an avoided-cost rule under Code Sec. 263A(f)(2). The general formula for determining interest that must be capitalized is the amount of production expenditures multiplied by the weighted-average interest rate on the debt during the time the production occurs. In other words, the production expenditures represent the base amount and some fraction of that amount represents the interest that must be capitalized. A larger base will lead to more interest capitalized.

In Dominion Resources, Inc. v. U.S., 2012 PTC 141 (Fed. Cir. 5/31/12), the Federal Circuit, in an issue of first impression, examined the regulation behind that rule. It declared that Reg. Sec. 1.263A-11(e)(1)(ii)(B), as applied to property temporarily withdrawn from service in order to make improvements, is not a reasonable interpretation of Code Sec. 263A because it unreasonably links the interest capitalized when making an improvement to the property's adjusted basis. The court concluded that the relevant statute that the regulation was interpreting was circular and the regulation itself was "absurd" and invalid.

Facts

Dominion Resources, Inc., provides electric power and natural gas to individuals and businesses. In 1996, it replaced coal burners in two of its plants. When making those improvements, it temporarily removed the units from service one unit for two months, the other for three months. During that time, Dominion incurred interest on debt unrelated to the improvements.

On its corporate tax returns, Dominion deducted some of that interest from its taxable income. The IRS disagreed with Dominion's computation under Reg. Sec. 1.263A-11(e)(1)(ii)(B). The IRS applied the regulation to capitalize $3.3 million of that interest. Under a settlement agreement, the IRS allowed Dominion to deduct 50 percent and capitalize 50 percent of the disputed amount.

Still asserting that the entire disputed amount was deductible, Dominion filed suit seeking a refund of $297,699 in corporate income tax. Dominion sought to invalidate Reg. Sec. 1.263A-11(e)(1)(ii)(B), which provides that a portion of interest expense relating to production expenditures must be capitalized. The Court of Federal Claims denied Dominion's claim and granted summary judgment to the United States. That court held that the regulation was a permissible construction of Code Sec. 263A and that the IRS issued the regulation with a reasoned explanation that satisfied the applicable standard. Dominion appealed to the Federal Circuit Court of Appeals.

Before the Federal Circuit, Dominion and the IRS agreed that a certain amount of construction-period interest should be capitalized instead of deducted, but could not agree on the extent of that capitalization requirement. They agreed that under Reg. Sec. 1.263A-11(e), production expenditures are defined to include not only the amount spent on the improvement, but also the adjusted basis of the entire unit being improved. The issue on appeal was whether that latter inclusion of the adjusted basis of the unit violates various statutory provisions. Because the regulation requires a larger base amount (by including the adjusted basis amount), it results in a larger amount of interest to be capitalized. Thus, the practical impact of the rule is that it determines how much interest Dominion is required to capitalize instead of deduct from its taxable income as a result of burner improvements in its power plants.

Interest Required to be Capitalized under Reg. Sec. 1.263A-11(e)

Reg. Sec. 1.263A-11(e) defines what constitutes production expenditures (the base amount) and therefore determines the amount of interest capitalized under Code Sec. 263A. The general rule of Reg. Sec. 1.263A-11(e)(1) provides that, if an improvement constitutes the production of designated property under Reg. Sec. 1.263A8(d)(3), accumulated production expenditures with respect to the improvement consist of (1) all direct and indirect costs required to be capitalized with respect to the improvement, and (2) in the case of an improvement to a unit of real property (a) an allocable portion of the cost of land, and (b) for any measurement period, the adjusted basis of any existing structure, common feature, or other property that is not placed in service or must be temporarily withdrawn from service to complete the improvement (associated property) during any part of the measurement period if the associated property directly benefits the property being improved, the associated property directly benefits from the improvement, or the improvement was incurred by reason of the associated property.

Statute on Interest Capitalization Is Circular

The Federal Circuit noted that the relevant statutory provisions in Code Sec. 263A relating to interest capitalization comprise five subsections: Code Sec. 263A(a)(1), Code Sec. 263A(a)(2), Code Sec. 263A(f)(1), Code Sec. 263A(f)(2), and Code Sec. 263A(f)(4)(C). Each subsection refers to the next. A careful reading of the five subsections, the court noted, shows that each rule or definition refers to another rule or definition in a circular progression that brings the law back to the place it began with little elucidation of legal standards and definitions. In simple words, the court observed, the statute is circular.

Court Applies Chevron Analysis to Find Regulation Invalid

The Federal Circuit noted that the challenge to Reg. Sec. 1.263A-11(e) was only as applied to property temporarily withdrawn from service and not as applied to property that is not placed in service. Citing the Supreme Court's decision in Chevron, U.S.A., Inc. v. NRDC, 467 U.S. 837 (1984), the Federal Circuit said that the validity of a Treasury regulation is analyzed under the Chevron two-step test. First, step one 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.

As to Chevron step one, the Federal Circuit said that the lower court correctly recognized that the regulation does not contradict the text of the statute, but only because the statute is opaque. Code Sec. 263A(f)(2) states the amount of interest to be capitalized is that amount that could have been reduced if production expenditures had not been incurred. Then Code Sec. 263A(f)(4)(C) defines production expenditures as the amount required according to the general rules. Regardless of the definition of production expenditures, the Federal Circuit stated, the statute provides or assumes that sum would have been available to pay down the debt. Because the conclusion is assumed in the premises, the court concluded that the statute is circular. Thus, at Chevron step one, the Federal Circuit determined that the statute is ambiguous.

As to Chevron step two, the court found that Reg. Sec. 1.263A-11(e)(1)(ii)(B), as applied to property temporarily withdrawn from service, was not a reasonable interpretation of the avoided-cost rule set out in Code Sec. 263A(f)(2)(A)(ii). Specifically, the court concluded that the regulation was unreasonable in defining production expenditures to include the adjusted basis of the entire unit. According to the court, the regulation directly contradicts the avoided-cost rule that Congress intended the statute to implement. The avoided-cost rule recognizes that if the improvement had not been made, those funds (an amount X equal to the cost of the improvement) could have been used to pay down the debt and therefore reduce interest that accrued on the debt. Because the improvement was made, however, that amount X was not used to pay down the debt; therefore, interest accrued on that amount X.

To determine the accrued interest resulting from making the improvement instead of paying down the debt, the court said, one would multiply the interest rate by the amount X paid for the improvement. According to the court, one would not multiply the interest rate by the amount X paid for the improvement plus the adjusted basis of the entire unit. An amount equal to the adjusted basis of the unit would not have been available to pay down the debt had the improvement not been made. Those funds were expended at the time the property was acquired (before the decision to make the improvement) and are not made available to pay down debt by forgoing the improvement. The court used the following example to illustrate its point.

Example: An owner bought real property for $100,000 using a loan with a 3 percent interest rate. A few years later, the owner makes an improvement that costs $5,000. If the owner had used that $5,000 toward the debt instead of the improvement, the owner would have avoided accruing $150 in interest ($5,000 multiplied by 3 percent). The avoided-cost rule requires the owner to capitalize that $150 in interest. Reg. Sec. 1.263A-11(e)(1)(ii)(B), however, requires the owner to capitalize $3,150 in interest (($100,000 + $5,000) 3 percent).

The result in the above example, the court said, makes no sense, because there is no way that the owner could have avoided accruing $3,150 in interest by not making the improvement, as she did not expend or incur an amount equal to $105,000 when making the improvement.

The Federal Circuit noted that the House and Senate reports clarified the meaning of the statute and said that the regulation must implement the avoided-cost principle in particular that the interest to be capitalized is the amount that could have been avoided if funds had not been expended for construction. The adjusted basis, the court noted, 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. Instead, the owner expends funds in an amount equal to the cost of the improvement itself.

Indeed, the court observed, the statute uses the term production expenditures, the plain meaning of which is an amount actually expended or spent specifically, expended or spent on the improvement. Similarly, the statute states that the interest to be capitalized is an amount that could have been reduced if production expenditures had not been incurred. According to the court, a property owner would not expend or incur an amount equal to the adjusted basis when making the improvement. Thus, the regulation unreasonably links the interest capitalized when making an improvement to the adjusted basis.

Further, the court observed, the regulation leads to absurd results. Because the adjusted basis amount can have almost no relation to the improvement cost amount, the regulation can require capitalizing vastly different amounts of interest for the same improvements. In the instant case, Dominion's two improvements had similar costs of $5.3 million and $6.7 million. Yet, because the adjusted bases of the two units were drastically different, the regulations lead to production expenditures of $15 million and $138 million, respectively. The Federal Circuit concluded that there was no reasonable basis for requiring such wildly disproportionate results for similar improvements and the law did not intend such an absurd result. (Staff Contributor Parker Tax Publishing)

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