Proposed Regs Remove Associated Property Rule From Interest Capitalization Rules

(Parker Tax Publishing June 2024)

The IRS issued proposed regulations that remove the associated property rule from existing regulations on the interest capitalization requirements for improvements to designated property under Code Sec. 263A. The proposed rules also change the definition of "improvement" for purposes of applying the existing regulations. REG-133850-13.

Background

Code Sec. 263A(a) and (b) generally require the capitalization of direct and indirect costs of real or tangible personal property produced by the taxpayer. Under Code Sec. 263A(g)(1) and Reg. Sec. 1.263A-8(d)(3), the term "produce" includes "improve."

Code Sec. 263A(f) contains rules for capitalizing interest with respect to certain property produced by the taxpayer and for determining the amount of interest required to be capitalized. In general, Code Sec. 263A(f)(1) limits capitalization to interest that is paid or incurred during the production period and that is allocable to real property or certain tangible personal property produced by the taxpayer, referred to as "designated property" in the Code Sec. 263A regulations.

Under Code Sec. 263A(f)(2)(A), in determining the amount of interest required to be capitalized to any property, (1) interest on any indebtedness directly attributable to production expenditures with respect to the property is assigned to the property, and (2) interest on any other indebtedness is assigned to the property to the extent that the taxpayer's interest cost could have been reduced if production expenditures not attributable to indebtedness described in clause (1) had not been incurred (i.e., the avoided cost method).

Avoided Cost Method

Reg. Sec. 1.263A-8(a) provides that taxpayers must use the avoided cost method described in Reg. Sec. 1.263A-9 in determining the amount of interest required to be capitalized with respect to the production of designated property. Reg. Sec. 1.263A-9(a)(1) explains that, under the avoided cost method, any interest that the taxpayer theoretically would have avoided if accumulated production expenditures (as defined in Reg. Sec. 1.263A-11) (APEs) had been used to repay or reduce the taxpayer's outstanding debt must be capitalized. Under Reg. Sec. 1.263A-11(a), APEs generally mean the cumulative amount of direct and indirect costs described in Code Sec. 263A(a) that are required to be capitalized with respect to a unit of property.

Reg. Sec. 1.263A-9(c) provides that, to the extent a taxpayer's APEs exceed traced debt (that is, debt that is allocated to APEs with respect to the unit of property), the general formula for determining the amount of interest that must be capitalized is the average excess expenditures multiplied by the weighted average interest rate on the debt during the time the production occurs. A larger base of production expenditures leads to more interest capitalized.

Reg. Sec. 1.263A-11(e)(1)(i) provides that, if an improvement constitutes the production of designated property under Reg. Sec. 1.263A-8(d)(3), APEs with respect to the improvement consist of all direct and indirect costs required to be capitalized with respect to the improvement. In the case of an improvement to a unit of real property qualifying as the production of designated property under Reg. Sec. 1.263A-8(d)(3), Reg. Sec. 1.263A-11(e)(1)(ii) provides that APEs include an allocable portion of the cost of land, and 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 (associated property rule). In the case of an improvement to a unit of tangible personal property qualifying as the production of designated property under Reg. Sec. 1.263A-8(d)(3), Reg. Sec. 1.263A-11(e)(1)(iii) provides that APEs include the adjusted basis of the asset being improved if that asset either is not placed in service or must be temporarily withdrawn from service to complete the improvement.

Reg. Sec. 1.263A-12(a) explains that under Reg. Sec. 1.263A-9, a taxpayer must capitalize interest for computation periods that include the production period of a unit of designated property. In the case of property produced for self-use, Reg. Sec. 1.263A-12(d)(1) generally provides that the production period for a unit of property ends on the date that the unit is placed in service and all production activities reasonably expected to be undertaken are completed.

In Dominion Resources, Inc. v. U.S., 2012 PTC 141 (Fed. Cir. 2012), the Federal Circuit invalidated the associated property rule of Reg. Sec. 1.263A-11(e)(1)(ii)(B) for property temporarily withdrawn from service. The court concluded that the regulation was not a reasonable interpretation of the avoided cost rule in Code Sec. 263A(f)(2)(A)(ii) because it "unreasonably links" the interest capitalized when a taxpayer makes an improvement to the adjusted basis of the property temporarily withdrawn from service to complete the improvement. The court reasoned that to implement the avoided cost principle, the interest to be capitalized is the amount that could have been avoided if funds had not been expended for the improvement. However, the adjusted basis of the temporarily withdrawn property does not represent an "avoided" amount. The court found that "[a] property owner does not expend funds in an amount equal to the adjusted basis [of the temporarily withdrawn property] when making the improvement. Instead, she expends funds in an amount equal to the cost of the improvement itself." Thus, the court concluded that the regulation contradicts the avoided cost rule.

Proposed Regulations

On May 15, the IRS published proposed regulations (REG-133850-13) that remove the associated property rule and similar rules from the existing regulations on the interest capitalization requirements for improvements to designated property. The regulations are proposed to apply to tax years beginning after the date that final regulations are published in the Federal Register. However, taxpayers may choose to apply the proposed regulations for tax years beginning after May 15, 2024.

The IRS stated that it has considered the Federal Circuit's opinion in Dominion Resources and agrees with its rationale. Accordingly, the proposed regulations remove the associated property rule at Reg. Sec. 1.263A-11(e)(1)(ii)(B) (for improvements to real property) and Reg. Sec. 1.263A-11(e)(1)(iii) (for improvements to tangible personal property) for property temporarily withdrawn from service. For similar reasons, the proposed regulations remove the rule at Reg. Sec. 1.263A-11(e)(1)(ii)(A) (APEs with respect to an improvement to real property includes an allocable portion of the cost of land).

The IRS noted that in Dominion Resources, the challenge to Reg. Sec. 1.263A-11(e)(1)(ii)(B) applied only to improvements to property "temporarily withdrawn from service" and not to improvements to property that is "not placed in service." However, the IRS determined that the associated property rule at Reg. Sec. 1.263A-11(e)(1)(ii)(B) and Reg. Sec. 1.263A-11(e)(1)(iii) for improvements to property "not placed in service" also should be removed because under Reg. Sec. 1.263(a)-3(d), the definition of "improvement" is limited to amounts paid for activities performed after the property is placed in service. Amounts paid for activities performed prior to the date that property is placed in service are characterized as acquisition or production costs (rather than improvement costs) and are generally capitalized under Reg. Sec. 1.263(a)-2 and Code Sec. 263A. In addition, the APE rules in Reg. Sec. 1.263A-11(f) already address a situation in which a taxpayer incurs production costs with respect to property that has not been placed in service.

Because the proposed regulations would remove the associated property rule at Reg. Sec. 1.263A-11(e)(1)(ii)(B), the de minimis rule of Reg. Sec. 1.263A-11(e)(2) would be irrelevant. Accordingly, the proposed regulations also remove this de minimis rule. As a result of the proposed amendments to Reg. Sec. 1.263(a)-11(e) to remove from APEs the adjusted basis of associated real property, the adjusted basis of associated tangible personal property, and an allocable portion of the cost of the land when the taxpayer makes an improvement, a taxpayer would be required to include in APEs only the direct and indirect costs of the improvement itself.

The IRS recognizes that the proposed amendments to remove from APEs the adjusted basis of associated real property, the adjusted basis of associated tangible personal property, and an allocable portion of the cost of the land when the taxpayer makes an improvement may increase the potential for abuse. For example, a taxpayer may attempt to treat property produced for self use as having been placed in service (even though the placed-in-service requirements have not yet been met) and then attempt to characterize subsequent production activities as an improvement, thereby improperly excluding relevant costs from APEs. Reg. Sec. 1.263A-12(d)(1) provides that in the case of property produced for self-use, the production period for a unit of property does not end until the taxpayer places the property in service and all production activities reasonably expected to be undertaken are completed. The proposed regulations contain a cross-reference to Reg. Sec. 1.263A-12(d)(1) to emphasize that taxpayers must comply with the rules of that section when determining whether the production period has ended and therefore whether the taxpayer's production activities constitute an improvement.

Definition of "Improvement"

Reg. Sec. 1.263(a)-3 governs the definition of "improvement" for purposes of Code Sec. 263(a). In addition, Reg. Sec. 1.263(a)-3 includes certain exceptions, safe harbors, and elections that may be applied in determining whether certain amounts must be treated as improvement costs. According to the IRS, the treatment afforded by the application of Reg. Sec. 1.263(a)-3, including these exceptions, safe harbors, and elections, should also apply in determining whether costs must be treated as improvements for the computation of APEs for Code Sec. 263A interest capitalization purposes. Accordingly, the proposed regulations amend Reg. Sec. 1.263A-8(d)(3) to update the definition of "improvement" so that it is consistent with the definition of "improvement," including the exceptions, safe harbors, and elections provided under Reg. Sec. 1.263(a)-3. However, the IRS noted that the de minimis safe harbor election, as provided by Reg. Sec. 1.263(a)-1(f), is not an election under Reg. Sec. 1.263(a)-3 and generally does not apply to amounts paid for tangible property subject to Code Sec. 263A if these amounts comprise the direct or allocable indirect costs of other property produced by the taxpayer. Accordingly, the de minimis safe harbor election under Reg. Sec. 1.263(a)-1(f) generally would not apply in determining whether amounts should be included in the computation of APEs for interest capitalization under Code Sec. 263A.

For a discussion of the interest capitalization requirement, see Parker Tax ¶242,485.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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