Associated-property rule regulation held invalid.

• Author: Beavers, James A.

The Federal Circuit held that for purposes of determining the interest that a taxpayer must capitalize with respect to an improvement to property, the associated-property rule in Regs. Sec. 1.263A-11(e)(1)(ii)(B) was invalid as applied to property temporarily withdrawn from service.

Background

Dominion Resources (Dominion) 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. Although there was a great difference in the adjusted basis of the units (approximately $10 million for one and $131 million for the other), the amount of the improvement costs to each unit was similar ($5.3 million and $6.7 million).

On its corporate tax returns, Dominion deducted some of that interest from its taxable income and capitalized the rest. The IRS disagreed with Dominion's computation under Regs. Sec. 1.263A-11(e)(1)(ii)(B) and asserted that Dominion could deduct only a smaller amount of interest. Under a settlement, the IRS allowed Dominion to deduct 50% and to capitalize 50% of the disputed amount.

Still asserting that the entire disputed amount was deductible, Dominion filed suit in the Court of Federal Claims seeking a refund of $297,699 in corporate income tax, claiming that Regs. Sec. 1.263A-11(e)(1)(ii)(B) was invalid. The Court of Federal Claims denied Dominion's claim, holding that the regulation was a permissible construction of Sec. 263A (Dominion Resources, Inc., 97 Fed. Cl. 239 (2011)). Dominion appealed the court's decision to the Federal Circuit.

Allocation of Interest to Property Produced by a Taxpayer

Under Sec. 263A, a taxpayer is required to capitalize certain costs incurred in improving real property, instead of deducting the costs. In broad terms, interest is a cost covered by the capitalization requirement. Under Sec. 263A(f)(1), a taxpayer is required to capitalize interest when it is "allocable" to the property being improved. Under Sec. 263A(f)(2), interest is allocable "to the extent that the taxpayer's interest costs could have been reduced if production expenditures .. . had not been incurred." This is known as the avoided-cost rule.

The general formula to determine the amount of interest that a taxpayer must capitalize is the amount of...