Appeals Court Invalidates Associated-Property Regs

Article excerpt

In a case of first impression, the Court of Appeals for the Federal Circuit (reversing the Court of Federal Claims) held that the "associated property" rule requiring capitalization of interest expense under Sec. 263A was invalid insofar as it applies to property temporarily withdrawn from service. The question of the validity of the portion of the regulation that applies to property that is not placed in service was not addressed. For previous Tax Matters coverage of the case, Dominion Resources, Inc., at the trial court level, see "'Associated-Property' Regs Survive 'Strong' Challenge," July 2011, page 66.

As the Federal Circuit explained, Sec. 263A generally requires a taxpayer to capitalize certain costs incurred in improving real property, rather than take a current income tax deduction. These rules cover interest expense as an indirect cost that is allocable to the property The difficulty arises in determining what amount of interest expense is allocable to the property and therefore not currently deductible.

Dominion Resources, which provides electricity and natural gas to its customers, replaced coal burners in two of its plants, temporarily removing the units from service while making these improvements. At the same time, it incurred interest on debt not related to those improvements and deducted a large part of the interest on its tax returns.

The IRS applied the associated-property rule of Regs. Sec. 1.263A-11(e)(1)(ii)(B), which requires the amount allocable to nondeductible amounts under Sec. 263A for improvements to be calculated by including in accumulated production expenditures with respect to the improvement the adjusted basis of any structure that is not placed in service or must be temporarily withdrawn from service to complete the improvement, to require Dominion to capitalize $3.3 million of the interest expense.

Dominion challenged the validity of the regulation as it applied to property temporarily withdrawn from service. The Federal Circuit analyzed the regulation under the two-step test from Chevron, U. …