"Associated-Property" Regs Survive "Strong" Challenge
Schnee, Edward J., Journal of Accountancy
The U.S. Court of Federal Claims upheld regulations requiring imputed interest on the basis of business property temporarily removed from service to be included in capitalized costs of property improvements.
Virginia electric and natural gas utility Dominion Resources Inc. replaced coal burners in two of its electric generating plants, which it temporarily took offline. The taxpayer and the IRS agreed that the direct costs related to the burners had to be capitalized under IRC [section] 263A and associated regulations, the uniform capitalization, or "unicap" rules. They also agreed that debt directly related to the replacement had to be included in that capitalization. They disagreed, however, on the amount of interest on other debt that had to be allocated to associated boilers and generating equipment and capitalized as an indirect cost of taking them out of service (the "associated-property" rule).
IRC [section] 263A requires capitalization of the direct and allocable indirect costs of real or tangible personal property constructed, installed, produced or improved by the taxpayer and used in the taxpayer's trade or business or for-profit activity Under Treas. Reg. [section] 1.263A-9 (the "avoided-cost" method), such capitalized costs must include interest paid or incurred with respect to the property produced ("traced debt"). They also must include other interest to the extent it could have been avoided if the costs of producing or improving the property ("accumulated production expenditures") had instead been used to repay loans. Under Treas. Reg. [section] 1.263A-11(e)(1)(ii)(B), accumulated production expenditures include the adjusted basis of any existing property that is removed from service during the improvement. In other words, when taking property out of service to replace it, after capitalizing interest on debt directly related to the replacement, a taxpayer that pays or incurs interest on other debt must also capitalize interest on that debt, up to an amount of debt equal to the adjusted basis of the property taken out of service. The taxpayer argued that this requirement conflicts with IRC [section] 263A and is unreasonable.
The court applied the two-step test of Chevron U.S.A. Inc. v. Nat. Res. Def. Council Inc. (467 U.S. 837 (1984)). Under step one, the court has to determine if Congress directly addressed the issue in the Code and, if so, whether the regulation is consistent with the law. If the Code is silent or ambiguous on the issue, then under step two the court determines if the regulation is reasonable--that is, not arbitrary or capricious, procedurally defective or manifestly contrary to the statute. Under step one the taxpayer argued that production expenditures under the avoided-cost method should not include the existing property's basis, since it is not added to that of the improvement for purposes of depreciation, but rather remains subject to the depreciation method already being used. The court agreed that the use of "unit of property" in Treas. …