Federal Circuit Invalidates Section 263A Regulation Under the Chevron Test

Aug 15, 2012   

On May 31, 2012, the U.S. Court of Appeals for the Federal Circuit concluded that the associated property rule in Treas. Reg. § 1.263A-11(e)(1)(ii)(B) as applied to property temporarily withdrawn from service was not a reasonable interpretation of 26 U.S.C. Section 263A (“Section 263A”).  The Federal Circuit also found that the Treasury Department failed to provide a reasoned explanation when it promulgated that regulation.  Dominion Resources, Inc. v. United States, 97 Fed. Cl. 239 (Fed. Cir. 2012) is available here.  The Treasury Regulation at issue is available here while Section 263A is available here.

The factual background is incorporated in the opinion.  Dominion Resources is in the business of providing electric power and natural gas to individuals and businesses.  In 1996, it replaced coal burners in two of its plants.  While making those improvements, it temporarily removed the units from service “ one unit for two months and the other for three months.  During this period, Dominion incurred interest on debt unrelated to these improvements.  Dominion deducted some of this interest from its taxable income.  The IRS disagreed with the deduction computation under Treas. Reg. § 1.263A-11(e)(1)(ii)(B) and applied the regulation to capitalize $3.3 million of that interest instead of deducting it.  This distinction is notable because a deduction occurs immediately in the tax year, while capitalization occurs over later years.  In a settlement between the IRS and Dominion, the IRS allowed Dominion to deduct 50% and capitalize 50% of the disputed amount.  Dominion nonetheless disputed the amounts and sought to invalidate Treas. Reg. § 1.263A-11(e)(1)(ii)(B) in court.

Section 263A is comprised of five subsections, which the court described as “circular” because each rule referred to another rule in a progression such that the reader ends at the beginning.  Nevertheless, as a general rule, Section 263A requires capitalization of certain costs incurred in improving real property, instead of deduction.   Subsection (f) provides the general rule that interest is a cost requiring capitalization when the cost is allocable to the property.  Furthermore, the section states that “[s]ubsection (a) shall only apply to interest costs which are (A) paid or incurred during the production period, and (B) allocable to property which is described in subsection (b)(1)”  For determining what interests costs are allocable, subsections (f)(1) and (f)(2) provide that interest is allocable “to the extent that the taxpayers interest costs could have been reduced if production expenditures had not incurred.”  In determining the amount of interest required to be capitalized under Section 263A(f)(2), interest on any other indebtedness is assigned to such property that the taxpayers interest costs could have been reduced if production expenditures had not been incurred.  This subsection is generally considered the “avoided-cost principle.”

The regulation at issue defined what constituted production expenditures and determined the amount of interest capitalized. Under Treas. Reg. § 1.263A-11(e)(1), production expenditures subject to capitalization include not only the amount of allocable portion of the cost of land but also the adjusted basis of the entire unit being improved that is temporarily withdrawn from service, known as associated property.  Thus, by including the adjusted basis amount, the regulation increased the amount of interest to be capitalized.

The issue on appeal from the decision of the U.S. Court of Federal Claims, available here here, was whether the inclusion of the adjusted basis of the unit violates various statutory provisions.  Because Treas. Reg. § 1.263A-11(e)(1)(ii)(B) required a larger base amount, it resulted in a larger amount of interest to be capitalized.  The challenge to the regulation was only as applied to property that was temporarily withdrawn from service and not as applied to property that was not placed in service. 

The court analyzed the validity of Treas. Reg. § 1.263A-11(e)(1)(ii)(B) under what is commonly referred to as the “two-step test” set forth in Chevron, USA v. NRDC, 467 U.S. 837 (1984), available here.  Step one is whether Congress has directly spoken to the precise question at issue.  If the statute is silent or ambiguous, the second step resolves the question of whether the agencys answer is based on a permissible construction of that statute. 

In the present case, the regulation did not contradict the text of the statute but only because the statute is opaque, or as previously explained, circular.  Therefore, the Federal Circuit determined that the statute was ambiguous and was forced to turn to the second step of the Chevron test.

Under step two, the Court concluded that the regulation directly contradicted the “avoided-cost rule” which implemented Congresss concern with the avoided cost principle.  This rule recognizes that if the improvement had not been made, those funds could have been used to pay down the debt and therefore reduce interest that accrued on the debt.  In the instant case, the improvement was made and that amount was not used to pay down the debt and interest consequently accrued on that amount. 

Moreover, the adjusted basis did not represent an avoided amount because a property owner does not expend funds in an amount equal to the adjusted basis when making the improvement.  Instead, a property owner expends funds in an amount equal to the cost of the improvement itself.  Additionally, the statute uses the term “expenditures,” the plain meaning of which is an amount actually expended or spent on the improvement.  The Court explained that a property owner would not expend or incur an amount equal to the adjusted basis when making the improvement, and as a result, the regulation unreasonably linked the interest capitalized when making an improvement to the adjusted basis. It reasoned that the only way an amount equal to the adjusted basis could potentially satisfy the avoided-cost rule was by assuming that the property owner did not expend funds in an amount equal to the adjusted basis when making the improvement.  Even so, the Court stated that there was no reasonable explanation that assumed that a property owner would have sold the same unit that it removed from service for the sole purpose of improving.  Accordingly, the federal regulation unreasonably linked the interest capitalized when making an improvement to the adjusted basis.  Therefore, the associated property rule in Treas. Reg. § 1.263A-11(e)(1)(ii)(B) as applied to property temporarily withdrawn from service was not a reasonable interpretation of Section 263A(f)(2)(A)(ii) and was deemed to be invalid.

The Court further held that the associated property rule in Treas. Reg. § 1.263A-11(e)(1)(ii)(B) violated the State Farm requirement that the Treasury provide reasoned explanations for adopting regulations.  State Farm requires the Treasury to articulate a satisfactory explanation for its action, including a rational connection between the facts found and the choice made.  See Motor Vehicles Mfrs. Assn of the U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983).  The Court stated that the IRS failed to provide guidance that mentioned adjusted basis as part of the interest-capitalization method.  There was no rationale other than the general statement that the regulations were intended to implement the avoided-cost method. 

In conclusion, the IRS failed to provide any explanation for the way that the use of an adjusted basis implemented the avoided-cost rule and it did not satisfy the rule.  The Treasury did alert the interested public how the basis of the property being improved would be treated, but the explanation was not sufficient to satisfy the State Farm requirement that the regulation articulate a satisfactory or cogent explanation.

The attorneys at Fuerst Ittleman, PL have extensive civil and criminal tax litigation experience before the U.S. District Courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the U.S. Circuit Courts of Appeal.  You can contact us by calling 305.350.5690, or by emailing us at contact@fidjlaw.com.