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Following a long-standing Federal Circuit decision, Dominion Resources, Inc. v. United States, 681 F.3d 1313 (Fed. Cir. 2012), the IRS has issued proposed regulations (REG-133850-13) that, if finalized, would conform to the court holding that invalidated the IRS's "associated property" rule. As discussed herein, this case presented an issue of first impression concerning the validity and application of the Treasury Department's associated-property rule for capitalizing interest under IRC Section 263A(f) on a taxpayer's installation or construction of improvements or additions to property used to generate income. The associated-property rule relates to property temporarily removed from service in connection with the installation or addition of an improvement, and, in effect, requires the capitalized cost of the improvement to include both direct expenditures and imputed interest on the basis of the property temporarily removed from service, for the time of that removal.

The proposed regulations would remove certain rules from the interest capitalization requirements for improvements to designated property. The proposed regulations also would modify the definition of "improvement" and other rules due to the removal of certain rules. The draft rules are proposed to be effective for tax years beginning after the date the final regulations are published in the Federal Register. However, taxpayers may choose to apply these proposed regulations for tax years beginning after May 15, 2024 and on or before the date that final regulations are published in the Federal Register.

Background

In Dominion, a public utility replaced coal burners in two of its electric generating plants. To make these changes, Dominion removed the units from service for a few months. During this period when the plants were out of service, Dominion continued to incur interest on debt unrelated to the improvements. On its tax returns, it deducted some of that interest from its taxable income and capitalized interest expense only on the direct and indirect costs specifically allocated to the project.

The IRS denied the deduction for additional interest expense by applying Treas. Reg. Section 1.263A-11(e)(1)(ii)(B) to capitalize $3.3 million of the interest. Ultimately, the IRS and Dominion reached a settlement, with the IRS allowing the company to deduct 50% and capitalize 50% of the disputed amount. Dominion then sought a refund of the amount disallowed claiming that the entire disputed amount was deductible. The claim was disallowed and Dominion filed suit in the US Court of Federal Claims asserting that the applicable Income Tax Regulations, Treas. Reg. Section 1.263A-11(e)(1)(ii)(B), were invalid.

The Court of Federal Claims granted summary judgment to the government and held that the regulation was a permissible construction of IRC Section 263A and Treasury promulgated the regulation with a reasoned explanation in accordance with 5 U.S.C. Section 706(2) and Motor Vehicles Mfrs. Ass'n of the United States, Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). Dominion appealed and the US Court of Appeals for the Federal Circuit, overturned the lower court finding the regulation at issue invalid.

The Federal Circuit found that Treas. Reg. Section 1.263A-11(e)(1)(ii)(B) "unreasonably links" the interest capitalized when a taxpayer makes an improvement to the adjusted bases of the property temporarily removed from service to complete the improvement. The court observed that when implementing 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." Additionally, the court pointed out that the adjusted basis of the temporarily withdrawn property is not an "avoided" amount. The court also determined that a property owner expends funds in the amount equal to the cost of the improvement, not the amount equal to the adjusted basis of the temporarily withdrawn property. Therefore, the court ruled Treas. Reg. Section 1.263A-11(e)(1)(ii)(B) contradicts the avoided-cost rule.

Proposed regulations

Because Treasury and the IRS agree with the Federal Circuit's opinion, the proposed regulations would remove the associated property rule for improvements to real property (Treas. Reg. Section 1.263A-11(e)(1)(ii)(B)) and tangible personal property (Treas. Reg. Section 1.263A-11(e)(1)(iii)) for property temporarily withdrawn from service. The proposed regulations also would remove Treas. Reg. Section 1.263A-11(e)(1)(ii)(A) related to APEs for an improvement to real property that includes an allocable portion of the land cost.

Additionally, the proposed regulations would remove the associated property rule in Treas. Reg. Sections 1.263A-11(e)(1)(ii)(B) and 1.263A-11(e)(1)(iii) for improvements to property not placed in service because Treas. Reg. Section 1.263(a)-3(d) limits the definition of "improvement" to amounts paid for activities conducted after the property is placed in service. In the preamble to the proposed regulations, Treasury and the IRS point out that 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 [Treas. Reg. Section] 1.263(a)-2 and [IRC S]ection 263A."

With the removal of the associated property rule under Treas. Reg. Section 1.263A-11(e)(1)(ii)(B), the de minimis rule under Treas. Reg. Section 1.263A-11(e)(2) would no longer be relevant. Therefore, the proposed regulations would remove the de minimis rule.

The removal of all these rules would require a taxpayer to include in APEs only the direct and indirect costs of the improvements.

The proposed regulations would retain the substantive rules in Treas. Reg. Section 263A-11(f) but would clarify that the rules only apply to situations in which property is purchased and further produced before it is placed in service. The proposed regulations also would include a cross-reference to Treas. Reg. Section 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."

In addition, the proposed regulations would update the definition of "improvement" to make it consistent with the definition of "improvement," including the exceptions, safe harbors and elections under Treas. Reg. Section 1.263(a)-3. The de minimis safe harbor election in Treas. Reg. Section 1.263(a)-1(f) would generally not apply when determining whether a taxpayer should include certain amounts in its calculation of APEs for interest capitalization under IRC Section 263A.

Implications

Taxpayers would be required to include in APEs only the direct and indirect costs of the improvement itself because of the proposed modifications to Treas. Reg. Section 1.263(a)-11(e) to remove from APEs (1) the adjusted basis of associated real property, (2) the adjusted basis of associated tangible personal property, and (3) an allocable portion of the land cost if a taxpayer makes an improvement.

The proposed regulations do not contain method change transition rules but note that a change in a taxpayer's treatment of interest to a method consistent with Treas. Reg. Sections 1.263A-8(d)(3) and 1.263A-11(e) and (f), as applicable, is a change in method of accounting to which IRC Sections 446 and 481 apply. It is anticipated the final regulations will be accompanied by automatic method change procedural guidance to comply. Presently, Section 12.14 of automatic change Revenue Procedure 2023-24 provides for a method change for interest capitalization costs. The automatic procedure, however, applies only to a taxpayer that wants to change:

1. Its method of accounting for interest from not capitalizing any interest
2. Capitalizing interest in accordance with its method of accounting for financial reporting purposes
3. Applying an improper method of capitalizing interest under Treas. Reg. Sections 1.263A-8 through -14

For the production of designated property, the automatic procedure also applies to a taxpayer that wants to change to capitalizing interest with respect to the production of designated property in accordance with Treas. Reg. Sections 1.263A-8 through -14. As such, it appears that a change presently to comply with the proposed regulations would be a non-automatic filing under Revenue Procedure 2015-13, and subject to a user fee under Revenue Procedure 2024-1.