The IRS recently issued proposed regulations (REG-133850-13) to align IRS rules with a the Federal Circuit decision Dominion Resources, Inc. v. United States, 681 F.3d 1313 (Fed. Cir. 2012). If finalized, they would remove the associated property rule from the existing regulations that provide interest capitalization requirements for improvements to designated property.
Section 263A(f) and the regulations thereunder provide rules for capitalizing interest with respect to certain property produced by a taxpayer. When capitalizing interest, taxpayers must consider the application of the avoided costing rules that capture accumulated production expenses (APEs) for taxpayers making improvements to real or tangible personal property. Under those rules, greater amounts of APEs result in more interest required to be capitalized. In its current form, Treas. Reg. Sec. 1.263A-11(e)(1) generally provides that, with respect to improvements, APEs consist of:
- all direct and indirect costs required to be capitalized with respect to the improvement,
- in the case of real property
- an allocable portion of the cost of land, and
- the adjusted basis of any existing structure, common feature, or other property that is not placed in service or must be temporarily withdrawn from service to complete the improvement (i.e., associated property), and
- in the case of tangible personal property, the adjusted basis of the asset being improved, if the asset either is not placed in service or must be temporarily withdrawn from service to complete the improvement.
The Federal Circuit ruling in Dominion Resources invalidated the above associated property rule in the regulations, concluding that the rule was not a reasonable interpretation of the avoided cost method because it “unreasonably links” the interest capitalized when a taxpayer makes an improvement to the adjusted basis of the property temporarily withdrawn from service to complete the improvement.
The taxpayer in Dominion Resources was a public utility that replaced coal burners in two of its electric generating plants to make improvements. During the improvement, the two electric generating plants were temporarily removed from service and Dominion Resources deducted a portion of interest expense that it incurred. The IRS challenged the amount of interest expense that the taxpayer deducted, stipulating that the associated property rule required the taxpayer to include the adjusted basis of the electric generating plants temporarily withdrawn from service as APEs. The Court of Federal Claims upheld the validity of the associated property rule when it denied the taxpayer’s subsequent claim for refund. However, on appeal, the Federal Circuit overturned the lower court ruling, reasoning that the adjusted basis of the temporarily withdrawn property is not an "avoided" amount such that the associated property rule in Treas. Reg. Sec. 1.263A-11(e)(1)(ii)(B) contradicts the avoided cost method.
In alignment with the ruling, the proposed regulations would remove the associated property rule for improvements to real property and tangible personal property for property temporarily withdrawn from service. Based on the rationale in Dominion Resources, the proposed regulations would remove the rule that requires taxpayers to include an allocable portion of the cost of land as APEs. The proposed regulations would also remove the associated property rule for improvements to property not placed in service because, in accordance with Treas. Reg. Sec. 1.263(a)-3(d), an improvement is limited to amounts paid for activities performed after the property is placed in service. In addition, the proposed regulations would modify certain other rules to agree with the removal of the associated property rule.
The regulations are proposed to apply for tax years beginning after the date the final regulations are published in the Federal Register. Taxpayers may choose to implement the proposed regulations for tax years beginning after May 15, 2024, and before (or on) the date that final regulations are published.
Grant Thornton Insight:
While many taxpayers have relied on Dominion Resources to reduce the amount of interest required to be capitalized, some taxpayers may prefer to rely on the regulations in their current form to capitalize additional interest, which could be beneficial for a variety of reasons (e.g., limitation provisions of Section 163(j)). Once the proposed regulations are finalized, taxpayers will no longer have the option to apply the associated property rule.
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