Dominion Res., Inc. v. United States, 2011–5087.

• Citation: 109 A.F.T.R.2d 2012,681 F.3d 1313
• Decision Date: 31 May 2012
• Docket Number: No. 2011–5087.,2011–5087.
• Parties: DOMINION RESOURCES, INC., Plaintiff–Appellant, v. UNITED STATES, Defendant–Appellee.
• Court: U.S. Court of Appeals — Federal Circuit

681 F.3d 1313

109 A.F.T.R.2d 2012-2316

DOMINION RESOURCES, INC., Plaintiff–Appellant,

v.UNITED STATES, Defendant–Appellee.

No. 2011–5087.

United States Court of Appeals,Federal Circuit.

May 31, 2012.

Eric R. Fox, Ivins, Phillips & Barker, Chartered, of Washington, DC, argued for plaintiff-appellant. With him on the brief were Leslie J. Schneider and Patrick J. Smith.

Karen G. Gregory, Attorney, Tax Division, United States Department of Justice, of Washington, DC, argued for defendant-appellee. With her on the brief were Tamara W. Ashford, Deputy Assistant Attorney General, and Jonathan S. Cohen, Attorney.

Paul L. Gale, Troutman Sanders LLP, of Washington, DC, for amicus curiae.

Before RADER, Chief Judge, CLEVENGER, and REYNA, Circuit Judges.

Opinion for the court filed by Chief Judge RADER. Opinion concurring in part and concurring in the result filed by Circuit Judge CLEVENGER.

RADER, Chief Judge.

The United States Court of Federal Claims granted the United States' motion for summary judgment against Dominion Resources, Inc. See Dominion Res., Inc. v. United States, 97 Fed.Cl. 239 (2011). This case presents an issue of first impression for any appellate court. The CFC held that Treasury Regulation § 1.263A–11(e)(1)(ii)(B) is a permissible construction of the statute I.R.C. § 263A. Because the associated property rule in Treasury Regulation § 1.263A–11(e)(1)(ii)(B) as applied to property temporarily withdrawn from service is not a reasonable interpretation of I.R.C. § 263A and because the Treasury acted contrary to 5 U.S.C. § 706(2) in failing to satisfy the State Farm requirement to provide a reasoned explanation when it promulgated that regulation, this court reverses.

I.

Dominion provides electric power and natural gas to individuals and businesses. In 1996, it replaced coal burners in two of its plants. When making those improvements, it temporarily removed the units from service—one unit for two months, the other for three months. During that time, Dominion incurred interest on debt unrelated to the improvements.

On its corporate tax returns, Dominion deducted some of that interest from its taxable income. The IRS disagreed with Dominion's computation under Treasury Regulation § 1.263A–11(e)(1)(ii)(B), the regulation at issue here. The IRS applied the regulation to capitalize $3.3 million of that interest, instead of deduct. A deduction occurs immediately in that tax year, while capitalization occurs over later years. Under a settlement, the IRS allowed Dominion to deduct 50% and capitalize 50% of the disputed amount.

Still asserting that the entire disputed amount is deductible, Dominion filed this suit seeking a refund of $297,699 in corporate income tax. Dominion thus sought to invalidate Treasury Regulation § 1.263A–11(e)(1)(ii)(B). The CFC denied Dominion's claim and granted summary judgment to the United States. The CFC held that the regulation was a permissible constructionof I.R.C. § 263A and that Treasury promulgated that regulation with a reasoned explanation that satisfied 5 U.S.C. § 706(2) and Motor Vehicle Mfrs. Ass'n of the United States, Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 103 S.Ct. 2856, 77 L.Ed.2d 443 (1983).

II.

The Tax Reform Act of 1986 enacted I.R.C. § 263A (“Capitalization and Inclusion in Inventory Costs of Certain Expenses”). Generally, the statute requires capitalization of certain costs incurred in improving real property, instead of deduction. In broad terms, interest appears as a cost covered by the capitalization requirement.

The relevant statutory provisions in I.R.C. § 263A comprise five subsections. Each subsection refers to the next. A careful reading of the five subsections shows that each rule or definition refers to another rule or definition in a circular progression that brings the law back to the place it began with little elucidation of legal standards and definitions. In simple words, the statute is circular.

First, I.R.C. § 263A(a)(1) (“Nondeductibility of Certain Direct and Indirect Costs”) sets out the general rule that when improving real property, certain costs must be capitalized instead of deducted from taxable income. “In the case of any property to which this section applies, any costs described in paragraph (2) ... shall be capitalized.” I.R.C. § 263A(a)(1). The text of that statutory provision refers to subsection paragraph (2) (“Allocable Costs”), which defines such costs as including both “direct costs” and “indirect costs.” “The costs described in this paragraph with respect to any property are (A) the direct costs of such property, and (B) such property's proper share of those indirect costs (including taxes) part or all of which are allocable to such property.” I.R.C. § 263A(a)(2) (emphasis added).

Next, interest is a type of “cost” as discussed in subsection (f) (“Special Rules for Allocation of Interest to Property Produced by the Taxpayer”). Specifically, subsection (f)(1) states the general rule that interest is a cost requiring capitalization when that cost is “allocable” to the property. “Subsection (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) and which has [other requirements not relevant here].” I.R.C. § 263A(f)(1) (emphasis added).

To determine what interest costs are “allocable” as mentioned in subsection (f)(1), subsection (f)(2) (“Allocation Rules”) states the general rule that interest is allocable “to the extent that the taxpayer's interest costs could have been reduced if production expenditures ... had not been incurred.” “In determining the amount of interest required to be capitalized under subsection (a) with respect to any property ... (ii) interest on any other indebtedness shall be assigned to such property to the extent that the taxpayer's interest costs could have been reduced if production expenditures (not attributable to indebtedness described in clause (i)) had not been incurred.” I.R.C. § 263A(f)(2) (emphasis added). This is the avoided-cost rule and implements Congress' concern with the avoided-cost principle:

The legislative history of amendments to section 189 indicates Congress' intention that the Treasury Department issue regulations allocating interest to expenditures for real property during construction consistent with the method prescribed by Financial Accounting Standards Board Statement Number 34 (FAS 34). Under FAS 34, the amount of interest to be capitalized is the portionof the total interest expense incurred during the construction period that could have been avoided if funds had not been expended for construction

. Interest expense that could have been avoided includes interest costs incurred by reason of additional borrowings to finance construction, and interest costs incurred by reason of borrowings that could have been repaid with funds expended for construction.

S.Rep. No. 99–313, at 140, 144 (1986) (emphasis added); H.R.Rep. No. 99–426, at 625, 628 (1985) (same); Joint Committee on Taxation, JCS–10–87, 1987 WL 1364655 (1987) (same).

The term “production expenditures” mentioned in subsection (f)(2) is defined in subsection (f)(4)(C) to mean costs “required to be capitalized under subsection (a).” “The term ‘production expenditures' means the costs (whether or not incurred during the production period) required to be capitalized under subsection (a) with respect to the property.” I.R.C. § 263A(f)(4)(C). The text of that statutory provision refers to “subsection (a),” which means I.R.C. § 263A(a), the first statutory provision that began this discussion on the relevant statutory provisions.

The general formula to determine the amount of interest that must be capitalized is the amount of “production expenditures” multiplied by the weighted-average interest rate on the debt during the time the production occurs. In other words, the production expenditures represent the base amount and some fraction of that amount represents the interest that must be capitalized. A larger base will lead to more interest capitalized.

After a notice of proposed rulemaking in 1991, the Treasury published final regulations in 1994. The regulation at issue here defines what constitutes “production expenditures” (the base amount) and therefore determines the amount of interest capitalized. Treasury Regulation § 1.263A–11(e)(1) (“General Rule”) states:

If an improvement constitutes the production of designated property under § 1.263A–8(d)(3), accumulated production expenditures with respect to the improvement consist of (i) All direct and indirect costs required to be capitalized with respect to the improvement, (ii) In the case of an improvement to a unit of real property (A) An allocable portion of the cost of land, and (B) For any measurement period, 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 (associated property) during any part of the measurement period if the associated property directly benefits the property being improved, the associated property directly benefits from the improvement, or the improvement was incurred by reason of the associated property.

(emphasis added)

The parties agree that a certain amount of construction-period interest should be capitalized instead of deducted, but the extent of that capitalization requirement is the essence of this dispute. The parties agree that the Treasury regulation plainly defines production expenditures to include not only the amount spent on the improvement but also the adjusted basis of the entire unit being improved. For simplicity, adjusted basis can be considered as the original cost of the unit. The issue on appeal is whether that latter inclusion of the adjusted basis of the unit violates various statutory provisions. Because the regulation requires a larger base amount (by...