May 20, 2024

Better Late Than Never: IRS Proposes an End to Expansive Section 263A Associated Property Rule

Holland & Knight Alert
Brad M. Seltzer | Eli Brander

More than a decade after the associated property rule was invalidated by the U.S. Court of Appeals for the Federal Circuit in Dominion Resources, Inc. v. United States, 681 F.3d 1313 (Fed. Cir. 2012), the U.S. Department of the Treasury and the IRS belatedly proposed updated Section 263A regulations, removing the associated property rules. Under the regulations, the adjusted basis of a plant taken out of service, such as during a nuclear plant outage, was treated as an avoided cost subject to interest capitalization. The proposed regulations abandon the expansive application of the rule, clarifying that it "applies only to property purchased and further produced before it is placed in service."

Section 263A of the Internal Revenue Code contains rules for capitalizing certain expenses allocable to the production of real property and certain personal property. In the case of interest, Section 263A(f) limits the deductibility of interest that is paid or incurred during the production period that is either directly attributable to production expenditures with respect to the property or that would have theoretically been avoided if the funds used for accumulated production expenditures had instead been used to repay or reduce the taxpayer's outstanding debt (the avoided cost rule). Section 1.263A-11(e) provides that avoided costs include not only the actual costs of an improvement but also the adjusted basis of property not placed in service or that has been temporarily withdrawn from service to complete an improvement (the associated property rule).

In Dominion Resources, the Federal Circuit invalidated the government's expansive application of the associated property rule of Section 1.263A-11(e)(1)(ii)(B) as applied to real property temporarily withdrawn from service for repairs during a nuclear plant outage. The court held that the regulation was not a reasonable interpretation of the avoided cost rule and that interest on debt associated with temporarily withdrawn property does not represent an "avoided" cost.

In the newly released proposed regulations, the Treasury Department belatedly agreed with the Federal Circuit's rationale that the adjusted basis of the temporarily withdrawn property does not represent an "avoided" cost. Applying this rationale, the Treasury Department removed the associated property rule for property temporarily removed from service. While Dominion Resources only addressed property temporarily removed from service, the Treasury Department also applied the rationale to improvements to property "not yet placed in service" on the basis 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)."

Holland & Knight Insight

It is not entirely clear why it took the Treasury Department more than a decade to concede that its litigating position rejected in Dominion Resources, supra, was fundamentally flawed. Remnants of the discredited position are retained in the case of property purchased and further produced before it is placed in service, because the Treasury Department believes that (in contrast to the cost of property that is temporarily withdrawn from service) the cost of such property should properly be treated as a component cost of the original production activity.

For additional information, please contact the authors.

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