IRS Proposes Cutback in Interest Capitalization Requirements for Property Improvements

 

The IRS on May 15 published proposed regulations (REG-133850-13) that would remove the “associated property rule” and related rules from the regulations on interest capitalization requirements for improvements to “designated property.” The proposed regulations follow the rationale of the Federal Circuit decision in Dominion Resources, which invalidated the existing regulations.

The proposed regulations would also modify the definition of “improvement” for purposes of these regulations under Reg. §1.263A-8(d)(3) so that it is consistent with the definition provided in the tangible property regulations under Reg. §1.263(a)-3.

While the proposed regulations are proposed to apply to tax years beginning after the date that final regulations are published, taxpayers may apply the proposed regulations for tax years beginning after May 15, 2024, and on or before the date that final regulations are published.

Capitalization Requirements and Associated Property Rule

Internal Revenue Code Section 263A generally requires the capitalization of direct and indirect costs of real or tangible personal property produced or improved by a taxpayer. Section 263A(f) provides rules for capitalizing interest for these purposes and for determining the amount of interest required to be capitalized. The requirement to capitalize interest is limited to interest that is paid or incurred during the production period and that is allocable to real property or certain tangible personal property produced by the taxpayer (designated property).

The regulations under Section 263A specify that taxpayers must use the “avoided cost method” to determine the amount of interest required to be capitalized with respect to the production of designated property. Under the avoided cost method, the taxpayer must capitalize any interest that the taxpayer would have avoided if accumulated production expenditures (APEs) had been used to repay or reduce the taxpayer’s outstanding debt.

In the case of an improvement to real property qualifying as the production of designated property, the regulations include an “associated property rule,” which states that APEs include:

• An allocable portion of the cost of land, and
• 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of any existing structure, common feature, or other property that is not placed in service, or must be temporarily withdrawn from service to complete the improvement (associated property), during any part of the measurement period if the associated property directly benefits the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 is incurred by reason of the associated property.

Federal Circuit Decision in Dominion Resources

The Federal Circuit invalidated the associated property rule for property temporarily withdrawn from service in Dominion Resources, Inc. v. U.S., 681 F.3d 1313 (Fed. Cir. 2012). The court held that the regulation was not a reasonable interpretation of the avoided cost method and violated the requirement that the IRS provide a reasoned explanation for adopting a regulation.

The case involved a utility company that had to temporarily withdraw from service two electric generating plants while replacing coal burners in the plants. During this time, the taxpayer incurred interest on debt unrelated to the improvements. The IRS challenged the taxpayer’s deduction of some of that interest, arguing that the taxpayer’s APEs should include the cost of the improvements and the adjusted basis of the property temporarily withdrawn from service to complete the improvement.

The taxpayer challenged the validity of the associated property rule for property temporarily withdrawn from service. The Federal Circuit agreed with the taxpayer, concluding that the regulation unreasonably links the interest capitalized when a taxpayer makes an improvement to the adjusted basis of property temporarily withdrawn from service to complete the improvement.

New Proposed Regulations

In the preamble to the proposed regulations, the IRS agrees with the Federal Circuit’s rationale in Dominion Resources. It states that treating the adjusted basis of any associated property that is temporarily withdrawn from service to complete the improvement as a component of APEs contradicts the avoided cost method because the adjusted basis of the temporarily withdrawn property does not represent an “avoided” amount.

Following this rationale, the proposed regulations would remove the associated property rule for property temporarily withdrawn from service. In addition, the IRS goes further in the proposed regulations than the Dominion Resources decision, concluding that the associated property rule should also be removed for improvements to property “not placed in service.”

After the proposed changes to the rules – which would remove from APEs the adjusted basis of associated real property, the adjusted basis of associated tangible personal property, and an allocable portion of the cost of the land when the taxpayer makes an improvement – a taxpayer would be required to include in APEs only the direct and indirect costs of the improvement itself.

The proposed regulations retain the substantive rules in Reg. §1.263A-11(f), which relates to the cost of property purchased for further production prior to being placed in service. The holding in Dominion Resources was limited to improvements to property “temporarily withdrawn from service” and did not address situations in which a taxpayer purchases property for further production prior to placing the property in service. The IRS notes in the preamble to the proposed regulations that unlike the cost of property that is temporarily withdrawn from service to be improved, the cost of property purchased for further production prior to being placed in service represents an “avoided” amount under avoided cost principles because the cost of such property is a component cost of the original production activity. However, the proposed regulations do modify Reg. §1.263A-11(f) to clarify that Section 1.263A-11(f) applies only to situations in which property is purchased and further produced before the property is placed in service.

Insight

Effective in 2025 for calendar-year taxpayers, taxpayers will no longer be required to include associated property in the taxpayer’s APEs for property temporarily withdrawn from service or include associated land costs when making improvements to property.  Only the direct and indirect costs of the improvements will be required to be included in APEs – significantly reducing APEs and, therefore, interest capitalization in situations where the “associated property rule” would have applied.

Note that a change in a taxpayer’s treatment of interest to a method consistent with the proposed regulations is a change in method of accounting to which Sections 446 and 481 apply.

In informal conversations with IRS officials regarding what taxpayers must to do to comply with the proposed regulations (assuming their current method is different), the IRS has indicated that it is still evaluating whether an accounting method change to comply with the proposed regulations would fit into an existing automatic method change, require the introduction of a new automatic method change, or be effectuated via filing a non-automatic method change. If the IRS ultimately decides that the change must be made through non-automatic filing procedures, taxpayers seeking to adopt the proposed regulations would have to file the method change by the last day of the year of change and pay a filing fee to the IRS.

 

Written by Julie Robins and Connie Cunningham. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com