Dominion Resources: Further insights into regulatory deference
A recent decision helps piece together the circumstances for when deference is owed to a tax regulation.
June 28, 2012
After the U.S. Supreme Court’s 2011 decision in Mayo, it seemed that Treasury regulations carried a lot of weight. That is, it would be difficult, if not impossible, to find that they were invalid. That idea was diminished when the Court invalidated a statute of limitation regulation earlier this year in Home Concrete & Supply. The notion has been further diminished by the recent Federal Circuit ruling, Dominion Resources, Inc., No. 2011-5087 (Fed. Cir. 2012). More precisely, the deference owed to tax regulations has been clarified. Yet, the varying interpretations in the trial and appeals decisions likely mean further clarification regarding regulation deference is needed.
This article summarizes the May 2012 decision in Dominion Resources. It focuses on both the technical issue involving interest capitalization and the issue of regulatory deference.
Interest capitalization tax issues
The tax issue in Dominion Resources involved how much interest must be capitalized per Sec. 263A(f) when the utility company replaced coal burners in two plants. More specifically, the issue involved how accumulated production expenditures (APE) are to be computed in order to apply the avoided-cost method of determining the amount of interest expense to capitalize during the “production period.”
Generally, the avoided-cost method (Regs. Sec. 1.263A-9) comes into play when a taxpayer has APEs that exceed the borrowings specifically made for the production activity (traced debt). Avoided-cost debt requires a producer to capitalize interest on debt not directly traced to the production activity. The concept, borrowed from GAAP, is that if the taxpayer had not used cash for the production activity, it could have paid down its other debt.
APE is not the same as the measure of the direct and indirect costs to be capitalized to the basis of the asset being produced. Instead, APE is a broader measure that includes, for example, the “adjusted bases (or portion thereof) of any equipment, facilities, or other similar assets, used in a reasonably proximate manner for the production of a unit of designated property during any measurement period in which the asset is so used.” (Regs. Sec. 1.263A-11(d)(1))
Regs. Sec. 1.263A-11(e) describes additional APE where the property produced is an improvement to real property. In such a situation, APE includes:
(A) An allocable portion of the cost of the land; and
(B) 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.
The provisions emphasized above were the ones at issue in Dominion Resources and what the court found unlawful.
Regulatory deference issue
The more interesting aspect of Dominion Resources and the one of broader relevance is what standard, or tests, regulations must meet to receive deference. The court applied the Chevron two-step test and the State Farm requirement (State Farm, 463 U.S. 29 (1983), explained later), with the result that, under the Administrative Procedures Act (5 U.S.C. §706(2)), the court could find the regulation invalid.
Chevron analysis: The two-step Chevron test addresses two questions. First, has Congress “directly spoken to the precise question at issue”? If congressional intent behind the statute is ambiguous or not stated, then step two requires a determination of whether the regulation is a “permissible construction of the statute.” According to the Federal Circuit, the Supreme Court’s ruling in Mayo confirms that courts are required to apply Chevron deference to Treasury regulations.
The court in Dominion Resources found that Sec. 263A(f) was ambiguous due to its circular rules and definitions. The court next found that Regs. Sec. 1.263A-11(e)(1)(ii)(B) (see above) was “not a reasonable interpretation of the avoided-cost rule” of Sec. 263A(f)(2)(A)(ii). The court stated that the borrower’s adjusted basis of property did not represent funds that could have instead been used to pay down debt because it is unlikely the associated property would be sold. Thus, per the court, that adjusted basis amount should not be included in APE.
The court stated, “Selling the unit obviates the very reason for the improvement.” Thus, the court found the regulation invalid because it was “not a reasonable interpretation” of the statute.
State Farm analysis: The court found that the regulation violated the requirement of State Farm to provide a satisfactory rationale or explanation for the approach of a regulation.
Section 263A(f): The IRS may modify its regulation. Any modification is likely to emphasize the rationale for the rule to prevent future problems under a State Farm analysis.
Deference clarification: Varying interpretations of the outcome of the Chevron and State Farm analyses existed among the judges involved in the trial and appellate decisions in Dominion Resources. Thus, more guidance is likely needed on how these tests apply to tax regulations.
The U.S. Court of Federal Claims found no problem with step two of Chevron. It also found that enough of the rationale of Treasury could be “discerned” to uphold the regulation under the State Farm analysis.
The Federal Claims Court’s explanation of why there was no problem under step two indicates that a question likely remains as to who is to judge the “wisdom” of a regulatory policy choice taken by Treasury.
According to the lower court:
One might also question the wisdom of including the basis of associated property in calculating interest to be capitalized for an improvement because that inclusion constitutes a tax disincentive to making improvements to productive manufacturing capacity. Nonetheless, it is not this court’s province to be making such policy choices. In this very close case, the court cannot say that Treasury overstepped the latitude granted by the statute to adopt regulations prescribing the calculation of interest to be capitalized in connection with an improvement to existing property used by the taxpayer to produce income. (Dominion Res., Inc., 97 Fed. Cl. 239 (2011))
In the Federal Circuit Court’s decision, a concurring judge took an approach to step two of Chevron similar to that of the lower court. This judge noted that given that the avoided-cost rule already employs a fiction (that cash would be used to pay down debt), there could be justification for applying a similar fiction to existing property. The judge was not convinced that the regulation should be dismissed under step two “if Treasury can properly explain its reasoning, which it has yet to do.” This judge believed the case should be decided on the State Farm analysis and not on Chevron.
Thus, it is likely that given varying interpretations of how step two in Chevron should be applied, it is likely to be addressed in more cases. In the meantime, Treasury needs to figure out how Mayo, Home Concrete, Chevron, and State Farm apply to its regulation writing process to ensure that regulations are upheld.
Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984): see two-step analysis explained above.
Dominion Resources, Inc., No. 2011-5087 (Fed. Cir. 2012): some clarification of the Chevron and State Farm analyses.
Mayo Foundation for Medical Education and Research, Sup. Ct. Dkt. 09-837 (2011): Chevron deference applies to Treasury regulations. A regulation promulgated under Treasury’s general authority per Sec. 7805(a) was found to be valid because the matter was “one to which Congress has not directly spoken, and because the Treasury Department’s rule is a reasonable construction of what Congress has said.”
Motor Vehicles Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983): see explanation above.Home Concrete & Supply, LLC, 312 S. Ct. 1836 (2012): Where a prior Supreme Court decision has interpreted a statute, it must be followed in writing a regulation.
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Annette Nellen, Esq., CPA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She chairs the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax policy and reform and a blog.