Interest Capitalization Requirements for Improvements to Designated Property

DEPARTMENT OF THE TREASURY <SUBAGY>Internal Revenue Service</SUBAGY> <CFR>26 CFR Part 1</CFR> <DEPDOC>[REG-133850-13]</DEPDOC> <RIN>RIN 1545-BN93</RIN> <SUBJECT>Interest Capitalization Requirements for Improvements to Designated Property</SUBJECT> <HD SOURCE="HED">AGENCY:</HD> Internal Revenue Service (IRS), Treasury. <HD SOURCE="HED">ACTION:</HD> Notice of proposed rulemaking. <SUM> <HD SOURCE="HED">SUMMARY:</HD> This document contains proposed regulations that would remove the associated property rule and similar rules from the existing regulations on the interest capitalization requirements for improvements to designated property. In addition, this document contains proposed regulations that would modify the definition of “improvement” for purposes of applying those existing regulations. Lastly, this document contains proposed regulations that would modify other rules in those existing regulations in light of the proposed removal of the associated property rule. The proposed regulations would affect taxpayers making improvements to real or tangible personal property that constitute the production of designated property. </SUM> <EFFDATE> <HD SOURCE="HED">DATES:</HD> Written or electronic comments and requests for a public hearing must be received by July 15, 2024. </EFFDATE> <HD SOURCE="HED">ADDRESSES:</HD> Commenters are strongly encouraged to submit public comments electronically via the Federal eRulemaking Portal at <E T="03">https://www.regulations.gov</E> (indicate IRS and REG-133850-13) by following the online instructions for submitting comments. Requests for a public hearing must be submitted as prescribed in the “Comments and Requests for a Public Hearing” section. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Department of the Treasury (Treasury Department) and the IRS will publish for public availability any comments submitted to the IRS's public docket. Send paper submissions to: CC:PA:01:PR (REG-133850-13), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. <FURINF> <HD SOURCE="HED">FOR FURTHER INFORMATION CONTACT:</HD> Concerning the proposed regulations, Livia Piccolo of the Office of Associate Chief Counsel (Income Tax and Accounting), at (202) 317-7007; concerning submissions of comments or a public hearing, Vivian Hayes, (202) 317-6901 (not toll-free numbers) or by email at <E T="03">publichearings@irs.gov</E> (preferred). </FURINF> <SUPLINF> <HD SOURCE="HED">SUPPLEMENTARY INFORMATION:</HD> <HD SOURCE="HD1">Background</HD> This document proposes amendments to § 1.263A-11(e)(1)(ii) and (iii) of the Income Tax Regulations (26 CFR part 1) to remove the “associated property rule” and similar rules from the interest capitalization requirements for improvements that constitute the production of property under section 263A(f) of the Internal Revenue Code (Code). In addition, this document proposes amendments to § 1.263A-11(f) to clarify that § 1.263A-11(f) applies only to property purchased and further produced before it is placed in service. Finally, this document proposes to amend § 1.263A-8(d)(3) to update the definition of “improvement” so that it is consistent with the definition of “improvement”, including the exceptions, safe harbors, and elections provided under § 1.263(a)-3. Sections 263A(a) and (b) of the Code generally require the capitalization of direct and indirect costs of real or tangible personal property produced by the taxpayer. Under section 263A(g)(1) and § 1.263A-8(d)(3), the term “produce” includes “improve.” Section 263A(f) contains rules for capitalizing interest with respect to certain property produced by the taxpayer and for determining the amount of interest required to be capitalized. In general, section 263A(f)(1) limits capitalization 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, referred to as “designated property” in the section 263A regulations. <E T="03">See</E> § 1.263A-8(b)(1). Under section 263A(f)(2)(A), in determining the amount of interest required to be capitalized to any property, (i) interest on any indebtedness directly attributable to production expenditures with respect to the property is assigned to the property, and (ii) interest on any other indebtedness is assigned to the property to the extent that the taxpayer's interest cost could have been reduced if production expenditures not attributable to indebtedness described in clause (i) had not been incurred (avoided cost method). Section 1.263A-8(a) provides that taxpayers must use the avoided cost method described in § 1.263A-9 in determining the amount of interest required to be capitalized with respect to the production of designated property. Section 1.263A-9(a)(1) explains that, under the avoided cost method, any interest that the taxpayer theoretically would have avoided if accumulated production expenditures (as defined in § 1.263A-11) (APEs) had been used to repay or reduce the taxpayer's outstanding debt must be capitalized. Under § 1.263A-11(a), APEs generally mean the cumulative amount of direct and indirect costs described in section 263A(a) that are required to be capitalized with respect to a unit of property. Section 1.263A-9(c) provides that, to the extent a taxpayer's APEs exceed traced debt (that is, debt that is allocated to APEs with respect to the unit of property), the general formula for determining the amount of interest that must be capitalized is the average excess expenditures multiplied by the weighted average interest rate on the debt during the time the production occurs. A larger base of production expenditures leads to more interest capitalized. Section 1.263A-11(e)(1)(i) provides that, if an improvement constitutes the production of designated property under § 1.263A-8(d)(3), APEs with respect to the improvement consist of all direct and indirect costs required to be capitalized with respect to the improvement. In the case of an improvement to a unit of real property qualifying as the production of designated property under § 1.263A-8(d)(3), § 1.263A-11(e)(1)(ii) provides 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 was incurred by reason of the associated property (associated property rule). In the case of an improvement to a unit of tangible personal property qualifying as the production of designated property under § 1.263A-8(d)(3), § 1.263A- 11(e)(1)(iii) provides that APEs include the adjusted basis of the asset being improved if that asset either is not placed in service or must be temporarily withdrawn from service to complete the improvement. Section 1.263A-12(a) explains that under § 1.263A-9, a taxpayer must capitalize interest for computation periods that include the production period of a unit of designated property. In the case of property produced for self-use, § 1.263A-12(d)(1) generally provides that the production period for a unit of property ends on the date that the unit is placed in service and all production activities reasonably expected to be undertaken are completed. In <E T="03">Dominion Resources, Inc.</E> v. <E T="03">United States,</E> 681 F.3d 1313 (Fed. Cir. 2012), the Federal Circuit invalidated the associated property rule of § 1.263A-11(e)(1)(ii)(B) for property temporarily withdrawn from service. The court concluded that the regulation was not a reasonable interpretation of the avoided cost rule in section 263A(f)(2)(A)(ii) and that it violated the <E T="03">State Farm</E> requirement that the Treasury Department and the IRS provide a reasoned explanation for adopting a regulation. <E T="03">See Motor Vehicles Mfrs. Ass'n of the United States, Inc.</E> v. <E T="03">State Farm Mut. Auto. Ins. Co.,</E> 463 U.S. 29, 43 (1983). The taxpayer in <E T="03">Dominion Resources</E> was a public utility that replaced coal burners in two of its electric generating plants. This action required the taxpayer to temporarily withdraw the two electric generating plants from service. During that time, Dominion incurred interest on debt unrelated to the improvements. Dominion deducted some of that interest, and the IRS disagreed with the taxpayer's computations. The IRS argued that pursuant to § 1.263A-11(e)(1)(ii)(B), the taxpayer's APEs should include the cost of the improvements (that is, the amount spent to replace the coal burners), as well as the adjusted basis of the property temporarily withdrawn from service to complete the improvement (that is, the electric generating plants). The taxpayer and the IRS ultimately reached a settlement agreement, pursuant to which Dominion deducted 50 percent and capitalized 50 percent of the disputed amount. The taxpayer subsequently filed a claim for refund, asserting that the entire amount was deductible. The taxpayer challenged the validity of § 1.263A-11(e)(1)(ii)(B) as applied to its improvements. In <E T="03">Dominion Resources, Inc.</E> v. <E T="03">United States,</E> 97 Fed. Cl. 239 (Fed. Cl. 2011), the United States Court of Federal Claims upheld the validity of the associated property rule and denied the taxpayer's claim for refund. On appeal, the United States Court of Appeals for the Federal Circuit (Federal Circuit) reversed the lower court decision and invalidated the associated property rule of § 1.263A-11(e)(1) ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Preview showing 10k of 30k characters. Full document text is stored and available for version comparison. ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━