## Facts

- Dominion Resources, Inc., a public utility holding company, owned coal-fired electric generating units used in its business.
- In 1996, Dominion improved two plants by replacing coal burners, temporarily removing one unit from service for two months and another for three months.
- During the outage periods, Dominion continued paying interest on existing corporate debt that was not incurred for, and was unrelated to, the improvement projects.
- Dominion deducted a portion of that interest as a current expense on its tax returns rather than capitalizing it into the cost of the improvements.
- The IRS applied Treas. Reg. § 1.263A-11(e)(1)(ii)(B) (the “associated property rule”) and concluded that $3.3 million of interest had to be capitalized under I.R.C. § 263A(f).
- After a settlement allowing 50% capitalization and 50% deduction, Dominion sought a refund (about $297,699) and challenged the regulation’s validity as applied to property temporarily withdrawn from service.
- The Court of Federal Claims granted summary judgment to the government, upholding the regulation as a permissible construction of § 263A(f).

## Issues

1. Whether Treas. Reg. § 1.263A-11(e)(1)(ii)(B), as applied to property temporarily withdrawn from service during improvements, is a permissible interpretation of I.R.C. § 263A(f) under Chevron.
2. Whether Treasury’s promulgation of that rule was arbitrary and capricious under the APA for failing to provide a contemporaneous, reasoned explanation satisfying State Farm.

## Decision

- The Federal Circuit reversed the Court of Federal Claims.
- The court held that, as applied to property temporarily withdrawn from service, the associated property rule is not a reasonable interpretation of I.R.C. § 263A(f) and is substantively invalid.
- The court also held the regulation was arbitrary and capricious under 5 U.S.C. § 706(2) because Treasury failed to provide a contemporaneous, reasoned explanation for extending capitalization to the challenged circumstances.
- Dominion was entitled to treat the disputed interest as currently deductible for purposes of its refund claim.

## Legal Principles

- Under Chevron, a tax regulation must reflect a reasonable interpretation of the statute; tax regulations are reviewed under ordinary Chevron principles.
- I.R.C. § 263A(f) capitalizes interest only to the extent interest is “allocable” to production expenditures, measured by whether interest costs could have been reduced absent those expenditures.
- A regulation that imputes allocability and requires capitalization of interest on unrelated debt solely because existing, in-service property is temporarily idled for improvements exceeds § 263A(f) in that application.
- Under the APA’s arbitrary-and-capricious standard (State Farm), an agency must provide a contemporaneous, reasoned explanation establishing a rational connection between the facts found and the choice made; failure to do so can invalidate a regulation independently of Chevron.

## Conclusion

The Federal Circuit rejected Treasury’s effort to require capitalization of interest on unrelated corporate debt when operating property is temporarily taken out of service for improvements, holding the regulation unreasonable under § 263A(f) and invalid under the APA for lack of a reasoned explanation.


Dominion Res., Inc. v. United States, 681 F.3d 1313 (Fed. Cir. 2012)