  United States Court of Appeals
      for the Federal Circuit
              __________________________

          DOMINION RESOURCES, INC.,
               Plaintiff-Appellant,
                           v.
                  UNITED STATES,
                  Defendant-Appellee.
              __________________________

                      2011-5087
              __________________________

    Appeal from the United States Court of Federal
Claims in Case No. 08-CV-195, Judge Charles F. Lettow
              ___________________________

                Decided: May 31, 2012
             ___________________________

   ERIC R. FOX, Ivins, Phillips & Barker, Chartered, of
Washington, DC, argued for plaintiff-appellant. With him
on the brief were LESLIE J. SCHNEIDER and PATRICK J.
SMITH.

    KAREN G. GREGORY, Attorney, Tax Division, United
States Department of Justice, of Washington, DC, argued
for defendant-appellee. With her on the brief were
TAMARA W. ASHFORD, Deputy Assistant Attorney General,
and JONATHAN S. COHEN, Attorney.

    PAUL L. GALE, Troutman Sanders LLP, of Washing-
ton, DC, for amicus curiae.
               __________________________

  Before RADER, Chief Judge, CLEVENGER, and REYNA,
                   Circuit Judges.
DOMINION RESOURCES    v. US                                 2


Opinion for the court filed by Chief Judge RADER. Opin-
ion concurring in part and concurring in the result filed
by Circuit Judge Clevenger.
RADER, Chief Judge.
    The United States Court of Federal Claims granted
the United States’ motion for summary judgment against
Dominion Resources, Inc. See Dominion Res., Inc. v.
United States, 97 Fed. Cl. 239 (2011). This case presents
an issue of first impression for any appellate court. The
CFC held that Treasury Regulation § 1.263A-
11(e)(1)(ii)(B) is a permissible construction of the statute
I.R.C. § 263A. Because the associated property rule in
Treasury Regulation § 1.263A-11(e)(1)(ii)(B) as applied to
property temporarily withdrawn from service is not a
reasonable interpretation of I.R.C. § 263A and because
the Treasury acted contrary to 5 U.S.C. § 706(2) in failing
to satisfy the State Farm requirement to provide a rea-
soned explanation when it promulgated that regulation,
this court reverses.
                              I.
    Dominion provides electric power and natural gas to
individuals and businesses. In 1996, it replaced coal
burners in two of its plants. When making those im-
provements, it temporarily removed the units from service
— one unit for two months, the other for three months.
During that time, Dominion incurred interest on debt
unrelated to the improvements.
    On its corporate tax returns, Dominion deducted some
of that interest from its taxable income. The IRS dis-
agreed with Dominion’s computation under Treasury
Regulation § 1.263A-11(e)(1)(ii)(B), the regulation at issue
here. The IRS applied the regulation to capitalize $3.3
million of that interest, instead of deduct. A deduction
occurs immediately in that tax year, while capitalization
occurs over later years. Under a settlement, the IRS
allowed Dominion to deduct 50% and capitalize 50% of the
disputed amount.
3                                 DOMINION RESOURCES   v. US


    Still asserting that the entire disputed amount is de-
ductible, Dominion filed this suit seeking a refund of
$297,699 in corporate income tax. Dominion thus sought
to invalidate Treasury Regulation § 1.263A-11(e)(1)(ii)(B).
The CFC denied Dominion’s claim and granted summary
judgment to the United States. The CFC held that the
regulation was a permissible construction of I.R.C. § 263A
and that Treasury promulgated that regulation with a
reasoned explanation that satisfied 5 U.S.C. § 706(2) and
Motor Vehicles Mfrs. Ass’n of the United States, Inc. v.
State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983).
                            II.
    The Tax Reform Act of 1986 enacted I.R.C. § 263A
(“Capitalization and Inclusion in Inventory Costs of
Certain Expenses”).      Generally, the statute requires
capitalization of certain costs incurred in improving real
property, instead of deduction. In broad terms, interest
appears as a cost covered by the capitalization require-
ment.
    The relevant statutory provisions in I.R.C. § 263A
comprise five subsections. Each subsection refers to the
next. A careful reading of the five subsections shows that
each rule or definition refers to another rule or definition
in a circular progression that brings the law back to the
place it began with little elucidation of legal standards
and definitions. In simple words, the statute is circular.
    First, I.R.C. § 263A(a)(1) (“Nondeductibility of Certain
Direct and Indirect Costs”) sets out the general rule that
when improving real property, certain costs must be
capitalized instead of deducted from taxable income. “In
the case of any property to which this section applies, any
costs described in paragraph (2) … shall be capitalized.”
I.R.C. § 263A(a)(1). The text of that statutory provision
refers to subsection paragraph (2) (“Allocable Costs”),
which defines such costs as including both “direct costs”
and “indirect costs.” “The costs described in this para-
graph with respect to any property are (A) the direct costs
of such property, and (B) such property's proper share of
DOMINION RESOURCES    v. US                                 4


those indirect costs (including taxes) part or all of which
are allocable to such property.” I.R.C. § 263A(a)(2) (em-
phasis added).
    Next, interest is a type of “cost” as discussed in sub-
section (f) (“Special Rules for Allocation of Interest to
Property Produced by the Taxpayer”). Specifically, sub-
section (f)(1) states the general rule that interest is a cost
requiring capitalization when that cost is “allocable” to
the property. “Subsection (a) shall only apply to interest
costs which are (A) paid or incurred during the production
period, and (B) allocable to property which is described in
subsection (b)(1) and which has [other requirements not
relevant here].” I.R.C. § 263A(f)(1) (emphasis added).
    To determine what interest costs are “allocable” as
mentioned in subsection (f)(1), subsection (f)(2) (“Alloca-
tion Rules”) states the general rule that interest is alloc-
able “to the extent that the taxpayer's interest costs could
have been reduced if production expenditures … had not
been incurred.” “In determining the amount of interest
required to be capitalized under subsection (a) with
respect to any property … (ii) interest on any other in-
debtedness shall be assigned to such property to the
extent that the taxpayer's interest costs could have been
reduced if production expenditures (not attributable to
indebtedness described in clause (i)) had not been in-
curred.” I.R.C. § 263A(f)(2) (emphasis added). This is the
avoided-cost rule and implements Congress’ concern with
the avoided-cost principle:
    The legislative history of amendments to section
    189 indicates Congress’ intention that the Treas-
    ury Department issue regulations allocating in-
    terest to expenditures for real property during
    construction consistent with the method pre-
    scribed by Financial Accounting Standards Board
    Statement Number 34 (FAS 34). Under FAS 34,
    the amount of interest to be capitalized is the por-
    tion of the total interest expense incurred during
    the construction period that could have been
5                                 DOMINION RESOURCES    v. US


    avoided if funds had not been expended for con-
    struction. Interest expense that could have been
    avoided includes interest costs incurred by reason
    of additional borrowings to finance construction,
    and interest costs incurred by reason of borrow-
    ings that could have been repaid with funds ex-
    pended for construction.
S. Rep. No. 99-313, at 140, 144 (1986) (emphasis added);
H.R. Rep. No. 99-426, at 625, 628 (1985) (same); Joint
Committee on Taxation, JCS-10-87, 1987 WL 1364655
(1987) (same).
    The term “production expenditures” mentioned in
subsection (f)(2) is defined in subsection (f)(4)(C) to mean
costs “required to be capitalized under subsection (a).”
“The term ‘production expenditures’ means the costs
(whether or not incurred during the production period)
required to be capitalized under subsection (a) with
respect to the property.” I.R.C. § 263A(f)(4)(C). The text
of that statutory provision refers to “subsection (a),” which
means I.R.C. § 263A(a), the first statutory provision that
began this discussion on the relevant statutory provisions.
    The general formula to determine the amount of in-
terest that must be capitalized is the amount of “produc-
tion expenditures” multiplied by the weighted-average
interest rate on the debt during the time the production
occurs. In other words, the production expenditures
represent the base amount and some fraction of that
amount represents the interest that must be capitalized.
A larger base will lead to more interest capitalized.
    After a notice of proposed rulemaking in 1991, the
Treasury published final regulations in 1994. The regula-
tion at issue here defines what constitutes “production
expenditures” (the base amount) and therefore deter-
mines the amount of interest capitalized. Treasury
Regulation § 1.263A-11(e)(1) (“General Rule”) states:
    If an improvement constitutes the production of
    designated property under § 1.263A–8(d)(3), ac-
DOMINION RESOURCES   v. US                                6


   cumulated production expenditures with respect
   to the improvement consist of (i) All direct and in-
   direct costs required to be capitalized with respect
   to the improvement, (ii) In the case of an im-
   provement to a unit of real property (A) An alloc-
   able portion of the cost of land, and (B) For any
   measurement period, the adjusted basis of any ex-
   isting structure, common feature, or other prop-
   erty 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 im-
   proved, the associated property directly benefits
   from the improvement, or the improvement was
   incurred by reason of the associated property.
(emphasis added)
    The parties agree that a certain amount of construc-
tion-period interest should be capitalized instead of
deducted, but the extent of that capitalization require-
ment is the essence of this dispute. The parties agree
that the Treasury regulation plainly defines production
expenditures to include not only the amount spent on the
improvement but also the adjusted basis of the entire unit
being improved. For simplicity, adjusted basis can be
considered as the original cost of the unit. The issue on
appeal is whether that latter inclusion of the adjusted
basis of the unit violates various statutory provisions.
Because the regulation requires a larger base amount (by
including the adjusted basis amount), it results in a larger
amount of interest to be capitalized. Thus, the practical
impact determines how much interest Dominion must
capitalize instead of deduct from its taxable income as a
result of burner improvements in its power plants.
   The challenge to the regulation is only as applied to
property “temporarily withdrawn from service” and not as
applied to property that “is not placed in service.”
7                                  DOMINION RESOURCES   v. US


    This court     has   jurisdiction   under    28   U.S.C.
§ 1295(a)(3).
                            III.
     This court reviews the CFC’s grant of summary judg-
ment without deference. The validity of a Treasury
regulation is analyzed under the Chevron two-step test.
First, step one determines whether Congress has directly
spoken to the precise question at issue. Chevron, U.S.A.,
Inc. v. NRDC, 467 U.S. 837, 842-43 (1984). If the statute
is silent or ambiguous, then step two determines whether
the agency’s answer is based on a permissible construc-
tion of the statute. Id.
    Last year, the Supreme Court confirmed that courts
apply Chevron deference to Treasury regulations. See
Mayo Found. for Med. Educ. and Research v. United
States, 131 S.Ct. 704, 711-13 (2011).
                            IV.
     As to Chevron step one, the CFC correctly recognized
that the regulation does not contradict the text of the
statute but only because the statute is opaque. See Do-
minion Res., 97 Fed. Cl. at 253. Subsection (f)(2) states
the amount of interest to be capitalized is that amount
that “could have been reduced if production expenditures
… had not been incurred.” Then subsection (f)(4)(C)
defines “production expenditures” as the amount required
according to the general rules. Regardless of the defini-
tion of “production expenditures,” the statute provides or
assumes that sum would have been available to pay down
the debt. The conclusion has been assumed in the prem-
ises, and therefore the statute is circular. As demon-
strated in the discussion above, each rule or definition
refers to another rule or definition in a progression such
that the reader ends at the beginning. Subsection (a)(1)
refers to (a)(2) refers to (f)(1) refers to (f)(2) refers to
(f)(4)(C) refers back to (a). Thus, at Chevron step one, this
court determines that the statute is ambiguous. In such
DOMINION RESOURCES   v. US                               8


an instance, this court detects no Chevron step one viola-
tion.
    As to Chevron step two, however, Treasury Regulation
§ 1.263A-11(e)(1)(ii)(B) as applied to property temporarily
withdrawn from service is not a reasonable interpretation
of the avoided-cost rule set out in the statute at I.R.C.
§ 263A(f)(2)(A)(ii). Specifically, the regulation is unrea-
sonable in defining “production expenditures” to include
the adjusted basis of the entire unit.
    The regulation directly contradicts the avoided-cost
rule that Congress intended the statute to implement.
The avoided-cost rule recognizes that if the improvement
had not been made, those funds (an amount x equal to the
cost of the improvement) could have been used to pay
down the debt and therefore reduce interest that accrued
on the debt. Because the improvement was made, how-
ever, that amount x was not used to pay down the debt;
therefore, interest accrued on that amount x.
    To determine the accrued interest resulting from
making the improvement instead of paying down the
debt, one would multiply the interest rate by the amount
x paid for the improvement. One would not multiply the
interest rate by the amount x paid for the improvement
plus the adjusted basis of the entire unit. An amount
equal to the adjusted basis of the unit would not have
been available to pay down the debt had the improvement
not been made. Those funds were expended at the time
the property was acquired (before the decision to make
the improvement) — and are not made available to pay
down debt by forgoing the improvement.
    For example, let’s say an owner purchased real prop-
erty for $100,000 by a loan with a 3% interest rate. A few
years later, she made an improvement that cost $5,000. If
she had used that $5,000 toward the debt instead of the
improvement, she would have avoided accruing $150 in
interest ($5,000 multiplied by 3%). The avoided-cost rule
requires her to capitalize that $150 in interest. The
Treasury regulation, however, requires her to capitalize
9                                DOMINION RESOURCES   v. US


$3,150 in interest ($100,000 + $5,000 then multiplied by
3%). That result makes no sense, because there is no way
that she could have avoided accruing $3,150 in interest by
not making the improvement, as she did not expend or
incur an amount equal to $105,000 when making the
improvement.
    The House and Senate reports clarify the meaning of
the statute. The regulation must implement the avoided-
cost principle — in particular that the interest to be
capitalized is the amount “that could have been avoided if
funds had not been expended for construction.” S. Rep.
No. 99-313, at 140, 144 (1986); H.R. Rep. No. 99-426, at
625, 628 (1985); Joint Committee on Taxation, JCS-10-87,
1987 WL 1364655 (1987). The adjusted basis does not
represent such an “avoided” amount. A property owner
does not expend funds in an amount equal to the adjusted
basis when making the improvement. Instead, she ex-
pends funds in an amount equal to the cost of the im-
provement itself.
    Indeed, the statute uses the term production “expen-
ditures,” the plain meaning of which is an amount actu-
ally expended or spent — specifically, expended or spent
on the improvement. Similarly, the statute states that
the interest to be capitalized is an amount that could have
been reduced if production expenditures had not been
“incurred.” A property owner would not expend or incur
an amount equal to the adjusted basis when making the
improvement. Thus, the regulation unreasonably links
the interest capitalized when making an improvement to
the adjusted basis.
    Further, the Treasury regulation leads to absurd re-
sults. Because the adjusted basis amount can have
almost no relation to the improvement cost amount, the
regulation can require capitalizing vastly different
amounts of interest for the same improvements. Here,
Dominion’s two improvements had similar costs of $5.3
million and $6.7 million. Yet, because the adjusted bases
of the two units are drastically different, the regulation
DOMINION RESOURCES   v. US                               10


leads to “production expenditures” of $15 million and
$138 million, respectively. This court detects no reason-
able basis for requiring such wildly disproportionate
results for similar improvements. The law did not intend
such an absurd result.
     The only way that an amount equal to the adjusted
basis could potentially satisfy the avoided-cost method is
by assuming that the property owner would have sold the
unit and used the sale proceeds to pay down the debt.
The CFC correctly recognized that the United States’
argument was “removed from reality because the associ-
ated property is being improved to continue in service.”
Dominion Res., 97 Fed. Cl. at 258. In particular as to this
industry, the United States’ argument “is, of course, a
fiction, given that the generating units in question are
large, immobile parts of large power plants which could
not realistically be sold individually.” Id. at 253. The
CFC erred by concluding that the United States’ fiction
was a “policy choice” by the agency and thus permissible.
See id. at 258. This court discerns no reasonable explana-
tion that assumes that a property owner would have sold
the same unit that it removed from service for the sole
purpose of improving. Selling the unit obviates the very
reason for the improvement. As discussed above, the
Treasury regulation contradicts the avoided-cost rule that
the law implemented. Thus, the regulation is not a
reasonable interpretation of the statute.
    Therefore, the associated-property rule in Treasury
Regulation § 1.263A-11(e)(1)(ii)(B) as applied to property
temporarily withdrawn from service is not a reasonable
interpretation of I.R.C. § 263A(f)(2)(A)(ii) and is invalid.
                             V.
    The associated-property rule in Treasury Regulation
§ 1.263A-11(e)(1)(ii)(B) as applied to property temporarily
withdrawn from service also violates the State Farm
requirement that Treasury provide a reasoned explana-
tion for adopting a regulation. State Farm requires that
the Treasury “articulate a satisfactory explanation for its
11                                DOMINION RESOURCES   v. US


action, including a rational connection between the facts
found and the choice made.” Motor Vehicles Mfrs. Ass’n of
the United States, Inc. v. State Farm Mut. Auto. Ins. Co.,
463 U.S. 29, 43 (1983). “We have frequently reiterated
that an agency must cogently explain why it has exercised
its discretion in a given manner.” Id. at 48. An agency
rule is arbitrary and capricious if it “entirely failed to
consider an important aspect of the problem, offered an
explanation for its decision that runs counter to the
evidence before the agency, or is so implausible that it
could not be ascribed to a difference in view or the product
of agency expertise.” Id. at 43.
    In Notice 88-99, the IRS provided guidance on the up-
coming regulations. 1988-36 I.R.B. 29, 1988-2 C.B. 422
(August 16, 1988). Nowhere did this guidance mention
adjusted basis as part of the interest-capitalization
method. In the notice of proposed rulemaking, however,
the IRS first made mention that it would include adjusted
basis in the calculation. See Capitalization of Interest, 56
Fed. Reg. 40,815-01 (proposed Aug. 16, 1991). Still, this
notice provided no rationale other than the general
statement that the regulations are intended to implement
the avoided-cost method. See Dominion Res., 97 Fed. Cl.
at 255 (“Although the preamble explains how to apply the
associated-property rule, it does not give a reason for its
inclusion.”), 258-59 (“Sections of Treasury’s proposed
regulation explained the avoided-cost method without
reference to improvements to existing property.”). Simi-
larly, the IRS provided no rationale in the final regula-
tions. See Capitalization of Interest, 59 Fed. Reg. 67,187
(Dec. 29, 1994).
    The Court of Federal Claims recognized that “it is a
stretch to conclude that Treasury cogently explained why
it has exercised its discretion in a given manner respect-
ing capitalization of interest under the associated-
property rule.” Dominion Res., 97 Fed. Cl. at 259. Yet,
the trial court erroneously stretched to conclude that “the
path that Treasury was taking in the rulemaking proceed-
ings can be discerned, albeit somewhat murkily.” Id.
DOMINION RESOURCES   v. US                             12


    The notice provides no explanation for the way that
use of an adjusted basis implements the avoided-cost rule.
Indeed, it does not satisfy the avoided-cost rule. Though
the CFC noted that “Treasury did, however, at least alert
interested potential commentators that treatment of the
basis of the property being improved was at issue insofar
as capitalization was concerned,” id. at 259, this is not
sufficient to satisfy the State Farm requirement that the
regulation must articulate a satisfactory or cogent expla-
nation.
                      REVERSED.
  United States Court of Appeals
      for the Federal Circuit
               __________________________

           DOMINION RESOURCES, INC.,
                Plaintiff-Appellant,
                            v.
                   UNITED STATES,
                   Defendant-Appellee.
               __________________________

                       2011-5087
               __________________________

    Appeal from the United States Court of Federal
Claims in case no. 08-CV-195, Judge Charles F. Lettow.
               __________________________

CLEVENGER, Circuit Judge, concurring in part and con-
curring in the result.
    I agree with my colleagues that the government failed
to shoulder the burden assigned to it by State Farm, and
that Treasury Regulation § 1.263A-11(e)(1)(B), as it
applies to property temporarily withdrawn from service,
is accordingly unlawful. But I do not share the majority’s
view that this outcome also must derive from an irrecon-
cilable incompatibility between I.R.C. § 263A’s avoided
cost principle and the regulation’s policy of treating
interest allocated to property withdrawn from service as
an avoidable cost. The broad conclusion endorsed by the
panel is unnecessary when this case can be resolved on
narrower grounds.
DOMINION RESOURCES    v. US                                 2


                              I
    There appears to be no dispute among the panel that
the government has not articulated any rational explana-
tion for many details of the regulation before us, from the
regulation’s first proposal in the mid-’90s up to the cur-
rent date. Such a failure makes the regulation proce-
durally unlawful. I would reverse on the grounds set
forth in part V of the majority opinion, but would give the
government another chance to explain and justify its view
that the adjusted basis of property temporarily with-
drawn from service can be taken into account in determin-
ing production expenses.
                              II
    Regarding the majority’s Chevron review, I agree with
its conclusion that section 263A(f)(4)(C) of the Tax Code
leaves a sizeable “gap” concerning what is and is not to be
considered a “production expenditure.” As per Chevron
step one, this gap invites the government to promulgate
regulations more fully defining this term.
    Where I depart from the majority is in my conception
of what exactly it means for an expense to be an “avoided
cost.” In this appeal we are concerned with interest
accumulating on a utility’s operating debt. All agree that,
when the utility takes on an improvement project, it is
only fair that some of the interest accumulated during the
project be capitalized, along with the project’s direct costs,
as “production expenditures.” A shorthand is to think of
the utility borrowing money from itself to pay for the
project. Both the “borrowed” principal and the accumu-
lated interest are capitalized. So far, so good.
   The “avoided cost” rubric is another shorthand for the
same concept. It says, if the utility had not taken on the
improvement project, then the money it spent on the
3                                DOMINION RESOURCES   v. US


project would have been available to pay down the operat-
ing debt. As a result, both the money spent and the
interest that accumulated on that money (because the
debt was not paid down) are charged to the project.
    This appeal focuses on a subtle aspect of this regula-
tory approach. Say, as part of the hypothetical project,
that the utility has to remove from service a plant that
otherwise would have been running—generating electric-
ity, employing workers, and generally creating value.
Now that plant is non-operational, at least for the time it
takes to complete the improvement. Is the plant’s conver-
sion from operational to (temporarily) non-operational
status a “cost” of the improvement project? Can it be
charged as a “production expenditure”? How?
    One vision of the associated-property rule in Treasury
Regulation § 1.263A-11(e)(1)(B) is as an attempt to an-
swer these questions. Yes, this approach says, the lost
value associated with the withdrawal of property from
service is a production expenditure that must be capital-
ized. But putting an actual number on the lost value
presents administrative difficulties. Do we measure lost
value in terms of revenue generated? Workers employed?
Electricity produced? Some combination of these? What
about other, less tangible forms of value?
    For convenience, one might propose to elide such an
administratively-difficult assessment and simply assume
that the lost value more or less equals the interest that
accrued on the value wrapped up in the plant (i.e., the
taxpayer’s basis) while the plant was inoperative. So, this
approach says, the taxpayer is instructed to take what-
ever basis it has in the plant and compute the interest
that accrued on that basis during the period of non-
operation.
DOMINION RESOURCES   v. US                                4


     The majority is correct that fitting this approach into
the “avoided cost” rubric requires adoption of a surprising
fiction. If the interest accrued on the plant is to be
thought of as an “avoided cost,” one must assume (coun-
terfactually) that the taxpayer could have liquidated the
plant and used the proceeds to pay down its operating
debt. The majority views this fiction as such a departure
from economic reality as to render the associated-property
rule invalid. But, mindful that the avoided cost rule is in
its entire concept a fiction, I am not convinced that its
application here is so surprising as to merit overturning
the regulation under step two of Chevron, if Treasury can
properly explain its reasoning, which it has yet to do.
     The “avoided cost” rule is full of surprising fictional
assumptions. Take, for example, a utility instructed by
regulators to make some token improvement to its plant
or have the plant shut down. Assuming this modest
improvement would not require the plant to be withdrawn
from service, no party to this appeal would dispute that
the improvement costs (including associated interest)
would be capitalized according to the “avoided cost”
principle. But in no real sense are these “avoided costs,”
as no rational utility would embrace regulatory shutdown
merely to avoid the cost of a token improvement. It seems
to me no more or less strange to say that a utility might
“avoid” the cost of a plant being temporarily inoperable by
selling it. The avoided cost rule is one of theoretical
possibility, not economic reality.
    If we accept that there are real costs incurred in shut-
ting down a property while improvements are made on it,
such costs (assuming they can be quantified rationally)
could have been avoided if funds had not been expended
for the improvements. In reality, the cost of shutting
down a property is no less “incurred” or “expended” than
is the amount of money spent on the improvements. In
5                                  DOMINION RESOURCES    v. US


other words, treating the cost of shutting down a plant
temporarily while improvements are made as a “produc-
tion expenditure” does not necessarily contradict the
avoided cost rule that underlies section 263A. Indeed, I
do not understand the majority to hold that the costs
incurred in shutting down a property for improvements
can never be treated as production expenditures. Instead,
I read the majority to hold more pointedly that the ad-
justed basis of the property withdrawn from service
cannot ever be treated as a production expenditure.
     Further, it seems to me that the associated property
rule might be separately justified as necessary to fully
implement aspects of the tax regime that every party
acknowledges as lawful. It is important to keep in mind
that this dispute concerns only the use of basis in under-
lying property that has been removed from service. No
one here disputes that the full basis of underlying prop-
erty can and should be taken into account for interest
capitalization where the property never went into service
in the first place. For example, if a taxpayer acquires a
factory, then improves it before bringing the factory
online, there is no dispute that the taxpayer’s full basis in
the factory (i.e., his purchase price, presumably) is taken
into account in computing the amount of interest to be
capitalized as an expense associated with acquiring the
improved factory. In its briefing, the appellant acknowl-
edged such an assessment as appropriate, but character-
ized it as involving “purchased property” and not invoking
the associated property rule at issue here, even though
Treasury Regulation § 1.263A-11(e)(1)(B) on its face
applies to property “that is not placed in service.” See
Appellant Br. 19; see also Treas. Reg. § 1.263A-1(e)(2)(i)
(cited by appellant as the “purchased property rule”).
Irrespective of how it is couched, the larger point is this: a
taxpayer’s basis in property into which improvements are
DOMINION RESOURCES   v. US                               6


incorporated does, in some cases, affect the amount of
interest he must capitalize as a cost of that improvement.
    Such is undisputed. But, says the government, it cre-
ates an easy opportunity for tax evasion. A clever tax-
payer, one who seeks to acquire the same improved
factory just described but with smaller tax consequences,
could structure his operations so that he falls outside the
purchased property rule. Rather than buy a factory and
then immediately set to work improving it, he puts the
factory into service for some minimal period of time. His
basis depreciates accordingly, albeit minimally. Then he
takes the factory out of service and starts improving it.
Because he now falls outside the strict text of the pur-
chased property rule, his basis in the factory no longer
contributes to the amount of interest he must capitalize,
and so his tax burden drops substantially—even though
the taxpayer’s activities had no economically meaningful
purpose other than tax avoidance.
     The associated-property rule would plug this regula-
tory gap; the majority’s reasoning reopens it. To me that
is a step that should be taken with caution, and is neither
fully justified nor necessary here.
     Finally, I note that in this case the government has
had substantial difficulty coming to grips with its own
arguments. It apparently convinced the Court of Federal
Claims that the associated property rule could be justified
as an attempt to capture the opportunity costs associated
with withdrawing property from service, even though it
failed to explain as much in promulgating its rule. But its
appellate briefing was, to say the least, opaque. And at
oral argument, the government specifically rejected the
“opportunity costs” approach, only to reverse its position
in a post-argument letter. A litigant can, of course, be
held to the consequences of its own failure to cogently
7                                 DOMINION RESOURCES   v. US


present its case, particularly where that litigant is the
federal government. But in such circumstances, the best
approach is to tailor those consequences to the facts of the
case.
     The outcome of this case can and should extend from
State Farm. The government’s failure to justify its regu-
lation ab initio left open the question of whether the
avoided cost principle necessarily undermines any ration-
ale that could justify treating an adjusted basis of prop-
erty withdrawn from service for improvement as a
production expenditure, for purposes of calculating inter-
est to be capitalized. Such reaffirms my conclusion that
this appeal does not present an appropriate vehicle for
deciding the Chevron question. It is therefore a more
discreet approach to leave that question aside. The
approach taken by the majority goes too far in that it
creates a binding rule (at least in this circuit) that the
government can never re-promulgate its associated-
property rule for property temporarily withdrawn from
service, no matter how well-formed its reasoning. I
therefore concur in the result, and in Part V, of the major-
ity’s opinion, but otherwise respectfully dissent.
