                        T.C. Memo. 2006-40



                      UNITED STATES TAX COURT



        ANSCHUTZ COMPANY AND SUBSIDIARIES, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 6169-03.             Filed March 13, 2006.



     John W. Bonds, Jr., Andrew B. Clubok, Thomas L. Evans,

Matthew J. Gries, Todd F. Maynes, Herbert N. Beller, Mark B.

Hamilton, and Tony Y. Lam, for petitioners.

     Virginia L. Hamilton and Michael C. Prindible, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     HAINES, Judge:   Respondent determined the following

deficiencies in petitioners’ Federal income taxes:
                                - 2 -



               Tax Year Ended           Deficiency

               July 31, 1994              $467,424
               July 31, 1995             4,837,121
               July 31, 1996             9,503,991

After concessions,1 the issues for decision are:   (1) Whether

Qwest’s incremental cost allocation method is a reasonable

allocation method for purposes of sections 263A and 460 for tax

years ended July 31, 1994 (1994), July 31, 1995 (1995), and July

31, 1996 (1996) (collectively, years in issue); and (2) whether

respondent abused his discretion in determining that Qwest’s

incremental cost allocation method failed to clearly reflect

income under section 446.2




     1
       Petitioners agree to: (1) Decrease the cost of sales for
costs allocated to conduits sold to Metropolitan Fiber Systems
(MFS) in the MFS Dallas and MFS Los Angeles projects by $915,870
and $635,317, respectively, and increase the basis in the
retained conduits installed for petitioners’ own account during
these projects by $915,870 and $635,317, respectively; and (2)
decrease the cost of sales for costs allocated to conduit sold to
MCI Telecommunications Corporation (MCI) in the MCI Dillard-
Myrtle Creek project by $265,912, and increase the basis in the
retained conduits installed for petitioners’ own account during
this project by $265,912.

     The parties agree that adjustments proposed by respondent in
the notice of deficiency for net operating loss, additional sec.
263A costs, additional sec. 263A(f) interest, adjustment to NOL
carryover, and additional charitable deduction are computational
adjustments that are dependent on our decision in this case.
     2
        Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
are to the Tax Court Rules of Practice and Procedure. Amounts
are rounded to the nearest dollar.
                                - 3 -



                           FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.    At the time the petition

was filed, petitioners were Delaware corporations with their

principal place of business in Denver, Colorado.

I.   Corporate Structure

     Evergreen Leasing Corporation (Evergreen) was incorporated

on June 10, 1966.    Evergreen was primarily in the boxcar leasing

business, but part of its charter indicated that Evergreen would

provide telecommunications services.    On March 20, 1989,

Evergreen’s name was changed to Southern Pacific

Telecommunications Corporation (SP Telecom).    In April 1995, SP

Telecom’s name was changed to Qwest.3

     Qwest was formerly a wholly owned subsidiary of Southern

Pacific Transportation Company (Southern Pacific).    On September

30, 1991, Southern Pacific divested itself of its common stock

interest in Qwest.   As a result, Qwest became a 75-percent-owned

subsidiary of Anschutz Company.    On November 5, 1993, Anschutz

Company purchased another 15 percent of Qwest.    In August 1995,

Anschutz Company purchased the remaining 10 percent of Qwest,


     3
       For convenience purposes, Qwest and its previous business
forms will be referred to as “Qwest”.
                               - 4 -

making Qwest a wholly owned subsidiary.

      During the years in issue, Phillip F. Anschutz (Mr.

Anschutz) was the direct, sole owner of Anschutz Company.

During the years in issue, Anschutz Company was the parent

corporation of an affiliated group of corporations, as defined by

section 1504(a), which included Qwest.    Anschutz Company and its

affiliated subsidiaries will hereinafter be referred to as

petitioners.

      Mr. Anschutz moved Qwest’s headquarters from San Francisco

to Denver in 1994 in order to have the company near his office

for monitoring and control purposes.   During the years in issue,

Mr. Anschutz was in almost daily contact with Qwest executives.

Mr. Anschutz had final approval on any decision by Qwest that

involved investment.

II.   Evolution of Qwest’s Telecommunications Business

      While its charter indicated that it would provide

telecommunications services, Qwest’s initial involvement in the

telecommunications business was not until 1987, when it acted as

a liaison between Southern Pacific and MCI Telecommunications

Corporation (MCI).   Qwest’s business operations further evolved

through the years as it began constructing fiberoptic conduit

systems.   Qwest first worked as a general contractor and hired

subcontractors to do the majority of the work.   By the end of the

years in issue, Qwest performed most of the construction on its
                                - 5 -

own.

       A.   Development of Conduit-Encased Fiberoptic Cable

       Prior to the late 1980s, long-distance carriers often buried

cable directly in the ground.    In the late 1980s, the idea of

encasing fiberoptic cable4 in flexible conduit was developed.

The conduit provides the cable greater protection from being cut,

is more readily accessible for maintenance purposes, and, once

buried, allows the installation of fiberoptic cable at a later

date by pulling the cable through the buried conduit.    Fiberoptic

cables, or fibers, are pulled through buried conduit by way of

hand holes, which are installed at appropriate intervals along

the conduit route.

       B.   Use of Southern Pacific’s Rights-of-Way to Install
            Conduit

       As fiberoptic cable became the preferred medium for the

long-distance transmission of data, Southern Pacific developed

the idea of using its railroad rights-of-way to lay fiberoptic

cable for long-distance data carriers.    The use of Southern

Pacific’s railroad rights-of-way was advantageous because:      (1)

The easements already existed and thus negotiations with private


       4
        Optical fibers, each approximately the width of a human
hair, are wound into cables, usually in multiples of 6 or 12.
Each fiber can be individually connected to specialized optical
equipment that makes possible the transmission of laser-generated
light signals over the fibers. Dark fibers are optical fibers
that are not yet connected to the optical equipment. Lit fibers
are optical fibers that have been connected to the optical
equipment and can transmit light signals.
                                - 6 -

owners and government agencies for such rights were not

necessary; (2) specialized equipment could ride the rails and be

used to perform the installation efficiently and economically;

(3) railroad rights-of-way are often the most direct routes

between locations; and (4) railroad rights-of-way are more secure

than other rights-of-way, such as those for highways, telephone

poles, or overhead power transmission lines.

     C.    Qwest as a Liaison

     In 1987, Qwest first participated in a conduit project,

acting as a liaison between Southern Pacific and MCI.   Qwest

obtained an easement for MCI for the right to install conduit and

fiber on a Southern Pacific right-of-way from Houston to Los

Angeles.   MCI performed its own construction on this route.    In

exchange for the easement, MCI paid approximately $13 million in

cash and provided capacity in the form of 36 DS-3s along the

route.5

     D.    Qwest’s First Conduit Installation Project

           1.   Conduit Installation Process

     Once Qwest began installing conduit and pulling fiber, as

discussed infra, Qwest used Southern Pacific’s railway and

equipment in the construction process.   Qwest used a specialized

rail plow to install the conduit along the railroad rights-of-



     5
       Each DS-3 line represents capacity to transmit 672 long-
distance calls simultaneously.
                                - 7 -

way.    The rail plow functioned as part of a plow train, which

consisted of locomotives, rail plow cars, and several supply

cars.    The supply cars carried the conduit and other construction

materials needed for the installation and continuously fed these

supplies to the rail plows.

       As the locomotives pulled the plow train forward, the rail

plow dug a trench and simultaneously lowered and buried the

conduit.    The rail plow could install multiple conduits at the

same time.    The rail plow installed the conduits at a depth of

approximately 42 to 56 inches and at a distance of 8 feet from

the nearest rail.    The rail plow also buried a warning tape

approximately 1 foot from the surface and backfilled the land to

its original contour.    The plow train could install conduits up

to 4 miles a day, depending on the availability of track time and

the severity of the terrain.

       In situations where a rail plow could not be used, Qwest

used a tractor plow, backhoe, or other similar machinery.    If the

conduit needed to be laid across a bridge or through a tunnel,

the conduit was typically placed in a galvanized steel pipe and

attached to the side of the bridge or along the tunnel floor or

wall.    If the conduit needed to be run under a river or other

obstruction, regular or directional boring techniques were used

to bore small tunnels through which the conduit could be fed.
                                - 8 -

     After the conduit was buried along a railroad track or other

right-of-way, or attached to a bridge or tunnel, Qwest could

pull fiber through the conduit using hand holes.

            2.   The Coast Route Project

     In December 1988, Qwest began its first conduit installation

project along the Coast Route, a route running from Los Angeles

to San Francisco.   Qwest acted primarily as a general contractor

and subcontracted out most of the construction work to third

parties.    The Coast Route project was performed for several long-

distance carriers, including AT&T, Sprint, WilTel, and MCI.     All

of the Coast Route customers did not purchase conduit along the

entire route, and each customer’s fiberoptic cable was pulled

only through the portions of the conduit purchased by that

customer.    However, Qwest laid multiple conduits along the entire

route for its own potential future use or sale.    Up to this

point, installations of multiple conduits had not been done in

the telecommunications industry.

     As a result of the project, Qwest obtained several

unconnected segments of empty conduit along the Coast Route.

From the long-distance carriers, Qwest received cash compensation

and capacity in the form of 18 DS-3s along MCI’s fiberoptic

cable.   Qwest offered the DS-3 capacity as a wholesale

opportunity to long-distance carriers.
                               - 9 -

     E.   Other Projects Before the Years in Issue

     On March 14, 1991, Qwest purchased an installed conduit

system from MCI involving the Union Pacific right-of-way from

Wells, Nevada, to Salt Lake City, Utah.

     On September 30, 1991, Qwest entered into an easement

agreement with Southern Pacific.    The agreement gave Qwest a

nonexclusive easement along Southern Pacific’s rights-of-way for

the construction and operation of fiberoptic conduit systems.

Qwest also entered into additional easement agreements with other

railroads and parties both before and during the years in issue.

III. Qwest’s Operations During the Years in Issue

     A.   Qwest’s Five-Year Plans

     During the years in issue, documents titled “five-year

plans” were authored within Qwest.     The five-year plan for 1995

through 1999 (the 1995 five-year plan) stated “The primary

business focus of [Qwest] is to create a nationwide, owned,

facility based network and utilize it to carry profitable,

revenue traffic.”   The 1995 five-year plan also stated that Qwest

would build 6,617 miles of fiberoptic conduit for its own use and

15,502 miles for sale to third-party customers.    The 1995 five-

year plan estimated that, if the conduit were sold at an average

of $30,000 per conduit mile, $465 million of revenue would be

generated.   The $30,000 figure was arrived at by looking at prior
                              - 10 -

sales, and the value could be realized only if the conduit was

actually sold.

     Qwest hired Coopers & Lybrand LLP (CLC), a professional

consulting firm, to review its 1995 five-year plan.   CLC

determined:   (1) The demand for long-distance conduit builds had

slowed; (2) the country did not need another nationwide

fiberoptic network; (3) the creation of another network could not

be justified in terms of capacity or cost; (4) Qwest would be at

a cost disadvantage to existing nationwide carriers, such as MCI,

AT&T, and Sprint; (5) Qwest’s installation of additional conduit

would be “very risky”; and (6) Qwest’s revenue projections “may

be optimistic”.

     Qwest’s Board of Directors minutes for the period January

22, 1994, through December 23, 1996, do not contain any

resolutions approving any of the five-year plans.

     B.   Construction Projects

     During the years in issue, Qwest engaged in 21 construction

projects, 19 of which were for third-party customers.6    During

the years in issue, Qwest performed the majority of the

construction, only subcontracting out small portions of the work.

In four construction projects, Qwest installed conduit or pulled

fiber for third-party customers without retaining assets for



     6
        The Cal Fiber and Dallas-Houston projects were not done
for third-party customers.
                               - 11 -

itself (third-party-only projects).7    In 12 projects, Qwest

installed conduit for third-party customers while simultaneously

installing conduit along the same route for its own potential

future use or sale (conduit installation projects).    In the

remaining three projects, Qwest pulled fiber using conduit

previously laid and retained by Qwest and granted third-party

customers indefeasible rights of use (IRUs) in a certain number

of fibers (IRU projects).

          1.   Conduit Installation Projects

     In the conduit installation projects, Qwest generally

followed the same procedure:   (1) Qwest contracted with a third-

party customer for installation of conduit over a certain route;

(2) conduit was installed along Southern Pacific’s or other

railroad companies’ rights-of-way; (3) Qwest received cash

compensation or DS-3 capacity for installing the conduit; and (4)

Qwest simultaneously installed and retained additional conduits

for its own potential future use or sale.    Qwest and the customer

negotiated and agreed to a fixed price, with adjustments possible

under specific circumstances, for Qwest to install conduit over a

particular route.   During the years in issue, Qwest charged its

customers approximately $30,000 to $40,000 per conduit mile.



     7
        The third-party-only projects include: (1) USW Clifton-
Rifle; (2) PAC Bell; (3) USW Romero-Santa Fe; and (4) MFS Denver
IRU. These projects are not directly in issue and will not be
discussed in detail.
                              - 12 -

The customer purchased fiberoptic cable separately, and Qwest or

the customer pulled the fiber through the conduit.    The entire

conduit and fiber became the property of the customer once the

contract was completed.

     In addition to installing conduit for its customers, Qwest

installed additional conduits for its own potential future use or

sale.   The rail plow allowed Qwest to install multiple conduits

at the same time and at a relatively modest additional cost.

Generally, the only additional costs of adding the retained

conduits were the cost of the material, including the conduit and

hand holes, and the cost of handling that material.    These costs

were mostly covered by profits from the third-party customer

contracts.

     At the time of installation, Qwest did not have customers

lined up to purchase the retained conduit.   With rare exception,

Qwest always kept at least one conduit for itself in connection

with all of its conduit projects.

     Petitioners have conceded the adjustments to the MFS Los

Angeles, MFS Dallas, and MCI Dillard-Myrtle Creek projects.     See

supra note 1.   The nine conduit installation projects still in

issue, in chronological order, are: (1) MCI San Jose to Reno, and

Reno to Wells; (2) MCI Salt Lake City to Denver; (3) Viacom San

Francisco Bay; (4) MCI Denver to El Paso; (5) MCI Kansas City to

St. Louis; (6) US West Phoenix to Mesa; (7) MCImetro Dallas; (8)
                                - 13 -

US West Grants to Gallup; and (9) MFS Anaheim.    The third-party

customer contracts for these nine conduit installation projects

constitute long-term contracts as defined by section 460(f).

           2.   IRU Projects

     By November 1995, Qwest was in negotiations with WorldCom

Network Services, Inc. (WorldCom), for rights to use a limited

number of fibers in fiberoptic cable installed along particular

routes.   On February 26, 1996, Qwest granted WorldCom an IRU in

24 dark fibers over three routes:    (1) WorldCom Dallas-Houston;

(2) WorldCom Denver-El Paso; and (3) WorldCom Santa Clara-SLC.

Pursuant to the IRU agreement, Qwest pulled fiber for the three

IRU projects, as described above.

     In addition to pulling fiber for WorldCom, Qwest also pulled

fiber for its own potential future use or sale.    Instead of

pulling 24-fiber fiberoptic cables, Qwest pulled cables with a

larger number of fibers.   While WorldCom had an IRU in 24 of the

fibers, Qwest retained control over the remaining fibers in the

same cable.

     The IRU agreement constitutes a long-term contract as

defined by section 460(f).     For tax purposes, Qwest’s granting of

the IRUs to WorldCom was treated as a sale of those fibers.     The

total contract price for the IRU agreement was $65,196,466.
                               - 14 -

          3.     Projects With No Third-Party Customer8

     In two instances, Qwest installed conduit and pulled fiber

for itself without having a customer contract in place.

     In the Cal Fiber project, Qwest linked unconnected segments

of empty conduit.    The unconnected segments of conduit were

previously installed and retained by Qwest as part of the Coast

Route project.

     Qwest completed the Cal Fiber project in March 1995 by

laying 153 miles of new conduit, pulling fiber through the

conduit, and lighting the fiber.    The Cal Fiber project gave

Qwest a completed fiberoptic system from Roseville, California,

to Los Angeles, California.    Qwest’s total construction cost for

the Cal Fiber project was $32,496,284.    Northern Telecom Finance

Corporation provided financing for the majority of the Cal Fiber

project costs, with the balance funded by internal financing.

     In the Dallas-Houston project, Qwest installed conduit,

pulled fiber, and lit the fiber for its own account.      Qwest began

construction of the Dallas-Houston project in February 1995 and

completed it in May 1997.    At the time Qwest began the Dallas-

Houston project, Qwest anticipated that WorldCom Network

Services, Inc., d.b.a. WilTel (WilTel), would purchase the

conduit, which it in fact did.    The Dallas-Houston project



     8
        Cost allocations relating to projects without third-party
customers are not in issue.
                              - 15 -

resulted in approximately 270 conduit miles and a total

construction cost of $25,249,137.

     C.   Telecommunication Services

     During the years in issue, Qwest also provided

telecommunication services, which included:   (1) Selling of

transmission capacity in bulk, including both dedicated line and

switched services, to interexchange carriers and competitive

access providers; and (2) providing long-distance services to a

customer base of end users in the business, education, and

government sectors, also known as commercial services.

Qwest provided its telecommunication services primarily using

capacity it received:   From leases with other long-distance

carriers; from certain of its customers’ fiberoptic cables; from

the digital microwave transmission network acquired through its

purchase of Qwest Transmission, Inc. (Qwest Transmission), in

January 1995; and from the fiberoptic systems it owned along the

Dallas-Houston and Cal Fiber routes.

     Qwest initially started to market its switched services and

commercial services by hiring a sales force in 1994 and 1995.

The focus was on cities such as Los Angeles, Phoenix, San

Francisco, Denver, and Salt Lake City.    By 1996, Qwest cut back

on the sales activities because maintaining the sales staff and

offices and leasing transmission capacity from other long-

distance carriers became too expensive.
                               - 16 -

     D.   Other Transactions

          1.    Advantis

     On September 10, 1993, Qwest entered into an asset and stock

purchase agreement with Advantis, a communications network joint

venture of IBM and Sears Roebuck Company (Sears), carrying Sears

and IBM voice and data traffic worldwide.      Pursuant to this

agreement, on November 5, 1993, Qwest sold Advantis substantially

all of its then-owned capacity rights in the fiberoptic cables

owned by MCI along with certain realty and related equipment.     In

exchange, Qwest received $185 million and the right to use the

capacity sold to Advantis, if not needed by Advantis, free of

charge in order to provide service to Qwest’s dedicated line

customers for the 12-month period following the date of the sale

to Advantis.   Qwest also agreed to lay conduit and pull fiber

between Los Angeles and Sacramento and provide Advantis with a

certain portion of this capacity.

          2.    Qwest Transmission

     Qwest Communications, Inc. and Subsidiaries (Qwest

Communications) were in the telecommunications business as a

carrier’s carrier, providing digital private line service to the

long-distance industry since 1981.      On April 6, 1995, Qwest

Communications changed its name to Qwest Transmission.9



     9
        To avoid confusion, Qwest Communications is hereinafter
referred to as Qwest Transmission.
                                - 17 -

     On January 31, 1995, Qwest purchased all of the outstanding

stock of Qwest Transmission for $18,770,000.    Qwest Transmission

had an existing digital microwave radio network serving an

approximately 3,500 mile route, ranging from the Texas-Mexico

border to Cincinnati, then branching off to Chicago and

Philadelphia.10    At the same time as the Qwest Transmission

acquisition, Qwest also acquired Qwest Properties, Inc., a lessor

of a telecommunications switching facility11 in Dallas, Texas.

     Qwest Transmission’s available capacity allowed Qwest to

transfer existing revenue traffic to the Qwest Transmission

network, reducing its current leased facility expense.

          3.      Fiber Systems, Inc.

     In January 1995, Qwest purchased certain assets from Fiber

Systems, Inc. for $1,750,000, which were placed into an Anschutz

Company subsidiary, FSI Acquisition Corporation.

          4.      Five Star Telecom, Inc.

     In March 1996, Qwest’s Board of Directors agreed to enter

into leases with Five Star Telecom, Inc., for three switches in


     10
        Microwave systems, the development of which predated the
development of fiberoptic technology, offer a means of
transmitting lower volume and narrower bandwidths of voice, data,
and video signals. Microwave systems use radio frequencies to
transmit data between transmission towers.

     11
        A switch is a device that selects the paths or circuits
to be used for transmission of information and establishes a
connection.
                             - 18 -

New York, Florida, and Indiana.

          5.   WilTel

     On July 1, 1996, WilTel and Qwest entered into an asset

purchase agreement, in which Qwest sold its right, title, and

interest in certain telecommunications service agreements for

$5,500,000.

          6.   Frontier Communications

     In 1995, Qwest began negotiations with Frontier regarding

the use of optical fibers and other related property.   On October

18, 1996, Qwest executed an IRU agreement with Frontier

Communications, granting Frontier Communications the right to use

certain optical fibers and other property in a fiberoptic

telecommunications system to be constructed by Qwest.

          7.   MFS of California, Inc.

     On November 1, 1994, Qwest and MFS of California, Inc. (MFS)

entered into a conduit exchange, in which Qwest exchanged

approximately 47 miles of conduit between San Jose and Oakland

for approximately 60 miles of conduit constructed by MFS from San

Francisco to San Jose.

     In June 1996, Qwest and MFS entered into an optical fiber

swap agreement for the exchange of 12 dark fibers from the San

Francisco and Oakland Bay Bridges to both parties’ points of
                               - 19 -

presence (POPs).12   The purpose of the agreement was to provide

connectivity to the POPs.

           8.   MCI Swaps

      On April 3, 1995, Qwest entered into a letter agreement with

MCI for construction/conduit swaps in Santa Barbara, San Jose,

Sacramento, and St. Louis.

IV.   Qwest’s Incremental Cost Allocation Method

      During the years in issue, petitioners used an accrual

method of accounting for tax purposes.   In most cases,

petitioners reported income from their customer contracts using

the percentage of completion method.

      Because Qwest was engaged in the simultaneous installation

and sale of conduit or fiber to third-party customers and the

installation and retention of additional conduits or fibers for

its own potential future sale or use, Qwest allocated total

project costs between the third-party contracts and the retained

assets using an incremental cost allocation method.   Qwest

developed the incremental cost allocation method in part by

looking at third-party subcontractors’ bids to install conduits.

Bids to install only one conduit, when compared to the bids to

install multiple conduits, indicated that the third-party

subcontractors increased the bid on an incremental basis as more


      12
        A POP is the point at which a line from a long-distance
carrier connects to the line of the local telephone company or to
the user if no local telephone company is involved.
                              - 20 -

conduits were added.

     Qwest’s incremental cost allocation method is described as

follows:   (1) Qwest allocated to the customer contracts what it

determined to be direct costs associated with those contracts;

(2) Qwest allocated to its retained assets what it determined to

be the direct costs associated with its retained conduits and

fibers; and (3) Qwest allocated what it determined to be indirect

costs incrementally between the customer contracts and its

retained assets.   The incremental cost allocation method was used

for both the conduit installation projects and the IRU projects,

but the method varied slightly.

     A.    Incremental Cost Allocation Method in the Conduit
           Installation Projects

     To determine what costs should be allocated to Qwest’s

retained conduits in the conduit installation projects, Qwest

developed an incremental base rate.    By evaluating Qwest’s

construction costs, Senior Vice President for Construction Daniel

O’Callaghan (Mr. O’Callaghan) and Qwest Assistant Vice President

Ronald Pearce (Mr. Pearce) determined that an incremental base

rate of $6,019 per conduit mile should be utilized.    The

incremental base rate included:   (1) $2,376 for conduit material,

assuming a cost to Qwest of 45 cents per foot; (2) $370 for other

material related to installation; (3) $2,640 for labor

attributable to the installation of the additional conduit; (4)

$581 for equipment costs; and (5) $53 for overhead.    The
                               - 21 -

incremental base rate could be adjusted to reflect variations in

conduit material costs.   For example, Qwest adjusted its

incremental base rate for the MCI Denver-El Paso conduit project

from $6,019 to $6,500 per conduit mile due to an increase in

conduit material costs from $2,376 to $2,856 per mile.13

     The incremental base rate did not include the cost of

digging the trench or the costs associated with perfecting the

rights-of-way because these costs would have been incurred when

installing the conduit for the third-party customer regardless of

whether Qwest chose to install additional conduit.     The

incremental base rate did not include adjustments based on

terrain and was not increased as a result of budget overruns.

     Using the incremental base rate, with appropriate

adjustments, Qwest determined the incremental costs per conduit

mile of conduits retained by Qwest were:

                                    Incremental cost
           Project                  per conduit mile

     MCI San Jose-Reno-Wells               $8,129
     MCI Salt Lake City-Denver              7,629
     MFS Los Angeles                        6,019
     MFS Dallas                             6,019
     Viacom San Francisco Bay               6,019
     MCI Denver-El Paso                     6,500
     MCI Kansas City-St. Louis              5,999
     US West Phoenix-Mesa                   5,066
     MCImetro Dallas                        5,417
     US West Grants-Gallup                  6,806
     MFS Anaheim                            6,584



     13
          The $1 discrepancy is due to rounding.
                              - 22 -

Using the MCI Denver-El Paso project as an example, Qwest used

the incremental cost allocation method as follows:14

     Indirect costs allocated to Qwest’s retained assets
     Qwest conduit miles                      2,295
     Times: incremental cost/mile       *    $6,500
                                        $14,917,629
     Plus: Qwest capitalized interest   + 1,072,296
     Project costs allocated to Qwest   $15,989,925

     Indirect costs allocated to customer contracts

     Total project costs                  $39,151,405
     Less: project costs                  (15,989,925)
     allocated to Qwest
     Project costs
     allocated to customer                $23,161,480

     Divide: customer conduit miles       /       761
     Incremental cost/mile allocated
     to customer                              $30,422


     B.   Incremental Cost Allocation Method in the IRU Projects

     Qwest also used an incremental cost allocation method to

allocate costs for the IRU projects involving WorldCom.    For

these projects, Qwest allocated existing conduit costs, the labor

costs of pulling fiber, and right-of-way costs entirely to the

IRU agreement because these costs did not increase by installing

a cable with more than 24 fibers.15    The cost of new conduit, or


     14
        We note that these calculations were provided by
petitioners, and there appear to be mathematical errors.
However, because petitioners relied on these calculations, we
have left the errors uncorrected.
     15
        For the WorldCom Dallas-Houston project, since the fiber
was previously installed for Qwest’s account, Qwest allocated the
existing conduit costs, the costs of pulling fiber through that
                                                   (continued...)
                             - 23 -

endlinks, was allocated to the IRU agreement, and if any retained

conduit was installed, the incremental cost of adding such

conduit was allocated to Qwest’s retained assets.   Finally, Qwest

allocated cable material, splicing, and testing costs between the

IRU agreement and its retained assets based on the ratio of

fibers sold to WorldCom to fibers retained by Qwest.   As an

example, in the Dallas-Houston IRU project, Qwest installed a 72-

fiber fiberoptic cable, and WorldCom had an IRU in 24 of those.

Qwest allocated 24/72ths of the costs of cable material, splicing

and testing to the IRU agreement and 48/72ths to Qwest’s retained

assets.

V.   Tax Returns for the Years in Issue

     Petitioners timely filed consolidated Federal income tax

returns for the years in issue.

     On February 4, 2003, respondent mailed a notice of

deficiency to petitioners for the years in issue.   As reflected

in the notice of deficiency, respondent determined that an

average cost allocation approach should be used for all of

petitioners’ conduit installation and fiber pulling projects.   In

the notice of deficiency, respondent explained:

     certain incremental costs included in your cost of
     sales claimed on your tax returns for taxable years
     ending 7-31-94, 7-31-95 and 7-31-96 in the amounts of
     $20,149,787, $10,977,427 and $14,602,442, respectively,


          15
           (...continued)
conduit, and the right-of-way costs to Qwest’s retained assets.
                              - 24 -

     are not allowable because they are capital
     expenditures. Accordingly your income is increased by
     $20,149,787, $10,977,427 and $14,602,442 for taxable
     years ending 7-31-94, 7-31-95 and 7-31-96 respectively.

Using the MCI Denver-El Paso project as an example, respondent

allocated the project costs as follows:16

     Total project costs                $39,151,405
     Less: direct costs allocated       ( 1,279,689)
     to customer
     Project costs to allocate          $37,871,716
     Divide: total conduit miles        /     3,056
     Average cost per conduit mile          $12,391

     Multiply: customer conduit miles   *       761
     Costs allocated to customer         $9,433,853
     Add: direct costs allocated        + 1,279,689
     to customer
     Project costs allocated            $10,713,542
     to customer

     Total project costs                $39,151,405
     Less: project costs allocated      (10,713,542)
     to customer
     Project Costs Allocated to Qwest   $28,437,863


     On April 24, 2003, petitioners filed a petition with this

Court disputing the determinations in the notice of deficiency.

As relevant, petitioners state:

     The Commissioner * * * erred in failing to determine
     that petitioners properly and reasonably allocated
     costs between long-term contracts with customers for
     the installation of conduit or fiber optic cable and
     additional conduit or fiber optic cable retained by
     petitioners in accordance with applicable Treasury
     regulations, and in failing to determine that


     16
        We note that these calculations were provided by
respondent, and there appear to be mathematical errors. However,
because respondent relied on these calculations, we have left the
errors uncorrected.
                              - 25 -

     petitioners’ method of allocating costs between long-
     term contracts and retained assets clearly reflected
     their income.

                              OPINION

     Respondent contends that Qwest’s incremental cost allocation

method is not a reasonable allocation method under section

1.263A-1(f)(4), Income Tax Regs.   Further, respondent asserts

that Qwest’s incremental cost allocation method fails to clearly

reflect income, and thus respondent may change it to an average

cost allocation method.   Petitioners argue that Qwest’s

incremental cost allocation method was reasonable because it was

based on Qwest’s decision-making process and on the economic

reality of the underlying transactions.

     To reach our holdings, we must first lay out the statutory

and regulatory framework and determine how the Code sections in

issue apply to the instant case.   Second, we must determine the

meaning of “reasonable allocation” for purposes of sections

1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax Regs., and

then decide whether Qwest’s incremental cost allocation method

satisfies this requirement.   Finally, we must determine whether

respondent abused his discretion in finding that Qwest’s

incremental cost allocation method failed to clearly reflect

income under section 446 and the regulations thereunder.
                                - 26 -

I.     Statutory and Regulatory Framework

       The parties agree that two Code sections are implicated by

Qwest’s incremental cost allocation method, sections 263A and

460.    However, the parties differ on the interpretation of each

section and its accompanying regulations and how each is applied

to the facts of the instant case.

       A.   Section 460:   Allocation of Costs to Long-Term
            Contracts

       Qwest’s cost allocation to its customer contracts is

governed by section 460.     Section 460 contains special rules for

the tax reporting of long-term contracts.       In general, section

460 requires that the taxable income from a long-term contract

shall be determined under the percentage of completion method.

Sec. 460(a).    A long-term contract is defined as one which is not

completed within the same taxable year in which the contract was

entered into.    Sec. 460(f)(1).   The contract must be for the

manufacture, building, installation, or construction of property.

Id.    Section 460(c)(1) provides that all costs which directly

benefit or are incurred by reason of the long-term contract shall

be allocated to such contract in the same manner as costs are

allocated to extended period long-term contracts under section

451 and the accompanying regulations.       We are thus directed to
                              - 27 -

the regulations at section 1.451-3(d)(6), Income Tax Regs., to

allocate costs to a long-term contract.17

     The regulations provide that direct material and direct

labor costs attributable to a long-term contract must be

allocated to that long-term contract.18   Sec. 1.451-3(d)(6)(i),

Income Tax Regs.; see also sec. 1.451-3(d)(5), Income Tax Regs.

Indirect costs, those costs other than direct material and direct

labor costs, are subject to two levels of allocation.19    See sec.

1.451-3(d)(6)(ii), (8)(iv), Income Tax Regs.

     In the first level allocation, the regulations recognize

that some indirect costs benefit both long-term contracts and

“other activities of the taxpayer.”    Sec. 1.451-3(d)(6)(ii),

Income Tax Regs.   “Accordingly, such costs require a reasonable

allocation between the portion of such costs that are


     17
        The Commissioner issued regulations pursuant to sec.
460, applicable to contracts entered into on or after Jan. 11,
2001. Sec. 1.460-1(h)(1), Income Tax Regs. These regulations do
not apply to the instant case.
     18
        Direct material costs are costs of materials that have
“become an integral part of the subject matter * * * and those
materials which are consumed in the ordinary course of building,
constructing, installing or manufacturing the subject matter”.
Sec. 1.451-3(d)(6)(i), Income Tax Regs. Direct labor costs are
the costs of labor that “can be identified or associated with a
particular * * * long-term contract.” Id.
     19
        The regulations under secs. 460 and 263A do not use the
terminology “first level” and “second level” allocations.
However, the effect of those regulations is to break the
allocations into two distinct steps. For purposes of clarity, we
refer to these steps as “first level” and “second level”.
                               - 28 -

attributable to * * * long-term contracts and the portion

attributable to the other activities of the taxpayer.”    Id.   If

indirect costs need only be allocated between one long-term

contract and the taxpayer’s other activities, the allocation

stops at the first level.

     If indirect costs must be allocated to multiple long-term

contracts, the regulations provide a second level allocation:

          The indirect costs required to be allocated to a
     long-term contract under paragraph * * * (d)(6)(ii) of
     this section shall be allocated to particular contracts
     for the year such costs are incurred using either--

               (A) A specific identification
          (or “tracing”) method, or

               (B) A method using burden rates, such as
          ratios based on direct costs, hours, or other
          items, or similar formulas, so long as the
          method employed for such allocation
          reasonably allocates indirect costs among
          long-term contracts completed during the
          taxable year and long-term contracts that
          have not been completed as of the end of the
          taxable year. * * *

Sec. 1.451-3(d)(8)(iv), Income Tax Regs.

     B.   Allocation of Costs to Property Produced by the
          Taxpayer Under Section 263A

     Section 263A governs the capitalization of costs for

property produced by the taxpayer and property acquired by

the taxpayer for resale.20   Sec. 263A(a) and (b)(1).

Section 263A does not apply to any property produced by the


     20
        The term “produced” includes constructed, built,
installed, manufactured, developed, or improved. Sec. 263A(g).
                             - 29 -

taxpayer pursuant to a long-term contract.    Sec. 263A(c)(4).

Under section 263A, as relevant to the present case, the

direct costs and certain indirect costs allocable to real or

tangible personal property produced by the taxpayer must be

capitalized.    Sec. 263A(a)(1); sec. 1.263A-1(a)(3), Income

Tax Regs.21    Direct costs that must be capitalized include

direct material and direct labor costs.    Sec. 1.263A-

1(e)(2), Income Tax Regs.    Indirect costs that must be

capitalized are those costs that are properly allocable to

the property produced when those costs directly benefit or

are incurred by reason of the production activities.      Sec.

1.263A-1(e)(3)(i), Income Tax Regs.

     Like the regulations under section 451, the regulations

under section 263A provide for two levels of allocation for

indirect costs.    See sec. 1.263A-1(e)(3)(i), (f)(4), (g)(3),



     21
         Though not called to our attention by the parties, the
current regulations under sec. 263A apply to taxable years
beginning after Dec. 31, 1993. Sec. 1.263A-1(a)(2)(i), Income
Tax Regs. The current regulations provide that, for taxable
years beginning before Jan. 1, 1994, a position taken on a tax
return when applying sec. 263A will be considered reasonable if
consistent with the temporary regulations. Sec. 1.263A-
1(a)(2)(ii), Income Tax Regs.; see also sec. 1.263A-1T, Temporary
Income Tax Regs., 57 Fed. Reg. 12419 (Apr. 10, 1992). Therefore,
the temporary regulations are relevant to the first year in
issue, and the current regulations apply to the last 2 years in
issue. While the temporary and current regulations differ in
structure, the rules provided therein are essentially the same.
Because the difference in structure does not impact our
rationale, the temporary regulations will not be discussed
further.
                             - 30 -

Income Tax Regs.   In the first level allocation, “Indirect

costs may be allocable to both production and resale

activities, as well as to other activities that are not

subject to section 263A.    Taxpayers subject to section 263A

must make a reasonable allocation of indirect costs between

production, resale, and other activities.”    Sec. 1.263A-

1(e)(3)(i), Income Tax Regs.    If the indirect costs need

only to be allocated between one item of taxpayer-produced

property and the taxpayer’s other activities, or between one

item of property acquired for resale by the taxpayer and the

taxpayer’s other activities, the allocation stops at the

first level.

     If indirect costs must be allocated among different

items of property subject to section 263A, the regulations

provide for a second level allocation.    See sec. 1.263A-

1(f), Income Tax Regs. The cost allocation method used at

the second level must be reasonable under section 1.263A-

1(f)(4), Income Tax Regs.    Sec. 1.263A-1(g)(3), Income Tax

Regs.   For the second level allocation, the regulations

provide:

     A taxpayer may use the methods described in paragraph
     (f)(2) [specific identification method] or (3) [burden
     rate and standard costs methods] of this section if
     they are reasonable allocation methods within the
     meaning of this paragraph (f)(4). In addition, a
     taxpayer may use any other reasonable method to
     properly allocate direct and indirect costs among units
     of property produced or property acquired for resale
                             - 31 -

     during the taxable year. An allocation method is
     reasonable if, with respect to the taxpayer’s
     production or resale activities taken as a whole--

               (i) The total costs actually capitalized
          during the taxable year do not differ
          significantly from the aggregate costs that
          would be properly capitalized using another
          permissible method described in this section
          or in §§ 1.263A-2 and 1.263A-3, with
          appropriate consideration given to the volume
          and value of the taxpayer’s production or
          resale activities, the availability of
          costing information, the time and cost of
          using various allocation methods, and the
          accuracy of the allocation method chosen as
          compared with other allocation methods;

               (ii) The allocation method is applied
          consistently by the taxpayer; and

               (iii) The allocation method is not used
          to circumvent the requirements of the
          simplified methods in this section or in §
          1.263A-2, 1.263A-3, or the principles of
          section 263A.

Sec. 1.263A-1(f)(4), Income Tax Regs.

     C.   Application of Sections 460 and 263A to Qwest’s Conduit
          Installation Projects

     The instant case presents a unique issue:   When a taxpayer

performs a long-term contract and simultaneously produces

property retained by the taxpayer, how are the indirect costs of

the two activities allocated under sections 263A and 460?   The

sections, applicable regulations, and prior caselaw provide

limited guidance as to how the two Code sections interact when

both must be applied to the same project.

     Respondent asserts that the order in which the Code sections

and regulations are applied will make a difference in the outcome
                             - 32 -

of the amount of indirect costs that must be capitalized under

section 263A and the amount of costs that must be recovered under

the percentage of completion method of section 460.22   However, a

careful reading of the regulations shows that the rule for the

first level allocation is identical under both regimes, and thus

the order in which they are applied is irrelevant.   The Code

sections and regulations work in tandem to provide for a single,

comprehensive set of cost allocation rules.

     First, we must clarify what costs and which level of cost

allocation are at issue in the instant case.   Both parties agree

that Qwest’s first level allocation of indirect costs is at

issue; i.e., how Qwest allocates indirect costs between its long-

term customer contracts and its self-produced retained assets.

Thus, our focus will remain on the first level allocation of

indirect costs.

     Sections 1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax

Regs., provide the rules for the first level allocations.   Both

sections require the taxpayer to make a “reasonable allocation”



     22
        Respondent then argues that sec. 263A should be applied
first. However, respondent ignores the language of sec.
263A(c)(4), which provides that sec. 263A does not apply to any
property produced by the taxpayer pursuant to a long-term
contract as defined by sec. 460. Given this language, the
argument could be made that, in situations such as the present
case, sec. 460 would apply first. Petitioner does not raise this
argument. In our analysis, infra, we find that the order of
application of the sections is not determinative of the outcome,
and thus we do not discuss this argument further.
                              - 33 -

of costs between:   (1) Activities subject to that section (either

taxpayer-produced property and property held for resale or long-

term contracts); and (2) “other activities”.   See secs. 1.263A-

1(e)(3)(i), 1.451-3(d)(6)(ii), Income Tax Regs.   Neither section

provides a definition of “reasonable allocation.”23   See secs.

1.263A-1(e)(3)(i), 1.451-3(d)(6)(ii), Income Tax Regs.     Because

the rules for the first level allocation are the same, the result

will not differ depending on which section is applied first, as

respondent contends.   Instead, the rules can be applied

simultaneously to a first level allocation.

     After the first level allocation is complete, costs will be

separated between long-term contracts, taxpayer-produced property

or property held for resale, and if applicable, other property

not subject to either section.   For the second level allocations,

section 1.263A-1(f) and (g), Income Tax Regs., will govern all

costs previously allocated to the taxpayer-produced property or

property held for resale.   Section 1.451-3(d)(8)(iv), Income Tax

Regs., will govern all costs previously allocated to the long-

term contracts.

     As applicable to the instant case, in its first level

allocation, Qwest must make a “reasonable allocation” of indirect

costs between its customer contracts and its retained assets.


     23
        Respondent contends that the reasonableness standard
found in sec. 1.263A-1(f)(4), Income Tax Regs., should apply to
the first level of allocation. This argument is addressed infra.
                              - 34 -

See secs. 1.263A-1(e)(3)(i), 1.451-1(d)(6)(ii), Income Tax Regs.

Next, we must define “reasonable allocation” for purposes of

sections 1.263A-1(e)(3)(i) and 1.451-1(d)(6)(ii), Income Tax

Regs., and then determine whether Qwest’s incremental cost

allocation method satisfies that definition.

II.   Definition of “Reasonable Allocation” for Purposes of
      Sections 1.263A-1(e)(3)(i) and 1.451-1(d)(6)(ii), Income Tax
      Regs.

      Respondent argues that the language of section 1.263A-

1(g)(3), Income Tax Regs., requires that the reasonableness

standard of section 1.263A-1(f)(4), Income Tax Regs., governs the

first level allocations in the present case.   In the alternative,

respondent contends that the reasonableness standard of section

1.263A-1(f)(4), Income Tax Regs., should be incorporated into the

undefined phrase “reasonable allocation” in sections 1.263A-

1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax Regs.   To support

this contention, respondent notes the parallel structure of the

regulations under sections 263A and 451 and cites legislative

history.   On the other hand, petitioners contend that because

“reasonable allocation” is not defined by sections 1.263A-

1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax Regs., “reasonable”

should be interpreted using its ordinary meaning.

      A.   The Language of Section 1.263A-1(g)(3),
           Income Tax Regs.

      Respondent argues that the language of section 1.263A-

1(g)(3), Income Tax Regs., requires that the reasonableness
                              - 35 -

standard of section 1.263A-1(f)(4), Income Tax Regs., governs the

first level allocation in the present case.   Specifically,

respondent states:

          As a preface to Treas. Reg. §1.263A-1(g),
     paragraph (f)(1) states that paragraph (g) provides
     general rules of applying paragraph (f)’s detailed
     allocation methods. In the general rule applicable to
     this case, Treas. Reg. § 1.263A-1(g)(3) provides that
     Common Costs are generally to be first allocated to
     “intermediate cost objectives.” The regulation uses
     “activities” to illustrate what is meant by
     intermediate cost objectives. Thus, it intends that
     the phrase “intermediate cost objectives” refers to the
     first level of cost allocation referenced above, i.e.,
     between § 263A activities and other activities. Treas.
     Reg. § 1.263A-1(c). Treas. Reg. § 1.263A-1(g)(3)
     further states that this allocation of Common Costs at
     the intermediate level, or first level of allocation
     between section 263A and non-263A activities, is to be
     allocated using * * * any other reasonable allocation
     method as defined under paragraph (f)(4).

Respondent’s argument is premised on the notion that section

1.263A-1(g)(3), Income Tax Regs., governs Qwest’s first level

allocations between its customer contracts and its retained

assets.   However, respondent’s interpretation of section 1.263A-

1(g)(3), Income Tax Regs., is not supported by the language of

sections 1.263A-1(f)(1), (g)(1) and (2), Income Tax Regs.

     In pertinent part, section 1.263A-1(f)(1), Income Tax Regs.,

provides:   “The language of paragraph (f) sets forth various

detailed * * * cost allocation methods * * * [used] to allocate

direct and indirect costs to property produced and property

acquired for resale.”   This language explicitly limits the cost

allocation methods of section 1.263A-1(f), Income Tax Regs., to
                              - 36 -

property already subject to section 263A.   Section 1.263A-

1(f)(1), Income Tax Regs., goes on to state:   “Paragraph (g) of

this section provides general rules for applying these allocation

methods to various categories of costs.” (Emphasis added.)    This

language indicates that section 1.263A-1(g), Income Tax Regs.,

gives general rules for applying cost allocation methods already

limited to property subject to section 263A.   Because the first

level allocation deals with property not subject to section 263A,

we find the language of section 1.263A-1(f)(1), Income Tax Regs.,

limits the application of section 1.263A-1(g), Income Tax Regs.,

to the second level allocation.

     This interpretation is supported by the language of section

1.263A-1(g)(1) and (2), Income Tax Regs.    Section 1.263A-1(g)(1),

Income Tax Regs., provides that “Direct material costs * * * must

be allocated to the property produced or property acquired for

resale by the taxpayer using the taxpayer’s method of accounting

* * *.” (Emphasis added.)   Section 1.263A-1(g)(2), Income Tax

Regs., provides that “Direct labor costs * * * are generally

allocated to property produced or property acquired for resale”.

(Emphasis added.)   The above-emphasized language limits those

subparagraphs to property already subject to section 263A.

     Section 1.263A-1(g)(3), Income Tax Regs., states:

     Indirect costs * * * are generally allocated to
     intermediate cost objectives such as departments or
     activities prior to the allocation of such costs to
     property produced or property acquired for resale.
                                - 37 -

     Indirect costs are allocated using either a specific
     identification method, a standard cost method, a burden
     rate method, or any other reasonable allocation method
     (as defined under the principles of paragraph (f)(4) of
     this section).

Respondent contends that “intermediate cost objectives”

distinguishes between property subject to and property not

subject to section 263A.   The cited language is less than clear,

and the regulations do not expand on or define “intermediate cost

objectives” other than to offer examples “such as departments or

activities”.   However, when read in the context of the above-

analyzed regulations, we find that the phrase “intermediate cost

objectives” is not meant to distinguish between property subject

to and property not subject to section 263A.

     For the above reasons, we find that section 1.263A-1(g)(3),

Income Tax Regs., does not require that the reasonableness

standard of section 1.263A-1(f)(4), Income Tax Regs., govern the

first level allocation.

     B.   The Language and Parallel Structure of Sections
          1.263A-1 and 1.451-3, Income Tax Regs.

     Respondent argues that the parallel structure of sections

1.263A-1 and 1.451-3, Income Tax Regs., indicates that the

reasonableness standard of section 1.263A-1(f)(4), Income Tax

Regs., should be incorporated into the undefined phrase

“reasonable allocation” in sections 1.263A-1(e)(3)(i) and 1.451-

3(d)(6)(ii), Income Tax Regs.    However, respondent’s argument is

not supported by the actual structure of the regulations.    In
                               - 38 -

trying to establish a reasonableness standard for the first level

allocation, respondent collapses the two levels of allocation

into one.

     As discussed above, the regulations under both sections 263A

and 451 provide for two levels of allocations.   At the first

level, section 1.263A-1(e)(3)(i), Income Tax Regs., provides that

“Taxpayers subject to section 263A must make a reasonable

allocation of indirect costs between production, resale, and

other activities.”   Likewise, section 1.451-3(d)(6)(ii), Income

Tax Regs., “[requires] a reasonable allocation between the

portion of such costs that are attributable to * * * long-term

contracts and the portion attributable to the other activities of

the taxpayer.”    “Reasonable allocation” is not defined in either

section.    See secs. 1.263A-1(e)(3)(i), 1.451-3(d)(6)(ii), Income

Tax Regs.

     With respect to the second level allocation, section 1.263A-

1(g)(3), Income Tax Regs., provides that the indirect costs of

property produced or property acquired for resale be “allocated

using either a specific identification method, a standard cost

method, a burden rate method, or any other reasonable allocation

method (as defined under the principles of paragraph (f)(4) of

this section).”   In relevant part, section 1.263A-1(f)(4), Income

Tax Regs., states:   “a taxpayer may use any other reasonable

method to properly allocate direct and indirect costs among units
                              - 39 -

of property produced or property acquired for resale”, and then

sets forth a reasonableness standard.   (Emphasis added.)   As

found above, section 1.263A-1(f)(4), Income Tax Regs., applies

only to the second level allocation.    Similarly, section 1.451-

3(d)(8)(iv), Income Tax Regs., requires that indirect costs

previously allocated to long-term contracts under paragraph

(d)(6)(ii) shall be allocated to a particular long-term contract

using a specific identification method, a burden rate method, “or

similar formulas, so long as the method employed * * * reasonably

allocates indirect costs”.   However, unlike section 1.263A-

1(f)(4), Income Tax Regs., section 1.451-3(d)(8)(iv), Income Tax

Regs., does not provide a reasonableness standard.

     What respondent asks the Court to do is take the

reasonableness standard from the second level allocation under

the section 263A regulations and apply it to the first level

allocation under the regulations of sections 263A and 460.     While

the regulations under both sections have a parallel structure,

such structure works against respondent’s interpretation.    The

regulations clearly separate the two levels of allocations, and

as found above, the reasonableness standard of section 1.263A-

1(f)(4), Income Tax Regs., applies only to the second level

allocation.   The structure of the regulations supports limiting

the reasonableness standard of section 1.263A-1(f)(4), Income Tax

Regs., to the second level allocation only.
                              - 40 -

     In addition, the explicit language of section 1.263A-

1(f)(4), Income Tax Regs., indicates that the reasonableness

standard should not be read into section 1.451-3(d)(6)(ii),

Income Tax Regs.   The reasonableness standard of section 1.263A-

1(f)(4), Income Tax Regs., can apply only when section 263A is at

issue.   Section 1.263A-1(f)(4), Income Tax Regs., cannot apply

when only section 460 is at issue.     The first of three prongs to

the reasonableness standard states:    “The total costs actually

capitalized during the taxable year do not differ significantly”.

Sec. 1.263A-1(f)(4), Income Tax Regs. (emphasis added).    While

both sections 263A and 460 are at issue in the instant case, this

will not always be so.

     Section 1.451-3(c)(3), Income Tax Regs., requires that under

the percentage of completion method, costs incurred during the

taxable year with respect to a long-term contract must be

deducted in that year.   Again, section 1.451-3(d)(6)(ii), Income

Tax Regs., requires that costs must be reasonably allocated among

the taxpayer’s long-term contracts and “other activities”.    In

situations where the “other activities” are not subject to the

capitalization requirements of section 263A, the reasonableness

standard of section 1.263A-1(f)(4), Income Tax Regs., cannot

apply because no costs would “actually [be] capitalized”.    Thus,

the reasonableness standard of section 1.263A-1(f)(4), Income Tax
                                - 41 -

Regs., cannot always be read into section 1.451-3(d)(6)(ii),

Income Tax Regs., as respondent suggests.

     For these reasons, the language and parallel structure of

the regulations do not support incorporating the reasonableness

standard of section 1.263A-1(f)(4), Income Tax Regs., into the

undefined phrase “reasonable allocation” in sections 1.263A-

1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax Regs.

     C.     Legislative History of Section 263A

     Respondent maintains that the legislative history of section

263A indicates that the reasonableness standard of section

1.263A-1(f)(4), Income Tax Regs., should be incorporated into

sections 1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax

Regs.     Respondent asserts that “This incorporation is necessary

to satisfy Congressional intent to provide a single comprehensive

set of harmonious rules to govern the capitalization of costs of

producing property”.

     The uniform capitalization rules of section 263A and the

special rules for long-term contracts under section 460 were

enacted as part of the Tax Reform Act of 1986, Pub. L. 99-514,

100 Stat. 2085.     With regard to the uniform capitalization rules,

the Senate report states:

          The Committee believes that, in order to more
     accurately reflect income and make the income tax
     system more neutral, a single, comprehensive set of
     rules should govern the capitalization of costs of
     producing, acquiring, and holding property * * *
                               - 42 -

       subject to appropriate exceptions where application of
       the rules might be unduly burdensome.

                 *    *    *    *    *    *    *

            The uniform capitalization rules will be patterned
       after the rules applicable to extended period long-term
       contracts, set forth in the final regulations issued
       under section 451. Accordingly, taxpayers subject to
       the rules will be required to capitalize not only
       direct costs but also an allocable portion of most
       indirect costs that benefit the assets produced or
       acquired for resale * * *. The committee recognizes
       that modifications of the rules set forth in the long-
       term contract regulations may be necessary or
       appropriate in order to adapt such rules to production
       not involving a contract, and intends that the Treasury
       Department will have the authority to make such
       modifications.

            * * * The existing long-term contract regulations
       provide a large measure of flexibility to taxpayers in
       allocating indirect costs to contracts inasmuch as they
       permit any reasonable method of allocation authorized
       by cost accounting principles. The committee expects
       that the regulations under this provision will adopt a
       similarly liberal approach and permit allocations of
       costs among numerous items produced or held for resale
       by a taxpayer to be made on the basis of burden rates
       of other appropriate methods similar to those provided
       under present law.

S. Rept. 99-313, at 140-142 (1986), 1986-3 C.B. (Vol. 3) 1, 140-

142.    In less detail, the House report states:   “allocations of

indirect production costs among items produced, or between

inventory and current expense, are to be made under rules similar

to those provided under present law.”    H. Rept. 99-426, at 626

(1985), 1986-3 C.B. (Vol. 2) 1, 626.

       The legislative history, as quoted above, clearly indicates

that Congress intended the uniform capitalization rules to be
                                - 43 -

patterned after the regulations under section 451, taking a

“similarly liberal approach”.    See S. Rept. 99-313, supra at 141,

1986-3 C.B. (Vol. 3) at 141; H. Rept. 99-426, supra at 626, 1986-

3 C.B. (Vol. 2) at 626.    Respondent argues that consequently, the

definitions of section 1.263A-1(f)(4), Income Tax Regs., “and the

principles of its detailed guidance for the allocation of costs

should govern * * * the interpretation of ‘reasonable method’

under the section 451 regulations.”      We interpret the legislative

history differently.

     The Senate report does not state that the regulations under

sections 263A and 451 should be identical.     Nor does the Senate

report state that the same rules should apply to allocations

under the two sections.    The Senate report provides only that the

uniform capitalization rules be “patterned” after the section 451

regulations, and it explicitly acknowledges that changes may be

needed “in order to adapt such rules to production not involving

a [long-term] contract”.   The Senate report suggests that

Congress knew differences existed between allocations under

sections 263A and 451, and thus different rules would be

required.

     Respondent further contends that, by not incorporating the

reasonableness standard of the section 263A regulations into the

section 451 regulations, the “choice” of which Code section to

apply first “will lead to radically different results,” thus
                                - 44 -

violating Congress’s “intent of harmony between the two Code

sections.”    Respondent is presumably focusing on the language of

the Senate report that “in order to more accurately reflect

income and make the income tax system more neutral, a single,

comprehensive set of rules should govern the capitalization of

costs of producing, acquiring, and holding property”.       S. Rept.

99-313, supra at 140, 1986-3 C.B. (Vol. 3) at 140.       This argument

is unpersuasive.     As found above, the rules for the first level

allocations under both sections 1.263A-1(e)(3)(i) and 1.451-

3(d)(6)(ii), Income Tax Regs., are identical, requiring only that

a “reasonable allocation” be made.       The two sections can be

applied simultaneously and will end with the same result under

the first level allocation, regardless of which section the

taxpayer focuses on.

     Accordingly, we find that the legislative history does not

support incorporating the reasonableness standard of section

1.263A-1(f)(4), Income Tax Regs., into the first level

allocations under sections 1.263A-1(e)(3)(i) and 1.451-

3(d)(6)(ii), Income Tax Regs.

     D.      The Ordinary Meaning of Reasonable

     Where a term is not defined in a statute, it should be given

its ordinary meaning.     Crane v. Commissioner, 331 U.S. 1, 6

(1947); Keene v. Commissioner, 121 T.C. 8, 14 (2003); De Cou v.

Commissioner, 103 T.C. 80, 87 (1994); Goodson-Todman Enters.,
                              - 45 -

LTD. v. Commissioner, 84 T.C. 255, 277 (1985).   When there is no

indication that Congress intended the term to have a specific

meaning, courts may look to sources such as dictionaries for a

definition.   Keene v. Commissioner, supra at 14-15.

     Respondent argues that the dictionary meaning of

“reasonable” should not be used because section 1.263A-1(f)(4),

Income Tax Regs., offers specific guidance as to its meaning.

However, as discussed above, the legislative history does not

suggest that Congress intended the reasonableness standard of

section 1.263A-1(f)(4), Income Tax Regs., to apply to section

1.263A-1(e)(3)(i) or 1.451-3(d)(6)(ii), Income Tax Regs.

Therefore, we find that the term “reasonable” is not defined for

purposes of sections 1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii),

Income Tax Regs., and we may look to the dictionary definition of

the term to give it its ordinary meaning.

     “Reasonable” is defined as “being in agreement with right

thinking or right judgment: not conflicting with reason * * *

possessing good sound judgment”.   Webster’s Third New

International Dictionary 1892 (1993).   In other words, something

is reasonable if there is a   logic to it and a sound basis and

justification for it.   Because it is undefined in sections

1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax Regs., we

give “reasonable” this meaning in interpreting the phrase

“reasonable allocation”.   Accordingly, Qwest’s incremental cost
                               - 46 -

allocation method will be a “reasonable allocation” method if

there is a logic to it and a sound basis and justification for

it.

III. The Reasonableness of Qwest’s Incremental Cost Allocation
     Method

      Respondent determined that Qwest’s incremental cost

allocation method is unreasonable.      In support of this

determination, respondent argues that Qwest’s incremental cost

allocation method:   (1) Does not meet the reasonableness standard

found in section 1.263A-1(f)(4), Income Tax Regs.; (2) is

inconsistent with the congressional objective of preventing

distortion in the organization of economic activity; and (3) is

inconsistent with the Supreme Court’s requirement of taxpayer

parity.    Petitioners contend that Qwest’s incremental cost

allocation method is the most reasonable method because it

reflected the economic reality of the transactions.

      Generally, a taxpayer bears the burden of proving the

Commissioner’s determinations incorrect.      Rule 142(a)(1); Welch

v. Helvering, 290 U.S. 111, 115 (1933).24     Respondent determined

that Qwest’s cost allocation method was unreasonable, and

petitioners bear the burden of proving this determination

incorrect.


      24
        Under sec. 7491(a), the burden of proof may shift to the
Commissioner in certain situations. Petitioners do not argue
that the burden shifts to respondent.
                               - 47 -

     A.   The Reasonableness Standard of Section 1.263A-1(f)(4),
          Income Tax Regs.

     As found above, the reasonableness standard of section

1.263A-1(f)(4), Income Tax Regs., only applies to second level

allocations.   The issue in the instant case is whether Qwest’s

first level allocations, i.e., those between property produced

under its customer contracts and its retained assets, were

reasonable.    Therefore, the reasonableness standard of section

1.263A-1(f)(4), Income Tax Regs., is irrelevant in determining

whether Qwest’s incremental cost allocation method is reasonable.

     B.   Distortion in the Organization of Economic Activity

     Respondent contends that Qwest’s incremental cost allocation

method fails to match Qwest’s income and expenses, resulting in

dramatic tax deferral, and is thus unreasonable because it

violates congressional intent.    Respondent’s argument is based on

hindsight, not on the facts as they were at the time Qwest made

its allocations, and is thus unpersuasive.

     The Senate report accompanying the Tax Reform Act of 1986

states:

          The committee believes that present-law rules
     regarding the capitalization of costs incurred in
     producing property are deficient in two respects. * * *
     Second, different capitalization rules may apply under
     the present law depending on the nature of the property
     and its intended use. These differences may create
     distortions in the allocation of economic resources and
     the manner in which certain economic activity is
     organized.
                               - 48 -

          The Committee believes that, in order to more
     accurately reflect income and make the income tax
     system more neutral, a single, comprehensive set of
     rules should govern the capitalization of costs of
     producing, acquiring, and holding property * * *
     subject to appropriate exceptions where application of
     the rules might be unduly burdensome.

S. Rept. 99-313, supra at 140, 1986-3 C.B. (Vol. 3) at 140.     The

concern expressed in the Senate report is that taxpayers can

structure their economic activity in such a way that creates a

mismatch of income and expenses.    Respondent suggests that

Qwest’s goal in using its incremental cost allocation method was

to create such a mismatch.

     As an example, in the MCI Denver-El Paso project, Qwest

allocated $30,422 per conduit mile to the customer contract,

while allocating only $6,500 per conduit mile to the retained

conduit.    Respondent contends that Qwest knew its retained

conduit was worth at least $30,000 to $40,000 per conduit mile,

but Qwest intentionally allocated a disproportionate amount of

expenses to the single conduit laid pursuant to a customer

contract.    Because more expenses were allocated to the customer’s

conduit, respondent contends that Qwest’s income was understated

when Qwest reported its income on the percentage of completion

basis under section 460.    Also, fewer expenses had to be

capitalized under section 263A.    The result was that Qwest was

able to take advantage of the expense deductions up front and
                               - 49 -

delayed the recognition of income until the retained conduits

were later sold.

     Respondent’s contention assumes that Qwest knew the amount

of future economic benefit it would realize from the retained

conduits at the time it made the cost allocations.    Respondent

focuses on Qwest’s 1995 five-year plan, which stated Qwest’s goal

of offering 15,502 miles of conduit for sale to third-party

customers.   The 1995 five-year plan estimated that, if the

conduit were sold at an average of $30,000 per conduit mile, this

would generate revenue of $465 million.    Respondent also notes

that after the years in issue, Qwest was able to sell most of its

retained conduits.

     Respondent fails to consider the extensive testimony and

evidence that, at the time the allocations were made, the value

of the retained conduits was uncertain.    The estimated value of

the retained conduits at $30,000 per mile could be realized only

if the conduits were actually sold.     At the time of installation,

Qwest did not have customers lined up to purchase the retained

conduits.    In its report to Qwest, CLC concluded that the country

did not need another nationwide fiberoptic network, and Qwest’s

installation of additional conduits would be “very risky” and its

revenue projections “may be optimistic”.    Further, Mr. Anschutz

and Mr. O’Callaghan credibly testified that installing additional
                              - 50 -

conduit was speculative and Qwest knew that the retained conduit

could potentially have little or no value.

     Respondent’s accounting expert, Professor Charlotte Wright

(Professor Wright), testified:

     the question put to me was, Would an incremental cost
     accounting method * * * present a true and fair view of
     the results of operations during the current period.

          And then since these would be--capitalize future
     economic performance, it concerned me that a method
     that resulted in only minor costs--a minor amount of
     costs being capitalized * * * would result in an
     understatement of their assets in the current period
     and then, going forward, an overstatement for financial
     reporting of their profits in the future * * *.

However, Professor Wright concluded that “if there was a genuine

concern that you would never recover an allocated portion of the

total costs, then a method that allocated less to the retained

assets, such as an incremental method, would be appropriate.”

     Petitioners firmly established that the value of Qwest’s

retained conduits was uncertain when the cost allocations were

made.   Respondent’s expert testified that when the future

economic benefit of a retained asset is uncertain, a method that

allocates less expense to that asset may be appropriate.

Accordingly, we find that Qwest’s incremental cost allocation

method was not used to distort the organization of economic

activity and does not violate congressional intent.
                                 - 51 -

     C.   Taxpayer Parity

     Respondent argues that Qwest’s incremental cost allocation

method is unreasonable because it violates the principles of

taxpayer parity as required by the Supreme Court in Idaho Power

Co. v. Commissioner, 418 U.S. 1 (1974).     Respondent states:

     Because Qwest is simultaneously constructing identical
     assets for itself and for customers, Qwest’s
     incremental method must also satisfy the * * * taxpayer
     parity standards set forth in Idaho Power. By failing
     to do so, Qwest’s incremental method results in an
     unfair competitive advantage for Qwest compared to its
     competitors, a result contrary to the guidance of Idaho
     Power.

Respondent misinterprets Idaho Power Co., and thus the argument

is unpersuasive.

     In Idaho Power Co. v. Commissioner, supra, the taxpayer

capitalized depreciable operating and maintenance costs of

transportation equipment used in constructing its capital

facilities on its books, but for Federal income tax purposes, it

claimed the depreciation as current expense deductions under

section 167(a).    Id. at 5-6.   The Commissioner disallowed the

construction-related depreciation deduction, determining that

depreciation was in that context a nondeductible capital

expenditure to which section 263(a)(1) applied.     Id. at 6.    The

Supreme Court upheld the Commissioner’s determination, and

emphasized the importance of matching income with expenses by

capitalizing costs incurred in the construction of capital assets
                              - 52 -

over those assets’ useful lives.   Id. at 11-14.   The Supreme

Court also stated:

     An additional pertinent factor is that capitalization
     of construction-related depreciation by the taxpayer
     who does its own construction work maintains tax parity
     with the taxpayer who has its construction work done by
     an independent contractor. The depreciation on the
     contractor’s equipment incurred during the performance
     of the job will be an element of cost charged by the
     contractor for his construction services, and the
     entire cost, of course, must be capitalized by the
     taxpayer having the construction work performed. The
     Court of Appeals’ holding [that the taxpayer could
     currently deduct the depreciation expense] would lead
     to disparate treatment among taxpayers because it would
     allow the firm with sufficient resources to construct
     its own facilities and to obtain a current deduction,
     whereas another firm without such resources would be
     required to capitalize its entire cost including
     deprecation charged to it by the contractor.

Id. at 14.   To clarify, the Supreme Court was concerned that the

tax treatment of construction-related depreciation should be the

same between:   (1) A taxpayer who constructs its own capital

asset; and (2) a taxpayer who hires a contractor to construct a

capital asset, and thus bears the burden of that depreciation

through the price charged by the contractor for his construction

services.

     Respondent attempts to extend the tax parity rationale of

Idaho Power Co. v. Commissioner, supra, beyond what the Supreme

Court intended.   Using the MCI Denver-El Paso conduit

installation project as an example, respondent states:

     Qwest * * * had available for its own use or future
     sale to other customers three buried conduits compared
     to MCI’s one identical conduit on the Denver to El Paso
                              - 53 -

     route. Under its method, Qwest’s tax basis per conduit
     mile in each of its three conduits is $6,967 (including
     capitalized interest). MCI, on the other hand, paid
     Qwest approximately $32 million for its one conduit
     that covered 761 miles * * *. So MCI’s tax basis per
     mile in the identical asset is $41,694. This is six
     times Qwest’s basis for the identical asset.

                  *   *   *   *     *   *    *

          This huge disparity in tax basis of identical
     assets between Qwest’s assets and those of its
     customers results in Qwest having an enormous
     competitive advantage in the industry. With this
     situation, Qwest is in a position to either price its
     services lower than its competitors, to the
     competitors’ detriment, or to reap a much higher
     percentage profit than its competitors for providing
     identical services. * * * such a situation violates the
     basic principle of taxpayer parity as espoused by the
     Supreme Court in Idaho Power and is a powerful
     indication of the unreasonableness of Qwest’s
     incremental method * * * .

Idaho Power Co. v. Commissioner, supra, does not stand for the

proposition that taxpayers’ bases in identical property should be

the same, nor does it stand for the elimination of the

competitive advantage a taxpayer may have by constructing its own

capital assets.

     The principle of taxpayer parity found in Idaho Power Co. v.

Commissioner, supra, is not the same as competitive equality.

Qwest’s competitive advantage did not arise from the use of its

incremental cost allocation method, but was a function of its

business model and of the resources it had available.    We find

that Qwest’s incremental cost allocation method does not violate

the principle of taxpayer parity.
                                - 54 -

     D.    Economic Reality of Qwest’s Conduit Installation
           and Fiber Pulling Projects

     Petitioners argue that Qwest’s incremental cost allocation

method is reasonable because it reflected Qwest’s decision-making

process and was based on the economic reality of the

transactions.    However, respondent contends that Qwest’s

incremental cost allocation method did not accurately reflect its

business strategy.

            1.   Respondent’s Characterization of Qwest’s Business
                 Strategy

     Respondent argues that Qwest’s business strategy during the

years in issue was to become a full-service telecommunications

company, and that obtaining third-party contracts was simply a

means of financing the building of a nationwide fiberoptic

network.    Respondent cites Qwest’s 1995 five-year plan, which

states:    “The primary business focus of [Qwest] is to create a

nationwide, owned, facility based network and utilize it to carry

profitable, revenue traffic.”    Respondent asserts that the other

transactions during the years in issue support respondent’s

characterization.    Respondent also notes that Qwest offered

telecommunications services during the years in issue.

Respondent’s argument is based in large part on hindsight, as it

looks at the development of Qwest subsequent to the years in

issue, not as Qwest was operating during the years in issue.
                              - 55 -

     No five-year plans were ever adopted by Qwest’s Board of

Directors.   Further, Mr. Anschutz, Mr. O’Callaghan, Mr. Pearce,

and other witnesses credibly testified that Qwest’s goal during

the years in issue was not to become a full-service

telecommunications company.   Mr. Anschutz testified that “Our

intent was to make contracts with buyers for segments of

construction along the railroad and, if we could, to make money

on those contracts for construction and, in the process, lay

incremental conduit, or in some case fiber, as we went.”   While

many of Qwest’s other transactions indicate that Qwest’s business

was expanding during the years in issue, these transactions do

not contradict the witnesses’s testimony.   Many of the

transactions were entered into to service Qwest’s existing

telecommunications service customers.   When questioned about the

telecommunications services offered during the years in issue,

Mr. Anschutz explained that those services were “an experiment

during the years in issue--yes there were substantial revenues,

but even larger losses, and that’s why the experiment was shut

down.”

     It is not clear from respondent’s argument how, if we were

to accept his characterization of Qwest’s business strategy, this

would impact the reasonableness of Qwest’s incremental cost

allocation method.   Presumably, it would cast doubt on

petitioners’ characterization of the economic reality of their
                              - 56 -

transactions or on the amount of costs allocated to Qwest’s

retained conduits.   Nevertheless, for the above-stated reasons,

we do not accept respondent’s characterization of Qwest’s

business strategy.

          2.   Petitioners’ Characterization of Qwest’s
               Transactions and Decision-Making Process

     Petitioners contend that Qwest’s incremental cost allocation

method reflected Qwest’s decision-making process and the economic

reality of the underlying transactions.   Specifically,

petitioners state:

     Under its long-term customer contracts, Qwest obligated
     itself to incur costs to satisfy its contractual
     obligations, and then decided whether to make the
     incremental investment necessary to install additional
     empty conduits or fibers. In other words, Qwest’s
     basic approach was to get a customer to pay enough to
     justify installing and selling the conduit the customer
     wanted, and then to consider whether to incur the
     limited incremental risk of installing additional
     conduit for its own potential future use or sale. * * *
     Qwest’s cost allocation was entirely consistent with
     its business strategy.

As discussed below, respondent argues that several facts

contradict petitioners’ characterization.

               a.    General Procedure Followed by Qwest

     The parties stipulated that Qwest generally followed the

same procedure in its conduit installation projects:   (1) Qwest

contracted with a third-party customer for installation of

conduit over a certain route; (2) conduit was installed along

Southern Pacific’s or other railroad companies’ rights-of-way;
                              - 57 -

(3) Qwest received cash compensation or DS-3 capacity for

installing the conduit; and (4) Qwest simultaneously installed

and retained additional conduits for its own potential future use

or sale.   With respect to the IRU projects, Qwest:   (1)

Contracted with WorldCom to pull a certain number of fibers; and

(2) instead of pulling a fiberoptic cable with just enough fibers

to satisfy the IRU agreement, Qwest pulled a fiberoptic cable

with additional fibers for its own potential future use or sale.

                b.   Qwest’s Primary Focus

     Petitioners argue that Qwest would not have installed the

additional conduits or pulled additional fiber without first

having the third-party customer contracts in place.    Respondent

argues that Qwest’s primary focus was not the installation of

conduit or pulling of fiber for third-party customers, pointing

to the two projects with no third-party customer contracts in

place.25

     During the years in issue, Qwest engaged in nine conduit

installation projects for third-party customers26 and three IRU

projects for WorldCom.   In each instance, Qwest made the decision



     25
        It is important to note that the cost allocations with
respect to these two projects are not at issue; respondent only
uses them to question Qwest’s incremental cost allocation method
utilized in the projects in issue.
     26
        As noted supra, Qwest actually engaged in 12 such
conduit installation projects, but only 9 of these projects are
still in issue.
                               - 58 -

to install additional conduit or pull additional fiber only after

the customer contract was entered into.   Petitioners’ witnesses

credibly testified that Qwest would not have installed conduit or

pulled fiber for its own potential future use or sale without the

third-party customer contracts.   The Cal Fiber project and the

Dallas-Houston Project do not cast doubt on this decision-making

approach.

     In the Cal Fiber project, Qwest linked unconnected segments

of empty conduit that were previously installed and retained by

Qwest as part of the Coast Route Project.    As part of the Cal

Fiber project, Qwest laid 153 new miles of conduit to complete a

fiberoptic system from Roseville, California, to Los Angeles,

California.   The Coast Route project was the first project in

which Qwest simultaneously installed conduits for third-party

customers and multiple conduits for its own potential future use

or sale.    As a result of the Coast Route project, Qwest obtained

several unconnected segments of empty conduit along the Coast

Route.   Petitioners argue that installing conduit to connect

these segments was not a departure from Qwest’s normal business

strategy because Qwest was installing only small portions of

conduit to connect a much bigger system of conduits.    The cost

was relatively modest, and Qwest took the risk because a

connected fiberoptic system could potentially have a much higher

value.
                               - 59 -

     In the Dallas-Houston project, Qwest installed 270 miles of

conduit, pulled fiber, and lit the fiber without a third-party

contract in place.   Petitioners explain that this was not a

departure from Qwest’s normal business strategy because Qwest

began construction only after management assured Mr. Anschutz

that WilTel would purchase the conduit.   Subsequently, WilTel

purchased the Dallas-Houston conduit system.

     The Cal Fiber and Dallas-Houston projects were departures

from Qwest’s general conduit installation and fiber-pulling

procedures.   However, the significance respondent attaches to the

departures is not justified.   The testimony shows that the

projects were consistent with Qwest’s overall business strategy

of installing conduit or pulling fiber only when the risk of

doing so could be limited.   These projects do not suggest that

Qwest’s primary focus in the projects at issue was its retained

assets rather than the conduit installed or fiber pulled for the

third-party customer, as respondent contends.

     Accordingly, we find that Qwest’s primary focus in its nine

conduit installation projects and three IRU projects was the

third-party customer contracts.   But for the existence of the

third-party contracts, Qwest would not have installed additional

conduit or pulled additional fiber.
                                - 60 -

                  c.   Allocation of Costs Necessary to Complete the
                       Third-Party Customer Contracts to Those
                       Contracts

     Because certain costs were necessary to complete the third-

party customer contracts, regardless of how many additional

conduits or fiber were installed or pulled, Qwest allocated those

costs to third-party customer contracts.    Petitioners argue that

this is consistent with the economic reality of the transactions

because Qwest would not have incurred the costs absent the

customer contract.     Respondent recognizes that Qwest had to incur

certain fixed costs regardless of whether one conduit is

installed (or a 24-fiber cable is pulled), or multiple conduits

are installed (or a cable with more than 24 fibers is pulled)

simultaneously.    However, respondent argues that a portion of the

fixed costs, such as the costs of digging a trench and the costs

associated with perfecting Qwest’s rights-of-way, should also be

allocated to the retained assets because those costs also benefit

the retained assets.    Further, respondent argues that a portion

of cost adjustments based on terrain and budget overruns should

also be allocated to Qwest’s retained assets.

     As found above, Qwest would not have installed additional

conduit or pulled additional fiber without first securing the

customer contract.     Accordingly, we find that Qwest’s allocation

of those costs to only the customer contract was consistent with
                                - 61 -

Qwest’s decision-making process and the economic reality of the

transactions.

                d.     Allocation of Incremental Costs to Qwest’s
                       Retained Assets

     Qwest allocated only the direct costs of material and an

incremental portion of labor and indirect costs to its retained

conduits.   With respect to the retained fiber, Qwest allocated

only the incremental costs of installing any additional conduits

and endlinks and the costs of the retained fiber and of splicing

and testing that fiber.    Petitioners argue that the allocation of

these costs is consistent with the economic reality of the

transactions because these costs were the only additional costs

incurred by Qwest as a result of its decision to install

additional conduit or pull additional fiber.    Further,

petitioners argue that the allocation also reflected Qwest’s

willingness to incur only an incremental risk by installing the

retained assets.     Respondent does not contest that at least these

costs should be allocated to Qwest’s retained assets.      However,

respondent questions how Qwest arrived at its incremental base

rate.

     Before the years in issue, Qwest acted primarily as a

general contractor and subcontracted most of the construction

work out to third parties.    Bids submitted by subcontractors to

install only one conduit, when compared to the bids to install

multiple conduits, indicated that the third-party subcontractors
                              - 62 -

increased their bid on an incremental basis when more conduits

were added.   Qwest used this idea as the foundation for its

incremental cost allocation method and the development of its

incremental base rate.

     Mr. O’Callaghan and Mr. Pearce developed an incremental base

rate of $6,019 per conduit mile.   The incremental base rate

included:   (1) $2,376 for conduit material, assuming a cost to

Qwest of 45 cents per foot; (2) $370 for other material related

to installation; (3) $2,640 for labor attributable to the

installation of the additional conduit; (4) $581 for equipment

costs; and (5) $53 for overhead.   The incremental base rate did

not include costs such as those for of digging the trench or for

perfecting the rights-of-way, nor was it adjusted to reflect cost

increases based on terrain or budget overruns.

     First, respondent questions the development of the

incremental base rate, implying that Qwest arbitrarily arrived at

$6,019.   Mr. O’Callaghan and Mr. Pearce testified that they

looked at all costs associated with the installation of conduit

to determine what costs were fixed and what costs increased when

more conduits were added.   They then looked at the costs that

increased, such as labor, equipment costs, and overhead, and came

up with the average cost increase per conduit mile when

additional conduits were installed.    To this figure, they added

the average cost of conduit material to arrive at $6,019.   Mr.
                              - 63 -

Pearce testified that their calculations were reflected on

spreadsheets on his laptop computer, and when he retired in 1999,

he returned the computer to Qwest.     Qwest could not find the

spreadsheets.   Despite the missing underlying spreadsheets, we

find that Mr. O’Callaghan and Mr. Pearce credibly justified

Qwest’s use of an incremental base rate of $6,019.

     Respondent also questions why the incremental base rate did

not include the costs of digging the trench, costs associated

with perfecting rights-of-way, and why the base rate was not

adjusted to reflect cost increases based on terrain or budget

overruns.   However, respondent recognizes that Qwest had to incur

these costs regardless of whether one conduit or multiple

conduits were installed.   As found above, because Qwest was

obligated to incur these costs to perform its customer contracts,

allocating all of these costs to the customer contracts reflects

the economic reality of the projects.

     Because Qwest incurred only certain incremental costs to

install additional conduit or pull additional fiber, and because

Qwest was willing to incur only limited risk to do so, we find

that Qwest’s allocation of only those costs to its retained

assets was consistent with Qwest’s decision-making process and

the economic reality of the transactions.
                                 - 64 -

                 e.    Summary

     With regard to the projects in issue, petitioners have shown

that Qwest would not have installed additional conduit or pulled

additional fiber without first securing a customer contract.

Qwest’s allocation of all costs necessary to complete the

customer contract to that contract is consistent with Qwest’s

business strategy.    Qwest’s allocation of the incremental costs

to its retained assets reflects the risk involved with and the

incremental cost of installing those assets.    For these reasons,

we find that Qwest’s incremental cost allocation method is

consistent with its business strategy because it reflects Qwest’s

decision-making process and the economic reality of the projects

at issue.

            3.   Expert Testimony

     Petitioners’ cost accounting expert, Professor Charles E.

Horngren (Professor Horngren), is the Edmund W. Littlefield

Professor of Accounting, Emeritus, at Stanford University.    He

has been a professor for more than 37 years and his cost

accounting treatise, originally published in 1962, is currently

in its 12th edition.    In Professor Horngren’s expert opinion,

when costs are allocated consistently with one’s business

strategy, the allocations are reasonable.    In his expert report,

Professor Horngren explains:

          The basic Qwest idea was to get a customer who
     pays enough to justify installing and selling one
                                - 65 -

     conduit. Without that customer, investments in
     additional retained conduits are too great in amount,
     particularly when the potential benefit is so risky. *
     * * On the other hand, the incremental expected costs
     are sufficiently low to warrant accepting the risks.
     In short, the business strategy is buttressed by cost
     allocations that encourage prudent risk-taking. * * *
          Because its cost allocations harmonized with sound
     business strategy, Qwest adopted a reasonable
     allocation method.

Professor Horngren’s expert testimony strongly supports the

reasonableness of Qwest’s incremental cost allocation method.

     Professor Wright, respondent’s accounting expert, did not

conclude that Qwest’s incremental cost allocation method was

unreasonable.27    As described above, Professor Wright testified

that if the future economic value of the retained property is

uncertain, an incremental cost allocation method may be

appropriate.   Because petitioners have established that the value

of Qwest’s retained conduit was uncertain, Professor Wright’s

testimony also supports the reasonableness of Qwest’s incremental

cost allocation method.

          4.      Conclusion

     Because Qwest’s incremental cost allocation method was based

on the economic reality of the projects in issue, consistent with

its decision-making process, and supported by expert testimony,

we find that there was a logic to it and a sound basis and


     27
        Respondent also introduced the expert report of John C.
Donovan. However, Mr. Donovan’s report focused largely on FCC
regulations that were not applicable to the years in issue. For
this reason, we did not consider his report.
                                - 66 -

justification for it.     Petitioners have met their burden of

proof.     Therefore, we hold that Qwest’s incremental cost

allocation method is a reasonable allocation method for purposes

of sections 1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax

Regs.

IV.   Clear Reflection of Income and Respondent’s Average Cost
      Allocation Method

        Respondent argues that under section 446(b), respondent may

change Qwest’s method of accounting to an average cost allocation

method.     Respondent’s sole basis for this position is that,

because Qwest’s incremental cost allocation method fails to meet

the reasonableness requirement of section 1.263A-1(f)(4) and

(g)(3), Income Tax Regs., Qwest’s method of accounting does not

clearly reflect income.

        Under section 446(a), a taxpayer may compute its taxable

income under the method of accounting it regularly uses to

compute its income in keeping its books.     However, section 446(b)

vests the Commissioner with broad discretion to change the

taxpayer’s method of accounting if he determines that the

taxpayer’s particular method of accounting fails to clearly

reflect income.     Thor Power Tool Co. v. Commissioner, 439 U.S.

522, 532 (1979); Brown v. Helvering, 291 U.S. 193, 203 (1934);

Bank One Corp. v. Commissioner, 120 T.C. 174, 287-288 (2003);

Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 370

(1995); see also sec. 1.446-1(a)(2), Income Tax Regs.
                                - 67 -

       Generally, the Commissioner’s determination under section

446(b) is to be respected unless it is found to be an abuse of

discretion.     Exxon Mobile Corp. v. Commissioner, 114 T.C. 293,

324 (2000); Ansley-Sheppard-Burgess Co. v. Commissioner, supra at

371.    In reviewing the Commissioner’s determination, the function

of the Court is to determine whether there is an adequate basis

in law for the Commissioner’s conclusion.       RCA Corp. v. United

States, 664 F.2d 881, 886 (2d Cir. 1981); Ansley-Sheppard-Burgess

Co. v. Commissioner, supra at 371.       Finding that the Commissioner

abused his discretion under section 446(b) is not preconditioned

on finding that the taxpayer’s method clearly reflects income.

See Bank One Corp. v. Commissioner, supra at 289.

       Section 1.263A-1(g)(3), Income Tax Regs., does not require

that the reasonableness standard of section 1.263A-1(f)(4),

Income Tax Regs., be applied to first level cost allocations

under sections 1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii), Income

Tax Regs.     As held above, Qwest’s incremental cost allocation

method is a reasonable allocation method for purposes of sections

1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax Regs.      For

these reasons, respondent’s sole basis for arguing that Qwest’s

method of accounting does not clearly reflect income necessarily

fails.    Respondent’s determination that Qwest’s incremental cost

allocation method fails to clearly reflect income does not have

an adequate basis in the law.     Therefore, we hold that respondent
                                - 68 -

abused his discretion and may not change Qwest’s incremental cost

allocation method to an average cost allocation method under

section 446(b).

V.   Conclusion

     Petitioners have met their burden of proving that Qwest’s

incremental cost allocation method is a reasonable allocation

method for purposes of sections 1.263A-1(e)(3)(i) and 1.451-

3(d)(6)(ii), Income Tax Regs.    Additionally, respondent’s

determination that Qwest’s incremental cost allocation method

failed to clearly reflect income was an abuse of discretion, and

thus respondent may not change Qwest’s method to an average cost

method.

     In reaching our holdings, we have considered all arguments

and contentions made, and, to the extent not mentioned, we

conclude that they are moot, irrelevant, or without merit.

     To reflect the foregoing and the concessions of the parties,

                                               Decision will be

                                          entered under Rule 155.
