67 T.C. 760">*760 SUPPLEMENTAL OPINION

On November 10, 1975, we filed our Findings of Fact and Opinion in the instant case (65 T.C. 278">65 T.C. 278), which held that petitioner ¹ was entitled to include in the basis of self-constructed telephone and powerplant properties that qualify as new section 38 property the capitalized depreciation of property used in its construction on which no investment credit had been allowed.

1977 U.S. Tax Ct. LEXIS 160">*162 The problem with which we were faced in our prior opinion is outlined in detail therein. The following brief recapitulation 67 T.C. 760">*761 is necessary, however, in order to understand more easily the issue now before us: The Supreme Court has held that depreciation on capital assets used in the construction of other capital assets must be treated for tax purposes as a cost of acquiring the constructed asset and, therefore, such depreciation must be capitalized as part of the basis of the constructed asset rather than taken as a current deduction. Commissioner v. Idaho Power Co., 418 U.S. 1">418 U.S. 1 (1974). Section 48(a)(1) defines "section 38 property," inter alia, as property "with respect to which depreciation * * * is allowable." A logical interplay of Idaho Power and section 48(a)(1) would mean that once a capital asset was used in the construction of another capital asset, ² a depreciation deduction with respect to the construction-related asset would no longer be allowable (because it must instead be capitalized), and the construction-related asset would at that point cease to qualify as section 38 property. Once the asset no longer qualifies as section1977 U.S. Tax Ct. LEXIS 160">*163 38 property, section 47 ³ would become applicable, and a part or all of the investment credit taken on the construction-related asset would be recaptured.

1977 U.S. Tax Ct. LEXIS 160">*164 Respondent's regulations, however, do not permit the tax consequences to proceed in this fashion. Section 1.48-1(b)(4), Income Tax Regs., in defining "depreciation allowable," provides that where depreciation on a construction-related asset is not allowed as a deduction but must be capitalized as part of the basis of the constructed asset, a deduction for depreciation shall be treated as allowable for the taxable year with respect to the property on which the depreciation is sustained. Thus, because respondent treats the deduction as 67 T.C. 760">*762 allowable for the taxable year, the asset continues to qualify as a section 38 asset for that year and no recapture is effected. Respondent's generosity is tempered, however, by section 1.46-3(c)(1), Income Tax Regs., which provides, in part, as follows:

However, for purposes of determining qualified investment, the basis of new section 38 property constructed, reconstructed, or erected by the taxpayer shall not include any depreciation sustained with respect to any other property used in the construction, reconstruction, or erection of such new section 38 property. * * *

In our prior opinion, we recognized that the regulatory scheme1977 U.S. Tax Ct. LEXIS 160">*165 of sections 1.46-3(c)(1) and 1.48-1(b)(4) was at odds with the normal interaction of Idaho Power and the investment credit statutory provisions; nevertheless, we held that such an approach was reasonable and consistent with the statutes' purpose in that it served to prevent manipulations by taxpayers whereby they could receive, in essence, a double investment credit. 65 T.C. 278">65 T.C. 286.

However, we held the above-quoted portion of section 1.46-3(c)(1), Income Tax Regs., to be invalid to the extent that, in determining the qualified investment in new section 38 constructed property, it excluded from that property's basis the capitalized depreciation on construction-related assets on which no investment credit had been previously allowed. Because no investment credit had been allowed with respect to these assets, we found the regulatory abuse-prevention scheme to be inapplicable. 65 T.C. 278">65 T.C. 287.

The issue now before us arises out of petitioner's objection to respondent's deficiency computation submitted to this Court under Rule 155, Tax Court Rules of Practice and Procedure.

In order to understand the present controversy, 1977 U.S. Tax Ct. LEXIS 160">*166 it is first necessary to examine the manner in which the actual amount of the allowable investment credit is computed. For the taxable years before us (1964 and 1965), section 46(a) allowed an investment credit equal to 7 percent of a taxpayer's "qualified investment" in section 38 property. For these same years, section 46(c) defined "qualified investment" in new section 38 property as follows:

(c) Qualified Investment. --

67 T.C. 760">*763 (1) In general. -- For purposes of this subpart, the term "qualified investment" means, with respect to any taxable year * * *

* * *

(2) Applicable percentage. -- For purposes of paragraph (1), the applicable percentage for any property shall be determined under the following table: