lic utility property, and federal income tax expense by reason of which the ITC is limited) is consistent with the commission's ratemaking authority over public utility property to which section 46(f) applies in accordance with section 1.46-6(b) (1) of the regulations. Whether the exclusion of nonpublic utility operations from the computation of ratemaking costs is consistent with the requirements of section 46 (f) (2) of the Code (even though the amount of ITC so computed may exceed the amount of ITC from investments in public utility property allowed based on the combined taxable income from public utility and nonpublic utility operations) may be analyzed as follows: Section 46(f) of the Code recognizes that in a ratemaking context there is a fundamental relationship between the use of the ITC, the rate base, and the cost of service. In its exclusion of nonpublic utility operations in this case, the regulatory commission has not isolated the ITC from other ratemaking factors but has kept constant the ITC's fundamental relationship with other cost of service factors. In particular, although the ITC used to reduce cost of service is greater than ITC actually allowed, the federal income tax expense (used to compute cost of service) by which ITC is limited under section 46(a), is commensurately greater than federal income taxes incurred. HOLDING The amount of ITC that this public utility taxpayer flows-through to income does not exceed the ratable portion allowed to be flowed-through by reason of the taxpayer's election of section 46 (f) (2) of the Code. Section 47.-Certain Dispositions, etc., of Section 38 Property 26 CFR 1.47-1: Recomputation of credit allowed by section 38. Business investment credit for energy property. See T.D. 7765, page 22. Section 48.-Definitions; Special 26 CFR 1.48-1: Definition of section 38 property. Investment credit; self-constructed property; constructionrelated depreciation. The basis of self-constructed section 38 property includes depreciation sustained on construction assets for which no investment credit was allowable and excludes depreciation sustained on construction assets for which investment credit was allowable; Rev. Rul. 69-228 revoked. Rev. Rul. 81-1 ISSUE Does the basis of self-constructed "section 38 property" include depreciation sustained with respect to any other property used in the construction of such self-constructed property for purposes of the investment tax credit? FACTS The taxpayer, a corporation, uses its own motor vehicles and other equipment in the construction of new plant facilities that qualify for the investment tax credit. Depreciation attributable to the use of the construction assets was capitalized and properly included in the basis of the new selfconstructed plant facilities for depreciation purposes. LAW AND ANALYSIS Section 38 of the Internal Revenue Code provides a credit against federal income tax for investment in section 38 property. The determination of what property qualifies as section 38 property is made under rules provided in section 48. Section 46 of the Code provides for the determination of the amount of the investment tax credit to be allowed by section 38 for qualified investment. Section 1.46-3 (c) (1) of the Income Tax Regulations provides that the basis of any new section 38 property shall be determined in accordance with the general rules for determining the basis of property. Thus, the basis of property would generally be its cost, unreduced by the adjustment to basis provided by section 48(g)(1) of the Code with respect to property placed in service before January 1, 1964, and any other allowable adjustments to basis, such as depreciation, and would include all items properly includable in the depreciable basis of the property, such as the costs of installation and freight. However, for purposes of determining qualified investment, the basis of new section 38 property constructed by the taxpayer shall not include any depreciation sustained with respect to any other property used in construction of such new section 38 property Section 1.46-3 (c) (1) is cross-referenced to section 1.48-1(b) (4). Section 48 of the Code provides that the term "section 38 property" means property with respect to which depreciation is allowable and having a useful life of three years or more. Section 1.48-1 of the regulations discusses this requirement for property to qualify as "section 38 property." Section 1.48-1(b) (4) provides that if depreciation sustained on property is not an allowable deduction for the taxable year but is added to the basis of property being constructed, for investment credit purposes, a deduction for depreciation shall be treated as allowable for the taxable year with respect to the property on which depreciation is sustained. For example, if $1,000 of depreciation sustained with respect to property No. 1, which is placed in service in 1964 by taxpayer A, is not allowable to A as a deduction for 1964 but is added to the basis of property being constructed by A (property No. 2), a deduction for depreciation shall be treated as allowable to A for 1964 with respect to property No. 1. However, the $1,000 amount is not includ For purposes of qualifying the construction assets of section 38 property, section 1.48-1 (b) (4) of the regulations recognizes that depreciation of the construction assets is treated as allowable for the taxable year even though that depreciation is capitalized as part of the cost of self-constructed assets. The construction assets, if otherwise qualified as section 38 property will qualify for the investment tax credit in the year they are placed in service. In addition, the investment credit will not be subject to recapture under section 47 of the Code merely because these assets are used in constructing other assets. However, for purposes of computing the investment tax credit for the self-constructed assets, sections 1.46-3 (c) (1) and 1.48-1 (b) (4) exclude from basis any depreciation attributable to these construction assets. The exclusion of depreciation is necessary to prevent the cost of the construction assets from being used twice for investment tax credit purposes, once when that asset was placed in service and again as part of the basis of the new self-constructed section 38 property when that asset is placed in service. Section 1.46-3(c)(1) of the regulations contains the rule that for purposes of determining qualified investment, the basis of self-constructed section 38 property shall not include any depreciation with respect to any other property used in its construction and refers to section 1.48-1 (b) (4). Section 1.48-1(b) (4) governs the year in which depreciation of construction assets is considered allowable for investment credit purposes and illustrates the section 1.46-3 (c) (1) rule with an example in which depreciation of a construction asset is excluded from the basis of a self-constructed asset. Since these regulations deal in part with the same subject matter, they should be construed together. Section 1.48-1(b) (4) of the regulations, which applies the principle in section 1.48-1 (b) (1) governing when depreciation is allowable, is addressed only to construction assets that are section 38 property. Therefore, because section 1-48-1(b) (4) deals in part with section 1.46-3 (c) (1) and should be construed in conjunction with that regulation, section 1.46-3(c)(1) likewise refers only to construction assets that are section 38 property. See concurring opinion in United Telecommunications, Inc. v. Commissioner, 65 T.C. 278 (1975), acq. in result, 1980-1 C.B. 1, supplemented by 67 T.C. 760 (1977), aff'd 589 F.2d 1383 (10th Cir. 1978). HOLDING For investment tax credit purposes, the basis of self-constructed assets includes depreciation sustained on construction assets for which no investment tax credit was allowable and excludes depreciation sustained on construction assets for which investment tax credit was allowable. EFFECT ON OTHER REVENUE RULINGS Rev. Rul. 69-228, 1969-1 C.B. 29, concerns capitalized depreciation on construction equipment acquired by the taxpayer prior to January 1, 1962 (non-section 38 property) used to construct new plant facilities that qualify as section 38 property. It concludes that such depreciation is not includable in the basis of the plant facilities for purpoess of determining qualified investment. Since that conclusion is inconsistent with the above ruling, Rev. Rul. 69-228 is revoked. 26 CFR 1.48-1: Definition of section 38 property. Investment credit; cafeterias. The operation of cafeterias is a retail activity, not a manufacturing activity within the meaning of sec tion 48(a)(1)(B)(i) of the Code, and leasehold improvements to the cafeteria facility that are not tangible personal property do not qualify as section 38 property. Rev. Rul. 81-66 ISSUE Is the preparation of food and drink by cafeteria employees for direct sale to the public a manufacturing activity within the meaning of section 48(a) (1) (B) (i) of the Internal Revenue Code? FACTS The taxpayer is a corporation that operates a number of cafeterias and is engaged in the business of selling prepared food and drink to the public primarily for consumption on the premises of these cafeterias. Most of the food items sold to customers are prepared by cafeteria employees on the site. In 1977, the taxpayer opened several new cafeterias on leased premises. The leases are generally for a term of 20 years. Each of these cafeterias contains approximately 12,000 square feet of floor space and seats about 300 customers. The leases provide that the lessor will furnish the building and certain unfinished interior improve ments and that the lessee will finish all unfinished improvements and add certain other leasehold improvements required for the operation of a cafeteria. The leasehold improvements made by the lessee, with the exception of trade fixtures and signs, will become the property of the lessor upon termination of the lease. The leasehold improvements in issue are outside the cafeteria buildings, are depreciable property, and have useful lives of 3 years or more. LAW AND ANALYSIS Section 38 of the Code allows a credit against federal income tax for qualified investment in "section 38 property." The determination of what property qualifies as section 38 property is made in accordance with the rules provided in section 48. Section 48(a)(1) of the Code provides that the term "section 38 property" means (a) tangible personal property or (b) other tangible property (not including a building and its structural components) used as an integral part of certain specified activities such as manufacturing. Section 1.48-1 (d) (2) of the Income Tax Regulations provides that for purposes of the credit allowed by section 38 of the Code the term "manufacturing" includes the construction, reconstruction, or making of property out of scrap, salvage, or junk material, as well as from new or raw material, by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles. If the activities associated with the operation of a cafeteria are manufacturing within the meaning of section 48(a)(1)(B) of the Code, property that is determined to be other tangible property (except for a building and its structural components) used as an integral part of such activity may qualify as section 38 property. The Committee Reports for the Revenue Act of 1962 [Pub. L. 87-834, 1962-3 C.B. 111] (H.R. Rep. No. 1447, 87th Cong., 2nd Sess. (1962), 1962-3 C.B. 405, 516; S. Rep. No. 1881, 87th Cong., 2nd Sess. (1962), 1962-3 C.B. 707, 859) state that the term “manufacturing" is to be given its commonly accepted meaning. Activities involving the sale of merchandise, food and other items to the general public for personal or household consumption, and the rendering of services incidental to the sale of goods are considered to be retail activities rather than manufacturing within the commonly accepted meaning of the term. Processing incidental or subordinate to selling is often conducted at retail stores. For example, drug stores prepare prescriptions, restaurants pre pare meals, and meat markets cut meat. The operation of a cafeteria, like the operation of a restaurant or cafe, is considered in the trade to be a retail activity rather than a manufacturing activity. The food and drink prepared by the cafeteria employees is for direct sale to and for the consumption by the general public. The food preparation activity is incidental or subordinate to the selling of the prepared meals and is not considered to be similar to any of the activities encompassed by the definition of manufacturing provided by section 1.48-1 (d) (2) of the regulations. HOLDING The operation of cafeterias is a retail activity and not a manufacturing activity within the meaning of section 48(a)(1) (B) (i) of the Code. Therefore, leasehold improvements to the cafeteria facility that are not tangible personal property as defined in section 1.48-1(c) of the regulations do not qualify as section 38 property. 26 CFR 1.48-1: Definition of section 38 property. Investment credit; pollution control property. A water piping system, a waste water collection tank, and a deep well constructed and used by a chemical manufacturing company for waste removal and disposition qualify as section 38 property. Rev. Rul. 81-120 ISSUE Do certain assets that qualify as other tangible property and are used for pollution control purposes qualify, under the circumstances described below, for the investment tax credit provided by section 38 of the Internal Revenue Code? FACTS The taxpayer, a chemical manufac turing corporation, is a bulk producer of heavy chemicals by continuous or batch-continuous processes. The principal products produced are sulfuric acid, hydrofluoric acid, and alum. The taxpayer constructed, as part of its new production facility, a river water piping system, a waste water collection tank, and a deep well in order to meet the pollution control requirements of the state and Federal governments. These specifically named assets are owned and used by the taxpayer. As part of its pollution control program, the taxpayer developed a cooling process for removing waste hydrogen fluoride gas from the effluent gas stream produced during the process used to manufacture hydrofluoric acid. This cooling process changes the hydrogen fluoride from a gas to a liquid by taking cooling water from the adjacent river and circulating it around pipes containing hydrogen fluoride gas. Since the water never mixes with the gas, it is returned to the river through the river water piping system without being treated. The recovered liquid hydrogen fluoride is either sold or reused in the manufacturing process. Another part of the pollution control program is the inherently permanent, free-standing, rubber-lined, steel waste water collection tank. Usually an acid stream is recirculated through the cooling towers to reduce the temperature of the process gas. However, when the cooling towers are being washed and are not available, river water is then diverted to a separate facility for cooling the hydrogen fluoride. While the cooling towers are out of service for repairs, river water may also be used for washing the towers because the towers are not being used for processing. When the river water is used in the separate facility for directly cooling the hydrogen fluoride, or is used to wash the cooling towers, it comes in contact with the gas and becomes acidic. The acidic water cannot be discharged into the river until it is properly treated. In order to accomplish this, the acidic water is collected in the waste water tank and part of the water is recycled into the gas process, the rest of the water is treated before being discharged. In addition, as part of a disposal system for liquid wastes generated by the acid production process, the taxpayer constructed a deep well that is lined with a steel casing and a protective plastic liner and is about 5,000 feet deep. The waste products disposed of in this manner are not reused. All the assets in question are depreciable property with a useful life of 3 years or more. LAW AND ANALYSIS Section 38 of the Code allows a credit against federal income tax for qualified investment in "section 38 property." Section 48 of the Code provides that the term "section 38 property" means tangible personal property, or other tangible property (not including a building or its structural components) if such other property is used as an integral part of certain specified activities, or constitutes a bulk storage facility used in connection with these specified activities. Section 1.48-1(a) of the Income Tax Regulations provides that the term "section 38 property' means property (1) with respect to which depreciation (or amortization in lieu of depreciation) is allowable to the taxpayer, (2) which has an estimated useful life of 3 years or more (determined at the time such property is placed in service), and (3) which is either (i) tangible personal property, or (ii) other tangible property used as an integral part of manufacturing, production, or extraction, or is a storage facility used in connection with any of the foregoing activities. Section 1.48-1 (d) (4) of the regulations provides that property is used as an integral part of a specified activity if it is used directly in the activity and is essential to the completeness of the activity. To qualify as section 38 property, an asset used for pollution control that is properly classified as other tangible property must be used as an integral part of one of the activities specified in section 1.48-1(a) of the regulations or in the case of a qualifying storage facility, the asset must be used in connection with one of the specified activities. In Rev. Rul. 73-420, 1973-2 C.B. 9, the taxpayer's disposal dams were used directly in the taxpayer's mineral extraction activity and were essential to the completeness of such activity. Therefore, the disposal dams were held to be an integral part of a qualified activity within the meaning of section 1.48-1(d) (4) of the regulations. In the present case, the river water piping, the waste water collection tank, and the deep well are used for waste removal and disposal. These items of property, which are used for the removal and disposition of waste material, are essential to the manufacturing process and are used directly in the activity. Therefore, each of these items of property is used as an integral part of a qualifying activity within the meaning of section 1.48-1 (d) (4) of the regulations. HOLDING The piping system for recycling the cooling water, the waste water collection tank, and the deep well qualify as section 38 property for purposes of the investment tax credit. 26 CFR 1.48-1: Definition of section 38 property. Investment credit; lodging facilities; furniture. Furniture leased to owners and operators of apartment buildings, duplex houses, and similar establishments that lease those facilities to tenants for periods of more than 30 days is property used in connection with the furnishing of lodging and is not section 38 property for investment credit purposes. However, furniture leased directly to tenants of those facilities qualifies as section 38 property for purposes of the credit. Rev. Rul. 78-438 revoked. Rev. Rul. 81-133 ISSUE Is furniture leased to customers under the circumstances described below property used in connection with the furnishing of lodging and, therefore, not "section 38 property" for investment tax credit purposes? FACTS Situation 1-The taxpayer, a corfurniture. It leases furniture to owners poration, is in the business of leasing and operators of apartment buildings, duplex houses, and similar establish ments that lease those facilities to tenants for periods of more than 30 days. All of the furniture is depreciable, tangible personal property with a useful life of 3 years or more. Situation 2-The facts are the same as in Situation 1 except that the furniture is leased directly to tenants in those facilities. LAW AND ANALYSIS Section 48(a) (3) of the Internal Revenue Code provides that property that is used predominantly to furnish lodging or in connection with the furnishing of lodging shall not be treated as section 38 property. In Situation 1, the taxpayer leases furniture to owners and operators of lodging facilities. The furniture is used. predominantly in serving tenants and is property used in connection with the furnishing of lodging as that term is defined in section 48(a) (3) of the Code. In Situation 2, however, the tenants, who are the lessees, do not furnish lodging to themselves. Therefore, the furniture leased to the tenants is not used predominantly to furnish lodging or in connection with the furnishing of lodging. In Aaron Rents, Inc. v. United States, 462 F. Supp. 65 (N.D. Ga. 1978), the court held that the taxpayer was not entitled to the investment tax credit, allowed by section 38 of the Code, with respect to furniture leased to owners or operators of apartment houses or other types of lodging facilities. The taxpayer was, however, entitled to the credit for furniture leased directly to tenants of those facilities. HOLDING The furniture leased to owners and operators in Situation 1 is property used in connection with the furnishing of lodging and, therefore, is not section 38 property for investment tax credit purposes. However, the furniture leased directly to tenants in Situation 2 is not property used predominantly to furnish lodging nor is it used predominantly in connection with the furnishing of lodging and, therefore, is section 38 property for purposes of the credit. EFFECT ON OTHER DOCUMENTS Rev. Rul. 78-438, 1978-2 C.B. 10, which held furniture leased by a taxpayer to tenants in lodging facilities to be property used in connection with the furnishing of lodging and, therefore, not section 38 property for investment tax credit purposes, is revoked. 26 CFR 1.48-9: Definition of energy property. (Also Section 47; 1.47-1.) T.D. 7765 TITLE 26.-INTERNAL REVE- Investment Credit AGENCY: Internal Revenue Service, after consultation with the DepartTreasury. ACTION: Final regulations. SUMMARY: This document contains final regulations relating to the business investment credit for energy property. Changes in the applicable tax law were made by the Energy Tax Act of 1978 [Pub. L. 95-618, 1978-3 C.B. (Vol. 2) 1]. These regulations will provide the public with the guidance needed to comply with the law. DATES: These regulations are effective, in general, for the period beginning on October 1, 1978, and ending December 31, 1982. FOR FURTHER INFORMATION CONTACT: Mary Frances Pearson of the Legislation and Regulations Division, Office of the Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, Attention: CC: LR:T (202-566-3458, not a toll-free number). SUPPLEMENTARY BACKGROUND This document contains amendments to the Income Tax Regulations (26 CFR Part 1) under section 48 of the Internal Revenue Code of 1954. These amendments were proposed in the Federal Register for September 19, 1980 (45 F.R. 62496). A public hearing concerning the proposed amendments was held on December 4, 1980. These amendments conform the regulations to certain changes made by section 301 (b) of the Energy Tax Act of 1978 (Pub. L. 95-618, 92 Stat. 3174 [supra at 21]) and are issued under the authority contained in Code sections 7805 (68A Stat. 917, 26 U.S.C. 7805) and 38(b) (76 Stat. 962, 26 U.S.C. 38). After careful consideration of the comments submitted in response to the notice of proposed rulemaking, and ment of Energy, the proposed rules are adopted, as revised by this Treasury Decision. WINDFALL PROFIT TAX This regulation does not reflect any amendments under sections 221-223 of the Crude Oil Windfall Profit Tax Act of 1980 (Pub. L. 96-223, 94 Stat. 229 [1980-3 C.B. 2, 32-39]). Under that Act, certain categories of energy property have been expanded and effective dates for certain energy property have been extended. A subsequent notice of proposed rulemaking will cover those amendments. IN GENERAL In general, a taxpayer may claim a 10-percent investment credit (regular credit) for certain tangible business property. The taxpayer may apply the regular credit against a portion of its tax liability. Unused credits may be carried forward or carried back. If property for which the regular credit was claimed is disposed of before the end of its estimated useful life, the credit must be recomputed on the basis of its actual life. For the period beginning October 1, 1978, and ending December 31, 1982, section 301(b) of the Energy Tax Act of 1978 [Pub. L. 95-618, 1978-3 C.B. (Vol. 2) 1, 21] adds a 10 percent credit for energy property (energy credit). The rules for the regular credit apply, in general, to the energy credit. However, the energy credit may offset 100 percent of the tax liability remaining after applying the regular credit. Energy property is defined as alternative energy property, solar or wind energy property, specially defined energy property, recycling equipment, shale oil equipment, and equipment used to produce natural from gas geopressured brine. Energy property must be new section 38 property. For the energy credit only, buildings and |