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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.
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