By Kim Dixon

WASHINGTON (Reuters) - The U.S. Tax Court ruled on Tuesday against the Internal Revenue Service in a closely watched dispute over the legality of interest tax breaks taken by UK utility Scottish Power, in the first major decision in years weighing the issue.

The IRS challenged $932 million in interest deductions taken by the Scottish Power on $4 billion in notes issued between company units. The IRS argued the deals should be treated as equity, which would nullify the tax breaks.

The Tax Court, which reviews the bulk of trial-level tax cases, said the government did not prove its case and ruled the deductions legal.

"We recognize that there are features in this case pointing to both debt and equity," the Tax Court said in its ruling. "Nevertheless, in view of the record as a whole, we find that the advance was more akin to debt than equity."

Among factors the court cited, were the specified maturity rates of the debt and the expectation of repayment.

The IRS has been scrutinizing corporate debt issuance to foreign units for years, at times arguing deals are structured to skirt billions of dollars in tax. The Scottish Power ruling was the Tax Court's first major decision in this area since the late 1990s.

Under corporate tax law, interest paid on debt is tax deductible, a feature of the U.S. tax code that is often abused and that critics say unwisely favors debt over equity. In this case, Scottish Power's deductions cut its taxable U.S. income.

Scottish Power is one of Britain's "Big Six" energy suppliers; it is a unit of Iberdrola Renewables, owned by Spain's Iberdrola SA, one of the world's largest utilities.

The Scottish Power case involved the company's 1999 purchase of U.S. utility PacifiCorp. A separate U.S. corporate unit became the parent company, which then issued fixed-rate notes to Scottish Power.

Multinational companies say they have the right to structure subsidiaries as they like, with debt or equity, regardless of the business purpose or accompanying tax benefits.

Foreign companies, particularly in the UK, have developed highly structured ways of developing interest deductions in the United States to trim their U.S. tax bills without generating taxable income in the UK, tax lawyers said.

Though interest expenses on debt are deductible in the United States, dividend payments on shares of stock are not.

(Reporting by Kim Dixon; Editing by Kevin Drawbaugh and Leslie Adler)