Alaska v. ConocoPhillips, 3AN-10-05484 CI, (Alaska 2011) State's Brief

8/4/2019 Alaska v. ConocoPhillips, 3AN-10-05484 CI, (Alaska 2011) State's Brief

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IN THE SUPERIOR COURT FOR THE STATE OF ALASKATHIRD JUDICIAL DISTRICT AT ANCHORAGE

CONOCOPHILLIPS ALASKA, INC.,

STATE OF ALASKA, DEPARTMENT OFREVENUE, TAX DIVISION,

Appellee.

Appellant,v.

))))))) Case No. 3AN.. I0 ..05484 CI) OAR No. 07-0565-TAX))

- - - - - - - - - - - - - - - - - )APPEAL FROM THE OFFICE OF ADMINISTRATIVE HEARINGS,CHIEF ADMINISTRATIVE LAW JUDGE TERRY L. THURBON, PRESIDING

APPELLANT'S BRIEFDANIEL S. SULLIVANATTORNEY GENERAL

Kenneth J. Diemer (AK Bar No. 9211075)Assistant Attorney GeneralAlaska Department ofLaw1031 W. 4th Avenue, Suite 200Anchorage, AK 99501(907) 269-5255R. Scott Taylor (AK Bar No. 8507110)Senior Assistant Attorney GeneralAlaska D e ~ a r t m e n t of Law1031 W.4 Avenue, Suite 200Anchorage, AK 99501(907) 269-5255

Filed in the Superior Courtin Anchorage, Alaskathis _ day ofNovember 2010.By: _

Clerk of Superior Court


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TABLE OF CONTENTSINTRODUCTION AND SUMMARY OF ARGUMENT 1JURISDICTIONAL STATEMENT 3ISSUES PRESENTED FOR REVIEW 4STATEMENT OF THE CASE 4ARGUMENT 9I. CONOCOPHILLIPS' PAY1VIENT OF A MAKE-WHOLE PREMIUMUPON

THE EARLY TERMINATION OF ITS TANKER LEASE IS NOT ANORDINARY AND NECESSARY COST INCURRED TO TRANSPORT ITSOIL UNDER 5 AAC 55.191(a) 9

II. THE DEPARTMENT REASONABLY INTERPRETED ITS PRODUCTIONTAX REGULATIONS TO EXCLUDE THEMAKE-WHOLE PREMIUMPAYMENT FROM CONOCOPHILLIPS' DEDUCTIBLE TRANSPORTATIONCOSTS 14

III. THE DEPARTMENT REASONABLY INTERPRETED ITS PRODUCTIONTAX REGULATIONS TO TREAT THE PER-BARREL FEE RECEIVED FOROIL EXCHANGED WITH WILLIAMS AS AN OFFSET TOTRANSPORTATION COSTS 21

CONCLUSION 26


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TABLE OF AUTHORITIESCasesKuzmin v. State, Commercial Fisheries Entry Comm 'n, 223 P.3d 86

(Alaska 2009) 15, 17,25State, Dep 't0/Revenue v. Atlantic Richfield Company, 858 P.2d 307(Alaska 1993) 3, 8, 16State, Dep't o/Revenue v. DynCorp, 14 P.3d 981 (Alaska 2000) 8,15,21State, Dep't o/Revenue v. Parsons, Corp., 843 P.2d 1238 (Alaska 1992) 16Tesoro Alaska Petroleum Co. v. Kenai Pipe Line Co., 746 P.2d 896(Alaska 1987) 8, 15, 16,26Welch v. Helvering, 290 U.S. 111 (1933) 12,18,19

StatutesAS 22.1 0.020(d) 4AS 43.05.240 24AS 43.05.241 24AS 43.05.245 24, 25AS 43.05.480(a) 4AS 43.55 150(A) 11AS 44.62.560 4Former AS 43.55.011(b) 1, 23Former AS 43.55.150 1,9FonnerAS 43.55.150(a) 13

RulesAlaska Rule ofAppellate Procedure 602(a)(2) 4

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Regulations15 AAC 55.151(b) 2315 AAC 55.151(b)(3) 23,2515 AAC 55.180 9, 15, 17, 2315 AAC 55.180(a) 915 AAC 55.191 13,2315 AAC 55.191(a) passim15 AAC 55.191 (b) 915 AAC 55. 191 (b)(3)(D) 2015 AAC 55.191U) 1315 AAC 55.195(a) 915 AAC 55.195(b)(c)(f)(h) 1015 AAC 55.196 10,15,2015 AAC 55.196(d) 15

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AUTHORITIES PRINCIPALLY RELIED UPON

AS 43.55.011 states in part:

(b) The percentage-of-value amount equals 12.25 percent of the gross value at the pointofproduction of taxable oil produced on or before June 30, 1981, from the lease orproperty and 15 percent of the gross value at the point of production of taxable oilproduced from the lease or property after June 30, 1981; except that for a lease orproperty coming into commercial oil production after June 30, 1981, the percentage-ofvalue amount equals 12.25 percent of the gross value at the point of production of taxableoil produced from the lease or property in the first five years after the start of commercialoil production and equals 15 percent of the gross value at the point of production oftaxable oil produced thereafter from the lease or property.AS 43.55.150 states in part:(a) For the purposes ofAS 43.55.011-43.55.150, the gross value shall be calculated usingthe reasonable costs of transportation of the oil or gas. The reasonable costs oftransportation shall be the actual costs . . .15 AAC 55.151 states in part:

(b) The gross value at the point of production for a producer's oil or gas must becalculated as follows:(1) a destination value must be determined for the oil or gas. . .(2) except as otherwise provided under (i) of this section, the producer'sreasonable costs of transportation under 15 AAC 55.180 and 15 AAC 55.191 must besubtracted from the destination value determined under (1) of this subsection; . . .(3) if oils of different qualities or oil and NGLs are commingled, the valuecalculated under (2) of this subsection must be adjusted for any consideration paid orreceived for quality differentials, regardless ofwhether prescribed by a filed tariff;15 AAC 55.180 states in part:(a) Except as provided in (b) of this section, the reasonable cost of transportation is theactual cost of transportation as determined in 15 AAC 55.191(a) and (b), if the actualcosts incurred are ordinary and necessary transportation expenses.

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15 AAC 55.191 states in part:(a) Reasonable costs of transportation are the ordinary and necessary costs incurred totransport the oil or gas from the point ofproduction to the sales delivery point . . .(b) Actual costs of transportation allowable for purposes of 15 AAC 55.180(a)are

(3) if transportation of oil is by a vessel that is owned or effectively owned, inwhole or in part, by the producer of that oil, the producer's actual cost for thattransportation, which is the sum of

(C) depreciation of the vessel as calculated by the producer for financialaccounting purposes and used for reporting income and expenses to shareholders andowners, or as provided in 15 AAC 55.195(a), (b), (c), (t) or (h) or 15 AAC 55.196, asapplicable; and(D) an amount that, when added to the amount of depreciation allowedunder (C) of this paragraph, will provide a reasonable return on the acquisition cost, asprovided in 15 AAC 55.195(a), of the vessel over its expected useful life as used forfinancial accounting purposes and used for reporting income and expenses toshareholders and owners, or on the adjusted shipyard cost or invested capital as provided

in 15 AAC 55.l95(b), (c), (1), or (h) or 15 AAC 55.196 as applicable;

(0) A producer shall report any reimbursed costs to the department. Reimbursed costs arenot allowable as actual costs of transportation under this section.15 AAC 55.195 states in part:

(b) For a vessel or LNG facility placed in service on or after January 1, 1995, and beforeJanuary 1,2002, or for a capitalized improvement placed in service on or after January 1,1995, and before January 1, 2002, that extends the life of a vessel or LNG transportationfacility, (1) a reasonable return including depreciation under 15 AAC 55.191(b)(3)(C)and (D) or each $1,000,000 of adjusted shipyard cost, for oil or gas produced beforeJanuary 1, 2002; and (2) a cost of capital allowance will be allowed as provided in (d) or(f) of this section or 15 AAC 55.196, as applicable, for oil or gas produced on or afterJanuary 1, 2002 . . .

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15 AAC 55.196 states in part:(a) Except if 15 AAC 55.l95(a) applies, for oil or gas produced on or after January 1,2003, a cost of capital allowance that consists of depreciation and a return on investedcapital will be allowed under this section for a vessel, or an improvement completed onor after January 1, 2002 to a vessel, owned or effectively owned by the producer,asprovided in 15 AAC 55.191. However, a producer may elect to expense the first$1,000,000 in costs incurred with respect to improvements during a calendar year

(d) A cost of capital allowance under this section must be calculated using themethodology set out in the department's publication Computationof a Cost-of- CapitalAllowance under 15 AAC 55.196, Incorporating Depreciation and Return on InvestedCapital for Marine Vessels and Improvements, dated November21,2002 and adopted byreference.

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INTRODUCTION AND SUMMARY OF ARGUMENTThis is an appeal by the Alaska DepartmentofRevenue of a decision

by the Office of Administrative Hearings (OAR) requiring the Department torecalculate ConocoPhilips' oil production tax liability for 2003. The tax at issueisthe oil production tax imposed under former AS 43.55.01 1(b) on the "gross valueat the point of production," which is calculated by deducting "the reasonable costsof transportation" from the sales price.I The "reasonable costs of transportation"are defined by regulation as "the ordinary and necessary costs incurred to transportthe oil or gas from the pointofproduction to the sales delivery point.,,2

In deciding ConocoPhillips' appeal of the Division's adjustments toits deductible transportation costs, OAH Chief Administrative Law Judge (ALJ)Terry Thurbon held that the Department erred: (1) in excluding a "make-whole"premium of $34,156,402 that ConocoPhillips paid for its early termination of itslease of a tanker, the Polar Endeavor; and (2) in offsetting a $.0275 per barrel"administrative fee" ConocoPhillips received for crude oil exchanged withWilliams Alaska Petroleum for use in Williams' Golden Valley refinery. [R. 83]These alleged errors, with respective effects of increasing ConocoPhillips' 2003oil production tax by $272,553 and $93,282, are the subjectof this appeal. [R. 68,70]

2Former AS 43.55.011(b) (1981); former AS 43.55.150 (1989).15 AAC 55.191(a).

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In reviewing these transportation cost issues, ALI Thurbonerroneously restricted her view to the four comers of C o n o c o P h i I l i p s ~ third-partycontracts. Considering both issues to be matters of " p u r e ~ y legal contractinterpretation," she found the respective contracts to unambiguously requireConocoPhiIlips to pay the make-whole premium upon terminating its tanker leaseand to define the per-barrel charge as an "administrative fee." [R. 73, 80] But theterms of these contracts were not at issue. In restricting her review to simplecontract interpretation, the ALI overlooked the real legal issue of whether theDepartment's adjustments were consistent with Alaska's 2003 oil production taxstatutes and regulations. The OAR decision provides no analysis - much less adecision - on the appealed issues of whether the make-whole payment legallyqualified for deduction from the sales price as an "ordinary and necessary"transportation cost or whether the per-barrel "administrative fee" was actuallyreimbursement for non-deductable administrative costs.

The Department now appeals the OAR decision for an actualdetennination of ConocoPhillips' challenge to the Department's transportationcost adjustments. Because the make-whole premium was neither an "ordinary"nor "necessary" cost incurred to transport ConocoPhillips' oil to the sales deliverypoint, the Department properly detennined that the premium was not a reasonablecost of transportation and disallowed the deduction. And because ConocoPhillipsfailed to prove that the additional per-barrel fee from Williams was reimbursement

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for actuaJ non-deductible costs, the Department properly treated it as an offset totransportation costs.

An Alaska oil producer's production tax liability is not determined -as implied by the OAR decision - by the terms of a producer's third-partycontracts, but by application of the applicable Alaska production tax statutes andregulations. Moreover, the calculation of "gross value at the point of production"involves "interpretation of a complex tax statute and regulations that implicate thespecial expertise" of the Department, and is entitled to the rational basis standardof review.3 The OAH should have deferred to the Department's interpretation ofits regulations "unless it is unreasonable.,,4 Both of the Department's adjustmentsto ConocoPhillips' transportation cost deductions were well within reasonableinterpretations of the production tax regulations. For all of these reasons the OAHdecision must be reversed on appeal and the Department's calculation ofConocoPhillips' 2003 production tax liability should be affinned.

JURISDICTIONAL STATEMENT

The Department appeals from the Decision of the OAR datedNovember 29, 2009. [R. 66-84] The Department's Request for Reconsiderationwas denied on January 26, 2010. [R. 1] Notice of Appeal was timely filed onFebruary 25, 2010. This court has jurisdiction to consider this tax appeal under

3 State, Department of Revenue v. Atlantic Richfield Co., 858 P.2d307, 308 (Alaska 1993).

4 Id.

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AS 22.l0.020(d), AS 43.05.480(a), AS 44.62.560, and Alaska Ruleof AppellateProcedure 602(a)(2).

ISSUES PRESENTED FOR REVIEWThree issues are presented for superior court review:

1. Whether ConocoPhillips' payment of a make-whole premium uponthe early termination of its tanker lease qualifies as an ordinary and necessarytransportation cost under 15 AAC 55.191(a);

2. Whether the OAH erred in not deferring to the Department'sreasonable interpretation of its production tax regulations to exclude considerationof the make-whole premium payment from ConocoPhillips' ordinary andnecessary costs incurred to transport its oil to the sales delivery point; and

3. Whether the OAR further erred in reversing the Department'sinterpretation of its production tax regulations to offset against ConocoPhillips'deductible transportation costs the per-barrel "administrative fee" received for oilexchanged with Williams for use in Williams' Golden Valley refinery.

STATEMENT OF THE CASEConocoPhillips Alaska, Inc. (ConocoPhillips) is Alaska's largest oil

and gas producer. [R.273] In 2003, ConocoPhillips produced 140 million barrelsof Alaska North Slope crude oil (ANS) and received more than $4 biBion fromsales of ANS. [R. 272] ConocoPhillips transports its produced ANS from theNorth Slope to the port of Valdez through the Trans Alaska Pipeline System(TAPS). In 2003, some of ConocoPhillips' ANS was diverted from the TAPS

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under an exchange agreement with Williams Alaska Petroleum for use inWilliams' Golden Valley refinery. [R. 66] ConocoPhillips received an equalvolume of degraded oil, subsequent to refinery processing, that Williams returnedto the TAPS. From Valdez, ConocoPhillips transports its ANS to markets on theU.S. West Coast and Hawaii by tanker. [R. 66, 273]

One tanker used to transport ConocoPhillips' ANS in 2003 was thePolar Endeavor. Polar Tankers, Inc., an affiliate ofConocoPhillips, purchased thePolar Endeavour on June 28, 2001 for $205 million. [R. 327] Two months later,Polar Tankers sold the vessel to Arctic Funding Limited Partnership for $205million and simultaneously leased it back under a 10-year "synthetic lease"agreement for lease payments of approximately $15 million per year. [R. 327; Tr.12] At the end of the lease term, Polar Tankers would have the option torepurchase the vessel for the original financed acquisition cost. [Tr. 12] Underthe agreement, Polar Tankers had an option to repurchase the vessel at any timeduring the lease by paying both the original financed acquisition cost and a "makewhole premium" to be paid to the holders ofArctic Funding Limited Partnership'soutstanding notes under the terms of the Arctic Funding Note PurchaseAgreement. [R. 184-184; Tr. 12-13] The make-whole premium is effectively apre-payment of interest to make the note-holders whole for the income lost uponearly termination of the lease.

A "synthetic lease" is a technique of off-balance-sheet financing forasset acquisition that is characterized as an operating lease for financial accounting

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purposes, but retains aspects of ownership such that the lessee-corporate user isstill regarded as the tax owner of the asset.s As described by ConocoPhillips: "Forbook purposes, synthetic lease payments are treated as rent expense. For taxpurposes, the asset is capitalized and depreciated." [R. 327] Use of a syntheticlease "substantial ly enhances the financial ratios of the lessee/corporate userbecause neither the asset, nor any financing liability or equity ownership interestin the property appears on the lessee-corporate user's balance sheet.,,6 Thesynthetic lease allowed ConocoPhillips to avoid reporting the financed acquisitioncost of the Polar Endeavor on its balance sheet as a debt obligation. [R. 184-185]

In January 2003, the Financial Accounting Standards Board issuedInterpretation No. 46, requiring companies to report the existence of syntheticleases on their financial statements. [R. 185] For ConocoPhillips, this meant thatit would now be "required to report the unamortized acquisition cost [o f the PolarEndeavor] as debt on its consolidated balance sheet." [R. 185] With theadvantage of a synthetic lease over tradit ional financing gone, ConocoPhill ipsbegan "a company-wide program of retiring synthetic leases and similar financingarrangements affected by InterpretationNo. 46." [R. 185] On December 21, 2003- only two and one-half years into the lO-year lease agreement - Polar Tankersrepurchased the Polar Endeavour for the for the initial amount financed plus an

See John C. Murray, Off-Balance-Sheet Financing: Synthetic Leases,32 REAL PROP. PROS. & TR. J, 193, 195 (Summer 1997).

6 Id. at 210.

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additional $34,156,402 as a "make-whole premium" to the note-holders. [R. 327]The amount of the make-whole premium was the difference between the 6.85%interest on the notes and the 4.165% reinvestment yield then available, over theremaining seven and one-half year life of the notes, multiplied by $198,850,000,the principal amount of the notes. [R. 186, 834]

Following an audit for tax year 2003, the Department issued aNotice ofAssessment to ConocoPhillips for $558,856 in additional oil productiontax. [R. 250] ConocoPhillips disputed a number of the Department's auditadjustments, most of which were resolved through the informal conferenceprocess. [R. 67-68] Three issues from the Department's Informal ConferenceDecision (rCD) of August 15, 2007 were formally appealed by ConocoPhillips tothe Office ofAdministrative Hearings (OAH). [R.242-247]

As there were no material facts in dispute, the appeal was submittedto the OAR on the written record, briefing and oral argument. [R. 66] ChiefAdministrative Law Judge (ALJ) Terry Thurbon issued the OAR Decision onNovember 29, 2009, finding that the Department had erred with respect to twotransportation cost adjustments: (1) excluding the make-whole premiumConocoPhillips paid upon early termination of the synthetic lease; and (2)offsetting a per-barrel "administrative fee" ConocoPhillips received for crude oilexchanged with Williams Alaska Petrole.um. [R. 83]

The Department's request for reconsideration was denied by theALl. [R. 1] The Department now appeals these two issues to this Court.

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STANDARD OF REVIEWIn reviewing a decision of the OAH, the superior court applies the

"substantial evidence" test to questions of fact, and the "substitution of judgmenttest" for questions of law.7 This case concerns the Department's interpretation ofits oil production tax statute and regulations, which are questions of law.s "Therational basis tes t is used where the questions at issue implicate special agencyexpertise or the determination of fundamental policies within the scope of theagency's statutory function.,,9 The issues in this case "center around theinterpretation of a complex tax statute and regulations that implicate the specialexpertise of [the Department]" - circumstances where the Alaska Supreme Courthas held that the "rational basis standard of review" applies. 10 Under the rationalbasis standard, "the court defers to the agency's interpretation unless it isunreasonable.")} The agency's decision must be affirmed if it "is supported by thefacts and has a reasonable basis in law."12

7 State, Dep't of Revenue v. DynCorp, 14 P.3d 981, 985 (Alaska2000).

8 State, Dep't of Revenue v. Atlantic Richfield Company, 858 P.2d307,308 (Alaska 1993).9 Tesoro Alaska Petroleum Co. v. Kenai Pipe Line Co., 746 P.2d 896,

903 (Alaska 1987).10 ld.11 ld.12 Id.

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ARGUMENT

I. CONOCOPHILLIPS' PAYMENT OF A MAKE-WHOLE PREMIUMUPON THE EARLY TERMINATION OF ITS TANKER LEASE ISNOT AN ORDINARY AND NECESSARY COST INCURRED TOTRANSPORT ITS OIL UNDER 15 AAC 55.191(a).

This appeal concerns the application and interpretation of a complexset of interrelated oil production tax regulations. The taxable "gross value at thepoint of production" is calculated by subtracting the producer's "reasonable costsof transportation of the oil" from the sales price. 13 The "reasonable cost oftransportation" is defined by 15 AAC 55.180 as "the actual cost of transportationas determined in 15 AAC 55.191(a) and (b), if the actual costs incurred areordinary and necessary transportation expenses."

The "reasonable costs of transportation" are further defined in 15AAC 55.191(a) as "the ordinary and necessary costs incurred to transport the oil orgas from the point of production to the sales delivery point." A n d ~ where the"transportation of oil is by a vessel that is owned or effectively owned, in whole orin part, by the producer of that oil," 15 AAC 55.191 (b) defines the "actual costs oftransportation allowable for purposes of 15 AAC 55.180(a)" to includedepreciation and a "reasonable return on the acquisition cost, as provided in 15AAC 55.195(a), of the vessel over its expected useful life as used for reportingincome and expenses to shareholders and owners, or on the adjusted shipyard cost

13 Former AS 43.55.150 (1989).

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or invested capital as provided in 15 AAC 55.195(b), (c), (t) or (h) or 15 AAC55.196 as applicable."

The allowable return on invested capital for marine vessels is set outin 15 AAC 55.196, which states in part:

(a) Except if 15 AAC 55.195(a) applies, for oil and gas produced onor after January 1, 2003, a cost of capital allowance that consists ofdepreciation and a return on invested capital will be allowed underthis section for a vessel, or an improvement completed on or afterJanuary 1, 2002 to a vessel, owned or effectively owned by theproducer, as provided in 15 AAC 55.191. . . .(d) A cost of capital allowance under this section must be calculatedusing the methodology set out in the department's publicationComputation ofa Cost-ofCapital Allowance under 15 AAC 55. 196Incorporating Depreciation and Return on Invested Capital forMarine Vessels and Improvements, dated November 21, 2002 andadopted by reference.

The referenced manual "sets out the methodology to be used by producers incomputing the cost-of-capital allowance for marine vessels and improvementsunder 15 AAC 55.196." [R. 874] Computation of an allowance "is performedusing a series of input schedules and calculation tables" in an electronicspreadsheet program provided by the Department. [R. 279, 874; Tr. 8] Themanual provides instructions for the input schedules and calculation tables, alongwith illustrative examples. [R. 874-908]

For its 2003 oil production tax return, ConocoPhillips included in itscomputation of its deductible cost-of-capital allowance the $34.1 million make-whole premium that it paid to the note-holders to make up for the interest lost dueto the early termination of the synthetic lease. [R. 268] In its cost-of-capital input

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schedules, ConocoPhilJips called this expense: "Prepayment for closingpartnership." [R. 286] At audit, the Department applied the oil production taxregulations to disallow the inclusion o f the make-whole premium in the cost-of-capital allowance, finding that such "prepayment penalties" " ar e n ot ordinary andnecessary expenses o f transportation o f ANS crude oil." [R. 291] "Theunwinding o f the synthetic lease activity is related to a financing activity o f aninvestment in a limited partnership and not primari ly driven by the acquisition oroperation o f a vessel." [R. 292]

T he D ep ar tm en t' s determination flows directly from th e plainmeaning o f its regulations and is consistent with the statutory scheme al lowingonly "the reasonable costs o f transportation o f the oil" for purposes of determiningthe taxable "gross value at the point of production.,,14 Reasonable costs aredefined in 15 AA C 55.191(a) as "the ordinary and necessary costs incurred totransport the oil or gas from the point of production to th e sales delivery point.""Ordinary an d necessary" business expenses are tax-deductible under the federalInternal Revenue Code. In that context, "ordinary and necessary expense" isdefined in B la ck 's L aw Dictionary as: "A n expense that is normal or usual andhelpful or appropriate for the operation of a particular trade or business .... ,,15 Th ecommon meaning o f the adjective "necessary" is "absolutely essential" or "needed

14

1.5AS 43.55 150(A).BLACK'S LAW DICTIONARY 659 (9th ed. 2009).

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16

17

to achieve a certain result or effect.,,16 While payment of the make-wholepremium to the note-holders may have been required as a consequence ofConocoPhillips' election to terminate the lease early, it was neither an ordinary,nor necessary, cost to transport ConocoPhillips' oil to market.

The make-whole premium was a pre-payment of interest paid as anearly-termination penalty to make the note-holders whole. [R. 831-834] It is not anormal, usual, or appropriate expense for transporting oil - and it was certainly notan essential or needed expense for ConocoPhillips to transport its oil to the salesdelivery point. With more than seven years left in its fully-operational syntheticlease, ConocoPhillips did not need to collapse the lease in order to transport its oil.Indeed, its means of transportation here - the tanker Polar Endeavor - remainedunaffected by the termination of the lease. The payment of the make-wholepremium was simply unrelated to any oil transportation needs and wasappropriately excluded from ConocoPhillips' cost-of-capital allowance.]7

THE AMERICAN HER1TAGE DICTIONARY OF THE ENGLISH LANGUAGE1207 (3rd ed. 1996)The Department's determination does not question ConocoPhillips'business judgment in terminating the lease early. As the United State's Supreme

Court noted in Welch v. Helvering, just because money may have been "well andwisely spent," does not make it a deductible "ordinary and necessary" expense ofthe operation of the business." 290 U.S. 111, 115-16 (1933). Here, the fact thatConocoPhillips may have had legitimate business reasons for incurring the makewhole premium payment does not make it a deductible "ordinary and necessarycost incurred to transport the oil .. . from the point of production to the salesdelivery point.H 15 AAC 55.19I(a).

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18

The production tax statutes require costs to be "reasonable" and"actual" costs of transportation in order to qualify as deductions for determiningthe taxable gross value of a producer's oil. 18 The Department's regulationsexplicitly set out the "reasonable costs of transportation" that are deductible as"the ordinary and necessary costs incurred to transport the oil or gas from the pointof production to the sales delivery point."19 These include "voyage and portcosts," which are further broken out in the regulation to include costs such as: fuelfor the vessel; port and dock fees; tug and pilotage fees; customs fees and duties;and "other costs directly associated with the operation or maintenance of thevessel.,,20 The transportation cost deduction pennitted under the regulations for acost-of-capital allowance specifically includes inputs for the lease payments undera synthetic lease and "the repurchase price paid by the producer at the end of thelease - as those costs are both "ordinary and necessary" for the transportation ofoil. [R. 886] All of these types of allowed costs are typical and unavoidable forthe marine transportation of a producer's crude oil.

Payments of interest and penalties, like the make-whole premium,are excluded because they are unrelated to transporting oil. The oil production taxstatutes, the express language of the implementing regulations, and common

Former 43.55.150(a) (1989).19 15 AAC 55.191 ("Calculation of reasonable costs of transportation

for oil and gas.").20 15 AAC 55.1910) (listing twenty-three subcategories of "allowable

voyage and port costs").

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sense, all support the Department's detennination that the make-whole premiumdoes not qualify as a deductible transportation cost to reduce the taxable value ofConocoPhillips' oil production.

In holding that the Department erred in excluding the make-wholepremium from the cost-of-capital allowance, the OAH ALl focused only onwhether the note purchase agreement required payment of the premium along withthe repurchase price. [R.73] While a make-whole premium may be an "ordinary"provision in a synthetic lease and a "necessary" payment upon early tennination ofthe lease, the OAH Decision fails to explain how such a contractual interestpenalty qualifies as a deductible "ordinary and necessary cost of transportation"under Alaska's production tax regulations. [R. 72-75] Because the Departmentproperly applied its regulations to exclude the make-whole premium fromConocoPhillips' deductible cost-of-capital allowance, as not a cost incurred totransport its oil, this Court must reverse the OAH Decision on this point andaffirm the Department's action.II. THE DEPARTMENT REASONABLY INTERPRETED ITS

PRODUCTION TAX REGULATIONS TO EXCLUDE THE MAKE-WHOLE PREMIUM PAYMENT FROM CONOCOPHILLIPS'DEDUCTIBLE TRANSPORTATION COSTS.The issues in this case involve the Department's interpretation of its

regulations defining the "reasonable cost of transportation" deduction used forcomputing a producer's oil production tax liability under AS 43.55.011(b). Inparticular, the determination of the cost-of-capital allowance permitted as a

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deductible "ordinary and necessary transportation expense" involves theapplication of multiple related regulations and the Department's manual settingout the computation methodology to be used. 21 The regulations alone are dense.22And they incorporate the Department's Return on Invested Capital publication thatprovides a series of input schedules and calculation tables "to be used byproducers in computing the cost-of-capital allowance for marine vessels andimprovements under 15 AAC 55.196.,,23 [R.874]

Clearly, this is a complex set of tax regulations, where thespecialized knowledge and experience of the Department's Tax Division would beespecially probative as to their meaning. This is precisely the situation where theAlaska Supreme Court has held that deference "shall" be given to an agencyd . . l' . bl 24eClsIon, un ess It IS unreasona e.

This "rational basis" standard of review is applied "when a caserequires resolution of policy questions which lie within the agency's area ofexpertise and are inseparable from the facts underlying the agency decision.,,25

2000).

21

22

23

24

See supra pp. _.See 15 AAC 55.180, et seq.15 AAC 55.196(d).State, Dep't of Revenue v. DynCorp, 14 P .3d 981, 984 (Alaska

25 Tesoro Alaska Petroleum Co. v. Kenai Pipe Line Co., 746 P.2d 896,903 (Alaska 1987). See also Kuzmin v. State, Commercial Fisheries EntryComm 'n, 223 P.3d 86, 89 (Alaska 2009) ("When reviewing an agency'sinterpretation of its own regulation, we apply the reasonable basis standard ofreview. We will defer to the agency unless its 'interpretation is plainly erroneous

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Tesoro, 746 P.2d at 904.

The Alaska Supreme Court has specifically applied this deferential standard toissues that "center around the interpretation of a complex tax statute andregulations that implicate the special expertise of [the Department ofRevenue].,,26

The question at issue here - whether the make-whole premiumqualifies for input into the cost-of-capital allowance computation as an ordinaryand necessary cost for transporting oil - is a policy question well within the scopeof the Department's statutory function of administering the state's tax and revenuelaws. Unlike statutory interpretation, this is not the type of question that "isregular grist for judicial mills" and "within the scope of the court's specialcompetency. ,,27 The Department's decision here must be reviewed under the"rational basis" standard and upheld unless it is unreasonable.

The rational basis standard of review makes this an easy case. TheDepartment's exclusion of the make-whole premium from the retum-on-investment calculation is a straight-forward application of its regulations allowing

and inconsistent with the regulation.' This 'deferential standard of reviewproperly recognizes that the agency is best able to discern its intent inpromulgating the regulation at issue. '" [citations and footnotes omitted]).

26 State, Dep't ofRevenue v. Atlantic Richfield Company, 858 P.2d 307, 308(Alaska 1993). See also State, Dep't ofRevenue v. Parsons, Corp., 843 P.2d 1 2 3 8 ~ 1241(Alaska 1992) ("In the present case, the reasonable basis test applies. The facts arecomplex. Interpreting the Multistate Tax Compact ( 'Compact' ) depends upon the'particularized experience and knowledge of the administrative personnel.' We aresatisfied that the reasonable basis test is appropriate because this case' requires resolutionof policy questions which lie within the agency's area of expertise and are inseparablefrom the facts underlying the agency's decision.' Therefore, we will not reverse DOR'sdecision if there is a reasonable basis to support it." [citations and internal quotesomitted]).

27

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deductions only for "ordinary and necessary transportation expenses.,,28 Asexplained above, the make-whole premium paid by ConocoPhillips was neither an"ordinary" nor "necessary" cost "incurred to transport the oil .. . from the point ofproduction to the sales delivery point.,,29 It was an interest penalty paid to makethe note-holders whole despite the early collapse of the lease. In no sense can theDepartment's application of its regulations be construed as unreasonable.Applying the rational basis standard of review, this court must defer to theDepartment's decision, because it is not "plainly erroneous and inconsistent withthe regulation[s].,,3o

The ALI mistakenly viewed this issue as solely a matter of contractinterpretation, to which a non-deferential standard of review applies: "The legalquestion here is simply whether the note purchase agreement requires payment ofthe premium along with the repurchase price, which it clearly does." [R. 73]Finding that the terms of the contract with the lessors required payment of a makewhole premium upon early collapse of the lease, the ALI held that it was therefore"necessary" for ConocoPhillips to make this payment when it repurchased thePolar Endeavor in 2003. [R. 72-74] But the Department never questioned theterms of the note purchase agreement, nor ConocoPhillips' business decision tocollapse the synthetic lease early and incur the interest penalty.

28

2930

15 AAC 55.180.15 AAC 55.191(a).Kuzmin, 223 P.3d at 89.

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The question here is not whether the make-whole premium was aHnecessary" payment under. the tenus of a private contract, but whether such apenalty payment qualifies as "ordinary and necessary costs incurred to transportthe oil or gas from the point of production to the sales delivery point.,,31 As to thatquestion, the Department applied its specialized knowledge in interpreting itsregulations and Return on Invested Capital manual. The ALl should havedeferred to the Department's determination of what constitutes deductible"ordinary and necessary" transportation costs for purposes of calculating oilproduction taxes under its regulations.32

Even when the issue does not involve specialized knowledge of oilproduction transportation costs, but is a general income taxation question of whatqualifies as a deductible "ordinary and necessary" business expense, courts deferto the detennination made by the taxing authority. In Welch v. Helvering,33 theissue before the United States Supreme Court was whether certain payments by a

31 15 AAC 55.l91(a).

290 U.S. 111 (1933).

32 The ALl opined that she would reach the same result "[e]ven if adeferential standard of review were applicable," because "[t]here is no reasonablebasis for the department allowing some but not all of the contractually requiredconsideration to be included in the cost-of-capital allowance calculation underthese circumstances." [R.74-75] But this also flows from the ALl's flawed viewof the issue as merely one of contract interpretation. When properly seen as aquestion of whether the payment qualified for inclusion in the deduction under theapplicable production tax regulations, the Department could reasonably concludethat the make-whole payment of future lost interest to the note-holders from theearly collapse of the lease was not an "ordinary and necessary" transportationexpense.

33

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taxpayer were "ordinary and necessary" expenses in carrying on a business, withinthe meaning of the revenue code allowing deductions o f such expenses incomputing net income. In upholding th e Commissioner o f Internal Revenue'sfinding that the taxpayer's payments "came closer to capital outlays than toordinary and necessary expenses in the operation o f his business," Justice Cardozonoted that the Commissioner's determination ha d "the support of a presumption o fcorrectness, and the petitioner has the burden o f proving it to be wrong."

Unless we can say from facts within our knowledge that these areordinary and necessary expenses according to the ways o f conductand the forms of speech prevailing in the business world, the ta xmust be confirmed. Bu t nothing told us by this record or within th esphere o f our judicial notice permits us to give that extension to whatis ordinary and necessary. I n d e e d ~ to do so would open the door tomany bizarre analogies.34Here, it is the AL l's determination that is manifestly unreasonable

and opens the door to bizarre analogies. According to the OAR Decision, theDepartment is required to include in a producer's cost-of-capital allowance allcosts contractually incurred upon the voluntary early termination o f a syntheticlease. Potentially, any payments required by such a third-party contract wouldhave to be included in the calculation of deductible transportation costs -irrespective o f whether they are ordinary and necessary to transporting theproducer's oil.

Th e cost-of-capital allowance is the "reasonable return on theacquisition cost" of the vessel, allowed as a deductible cost o f transportation when

34 Id. at 115.

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35

a producer-owned vessel is used to transport its oil.35 The OAR Decision wouldallow a producer to include in its cost-of-capital allowance contract costs incurredfor breach, liquidated damages, or other penalties for non-performance, eventhough they are not capital costs of a vessel and are unrelated to the acquisitioncost of a tanker. 36 Interpreting the regulations in this manner forces the State tosubsidize costs that have nothing to do with transportation of a producer's oil.

The OAR Decision treats the interest penalty imposed onConocoPhillips for its business decision to collapse the synthetic lease early as anordinary and necessary cost of acquiring the Polar Endeavor, even though the fullrepurchase price of the vessel is already included in the cost-of-capital allowance.The OAH Decision, if not reversed, would require the State to share InConocoPhillips' interest penalty to the note-holders through the collection ofreduced oil production taxes over the remaining economic life of the tanker: until2025. [R. 292] The language and logic of Alaska's oil production tax permits areasonable return on vessel acquisition cost as an ordinary and necessarytransportation cost. It is the ALI's decision to require allowance of a reasonablereturn on a non-capitalized interest penalty that is unreasonable and contrary to theregulatory scheme.

15 AAC 55.191(b)(3)(D).36 The full re-purchase price paid by a producer for the vessel upon thetermination of a synthetic lease is appropriately and explicitly included in the costof-capital allowance as an "ordinary and necessary" transportation cost under 15AAC 55.196. [R.886]

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The facts are undisputed and on this issue, this Court must "exerciseits independent judgment in interpreting and applying the law to the facts.37 Andshall defer to the Department's decision where, as here, the question of law"involves particularized agency expertise or where the agency's specializedknowledge and experience would be especially probative as to the meaning of astatute or regulation. ,,38 The GAB decision on this issue must be reversed, as theALJ misconstrued the issue and applied the wrong legal standard. TheDepartment's exclusion of the make-whole premium from the cost-of-capitalallowance should be affirmed as it is not an unreasonable application of theproduction tax regulations.III. THE DEPARTMENT REASONABLY INTERPRETED ITSPRODUCTION TAX REGULATIONS TO TREAT THE PERBARREL FEE RECEIVED FOR OIL EXCHANGED WITHWILLIAMS AS AN OFFSET TO TRANSPORTATION COSTS.

The ALl similarly erred in reversing the Department's reduction ofConocoPhillips' transportation costs by the amount of a $.0275 per-barrel feereceived for barrels exchanged with Williams for use in its Golden Valleyrefinery. Giving no deference to the Department's application of its productiontax regulations, the ALI looked "at this as a purely legal contract interpretationissue." [R. 80] The ALJ found "[t]he unambiguous tenns of the exchangeagreemenf' with Williams labeled the fee "administrative," paid in addition to

3738

Dyncorp, 14 P.3d at 984.Id.

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consideration for quality differentials of the degraded oil returned by Williams tothe TAPS, and concluded that the fee was unrelated to transportation costs as"separate consideration, ostensibly to compensate ConocoPhillips Alaska for costsassociated with administering the agreement." [R. 80] But the legal issue onadministrative appeal - one that cannot be resolved by the language of a third-party contract alone - was whether the Department's adjustment toConocoPhillips' transportation costs was consistent with Alaska's oil productiontax regulations.

The exchange agreement provides for the diversion of some ofConocoPhillips' ANS from the TAPS to Williams' refinery. [R. 70] Theagreement requires Williams to return an equal volume of degraded ANS into theTAPS. [R. 70] The TAPS quality bank administrator then assessesConocoPhillips a per-barrel fee for the degraded quality of the exchanged oil. The"PRICE" provision of the exchange agreement compensates ConocoPhillips forthe oil exchange as follows:

The exchange differential paid by Williams to [ConocoPhillips] shallbe equal to any quality bank degradation charges per barrel asassessed by the quality bank administrator. Any changes to theTAPS, including but not limited to retroactive adjustments, shallapply to this contract. Williams also agrees, in addition to qualitybank assessments, to pay an administration fee of $0.0275 perexchange barrel. [R.70]ConocoPhillips reported its quality bank payments on its oil

production tax return and included the reimbursements paid by Williams pursuantto the exchange agreement, but not the additional $.0275 per-barrel

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"administration fee." [R. 314] The applicable production tax is imposed on the"gross value at the point of production.,,39 The Department's regulation 15 AAC55.151(b) detennines how the "gross value at the point of production for aproducer's oil or gas must be calculated":

(1) a destination value must be determined for the oil or gas; .. .(2) except as otherwise provided under (i ) of this section, theproducer's reasonable costs of transportation under 15 AAC 55.180and 15 AAC 55.191 must be subtracted from the destination valuedetennined under (1) of this subsection; ...(3) if oils of different qualities or oil and NGLs are commingled,the value calculated under (2) of this subsection must be adjusted forany consideration paid or received for quality differentials,regardless ofwhether prescribed by a filed tariff. [emphasis added]At audit, the Department included the additional per-barrel payment

as an offset to ConocoPhillips' transportation costs, pursuant to 15 AAC55.l51(b)(3). [R.31S] This treatment was upheld in the Department's ICD afterinfonnal appeal, because:

there is no indication that [the "administration fee"] is areimbursement of any costs, either deductible or non-deductible.The fee is simply additional compensation for each barrel that wasdegraded. It is unrelated to any administrative costs incurred byConocoPhillips.15 AAC 55.l51(b)(3) provides that if oils of different qualities arecommingled, the transportation costs calculated under 15 AAC55.151(b)(2) must be adjusted for any consideration paid or receivedfor quality differentials. ConocoPhillips received additionalconsideration of $.0275 per barrel for oil degraded and returned byWilliams. The Department properly adjusted transportation costs forthis additional consideration received. [R.270]

39 Former AS 43.55.011(b) (1981)

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The leD should be affirmed on this issue because the Department'sdetennination that the additional per-barrel fee should be treated as an offset totransportation costs is a reasonable interpretation of its production tax regulationsand ConocoPhillips presented no evidence to support its claim that the fee wasactually reimbursement for costs unrelated to the transportationof its oil.

Under AS 43.05.245, the Department's tax assessment "is presumedsufficient for all legal purposes. However, nothing prevents a taxpayer frompresenting evidence or other information in an infonnal conference under AS43.05.240 or in appeal [to OAH] under AS 43.05.241 in order to rebut thepresumed sufficiency of an assessment ...." Accordingly, the Department'sassessment including the $.0275 per-barrel fee in ConocoPhillips' taxable oilproduction revenue is presumed correct unless and until rebutted by evidenceproduced by the taxpayer at infonnal conference or on appeal before the 0 AH.ConocoPhillips produced no such evidence.

In its appeal to the OAR, ConocoPhillips argued: "Theadministrative fee is not a component of the oil price, nor is it reimbursement of adeductible cost of transportation, and should not be included in the calculationoftaxable value." [R. 246-47] But ConocoPhillips failed to "present evidence orother information" at infonnal conference or before the OAR to support itsargument that the fee is "revenue or profit unrelated to the disposition of oil" and"plays no role in the production tax calculation." [Tr. 63, 43] Indeed, there is

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absolutely no evidence that ConocoPhillips incurred any actual "administration"expense in relation to the exchange agreement.

Under AS 43.05.245, it was ConocoPhillips' burden to prove that thefee was not "consideration paid or received for quality differentials" and unrelatedto its production tax liability. The ALJ turned this burden on its head, faulting theDepartment's ICD for concluding "without reference to specific facts, that the fee'i s unrelated to any administrative cost incurred by ConocoPhillips.'" [R.81] TheALl could only speculate that the fees were "ostensibly to compensateConocoPhillips Alaska for costs associated with administering the agreement."[R. 80] In the absence of evidence from the taxpayer that there really were suchcosts, the "presumed sufficiency" of the Department's assessment should stand.

Moreover, as noted above, the Department's interpretation of its oilproduction tax regulations is entitled to deference and its determination should bereversed only if "plainly erroneous and inconsistent with the regulation. ,,40 Thefee was additional compensation paid by Williams "per exchange barrel" ofdegraded oil. [R. 70] The Department reasonably considered it to fall under 15AAC 55.151(b)(3), as "consideration received" for quality differentiatedexchanged oil. And it was also reasonable for the Department to consider this per-barrel revenue received by ConocoPhillips during the TAPS transportation of itsANS as an offset to transportation costs - especially in the absence of any

40 Kuzmin v. State, Commercial Fisheries Entry Comm 'n, 223 P.3d 86,89 (Alaska 2009).

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evidence that any non-transportation costs were actually incurred as a result of theexchange agreement. This adjustment to ConocoPhill ips ' transportation costsshould be affinned because the Department's assessment was not rebutted and hasa reasonable basis in law.41

CONCLUSIONThese two appealed adjustments to ConocoPhillips' transportation

cost deductions, made in the Department's 2003 Notice of Assessment foraddit ional oil production tax, are well supported by the applicable oil productiontax statutes and regulations. In no event can either of the Department'sadjustments be held to be "unreasonable." Accordingly, this Court should reversethe November 29, 2009 Decision of the OAR on these two issues. TheDepartment's calculation of ConocoPhillips' 2003 production tax liability, as setout in its Infonnal Conference Decision of August 15, 2007, should be affirmed.

DATED this 12th day ofNovember, 2010 at Anchorage, Alaska.DANIEL S. SULLIVANATTORNEYGENERAL

By: ~ - e r - - - - ! ~ ~ 7 1 - 1 __-Assistant Attorney GeneralAlaska Bar No. 9211075

41 See, e.g., Tesoro Alaska Petroleum Co. v. Kenai Pipe Line Co., 746P.2d 896, 903 (Alaska 1987)

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By:

27

Senior Assistant Attorney GeneralAlaska BarNo. 8507110


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via U.S. Mail:1. APPELLANT'S BRIEF2. CERTIFICATE OF SERVICE

Case No. 3AN-IO-05484 CI

Marie EvansConocoPhillips Alaska, Inc.ATO-1668700 G StreetAnchorage, Alaska 99501

)

Law Office Assistant

Person(s) Served:

I hereby certify that on the 12th day ofNovember 2010, I caused a true andCERTIFICATE OF SERVICE


Leon T. VanceFaulkner Banfield, P.C.Attorney for ConocoPhillips Alaska, Inc.One Sealaska Plaza, Suite 202Juneau, AK 99801-1245

vs.

correct copy of the following document(s) to be served on the persons identified below

OAR No. 07-0565-TAX

CONOCOPHILLIPS ALASKA, INC.Appellee.

STATE OF ALASKA, DEPARTMENT OFREVENUE, TAX DIVISION,Appellant

234

567H910I I

1213

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DATED this 12th day ofNovember, 2010 at Anchorage, Alaska.does not oppose this late-filing ofAppellant's opening brief.

The Department of Revenue, pursuant to Alaska Rule of Appellate

administrative appeal, even though it is being filed one-week late. Undersigned counse


has conferred with Leon T. Vance, counsel for the Appellee, who stated that Appellee

NON-OPPOSED MOTION TO ACCEPTLATE-FILED OPENING BRIEF

By' 'i"u k. ~ ~ - o - r - - - - - - -Assistant Attorney GeneralAlaska Bar No. 8507110

DANIEL S. SULLIVANATTORNEY GENERAL

Procedure 503, moves to accept Appellant's opening brief in the above-captioned

vs.

OAHNo.07-0565-TAX




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IN THE S U P ER I OR C O U RT FO R TH E STATE OF ALASKATHIRD JUDICIAL D I ST R I CT A T A N CH O RA G E

vs.


OA R No. 07-0565-TAX

STATE OF ALASKA, DEPARTMENT OFREVENUE, TA X DIVISION,Appellant


I)))----------------)

4

89

65

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IIORDER GRANTING NON-OPPOSED M OT IO N T O A CC EP T

LATE-FILED OPENING BRIEF12 Appellant, State of Alaska's motion to accept late filing o f its Opening13 Brief filed November 12,2010 is hereby GRANTED.t415

16

17

1RJudge Eric A. AarsethSuperior Court Judge

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via U.S. Mail:

2. CERTIFICATE OF SERVICE

CERTIFICATE OF SERVICE


Marie EvansConocoPhillips Alaska, Inc.ATO-1668700 G StreetAnchorage, Alaska 99501

{/Law Office Assistant

Appellee.

vs.

1. NON-OPPOSED MOTION TO ACCEPT LATE-FILEDOPENING BRIEF and (pROPOSED) ORDER

I hereby certify that on the 12th day ofNovember 2010, I caused a true and

THIRD JUDICIAL DISTRICT AT ANCHORAGEIN TH E SUPERIOR COURT FO R TH E STATE OF ALASKA

Leon T. VanceFaulkner Banfield, P.C.Attorney for ConocoPhillips Alaska, Inc.One Sealaska Plaza, Suite 202Juneau, AK 99801-1245

Person(s) Served:

correct copy o f the following document(s) to be served on the persons identified below

CONOCOPHILLIPS ALASKA, INC.

STATE OF ALASKA, DEPARTMENT OFREVENUE, TA X DIVISION,Appellant I

)- = - - - ; - " " ' ; " " ; " " " ' ~ ~ ~ ~ - = - : ' - - : : : - ; - - - - - - - - )OAR No. 07-0565-TAX

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Appellant, State of Alaska's motion to accept late filing of its Openin

ORDER GRANTING NON-OPPOSED MOTION TOACCEPTLATE-FILED OPENING BRIEF



JUdicialAlala!an! I Deputy

vs.

I certify that on r ill 0acopy was mailed ti each'Of the followingt the'r address of record:

' )

Appellee.CONOCOPHILLIPS ALASKA, INC.


Brief filed November 12, 2010 is hereby GRANTED.

- - - : : - : - - : - : - : = - = - ~ - - - - - )OAHNo.07-0565-TAX

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Alaska v. ConocoPhillips, 3AN-10-05484 CI, (Alaska 2011) State's Brief

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Transcript of Alaska v. ConocoPhillips, 3AN-10-05484 CI, (Alaska 2011) State's Brief