F I L E D
United States Court of Appeals
Tenth Circuit
PUBLISH
APR 13 1999
UNITED STATES COURT OF APPEALS
PATRICK FISHER
Clerk
TENTH CIRCUIT
DUKE ENERGY NATURAL GAS
CORPORATION,
Petitioner - Appellant,
v.
COMMISSIONER OF INTERNAL
REVENUE,
No. 98-9008
Respondent - Appellee,
GAS PROCESSORS ASSOCIATION
(“GPA”) AND WESTERN GAS
RESOURCES, INC. (“WGR”),
Amici Curiae.
Appeal from the United States Tax Court
(CIR No. 12720-96)
David T. Harvin (Thomas P. Marinis, Jr., Sarah A. Duckers and Charles T. Fenn
with him on the briefs), Vinson & Elkins, L.L.P., Houston, Texas for Petitioner -
Appellant.
Teresa T. Milton, Tax Division, Department of Justice (Loretta C. Argrett,
Assistant Attorney General and Richard Farber, Tax Division, Department of
Justice with her on the brief), Washington, D.C., for Respondent - Appellee.
Richard B. Robinson, Lentz, Evans and King, P.C., Denver, Colorado, filed an
amici curiae brief for the Gas Processors Association (“GPA”) and Western Gas
Resources, Inc. (“WGR”).
Before EBEL, McWILLIAMS and LUCERO, Circuit Judges.
LUCERO, Circuit Judge.
Duke Energy Natural Gas Corporation (“Duke”), a Denver-based company,
appeals an adverse Tax Court judgment requiring it to depreciate the value of its
natural gas gathering systems over fifteen rather than seven years because those
assets transport, rather than produce, gas. Exercising our jurisdiction to review
the Tax Court’s decision under 26 U.S.C. § 7482, we reverse and hold that
gathering systems are assets used in the exploration for and production of
petroleum and natural gas deposits for purposes of the Internal Revenue Code’s
Modified Accelerated Cost Recovery System (“MACRS”).
I
Duke is the common parent of affiliated corporations that filed consolidated
tax returns for the tax years at issue. Duke’s wholly owned subsidiary, known
during the time period at issue in this case as Associated Natural Gas, Inc., owns
and operates several natural gas gathering systems and processing plants that
service gas fields in Colorado, Louisiana, Texas, Alabama, Oklahoma, and
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Kansas. The amount in dispute is $1,152,458, for the tax years ending September
30, 1991, and September 30, 1992. 1
Natural gas emerges from wells as a mixture of gas, liquid condensate and,
occasionally, oil. Unprocessed natural gas (“raw gas”) is separated from this
mixture when it passes through a separator near the well or at a central gathering
point. After separation, the raw gas continues to contain entrained natural gas
liquids (“NGLs”), water, and impurities that interfere with domestic or
commercial use of the gas.
Gathering systems generally consist of interconnected subterranean natural
gas pipelines and related compression facilities that collect the raw gas from wells
and deliver it to a central point, such as a processing plant. The gas is transferred
from the well owner’s separator to gathering systems either where the gathering
systems connect with the gas separation facilities, or at a common field point at
which raw gas from multiple fields is gathered. Once gathered, the gas is treated
in most instances by a processing plant, which produces both commercially
marketable “pipeline quality” gas and separated NGLs, which can also be sold
profitably. Duke’s gathering systems deliver raw gas to either Duke’s processing
1
The government claims Duke owes $399,369 for the year ending September 1991
and $753,089 for the year ending September 1992.
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plants, processing plants owned by unrelated third parties, or transmission
pipelines without processing.
Generally, Duke gains title to the gas that flows through its gathering
systems under three types of long-term contracts with gas producers. 2 The
majority of these agreements are called “percentage of proceeds” contracts, under
which the parties share revenues from the sale of gas and NGLs after they leave
the processing plants. The second type is called a “keep whole” contract, that
provides for redelivery of a thermally equivalent volume of residue gas to the
producer. Under this kind of agreement, the producer receives that volume of
residue gas, while Duke receives the proceeds from the NGLs that are separated
in processing, and sometimes a processing fee. The third type is a “wellhead
purchase” agreement, under which the producer receives a stated price for the gas
delivered, and Duke sells both the dry gas and the NGLs. Additionally, Duke
provides for producer use of its lines and pressure maintenance under “gathering
fee” contracts.
Duke obtained its gathering systems both by developing its own and by
acquiring existing systems from third parties, some of whom are gas producers.
2
Within the oil and gas industry, a “producer” is “an operator who owns wells that
produce oil or gas.” Howard R. Williams & Charles J. Meyers, Manual of Oil and Gas
Terms 854 (9th ed. 1994). Duke concedes that it is not a producer of gas as that term is
used in the asset class descriptions of MACRS.
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Those systems that Duke acquired continue to serve the same fields and to
perform the same technical and physical functions as they did before Duke’s
acquisition.
II
The issue before us is whether Duke’s gathering system assets belong to a
class of assets that must be depreciated over fifteen years, or to a class that can be
depreciated over seven years. 3 MACRS, the current system of depreciation rules,
is the result of Congress’s 1986 revision of the Accelerated Cost Recovery
System (“ACRS”), see Tax Reform Act of 1986, Pub. L. 99-514 (codified as
amended in scattered sections of 26 U.S.C.), which Congress had originally
established in the Economic Recovery Act of 1981, Pub. L. 97-34. See generally
Simon v. Commissioner, 68 F.3d 41, 44-45 (2d Cir. 1995) (describing evolution
of ACRS). Section 167(a) of the Internal Revenue Code allows “as a depreciation
deduction a reasonable allowance for the exhaustion, wear and tear (including a
reasonable allowance for obsolescence) . . . of property used in [a] trade or
business.” Section 168 establishes the appropriate depreciation
deduction—including the applicable depreciation method, recovery period, and
convention—for tangible property. See I.R.C. § 167(b).
3
The parties stipulate that Duke’s processing plants are described in Asset Class
49.23 (“Natural Gas Production Plant”), and that these assets have a class life of fourteen
years and can be depreciated over seven years.
-5-
An “applicable recovery period,” for purposes of § 168(c), is based upon
the “class life” of the property. § 168(c), (e). “Class life” means the class life
that would have been applicable to the property as of January 1, 1986, under
§ 167(m). See I.R.C. § 168(i)(1). Section 167(m)(1), which has been repealed, 4
based “reasonable allowance” “on the class life prescribed by the Secretary which
reasonably reflects the anticipated useful life of that class of property to the
industry or other group.” The class lives of assets placed in service after
1986—including those at issue here—are set forth in Rev. Proc. 87-56, 1987-2
C.B. 674.
The asset classes that the parties identify as the likeliest candidates for
Duke’s gathering systems are the following:
[Asset Class] 13.2: Exploration for and Production of Petroleum and
Natural Gas Deposits:
Includes assets used by petroleum and natural gas producers for drilling of
wells and production of petroleum and natural gas, including gathering
pipelines and related storage facilities. Also includes petroleum and
natural gas offshore transportation facilities used by producers and others
consisting of platforms . . ., compression or pumping equipment, and
gathering and transmission lines to the first onshore transshipment facility.
[. . .]
4
See Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508,
§ 11812(a)(1).
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[Asset Class] 46.0: Pipeline Transportation:
Includes assets used in the private, commercial, and contract carrying of
petroleum, gas and other products by means of pipes and conveyors. The
trunk lines and related storage facilities of integrated petroleum and natural
gas producers are included in this class.
Rev. Proc. 87-56, 1987-2 C.B. 678, 684.
Duke argues that Asset Class 13.2, with a class life of fifteen years and a
depreciation recovery period of seven years, is the most appropriate for its
gathering systems; the IRS, on the other hand, asserts that Asset Class 46.0,
which has a class life of twenty-two years and a recovery period of fourteen years,
is the class to which Duke’s gathering systems belong. The Tax Court agreed
with the IRS, finding that Duke’s gathering systems “are primarily pipelines that
are used by a nonproducer privately, commercially, and/or contractually to carry
gas; they are not used by a producer to drill wells or produce gas.” Duke Energy
Natural Gas Corp. v. Commissioner, 109 T.C. 416, 420 (1997). Although Asset
Class 13.2 includes “gathering pipelines and related storage facilities,” the court
found that such assets must be owned by—and not merely used for the benefit
of—a producer in order to fall within that class. Id. at 420-21. 5
5
We note, however, that a district court within this circuit, in a case that is
currently on appeal, came to the opposite conclusion concerning the similar gathering
systems of a different taxpayer. See True v. United States, No. 96-CV-1050-J, 1997 WL
836474, at *9 (D. Wyo. Nov. 3, 1997) (finding that the transportation function of
gathering systems “cannot be fulfilled without providing a means for producers to get
crude oil from the lease to the collecting point,” and that therefore gathering systems
should be treated as part of Class 13.2).
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III
We review Tax Court decisions “in the same manner and to the same extent
as decisions of the district courts in civil actions tried without a jury.” I.R.C.
§ 7482(a)(1). Because all of the facts presented to the Tax Court were stipulated,
we review the purely legal question before us de novo. See Hawkins v.
Commissioner, 86 F.3d 982, 986 (10th Cir. 1996); Anderson v. Commissioner, 62
F.3d 1266, 1270 (10th Cir. 1995).
A
We begin with an inquiry into the primary use of Duke’s gathering lines
within the natural gas industry. See Treas. Reg. §1.167(a)-11(b)(4)(iii)(b)
(“Property shall be included in the asset guideline class for the activity in which
the property is primarily used.”). We consider primary use for classification
purposes “even though the activity in which [the] property is used is insubstantial
in relation to all the taxpayer’s activities.” Id. We conclude that the primary use
of Duke’s gathering system assets falls within the description of Asset Class 13.2:
“assets used by petroleum and natural gas producers for . . . production of . . .
natural gas, including gathering pipelines and related storage facilities.”
Within the industry and in the functional and contractual relationship
between producers and nonproducer gathering system owners, Duke’s gathering
systems are literally used by producers for gas production in a number of different
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ways. First, gathering systems maintain the correct and necessary amount of
system pressure without which gas could not flow from the well to the processing
plant or transmission pipeline. Second, the transformation of raw gas into residue
gas, which requires gas to be gathered and moved from wellhead to processing
plant, is generally a necessary part of the production of natural gas as a
marketable commodity. Finally, Duke and the producers with whom it contracts
utilize complex agreements to share and/or transfer property rights at various
points in the production and processing stages, such that the producers typically
retain some interest in the gas as it is moving through the gathering system . As
the parties agree, “producers would not be able to produce natural gas in the
absence of an adequately designed gathering system.” R. Doc. 23, at 14
(Stipulation of Facts, ¶ 45).
The gas industry’s primary use of gathering systems contrasts with its use
of transportation pipelines. Whereas gathering systems operate as low pressure
systems that serve localized areas, transmission systems operate at high pressure
and generally extend over long distances. Because they are more localized and
serve far fewer fields than transmission systems, the economic lives of gathering
systems are more closely tied to those of natural gas producers’ wells than are
transmission pipelines. Gathering lines on gathering systems have shorter
physical life spans than transmission lines that transport processed gas.
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Moreover, the complex contractual relationships between Duke and the producers
whose gas it gathers create more interdependent relationships than those between
transmission pipeline owners and gas producers, whose contracts during the
period at issue were in the midst of a transition to an open-access, fee-for-
transportation regime. The net effect is that the economic character of Duke’s
gathering activities is more akin to production than pipeline operation.
B
The plain language of Rev. Proc. 87-56 describes the property that can be
included within Asset Class 13.2 as “assets used by petroleum and natural gas
producers,” including “gathering pipelines and related facilities.” The literal terms
of this description include any gathering system, so long as it is used by a gas
producer. Furthermore, because the language of Asset Class 13.2 is inclusive—it
“[i]ncludes assets used by petroleum and natural gas producers for drilling . . . and
production”—we are persuaded that the plain language of Asset Class 13.2 leads
most logically to a reading that includes Duke’s gathering systems even though
they are “used by” producers through contractual arrangements with Duke.
Whereas Asset Class 13.2 specifically includes “gathering pipelines and
related facilities,” Asset Class 46.0, which is named “Pipeline Transportation,”
refers in its description to “assets used in the private, commercial, and contract
carrying of petroleum, gas and other products by means of pipes and conveyors.”
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Read together, the two asset classes distinguish between types of assets:
“gathering pipelines” fall within Asset Class 13.2, and “trunk lines and related
storage facilities” fall within Asset Class 46.0. Although gathering systems
literally employ pipes, it is undisputed that trunk lines and gathering systems are
mutually exclusive terms referring to different types of pipeline systems.
Although gathering lines, like trunk lines, may in a broad sense “transport” or
“carry” gas from one point to another within the literal terms of Asset Class 46.0,
we cannot ignore their more specific inclusion as assets used in the exploration for
and production of gas in Asset Class 13.2.
The government would have us read the words “used by” in Asset Class
13.2 to incorporate an ownership requirement, and therefore include only those
gathering systems that are assets belonging to oil and natural gas producers.
Because Duke is not a producer, the government argues, Duke’s gathering systems
merely transport gas through pipelines rather than operate as part of a larger
endeavor to explore for and produce natural gas deposits. The assets, therefore,
would fall within Asset Class 46.0 rather than 13.2, and would have to be
depreciated over fifteen years. 6
6
The government’s suggestion that asset classes should be applied categorically to
industries rather than to particular assets, thus classifying Duke’s assets under 46.0 on the
basis of Duke’s status as a non-producer, contradicts the “primary use” provision of
Treas. Reg. 1.167(a)-11(b)(4)(iii)(b), as well as the government’s own concession that
Duke’s processing plants fall within Asset Class 49.23, not 46.0.
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We are not persuaded by the government’s interpretation of the asset class
descriptions. “Use” does not mean “own” in either the legal dictionary definition
of the word use, see Black’s Law Dictionary 1541 (6th ed. 1990) (“To make use
of; to convert to one’s service; to employ; to avail oneself of; to utilize; to carry
out a purpose or action by means of; to put into action or service, especially to
attain an end.”), nor in everyday parlance. Employing such an interpretation of the
word “use” in this context would contradict the purpose of a Revenue Procedure,
which is “published for the information and guidance” of taxpayers as well as the
IRS. 26 C.F.R. § 601.601(d)(2)(i)(a); see also 26 C.F.R. § 601.601(d)(2)(i)(b)
(describing the Revenue Procedure as “a statement of procedure that affects the
rights or duties of taxpayers or other members of the public under the Code and
related statutes or information that, although not necessarily affecting the rights
and duties of the public, should be a matter of public knowledge”). 7 As discussed
7
Although ordinarily the IRS is not bound by Revenue Procedures, Rev. Proc. 87-
56 clearly meets the substantive and procedural requirements for it to have the “force and
effect of law.” Estate of Shapiro v. Commissioner, 111 F.3d 1010, 1017-18 (2d Cir.
1997) (describing test for whether the IRS is bound by a Revenue Procedure) (citing
Ward v. Commissioner, 784 F.2d 1424, 1430-31 (9th Cir. 1986)). Because Rev. Proc. 87-
56 is analogous to law in its force and effect, two well-established methods of interpreting
revenue statutes are relevant: we look to the “ordinary, everyday senses” of the statute’s
words, see Crane v. Commissioner, 331 U.S. 1, 6 (1947); and “if doubt exists as to the
construction of a taxing statute, the doubt should be resolved in favor of the taxpayer,”
Hassett v. Welch, 303 U.S. 303, 314 (1938) (footnote omitted).
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above, the assets at issue are clearly “used by” producers in the ordinary sense of
those words.
The Revenue Procedure before us creates and describes asset classes for the
purpose of establishing depreciation schedules, and contains critical information
affecting taxpayer decisions about capital investment. We cannot accept the
government’s attempt to interpolate the words “owned by” into the description of
Asset Class 13.2. We instead interpret that description to include any gathering
system, so long as it is used by a gas producer—whether under its own ownership
or through contractual arrangements—in the exploration for and production of
petroleum and natural gas. Moreover, the word “includes” in Asset Class 13.2
suggests that even if the gathering systems at issue are not “used by” producers
within the government’s proposed construction of “use,” the category nevertheless
includes precisely analogous assets used by non-producers to provide services
directly to producers. See I.R.C. § 7701(c) (“The terms ‘includes’ and ‘including’
when used in a definition contained in this title shall not be deemed to exclude
other things otherwise within the meaning of the term defined.”); United States v.
State Farm Fire & Casualty Co. (In re Joplin), 882 F.2d 1507, 1511 (10th Cir.
1989) (rejecting, under I.R.C. § 7701(c), an interpretation of the revenue laws that
would substitute the term “limited to” for “including”).
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The government argues that in previous iterations of the asset classes in
dispute, the IRS distinguished between assets owned by gas producers and those
owned by non-producers. See, e.g., Rev. Proc. 72-10, 1972-1 C.B. 721, 731
(superseding Rev. Proc. 71-25, 62-21); Rev. Proc. 71-25, 1971-2 C.B. 553, 556
(establishing Asset Class 13.2); Rev. Proc. 62-21, 1962-2 C.B. 418, 424
(establishing Guideline Class 17(b), which “[e]xclude[d] gathering pipelines and
related storage facilities of pipeline companies”). We first note that all of the
relevant provisions of the earliest Revenue Procedures the government cites to
support its interpretation of the current asset class descriptions have been
explicitly superseded. See Rev. Proc. 72-10, 1972-1 C.B. 721, 731 (superseding
Rev. Proc. 71-25, 62-21); Rev. Proc. 71-25, 1971-2 C.B. 553, 566 (superseding
Rev. Proc. 62-21).
More importantly, the language of the most recent—and relevant—of these
prior iterations does not establish that gathering systems of nonproducers have
been distinguished from those of producers for depreciation purposes since 1972.
See Rev. Proc. 77-10, 1977-1 C.B. 548, 548 (superseding Rev. Proc. 72-10, while
noting that the change “was not intended to modify the composition of the existing
classes of Rev. Proc. 72-10”). Rev. Proc. 72-10, 1972-1 C.B. 721, 723, which
establishes the immediately prior (and still relevant) iteration of the applicable
sentence of the description of Asset Class 13.2, states that the class “[i]ncludes
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assets used for drilling of wells and production of petroleum and natural gas,
including gathering pipelines and related storage facilities, when these are related
activities undertaken by petroleum and natural gas producers.” This description
relies upon essentially the same language as the current asset class in stating that
when gathering systems are “used for” the drilling and production processes of
producers, they belong in Asset Class 13.2. We are no more persuaded by the
government’s argument that the words “undertaken by”—which refer to
“activities”—necessarily implies that the assets must be “owned by” producers
than we are persuaded that the words “used by” necessarily require ownership.
The relevant earlier asset class descriptions provide us with no clear mandate to
distinguish between gathering systems based upon ownership, and we therefore
will not do so.
Furthermore, were we to read a distinction into the asset classes requiring
taxpayers to place the gathering systems of nonproducers in Asset Class 46.0 and
the gathering systems of producers in Asset Class 13.2, we would thereby create
an inconsistent regime for the depreciation of assets. If placed in different classes,
gathering systems used for the same purpose and serving identical wells would fall
under different depreciation schedules depending upon the producer or
nonproducer status of the asset’s owner. 8 Moreover, if a producer sells a gathering
8
The government argues that some asset classes inconsistently treat the same asset
(continued...)
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system to a nonproducer such as Duke, the system would shift from one asset class
to another without any change in its function or characteristics, and the system’s
new owner would be forced to depreciate the asset over a far longer period. 9
Absent an explicit distinction based on ownership in the Revenue Procedure, we
decline to create such an inconsistency.
C
Finally, we note that the primary regulatory body for the oil and gas
industry, the Federal Energy Regulatory Commission (“FERC”), treats gathering
systems as “production-related” assets rather than as transmission facilities.
(...continued)
8
based solely on its ownership rather than its use. See, e.g., Rev. Proc. 87-56, 1987-2 C.B.
674 (distinguishing between assets used in the drilling of onshore gas wells by petroleum
and natural gas producers, which fall under Asset Class 13.2 and are allowed a
depreciation schedule of seven years, and the same assets used by nonproducers, which
fall under Asset Class 13.1 and are allowed a depreciation schedule of five years); id. at
681-82 (excluding from Asset Class 37.11, “Manufacture of Motor Vehicles,” those
assets used in the manufacture of component parts of motor vehicles when they are used
by anyone other than car manufacturers). These use-based distinctions, however, fail to
persuade us that they represent an ownership-based deviation from the “primary use” rule.
See id. at 678 (stating that Asset Class 13.1 “[d]oes not include assets used in the [drilling
of oil and gas wells] by integrated petroleum and natural gas producers for their own
account”); id. at 682 (stating that Asset Class 37.11 “[d]o[es] not include assets used in
the manufacture of component parts if these assets are used by taxpayers not engaged in
the assembly of finished motor vehicles”).
9
In a memorandum decision, the Tax Court has itself noted the absurdity of a
similar interpretation of analogous language. See Illinois Cereal Mills, Inc. v.
Commissioner, 46 T.C.M. (CCH) 1001, 1030 (refusing to find that an ownership change
resulted in a change of “use” for purposes of determining the asset class of grain storage
tanks), aff’d, 789 F.2d 1234 (7th Cir. 1986).
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Although FERC has jurisdiction over the interstate transportation of natural gas,
see 15 U.S.C. § 717(b), it does not have jurisdiction over “the production or
gathering of natural gas.” Id. Under FERC’s multi-factor analysis of whether a
particular asset’s primary function is transportation or gathering and would
therefore not be under FERC’s jurisdiction, Duke’s assets would most likely
constitute assets used for gathering because of the diameter of the lines, their
spider web configuration, and the operating pressure of the line. See EP Operating
Co. v. FERC, 876 F.2d 46, 48 (5th Cir. 1989) (quoting Farmland Industries, Inc.,
23 FERC ¶ 61,063, 61,143 (1983)) (describing FERC’s primary function test); see
also Associated Natural Gas, Inc., 71 FERC ¶ 61,048 (1995) (declaratory order
stating that one of Duke’s gathering systems in this case is not subject to FERC
jurisdiction). Moreover, FERC’s own Uniform System of Accounts, see 18 C.F.R.
pt. 201, recognizes the function of gathering systems as a step between and related
to production and processing.
The Tax Court summarily dismissed the distinction that FERC makes
between gathering and transmission lines because FERC’s practices have not been
adopted by Congress or the Commissioner. See Duke Energy, 109 T.C. at 421.
Nevertheless, we find the distinction FERC makes to be persuasive that the gas
industry and the regulatory body overseeing it consider gathering systems to be
used for the activity of production, rather than transportation.
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IV
Because of the primary use of gathering systems in the process of producing
natural gas, as well as the plain language of the asset class descriptions, Duke’s
gathering systems fit more logically within Asset Class 13.2 than Asset Class
46.0. 10
We therefore REVERSE the Tax Court’s decision.
Because of this conclusion, we need not address the parties’ alternative
10
arguments that Duke’s gathering systems belong in either Asset Classes 49.23 (“Natural
Gas Production Plant”) or 00.3 (“Land Improvements”).
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