Duke Energy Natural Gas Corp. v. Commissioner

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

-2-
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.

-3-
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.

-4-
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).

-6-
 [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).

-7-
 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

-8-
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.

-9-
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.”

- 10 -
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.

- 11 -
 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).

- 12 -
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”).

- 13 -
 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

- 14 -
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...)

- 15 -
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).

- 16 -
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.

- 17 -
 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”).

- 18 -