Fifth Circuit Upholds $1.5 Billion Judgment Against Oil and Gas Company

(Parker Tax Publishing August 2022)

The Fifth Circuit affirmed the decision of a district court holding that an oil and gas company's agreements with two foreign governments to commodify those countries' oil and gas deposits were mineral leases rather than sales under Reg. Sec. 1.611-1(b)(1) because the companies retained economic interests in the mineral deposits the company extracted. The Fifth Circuit also held that in applying the renewable fuel credit under Code Sec. 6426(a), the company could deduct only the amount of the excise tax it actually paid after claiming the credit rather than the greater amount it would have paid without the credit. Exxon Mobil Corp. v. U.S., 2022 PTC 228 (5th Cir. 2022)).

Background

Exxon Mobil Corp. (Exxon) entered into agreements with Qatar and Malaysia to commodify those countries' abundant offshore oil and gas deposits. The main issue in this case was whether these agreements were mineral leases or sales.

The Qatari agreements granted Exxon rights to explore the North Field, a large offshore gas field within Qatar's territorial waters, for a fixed term - typically 20 years. In exchange for mineral rights, Exxon must extract gas and pay Qatar royalties based on the petroleum products it produces. These royalties include a percentage of the proceeds from the sale of petroleum products as well as a minimum amount based on how much gas Exxon brings through its facilities. Exxon also must build and operate facilities to transport, store, process, and market its products. According to Exxon, it invested $20 billion in such infrastructure, which includes a pipeline network, liquification facilities, and technologically advanced ships that transport gas to foreign countries. When the agreements end, Qatar keeps this infrastructure.

Malaysia's state-owned oil company entered into similar fixed-term agreements with Exxon. The Malaysian agreements give Exxon rights to extract offshore minerals in the Malay Basin. In exchange, Malaysia is entitled to in-kind royalties - set percentages of the oil extracted from the Malay Basin - and additional payments that turn on how much oil is produced. In addition, Exxon must make annual "abandonment cess" payments that do not depend on mineral production. These payments fund the costs of plugging wells at the end of their useful lives. As in Qatar, Exxon developed considerable extraction, transportation, storage, and processing infrastructure in Malaysia, which reverts to the state after the contracts expire.

Mineral Sales vs. Leases

Transfers of mineral interests are generally either leases or sales, which receive different income tax treatment. With mineral leases, the transferor's income from minerals is treated as ordinary taxable income. That is, a portion of the overall income from minerals is included only in the transferor's taxable income and is excluded from the transferee's taxable income. In addition, under Reg. Sec. 1.611-1, the transferor and transferee are each entitled to depletion deductions to the extent of their interest in the minerals. For mineral sales, the transferor realizes income only at the time of the sale. Income derived from the extraction of minerals is included in the transferee's taxable income, and only the transferee is entitled to depletion deductions. Income that the transferor receives from the transaction (i.e., the sales price) is taxed as capital gains.

The lease-or-sale classification turns on the concept of "economic interest," meaning a right to share in the profits and losses of a business. This concept is reflected in Reg. Sec. 1.611-1(b)(1), which provides that in order to have an economic interest in minerals in place, a person must have: (1) an investment in the minerals, and (2) income derived "solely" from extraction of the minerals.

Exxon's Tax Returns

On its tax returns for years 2006 to 2009, Exxon treated its mineral transactions with Qatar and Malaysia as leases. Exxon, as the transferee, thus did not include in its taxable income the portion of mineral-based income that it paid to Qatar and Malaysia as royalties. A few years later, Exxon amended its returns and filed a refund claim. In the amended returns, Exxon instead treated the mineral transactions as sales. Exxon's taxable income increased, because it now included all the income derived from minerals, including the royalties paid to Qatar and Malaysia. In turn, Exxon offset a portion of the increase in its taxable income by deducting some of the royalty payments it made to Qatar and Malaysia. Despite the increase in its taxable income, Exxon nevertheless requested a massive refund of $1 billion. Because Exxon had paid foreign tax on the money that it now included in its U.S. taxable income, Exxon claimed foreign tax credits which generated its mammoth refund request.

Exxon claimed on its amended returns that it made another mistake on its original returns. In 2008 and 2009, Exxon had an excise tax liability under Code Sec. 4081 of roughly $6 billion. However, Exxon also produced renewable fuels, and therefore qualified for a $960 million renewable fuels credit under Code Sec. 6426(a). Exxon applied the credit against its original $6 billion liability and paid a reduced excise tax of around $5 billion. On its original tax returns, Exxon deducted that lesser amount from its gross income rather than the $6 billion it would have owed in excise taxes had it not claimed the credit. However, on its amended returns, Exxon deducted $6 billion in excise tax - unreduced by the credit for renewables. In other words, Exxon increased its excise-tax deduction, and thus reduced its taxable income, by $960 million. That translated to a $300 million reduction in tax owed.

The IRS rejected Exxon's refund claim based on its treatment of the Qatar and Malaysia mineral transactions as sales rather than leases. A $200 million penalty was also applied under Code Sec. 6676(a) (as in effect prior to 2018) for Exxon's claiming an excessive refund without a reasonable basis. The IRS also rejected Exxon's refund claim based on its increased excise tax deduction. The IRS stated that since Exxon already used the credit to reduce the excise tax, it could not use the same credit to decrease its taxable income. Exxon paid the penalty and filed a refund action in a district court. The district court ruled in the government's favor on the lease-versus-sale and the credit issues. On the penalty issue, however, the court held for Exxon and ordered a refund.

Exxon appealed to the Fifth Circuit. Regarding the lease-versus-sale issue, Exxon focused on the word "solely" in Reg. Sec. 1.611-1(b)(1), and argued that Qatar and Malaysia did not have an economic interest in the minerals because they received additional sources of income besides mineral royalties - infrastructure, access to markets, and in Malaysia's case, abandonment cess payments. In other words, Exxon's view was that an economic interest depends on whether a party is entitled to oil payments and nothing else. On the issue of the renewable fuel credit, Exxon contended that the credit satisfies or pays the excise tax rather than merely altering the amount of tax imposed. Therefore, it asserted that it could deduct the full amount of excise tax imposed without a reduction for the credit. All in all, Exxon was seeking $1.5 billion refund from the IRS.

Analysis

The Fifth Circuit affirmed the district court. The Fifth Circuit found that Qatar and Malaysia had an economic interest because, in exchange for giving Exxon valuable rights to drill in the North Field and Malay Basis, Qatar and Malaysia retained rights to share in the minerals produced. The court noted that Qatar received a percentage of the proceeds from the sale of petroleum products and an additional amount that depends on how much gas Exxon delivered to its Qatari facilities. Malaysia was entitled to a set percentage of oil extracted from the Malay Basin, plus additional payments that turned on how much oil and gas was produced. The court said that such a durable stream of royalties, which are uncapped and last for the entire duration of the agreements, is the quintessential example of an economic interest.

In the court's view, the fact that the retained royalties reflected not only the value of oil and gas at the wellhead, but also the significant value that Exxon added through transportation and processing, did not dissolve Qatar's and Malaysia's economic interest. What mattered to the court was whether the payments depended on minerals. The court reasoned that Qatar's and Malaysia's right to income through royalties depended solely on minerals because without oil and gas, Qatar and Malaysia received no royalties. According to the court, that the countries were entitled to supplemental income was irrelevant.

Regarding the penalty, the Fifth Circuit said that it was a close call but that the district court correctly granted Exxon a refund on that issue, given that the lease/sale issue is a notoriously complex area of tax law. The Fifth Circuit also upheld the district court's decision regarding the application of the renewable fuel credit. The court explained that the commonly understood meaning of a "credit" is that it reduces the tax against which it is applied, and the fact that fuel producers may receive the renewable fuel credit as a direct payment did not change the court's conclusion. The court explained that fuel producers cannot claim direct payments in lieu of excise tax reductions, but must first apply the credit against their excise tax liability and only if their credit exceeds their excise tax can they receive the excess as a direct payment. Therefore, the credit reduced Exxon's excise tax and Exxon could deduct only the reduced amount.

For a discussion of depletion deductions and the economic interest requirement, see Parker Tax ¶95,305. For a discussion of the excise tax on taxable fuels and the renewable fuel credit, see Parker Tax ¶236,101.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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