The Alaska Supreme Court in a Dec. 16 decision upheld production taxes paid in 2005 and 2006 by Chevron, ConocoPhillips, ExxonMobil and Forest Oil, a dispute based on aggregation of fields for taxation purposes.
Attorney General Jahna Lindemuth said in a statement that the decision ensures the state retains some $500 million in taxes and interest.
Lindemuth called it a great result for the state, “Not only from a fiscal point of view, but it also recognizes the expertise of Department of Revenue in interpreting tax laws.”
The issue arose under an earlier production tax system, ELF, based on a production tax of 15 percent multiplied by the economic limit factor, a coefficient between zero and one which was calculated for each field, the Alaska Supreme Court said in its decision.
In 1989 the Legislature added the “field size factor,” the volume of production during a given month, as a component of ELF, the court said. “All else being equal, the field size factor produced a higher ELF (and therefore a higher tax rate) for larger fields and a lower ELF (and therefore a lower tax rate) for smaller fields,” based on the reasoning that while smaller fields needed production facilities similar to larger fields, with less production smaller fields had poor economics of scale and were less profitable.
The downside, the court said, was that the field size factor created an incentive for companies “to capitalize on tax breaks for smaller fields by classifying certain areas as independent fields even if the areas were economically interdependent with other, larger fields.”
The aggregation statute permitted Revenue to aggregate two or more fields “when economically interdependent oil or gas production operations are not confined to a single lease or property.” Aggregation was dependent, the court said, on whether the fields were “economically interdependent,” but the Legislature did not define that term in statute and Revenue never defined it in regulations.
Petition for assurance
Revenue adopted regulations permitting producers to petition for assurance that Revenue would not aggregate specific fields for ELF calculations. Requirements for the guarantee included showing that common production facilities would lower production costs; that the guarantee would increase the likelihood a new field would be developed; that oil would be accurately allocated; and that “operations ... would not be economically interdependent in the absence of the proposed use of common production facilities.”
But proof of those factors did not guarantee an advance ruling. And as with related regulations, “economically interdependent” was not defined.
The ELF-based tax system was repealed in 2006.
Prudhoe
Prudhoe initially had two participating areas, one for oil and one for natural gas, each with production facilities. A third participating area, Lisburne, was approved in 1986; Lisburne also had its own production facilities.
Nine additional reservoirs were later identified at Prudhoe and the Department of Natural Resources approved participating areas for each. Six of those, the satellite participating areas, are involved in the appeal, the court said: Aurora, Borealis, Midnight Sun, Orion, Polaris and Point McIntyre.
The satellites did not have their own production facilities. Their fluids were processed at facilities built to serve the original participating areas, with production measured at Pump Station No. 1 of the trans-Alaska oil pipeline and production allocated based on estimates of well productivity as determined by periodic tests of the wells.
The central production facilities could not handle all production, the court said, so “fluids from some wells were ‘backed out,’ or blocked, in favor of fluids from other wells based on the ‘best well produces’ principle,” favoring fluids with the highest ratio of oil to gas.
Satellite participating areas at Prudhoe had smaller field size factors and thus a lower ELF than the initial participating areas, with production from the initial participating areas taxed at a rate of about 12.5 percent and production from satellites at less than 0.5 percent.
As older wells in the initial participating areas tended to produce more gas, “lower-tax oil from the Satellite PAs backed out higher-tax oil from the initial PA wells at increasing rates,” growing from 217,896 barrels in 2000 to 1,224,090 barrels in 2004, the court said.
Advance rulings
Producers sought advance rulings from Revenue on aggregation, with multiple requests filed between August 1998 and November 2001, with Revenue telling producers as early as 2000 that it was examining the issue - but it never acted on the requests.
The department did, however, conduct internal analyses, producing “a variety of internal memoranda and internal departmental position papers acknowledging confusion over the interpretation of ‘economic interdependence’ and analyzing whether it would be better to clarify the term via statute, regulation, or administrative decision,” the court said.
While drafts seemed to indicate Revenue was looking at regulations to address the issue, the director of the Tax Division issued Revenue’s decision in January 2005 without regulations, notifying producers that the department had decided to aggregate the initial participating areas and satellite participating areas at Prudhoe effective Feb. 1, 2005.
“DOR found that operations at the Initial PAs and the Satellite PAs were economically interdependent, and, therefore, DOR aggregated them, referencing a variety of policy reasons for its decision,” the court said, “resulting in a higher ELF and a higher tax rate” on oil from the properties.
In finding the areas economically interdependent the department cited shared production facilities, decisions by the owners on which wells to produce and which to back out across participating areas and commingling of fluids.
The court quoted the department as saying that the Legislature intended ELF “to serve as a tax break for costlier production, but in Prudhoe Bay, non-aggregation gave a tax break to oil from the Satellite PAs even though that oil was less costly to produce due to its higher ratio of oil to gas than the oil from the initial PAs.”
Producers appeal
The producers appealed the decision in March 2005 and in November 2008, after an informal conference, the department affirmed its earlier decision.
The producers appealed to the Office of Administrative Hearings, which upheld Revenue’s decision “and concluded that DOR was not required to engage in formal rulemaking in interpreting the Aggregation Statute the way it did in its Decision.”
The producers then appealed to superior court, which held that Revenue had adopted a commonsense interpretation of the statute that did not require formal rulemaking.
The producers then appealed to the Alaska Supreme Court, which, in its Dec. 16 ruling, concluded Revenue’s decision “was not a regulation because it was a commonsense interpretation of the statute” and did not require regulations, affirming the superior court’s decision.
Regulations issue
The department had discussed the possibility of making a change through regulation in internal documents. The producers said in their Supreme Court appeal that Revenue’s decision constituted a regulation and since it was adopted without complying with requirements for establishing regulations the decision was invalid.
The court said that under Alaska statute regulation encompasses many statements by agencies, including policies and guides to enforcement, but “not every agency action or decision constitutes a regulation.” Regulations must meet two criteria, the court said: it must be an action that implements, interprets or make specific the law; and it must affect the public or be used by the agency in dealing with the public.
The court said “agencies must have some freedom to apply relevant statutes without the burden of adopting a regulation each time they do so.” The court said it had clarified that actions that are merely commonsense interpretations of existing requirements are not regulations requiring compliance with rulemaking standards.
But, the court said, agency actions may not be commonsense interpretations if the agency adds requirements of substance, interprets a statute in way that is expansive or unforeseeable or alters its previous statutory interpretation.
The court said Revenue clarified the scope of statute “by indicating the degree of economic interdependence that could warrant aggregation, but it did not add any specific criteria to the term ‘economically independent’ that went beyond the scope of the Aggregation Statute’s existing language.” It also found Revenue’s interpretation of “economic interdependence” to be consistent with dictionary definition of the terms.
The Legislature gave Revenue the discretion to aggregate fields to accomplish the purpose of taxing different fields at different rates to reflect underlying economics and incentivize development of smaller, less profitable fields, the court said. “When oil and gas operations in different fields become integrated such that there is no meaningful separation between production in the different fields, there is no justification for maintaining different effective tax rates on those fields.”
The court also found Revenue’s decision did not depart from previous interpretation of the Aggregation Statute.
It affirmed the lower court’s conclusion that Revenue’s decision was not a regulation but a commonsense interpretation of the Aggregation Statute and also upheld the lower court’s decision upholding Revenue’s decision.
