Duke Energy Natural Gas Corp. v. C.I.R.

Decision Date13 April 1999
Docket NumberNo. 98-9008,98-9008
Citation172 F.3d 1255
Parties-1818, 99-1 USTC P 50,449, 1999 CJ C.A.R. 2498 DUKE ENERGY NATURAL GAS CORPORATION, Petitioner--Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent--Appellee, Gas Processors Association ("GPA") and Western Gas Resources, Inc. ("WGR"), Amici Curiae.
CourtU.S. Court of Appeals — Tenth Circuit

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").


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 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 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. 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.


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).

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.

[ ... ]

[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 WL 770402 (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


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).


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 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...

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