Exxon Mobil Corp. v. United States

Decision Date03 August 2022
Docket Number21-10373
Citation43 F.4th 424
Parties EXXON MOBIL CORPORATION, Plaintiff—Appellant/Cross-Appellee, v. UNITED STATES of America, Defendant—Appellee/Cross-Appellant.
CourtU.S. Court of Appeals — Fifth Circuit

Kannon K. Shanmugam, Matteo Godi, Brian M. Lipshutz, Paul, Weiss, Rifkind, Wharton & Garrison, L.L.P., Washington, DC, Emily A. Parker, Esq., Holland & Knight, L.L.P., Dallas, TX, Adam Savitt, Paul, Weiss, Rifkind, Wharton & Garrison, L.L.P., New York, NY, for PlaintiffAppellant/Cross-Appellee.

Clint Aaron Carpenter, Bruce Raleigh Ellisen, Judith Ann Hagley, Esq., U.S. Department of Justice, Tax Division, Appellate Section, Washington, DC, Jonathan Lee Blacker, U.S. Department of Justice, Tax Division, Dallas, TX, Cory Arthur Johnson, U.S. Department of Justice, Tax Division, Washington, DC, for DefendantAppellee/Cross-Appellant.

David Blair, Carina Federico, Crowell & Moring, L.L.P., Washington, DC, for Amicus Curiae.

Before Clement, Graves, and Costa, Circuit Judges.

Gregg Costa, Circuit Judge:

In this tax doubleheader, Exxon seeks $1.5 billion from the IRS. The source of this whopping sum is two retroactive changes Exxon made to its returns. The first change involves a tax issue almost as old as the oil industry itself: whether a transaction is a mineral lease or mineral sale. See, e.g., Goldfield Consol. Mines Co. v. Scott , 247 U.S. 126, 38 S.Ct. 465, 62 L.Ed. 1022 (1918) ; Stratton's Indep., Ltd. v. Howbert , 231 U.S. 399, 34 S.Ct. 136, 58 L.Ed. 285 (1913). The second concerns a more recent development in the tax code: how an incentive for producing renewable fuels affects a company's excise tax, and in turn, its income tax. The district court rejected both changes but gave Exxon back a penalty the IRS imposed for requesting an excessive refund. We affirm.

I

The first issue—worth a billion dollars—involves agreements Exxon entered into with Qatar and Malaysia to commodify those countries' abundant offshore oil-and-gas deposits. The question is whether these agreements are mineral leases or mineral sales.

A

The Qatari agreements grant Exxon rights to explore the North Field, a large offshore gas field within Qatar's territorial waters. The agreements last for fixed terms, typically twenty 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 has invested $20 billion in such infrastructure, which includes a pipeline network to bring the offshore gas onshore, liquification facilities to turn the gas into liquid products for transportation, and technologically advanced ships that transport gas to foreign countries. By some measures, this infrastructure produces petroleum products that are twenty times as valuable as gas in place. When the agreements end, Qatar keeps this infrastructure. The agreements aim to develop an international market for Qatari gas.

Malaysia sought to create a domestic market for oil and gas. So its state-owned oil company1 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—that is, 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 has developed considerable extraction, transportation, storage, and processing infrastructure in Malaysia, which reverts to the state after the contracts expire.

Transfers of mineral interests are typically categorized as leases or sales. In a mineral lease, the transferor provides minerals in place and grants the transferee the right to explore those minerals in exchange for a share of the income from mineral production. See 5 MERTENS LAW OF FEDERAL INCOME TAXATION § 24:21 (2022). An example would be allowing someone to drill for oil on one's land in exchange for a 1/4 interest in the oil produced. See Murphy Oil Co. v. Burnet , 287 U.S. 299, 300, 53 S.Ct. 161, 77 L.Ed. 318 (1932). In a mineral sale, the transferor "makes an outright transfer" of mineral interests for fixed consideration that does not depend on mineral production. 5 MERTENS, supra , at § 24:16. An example would be selling a fixed amount of minerals under one's land for $200,000. See Whitehead v. United States , 555 F.2d 1290, 1292 (5th Cir. 1977).

Mineral leases and mineral sales receive different income-tax treatment. With mineral leases, the transferor's income from minerals is treated as ordinary taxable income. 5 MERTENS, supra , at § 24:66. That is, a portion of the overall income from minerals is included only in the transferor's taxable income and excluded from the transferee's taxable income. Id. The transferor and transferee are each entitled to depletion deductions to the extent of their interest in the minerals. See 26 C.F.R. § 1.611-1.

For mineral sales, the transferor realizes income only at the time of the sale. 5 MERTENS, supra , at § 24:19. Income derived from the extraction of minerals is included in the transferee's taxable income, and only the transferee is entitled to depletion deductions. Id. Income that the transferor receives from the transaction—the sales price—is taxed as capital gains. Id.

When it filed 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. The income that would have been taxable to Qatar and Malaysia in the mineral-lease context was now taxable to Exxon. 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. How so? Exxon's new math had the downstream effect of clearing the way for it to claim foreign-tax credits. Because Exxon had paid foreign tax on the money that it now included in its U.S. taxable income, Exxon was able to claim credit intended to prevent the double taxation of income. The foreign-tax credits generated its mammoth refund request.

The IRS rejected Exxon's refund claim. It also imposed a $200 million penalty for Exxon's claiming an excessive refund without a reasonable basis. Exxon paid the penalty and filed a refund action in district court.

After a bench trial, the district court ruled in the government's favor on the lease-versus-sale issue. On the penalty issue, however, the court held for Exxon and ordered a refund. Exxon appealed the lease-versus-sale issue, and the government cross-appealed the rejection of the penalty.

B

The lease-or-sale classification turns on the concept of "economic interest."2 If Qatar and Malaysia retain an economic interest in the mineral deposits that Exxon extracts, the agreements are leases; if not, the agreements are sales. Whitehead , 555 F.2d at 1292 ; see also 5 MERTENS, supra , at § 24:16.3

An "economic interest" is a right to share in the profits and losses of a business. One example is owning stock. The stock goes up when the company succeeds and down when it struggles. Similarly, it seems apparent that a party entitled to a percentage of the profits from any oil extracted has an economic interest in the oil. The more oil that is drilled, the more money the royalty holder makes. See Anderson v. Helvering , 310 U.S. 404, 409, 60 S.Ct. 952, 84 L.Ed. 1277 (1940) ("The holder of a royalty interest ... is deemed to have ‘an economic interest’ ....").

The law crystallizes this lay understanding. 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. 26 C.F.R. § 1.611-1(b)(1) (adopting the two-part test from Palmer v. Bender , 287 U.S. 551, 557, 53 S.Ct. 225, 77 L.Ed. 489 (1933) ).

Qatar and Malaysia have an economic interest. In exchange for giving Exxon valuable rights to drill in the North Field and Malay Basin, Qatar and Malaysia "retain[ ] a right to share in the [minerals] produced." Palmer , 287 U.S. at 557, 53 S.Ct. 225. Qatar receives a percentage of the proceeds from the sale of petroleum products and an additional amount that depends on how much gas Exxon delivers to its Qatari facilities. Malaysia is entitled to a set percentage of oil extracted from the Malay Basin, plus additional payments that turn on how much oil and gas is produced.

These uncapped royalties, which last for the entire duration of the agreements, are similar to royalties that case after case deems an economic interest. See Palmer , 287 U.S. at 553–59, 53 S.Ct. 225 (holding that a royalty of one-eighth of oil produced was sufficient for an economic interest); Rutledge v. United States , 428 F.2d 347, 350 (5th Cir. 1970) (holding that royalty payments pegged to the amount of material extracted constituted an economic interest); Wood , 377 F.2d at 307 (holding that a minimum guaranteed royalty payment created an economic interest); Gray v. Comm'r , 183 F.2d 329, 330–31 (5th Cir. 1950) (holding that an "overriding...

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