Saginaw Bay Pipeline Co. v. U.S., 01-2599.

• Decision Date: 30 July 2003
• Docket Number: No. 01-2599.,01-2599.
• Citation: 338 F.3d 600
• Parties: SAGINAW BAY PIPELINE COMPANY, CMS Saginaw Bay Company, Saginaw Bay Lateral Company, and CMS Saginaw Bay Lateral Company, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 600

338 F.3d 600

SAGINAW BAY PIPELINE COMPANY, CMS Saginaw Bay Company, Saginaw Bay Lateral Company, and CMS Saginaw Bay Lateral Company, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

No. 01-2599.

United States Court of Appeals, Sixth Circuit.

Argued May 7, 2003.

Decided and Filed July 30, 2003. Pursuant to Sixth Circuit Rule 206

ARGUED: Todd R. Mendel, BARRIS, SOTT, DENN & DRIKER, Detroit, Michigan, for Appellants. (argued and briefed), Barris, Sott, Denn & Driker, Detroit, MI. Thomas P. Marinis, Jr. (briefed), Vinson & Elkins, Houston, TX, for Appellants.

Teresa T. Milton, UNITED STATES DEPARTMENT OF JUSTICE, APPELLATE SECTION TAX DIVISION, Washington, D.C., for Appellee.

ON BRIEF: Todd R. Mendel, BARRIS, SOTT, DENN & DRIKER, Detroit, Michigan, Thomas P. Marinis, Jr., VINSON & ELKINS, Houston, Texas, for Appellants.

Teresa T. Milton, Richard Farber, UNITED STATES DEPARTMENT OF JUSTICE, APPELLATE SECTION TAX DIVISION, Washington, D.C., for Appellee.

Alan I. Horowitz, Tamara W. Ashford, MILLER & CHEVALIER CHARTERED, Washington, D.C., for Amicus Curiae.

Before: KRUPANSKY, SILER, and GILMAN, Circuit Judges.

OPINION

KRUPANSKY, Circuit Judge.

The plaintiffs-appellants, Saginaw Bay Pipeline Company, CMS Saginaw Bay Company, Saginaw Bay Lateral Company, and CMS Saginaw Bay Lateral Company (collectively "the plaintiffs," "Saginaw Bay," or "the pipeline companies"),¹ have contested the district court's disallowance, following a bench trial, of their claim against the defendant-appellee United States of America through the Internal Revenue Service (hereinafter "the defendant," "the government," or "the I.R.S.") for reimbursement of $3,474,244.00 in income tax payments, deposited under protest, which the I.R.S. had assessed via tax deficiency notices for the five calendar years 1991 through 1995. See Saginaw Bay Pipeline Co. v. United States, No. 99-CV-70454, 2001 WL 1203283 (E.D.Mich. Aug. 23, 2001) (ordering final judgment for the defendant United States); Saginaw Bay Pipeline Co. v. United States, 124 F.Supp.2d 465 (E.D.Mich.2000) (denying, on cross-motions, summary judgment to all litigants). The sole issue in controversy was (and remains) whether, under prevailing law, the plaintiffs' underground natural gas pipelines should be depreciated over a seven-year period, as argued by the plaintiffs, or instead should be subject to fifteen-year depreciation, as asserted by the government and as resolved by the district court. The factual and legal epicenter of the dispute is whether or not the subject pipeline system is a "gathering" pipeline (as defined and developed herein) used in the gas production process even though the plaintiffs are not themselves producers of natural gas.

In the late 1980s, Shell Western Exploration and Production, Inc. ("SWEPI"), a division of Shell Oil Company ("Shell"), commenced negotiations with the Michigan Consolidated Gas Corporation ("MichCon") for MichCon's construction and operation of a steel pipeline system to transmit unprocessed natural gas (known in prevailing industry parlance as "raw" or "wet" natural gas) from SWEPI's gas wellheads in eighteen distinct production fields located in the Michigan East Central Basin to its natural gas processing plant situated in Kalkaska, Michigan ("the Kalkaska facility"). MichCon, through its subsidiary MCN Corporation, formed the plaintiff entities for that purpose. Between 1988 and 1990, the plaintiffs constructed, in accordance with SWEPI's specifications, a 126-mile subterranean steel pipeline network traversing six Michigan counties which linked SWEPI's East Central Basin gas fields to the Kalkaska facility.

That system consisted of a central line leading into the Kalkaska processing plant, which was fed by lateral adjoining pipes which linked specific wellheads to "field separators"² and ultimately to the main pipeline. The main pipeline had a daily maximum capacity of 135 million cubic feet of "wet" gas. At all times material to this litigation, although the plaintiffs owned and operated the pipeline system, the transient "raw" natural gas remained the property of its producer throughout the transportation process.³ The producers compensated the plaintiffs for the use of the pipeline on a contractual "fee-for-service" basis.

Natural gas, in its "raw" form when extracted from the earth at the wellhead, is typically contaminated with numerous impurities, including, among other things, butane, ethane, pentane, propane, water, nitrogen, carbon dioxide, other inert gases, sulphur, sand, and drilling fluids. All adulterants must be substantially removed at a purification site such as the Kalkaska facility, leaving only nearly-pure "dry" methane gas, prior its sale to residential or commercial consumers. The cleansed, customer-ready "dry" petrochemical fuel is then exported from the purification plant to distributors or other customers via lines which, for purposes of this decision, shall be denominated "transmission" or "distribution" pipelines, which are pipelines designed and operated solely for the carriage of "dry" hydrocarbon gas, sometimes referred to in the fossil fuel business as "pipeline-quality gas."⁴ By contrast, because the Saginaw Bay pipeline was designed to, and was operated as, a conduit for "wet" natural gas, it constituted a species of natural gas transportation pipeline frequently described, within prevailing natural gas industry nomenclature, as a natural gas "gathering" pipeline.⁵

Because the respective functions of "gathering" pipelines, vis a vis "transmission" or "distribution" pipelines, as defined herein, are entirely distinct, the operating standards for the two systems are correspondingly dissimilar. For example, whereas "transmission" or "distribution" pipeline systems are typically unable to safely accommodate any significant presence of solid or liquid contaminants, "gathering" pipelines including the Saginaw Bay system must be equipped to handle at least limited amounts of the non-gaseous components of "raw" natural gas. Additionally, because "raw" natural gas ordinarily burns at a higher temperature than "dry" natural gas, "transmission" or "distribution" line service contracts generally provide for the transport of fossil fuel having a relatively low "heating value," usually no more than 950 British Thermal Units ("BTUs"); whereas "gathering" lines (including the Saginaw Bay system) transport "raw" gas with higher "energy values," typically ranging between 950 and 1400 BTUs. The Saginaw Bay service contracts specified that "the Gas shall have a total heating value per standard cubic foot of not less than 950 British thermal units." (Emphasis added).

Likewise, a "gathering" system must be constructed to function at relatively low pressures over comparatively short distances. The Saginaw Bay system could tolerate no more than 1440 pounds per square inch ("psi") of pressure, and covered only 126 miles. By contrast, a "transmission" or "distribution" line usually functions at comparatively higher pressures over longer distances, often totaling hundreds of miles.

Perhaps most significantly, "gathering" pipelines must be flushed out regularly — a process labeled "pigging" — to avert or delay excessive wear-and-tear pipeline corrosion and the accumulation of foreign obstructive materials, given the ubiquitous presence of contaminants dissolved within "wet" natural gas; whereas "transmission" or "distribution" lines conveying only clean "dry" gas never require that type of expensive and time-consuming routine maintenance. Record proof reflected that, during the interval pertinent to the instant action, at least some portions of the Saginaw Bay system required "pigging" twice or thrice daily.

Consequently, because the purposes and functions of "gathering" lines are commercially distinct from those of "transmission" or "distribution" lines, the coordinate economic costs and investment risks accompanying each are also diverse. The unique expenses and production delays affiliated with the regular "pigging" of "gathering" pipelines are obvious examples. The singular risks of serious damage to "gathering" lines by corrosion or obstruction, and the attendant initial need to construct a comparatively sturdy "gathering" pipeline relative to a "transmission" or "distribution" line, constitute further examples.

Additionally, a functional "transmission" or "distribution" line will ordinarily retain a useful and profitable economic life for as long as gas dealers or consumers connected by that line to the processing plant continue to purchase heating gas; however, a "gathering" line more likely may become obsolete, redundant, or otherwise unprofitable prior to its natural "wear-and-tear" expiration, if, for example, the field wellheads it services become depleted or otherwise unproductive, or comparatively inexpensive alternate sources of "raw" natural gas accessible to the processing plant become competitively available. Accordingly, "gathering" lines are not only more costly and labor-intensive to construct, maintain, and operate, but also generally have a shorter operational life span than "transmission" or "distribution" lines.

Because both "transmission" or "distribution" natural gas pipes, and "gathering" natural gas lines, constitute property used in a trade or business, the owner of either type of pipeline is entitled to a "reasonable allowance" for annual depreciation of that asset against the owner's ordinary business income for a finite number of years. See 26 U.S.C. § 167(a)(1). The depreciation allowance for tangible property used in a trade or business should be ascertained by reference to three factors — namely the legally-prescribed (1) "depreciation method," (2) "recovery period," and (3) "convention" — for the business asset at issue. See 26 U.S.C. §§ 167(b), 168(a). The adversaries sub judice have agreed that the instant controversy involves only element...