alaska v. conocophillips, 3an-10-05484 ci, (alaska 2011) conocophillips' brief

8/4/2019 Alaska v. ConocoPhillips, 3AN-10-05484 CI, (Alaska 2011) ConocoPhillips' Brief

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IN THE SUPERIOR COURT FOR THE STATEOF ALASKATHIRD JUDICIAL DISTRICT AT ANCHORAGESTATE OF ALASKA, DEPARTMENT OFREVENUE, TAX DIVISION,

Appellant,v.

CONOCOPHILLIPS ALASKA, INC.,A ellee.

JAN 18 2011.

Case No.: 3AN-I0-05484 CIOAH Case No. 07-0565-TAX

APPEAL FROM THE OFFICE OF ADMINISTRATIVE HEARINGS,CHIEF ADMINISTRATIVE LAW JUDGE TERRY L. THURBON, PRESIDINGBRIEF OF APPELLEE, CONOCOPHILLIPS ALASKA, INC.

Leon T. Vance (Alaska BarNumber 8309096)Faulkner Banfield, P.C.One Sealaska Plaza, Suite 202Juneau, Alaska 99801(907) 586-2210

By: t,.-.. - r . . ( j ~ ....Leon T.Vance

Filed in the Superior Courtin Anchorage, Alaskaon January , 2011.

B y : - : : : - - : - ~ ~ _ - : - - - : : : : - __Clerk of the Superior Court


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TABLE OF CONTENTS

TABLE OF CONTENTS ..................................................................................................... ITABLE OF AUTHORITIES ............................................................................................. IIICONSTITUTIONAL PROVISIONS, STATUTES, COURT RULES, ORDINANCESAND REGULATIONS PRINCIPALLY RELIED UPON ................................................ VINTRODUCTION ............................................................................................................... 1JURISDICTIONAL STATEMENT .................................................................................... 1ISSUES PRESENTED FOR REVIEW ............................................................................... 2STATEMENT OF THE CASE ........................................................................................... 2STANDARD OF REVIEW ................................................................................................. 2ARGUMENT ....................................................................................................................... 3

I. The OAH Properly Determined that the Make-Whole Premium Must Be Included in theCalculation of the Cost-Of-Capital Allowance ........................................................................... 3

A. Statement of the Case ................................................................................................... 31. Background ............................................................................................................... 32. Course of Proceedings .............................................................................................. 9

B. Argument ...................................................................................................................... 91. Framework of Statutes and Regulations ................................................................... 92. DOR Must Follow the Requirements of Its Own Regulation ................................. 123. As a Factual Matter, the Make-Whole Premium Was an Ordinary and NecessaryTransportation Expense .................................................................................................... 154. As a Matter of Law, the Make-Whole Premium Was an Ordinary and NecessaryExpense ............................................................................................................................. 175. The OAH Correctly Determined that DORs Interpretation of the Regulation WasNot Supported by a Reasonable Basis .............................................................................. 26

II. The OAH Correctly Determined that the Administrative Fee Paid for Facilitating anExchange Serving No Purpose for CPAI Was Not Compensation for Quality Differentials ... 27

A. Statement of the Case ................................................................................................. 271. Background ............................................................................................................. 272. Course of Proceedings ............................................................................................ 34

B. Argument .................................................................................................................... 351. The OAHs Decision Cured the Factual Mistakes in DORs Decision .................. 352. As a Matter of Law, the Administrative Fee Is Not Compensation for QualityDifferentials ...................................................................................................................... 38


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3. There Was No Reasonable Basis for DORs Erroneous Interpretation of ItsRegulation ......................................................................................................................... 44

CONCLUSION ................................................................................................................. 48


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TABLE OF AUTHORITIES

Cases

B. Forman Co., Inc. v. Commissioner of Internal Revenue, 453 F.2d 1144 (2d Cir.), cert.denied, 407 U.S. 934 (1972) .......................................................................................... 19

Button v. Haines Borough, 208 P.3d 194 (Alaska 2009) .................................................. 44

Commissioner of Internal Revenue v. Heininger, 320 U.S. 467 (1943) ...................... 15, 25

Commissioner of Internal Revenue v. Pacific Mills, 207 F.2d 177 (1st Cir. 1953) ..... 21, 25

Commissioner of Internal Revenue v. Polk, 276 F.2d 601 (10th Cir. 1960) ...................... 25

Deputy v. DuPont, 308 U.S. 488 (1940) ............................................................................ 19

Gulf Oil Corp. v. State, Department of Revenue, 755 P.2d 372 (Alaska 1988) ................... 19

Northwest Medical Imaging v. State, 151 P.3d 434 (Alaska 2006) .................................... 3

State v. Dyncorp, 14 P.3d 981 (Alaska 2000) ............................................................... 3, 19

State of Alaska, Department of Revenue v. Atlantic Richfield Company, 858 P.2d 307(Alaska 1993) ........................................................................................................... 13, 14

Sun Oil Company v. Commissioner of Internal Revenue, 562 F.2d 258 (3d Cir. 1977),cert. denied, 436 U.S. 944 (1978) .................................................................................. 20

Unocal Corp. v. Kaabipour, 177 F. 3rd 755 (9th Cir.), cert. denied, 528 U.S. 1061(1999) ............................................................................................................................... 5

Welch v. Helvering, 290 U.S. 111 (1933) .................................................................... 19, 21

Statutes

AS 43.05.280 ..................................................................................................................... 48

AS 43.05.405 ................................................................................................................. 9, 35

AS 43.05.430 ....................................................................................................................... 9

AS 43.05.435(2) ................................................................................................................ 17

AS 43.05.465(a). .................................................................................................................. 2

AS 43.05.480 ....................................................................................................................... 2


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AS 43.05.499(6) ....9, 35

AS 43.55.011 ................................................................................................................... 7, 9

AS 43.55.150 ............................................................................................................. 7, 9, 33

AS 44.62.560 ....................................................................................................................... 2

AS 44.62.570(b) .................................................................................................................. 2Regulations

15 AAC 55.151(b) ................................................................................................. 33, 35, 44

15 AAC 55.180 ........................................................................................................ 7, 10, 33

15 AAC 55.191 .............................................................................................................. 7, 34

15 AAC 55.191(a)..10

15 AAC 55.191(b).8, 10, 11, 24

15 AAC 55.191(o).....34

15 AAC 55.195 ........................................................................................................ 8, 11, 24

15 AAC 55.196(d) ......................................................................................................... 8, 11

Computation of a Cost-of-Capital Allowance under 15 AAC 55.196, IncorporatingDepreciation and Return on Invested Capital for Marine Vessels and Improvements(November 21, 2002) (ROI Regulation) .......................................................... 8, 11, 12

Other Authorities

Donald J. Weidner, Synthetic Leases: Structured Finance, Financial Accounting and TaxOwnership, 25 Iowa J. Corp. L. 445 (2000) .................................................................... 5

John C. Murray, Off-Balance Sheet Financing: Synthetic Leases, 32 Real PropertyProbate and Trust Journal 193 (1997)........................................................................ 5, 20


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CONSTITUTIONAL PROVISIONS, STATUTES, COURT RULES,

ORDINANCES AND REGULATIONS PRINCIPALLY RELIED UPON

Alaska Statute 43.05.435

The administrative law judge shall hear all questions de novo under AS43.05.405 - 43.05.499. The administrative law judge shall

(1) resolve a question of fact by a preponderance of the evidence or, if adifferent standard of proof has been set by law for a particular question, bythat standard of proof;

(2) resolve a question of law in the exercise of the independent judgment ofthe administrative law judge;

(3) defer to the Department of Revenue as to a matter for which discretionis legally vested in the Department of Revenue, unless not supported by areasonable basis.

Alaska Statute 43.05.465(a)

Within 180 days after the record on the appeal is closed, the administrativelaw judge shall issue a decision in writing. Unless reconsideration isordered under (c) of this section, the decision under this subsection is thefinal administrative decision.

Alaska Statute 43.05.480(a) and (c)

(a) Judicial review by the superior court of a final administrative decisionmay be had by a party to the appeal under AS 43.05.405 - 43.05.499 byfiling a notice of appeal in accordance with the applicable rules of courtgoverning appeals to that court in civil matters.

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(c) Appeals under this section are reviewed under AS 44.62.560 and 44.62.570.

Alaska Statute 44.62.570(b)

Inquiry in an appeal extends to the following questions: (1) whether theagency has proceeded without, or in excess of jurisdiction; (2) whether


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there was a fair hearing; and (3) whether there was a prejudicial abuse ofdiscretion. Abuse of discretion is established if the agency has notproceeded in the manner required by law, the order or decision is notsupported by the findings, or the findings are not supported by the

evidence.

Alaska Statute 43.55.011(a) and (b) (2003 Version)

(a) There is levied upon the producer of oil a tax for all oil produced fromeach lease or property in the state, less any oil the ownership or right towhich is exempt from taxation. The tax is equal to either the percentage-of-value amount calculated under (b) of this section multiplied by theeconomic limit factor determined for the oil production of the lease orproperty under AS 43.55.013.

(b) The percentage-of-value amount equals 15 percent of the gross valueat the point of production of taxable oil produced from the lease or property.

Alaska Statute 43.55.150(a) (2003 Version)

(a) For the purposes of AS 43.55.011 - 43.55.150, the gross value shall becalculated using the reasonable costs of transportation of the oil or gas. Thereasonable costs of transportation shall be the actual costs

Alaska Administrative Code 15 AAC 55.151(b) (2003 Version)

The gross value at the point of production for a producer's oil or gas mustbe calculated as follows:

(1) a destination value must be determined for the oil or gas

(2) except as otherwise provided under (i) of this section, the producer'sreasonable costs of transportation under 15 AAC 55.180 and 15 AAC55.191 must be subtracted from the destination value determined under (1)

of this subsection;

(3) if oils of different qualities or oil and NGLs are commingled, the valuecalculated under (2) of this subsection must be adjusted for anyconsideration paid or received for quality differentials, regardless ofwhether prescribed by a filed tariff;


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Alaska Administrative Code 15 AAC 55.180(a) (2003 Version)

(a) Except as provided in (b) of this section, the reasonable cost of

transportation is the actual cost of transportation as determined in 15 AAC55.191(a) and (b), if the actual costs incurred are ordinary andnecessary transportation expenses.

Alaska Administrative Code 15 AAC 55.191(a), (b) and (o) (2003

Version)

(a) Reasonable costs of transportation are the ordinary and necessary costsincurred to transport the oil or gas from the point of production to the salesdelivery point .

(b) Actual costs of transportation allowable for purposes of 15 AAC55.180(a) are

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(3) if transportation of oil is by a vessel that is owned or effectively owned,in whole or in part, by the producer of that oil, the producer's actual cost forthat transportation, which is the sum of

(A) voyage and port costs incurred with respect to that transportation, asprovided in (j) of this section;

(B) the positioning cost, amortized over 36 months, for that vessel;

(C) depreciation of the vessel as calculated by the producer for financialaccounting purposes and used for reporting income and expenses toshareholders and owners, or as provided in 15 AAC 55.195(a) , (b), (c), (f),or (h) or 15 AAC 55.196, as applicable; and

(D) an amount that, when added to the amount of depreciation allowed

under (C) of this paragraph, will provide a reasonable return on theacquisition cost, as provided in 15 AAC 55.195(a) , of the vessel over itsexpected useful life as used for financial accounting purposes and used forreporting income and expenses to shareholders and owners, or on theadjusted shipyard cost or invested capital as provided in 15 AAC 55.195(b),(c), (f), or (h) or 15 AAC 55.196, as applicable;


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(o) A producer shall report any reimbursed costs to the department.Reimbursed costs are not allowable as actual costs of transportation under

this section.

Alaska Administrative Code 15 AAC 55.195(b) (2003 Version)

For a vessel or LNG transportation facility placed in service on or afterJanuary 1, 1995, and before January 1, 2002, a cost of capital allowancewill be allowed as provided in 15 AAC 55.196 for oil or gasproduced on or after January 1, 2002.

Alaska Administrative Code 15 AAC 55.196(a) and (d) (2003 Version)

(a) Except if 15 AAC 55.195(a) applies, for oil or gas produced on or afterJanuary 1, 2003, a cost of capital allowance that consists of depreciationand a return on invested capital will be allowed under this section for avessel owned or effectively owned by the producer .

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(d) A cost of capital allowance under this section must be calculated usingthe methodology set out in the department's publication Computation of aCost-of-Capital Allowance under 15 AAC 55.196, IncorporatingDepreciation and Return on Invested Capital for Marine Vessels andImprovements, dated November 21, 2002 and adopted by reference.

State of Alaska Department of Revenue Tax Division Computation of a

Cost-of-Capital Allowance under 15 AAC 55.196 Incorporating

Depreciation and Return on Invested Capital for Marine Vessels and

Improvements, November 21,2002 (incorporated by 15 AAC 55.196(d))

(2003 Version)

Introduction

This publication sets out the methodology to be used by producers incomputing the cost-of-capital allowance for marine vessels andimprovements under 15 AAC 55.196. This methodology provides forseparately computing a cost-of-capital allowance for each individual vessel,including improvements to that vessel, to which 15 AAC 55.196 applies.


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Computation of an allowance is performed using a series of input schedulesand calculation tables that are generally organized on a calendar year basis.The input schedules consist of information supplied by the producer. The

calculation tables utilize the information in the input schedules to derive theallowance. In all schedules and tables, unless otherwise specified, each rowcorresponds to a calendar year. The rows are set out in chronological orderstarting with the earliest year to which the schedule or table in questionapplies. The columns are organized by category of data or computation,which are described below in the Instructions for Input Schedules andInstructions for Calculation Tables.

The input schedule and calculation table forms are set out following theinstructions. An illustrative example is also provided.

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Instructions for Input Schedules 3-1 through 3-6Expected Future Schedules

The entries for this table are schedules, to be submitted for the year forwhich the tax is calculated, showing the producer's various expected futurepost-service cash flow events for the vessel, for each future year. Theseitems include depreciation (Input Schedule 3-1), post-service CCF deposits(Input Schedule 3-2), CCF withdrawals (Input Schedule 3-3), otherrevenues and expenditures with after-tax benefits cash flows (InputSchedule 3-4), other revenues and expenditures with non-taxable cashflows (Input Schedule 3-5), and other revenues and expenditures withtaxable cash flows (Input Schedule 3-6). A new schedule is submitted eachyear. For any subsequent year for which the tax is calculated, if theproducer believes future cash flows will be different than those previouslyused for these years in previous calculations, the producer shall changethese entries for the year being calculated and future years. The entry forthe year being calculated is the amount actually incurred by the producer. Ifthe actual amount is not known at the time the tax is due the producer shallsubmit an amended schedule when the actual amount is known.

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Input Schedule 3-5: Other Revenues and Expenditures- Non-Taxable CashFlows


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These include the producer's anticipated amounts of other non-taxablerevenues and expenditures associated with the vessel, including cash flowsassociated with sale/leaseback agreements, or synthetic leases. Examplesare the purchase price of a vessel paid to the producer by a lessor who

intends to lease the vessel back to the producer, or the re-purchase pricepaid by the producer at the end of the lease, if the proceeds or theexpenditures are not taxable or deductible for tax to the producer. Theamount for any year is entered as the revenues minus the expenditures.

Input Schedule 3-6: Other Revenues and Expenditures- Taxable Cash FlowEvents

This shall include the producer's anticipated amounts of other taxablerevenues and expenditures associated with the vessel, including cash flows

associated with sale/leaseback agreements, or synthetic leases. Examplesare the lease payments associated with sale/leaseback agreements, orsynthetic leases. The amount for any year is entered as the revenues minusthe expenditures.

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APPENDIX: Example

Following is an example of using the methodology described in thispublication to calculate the cost-of-capital allowance. The example containsboth a hypothetical set of inputs, and the calculations that would result fromthose inputs. An Excel spreadsheet with this example is available from thedepartment.

The example is predicated on the following hypothetical set of circumstances:

I. Pre-Service

1. A vessel with a capitalized basis of $120 million begins useful life in 2003.

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III. Expected Future Schedules

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5. The vessel is subject to a synthetic lease, where the producer will sell thevessel to a lessor in 2003 for $100 million, lease it back for ten years for $6million per year, and buy the vessel back in 2012 at the original sales price.Input Schedule 3-5 shows the sale and re-purchase transactions, assuming

these are not taxable transactions to the producer.

6. Input Schedule 3-6 shows the above-mentioned lease payments,assuming the lease payments are tax deductible to the producer.


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INTRODUCTION

The Department of Revenue (DOR) appeals from a decision of the Office of

Administrative Hearings (OAH), which correctly determined that DOR had erred in

two distinct decisions it had made concerning the calculation of the production tax on oil

paid by ConocoPhillips Alaska, Inc. (CPAI) for 2003. The production tax is calculated

by taking the sales price of the oil at the point of disposition and deducting from it

various costs incurred in transporting it to the point of disposition in order to arrive at the

value upon which the tax is based. On the first issue, DOR incorrectly determined that

part of the consideration an affiliate of CPAI paid to acquire a tanker used to transport oil

to market was not an allowable element to include in the calculation of the deductible

transportation expenses. On the second issue, DOR incorrectly determined that an

administrative fee CPAI earned for facilitating an oil exchange transaction that provided

no benefit to CPAI was compensation for degradation of that oil, and therefore reduced

CPAIs deductible transportation expenses. In both instances the OAH carefully reviewed

the facts and controlling law and, applying the appropriate standard of review and

alternative standards of review, determined that there was no legal or reasonable basis for

DORs decisions. The OAHs decision should be affirmed.

JURISDICTIONAL STATEMENT

Appellee is satisfied with Appellants Jurisdictional Statement.


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ISSUES PRESENTED FOR REVIEW

1. Even though the relevant regulation required lease payments paid in

installments over time to be included in the Cost-of-Capital Allowance calculation, DOR

determined that a lower one-time payment substituting for those lease payments should

not be included in that calculation. Did the OAH correctly determine that it was not

necessary to defer to that decision?

2. DOR determined that a contract administration fee due whether or not oil was

degraded somehow constituted consideration for degradation of oil. Did the OAH

correctly determine that it was not necessary to defer to that decision?

STATEMENT OF THE CASE

Appellee will present the Statement of the Case in the appropriate argument

sections.

STANDARD OF REVIEW

The decision the OAH issued in its capacity as the Office of Tax Appeals, not the

DORs Informal Conference Decision, is the final administrative decision in this

matter.1 Judicial review of the OAHs decision is governed by AS 43.05.480, which

provides that the review of the final administrative decision occurs under AS 44.62.560

and .570.2 Under AS 44.62.570(b), the scope of review of the OAHs decision is limited:

1 AS 43.05.465(a).2 AS 43.05.480(c).


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(1) whether the agency has proceeded without, or in excess of jurisdiction;(2) whether there was a fair hearing; and (3) whether there was a prejudicialabuse of discretion. Abuse of discretion is established if the agency has notproceeded in the manner required by law, the order or decision is not

supportedby the findings, or the findings are not supported by theevidence.3

In practical terms, that means that in reviewing the OAHs decision this Court should

apply the substantial evidence test to questions of fact and the substitution of

judgment standard to questions of law.4

ARGUMENT

I. THE OAH PROPERLY DETERMINED THAT THE MAKE-WHOLEPREMIUM MUST BE INCLUDED IN THE CALCULATION OF THE COST-

OF-CAPITAL ALLOWANCE

A.Statement of the Case1. Background

Polar Tankers, Inc., is a subsidiary of ConocoPhillips Company, as is the taxpayer

here, CPAI. In 2001, Polar Tankers, then a subsidiary of Phillips Petroleum Company,

took possession of a new tanker, the Polar Endeavour.5 In order to finance the

acquisition of the tanker, Polar Tankers sold the Polar Endeavourto Arctic Funding

Limited Partnership for the sum of $205,000,000, and simultaneously leased the vessel

back from Arctic Funding for a term of 10 years.6 Under the terms of the lease, Polar

3

In this context, the term agency must be read to mean the OAH, because its decisionis the final administrative decision under review.4State v. Dyncorp, 14 P.3d 981, 985 (Alaska 2000);Northwest Medical Imaging v. State,151 P.3d 434, 438 (Alaska 2006).5 [R. 253].6 [R. 480, 494, 520].


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Tankers was to pay to Arctic Funding periodic rental payments, totaling approximately

$14.8 million per year, during the term of the lease, and at the end of the term it was

required to repurchase the vessel from Arctic Funding by payment of the initial

acquisition cost.7 Phillips Petroleum guaranteed Polar Tankers payment obligations

under the lease.8 The lease granted Polar Tankers the right to repurchase the vessel at any

time during the lease term by paying the initial financed acquisition cost plus a Debt

Yield-Maintenance Premium, along with other amounts not at issue.9

Arctic Funding, meanwhile, sold ten-year promissory notes in the principal

amount of $198,850,000 to various investors in order to fund its purchase of the vessel.10

Arctic Funding was to pay the noteholders semi-annual interest payments, funded by

Polar Tankers periodic rental payments, and then would pay the principal sum when the

notes became due in 2011.11 In the event that Polar Tankers exercised its early repurchase

right under the lease, Arctic Funding was required to pay the noteholders the principal

sum plus a Make-Whole Premium.12 The Make-Whole Premium was based on the

difference between: a) the present value of the expected future cash flows under the notes

(the underlying principal amount plus the remaining scheduled interest payments at the

7

[R. 292, 520, 543-44].8 [R. 566].9 [R. 542].10 [R. 399].11 [R. 478].12 [R. 413].


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time of the termination) discounted at governmental note yield rates prevailing at the time

of the repurchase; and, b) the underlying principal amount.13

That financing technique is called a synthetic lease transaction. The primary

advantage of structuring the financing in that manner is that although the Lessee (here,

Polar Tankers) was required to treat the synthetic lease as a financing transaction for

federal income tax purposes, it was permitted to treat the synthetic lease as an operating

lease for the purposes of financial reporting under Generally Accepted Accounting

Principles (GAAP).14

That meant that on the consolidated balance sheet of first Phillips

Petroleum Company and then ConocoPhillips Company (Polars parent companies) the

lease expense during a specific time period was reported as an operational expense for

that period, but the gross financed acquisition cost was not directly reported on the

balance sheet as a debt obligation, though it was disclosed generally in the Notes to

Consolidated Financial Statements and elsewhere in the financial reporting.

15

13 [R. 415, 834].14See Unocal Corp. v. Kaabipour, 177 F. 3rd 755, 765-66 (9th Cir.), cert. denied, 528U.S. 1061 (1999); Donald J. Weidner, Synthetic Leases: Structured Finance, Financial

Accounting and Tax Ownership, 25 Iowa J. Corp. L. 445, 447 (2000); John C. Murray,Off-Balance-Sheet Financing: Synthetic Leases, 32 Real Property, Probate and TrustJournal 193, 194 and 196 (1997). The term synthetic refers to the blended treatment the synthesis of the same transaction under IRS and GAAP standards. Weidner, 25Iowa J. Corp. Law at 449.15 [R. 706, 739, 753, 754].


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In August 2002, ConocoPhillips Company was created by a merger between

Phillips Petroleum Company and Conoco, Inc..16 After the merger was completed

ConocoPhillips was carrying more debt than it deemed desirable, and it adopted the

reduction of debt as an important part of its business plan.17 In January 2003 the

Financial Accounting Standards Board (FASB) issued Interpretation No. 46:

Consolidation of Variable Interest Entities.18 In summary, for ConocoPhillips, FASB

Interpretation No. 46 meant that by virtue of its guaranty of Polar Tankers payment

obligations under the synthetic lease, ConocoPhillips was required to report the

acquisition cost of the Polar Endeavouras debt on its consolidated balance sheet.19 The

advantage of a synthetic lease over traditional financing therefore disappeared, and the

addition of the cost of the Polar Endeavour, and other similarly financed assets, further

increased ConocoPhillipss reported debt, making debt reduction even more imperative.20

In December 2003, as part of ConocoPhillipss company-wide program of retiring

synthetic leases and similar financing arrangements affected by Interpretation No. 46,

Polar Tankers exercised its right to repurchase the Polar Endeavourfrom Arctic

Funding.21 As required under the lease agreement, Polar Tankers paid the initial

acquisition cost, $205,000,000, plus the Debt Yield-Maintenance Premium of

16

[R. 697].17 [R. 695].18 [R. 744, 753, 754].19 [R. 758, 762, 796-97, 806-07].20 [R. 758].21 [R. 253, 758, 797, 806-07].


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$34,156,402, along with other costs not at issue.22 That terminated Polar Tankers

obligation to pay periodic rental payments of approximately $14.8 million per year for

the seven years remaining on the lease, a total of over $100 million.23 The Debt Yield-

Maintenance Premium was defined as the amount of the Make-Whole Premium to be

paid by Arctic Funding to the noteholders according to the terms of the Arctic Funding

Note Purchase Agreement.24 That amount, as noted above, was calculated by taking the

difference between the present value of the expected future cash flows under the note,

discounted at then-current governmental note yield rates, and the principal amount to be

repaid under the note.25

Under AS 43.55.011 and .150, the value of the crude oil on which the production

tax at issue here is paid is calculated by deducting from the eventual sales price (or

equivalent) the reasonable costs of transportation incurred in getting the crude oil to a

market.

26

Under 15 AAC 55.180, reasonable costs of transportation include the actual

costs of transportation as calculated in 15 AAC 55.191, if they are ordinary and

22 [R. 253, 542, 823, 824, 834].23 [R. 292, 520, 542].24 [R. 498]. Polar therefore actually paid the Debt-Yield Maintenance Premium toArctic Funding, which in turn paid that amount to its noteholders as the Make-WholePremium. Because the Informal Conference Decision and the Office of Administrative

Hearings decision refer to Polars payment to Arctic Funding as the Make-WholePremium, this brief will do so as well.25 [R. 415-16, 841].26 The production tax statutes and regulations have been amended extensively since 2003.Unless otherwise noted, citations to the production tax statutes and regulations in thisbrief will refer to those statutes and regulations as they existed in 2003.


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necessary transportation expenses. Under AS 15 AAC 55.191(b)(3), the actual costs of

transportation allowed include depreciation and an amount that when added to

depreciation will provide a reasonable return on acquisition cost as provided in 15

AAC 55.195.

Under 15 AAC 55.195(b), the reasonable return calculation includes a cost of

capital allowance. Under 15 AAC 55.196(d), the cost of capital allowance must be

calculated using the method set forth in the DOR publication the regulation adopts by

reference: Computation of a Cost-of-Capital Allowance under 15 AAC 55.196,

Incorporating Depreciation and Return on Invested Capital for Marine Vessels and

Improvements (November 21, 2002) (ROI Regulation).27 The ROI Regulation

specifically recognizes synthetic lease transactions as a common financing mechanism

and demonstrates how they should be accounted for generally.28 In particular, the ROI

Regulation on the input schedules for Other Revenues and Expenditures Taxable Cash

Flow Events, provides:

This shall include the producers anticipated amounts of other taxablerevenues and expenditures associated with the vessel, including cash flowsassociated with sale/leaseback agreements, or synthetic leases. Examplesare the lease payments associated with sale/leaseback agreements, orsynthetic leases.29

27 [R. 837].28 [R. 843, 844, 850, 870].29 [R. 850].


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2. Course of ProceedingsCPAI, the taxpayer here, included in that input schedule the $34,156,402 Make-

Whole Premium in its calculation of the Cost-of-Capital Allowance.30 The Tax Division

disallowed that input, thus reducing the Cost-of-Capital Allowance.31 CPAI appealed that

disallowance within the Department of Revenue.32 The Department of Revenue upheld

the disallowance in an Informal Conference Decision, concluding that the Make-Whole

Premium was not an ordinary and necessary expense of marine transportation.33 Under

AS 43.05.430, CPAI appealed that decision to the OAH, acting in its capacity as the

Office of Tax Appeals.34 The OAH ruled that as a matter of law the Make-Whole

Premium was an ordinary and necessary expense and that DORs decision to disallow

that payment in the calculation of the Cost-of-Capital Allowance was not supported by a

reasonable basis.35 DOR sought reconsideration, which the OAH denied, and DOR

appealed the OAHs decision to this Court.36

B. Argument1. Framework of Statutes and Regulations

The tax at issue is the oil production tax imposed under AS 43.55.011(b) on the

gross value at the point of production of taxable oil. Under AS 43.55.150, the gross

30 [R. 286].31

[R. 291-92].32 [R. 323, 327].33 [R. 255].34 [R. 364-65]. See AS 43.05.405 and .499(6).35 [R. 72-75].36 [R. 1].


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value at the point of production must be calculated by deducting from the price at the

point of disposition the reasonable costs of transportation incurred in moving the oil to

the place of disposition. In the case of crude oil CPAI produces on Alaskas North Slope

and disposes of at refineries on the west coast, the oil is transported through the Trans-

Alaska Pipeline System from the North Slope to Valdez, and then by tanker from Valdez

to the west coast. Whether CPAI or its parent company charters tankers or owns the

tankers, the tankers are an essential element of transporting the crude oil to market.

In general, therefore, the costs incurred in acquiring the tankers that transport the

crude oil are ordinary and necessary expenses of transportation under 15 AAC

55.180(a) and 191(a). If a taxpayer obtains the tanker by chartering it from an

independent third party, the actual charter costs are deductible expenses.37 With respect

to tankers owned by the taxpayer or an affiliated company, however, the regulations

require the calculation of the allowable deduction in the following manner:


(A) voyage and port costs incurred with respect to that transportation ;


(C) depreciation of the vessel ; and

(D) an amount that, when added to the amount of depreciation allowedunder (C) of this paragraph, will provide a reasonable return on the

37 15 AAC 55.191(b)(2).


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adjusted shipyard cost or invested capital as provided in 15 AAC 55.195(b).38

Under 15 AAC 55.195(b), the amount to be combined with depreciation to provide

a reasonable return is defined to include a cost of capital allowance as provided in 15

AAC 55.196. And 15 AAC 55.196(d), in turn, specifically incorporates into the

regulation the ROI Regulation:

A cost of capital allowance under this section must be calculated using themethodology set out in the department's publication Computation of a Cost-of-Capital Allowance under 15 AAC 55.196, Incorporating Depreciation

and Return on Invested Capital for Marine Vessels and Improvements,dated November 21, 2002, and adopted by reference.

The Informal Conference Decision acknowledges that the ROI Regulation demonstrates

that DOR specifically recognizes synthetic leases as valid tanker financing arrangements

whose elements are to be included in the calculation of the cost-of-capital allowance.39

At multiple points in the calculation process the ROI Regulation directs taxpayers

to enter into the input schedules expenditures associated with the vessel, including cash

flows associated with sale/leaseback arrangements, or synthetic leases.40 In particular,

in Input Schedule 3-6: Other Revenues and Expenditures Taxable Cash Flow Events,

the regulation provides:

This shall include the producers anticipated amounts of other taxablerevenues and expenditures associated with the vessel, including cash flows

associated with sale/leaseback agreements, or synthetic leases. Examples

38 15 AAC 55.191(b)(3) (emphasis added).39 [R. 253].40 [R. 844, 850 (emphasis added)].


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are the lease payments associated with sale/leaseback agreements, orsynthetic leases.41

Indeed, the ROI Regulation specifically includes an example of a vessel financed through

a synthetic lease:

III. Expected Future Schedules

****

5. The vessel is subject to a synthetic lease, where the producer will sell thevessel to a lessor in 2003 for $100 million, lease it back for ten years for $6million per year, and buy the vessel back in 2012 at the original sales price.Input Schedule 3-5 shows the sale and re-purchase transactions, assumingthese are not taxable transactions to the producer.6. Input Schedule 3-6 shows the above-mentioned lease payments,assuming the lease payments are tax deductible to the producer.42

2. DOR Must Follow the Requirements of Its Own RegulationDORs regulations therefore specifically recognize expenses associated with

synthetic leases as ordinary and necessary expenses constituting part of the reasonable

costs of transportation that can be deducted in the calculation of the taxable value of oil.

And the ROI Regulation specifically directs taxpayers to input on Schedule 3-6 cash

flows associated with synthetic leases, without excluding cash flows that terminate

the lease payment cash flow, such as the Make-Whole Premium.43 Here, had Polar

Tankers continued making the lease payments under the terms of the lease for seven more

years in an amount in excess of $100 million dollars, DOR acknowledged that those cash

flows properly would be included in the cost-of-capital allowance calculation under the

41 [R. 850 (emphasis added)].42 [R. 870].43 [R. 850].


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ROI Regulation.44 There is no basis in the regulation for excluding from that calculation

the one-time cash flow of roughly $34 million associated with the same lease that Polar

Tankers paid under the terms of the lease as a substitute for the allowable cash flow of

over $100 million paid over time.

Thus, the ROI Regulation itselfrequires the inclusion of the Make-Whole

Premium in the cost-of-capital calculation. The Make-Whole Premium was incurred as a

result of the early repurchase of the Polar Endeavour under the terms of the synthetic

lease. It undeniably was an expenditure associated with the vessel, and more particularly

a cash flow associated with the synthetic lease. Under the terms of the ROI Regulation,

that cash flow must be accounted for in the cost-of-capital calculation, specifically in

Input Schedule 3-6. DOR is not free to ignore the plain language of its own regulation.45

In theAtlantic Richfieldcase, DOR wrote a regulation addressing the deductibility

under an income tax of interest paid on the construction of an oil pipeline. The regulation

permitted the deduction of all interest paid as a result of the construction of the pipeline,

and did not limit the deductibility to a portion of the interest attributable to debt secured

only by the pipeline itself; that is, even if assets of a parent company, as well as the

financed pipeline itself, were used to secure the debt, the regulation still would permit the

deduction of all interest paid. DOR argued that its decision nevertheless to apportion the

44 [R. 255] (Semiannual lease payments were includable in determining the cost-ofcapital allowance under 15 AAC 55.196.). See also [R. 254].45State of Alaska, Department of Revenue v. Atlantic Richfield Company, 858 P.2d 307,310 (Alaska 1993).


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deduction to reflect only interest associated with debt secured by the pipeline itself was

consistent with the statute and therefore should be upheld.46 The Alaska Supreme Court

disagreed, and, even though it was applying a rational basis standard of review, ruled

that DOR was bound by the plain language of the regulation as it had written it:

The regulation does not indicate that interest expense deductions are limitedin any way other than that the money be borrowed from a third party for thepurpose of constructing TAPS.

****The regulation as written, however, cannot be reasonably read to allow theuse of an apportionment formula.47

Here, too, DOR cannot ignore its own regulation. The regulation authorizes the

inclusion of all cash flows associated with the synthetic lease and does not limit the types

of cash flows in any way. However DOR might speculate about scenarios where it would

need to limit the regulation despite its lack of express limitations, there is no valid

concern here.48 The ROI regulation specifically uses lease payments as an example of

properly included cash flow, and DOR acknowledged the lease payments of more than

$100 million here would have been allowed. The Make-Whole Premium of some $34

million substituted for and terminated those undeniably allowable payments; it is equally

undeniably allowable. Whether other expenses would be deductible is not at issue. The

ROI regulation cannot reasonably read to exclude a cash flow associated with the lease

46Id. at 309-10.47Atlantic Richfield Company, 858 P.2d at 310.48 Appellants Brief at 19.


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that serves as the functional equivalent of the allowable lease payments. As it was in

Atlantic Richfield,DOR is bound by the regulation it wrote.

3. As a Factual Matter, the Make-Whole Premium Was an Ordinary andNecessary Transportation Expense

In addition, although the OAH ruled that the Make-Whole Premium was an

ordinary and necessary expense as a matter of law, that determination essentially is one

of fact:

Whether an expenditure is directly related to a business and whether it isordinary and necessary are doubtless pure questions of fact in most

instances.49

As such, the OAHs determination is reviewed under the substantial evidence standard,

and there is no question that the decision was supported by substantial evidence.

The OAH carefully and properly reviewed the Lease Agreement, under which

Polar Tankers had the obligation to fulfill the terms of the agreement in one of two

relevant ways:

1) It could make the semi-annual lease payments for the full ten years of the Lease

Agreement, which in 2003 would have required making payments of over $100

million, and then repurchase the vessel for $205 million at the end of the lease

term;50 or,

2) With proper notice, it could repurchase the vessel for $205 million before the

end of the lease term, pay a Make-Whole Premium, which in 2003 was an amount

49Commissioner of Internal Revenue v. Heininger, 320 U.S. 467, 475 (1943).50 [R. 520].


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of about $34 million, and terminate the Lease Agreement and obligation to make

lease payments (over $100 million remaining to be paid in 2003).51

Either course of action would fulfill Polar Tankers obligations under the terms of the

Lease Agreement, but one or the other was required. That is, Polar Tankers had the right

to terminate the obligation to pay $100 million in lease payments over seven more years,

but, to do so it had the obligation to pay the $34 million Make-Whole Premium. That was

not a penalty, but a negotiated, alternative form of payment of the consideration

required by the contract. Polar Tankers could elect to pay a larger nominal sum in

installments over time, or a smaller nominal sum at one time, but its contractual

obligation to pay one way or the other was clear.

The synthetic lease agreement itself clearly was ordinary, as DOR itself adopted a

regulation addressing such arrangements, and there is no question that the lease payments

required under it were necessary. Likewise, even though Polar did not have to exercise its

right to early termination and repurchase option, if it did so, there is no question that

under the express terms of the Lease Agreement the payment of the Make-Whole

Premium was required as a substitute for the lease payments and, therefore, necessary.

Substantial, undisputed evidence established that as a factual matter, as well as a legal

matter, the Make-Whole Premium was an ordinary and necessary expense.

51 [R. 542].


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4. As a Matter of Law, the Make-Whole Premium Was an Ordinary andNecessary Expense

If the issue is viewed as a legal one instead of a factual one, then in the exercise of

its independent judgment this Court still must conclude that the Make-Whole Premium

was an ordinary and necessary expense. First, contrary to DORs arguments, to the extent

the determination whether an expense is ordinary and necessary is a legal one, it is not

one involving DORs specialized expertise. Under AS 43.05.435(2), therefore, the OAH

correctly reviewed the issue using its independent judgment, and this Court can do so as

well.

The OAH focused on the issue as one of contract interpretation requiring no

deference to DOR, and correctly concluded that under the terms of the Lease Agreement

the Make-Whole Premium was both an ordinary and a necessary payment:

Once the repurchase option was exercised, the obligation to pay the $34.2million make-whole premium arose and was no more avoidable than the

obligation to pay the $205.0 million repurchase price itself.52

And, as discussed above, the consequence of making the $34 million payment was to

terminate the obligation to make over $100 million of lease payments over the next seven

years, lease payments that DOR acknowledged were allowable ordinary and necessary

expenses:

The use of synthetic leasing is not an unusual form of financing and semi-annual lease payments based on 6.85% interest on the notes would havebeen allowable if paid through the remaining term of the lease.

****

52 [R. 73].


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The company could have left the lease in effect and included thesemiannual lease payments in the ROI model, but it chose otherwise.

****Semiannual lease payments were includable in determining the cost-of

capital allowance under l5 AAC 55.196.53

But there is an additional reason why the OAH properly concluded that this legal

issue did not require deference to DORs interpretation. Contrary to DORs argument, the

determination whether an expense is ordinary and necessary is not an issue requiring the

exercise of DORs expertise, and DOR did not in fact use any special expertise to analyze

the issue. DORs brief does not point to any particular specialized analysis DOR

conducted; rather, it points to the Internal Revenue Code and legal and standard

dictionaries as justification for DORs interpretation.54 Nor could it point to any such

application of specialized expertise, for the Informal Conference Decision itself based its

analysis upon a United States Supreme Court decisions interpretation of ordinary and

necessary business expenses in the context of the federal income tax.55 Because DOR

relied on federal case law, not its own specialized knowledge and experience, the OAH

did not owe the DORs interpretation any deference, and neither does this Court:

Because the outcome of this case rests solely on the application ofestablished federal law to undisputed facts, it cannot be said that "theanswer depends on the particularized experience or knowledge of theadministrative personnel." Therefore, acting as the functional equivalent ofa court of original jurisdiction, the Office of Tax Appeals correctly

concluded that it owed no special deference to the decision reached by the

53 [R. 254-55].54 Appellants Brief at 11-12.55 [R. 254-55].


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department.56

Under federal case law, ordinary expenses are those that can be expected in a

particular business, even if they are not routinely incurred:

Ordinary has the connotation of normal, usual, or customary. To be sure, anexpense may be ordinary though it happen but once in the taxpayer'slifetime. Yet the transaction which gives rise to it must be of common orfrequent occurrence in the type of business involved.57

Necessary expenses are those that are appropriate and helpful to a business, without

any requirement that they be absolutely essential.58 In essence:

The test for determining deductibility [as an ordinary and necessarybusiness expense] is whether a hard-headed businessman, under thecircumstances, would have incurred the expense.59

There is no doubt that the payment of the Make-Whole Premium satisfies the tests

applied by the federal courts. The synthetic-lease arrangement was normal and customary

in the acquisition of tankers, as DOR acknowledged, and some form of alternative

payment upon early termination of the lease was normal and customary in such

arrangements and similar financing arrangements:

The lease is the most important document in characterizing the financingtransaction as a synthetic leasing transaction. This document willcommonly include a provision for the payment of a stipulated

56

Dyncorp, 14 P.3d at 984 (quoting Gulf Oil Corp. v. State, Department of Revenue,755 P.2d 372, 378 n.19 (Alaska 1988)).57Deputy v. DuPont, 308 U.S. 488, 495 (1940) (citations omitted).58Welch v. Helvering, 290 U.S. 111, 113 (1933).59B. Forman Co., Inc. v. Commissioner of Internal Revenue, 453 F.2d 1144 (2d Cir.),cert. denied, 407 U.S. 934 (1972).


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termination fee in the event of early termination or abandonment of thelease .60

The contractual provision allowing for the early repurchase plainly was an

appropriate and helpful one, as Polar Tankers saw fit to ensure its inclusion in the Lease

Agreement, and the exercise of the that option was, too. For sound business reasons,

Polar Tankers parent company, ConocoPhillips, had made the reduction of debt a

priority for 2003.61 Moreover, the adoption of Financial Accounting Standards Board

Interpretation Number 46 in early 2003 meant that ConocoPhillips was required to report

synthetic leases on it is financial statements:

During 2003, the company adopted Financial Accounting Standards BoardInterpretation No. 46 (FIN 46), Consolidation of Variable InterestEntities, for synthetic leases and other financing structures. This resultedin increasing the companys total debt from $19.8 billion at the end of 2002to $22.6 billion as of the beginning of 2003.62

As result of the financial accounting change, therefore, it was even more important

for ConocoPhillips to reduce debt, and the change eliminated the feature that made

synthetic leasing an attractive financing option. ConocoPhillips therefore elected to

60 John C. Murray, Off-Balance Sheet Financing: Synthetic Leases, 32 Real PropertyProbate & Trust Journal 193, 213-14 (1997). See also Sun Oil Company v. Commissionerof Internal Revenue, 562 F.2d 258, 260 (3d Cir. 1977), cert. denied, 436 U.S. 944 (1978)

(sale and leaseback arrangement, similar to a synthetic lease, allowed early terminationupon repurchase of property at price based on present value of outstanding rentalpayments plus an amount sufficient to ensure the lessor/lender a return of 5 percent perannum over the term of the investment).61 [R. 695].62 [R. 758].


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eliminate debt associated with synthetic leases and other Variable Interest Entities,

including the Arctic Funding synthetic lease for the Polar Endeavour.63

ConocoPhillipss officers believed that the elimination of debt by terminating the

synthetic lease and paying the associated cash flows was appropriate and helpful to its

business.64 That determination essentially is controlling:

the payment was thought by the taxpayer's officers to be beneficial, and weshould be slow indeed, even if we were inclined, which we are not, toquestion the soundness of their judgment.65

The Make-Whole Premium was incurred for the appropriate and helpful purpose of

eliminating debt; it was a necessary expense.

Most importantly, not only did hard-headed business people conclude that the

early repurchase of the vessel and the associated cash flow of the Make-Whole Premium

made sense, their decision objectively was reasonable. If Polar Tankers decided simply to

maintain the Lease Agreement through its entire life, in 2003 Polar Tankers faced the

certain payment of some $14.8 million per year for seven more years, over $100 million

in total (as well as the repurchase expense of $205 million in 2010). If it instead elected

to repurchase the vessel in 2003 (paying the $205 million repurchase expense then) and

incur the expense of the Make-Whole Premium, some $34 million, it was certain that it

would terminate the obligation to pay over $100 million over the next seven years. At the

63 [R. 806-07].64 [R. 695, 758, 797, 806-07].65Commissioner of Internal Revenue v. Pacific Mills, 207 F.2d 177, 180 (1st Cir. 1953). Seealso Welch v. Helvering, 290 U.S. 111, 113 (1933).


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time, it was impossible to know for certain which option ultimately would be the better

one financially, but it was an eminently sensible and reasonable decision to decide to pay

$34 million dollars in 2003 rather than over $100 million over the next seven years. The

Make-Whole Premium was an ordinary and necessary business expense and should be

included in the in the Cost-of-Capital Allowance calculation.

The early termination of the Lease Agreement and the payment of the Make-

Whole Premium eliminated lease payments that DOR acknowledges were allowable

ordinary and necessary expenses, so the Make-Whole Premium plainly is an allowable

ordinary and necessary expense. DOR nevertheless attempts to make a further distinction,

arguing that the payment of the Make-Whole Premium was not directly required to

provide marine transportation of oil.66 That strained parsing overlooks the purpose of all

payments associated with the synthetic lease: the acquisition of the means of marine

transportation, a tanker. Costs that are appropriate and helpful to the acquisition of the

tanker are necessary costs of marine transportation. There are many different business

considerations that will determine whether a producer charters or owns tankers, and how

it finances the acquisition of tankers, but the fundamental nature of the expense remains

that of acquiring a tanker essential to marine transportation.

It is true that Polar Tankers did not need to collapse the synthetic lease to transport

its oil, but in order to transport its oil it did need the tanker subject to that lease. And, to

66 [R. 255]; Appellants Brief at 12.


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fulfill its obligations under that lease, it either had to make lease payments for seven more

years, a total of over $100 million, or it had to pay the Make-Whole Premium of $34

million. No less than the unquestionably allowable lease payments themselves, the

payment of the Make-Whole Premium assured the acquisition of a tanker to transport

CPAIs oil from the TAPS Terminal across the ocean to market. As were the lease

payments, it was an ordinary and necessary expense of obtaining marine transportation.

DOR also argues that the Make-Whole Premium was not similar to other costs

specifically allowed under the regulations, such as voyage and port costs. But that

argument fails to acknowledge that the regulations recognize several distinct types of

types of costs as part of the reasonable costs of transportation. Voyage and port costs

indeed are one type of direct cost incurred on specific voyages. But the regulations also

specifically recognize indirect costs that although not tied to a specific voyage

nevertheless are essential to marine transportation, the acquisition costs of the vessel

itself:


(A) voyage and port costs incurred with respect to that transportation ;


(C) depreciation of the vessel ; and

(D) an amount that, when added to the amount of depreciation allowedunder (C) of this paragraph, will provide a reasonable return on the


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adjusted shipyard cost or invested capital as provided in 15 AAC 55.195(b).67

In order to acquire the vessel used in marine transportation, Polar Tankers either

had to make the lease payments for seven more years, at a cost of over $100 million, or it

had to pay $34 million in 2003 and terminate the obligation to make the lease payments.

The two types of payments were equally required under the Lease Agreement, and were

equally unavoidable. Both types of payments were ordinary and necessary expenses.

And DORs attempt to dismiss the Make-Whole Premium as a penalty also is

unavailing. First, the arms-length contract provided two clear choices: pay over $100

million in rental payments over seven years, or pay $34 million in 2003, terminating the

obligation to make further rental payments. There was no penalty, just a rough

equalization of the values of the two options. Polar was free to make either choice

without penalty, but the parties from the beginning attempted to ensure the financial

impact on the parties of each of the two choices was roughly equivalent (recognizing of

course, that the accurate prediction of future economic conditions is impossible).

But, even if characterized as a pre-payment penalty, the Make-Whole Premium

still was an allowable ordinary and necessary expense. The federal courts repeatedly have

allowed various legal expenses, penalties and fines paid to governmental entities as

ordinary and necessary business expenses, so long as they were a normal part of a

business and were not incurred in bad faith. For example, the United States Supreme

67 15 AAC 55.191(b)(3) (emphasis added).


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Court ruled that the legal fees incurred in the unsuccessful defense of a mail fraud claim

were ordinary and necessary business expenses.68 The Tenth Circuit determined that

penalty interest imposed on a tax deficiency was a deductible ordinary and necessary

business expense because the circumstances of the taxpayers business made accurate

reporting difficult and deficiencies therefore were to be expected.69 And the First Circuit

ruled that the taxpayers payment of a fine to the federal government to settle a charge of

violation of price controls was an ordinary and necessary expense.70 The payment here

was not a penalty, but characterizing it as such does not render it any less of an ordinary

and necessary expense.

Finally, there is no merit in DORs complaint that the OAHs Decision opens the

door to the allowance of all manner of improper costs.71 The OAH dealt with the specific

cost before it: a payment of a smaller lump sum in place of a larger sum due over the

course of the next seven years that DOR acknowledged was an allowable cost under the

ROI Regulation. DORs extrapolated examples simply were not at issue, and the OAH

carefully limited scope of its ruling:

This is not to say that all synthetic lease- or other agreement-driven costs,under all circumstances, must be considered "ordinary and necessary"transportation costs. Taxpayers necessarily must accept the tax

68

Heininger, 320 U.S. at 471-72.69Commissioner of Internal Revenue v. Polk, 276 F.2d 601, 603 (10th Cir. 1960)(livestock inventories were inherently difficult to value, making errors in reportinginventory value, and therefore penalties, a usual part of that business).70Pacific Mills, 207 F.2d at 181.71 Appellants Brief at 19-20.


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consequences of their business judgments, whether those consequencesincrease tax liability or decrease it. Under these particular circumstances,the department also must accept the tax consequences of the taxpayer'sexercise of business judgment .72

Neither CPAI nor any other taxpayer can argue that the decision upholding this plainly

allowable expense opens the door to the allowance of a laundry list of questionable

expenses. There is no reason for this Court to defer to DORs own decision, which was

not supported by a reasonable basis, because DOR might have a reasonable basis to

disallow other types of expenses not at issue.

5. The OAH Correctly Determined that DORs Interpretation of theRegulation Was Not Supported by a Reasonable Basis

Finally, though DOR barely acknowledges it, the OAH had an alternative basis for

its decision. The OAH correctly ruled that the ordinary and necessary expense analysis

did not require a deferential standard of review, but it analyzed the decision under that

standard, too. Using that standard, the OAH correctly concluded that DOR did not have a

reasonable basis for its decision.73

The OAH recognized that there was no meaningful distinction between the Make-

Whole Premium and the lease payments for which it served as a substitute. DOR

acknowledged that the lease payments were ordinary and necessary expenses, as was the

repurchase payment of $205 million. The Make-Whole Premium arose from the same set

of contractual obligations, and there is no reasonable basis for concluding it, too, was not

72 [R. 75].73 [R. 74-75].


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ordinary and necessary. Under the Lease Agreement, as of 2003 the total consideration

for the purchase of the Polar Endeavourconsisted of either: (1) seven more years of

lease payments, totaling over $100 million, plus the $205 million repurchase cost in

2010; or (2) the payment of the $34 million Make-Whole Premium, plus the $205 million

repurchase cost. There is no reasonable basis for concluding that although parts of the

total consideration for the vessel (the lease payments and the repurchase cost) are

ordinary and necessary expenses, the alternative consideration required by the very same

agreement (the Make-Whole Premium) is not. As the OAH noted in its order denying

reconsideration, it is unreasonably inconsistent for DOR to concede that the repurchase of

the Polar Endeavouris an ordinary and necessary transportation expense, but a portion of

the contracted repurchase price, the Make-Whole Premium, is not.74 The OAH properly

concluded DORs decision was not supported by a reasonable basis.

II.THE OAH CORRECTLY DETERMINED THAT THE ADMINISTRATIVEFEE PAID FOR FACILITATING AN EXCHANGE SERVING NO PURPOSE

FOR CPAI WAS NOT COMPENSATION FOR QUALITY DIFFERENTIALS

A.Statement of the Case1. Background

CPAI produces oil on the North Slope and transports it to Valdez through the

Trans-Alaska Pipeline System (TAPS). During 2003, CPAI diverted some of its oil

from the TAPS to Williams Alaska Petroleum, Inc., for use in its refinery near Fairbanks,

under the terms of three different contracts entered into by predecessors of CPAI with

74 [R. 1].


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various Williams companies or their predecessors. Two of the contracts were sales

contracts. One sales contract was entered into in 1998 between Phillips Petroleum

Company (then the owner of only a relatively small interest in producing Alaska North

Slope Units75) and Mapco Alaska Petroleum, Inc. (a predecessor of Williams); it will be

referred to as the Phillips Sales Contract.76 During 2003, Williams purchased from

CPAI 3,020,006 barrels of crude (approximately 8,300 barrels per day) under the Phillips

Sales Contract.77 The second sales contract was entered into between BP Oil Supply

Company and Williams Energy Marketing & Trading Company in December 1999 and

later assigned to a predecessor of CPAI; it will be referred to as the BP Sales

Contract.78 During 2003, Williams purchased 1,817,726 barrels of crude from CPAI

under the BP Sales Contract (approximately 6,600 barrels per day).79

The third contract is the only one at issue. Unlike the first two, it is not a sales

contract, but an exchange contract. In December 1999, at the same time it entered into the

BP Sales Contract, BP Oil Supply Company entered into an agreement with Williams

Energy Marketing & Trading Company for the use of oil at Williamss refinery near

75 [R. 1197, 1201].76 [R. 1208-09].77 [R. 227].78 [R. 1210-11].79 [R. 228].


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Fairbanks, which will be referred to as the Exchange Agreement.80 The parties

described the Exchange Agreement this way:

It is the intent of BP and Williams to exchange equal quantities of ANS inwhich BP shall deliver a minimum of zero (0) and a maximum of 160,000barrels per day daily average per month of ANS from TAPS at the[Williams Refinery] and, subsequent to processing, BP shall receive backfrom Williams the equal volume delivered.81

The barrels returned after processing would be returned to the TAPS by BP. The

consideration for the exchanged barrels consisted of two components:

The exchange differential paid by Williams to BP shall be equal to anyquality bank degradation charges per barrel as assessed by the TAPSquality bank administrator. Williams also agrees, in addition to qualitybank assessments, to pay an administration fee of $0.0275 per exchangebarrel.82

During 2003, CPAI provided Williams with 50,071,788 exchange barrels under the

agreement, an average of over 137,000 barrels per day.83

The Williams Refinery in Fairbanks was not able to make products from the entire

chain of components in the crude stream. It therefore distilled from the crude stream

some of the lighter hydrocarbon components, which it used to make refined petroleum

products, and then returned for redelivery to the TAPS the residue stream consisting

primarily of heavier hydrocarbon components.84 As of 1999, the Williams Refinery had

80 [R. 1212-13].81 [R. 1212-13 at 2]. See also [R. 208].82 [R. 1212-13 at 2]. See also [R. 208].83 [R. 228].84 [R. 1222].


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a throughput capacity of 210,000 barrels of crude per day.85 It would consume

approximately 64,000 barrels per day in making refined products, and would return

approximately 146,000 barrels per day of residue to TAPS.86 Williams purchased

approximately 57,000 barrels of crude per day from the State of Alaska, which the State

had taken as its royalty share, royalty-in-kind (RIK) barrels.87 At the time, Williams

was the sole purchaser of the States RIK barrels.88 Williams obtained the remainder of

its throughput needs, approximately 150,000 barrels per day, from other TAPS shippers,

through a combination of small purchases and other agreements.

In particular:

Williams rents crude oil from several TAPS shippers and returns to thepipeline the residual oil after removing the lighter components used tomake petroleum products.89

BP entered into the Exchange Agreement in December 1999 as it was closing its

acquisition of Atlantic Richfield Company.90 The Exchange Agreement did not

commence until the effective date of the acquisition of Atlantic Richfield Company, and

it expressly was conditioned on the consummation of the merger:

The obligations of BP Oil Supply Company (BP), a wholly ownedindirect subsidiary of BP Amoco, plc (BPA), under this agreement areexpressly conditioned on the prior satisfaction of each of the followingconditions:

85

[R. 1222].86 [R. 1222].87 [R. 1222].88 [R. 1220].89 [R. 1222].90 [R. 1212-13 at 1, 1218].


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(a) The proposed acquisition of Atlantic Richfield Company (ARCO) byBPA is approved by the Federal Trade Commission (FTC), and theacquisition is completed; and(b) the FTC does not disapprove the terms of this agreement.91

In 2003, after the merger had been completed and the Exchange Agreement had

taken effect, Williams no longer had to rent crude oil from various TAPS shippers.

Instead, it could purchase approximately 57,000 RIK barrels per day from the State, still

as the sole purchaser of the States RIK share, and small additional amounts such as the

8300 barrels per day it purchased from CPAI under the Phillips Sales Contract and the

6600 barrels per day it purchased from CPAI under the BP Sales Contract.92 It could

fulfill the remainder of its needs, up to 160,000 barrels per day, through the Exchange

Agreement, without purchasing or renting additional barrels from other shippers. The

only charges Williams incurred under the Exchange Agreement were the Quality Bank

degradation charge reimbursements and the administrative fee.

The Quality Bank degradation charges were incurred by CPAI solely as a result of

the Exchange Agreement. The Quality Bank is a mechanism for addressing the fact that a

barrel of oil exiting the pipeline at the TAPS Terminal in Valdez is made up of a

combined crude stream that may have come from multiple sources contributing crude oil

of varying quality, and that along the route of the TAPS oil may have been removed from

or returned to the crude stream with various impacts on the quality of the combined

91 [R. 1212-13 at 1, 209-10]. The BP Sales Contract contained the same provision. See[R. 1210-11 at 1].92 [R. 1237, 1239, 1243, 1253, 1255, 1257].


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stream.93 The entity taking possession of the barrel of crude may have contributed crude

to the combined stream that was of a higher or lower quality than that of the combined-

stream barrel it ultimately receives.94 The Quality Bank imposes a charge on shippers

who degrade the combined crude stream by contributing crude of lower quality to the

combined stream, whether on the North Slope or at a point downstream, such as

downstream from the Williams Refinery near Fairbanks.95 The charges are used to

compensate shippers who have contributed a higher quality stream of crude than that of

the combined stream they ultimately received.96

Under the Exchange Agreement, CPAI removed from the TAPS barrels of crude

of a certain quality for delivery to Williams, accepted from Williams an equal volume of

residue barrels of a reduced quality and then returned to the TAPS the reduced quality

residue barrels. As it therefore reduced the quality of the combined TAPS stream, CPAI

was assessed Quality Bank degradation charges. CPAI paid those degradation charges

along with its other Quality Bank obligations, identified and segregated the charges

related to the Exchange Agreement barrels from the other Quality Bank transactions and

billed Williams for reimbursement of those degradation charges.97 Williams paid those

93 [R. 1265].94 [R. 1265].95 [R. 1265].96 [R. 1265].97 [R. 228-29].


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amounts to CPAI, reimbursing CPAI for the Quality Bank charges it paid solely as a

result of exchanging barrels with Williams under the Exchange Agreement.

The administrative fee was the only other charge Williams incurred for receiving

up to 160,000 barrels of crude oil per day (and actually receiving some 137,000 barrels

per day in 2003) to help it meet its throughput requirements.98 The fee provided CPAI

some compensation for the administrative effort it expended in undertaking the

mechanics of exchanging 137,000 barrels per day (when, in contrast, it was selling to

Williams only about 11% of that amount, some 14,900 barrels per day) and conducting

the complicated tracking and sorting required to obtain reimbursement for Quality Bank

charges it incurred solely because of the exchange for which it received no other

compensation.99

In implementing the requirement in AS 43.55.150(a) that the taxable value of the

oil be determined by taking into account the reasonable costs of transportation, 15

AAC 55.151(b) (emphasis added) requires accounting for Quality Bank charges and

payments:

(b) The gross value at the point of production for a producer's oil mustbe calculated as follows:

(1) a destination value must be determined for the oil ;(2) except as otherwise provided under (i) of this section, the producer'sreasonable costs of transportation under 15 AAC 55.180 and 15 AAC

98 [R. 228].99 [R. 227-29].


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55.191 must be subtracted from the destination value determined under (1)of this subsection; (3) if oils of different qualities or oil and NGLs are commingled, the valuecalculated under (2) of this subsection must be adjusted for any

consideration paid or received for quality differentials .

And, under 15 AAC 55.191(o):

A producer shall report any reimbursed costs to the department.Reimbursed costs are not allowable as actual costs of transportation underthis section.

2. Course of ProceedingsConsistent with those regulations, CPAI reported both the Quality Bank

degradation charges it incurred as a result of the Exchange Agreement and the offsetting

reimbursements from Williams, so that the Quality Bank charges associated with the

Exchange Agreement simply had no impact on the calculation of CPAIs production

tax.100 Because the administrative fee was distinct from the Quality Bank reimbursement

and had nothing to do with transportation of CPAIs oil, however, CPAI did not report

the administrative fee as compensation for quality differentials or a reimbursed

transportation cost.101

The Tax Division on audit determined that the administrative fee should be offset

against CPAIs other Quality Bank expenses, reducing CPAIs deductible transportation

costs.102 CPAI appealed that determination within the Department of Revenue.103 In the

100 [R. 314].101 [R. 314].102 [R. 315].103 [R. 323, 335-36].


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Informal Conference Decision, the Department of Revenue upheld the reduction in

transportation expenses, ruling that the administrative fee was additional consideration

received for the degradation of crude oil under 15 AAC 55.151(b)(3).104 CPAI appealed

that decision to the OAH, acting in its capacity as the Office of Tax Appeals.105 The

OAH ruled that as a matter of law the administrative fee was not consideration for quality

differentials and DORs determination that it was was not supported by a reasonable

basis.106 DOR sought reconsideration, which the OAH denied, and DOR appealed the

OAHs decision to this Court.107

B. Argument1. The OAHs Decision Cured the Factual Mistakes in DORs Decision

The Administrative Fee arose from the Exchange Agreement, which was a unique

agreement for an unusual transaction. Fundamentally, DORs erroneous determination

that the Administrative Fee constituted additional compensation for the degradation of

exchanged oil was based on its faulty understanding of facts surrounding the Exchange

Agreement. For example, on Audit, the Tax Division based its determination on the

factually incorrect basis that the Exchange Agreement was an agreement for the sale of

oil:

ConocoPhillips also receives an additional "administrative fee" of $.0275per barrel from Williams per their sales contract.

104 [R. 270].105 [R. 242, 246]. See AS 43.05.405 and .499(6).106 [R. 80-83].107 [R. 1].


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****The term "administrative fee" is not truly representative of the additionalpayment made by Williams, since it based on the number of barrels soldtoWilliams and not based on any administrative expenses for managing the

contract. This is part of the full consideration being received, which wasnegotiated as additional payment under the contract terms for sales toWilliams. The $.0275 per barrel more accurately reflects revenue to offsetthe quality bank expenses for this sale to Williams, since it is included onthe invoice for quality bank reimbursement due.108

But, of course, the Exchange Agreement was not a contract for the sale of oil. Williams

received and returned an equal volume of oil.109 The returned barrels were of a lower

quality than the barrels delivered, but there was an exchange, not a sale, of oil.

The Informal Conference Decision did not perpetuate that factual error, but it

founded its analysis on equally faulty and fundamental factual errors. DOR erroneously

described the exchange transaction this way:

After processing the crude, Williams returned to TAPS degraded oil that itno longer needed. The owners of the crude being shipped through TAPSreceived compensation for the degradation of the common stream inaccordance with calculations of the TAPS quality bank administrator. Theowners, including ConocoPhillips, also received an additional fee of$.0275 for each barrel of ANS that William degraded and returned toTAPS.110

DOR thus erroneously suggests that through the Quality Bank process all shippers

received compensation from Williams for crude degradation. But that is not true. The

Quality Bank process imposed degradation charges on ConocoPhillips, not Williams.

108 [R. 314-15 (emphasis added)].109 [R. 1212-13 at 2]. See also [R. 208].110 [R. 270 (emphasis added)].


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ConocoPhillipspaidthose charges into the Quality Bank; it did not receive them, as DOR

states. It alone then obtained reimbursement from Williams under the terms of the

Exchange Agreement. Williams had no direct contact with the Quality Bank or any other

shipper. And, contrary to DORs erroneous assertion, the shippers in general did not

receive an additional fee of $.0275 per barrel from Williams. Williams paid the

administrative fee to ConocoPhillips alone, under the terms of the Exchange Agreement.

The OAHs decision, unlike DORs decision, is based on a correct understanding

and statement of the factual circumstances of the exchange transaction. As a factual

matter, CPAI exchanged barrels of crude with Williams; it did not sell barrels of crude to

Williams. As a factual matter, CPAI, not Williams, was assessed Quality Bank charges,

and CPAI, not Williams, paid the Quality Bank charges to the other shippers; with

respect to this transaction, CPAI did not receive any Quality Bank compensation. As a

factual matter, Williams reimbursed CPAI, and only CPAI, for the Quality Bank charges

CPAI paid as a result of Williamss actions. As a factual matter, Williams paid that

reimbursement to CPAI, and only CPAI, because only CPAI played any role in the

exchange and the Quality Bank charges it produced. And, as a factual matter, under the

terms of the Exchange Agreement the administrative fee was due not as a result of quality

differentials, but as a result of the exchange itself:

Under the plain terms of the exchange agreement, if hypotheticallyWilliams, instead of removing its target products from the input stream ormixing the stream with lesser quality oil, returned back to the TAPS oil ofthe same quality, ConocoPhillips Alaska would still be entitled to collectthe per-barrel administrative fee. Payment of the administrative fee is


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contingent upon exchanging barrels, not upon degradation of the quality ofoi1 so exchanged.111

DORs determination that the administrative fee was additional consideration for

quality differentials was based on an incorrect factual foundation. In contrast, because it

was based on the correct facts, there was substantial evidence supporting the OAHs

essentially factual determination that:

In short, the TAPS quality bank assessment payments are consideration forquality differentials; the [administrative] fee is consideration foradministration of the contract.112

This Court should affirm that det

alaska v. conocophillips, 3an-10-05484 ci, (alaska 2011) conocophillips' brief

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