District Court Disagrees on Depreciation Recovery Period for Gathering System

In Saginaw Bay Pipeline Co., DC MI, 8/23/01, a district court held that an appropriate modified accelerated cost recovery system (MACRS) recovery period for a taxpayer's "gathering pipelines" is 15 years.

Background

Under asset class 13.2 (Exploration for and Production of Petroleum and Natural Gas Deposits) of Rev. Proc. 87-56, "assets used by petroleum and natural gas producers for drilling of wells and production of petroleum and natural gas, including gathering pipelines and related storage facilities" have a seven-year MACRS recovery period. Alternatively, "assets used in the private, commercial, and contract carrying of petroleum, gas and other products by means of pipes and conveyors" fit within asset class 46.0 (Pipeline Transportation) and have a 15-year MACRS recovery period.

The company, relying on Duke Energy Natural Gas Corp., 172 F3d 1255 (10th Cir. 1999), rev'g 109 TC 416 (1997), argued that use within the industry is the determining factor, and the asset belongs in class 13.2. The IRS contended that the nature of the company's trade or business determines that the asset belongs in class 46.0; see Letter Ruling (TAM) 9548003, citing Rev. Proc. 71-25, that asset class 13.2 includes gathering pipelines when the "related activities [are] undertaken by petroleum and natural gas producers."

Duke Energy

In Duke Energy, the company's subsidiary owned and operated interconnected gas-gathering pipelines and compression facilities. The subterranean pipelines delivered "raw gas" to processing plants in oil and gas fields; however, Duke Energy did not own an interest in the wells that produced the collected gas. Most of Duke Energy's gathering systems delivered raw gas directly to processing plants owned by the company or unrelated third parties; the remaining systems delivered the gas to intra- and interstate pipelines without processing. Duke Energy contracted with producers to share or transfer property rights (or both) to the gas during various points in the production and processing stages.

The Tax Court decided that the determination of an asset's class under Rev. Proc. 87-56 is its primary use based on the taxpayer's particular activities, not the taxpayer's industry. It concluded that gathering pipelines owned by a corporation that does not have an interest in oil- or gas-producing wells were depreciable over 15 years as class 46.0 assets used for pipeline transportation. About this same time, a Wyoming district court (within the 10th Circuit) reached a different conclusion based on the industry-usage criterion; see True, 11/3/97.

The Tenth Circuit reversed the Tax Court's decision in Duke Energy and held that natural gas-gathering systems held by transportation entities belonged in asset class 13.2 and required seven-year depreciation. The court concluded that gathering systems are assets used for production activities rather than transportation, noting that gathering systems are a necessary part of natural gas production. The court rejected the government's argument that only producers could use asset class 13.2, reasoning that the "used by...producers" language in asset class 13.2 does not create an ownership requirement: "Use does not mean 'own' in either the legal definition...nor in everyday parlance." Rather, the asset class includes "any" gathering system as long as it is "used by a gas producer—whether under its own ownership or through contractual agreements—in the...production of... natural gas." The court's analysis was buttressed by its concern that distinguishing gathering systems owned by nonproducers from those owned by producers would create an "inconsistent regime" for asset depreciation.

Saginaw Bay Pipeline

The Michigan district court agreed with the Service's position, based on the statement in Regs. Sec. 1.167(a)-1(b) that "useful life" for depreciation means "the period over which the asset may reasonably be expected to be useful to the taxpayer in his trade or business." (Emphasis added.) Relying on this regulation, the district court concluded that the Tenth Circuit had incorrectly interpreted the term "used by" in asset class 13.2.

The district court noted that the business activities of gas production, gas transportation and gas processing are treated as separate business activities for both depreciation and depletion purposes. The court further concluded that because the company's primary business activity was the transportation of natural gas (not gas processing), its assets belong either in asset class 46.0 or asset class 00.3 (land improvement); "the most important issue in resolving this dispute is determining for what the system operator is paid. The answer is that the Plaintiffs who operate the System are paid for moving partially processed wet gas from one location to another. They do nothing else and are paid for nothing else." (Emphasis in original.)

From Jane Rohrs, Washington, DC