Alaska v. ConocoPhillips, 3AN-10-05484 CI, (Alaska 2011) State's Reply

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

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IN THE SUPERIOR COURT FOR THE STATE OF ALASKATHIRD JUDICIAL DISTRICT AT ANCHORAGE

STATE OF ALASKA, DEPARTMENT OFREVENUE, TAX DIVISIONAppellant,

v.

CONOCOPHILLIPS ALASKA, INC.,Appellee.

))))))) Case No. 3AN-10-05484 CI) OAH No. 07-0565-TAX))_________________________________ )

APPEAL FROM THE OFFICE OF ADMINISTRATIVE HEARINGS,CHIEF ADMINISTRATIVE LAW JUDGE TERRY L. THURBON, PRESIDINGREPLY BRIEF OF APPELLANT

Filed in the Superior Courtin Anchorage, Alaskathis _ day ofApril 2011.By: ------------------Clerk of Superior Court

JOHN J. BURNSATTORNEY GENERALR. Scott Taylor (AK Bar No. 850711 0)Senior Assistant Attorney GeneralAlaska Department of Law1031 W. 4th Avenue, Suite 200Anchorage, AK 99501(907) 269-5255


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TABLE OF CONTENTS

TABLE OF AUTHORITIES .......................................................................................................... iiINTRODUCTION And STANDARD OF REVIEW ...................................................................... 1ARGUMENT ................................................................................................................................... 4I. DOR REASONABLY INTERPRETED ITS PRODUCTION TAXREGULATIONS TO EXCLUDE THE PAYMENT OF THE MAKEWHOLE PREMIUM FROM CONOCOPHILLIPS' DEDUCTIBLETRANSPORTATION COSTS ............................................................................................... 4

A. DOR's Regulations Do Not Require Inclusion ofthe Make-WholePremium in the Cost-of-Capital Allowance ...................................................................... 6B. As a Matter of Fact, the Make-Whole Premium is Not an Ordinary andNecessary Transportation Expense .................................................................................. 10C. As a Matter of Law, the Make-Whole Premium Is Not an Ordinary andNecessary Transportation Expense .................................................................................. 12D. DOR's Interpretation of the Regulation Is Supported by a ReasonableBasis ................................................................................................................................. 14

II. DOR REASONABLY INTERPRETED ITS PRODUCTION TAXREGULATIONS TO TREAT THE PER-BARREL FEE RECEIVED FOROIL EXCHANGED WITH WILLIAMS AS AN OFFSET TOTRANSPORTATION COSTS ............................................................................................. 16CONCLUSION .............................................................................................................................. 18

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TABLE OF AUTHORITIESCasesCommissioner of nternal Revenue v. Heininger, 320 U.S. 467 (1943) ........................... 12

Earth Resources Co. v. State, Dep 't ofRevenue, 665 P.2d 960 (Alaska 1983) ................ 13GulfOil Corp. v. State, Dep't ofRevenue, 755 P.2d 372 (Alaska 1998) .......................... 13Handleyv. State, Dep'tofRevenue, 838 P.2d 123l(Alaska 1992) ........................... 4, 9, 10Rose v. Commercial Fisheries Entry Comm 'n, 647 P.2d 154 (Alaska 1982) ..................... 4State, Dep't ofRevenue v. Atlantic Richfield Company, 858 P.2d 307 (Alaska1993) ......................................................................................................................... 6, 7,13State, Dep 't ofRevenue v. Dyncorp, 14 P.3d 981 (Alaska 2000) ............................. 1, 3, 13State, Dep't ofRevenue v. OSG Bulk Ships, Inc., 961 P.2d 399 (Alaska 1998) ............... 13State, Dep 't ofRevenue v. The Parsons Corporation, 843 P.2d 1238 (Alaska1992) ................................................................................................................................. 13Tesoro Alaska Petroleum Co. v. Kenai Pipe Line Co., 746 P.2d 896 (Alaska1987) ...................................................................................................................... 10, 11, 14Union Oil Company ofCalifornia v. State (Alaska 1990) .................................... 11, 13, 14Welch v. Helvering, 290 U.S. I l l (1933) ......................................................................... 12

StatutesAS 43.05.010 ....................................................................................................................... 2AS 43.05.245 ..................................................................................................................... 18AS 43.05.405 ....................................................................................................................... 2AS 43.05.435 ....................................................................................................................... 3AS 43.05.480 ....................................................................................................................... 3AS 43.55.0ll(b) .................................................................................................................. 4AS 43.55.110(a) ............................................................................................................ 4, 13AS 43.55.150 .............................................................................................................. passimAS 43.55.150(a) ................................................................................................................ 15AS 44.64.010 ....................................................................................................................... 2

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Regulations15 AAC 55.151 ................................................................................................................. 1315 AAC 55.151- 15 AAC 55.197 .................................................................................... 1515 AAC 55.151(b) ....................................................................................................... 15, 1615 AAC 55.151(b)(3) ........................................................................................................ 1615 AAC 55.180 ................................................................................................................. 1615 AAC 55.180(a) ....................................................................................................... 11, 1215 AAC 55.191 ................................................................................................................. 1615 AAC 55.191(a) ....................................................................................................... 11, 1515 AAC 55.191(b) ............................................................................................................... 815 AA C 55.191 (b)( 3) .......................................................................................................... 515 AAC 55.191(b)(3)(D) .................................................................................................... 515 AAC 55.191(0) ....................................................................................................... 16, 1715 AAC 55.195 ................................................................................................................... 615 AAC 55.195(a) ............................................................................................................... 515 AAC 55.196 ......................................................................................................... 5, 6, 1015 AAC 55.196(d) ............................................................................................................... 515 AAC 55.197 ................................................................................................................. 13

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INTRODUCTION AND STANDARD OF REVIEW

In its Brief of Appellee, ConocoPhillips Alaska, Inc., misstates the issuespresented for review, as well as the standard of review applicable to this appeal of adecision from the Office of Administrative Hearings (OAH). This is an appeal of twoissues concerning adjustments made by the Department of Revenue (DOR) to deductibletransportation costs used for calculating ConocoPhillips' production tax liability for taxyear 2003. ConocoPhillips presents both issues to this court as a review of whether "theOAH correctly determine[d) that it was not necessary to defer to [DOR's adjustments]."[Appellee's Br. at 2] But both issues present legal questions of whether DOR'sadjustments were consistent with Alaska's 2003 oil production tax statutes andregulations. 1 Whether the OAH applied the correct standard of review is immaterial tojudicial review by the superior court. As an intermediate court of appeal, this court mustsubstitute its own judgment in reviewing questions of law and, where agency expertise isinvolved, uphold the agency's interpretation unless it is unreasonable.2

The legal issues presented here are: (1) whether the make-whole premiumpaid upon early termination of the synthetic lease qualified as an "ordinary andnecessary" cost incurred to transport ConocoPhillips' oil to the sales delivery point; and

(2) whether the per-barrel "administrative fee" received for oil exchanged with WilliamsState, Dep 't ofRevenue v. Atlantic Richfield Company, 858 P.2d 307, 308(Alaska 1993) (agency's interpretation of an administrative regulation is a question oflaw).

2 !d.; see also State, Dep 't ofRevenue v. Dyncorp, 14 P.3d 981, 985 (Alaska2000).

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was reimbursement for non-deductable administrative costs. DOR's adjustments onthese issues are supported by the plain language of the production tax regulations.Moreover, both issues "center around the interpretation of complex tax statutes andregulations that implicate the special expertise ofDOR," such that this court should applythe reasonable basis standard of review.3 DOR's adjustments to ConocoPhillips'transportation cost deductions were well within reasonable interpretations of theproduction tax regulations and should be affirmed.

ConocoPhillips wrongly claims that the "decision the OAH issued in itscapacity as the Office of Tax Appeals" is "the final administrative decision underreview," such that the term "agency" in the applicable standard of review "must be readto mean the OAH." [Appellee's Br. at 2-3 & n. 3] The administration of Alaska'srevenue laws rests exclusively with the Alaska Department of Revenue.4 The finaleagency decision on ConocoPhillips' 2003 production tax liability is the InformalConference Decision issued by Department of Revenue Appeals Officer [R. 250-271],not the appeal decision issued by the OAH.

The OAH is an "independent office" within the Alaska Department ofAdministration.5 It has original jurisdiction to hear administrative appeals from taxdecisions of DOR. 6 As the successor to the Office of Tax Appeals, the OAH is a "quasi-

3456

Atlantic Richfield Company, 858 P.2d at 308.AS 43.05.010, et seq.AS 44.64.010.AS 43.05.405.

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judicial agency" that exercises "its independent judgment in interpreting and applying thelaw to the facts in reviewing DOR tax decisions. And, like the superior court, the [OAH]shall defer to agency decisions only where a question of law involves particularizedagency expertise or where the agency's specialized knowledge and experience would beespecially probative to the meaning of a statute or regulation."7

As an intermediate court of appeal, this court must "independently reviewthe merits of the administrative determination."8 And that determination was theInformal Conference Decision issued by DOR, not the decision of the OAHadministrative law judge. It is the Department of Revenue that promulgates and appliesthe production tax regulations to determine a producer's tax liability- not the OAH.While the OAH decision constitutes "a final administrative decision" under AS 43.05.480for purposes of obtaining judicial review by the superior court, the OAH decision is notDOR's "agency" determination of ConocoPhillips' production tax liability. Thedeferential standard of review is owed to the agency interpreting its own regulations -here the Department of Revenue in its Informal Conference Decision - as it "properlyrecognizes that the agency is best able to discern its intent in promulgating the regulation

7 Dyncorp, 14 P.3d at 984; see also AS 43.05.435 (the administrative lawjudge shall resolve a question of fact by a preponderance of the evidence, resolve aquestion of law in the exercise independent judgment, and "defer to the Department ofRevenue as to a matter for which discretion is legally vested in the Department ofRevenue, unless not supported by a reasonable basis").

8 Dyncorp, at 985

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at issue."9 DOR's interpretation of its production tax regulations here should be upheldas "reasonable and not arbitrary." 10

ARGUMENT

I. DOR REASONABLY INTERPRETED ITS PRODUCTION TAXREGULATIONS TO EXCLUDE THE PAYMENT OF THE MAKE-WHOLE PREMIUM FROM CONOCOPHILLIPS' DEDUCTIBLETRANSPORTATION COSTS.

The main issue in this appeal concerns the propriety ofDOR's exclusion ofthe make-whole premium paid to note-holders from the cost-of-capital allowance that is

permitted as a deductible "ordinary and necessary transportation expense" used forcomputing ConocoPhillips' oil production tax liability under former AS 43.55.011(b).This production tax was assessed against "the gross value at the point of production oftaxable oil." Under AS 43.55.150, the "gross value shall be calculated using thereasonable costs of transportation of the oil." Pursuant to authority granted under AS43.55.110(a) to "adopt regulations ... necessary to the enforcement" of the productiontax, DOR promulgated regulations defining the "reasonable costs of transportation" as"the ordinary and necessary costs incurred to transport the oil or gas from the point ofproduction to the sales delivery point." 11

Where "transportation of oil is by a vessel that is owned or effectivelyowned" by the producer of that oil, DOR allows inclusion in "the producer's actual costs

9 Handley, 838 P.2d at 1233 (Alaska 1992) (quoting Rose v. CommercialFisheries Entry Comm'n, 647 P.2d 154, 161 (Alaska 1982)).10 !d.I I 15 AAC 55.191(a); 15 AAC 55.180(a).

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for that t r a n s p o r t a t i o n ~ ~ under 15 AAC 55.191 (b )(3): "voyage and ports costs incurredwith respect to that transportation"; "depreciation of the vessel"; and "an amount that,when added to the amount of depreciation .. . will provide a reasonable return on theacquisition cost, as provided in 15 AAC 55.195(a), of the vessel over its expected usefullife ...." 12 DOR then defines this depreciation and return on the invested capital cost of avessel in 15 AAC 55.196, as the "cost of capital allowance" to be used in calculation ofcosts ofvessel transportation for oil or gas. 15 AAC 55.196(d) requires that this "cost ofcapital allowance" be calculated using the methodology in DOR's 35-page publicationComputation of a Cost-of-Capital Allowance, which then provides a series of inputschedules and calculation tables. [R. 83 7-871] DOR also makes available to producersan Excel spreadsheet that will derive the calculation table values and provides anexample for computing a cost-of-capital allowance. [R. 869, 870]

In its audit of ConocoPhillip's 2003 production tax return, DOR appliedthese regulations to exclude the $34 million make-whole premium from ConocoPhillip'scost-of-capital allowance, because it was a payment to note-holders for early cancellationof notes, not an "acquisition cost" of the tanker, and, therefore, not an ordinary andnecessary cost ofmarine transportation. [R. 253-255]

12 15 AAC 55.191(b)(3)(D).

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A. DOR's Regulations Do Not Require Inclusion of the Make-WholePremium in the Cost-of-Capital Allowance.ConocoPhillips' argument that DOR's regulation "requires the inclusion of

the Make-Whole Premium in the cost-of-capital calculation" fails for at least threereasons. [Appellee's Br. at 13] First, nothing in the plain language of 15 AAC 55.195,15 AAC 55.196, or the referenced DOR publication even remotely suggests that a make-whole premium paid to note-holders qualifies for a cost-of-capital allowance.ConocoPhillips relies on the "Input Schedules" in DOR's Cost-of-Capital manual, which

allow inclusion of "expenditures associated with the vessel," providing as examples "thelease payments associated with . . . synthetic leases" and "the purchase price of a vessel .. . or the re-purchase price paid by the producer at the end of the lease." [Appellee's Br.at 12-14; R. 850] An example in the manual's Appendix similarly shows that where avessel is subject to a synthetic lease, the "sale and re-purchase transactions" and the"lease payments" are proper inputs into the cost-of-capital calculation. [R. 870] But"lease payments" for a tanker and its purchase or "re-purchase price" are ordinary andnecessary costs incurred for the marine transportation of a producer 's oil. The DORmanual does not direct a taxpayer to input expenditures that are not ordinary andnecessary transportation costs, much less "all cash flows associated with [a] syntheticlease"- as ConocoPhillips maintains. [Appellee's Br. at 14]

DOR did not "ignore the plain meaning of its own regulation." [Appellee 'sBr. at 13] Unlike the regulation in State, Dep 't of Revenue v. Atlantic Richfield

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Company, 13 which the supreme court held could not reasonably be read to allowDOR'suse of an apportionment formula to determine allowable interest expense deductions, thecost-of-capital allowance regulations can be reasonably read to exclude costs that are not"the acquisition cost" of a vessel and are not "reasonable and necessary" costs of marinetransportation of a producer's oil. Indeed, the production tax regulations must be read toexclude such costs. The authorizing statute, AS 43.55.150, specifies that the taxable"gross value shall be calculated using the reasonable costs of transportation of the oil orgas." Allowing costs unrelated to transportation of the producer's oil would exceed thescope of this statutory directive.

Second, the make-whole premmm did not serve "as the functionalequivalent of allowable lease payments." [Appellee's Br. at 15] Lease payments areallowed, on an annual basis, as actual costs incurred during that tax year for transportinga producer's oil to it sales delivery point. The make-whole premium was a payment tonote-holders to make up for the interest income they lost by ConocoPhillips' earlytermination of the ten-year synthetic lease. [Appellee's Br. at 4-7] Had the lease notbeen terminated, the $14.8 million per year "periodic rental payments" would have beenordinary and necessary expenses to lease the tanker transporting ConocoPhillips' crudeoil over the remaining seven and one-half years of the lease. The one-time, $34 million,make-whole premium was paid to cancel the financing notes early, not to lease the vessel.Compensation for interest foregone on the significant remaining term on the notes is not

13 858 P.2d 307,310 (Alaska 1993).

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an amount paid to lease a vessel or otherwise provide marine transportation: it is not anordinary and necessary transportation cost. 14 The "transportation cost" substitution forthe remaining lease payments was the full re-purchase price of the tanker, not the make-whole premium.

The cost-of-capital allowance provides a reasonable return on a producer'sacquisition cost of a vessel transporting its oil over its expected useful life, which DOR'sComputation of a Cost-of-Capital Allowance manual presumes to be 24 years. [R. 845]Including the $34 million make-whole premium in the cost-of-capital allowance in taxyear 2003, along with the full $205 million re-purchase price for the Polar Endeavor,would provide ConocoPhillips with a reasonable return on much more than the tanker's"acquisition cost" and would reduce its production tax liability by millions of dollars overthe tanker's remaining 22-year useful life. Had ConocoPhillips not terminated the lease,the remaining periodic lease payments would not have had the same effect, as they areallowed as transportation costs deductions only in the year that they are incurred to leasethe tanker to transport oil. In no sense was the make-whole premium merely a substitutefor the remaining lease payments.

14 Nor was the make-whole premium part of the "acquisition cost" of thetanker, for which the cost-of-capital allowance provides a reasonable return over thevessel's expected useful life as an actual cost of transportation. 15 AAC 55.19l(b).Upon termination of the synthetic lease, ConocoPhillips was required to pay "the initialacquisition cost" of $205 million as the re-purchase price for the Polar Endeavor, whichwas fully and appropriately included in the cost-of-capital allowance. [Appellee's Br. at6]

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Finally, DOR promulgated the regulations defining the "reasonable costs oftransportation" deductions allowed for assessing Alaska's oil production tax under AS43.55.150, and it is DORin which discretion is legally vested to decide the costs thatqualifY for inclusion in a cost-of-capital allowance for "a reasonable return on theacquisition cost . . . of the vessel over its expected useful life" for a producer that owns oreffectively owns a tanker. DOR drafted the manual for "Computation of a Cost-of-Capital Allowance," its input schedules, examples, and Excel spreadsheet. [R. 837-871]DOR's interpretation of these regulations is entitled to deference by this court and shouldbe affirmed as long as its application is reasonable and not arbitrary. 15

Even the OAH administrative law judge who mistakenly viewed the make-whole premium issue as one of purely contract interpretation, recognized that theselection of inputs "for the cost-of-capital allowance in a complex [production] taxregime implicates agency expertise and thus deference is owed." [R. 76-77] Apart fromthe two issues appealed here, the OAH decision deferred to DOR's determination ofreasonable transportation costs: upholding DOR's use of a particular SIC (standardindustrial code) in the return-on-investment model and DOR's method for determiningthe reasonable price of tanker fuel. (R. 75-79] "[T]the statute permits the department todetermine the 'reasonable costs of transportation' using reasonable methods of thedepartment's choosing." [R. 79]

15 Handley v. State, Dep't of Revenue, 838 P.2d 1231, 1233 (Alaska 1992)(the reasonable and not arbitrary test applies where an agency interprets its ownregulation; a deferential standard of review recognizes that the agency is best able todiscern its intent in promulgating the regulation).

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DOR had a reasonable basis for excluding the make-whole premium fromConocoPhillips' cost-of capital allowance: it was not an ordinary and necessary cost ofmarine transportation. DOR's adjustment here was entirely consistent with its productiontax regulations and was actually required by the legislative directive in AS 43.55.150 thatproduction tax value "shall be calculated using the reasonable costs of transportation ofthe oil."

B. As a Matter of Fact, the Make-Whole Premium is Not an Ordinary andNecessary Transportation Expense.CococoPhillips acknowledges that the OAH decided this issue "as a matter

of law," but nonetheless argues that the OAH "determination is essentially one of fact"and should be reviewed by this court under the substantial evidence standard.[Appellee's Br. at 15] The main fault with this argument is that the OAH expressly didnot make a factual determination that the make-whole premium qualified as a deductibleordinary and necessary transportation expense, but, instead, considered the issue to be amatter of "purely legal contract interpretation." [R. 73] DOR applied its production taxregulations to undisputed facts and determined that the make-whole premium did notqualifY for inclusion in the calculation ofConocoPhillips' cost-of-capital allowance under15 AAC 55.196, as it was not an ordinary and necessary marine transportation cost. [R.255] This court must independently review the merits of DOR's administrativedecision. 16 And the reasonable basis test applies to this court's review, as DOR construed

16 Handley, 838 P.2d at 1233 (citing Tesoro Alaska Petroleum Co. v. KenaiPipe Line Co., 746 P.2d 896,903 (Alaska 1987)).

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its own marine transportation cost regulations to exclude the make-whole premium: adetermination involving "policy questions within the DOR's area of expertise that areinseparable from the facts underlying the DOR's decision."17

Furthermore, ConocoPhillips' claim that substantial, undisputed evidenceestablished "as a factual matter" that the make-whole premium "was an ordinary andnecessary expense" [Appellee's Br. at 16] is not material to the relevant question ofwhether the premium qualified as an ordinary and necessary marine transportation costfor purposes of calculating ConocoPhillips' production tax liability. The issue is notwhether ConocoPhillips had a contractual obligation to compensate note-holders upon itselection to terminate the synthetic lease before the notes' maturity date - whether itincurred a "necessary" payment upon early termination- but whether such a make-wholeinterest payment qualifies as a deductible "ordinary and necessary" transportation costunder 15 AAC 55.180(a) and 15 AAC 55.191(a). The OAH decision provides noanalysis, much less any findings, on this issue and is entitled to no deference.

Even if DOR's interpretation of its regulations and cost-of-capitalcalculation schedules were not entitled to deference, the undisputed facts unquestionablysupport disallowance of the make-whole premium as an ordinary and necessarytransportation cost. The make-whole premium had nothing to do with the transportationof ConocoPhillips' oil. And the amount of this payment bore no relation to a reasonablerental value of the tanker or its acquisition cost, but was a function of the difference

17 Union Oil Company of California v. State, 804 P .2d 62, 64 (Alaska 1990)(citing Tesoro, 746 P.2d at 903)).

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between the 6.85% interest on the financing notes and the lower reinvestment yield of4.165% that was available at the time the lease was terminated. [Appellee's Br. at 4-5; R.253] The undisputed facts demonstrate that the make-whole interest payment of $34million, required upon early repayment of the financing notes, was neither an ordinarynor a necessary cost of marine transportation.

C. As a Matter of Law, the Make-Whole Premium Is Not an Ordinaryand Necessary Transportation Expense.ConocoPhillips' argument that "as a matter of law" the make-whole

premium is "an ordinary and necessary expense" is equally unavailing. [Appellees' Br.at 17-26] Fundamentally, the argument again omits the critical qualifier "transportation"from its analysis. The production tax regulations only allow deduction of "ordinary andnecessary transportation expenses."18 The relevant legal question, therefore, is not"whether an expense is ordinary and necessary," but whether it is an ordinary andnecessary transportation expense. Whether the make-whole premium would satisfy "thetests applied in federal court" for income-tax deductibility as an "ordinary and necessarybusiness expense" is immaterial to the transportation expense question at issue here. 19[Appellee's Br. at 19]

18 15 AAC 55.180(a).19 Though even on the ordinary business expense question, the federal courtsgive a "presumption of correctness" to the determination by the taxing authority, theCommissioner of Revenue, which ConocoPhillips is unwilling to acknowledge here.

Welch v. Helvering, 290 U.S. 111, 115 (1933); see also Commissioner of InternalRevenue v. Heininger, 320 U.S. 467,475 (1943).

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The Alaska Supreme Court has consistently applied a reasonable basis testto DOR's application of tax laws and construction of tax exemptions and deductions.20The few tax cases where the supreme court has not deferred to DOR - and insteadapplied the "substitution of judgment" test - have been on matters of pure statutoryconstruction,21 constitutional limitations on state taxation,22 and where the outcome rested"solely on the application of established federal law to undisputed facts." 23

The legislature delegated to DOR the discretion to promulgate regulationsdefining allowable transportation costs deductions,24 which it has done in 15 AAC 55.151- 15 AAC 55.197, and in its incorporated manual for Computation of Cost-of-CapitalAllowance, with its associated input schedules and electronic spreadsheets. There can beno question that the determination of allowable transportation costs requires specializedknowledge of the oil and gas industry and marine shipping in particular - not to mention

20 See, e.g., Atlantic Richfield Company, 858 P.2d at 308; State, Dep 't ofRevenue v. The Parsons Corporation, 843 P .2d 123 8, 1241 (Alaska 1992); Union OilCompany of California, 804 P.2d at 64; Gulf Oil Corp. v. State, Dep 't ofRevenue, 755P.2d 372, 378 n. 19 (Alaska 1998).

21 State, Dep't of Revenue v. OSG Bulk Ships, Inc., 961 P.2d 399, 403 n.6(Alaska 1998) (whether a particular Internal Revenue Code provision is modified by theAlaska Net Income Tax Act is a matter of pure statutory construction not within theparticular expertise of the agency).22 Earth Resources Co. v. State, Dep 't ofRevenue, 665 P.2d 960, 965 (Alaska1983) (question of whether a taxpayer's business is unitary applies a "judicial concept"and is a question of law which does not require agency expertise for resolution).23 Dyncorp, 14 P.3d at 984-985 (where DOR's regulation defining"reasonable cause" for late filing incorporates the body of federal law defining theInternal Revenue Code's reasonable-cause exception, "it cannot be said that the answerdepends on the particularized experience or knowledge of the administrative personnel").24 AS 43.55.110(a); AS 43.55.150.

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standards for accounting for depreciation and a cost-of-capital allowance system. This isnot the type of question that "is regular grist for judicial mills," implicating "analysis oflegal relationships to which courts are particularly well-suited."25 The question here isnot determined by federal law, but involves policy questions within DOR's expertise thatare inseparable from the facts underlying DOR's adjustment. It is the classic situationwhere deference is due to DOR and where the adjustment must be upheld as long as thereis a reasonable basis to support it.

D. DOR's Interpretation of the Regulation Is Supported by a ReasonableBasis.Lastly, ConocoPhillips relies on the OAH's alternative holding to argue

that DOR's decision was not supported by a reasonable basis. [Appellee's Br. at 26-27]The OAH found "inconsistency inherent" in DOR's allowing "transportation costdeductions as to some terms of the agreement [lease payments and re-purchase price]while rejecting other aspects of the taxpayer's required performance," undermining the"reasonable basis" for DOR's exclusion of the make-whole premium. [R. 74] The OAHconcluded that "[t]here is no reasonable basis for the department allowing some but notall of the contractually required consideration to be included in the cost-of-capitalallowance calculation under these circumstances." [R. 75]

But this finding errs by focusing exclusively on the terms of the syntheticlease and the "necessary" contractually-obligated payments due upon its earlytermination. DOR is authorized to subtract from destination value only "the reasonable

25 Tesoro, 746 P.2d at 904; Union Oil Company, 804 P.2d at 66.

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costs of transportation of the oil."26 DOR adopted regulations indenticying costs that canbe considered "the reasonable costs of transportation."27 The relevant legal question hereis whether DOR's adjustment was consistent with Alaska's 2003 oil production taxstatutes and regulations, not whether ConocoPhillips was required to make the makewhole interest payment to the note-holders.

DOR's reasonable basis for excluding the make-whole premium from thecost-of-capital calculation was simply that it was not incurred as a reasonable cost oftransportation of ConocoPhillips' oil. The measure of whether costs are allowable toreduce a producer's production tax liability is whether they are "ordinary and necessarycosts incurred to transport the oil."28 ConocoPhillips does not claim that DOR'simplementing regulations exceed the scope of the production tax statutes. Under theapplicable regulations, not all "contractually required consideration" qualifies forinclusion in a cost-of-capital allowance deduction as an ordinary and necessarytransportation cost, but only "the acquisition cost" of a vessel transporting a producer'soil. DOR's basis for making a distinction between ConocoPhillips' contractuallyobligated costs was actually required by the production tax scheme.

26

2728

AS 43.55.150(a); 15 AAC 55.151(b).15 AAC 55.151- 15 AAC 55.197.15 AAC 55.19l(a).

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II. DOR REASONABLY INTERPRETED ITS PRODUCTION TAXREGULATIONS TO TREAT THE PER-BARREL FEE RECEIVED FOROIL EXCHANGED WITH WILLIAMS AS AN OFFSET TOTRANSPORTATION COSTS.

Under 15 AAC 55.151(b)(3), a producer's reasonable costs oftransportation under 15 AAC 55.180 and 15 AAC 55.191 "must be adjusted for anyconsideration paid or received for quality differentials." Further, 15 AAC 55.191(o)provides that "[ r ]eimbursed costs are not allowable as actual costsof transportation underthis section." At audit, DOR reduced ConocoPhillips' 2003 transportation costs by theamount of the $.0275 per barrel fee received for barrels exchanged with Williams AlaskaPetroleum, Inc., for use in Williams' Golden Valley refinery. [R. 269, 315] The "feeof$.0275 per exchange barrel" is included in the "PRICE" provision of ConocoPhillips'exchange agreement with Williams. [R. 70] It is part of the "consideration received" foreach barrel of exchanged, quality-degraded oil. As per-barrel compensation receivedduring pipeline transit of ConocoPhillips' produced oil, DOR reasonably considered this"fee" as an offset to ConocoPhillips' transportation costs, which include quality bankexpenses, pursuant to 15 AAC 55.151(b) and 15 AAC 55.191(o). [R. 270]

DOR's treatment of this fee as a transportation cost reimbursement was notbased on factual mistakes, as ConocoPhillips argues in its brief. [Appellee's Br. at 35-38] It is uncontested that ConocoPhillips received from Williams a fee of $.0275 perbarrel of exchanged oil during the transportationof its produced oil to its sales destinationpoint. DOR's adjustment was based on nothing more than these undisputed facts. [R.269-270]

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While the exchange agreement with Williams denominated this additionalper-barrel fee as an "administrative fee," ConocoPhillips failed to present any realevidence supporting its claim that the fee was reimbursement for administrative costs"unrelated to the sale or transportation" of its oil and should play "no role in theproduction tax calculation." [Appellee's Br. at 40; Tr. 43] Absent proof to the contrary,DOR reasonably considered this fee to be a reimbursed transportation cost, as it wasassessed per-barrel and received by ConocoPhillips during the transportation of itsproduced oil to its sales delivery point.

ConocoPhillips claims that the "administrative fee" provided compensationfor "tangible administrative burdens" imposed by the exchange agreement. [Appellee'sBr. at 40, 43] But no provision of the exchange agreement requires ConocoPhillips toperform any administrative tasks, and ConocoPhillips' only evidence of such "burdens"is a statement in an affidavit of a supervisor that in order to "manage the exchangetransaction":

it was necessary for employees of ConocoPhillips Alaska, Inc., tocoordinate with Alyeska Pipeline Services Company the offtake ofcrude oil from and the return of residual oil to the Trans AlaskaPipeline System. Employees of ConocoPhillips Alaska, Inc., alsohad to analyze the Quality Bank charges against ConocoPhillipsAlaska, Inc., in order to identify and document those related to theexchange transaction, and then bill Williams for reimbursement ofthose charges. [Appellee's Br. at 40; R. 228-229]

If these were actual costs incurred during the transportation of its oil, ConocoPhillipsfurther failed to show that the "administrative fee" from Williams was not "reimbursedcosts" under 15 AAC 55.191 ( o) for transportation costs already subtracted from the

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destination value in determining the "gross value at the point of production" subject tothe production tax.

DOR's determination should be affirmed on this issue because it is areasonable application of the production tax regulations and ConocoPhillips failed torebut the assessment's presumed sufficiency under AS 43.05.245 with evidence that thefee was unrelated to the transportation of its oil or its production tax liability.

CONCLUSIONDOR's adjustments to ConocoPhillips' transportation cost deductions are

reasonable, not arbitrary, and supported by the applicable oil production tax statutes andregulations. Accordingly, this Court should reverse the November 29, 2009 Decision ofthe OAH on these two issues and affirm DOR's assessment of ConocoPhillips' 2003production tax liability, as set out in its Informal Conference Decision of August 15,2007.

DATED this ~ d a y ofApril, 2011 at Anchorage, Alaska.JOHN J. BURNSATTORNEY GENERAL

By: r.j!jj;Senior Assistant Attorney GeneralAlaska Bar No. 8507110

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CERTIFICATE OF SERVICE

This is to certify that on this date a copy of Reply BriefofAppellant, Non-Opposed Motion ToAccept Late-Filed Reply Briefand Proposed Order have been served by first class mail, postageprepaid, to the following attorneys or parties of record:

Leon T. VanceFaulkner Banfield, P.C.Attorney for ConocoPhillips Alaska, Inc.One Sealaska Plaza, Suite 202Juneau, AK 99801-1245d .... ,}( ~ V ) / L A - - E r i i""tfeer

Law Office Assistant

19

Marie EvansConocoPhillips Alaska, Inc.AT0-1668700 G StreetAnchorage, Alaska 99501


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Alaska v. ConocoPhillips, 3AN-10-05484 CI, (Alaska 2011) State's Reply

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