Opinion ID: 723905
Heading Depth: 2
Heading Rank: 1

Heading: The Kansas Tax

Text: 15 Our review of the Commission's interpretation of § 110 of the NGPA is governed by the familiar analysis of Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 104 S.Ct. 2778, 81 L.Ed.2d 694 (1984): if the Congress has directly spoken to the precise question at issue, the court must give effect to the unambiguously expressed intent of Congress; otherwise the court will defer to the administering agency's interpretation if it is reasonable in light of the structure and purpose of the statute. Id. at 842-43, 104 S.Ct. at 2781-82. In this instance, recall that § 110 of the NGPA permits a producer to recover ... State severance taxes attributable to the production of ... natural gas and borne by the seller, 15 U.S.C. § 3320(a)(1), and that a severance tax is defined as any severance, production, or similar tax, fee, or other levy imposed on the production of natural gas. 15 U.S.C. § 3320(c). In their application to a particular state tax, any or all of the terms attributable to the production, similar, other levy, and imposed on the production may be ambiguous. Plainly, as the Producer Petitioners acknowledge, our standard of review is that of Chevron step two. 16 The Kansas tax is levied primarily upon the value of recoverable reserves and secondarily upon the value of gas well equipment and materials. In estimating the volume of reserves, the volume of current production is an important factor; therefore, because the tax is partly dependent upon production, the Producer Petitioners allege that it is similar to a production tax. 17 In remanding Colorado Interstate we instructed the Commission to come up with a cogent theory of what makes a tax 'similar' to a production or severance tax under § 110. 850 F.2d at 773. The agency's determination was to hinge upon how the specific rules of the tax actually function. Id. at 774. According to the Producer Petitioners, however, the Commission responded largely by ignoring the practical application of the Kansas tax and its actual effect upon production incentives, and focused instead upon mere labels. 18 [320 U.S.App.D.C. 22] The principle advanced by the Producer Petitioners is that a tax whose assessment is measurably affected by a change in the level of production is at least in part attributable to, and effectively imposed on, the production itself. The Petitioners remind us that the Federal Power Commission held that the Kansas tax was recoverable under the Natural Gas Act, Opinion No. 699-D, 52 FPC 915, 915-16 (1974), and that the Congress incorporated into § 110 of the NGPA terms virtually identical to those it had used in the prior statute, see Opinion No. 699, 51 FPC 2212, 2301, 4 P.U.R.4th 401, reh'g denied in relevant part, 52 FPC 1604 (1974), aff'd sub nom. Shell Oil Co. v. FPC, 520 F.2d 1061 (5th Cir.1975)--which suggests that the Congress intended no significant contraction in the range of severance taxes that could be recovered. Indeed, the Conference Committee Report on § 110 states that the term severance tax should be construed broadly and may extend to any tax imposed upon mineral or natural resource production including an ad valorem tax or a gross receipts tax. H.R. C ONF. R EP. N O. 95-1752, 95th Cong., 2d Sess. 91 (1978), U.S.Code Cong. & Admin.News 1978, pp. 8800, 8861. 19 The two characteristics of a tax recoverable under § 110, in the view of the Producer Petitioners, are that its calculation is directly related to the rate of current production and that its non-recovery would operate as a disincentive to produce. It is not necessary that the tax be attributable exclusively to production, nor that it be computed in the same manner as a severance or production tax; it is enough that the assessed liability be to some extent attributable to the production of ... natural gas. The Producer Petitioners claim that the FERC's interpretation--under which the tax must be (1) laid upon the act of severing, (2) each Mcf or MMBtu of gas production, and (3) assessed at the time of removal, Colorado Interstate Remand Order, 65 FERC at 62,370, 62,371--effectively reads the term similar tax out of the statute. 20 Applying their more liberal construction of § 110, the Producer Petitioners contend that the Kansas tax fully satisfies the criteria for recoverability. First, while the tax is also affected by variables other than production, the amount of the tax increases or decreases as production increases or decreases. For example, as between two wells with the same reserves, the one expected to produce more gas will be taxed at a higher level. This argument, however, does little to dispel our understanding that the Kansas tax is by its terms a tax upon property. The value of a depletable asset is a function of its physical and its temporal dimensions; in the case of a gas well, these are respectively the volume of recoverable reserves and the timing of their recovery, which progressively depletes the reserve. The greater the volume of gas produced in a given tax year, the shorter the time over which all the proceeds will be realized and, consequently, the higher the present value of the asset. 21 The relevant question, therefore, is the obverse of the one suggested by the Producer Petitioners. We do not ask whether two wells with the same reserves would be taxed differently based upon their different anticipated rates of production; obviously they would be, whether the tax is imposed ad valorem upon property or upon production. The value of the reserves would be higher for the well with more rapid production because faster production reduces the time over which the flow of gas is turned into a stream of cash. Instead, we must inquire whether the same tax would be levied upon two wells with different reserves but the same level of production. If the tax is based upon production, then the amount of the tax would be the same; if the tax is based upon property, then the amounts would be different. By this criterion, as we shall see, the Kansas tax is laid upon property, not upon production. 22 In Colorado Interstate we posited that the high initial level of production caused by the pressure in a new well could, when annualized in accordance with Kansas's method of appraisal, yield a higher tax upon a property that started operation late in the year than upon an equally productive property that was in operation for the full year. 850 F.2d at 773. Prompted by that observation, the Producer Petitioners now attempt to explain that the State's use of an annualized figure for production when a new well operates for only [320 U.S.App.D.C. 23] part of its first tax year does not relax the relationship between the amount of the Kansas tax and the volume of production. To the contrary, they point out that a 1980 amendment to the Kansas tax law was designed to offset the disproportionately high levy on a well in operation less than six months during the tax year by reducing its appraised value by 40 percent. 23 Again, the Producer Petitioners' argument supports not their position but the Commission's. As the agency properly observes, an adjustment for the exaggerated level of initial production caused by the high pressure in a new well would be unnecessary if the Kansas tax were indeed based upon production. Any gas produced would be taxed; any gas left in the ground would not be taxed. Kansas authorized an adjustment precisely because its tax is based not upon production but upon gas in the ground; i.e., the State needed a reliable estimate of annual production to use in calculating the present value of recoverable reserves. Otherwise there would have been no need to annualize the partial year's output from a new well. 24 The Commission gave three reasons for rejecting the measurably attributable to production standard suggested by the Petitioners. First, it is just the type of murky standard that this court had criticized in Colorado Interstate. Colorado Interstate Rehearing Order, 67 FERC at 61,654. Second, the standard is cumbersome to administer; it requires virtually well-by-well analysis to ascertain exactly how much weight the state property appraiser gave to current production. Id. at 61,654-55. Third, simply providing that a tax be measurably related to production does not distinguish between a severance tax and an array of other taxes--income, personal property, real estate--that could vary in a more-or-less direct manner with production. Id. 25 What is required, contends the Commission, is that the tax vary directly with production on essentially a one-to-one basis. Colorado Interstate Rehearing Order, 67 FERC at 61,655. Indeed there is some support for that proposition in the history of § 110. In 1974 the Federal Power Commission interpreted the Natural Gas Act to allow recovery of the Kansas tax. Opinion No. 699-D, 52 FPC at 915-16. As we observed in Colorado Interstate, however, when the Congress enacted § 110 it supplemented the FPC's formula for recovery (all ... production, severance, or similar taxes, Opinion No. 699, 51 FPC at 2301) with the added requirement that the tax be imposed on the production of natural gas. 850 F.2d at 772. That new qualification is the basis upon which the Commission argues for a one-to-one relationship between the volume of production and the amount of the tax. 26 The Kansas tax, according to the FERC, is a property tax levied upon the value of recoverable reserves, gas well equipment, and materials, id. at 62,374; current production is only a yardstick by which the value of the leasehold is measured, id. at 62,371-72. The appraised value of the reserves depends upon the estimated future production of the well (as determined in part by actual production over the most recent three- or five-year period) and market prices, reduced by operating costs, all forecasted over the probable period of production and discounted to present value. See Colorado Interstate, 850 F.2d at 771. Because of differences in the anticipated rate of production and in the estimated quantity of reserves, the tax upon two wells producing the same volume of gas may vary nearly by a factor of ten. Id. 27 At oral argument, we asked counsel for the Producer Petitioners whether in practice the tax on a well varies over time in direct relation to the well's production. If not, the tax could not properly be characterized as being based upon production. Because the answer to this question has important implications, we take a moment to examine the mechanics of the tax calculation in somewhat greater detail. 28 The value of recoverable reserves, for the purpose of the Kansas tax, is based predominantly upon the value of the well's average production multiplied by a present worth factor. The present worth factor, in turn, depends upon the estimated quantity of the reserves, the time value of money, the expected rate of change in the price of gas, and the expected rate of change in production. The Kansas Department of Revenue promulgates [320 U.S.App.D.C. 24] a present worth factor for use in valuing all properties in a major proven gas field. Assuming that the Department determines present worth factors ex ante and does not revise them periodically, then the only variable affecting the annual appraisal of a well is the value of the well's production. Under these circumstances, the Kansas tax would, in our view, be sufficiently like a tax imposed on the production of natural gas to be recoverable under § 110. Although the tax is called an ad valorem tax and calculation of the tax is based upon the present value of recoverable reserves, any change in the amount of the tax due would depend in practice entirely upon a change in the value of production from year-to-year. 29 The question, therefore, becomes whether there is a change over time in the present worth factor for a particular well or field. If so, then the tax will depend upon the magnitude of that change (and upon any variation in production, of course). In fact, because increased production diminishes the remaining recoverable reserves, and thus typically reduces the anticipated life of a well, periodically updating the present worth factor could yield a tax that is completely unrelated to, or even negatively correlated with, production. Counsel for the Producer Petitioners was not able to refer us to any evidence in the record indicating that the present worth factor for a single field remains constant over time. Therefore, the Petitioners could not show that the Kansas tax necessarily varied in direct relation to production. 30 Because the Producer Petitioners bear the burden of showing that the Commission's analysis of the Kansas tax is unreasonable, their inability to demonstrate that the present worth factors are invariant over time could have been an end to the matter. Nonetheless, we searched the record independently--but the result was only to increase our confidence that variables other than production can have a material impact upon the tax assessed. Tables captioned Major Proven Gas Areas and Fields show a substantial change in the present worth factor for certain fields over the three years from 1986 to 1989. Indeed, the prevailing pattern is for the present worth factor to decline with the passage of time, which is what we would expect. As the anticipated life of a well declines, the present value of the recoverable reserves decreases correspondingly; that is consistent with our hypothesis that higher production foreshadows a diminished remaining life, which in turn can result in not a higher but a lower tax. 31 There is more. One appraiser for the Kansas Department of Revenue has identified seven factors other than current production that he considers in determining the present value of reserves: age of the well; quality of the oil and gas; nearness to market; operating costs; character, extent, and permanency of the market; probable life of the well; and the number of other wells being operated. Furthermore, Kansas assesses the tax upon each physical unit of reserves, year after year until the unit is produced. In order to qualify as a severance or production tax under § 110, however, a physical unit must be taxed only once--at the time of production. Colorado Interstate Remand Order, 65 FERC at 62,371. The Commission also observes that a typical well in the Permian Basin, roughly 2800 feet deep, will be appraised at a value that includes $56,000 for equipment alone, i.e., exclusive of the value of any gas reserves. Even after a well has been shut-in for two years the equipment on a normal well is valued at $4,200. If the Kansas tax were based upon production, then there would be no tax on a non-producing well. 32 Singly and cumulatively, the Commission's arguments are convincing and neither of the Producer Petitioners' two principal contentions persuade us otherwise. First, the Producer Petitioners contend, mistakenly, that non-recovery of a property tax based in part upon production operates as a disincentive to produce and thus defeats a primary objective of the NGPA. If the present value of reserves is computed by the Kansas formula, then (other things being equal) the higher the tax rate the greater the incentive to produce. Although higher production is a factor tending to increase the Kansas tax this year, it reduces the expected future production from the well, a factor tending to decrease the Kansas tax in all future years. [320 U.S.App.D.C. 25] The tax-reducing effect of decreased life expectancy will almost always exceed the tax-increasing effect of higher production. 1 In short, if demand is inelastic (as it would be when the ceiling is well below market price), a recoverable tax would have little effect upon production at the margin; but a non-recoverable tax would be an incentive to extract gas more rapidly in order to minimize the impact of the tax. 33 Second, the Petitioners advance the theory (in their Reply Brief) that a tax qualifies for reimbursement under § 110 ... if production is a factor in the calculation. By that standard, an ordinary property tax would qualify as a tax on production; the value of any asset is, after all, the present worth of the benefits that the asset is expected to produce--whether impounded in an established market price or estimated by an appraiser. The Commission reasonably declined to adopt a standard--overbroad, administratively cumbersome, and almost infinitely elastic--with so little to recommend it. 34 Weighing the various arguments--and mindful that as we said in Colorado Interstate, any Commission interpretation of § 110 that is not precluded by the statutory language and traditional methods of statutory construction, and that is reasonable, will control, 850 F.2d at 774--we conclude that the FERC's interpretation of § 110 of the NGPA is reasonable. Furthermore, applying that interpretation, the Commission reasonably determined that the Kansas ad valorem tax is not a severance tax within the meaning of that section.