Clajon Gas Co., L.p.; Aquilla Gas Pipeline Corporation; Tax Matters Partner, Appellants, v. Commissioner of Internal Revenue, Appellee,gas Processors Association; Western Gas Resources, Inc.; American Petroleum Institute. Amici on Behalf of Appellant, 354 F.3d 786 (8th Cir. 2004)

Clajon Gas Company ("Clajon")¹  appeals an adverse United States Tax Court²  judgment requiring Clajon to depreciate the value of its natural gas pipeline system during certain audit years³  using a fifteen-year, rather than a seven-year, depreciation schedule. For the reasons set forth herein, we reverse the Tax Court.

We begin our analysis of this taxpayer claim with a discussion about the relevant processes and facilities involved in the production of natural gas. Natural gas production is a multi-step process. These steps include extraction of the gas from the earth, processing to make it marketable, and transportation to storage. Natural gas emerges from the ground as a mixture of natural gas (methane), liquid condensate and, sometimes, oil. Gas typically flows from the well to a gathering system through "gathering pipelines," and the gathering system then aggregates the gas for delivery to a gas processing plant, transmission pipeline, or other central point. The gathering system may "dehydrate" the gas to remove water and "treat" the gas to remove corrosive substances. Without dehydration and treatment, natural gas is unusable. Gas that contains natural gas liquids ("NGLs")-such as ethane, propane, butane, and natural gasoline-is referred to as "wet gas." Wet gas must be processed at a gas processing plant to remove the NGLs before the gas can be transmitted to consumers. The resulting "residue gas" is delivered to a transmission line at the outlet of the processing plant. The company extracting the gas may own the gathering system, or it may be owned by an independent pipeline company that is not in the business of extracting gas from the earth.

The central issue in this case is whether Clajon's natural gas gathering pipeline systems⁴  should be-for tax purposes-properly classified as production facilities or as transportation facilities. This issue, in large part, turns on the manner in which the pipelines are used in the collection and production of natural gas.⁵ 

Clajon owns and operates natural gas gathering pipeline systems. A "gathering-pipeline system" is a system of interconnected subterranean pipelines and related compression facilities that collect the raw gas from wells and deliver it to a central point, such as a processing plant. Gathering lines may include thousands of miles of pipe that are typically located over a relatively small area. A gathering system's smaller diameter pipelines,⁶  sometimes called feeder lines or lateral lines, connect individual wells or one or more central production facilities to larger diameter lines, or trunk lines, that deliver the gas to a gas processing plant or to a transmission line. Due to the short distances raw gas must travel in a gathering system, gathering lines typically are designed to function at relatively low pressure.

In contrast, a "transmission-pipeline system" carries residue gas from remote areas of production to local gas distribution systems for the end-use market. Typically, a transmission-pipeline company will not permit gas in its pipelines that does not meet its gas-contract specifications as to the content of NGLs, water, and other impurities. Transmission pipelines deliver this "pipeline quality" gas to gas distribution systems typically owned by local utilities that deliver it to industrial, commercial, and residential customers. Unlike gathering lines, transmission lines are not exposed to the same corrosive chemicals because those chemicals have been removed as part of the gathering and treatment processes. Transmission lines generally range from twenty to forty-two inches in diameter and may span hundreds or thousands of miles located over a large area. Consequently, transmission pipelines are designed to withstand the higher pressure required to move the gas greater distances.

Gathering pipelines typically have a shorter physical life-due to the corrosive effect of the impurities-than do transmission pipelines. The economic useful life of gathering pipelines is dependent on the productive life of a particular gas field or fields localized in one area-when all of the economically recoverable reserves in a field have been produced, the production activity in that field terminates, and the gathering system serving that field may cease to be useful. On the other hand, the economic useful life of a transmission line is not tied to the economic useful life of any one gas field, as transmission lines serve multiple fields spread over a much larger area.

Clajon, a company that does not itself produce natural gas, contracted with gas producers who paid Clajon for the use of its gathering pipelines.⁷  The majority of these contracts called for the producer to be paid a percentage of the proceeds derived from the sale of the natural gas after processing. Under a gas transportation contract, Clajon charged its customers a fee to move gas through its systems.

The issue facing us is straightforward: If Clajon's gathering systems are classified as production assets, they depreciate over a seven-year period. However, if the gathering systems are classified as transportation assets, they should depreciate over a fifteen-year period.

Our inquiry begins with an examination of the modified accelerated cost recovery system ("MACRS"),⁸  the current system of depreciation rules. Under MACRS, the recovery period for a given asset is determined by the Asset Guideline Class to which the asset belongs under 26 U.S.C. § 167(m) of the Internal Revenue Code.⁹  The asset classes are set out in Rev. Proc. 87-56, 1987-2 C.B. 674. Saginaw Bay Pipeline Co., CMS v. United States, 338 F.3d 600, 604 n. 6 (6th Cir. 2003); Duke Energy Natural Gas Corp. v. Comm'r, 172 F.3d 1255, 1257 (10th Cir. 1999).

Clajon contends that its gathering pipelines fall within Asset Class 13.2. This class " [i]ncludes 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." Rev. Proc. 87-56, 1987-2 C.B. 678. Natural gas production assets, including gathering pipelines under Asset Class 13.2, are depreciated over seven years. Rev. Proc. 87-56, 1987-2 C.B. 674. Natural gas processing plants are likewise depreciated over seven years under Asset Class 49.23.

The IRS contends that Clajon's pipelines fall within Asset Class 46.0. This class " [i]ncludes assets used in the private, commercial, and contract carrying of petroleum, gas and other products by means of pipes and conveyors. The trunk lines and related storage facilities of integrated petroleum and natural gas producers are included in this class." Rev. Proc. 87-56, 1987-2 C.B. 684. Transmission pipelines are depreciated over fifteen years under Asset Class 46.0. Rev. Proc. 87-56, 1987-2 C.B. at 684. Gas distribution assets also are depreciated over fifteen years under Asset Class 49.24. Rev. Proc. 87-56, 1987-2 C.B. at 686.

We review tax court decisions as we do civil bench trials in district court. Black Hills Corp. v. Comm'r of Internal Revenue, 73 F.3d 799, 804 (8th Cir. 1996). We review de novo legal questions and mixed questions of law and fact; we review findings of fact under the clearly erroneous standard. Id. Clajon, as the plaintiff and taxpayer, must carry the burden of proving its entitlement to a claimed deduction that has been contested by the IRS. Helvering v. Taylor, 293 U.S. 507, 514, 55 S. Ct. 287, 79 L. Ed. 623 (1935). However, "if doubt exists as to the construction of a taxing statute, the doubt should be resolved in favor of the taxpayer." Saginaw, 338 F.3d at 604 (quoting Hassett v. Welch, 303 U.S. 303, 314, 58 S. Ct. 559, 82 L. Ed. 858 (1938)).

The depreciation "recovery period" is dependent on the "class life," a term reflecting the "anticipated useful life of that class of property to the industry or other group." 26 U.S.C. § 167(m) (1) (repealed) incorporated by reference into § 168(i) (1). Asset classifications are based on a "use-driven" functional standard or, in other words, on how the asset is primarily used. 26 C.F.R. § 1.167(a)-11(b) (4) (iii) (b), Treas. Reg. Proper asset-class selection thus hinges on the primary use of the property. Treas. Reg. § 1.167(a)-11(b) (4) (iii) (b). We consider primary use for classification purposes "even though the activity in which [the] property is used is insubstantial in relation to all the taxpayer's activities." Id.

The government argues that the asset's primary use must be based on how the taxpayer uses the asset, not on how the asset itself is used. The government asserts that Treas. Reg. § 1.167(a)-11(b) (4) (iii) (b) makes plain that it is the taxpayer's-and not another's-primary use of the property that determines classification. The government bases its stance on the included sentence, "Property shall be classified according to primary use even though the activity in which such property is primarily used is insubstantial in relation to all the taxpayer's activities," and asserts that this reference to the taxpayer indicates that the "use" must be how the taxpayer uses the asset. Id.

Though this is the first time our circuit has faced this precise issue, other circuits have already addressed it. After careful consideration of the arguments, we, like our sister circuits in the Saginaw Bay and Duke Energy cases, conclude that Clajon primarily used its gathering system assets in a manner that falls within the description of Asset Class 13.2: "assets used by petroleum and natural gas producers for... production of ... natural gas, including gathering pipelines and related storage facilities."

As noted, there is a difference between "gathering pipelines" and "transmission pipelines." The Saginaw Bay and Duke Energy courts-faced with virtually identical facts distinguished the two systems before determining that the pipelines in those cases were "gathering pipelines." We agree with their analysis and find that the pipelines at issue here are "used" to gather natural gas from the wellhead and deliver it to a gathering system and treatment plant. It just so happens that the owner of the pipelines-Clajon-is not the entity gathering the natural gas. Rather, Clajon is the pipeline owner that leases the space to producers. However, this difference in ownership status does not change how the pipelines are actually used.

Revenue Procedure 87-56 describes the property included in Asset Class 13.2 as "assets used by petroleum and natural gas producers," including "gathering pipelines and related facilities." The government argues that gathering pipelines must be owned by a producer to qualify under Asset Class 13.2. Clajon, admittedly, is not a producer-as that term is defined in the industry-of natural gas.¹⁰  Rather, Clajon owns the pipelines that, through various contracts, are leased to producers to transport natural gas from the well to production plants. However, the provision's plain language does not require that the producer must also be the owner of the gathering system assets.

The IRS argues that because Clajon is not a "producer," Clajon's pipeline system merely "transports" natural gas rather than contributes to the "production" of natural gas. Therefore, asserts the IRS, the assets must fall within Asset Class 46.0. Again, however, the Duke Energy and Saginaw Bay courts discounted the IRS's reading of the provision, and we agree with their conclusion. The Duke Energy court noted that if these assets were divided into two groups based on the ownership of these types of pipelines-regardless of the fact that the pipelines were used for the same purpose-it would "create an inconsistent regime for the depreciation of assets." Duke Energy, 172 F.3d at 1261.

If placed in different classes, gathering systems used for the same purpose and serving identical wells would fall under different depreciation schedules depending upon the producer or nonproducer status of the asset's owner. Moreover, if a producer sells a gathering system to a nonproducer such as Duke, the system would shift from one asset class to another without any change in its function or characteristics, and the system's new owner would be forced to depreciate the asset over a far longer period.

Duke Energy, 172 F.3d at 1261. The Duke Energy court refused to create this dichotomy absent an explicit distinction based on ownership in Rev. Proc. 87-56. Id.

In response, the government notes that previous versions of the relevant asset-class regulations distinguished gathering-system assets owned by gas producers and non-producers.¹¹  However, not only have these historical provisions been superseded,¹²  but the provision most recently superseded,¹³  and the currently-applicable version of this provision,¹⁴  do not distinguish between the gathering system assets of producers and non-producers for depreciation purposes. Nothing in Rev. Proc. 72-10, 1972-1 C.B. 721, 723¹⁵  suggests that an ownership distinction should be made, nor does the "used for" language in Rev. Proc. 87-56, 1987-2 C.B. 674, 678, 684, suggest that "ownership" is a distinguishing factor when determining the appropriate asset class for depreciation purposes. Therefore, we, like the Sixth and Tenth Circuit Courts of Appeal, refuse to read such a distinction into the provision.

Both the plain language of the asset class descriptions and the primary use of Clajon's gathering systems in the process of producing natural gas leave us with the firm conclusion that Clajon's gathering systems fall within Asset Class 13.2 rather than Asset Class 46.0. We, therefore, reverse the Tax Court's decision.¹⁶