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Colorado Supreme Court decision finds in favor of BP with reversal of lower court decision on a severance tax deduction

A decision from the Colorado Supreme Court could entitle a number of oil and gas companies to significant tax refunds for expenses related to cost of capital in the transportation and processing of their oil and gas over the past three years. It is unclear exactly how much the state may owe its oil and gas operators, but most estimates range in the hundreds of millions of dollars.

The unanimous decision by the Supreme Court found the State of Colorado incorrectly disallowed tax deductions related to BP’s cost of capital in the transportation, manufacturing and processing of natural gas.

The case goes back to the 1980s when Atlantic Richfield and Amoco Production began producing coalbed natural gas in southwest Colorado. The court defined BP as the successor by virtue of BP’s mergers with those two companies.

Bill Mueldener - Hein & Associates - Oil & Gas 360

Principal and Denver Office Managing Partner Bill Mueldener, Hein & Associates

The decision centered on determining what could be included as tax deductions, Bill Mueldener, principal and Denver office managing partner for Hein & Associates LLP, explained to Oil & Gas 360®. BP argued that it should be able to deduct the cost of building its own midstream assets in Colorado with a return on investment in mind.

“The state has always allowed a deduction for transportation systems, but they said it only covered the cost of building the system and the depreciation on the system. The issue that has never been defined is what method of depreciation do you use? Is it over 10 years? 30 years?

“The BP case, though, was more about the cost of building the pipeline plus some return on investment,” said Mueldener. When a third-party company like Kinder Morgan (ticker: KMI) builds assets to transport gas, they consider the return on their investment in the project. BP (ticker: BP) said they wanted to include that return as part of their cost of capital.

“They felt that would be more representative of what the market would charge to move this gas to market,” said Mueldener. “The costs are more than just building the asset; they include owning and operating it as well.”

In its decision, the Colorado Supreme Court communicated its findings in this statement: “We conclude by holding that the plain language of section 39-29-102(2)(a) authorizes a deduction for any transportation, manufacturing, and processing costs, and that the cost of capital is a deductible cost that resulted from investment in transportation and processing facilities. Accordingly, we reverse and remand to the court of appeals with instructions to return the case to the district court for proceedings consistent with this opinion.”

Effect of the high court’s reversal on local governments

Local governments are concerned about the news, as it will likely mean less money coming in to their coffers moving forward. La Plata County estimates that severance taxes could decrease by about 13% annually given the ruling, reports Durango Herald.

“They’ll [local governments] probably be receiving less because now that you can deduct some of those business expenses … there’s going to be less coming to the state in terms of revenue,” said Sen. Kent Lambert, R-Colorado Springs, vice-chairman of the Joint Budget Committee.

“This was not what [the Department of Revenue] expected coming out of the Supreme Court,” Lambert continued. “This just came up, there’s no instructions. … We’re doing the best with what we have right now.”

Lawmakers introduced a bill this week aimed at paying some of the refunds through the use of reserves funds. The legislative session has until tomorrow, the end of the current legislative session, to make a decision.

Democrats in the legislature are also pushing for a last-minute bill to prohibit companies from claiming the deduction in the future. The legislation passed the Democrat-controlled House committee Monday evening, but faces an uphill battle.

The effects will be limited to major players, only 2 years of deductions might be affected

The actual dollar amount Colorado will need to pay back will be hard to determine, said Mueldener, who had heard estimates ranging from $200 million to more than $900 million. The higher estimates were probably too large, he said.

“Some companies were already taking the deduction,” he explained. What qualified as a cost of capital which companies could take a deduction on was not well defined. Mueldener noted BP was likely audited due to its size, prompting the court case.

“The decision is wide-reaching, but it only affects companies with self-owned midstream assets.” Only companies large enough to build their own transportation systems would be looking at potentially taking the deduction, narrowing the list down to Colorado’s major operators.

Because there is a three-year statute of limitations in the state, the deductions oil and gas companies can take now is limited as well. “Almost no company in 2015 was paying severance tax because the property taxes were determined by the value of assets in 2014, making them large compared to the value of severance taxes,” meaning that because of the property taxes paid by oil and gas companies and their associated tax credits toward severance tax payments, few companies would be able to take the deduction for 2015. “Because of that the three-year statute of limitations, you’re really only looking at two years this might affect.”

Cost of Capital Discussion in the Colorado Supreme Court BP Decision

The Cost of Capital Is a Deductible Transportation, Manufacturing, and Processing Cost Under Section 39-29-102(3)(a)

¶21 Generally, the cost of capital is “the rate of return that is required to induce investors to purchase the securities of a firm. This rate of return is the same as the investor’s opportunity cost of capital, which is the rate of return that an investor can earn on an investment of similar risk.” Atl. Richfield, 226 F.3d at 1147 (citations omitted). In other words, the cost of capital is the amount of money that an investor could have earned on a different investment of similar risk. See id. In this case, the cost of capital is the amount of money that BP’s predecessors could have earned had they invested in other ventures rather than in building transportation and processing facilities. The investment in other ventures must be of similar risk and must be calculated over the time period beginning with the initial investment in the new facilities and ending with the first depreciation deduction for the same facilities.
¶22 The cost of capital is a concept that recognizes that BP’s predecessors had investment choices when they invested money to construct the transportation, manufacturing, and processing facilities that service their natural gas wells. Alternatively, they could have purchased facilities to service the wells or paid a third party to transport and process the natural gas.
¶23 If BP’s predecessors had purchased existing facilities to service their wells, then they would have immediately begun to recover the cost of their investment through depreciation deductions. Then, the predecessors could have invested the proceeds in another investment and earned a return on that investment years before BP’s


predecessors could begin to recover their investment to build the facilities. The same would be true if the predecessors had chosen to pay a third party to transport and process the natural gas because the amounts paid to the third party would be transportation, manufacturing, and processing costs which are deductible under the severance tax statute. § 39-29-102(3)(a). Simply, if the predecessors had chosen an alternative investment rather than building the facilities, they would have recovered their investment earlier in time. This earlier cost recovery is more valuable than the delayed cost recovery because the predecessors could have invested the proceeds and earned a return before recovering the cost of their investment to build the facilities. Accordingly, the cost of capital for choosing to construct the facilities is the difference between the amount of cost recovery that the predecessors actually received from constructing the facilities, and the amount of cost recovery or deductions that the predecessors could have received if they had invested in existing facilities or paid a third party. The question here is whether the amount that BP’s predecessors could have earned or recovered from an alternative investment—the cost of capital—is a transportation, manufacturing, and processing cost under the severance tax statute.  

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