Menu
Tax Notes logo

Exxon Seeks Summary Judgment on Change in Accounting Method Issue

FEB. 11, 2019

Exxon Mobil Corp. v. United States

DATED FEB. 11, 2019
DOCUMENT ATTRIBUTES
  • Case Name
    Exxon Mobil Corp. v. United States
  • Court
    United States District Court for the Northern District of Texas
  • Docket
    No. 3:16-cv-02921
  • Institutional Authors
    Thompson & Knight LLP
    Miller & Chevalier Chtd
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Tax Analysts Document Number
    2019-5365
  • Tax Analysts Electronic Citation
    2019 WTD 30-22
    2019 TNT 30-19

Exxon Mobil Corp. v. United States

EXXON MOBIL CORPORATION,
Plaintiff,
v.
UNITED STATES OF AMERICA,
Defendant.

IN THE UNITED STATES DISTRICT COURT
NORTHERN DISTRICT OF TEXAS
DALLAS DIVISION

PLAINTIFF EXXON MOBIL CORPORATION'S BRIEF IN SUPPORT OF MOTION
FOR PARTIAL SUMMARY JUDGMENT REGARDING
CHANGE IN METHOD OF ACCOUNTING

Emily A. Parker
Texas Bar No. 15482500
emily.parker@tklaw.com

Mary A. McNulty
Texas Bar No. 13839680
mary.mcnulty@tklaw.com

William M. Katz, Jr.
Texas Bar No. 00791003
william.katz@tklaw.com

J. Meghan Nylin
Texas Bar No. 24070083
meghan.nylin@tklaw.com

Leonora S. Meyercord
Texas Bar No. 24074711
lee.meyercord@tklaw.com

THOMPSON & KNIGHT LLP
1722 Routh Street, Suite 1500
Dallas, Texas 75201
(214) 969-1700
(214) 969-1751 (Fax)

Kevin L. Kenworthy
D.C. Bar No. 414887
kkenworthy@milchev.com

George A. Hani
D.C. Bar No. 451945
ghani@milchev.com

Andrew L. Howlett
D.C. Bar No. 1010208
ahowlett@milchev.com

MILLER & CHEVALIER, CHARTERED
900 16th Street, NW
Washington, DC 20006
(202) 626-5800
(202) 626-5801 (Fax)


TABLE OF CONTENTS

I. INTRODUCTION

II. OVERVIEW OF TAXATION OF MINERAL LEASES

III. UNDISPUTED FACTS

A. ExxonMobil treated the Transactions as mineral leases on its original 2006 – 2009 tax returns and never included SOQ and Petronas's royalties in its income

B. ExxonMobil treated the Transactions as purchases on its amended 2006 – 2009 tax returns and must include in its income all of the income from the purchased property

IV. SUMMARY JUDGMENT STANDARD

V. ARGUMENT AND AUTHORITIES

A. Treating the Transactions as mineral leases was not the adoption of a method of accounting, and correcting the treatment to purchases was not a change in method of accounting

1. A method of accounting determines when — not whether — an item is includible in income or allowable as a deduction

2. The Treasury Regulations defining a change in method of accounting confirm that a method of accounting must determine the time for including an item of income or allowing a deduction

3. The section 481 adjustment associated with a change in method of accounting confirms that a method of accounting must address timing

B. A “lifetime taxable income” test is not the proper test to determine whether there is a change in method of accounting

1. A lifetime taxable income test conflicts with the Treasury Regulations

2. The cases cited in the IRS's revenue ruling do not support a lifetime taxable income test

3. The revenue ruling setting forth the IRS's lifetime taxable income test is not binding on this Court

VI. CONCLUSION

TABLE OF AUTHORITIES

Cases

Anderson v. Liberty Lobby, Inc., 477 U.S. 242 (1986)

Cargill v. United States, 91 F. Supp. 2d 1293 (D. Minn. 2000)

Celotex Corp. v. Catrett, 477 U.S. 317 (1986)

Convergent Technologies, Inc. v. Comm'r, No. 29655-91, 1995 WL 422677 (T.C. Jul. 19, 1995)

Florida Progress v. United States, 156 F. Supp. 2d 1265 (M.D. Fla. 1998), aff'd per curiam on other issues, 264 F.3d 1313 (11th Cir. 2001)

Foil v. Comm'r, 920 F.2d 1196 (5th Cir. 1990)

Fontenot v. Upjohn Co., 780 F.2d 1190 (5th Cir. 1986)

Gen. Motors Corp. v. Comm'r, 112 T.C. 270 (1999)

Graff Chevrolet Co. v. Campbell, 343 F.2d 568 (5th Cir. 1965)

Hillsboro Nat'l Bank v. Comm'r, 460 U.S. 370 (1983)

Johnson v. Comm'r, 108 T.C. 448 (1997), aff'd in part, rev'd in part, 184 F.3d 786 (8th Cir. 1999)

Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir. 1984)

Leonhart v. Comm'r, No. 6743-65, 1968 WL 1212 (T.C. May 27, 1968), aff'd, 414 F.2d 749 (4th Cir. 1969)

Pelton & Gunther P.C. v. Comm'r, No. 23914-97, 1999 WL 801399 (T.C. Oct. 8, 1999)

Peoples Bank & Trust Co. v. Comm'r, 415 F.2d 1341 (7th Cir. 1969)

Primo Pants Co. v. Comm'r, 78 T.C. 705 (1982)

Rankin v. Comm'r, 138 F.3d 1286 (9th Cir. 1998)

Saline Sewer v. Comm'r, No. 9540-91, 1992 WL 79079 (T.C. Apr. 21, 1992)

Shamrock Oil & Gas Corp. v. Comm'r, 35 T.C. 979 (1961), aff'd, 346 F.2d 377 (5th Cir. 1965)

Tate & Lyle, Inc. v. Comm'r, 103 T.C. 656 (1994), rev'd on other grounds, 87 F.3d 99 (3d Cir. 1996)

Thomas v. Perkins, 301 U.S. 655 (1937), aff'g 86 F.2d 954 (5th Cir. 1936)

Transco Expl. Co. v. Comm'r, 949 F.2d 837 (5th Cir. 1992)

United States v. Diebold, Inc., 369 U.S. 654 (1962)

United States v. Woods, 134 S. Ct. 557 (2013)

W.A. Holt Co. v. Comm'r, 368 F.2d 311 (5th Cir. 1966)

Statutes

26 U.S.C. § 63(a)

26 U.S.C. § 446(e)

26 U.S.C. § 481(a)(2)

26 U.S.C. § 4836

26 U.S.C. § 611(a)

26 U.S.C. § 612(a)

26 U.S.C. § 613(a)

26 U.S.C. § 614(d)

26 U.S.C. § 614(e)(2)

26 U.S.C. § 6110(i)(1)

26 U.S.C. § 6110(k)(3)

26 U.S.C. § 7803(b)(2)

Rules

FED. R. CIV. P. 561

FED. R. CIV. P. 56(a)7

Regulations

Treas. Reg. § 1.446-1(e)(2)

Treas. Reg. § 1.446-1(e)(2)(ii)(a) (as amended by T.D. 7073, 1970-2 C.B. 98, 1970 WL 123193)

Treas. Reg. § 1.446-1(e)(2)(ii)(b)

Treas. Reg. § 1.481-1(c)(2)

Treas. Reg. § 1.481-1(c)(3)

Treas. Reg. § 1.611-1(a)(1)

Treas. Reg. § 601.201(a)(6)

Treas. Reg. § 601.601(d)(2)(v)(e)

Other Authorities

IRS FSA 199911004, 1999 WL 148540 (Mar. 19, 1999)

Problems Arising from Changes in Tax-Accounting Methods, 73 HARV. L. REV. 1564 (1960)

Rev. Proc. 2002-18, 2002-1 C.B. 678, 2002 WL 393159 (Apr. 1, 2002)

Rev. Rul. 90-38, 1990-1 C.B. 57, 1990 WL 657148 (Apr. 10, 1990)

Rev. Rul. 2008-30, 2008-1 C.B. 1156, 2008 WL 2264495 (Jun. 23, 2008)


I. INTRODUCTION

Pursuant to Federal Rule of Civil Procedure 56, Exxon Mobil Corporation (“ExxonMobil”) moves for partial summary judgment on the “change in method of accounting” defense asserted by Defendant United States of America (“Defendant”). See Def.'s Answer [Dkt. 14] at 6–7. This defense challenges whether ExxonMobil may treat the transactions at issue in Qatar and Malaysia (collectively, the “Transactions”) as purchases, rather than as mineral leases, on its amended 2006 – 2009 U.S. federal income tax returns. Defendant argues that ExxonMobil must continue to treat the Transactions as mineral leases, even if such treatment is improper, because treating the Transactions as purchases was a “change in method of accounting” that required the prior consent of the Commissioner of the Internal Revenue Service (the “IRS”). See id. ExxonMobil's position is that it made no change in method of accounting when it treated the Transactions as purchases on its 2006-2009 amended returns and therefore prior IRS consent was not required.1

No change in method of accounting occurs when the issue presented is whether a taxpayer should include an item in its income. Instead, a change in method of accounting occurs only if the issue presented is when the taxpayer includes an item in its income. As explained below, ExxonMobil's treatment of the Transactions as purchases, rather than mineral leases, was not a change in method of accounting, and summary judgment is therefore appropriate.

ExxonMobil originally treated the Transactions as mineral leases. In a mineral lease, the lessee, in this case ExxonMobil, includes in income only its share of the operating income from the leased mineral. Thus, ExxonMobil did not include, and would never include, in its income royalties that belong to the State of Qatar (“SOQ”) and Petroliam Nasional Berhad (“Petronas”), the Malaysian national oil and gas company. As a matter of law, royalties under a mineral lease are the lessor/recipient's share of income from production of its share of the mineral in place — i.e., in the ground — and thus are not includible in the lessee/payor's income. Therefore, on its original returns, ExxonMobil included in its income only its share of production as the lessee of the mineral in place. ExxonMobil later amended its tax returns and treated the Transactions as purchases and, as a result, must include in its income all income from the purchased property, rather than only the lessee's share of income under a mineral lease.

ExxonMobil did not adopt a method of accounting when it treated the Transactions as mineral leases and therefore could not change a method of accounting when it treated the Transactions as purchases. The issue in this case is whether the Transactions are purchases or mineral leases. The tax consequence of that treatment is whether an item is included or excluded from ExxonMobil's income. This is not a method of accounting issue. In addition, treating the Transactions as purchases was not a change in method of accounting for two reasons. First, because the original treatment was not a method of accounting, correcting the treatment could not be a change in method of accounting. Second, because the corrected treatment included additional amounts in ExxonMobil's income that otherwise would never have been included in its income, the Treasury Regulations and case law expressly exclude the correction from the definition of a change in method of accounting.

For all these reasons, ExxonMobil's treatment of the Transactions as purchases on its amended 2006 – 2009 tax returns was not a change in method of accounting, and ExxonMobil is therefore entitled to summary judgment.

II. OVERVIEW OF TAXATION OF MINERAL LEASES

Before addressing the undisputed facts and governing law, it is important to understand what a mineral lease is and how it differs from a typical lease of real estate. A mineral lease is not a “lease” for federal income tax purposes; it is a unique sharing arrangement in which both the lessor and the lessee own an interest in the mineral in place (i.e., in the ground).2 Shamrock Oil & Gas Corp. v. Comm'r, 35 T.C. 979, 1040 (1961), aff'd, 346 F.2d 377 (5th Cir. 1965); Thomas v. Perkins, 301 U.S. 655, 661 (1937), aff'g 86 F.2d 954 (5th Cir. 1936). The lessor contributes the mineral in place to the sharing arrangement, and the lessee agrees to explore and develop the mineral. Shamrock Oil & Gas Corp, 35 T.C. at 1040. The lessor retains ownership of a non-operating mineral interest continuing over the productive life of the transferred interest (commonly referred to as the “royalty”), and the lessee acquires ownership of an operating mineral interest. Id. (the lessor retains a royalty “in any production from the property which follows its exploitation”).3 The royalty is the lessor's retained share of production from its ownership of the mineral in the ground (i.e., the mineral in place); that is, the royalty owner owns the mineral in the ground and the income from that mineral interest (the royalty income). Id. Therefore, the royalty income is the lessor's income from its mineral property, and the lessor (i.e., the royalty owner) is entitled to a depletion deduction in computing its taxable income. Id.; Thomas, 301 U.S. at 661–63.4 By contrast, the royalty income is not included in the lessee's income, and the lessee may not claim depletion with respect to the lessor's property. Shamrock Oil & Gas Corp, 35 T.C. at 1040. The tax treatment of a mineral lease is the same regardless of whether the royalty payment is made to the lessor in cash or in-kind — i.e., through delivery of the extracted mineral, rather than cash derived from its sale. Thomas, 301 U.S. at 662 (finding that an in-kind royalty should be treated the same as “where the lessee sells all the oil and pays over the royalty in the form of cash”).

III. UNDISPUTED FACTS

There is no genuine dispute as to any material fact about how ExxonMobil treated the Transactions on its original and amended tax returns for 2006 – 2009. The Court may therefore resolve through summary judgment whether ExxonMobil's treatment of the Transactions as purchases was a change in method of accounting.

A. ExxonMobil treated the Transactions as mineral leases on its original 2006 – 2009 tax returns and never included SOQ and Petronas's royalties in its income.

On its original 2006 – 2009 tax returns, ExxonMobil treated the Transactions as mineral leases and the payments to the SOQ and Petronas (in cash and in kind) as royalties. Ex. 1 (Merkle Decl. ¶ 3) (App. at 3).5 Accordingly, ExxonMobil never included the royalties in its income and was not entitled to and did not include any portion of the payments to the SOQ or Petronas, as the lessors of the mineral property, in its cost of the mineral property for purposes of computing cost depletion. Ex. 1 (Merkle Decl. ¶¶ 4–6, 8–10) (App. at 3–4).6

The IRS agrees that ExxonMobil treated the Transactions as mineral leases on its original 2006 – 2009 tax returns. See Ex. 2 (Gonzalez Decl., Ex. A) (App. at 14) (original tax returns treated the Transactions in Qatar as mineral leases); Ex. 2 (Gonzalez Decl., Ex. B) (App. 34) (original tax returns treated the Transactions in Malaysia as mineral leases).

B. ExxonMobil treated the Transactions as purchases on its amended 2006 – 2009 tax returns and must include in its income all of the income from the purchased property.

On its amended 2006 – 2009 tax returns, ExxonMobil treated the Transactions as purchases of the property from the SOQ and Petronas. Ex. 2 (Gonzalez Decl. ¶ 5) (App. at 7). Accordingly, ExxonMobil must include in its income all of its partnership share of the income from the property purchased by the partnership from the SOQ and all of the income from the property purchased from Petronas in Malaysia, rather than only the lessee's share of income under a mineral lease. Ex. 2 (Gonzalez Decl. ¶ 8) (App. at 7–8).7

On its amended returns, ExxonMobil treated the payments to the SOQ and to Petronas on which its claim is based as contingent purchase price payments — rather than royalties — and determined that a portion of each payment was principal and the remainder was imputed interest under section 483.8 Ex. 2 (Gonzalez Decl. ¶ 9) (App. at 8). ExxonMobil capitalized the principal component of each payment and took depletion deductions with respect to the property purchased in each Transaction. Ex. 2 (Gonzalez Decl. ¶ 9) (App. at 8). ExxonMobil apportioned the interest deductions between U.S. and foreign source income. Ex. 2 (Gonzalez Decl. ¶ 9) (App. at 8). Depletion deductions reduced ExxonMobil's foreign source income. Ex. 2 (Gonzalez Decl. ¶ 9) (App. at 8). As a result, ExxonMobil's taxable income on the amended returns was greater than on its original returns because its foreign source taxable income increased by more than its U.S. source taxable income was reduced by the allocated interest deductions. Ex. 2 (Gonzalez Decl. ¶ 9) (App. at 8). ExxonMobil used some of its excess foreign tax credits to satisfy the tax on the additional foreign source income generated by its corrected treatment and carried over the remaining excess foreign tax credits to subsequent years. Ex. 2 (Gonzalez Decl. ¶ 10) (App. at 8).

The IRS agrees that ExxonMobil treated the Transactions on its amended 2006 – 2009 tax returns as purchases, as described above. See Ex. 2 (Gonzalez Decl., Ex. A) (App. at 14–15); Ex. 2 (Gonzalez Decl., Ex. B) (App. 35). Accordingly, there is no material fact dispute about how ExxonMobil treated the Transactions on its original and amended returns.

IV. SUMMARY JUDGMENT STANDARD

Courts “shall grant summary judgment if the movant shows that there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law.” FED. R. CIV. P. 56(a); Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247 (1986). In making this determination, the Court must view all evidence and draw all reasonable inferences in the light most favorable to the party opposing the motion. United States v. Diebold, Inc., 369 U.S. 654, 655 (1962). The moving party bears the initial burden of informing the Court of the basis for its belief that there is no genuine issue for trial. Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986). Because ExxonMobil is moving for summary judgment on Defendant's defense, it can “obtain summary judgment simply by disproving the existence of any essential element of” that defense. Fontenot v. Upjohn Co., 780 F.2d 1190, 1194 (5th Cir. 1986).

V. ARGUMENT AND AUTHORITIES

A. Treating the Transactions as mineral leases was not the adoption of a method of accounting, and correcting the treatment to purchases was not a change in method of accounting.

As explained above, if the Transactions are mineral leases, ExxonMobil would never include in its income the royalties paid to the SOQ and Petronas, as a matter of law, because those royalties would represent the SOQ's and Petronas's share of production from their ownership of the mineral in place. In contrast, if the Transactions are purchases, as a matter of law, ExxonMobil must include in its income all of the income from the purchased property, rather than only the lessee's share of income under a mineral lease. Because originally treating the Transactions as mineral leases established that an item (i.e., the royalty income) was never includible in ExxonMobil's income, that treatment was not a method of accounting. And because treating the Transactions as mineral leases was not a method of accounting, ExxonMobil's treatment of the Transactions as purchases was not a change in method of accounting. Accordingly, ExxonMobil is entitled to summary judgment as a matter of law.

1. A method of accounting determines when — not whether — an item is includible in income or allowable as a deduction.

To determine if ExxonMobil's treatment of the Transactions as purchases is a change in method of accounting, one must first determine what constitutes a “method of accounting” and whether ExxonMobil adopted a “method of accounting” when it originally treated the Transactions as mineral leases. Although the Internal Revenue Code uses the term “method of accounting,” it does not define it. Instead, section 446(e) states only that “a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary.” 26 U.S.C. § 446(e). Because Congress has not defined “method of accounting” in the Internal Revenue Code, courts have been forced to do so.9

The courts have found that a method of accounting determines when, not whether, an item is includible in income or allowable as a deduction. For example, in Tate & Lyle, Inc. v. Commissioner, the Tax Court considered whether a taxpayer's failure to report as income interest excludible from its income under a tax treaty presented a method of accounting issue. 103 T.C. 656, 668–69 (1994), rev'd on other grounds, 87 F.3d 99 (3d Cir. 1996). After finding that a “method of accounting for income only determines when an item is includable in income” and “never comes into play if the item is excluded from gross income,” the Tax Court held that the taxpayer's treatment was not a method of accounting because the interest was excluded from income by the treaty. Id. at 669 (emphasis added). Multiple authorities support the Tax Court's conclusion that a method of accounting exists only if the issue presented is when — not whether — an item is includible in income or allowable as a deduction.10

ExxonMobil has found no case even discussing whether a change from mineral lease to purchase treatment (or vice versa) presents a change in method of accounting issue. On the contrary, the cases confirm that no change in method of accounting results when the issue is whether — not when — income is taxable to the taxpayer. For example, the taxpayer in Saline Sewer v. Commissioner operated and maintained sanitary sewer lines and excluded customer connection fees from its gross income by treating them as nontaxable capital contributions. No. 9540-91, 1992 WL 79079, at *1 (T.C. Apr. 21, 1992) (no appeal). The IRS challenged the taxpayer's treatment of the connection fees, included them as taxable income, and argued that the change from nontaxable capital contributions to taxable income was a change in method of accounting. Id. The Tax Court found that the income inclusion was not a change in method of accounting because “where the matter of proper timing is not involved, a change in the accounting treatment of an item will not be considered a change in the taxpayers' 'method of accounting.'” Id. at *2–3 (citing Treas. Reg. § 1.446-1(e)(2)(ii)(b)). The Tax Court emphasized that “we are not faced with the question as to the proper time at which the fees should be reported in income, but rather whether the fees should be reported in income at all.” Id. at *3. The IRS did not appeal Saline Sewer and followed its rationale in a later Field Service Advice. See IRS FSA 199911004, 1999 WL 148540, at *8–9 (Mar. 19, 1999).11

In Florida Progress v. United States, the district court confronted the same issue as in Saline Sewer and reached the same result. 156 F. Supp. 2d 1265, 1276 (M.D. Fla. 1998), aff'd per curiam on other issues, 264 F.3d 1313 (11th Cir. 2001). The court first determined that the connection fees were taxable income, rather than nontaxable capital contributions. The court then held that the change from nontaxable to taxable was not a change in method of accounting because the taxpayer's exclusion of the fees from its gross income involved “whether items would be reported, not when they would be reported.” Id. at 1276 (emphasis in original); see also Pelton & Gunther P.C. v. Comm'r, No. 23914-97, 1999 WL 801399, at *4 (T.C. Oct. 8, 1999) (IRS's corrected treatment of litigation costs paid on behalf of clients as loans, rather than deductible litigation costs, was not a change in method of accounting because the issue was whether the costs were ever deductible).

Finally, in Convergent Technologies, Inc. v. Commissioner, the Tax Court allowed a taxpayer to correct its treatment of stock warrants, so they were expensed and deducted in one year, rather than capitalized and amortized over a period of years. No. 29655-91, 1995 WL 422677, at *6–7 (T.C. Jul. 19, 1995). The Tax Court viewed the IRS's position — which would have denied the taxpayer any deduction with respect to issuance of the warrants — as changing “the focus of this case from one of timing, as [the IRS] contends, to one of characterization of the item, as [the taxpayer] contends.” Id. at *14. Because the IRS's position that the stock warrants were never deductible made the issue in Convergent whether, not when, the stock warrants were deductible, the Tax Court held that no change in method of accounting resulted and the taxpayer could correct how it treated the warrants without IRS consent. Id. at *14-15.

The issue presented here, as in the cases discussed above, is whether the payments ExxonMobil makes to the SOQ and Petronas (a) are never included in ExxonMobil's income as the SOQ's and Petronas's share of production (i.e., royalty income) under mineral lease treatment, or (b) are included in ExxonMobil's income under purchase treatment. Because the issue presented is whether, not when, the payments are includible in ExxonMobil's income, the original mineral lease treatment was not a method of accounting, and correcting to purchase treatment was not a change in method of accounting.12 Summary judgment for ExxonMobil is therefore appropriate.13

2. The Treasury Regulations defining a change in method of accounting confirm that a method of accounting must determine the time for including an item of income or allowing a deduction.

Treasury Regulations section 1.446-1(e)(2)(ii)(b) provides that a change in method of accounting does not include the “adjustment of any item of income or deduction which does not involve the proper time for the inclusion of the item of income or the taking of a deduction.” Under this standard, correcting an item's treatment from deductible to nondeductible is not a change in method of accounting. See Treas. Reg. § 1.446-1(e)(2)(ii)(b). For example, correcting an item from a deductible business expense to a nondeductible personal expense is not a change in method of accounting, nor is correcting an item from a deductible salary expense to a nondeductible dividend. Id. The Treasury Regulations thus confirm that when the issue presented is whether an item is includible in income or allowable as a deduction, there is no change in method of accounting. That is the situation here.

If the Transactions are mineral leases, ExxonMobil's income never includes the royalties paid to the SOQ and Petronas. As the lessor/owner of the mineral in place, the SOQ and Petronas received the royalty payments as their share of income from the mineral in place. Because the royalty income is never included in ExxonMobil's income as the lessee of the mineral property, there is no “item” of income that could be subject to a method of accounting under mineral lease treatment. As a result, there is no “item” that could be subject to a later change in method of accounting when ExxonMobil treated the Transactions as purchases.

3. The section 481 adjustment associated with a change in method of accounting confirms that a method of accounting must address timing.

If a change in method of accounting occurs — regardless of whether it is initiated by the taxpayer or the IRS — the taxpayer must make an adjustment under section 481 in the year of the change to prevent the taxpayer from omitting income or receiving a double deduction. 26 U.S.C. § 481(a)(2). The section 481 adjustment is the aggregate amount of additional income or deductions that the taxpayer would have reported in years prior to the year of the change, assuming that the taxpayer had used the new method of accounting in such prior years. Treas. Reg. § 1.481-1(c)(2), (3). Depending on the facts, the adjustment may increase or decrease the taxpayer's taxable income for the year of the change. Id. The section 481 adjustment takes into account all prior years, regardless of whether the statute of limitations is open or closed for such years. Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 572 (5th Cir. 1965).

In explaining why a section 481 adjustment for closed years does not violate the statute of limitations, courts emphasize that a method of accounting involves deferral — i.e., timing — rather than a permanent exclusion of income or expense, as explained by the Fifth Circuit in Graff Chevrolet Co. v. Campbell:

When a taxpayer uses an accounting method which reflects an expense before it is proper to do so or which defers an item of income that should be reported currently, he has not succeeded (and does not purport to have succeeded) in permanently avoiding the reporting of any income; he has impliedly promised to report that income at a later date, when his accounting method, improper though it may be, would require it.

Id. (citing Note, Problems Arising from Changes in Tax-Accounting Methods, 73 HARV. L. REV. 1564, 1576 (1960)).

Courts' emphasis on deferral and timing shows that ExxonMobil's original treatment of the Transactions as mineral leases was not a method of accounting. When treating the Transactions as mineral leases, ExxonMobil did not include in its income the royalties paid to the SOQ and Petronas because they were the lessors' share of production from the mineral in place. ExxonMobil never impliedly promised to report the royalty income at a later date because it would never be ExxonMobil's income. Accordingly, treating the Transactions as mineral leases determined whether, not when, an item was included in ExxonMobil's income. Thus, mineral lease treatment was not a method of accounting. Correspondingly, because treating the Transactions as mineral leases was not a method of accounting, treating the Transactions as purchases was not a change in method of accounting.

B. A “lifetime taxable income” test is not the proper test to determine whether there is a change in method of accounting.

ExxonMobil expects Defendant to argue that the relevant test for determining whether there is a change in method of accounting is a “lifetime taxable income test,” even though this test cannot be found in the Internal Revenue Code or the Treasury Regulations. Instead, the so-called lifetime taxable income test is found in a revenue ruling issued by the IRS sixteen years after Saline Sewer and ten years after Florida Progress, in which the IRS declined to follow the holdings in both cases. See Rev. Rul. 2008-30, 2008-1 C.B. 1156, 2008 WL 2264495 (Jun. 23, 2008). Under the so-called lifetime taxable income test, a change in method of accounting occurs whenever a taxpayer's lifetime taxable income — i.e., net income — would be the same under either method of accounting at issue.14 The IRS appears to have created this test in response to various cases that use the term “taxable income” colloquially to mean income taxable to the taxpayer, rather than to mean the defined term for “taxable income.” 26 U.S.C. § 63(a) (“taxable income” is defined as “gross income minus the deductions allowed by this chapter”).

The IRS's lifetime taxable income test is not the proper measure for determining whether a change in method of accounting has occurred for at least three reasons. First, as explained below, a lifetime taxable income test conflicts with the Treasury Regulations. Second, a lifetime taxable income test is not supported by case law, including the cases cited in the revenue ruling setting forth the test. Third, that revenue ruling is not binding on this Court.

1. A lifetime taxable income test conflicts with the Treasury Regulations.

The Treasury Regulations define a change in method of accounting as a change in the timing of an item of gross income or deduction, not taxable or net income. A change in method of accounting is a “change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan.” Treas. Reg. § 1.446-1(e)(2)(ii)(a) (emphasis added). A “material item” is “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.” Id. The term “income,” as used in the definition of “material item,” logically refers to “gross income” because that is the term used in the definition of a change in an overall method of accounting. See id. (defining a change in method of accounting as a “change in the overall plan of accounting for gross income or deductions” (emphasis added)).15

Importantly, the Treasury Regulations defining a change in method of accounting do not refer to the proper time for reporting “taxable income” — i.e., net income — or the proper time for reporting items (plural) of “income and deductions” (conjunctive). These terms would be used to describe “taxable income” or net income, if that was intended. Therefore, the regulations' use of the singular term “item” and the disjunctive term “or” is substantive, and those terms refer to gross income, not net taxable income.16

Interpreting “income” to mean “gross income” and not “net income” in this context finds strong support in the Tax Court's decision in Leonhart v. Commissioner, No. 6743-65, 1968 WL 1212 (T.C. May 27, 1968), aff'd, 414 F.2d 749 (4th Cir. 1969). In Leonhart, the Tax Court was determining the meaning of the term “material item” in the Treasury Regulations, which stated: “A change in the method of accounting includes a change in the over-all method of accounting for gross income or deductions, or a change in the treatment of a material item.” The Tax Court stated: “It is obvious that 'material item' should be read in context as 'material item of gross income or deductions' and should not be construed as meaning 'a material item of net income.'” Id. at *32 (emphasis added). Leonhart was decided two years before the Treasury Regulations were amended to define a material item as “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.” Treas. Reg. § 1.446-1(e)(2)(ii)(a) (as amended by T.D. 7073, 1970-2 C.B. 98, 1970 WL 123193). Consistent with the Tax Court's decision in Leonhart, the Treasury Regulations did not define material item by reference to net income. Given the timing of the Leonhart decision and the omission of any reference to net income in the definition of “material item” added in 1970, the regulations should be read in light of the Tax Court's statement in Leonhart.

Based on the Treasury Regulations' express language — including the examples illustrating that a change in method of accounting concerns when, not whether, an item is includible in income or allowable as a deduction — this Court should reject the IRS's lifetime taxable income test. The Treasury Regulations preclude finding that ExxonMobil's treatment of the Transactions as purchases is a change in method of accounting, regardless of whether ExxonMobil's lifetime taxable income is the same. The IRS's focus on lifetime taxable income is simply misplaced in this case.

2. The cases cited in the IRS's revenue ruling do not support a lifetime taxable income test.

The IRS cited five cases in Revenue Ruling 2008-30 to support its lifetime taxable income test: Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir. 1984); Peoples Bank & Trust Co. v. Comm'r, 415 F.2d 1341 (7th Cir. 1969); Primo Pants Co. v. Comm'r, 78 T.C. 705, 723 (1982); Johnson v. Comm'r, 108 T.C. 448 (1997), aff'd in part, rev'd in part, 184 F.3d 786 (8th Cir. 1999); and Rankin v. Comm'r, 138 F.3d 1286 (9th Cir. 1998). None of these cases address whether an item is includible in the taxpayer's income or allowable as a deduction.

The taxpayers in Knight-Ridder, Johnson, and Rankin all received income and took an accelerated deduction for future expenses. Knight-Ridder Newspapers, Inc., 743 F.2d at 786–87; Johnson, 108 T.C. at 494–96; Rankin, 138 F.3d at 1287. The courts determined (or the parties stipulated) that the taxpayers could not deduct the expenses until they were actually incurred.17 Knight-Ridder Newspapers, Inc., 743 F.2d at 798; Johnson, 108 T.C. at 495; Rankin, 138 F.3d at 1287. To avoid a change in accounting method and an unfavorable section 481 adjustment, the taxpayers argued that their original method of taking a current-year deduction for future expenses resulted in a permanent exclusion of income if the future expenses were never incurred. Knight-Ridder Newspapers, Inc., 743 F.2d at 799; Johnson, 108 T.C. at 494; Rankin, 138 F.3d at 1289. The courts correctly found that if the expenses were never incurred, the taxpayers must, as a matter of law, apply the tax benefit rule to include in their income an amount offsetting the earlier deductions.18 Knight-Ridder Newspapers, Inc., 743 F.2d at 799; Johnson, 108 T.C. at 495–96; Rankin, 138 F.3d at 1289 & n.4. On that basis, the courts found that the change was a change in method of accounting. These cases are therefore distinguishable because they did not involve the permanent exclusion of an item from the taxpayers' income, as this case does.

Primo Pants likewise did not address whether an item is includible in a taxpayer's income or allowable as a deduction. The taxpayer in Primo Pants incorrectly valued its inventory when computing its cost of goods sold and argued that its valuation method was not a timing issue because it resulted in deductions that the taxpayer could not take. 78 T.C. 705, 722 (1982). The Tax Court disagreed:

Since each year's closing inventory becomes the opening inventory for the succeeding year, the system will automatically self-correct whenever the closing inventory is correctly valued. The cumulative income over the period of years involved will be the same total, but income will be deferred each year until the closing inventory is finally corrected.

Id. at 723–24. Therefore, the Tax Court found a change in accounting method because “the present case involves only postponement of income and therefore involves a timing question.” Id. at 723. The same is not true here.

If the Transactions are mineral leases, the royalty income is never included in ExxonMobil's income because it belongs to the SOQ and Petronas as the owners of the royalty (i.e., the mineral in the ground). The tax benefit rule will never apply to require ExxonMobil to include the royalty income in its income. This situation also differs from inventory valuation, where income is deferred and self-corrects over time. Thus, unlike the taxpayers in Knight-Ridder, Johnson, Rankin, and Primo Pants, under ExxonMobil's treatment of the Transactions as mineral leases, the royalty income will never be included in ExxonMobil's income.

None of the cases cited by the IRS in Revenue Ruling 2008-30 support the conclusion that excluding or including an item in income is a change in method of accounting. In fact, two of the cited cases expressly confirm that no change in method of accounting issue is presented when the issue is whether an item is ever includible in income or allowable as a deduction. See Knight-Ridder Newspapers, Inc., 743 F.2d at 798 (finding that a reserve was a method of accounting because it “did not determine whether or not a rebate would be deducted, but when that deduction would occur”); Rankin, 138 F.3d at 1288 (noting that “§ 481 concerns only tax errors that involve when income is reported — not those concerning how much income is reported, or whether a deduction would ever have been appropriate.”).

Finally, the IRS's reliance on Peoples Bank is puzzling, as that case does not address a lifetime taxable income test. The court in Peoples Bank found that a section 481 adjustment did not violate the statute of limitations because it was consistent with the taxpayer's implied agreement to report an item at a later date. See Peoples Bank, 415 F.2d at 1344. By contrast, when ExxonMobil originally treated the Transactions as mineral leases, there was no implied agreement that it would ever include the royalty income in its income. Therefore, the reasoning of Peoples Bank, to the extent relevant, supports ExxonMobil's position that this case does not present a change in method of accounting issue.19

3. The revenue ruling setting forth the IRS's lifetime taxable income test is not binding on this Court.

Revenue rulings are not binding on this Court or any court. See Treas. Reg. § 601.201(a)(6); Foil v. Comm'r, 920 F.2d 1196, 1201 (5th Cir. 1990) (“IRS Revenue Rulings do not have the force of law, and are not binding on this Court.”). Further, because the facts and issues presented in this case substantially differ from those in the revenue ruling adopting the so-called lifetime taxable income test, that ruling is not even relevant here. Treas. Reg. § 601.601(d)(2)(v)(e) (“[S]ince each Revenue Ruling represents the conclusion of the Service as to the application of the law to the entire state of facts involved, taxpayers, Service personnel, and others concerned are cautioned against reaching the same conclusion in other cases unless the facts and circumstances are substantially the same.”). Revenue Ruling 2008-30 did not involve a correction from mineral lease treatment to purchase treatment.

In sum, a lifetime taxable income test is not the proper test for a change in method of accounting. That test conflicts with the Treasury Regulations and is not supported by case law. In fact, the relevant cases support ExxonMobil's position that treating the Transactions as mineral leases was not a method of accounting and that correcting to purchase treatment was not a change in method of accounting. ExxonMobil's corrected treatment of the Transactions determined whether, not when, to include an item in ExxonMobil's income.

VI. CONCLUSION

For the foregoing reasons, ExxonMobil respectfully requests that the Court grant its motion for partial summary judgment and find that ExxonMobil's treatment of the Transactions as purchases on its amended 2006 – 2009 tax returns was not a change in method of accounting. ExxonMobil further requests all other relief to which it is entitled.

Respectfully submitted,

THOMPSON & KNIGHT LLP

By: Emily A. Parker
Texas Bar No. 15482500
emily.parker@tklaw.com

Mary A. McNulty
Texas Bar No. 13839680
mary.mcnulty@tklaw.com

William M. Katz, Jr.
Texas Bar No. 00791003
william.katz@tklaw.com

J. Meghan Nylin
Texas Bar No. 24070083
meghan.nylin@tklaw.com

Leonora S. Meyercord
Texas Bar No. 24074711
lee.meyercord@tklaw.com

1722 Routh Street, Suite 1500
Dallas, Texas 75201
(214) 969-1700
FAX (214) 969-1751

MILLER & CHEVALIER, CHARTERED

Kevin L. Kenworthy
D.C. Bar No. 414887
kkenworthy@milchev.com

George A. Hani
D.C. Bar No. 451945
ghani@milchev.com

Andrew L. Howlett
D.C. Bar No. 1010208
ahowlett@milchev.com

900 16th Street NW
Washington, D.C. 20006
(202) 626-5800
FAX (202) 626-5801

ATTORNEYS FOR PLAINTIFF
EXXON MOBIL CORPORATION

FOOTNOTES

1ExxonMobil's motion for partial summary judgment does not require the Court to resolve the merits of ExxonMobil's claims that the Transactions were purchases; rather, the motion addresses only the validity of Defendant's “change in method of accounting” defense.

2The lessee of a mineral property acquires and owns a depletable interest in the mineral in place, whereas a lessee of real estate does not own a depreciable interest in the real estate and has only a right to use the property in exchange for deductible rents paid to the lessor. See Cargill v. United States, 91 F. Supp. 2d 1293, 1295 (D. Minn. 2000) (explaining that in “return for its use of the facility,” Cargill made deductible “rent payments” to the facility's owner and that this arrangement was a “lease for tax purposes”).

3An operating mineral interest is burdened with the costs of production of the mineral, whereas a non-operating mineral interest is not. 26 U.S.C. §§ 614(d), (e)(2). An operating mineral interest is commonly referred to as a “working interest.”

4A reasonable deduction for depletion is allowed in computing taxable income from mines, oil and gas wells, other natural deposits, and timber. 26 U.S.C. § 611(a). Depletion may be determined with reference to the taxpayer's cost basis in the depletable natural resources (cost depletion) or, where allowable, as a percentage of gross income from the property (percentage depletion). 26 U.S.C. §§ 611(a), 612(a), 613(a); Treas. Reg. § 1.611-1(a)(1). Unless otherwise indicated, all references to the Treasury Regulations are to 26 C.F.R. as amended, for the years in issue.

5All citations to “Exs.” are to exhibits attached to the Appendix in Support of Exxon Mobil Corporation's Motion for Partial Summary Judgment Regarding Change in Method of Accounting. Specific page references in the Appendix are included for each citation.

6Although ExxonMobil's original treatment of the Transactions as mineral leases is undisputed, the specific return entries varied slightly over time for both Malaysia and Qatar. The in-kind payments to Petronas and the in-kind production attributable to the payments were not reported on ExxonMobil's 2006 – 2009 original returns. Ex. 1 (Merkle Decl. ¶ 4) (App. at 3). On ExxonMobil's original 2006 – 2009 tax returns, the cash payments to Petronas were included as a cost of goods sold on line 2 and an amount equal to the cash payments was included in line 1 (Gross receipts or sales), resulting in no gross profit attributable to the payments on line 3. Ex. 1 (Merkle Decl. ¶ 5) (App. at 3). In Qatar, ExxonMobil's affiliate is a shareholder in the Qatari joint stock companies, which are treated as partnerships for U.S. federal income tax purposes and made the payments to SOQ. Ex. 2 (Gonzalez Decl. ¶ 3) (App. at 6–7). On ExxonMobil's original 2006 – 2008 tax returns, the payments by the two Qatari joint stock companies that made payments to SOQ during those years and an amount equal to such payments were reported on line 10 (Other income), resulting in no income on line 10 attributable to such payments. Ex. 1 (Merkle Decl. ¶ 6) (App. at 4). On ExxonMobil's original 2009 return, the payments by the four Qatari joint stock companies that made payments in that year were included on line 26 (Other deductions) and an amount equal to the payments was included in line 1 (Gross receipts or sales). Ex. 1 (Merkle Decl. ¶ 8) (App. at 4). Because the change in method of accounting issue in this case involves whether an item is ever includible in ExxonMobil's income as a matter of law, ExxonMobil's varied reporting is legally irrelevant.

7The Qatar transactions are between the SOQ and Qatari joint stock companies, which are treated as partnerships for federal income tax purposes. Ex. 2 (Gonzalez Decl. ¶ 3) (App. at 6–7). Since ExxonMobil's affiliate is allocated its share of the partnerships' income, gain, loss, deductions and credits, these partnerships will be ignored for purposes of ExxonMobil's motion and the focus in the motion will be on ExxonMobil's share of the partnerships' income. Ex. 2 (Gonzalez Decl. ¶ 3) (App. at 6–7).

8Unless otherwise stated, all “section” references herein are to the Internal Revenue Code (26 U.S.C.), as amended, through the years in issue.

9The Treasury Regulations likewise do not define a “method of accounting,” but they do define a change in method of accounting. See Treas. Reg. § 1.446-1(e)(2).

10See Gen. Motors Corp. v. Comm'r, 112 T.C. 270, 296 (1999) (“An accounting practice that involves the timing of when an item is included in income or when it is deducted is considered a method of accounting.”); Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 798 (11th Cir. 1984) (finding that a reserve was a method of accounting because it “did not determine whether or not a rebate would be deducted, but when that deduction would occur”); see also W.A. Holt Co. v. Comm'r, 368 F.2d 311, 312 (5th Cir. 1966) (whether bad debts are ever deductible is not a method of accounting).

11Field Service Advice 199911004 addresses correcting the treatment of membership fees paid to a country club from not taxable to taxable. Field Service Advice is taxpayer-specific advice given by the IRS Office of Chief Counsel (the chief law officer for the IRS) to field counsel and IRS offices. 26 U.S.C. §§ 6110(i)(1); 7803(b)(2). It is not precedential, but it may be cited to show the IRS's interpretation of the law. See 26 U.S.C. § 6110(k)(3); Transco Expl. Co. v. Comm'r, 949 F.2d 837, 840 (5th Cir. 1992) (finding that the IRS's “prior rulings were significant since they disclosed the interpretation of the statute by the agency charged with administering the revenue laws”).

12In any event, ExxonMobil improperly treated the transactions by two of the Qatari joint stock companies (ExxonMobil Ras Laffan (III) Limited and ExxonMobil Qatargas (II)) as mineral leases for only one year (2009). Ex. 1 (Merkle Decl. ¶ 7–8) (App. at 4); Ex. 2 (Gonzalez Decl., Ex. A) (App. at 15). Therefore, ExxonMobil did not adopt a method of accounting with respect to these transactions, and the corrected treatment is not a change in method of accounting. Rev. Rul. 90-38, 1990-1 C.B. 57, 1990 WL 657148 (Apr. 10, 1990); Rev. Proc. 2002-18, 2002-1 C.B. 678, 2002 WL 393159 (Apr. 1, 2002) (a taxpayer adopts an improper method of accounting only if it uses that method for more than one year).

13Cargill Inc. v. United States involved a real estate lease rather than a mineral lease and is therefore irrelevant. 91 F. Supp. 2d 1293 (D. Minn. 2000). Cargill, as either the lessee or purchaser of real estate, was entitled to deduct the same amount, either as rent or depreciation, for the subject property. Changing from real estate lease to purchase treatment, therefore, affected only the timing and character of Cargill's deductions, not the amount, so the court held this was a change in accounting method. By contrast, ExxonMobil, as a mineral lessee, does not recognize as income any of the royalty income, but as a purchaser, must recognize all income from the mineral property. Correcting from mineral lease to purchase treatment, therefore, determines the amount of ExxonMobil's income, so this is not an accounting method issue or a change in accounting method.

14ExxonMobil does not concede that lifetime taxable (net) income would be the same under mineral lease and purchase treatment, and the Court does not have to decide this issue to grant its motion.

15Neither the IRS nor Defendant has ever contended, and has no basis for contending, that ExxonMobil changed its overall method of accounting.

16The word “or” is “almost always disjunctive.” United States v. Woods, 134 S. Ct. 557, 567 (2013).

17The courts rejected the taxpayers' argument that they were entitled to a current deduction for future expenses because they set aside the amounts to pay the expenses in a reserve (Knight-Ridder), escrow (Johnson), or indemnity fund (Rankin). Knight-Ridder Newspapers, Inc., 743 F.2d at 786–87; Johnson, 108. T.C. at 451; Rankin, 138 F.3d at 1287. Amounts set aside to pay future expenses are not incurred.

18For example, if a taxpayer deducted $100 for future expenses and never incurred these expenses, the taxpayer would be required to include $100 in income to recover the improper deduction. See Hillsboro Nat'l Bank v. Comm'r, 460 U.S. 370, 383–84, 389 (1983) (internal footnotes omitted) (finding that the tax benefit rule requires a “balancing entry when an apparently proper expense turns out to be improper.”). Although Knight-Ridder and Johnson do not mention the tax benefit rule by name, the courts' analysis demonstrates that the tax benefit rule prevents the taxpayer's original treatment from resulting in a permanent exclusion from income. As the court in Knight-Ridder explained: “Any excess deductions in earlier years are offset by an equal amount of taxable income in the final day. The question becomes one of timing, whether income is taxed when the amounts are added to the reserve or when the reserve is abandoned at the Day of Armageddon.” 743 F.2d at 799. Likewise, the court in Johnson implicitly applied the tax benefit rule; otherwise, the taxpayer's treatment would have produced a permanent exclusion of income. 108 T.C. at 495–96.

19In reaching its decision, the court in Peoples Bank relied on the Fifth Circuit's statement from Graff Chevrolet that is quoted above in section V.A.3 and that supports ExxonMobil's position here.

END FOOTNOTES

DOCUMENT ATTRIBUTES
  • Case Name
    Exxon Mobil Corp. v. United States
  • Court
    United States District Court for the Northern District of Texas
  • Docket
    No. 3:16-cv-02921
  • Institutional Authors
    Thompson & Knight LLP
    Miller & Chevalier Chtd
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Tax Analysts Document Number
    2019-5365
  • Tax Analysts Electronic Citation
    2019 WTD 30-22
    2019 TNT 30-19
Copy RID