Recently, in Exxon Mobil Corp. v. United States (No. 3:22-cv-00515), a District Court in Texas ruled that the taxpayer was entitled to interest deductions on a production loan entered into as part of a multibillion-dollar natural gas development project. Outside the esoterica of natural resources taxation, the Court's order is important because it is an early example of a court considering and rejecting the IRS's recent and increasingly aggressive use of the economic substance doctrine outside of the tax shelter context.  

Brief summary of the case 

The taxpayer entered into a natural gas development project with the government of Qatar referred to as the “Al Khaleej Gas Partnership.” The government of Qatar granted valuable gas extraction rights, and Exxon contributed more than $1 billion of cash, as well as the technical skill and know-how necessary to build and operate a natural gas extraction facility. The parties agreed to share profits once Exxon's cash contribution was recouped.

In 2003, the Al Khaleej Gas Partnership was amended and expanded to cover additional offshore production capacity. To finance the billions of dollars of additional capital expenditures, the parties agreed that Qatar would provide additional capital in return for “production payments," a technical oil & gas concept that Section 636 treats as debt. Qatar's rights to the production payments were embodied in the same Development and Production Sharing Agreement (DPSA), but were assignable by Qatar separately from the profit share.

De Facto partnership classification

A first issue in the case was the characterization of the DPSA: was it a lease for mineral royalty payments or a “de facto partnership" between Exxon and Qatar with a separate production loan. In concluding that DPSA gave rise to a partnership for Federal income tax purposes, the Court looked at factors such as parties' profit sharing, the consistent tax reporting of the arrangement as a partnership by Exxon, joint management, & a joint account for project revenues and expenses maintained by the project operator.  

The Court particularly stressed that various committees established by the DPSA gave the parties joint control overall all significant operational decisions as to the Al Khaleej project. Thus, despite being cast in the form of a contractual relationship, not a legal entity, the court found the Al Khaleej development project to be a partnership.  

Embedded, as noted above, in the DPSA was a separately assignable right to production payments. Due to its separate assignability/severability (Compare Rev. Rul. 88-31), the Court looked at the production payments as a loan to the de facto partnership. 

What remained to be seen was whether the IRS could then use the Economic Substance doctrine to disallow the deductions for interest on this loan.  

Economic substance doctrine held inapplicable

Section 636(a) provides that a “production payment … shall be treated … as if it were a mortgage loan on the property….” A portion of payments on a loan would normally be deductible as interest. See Section 163(a). Interest deductions were beneficial to Exxon. Testimony at trial showed that the production payment was added to DPSA with a view to tax benefits.

The Court was presented with whether the taxpayer's motive invalidated this tax deduction. The IRS argued that, under the Economic Substance Doctrine (as well as substance-over-form), the deduction was disallowed.

Refusing to use Economic Substance Doctrine as a “smell test,” the Court soundly rejected the IRS's use of Economic Substance Doctrine for several different reasons.

One reason was that the choice of debt or equity to finance a business is often driven solely by tax considerations. The Courts, including the Supreme Court in John Kelly Co., have allowed shareholders to structure part of their investment in a controlled corporation as debt to obtain interest deductions. Thus, debt-equity was an area where the Economic Substance Doctrine and the taxpayer's motives were simply irrelevant.

Second, Section 636, as noted above, treats production payments as a loan. Applying the Economic Substance Doctrine would effectively override a clear statute.     

Third, the production loan figured in a larger business transaction that indisputably had economic substance - i.e., a multibillion-dollar natural gas project. The court's analysis was reminiscent of the UPS case where the Eleventh Circuit rejected the IRS's use of the economic substance doctrine to negate the tax savings from a business transaction, with real economic effects. See United Parcel Service of America Inc. v Commissioner of Internal Revenue Service. The Court also rejected the IRS's attempt to “slice and dice” an overall transaction in order to excise the tax-advantaged step. 

Fourth, the production loan itself was a key business term that the Court found had economic substance, so that even if the ESD were relevant, it was satisfied. The parties negotiated additional funding in the 2003 amendment, and a production loan was simply a tax-efficient structure for that business goal.  

Implications of the decision

Economic substance analysis isn't new. However, recently, the IRS has attempted to transport it from the Son-of-BOSS type of transactions to tax planning connected to transactions with economic effects or where the IRS simply sees the statutory text as producing a windfall. ExxonMobil is a recent rejection of that approach. Hopefully it also will mark the beginning of a trend.