Co-author David Gair
The principal contention in the tax refund case of Exxon v. United States was whether certain mineral related transactions between Exxon and the countries of Qatar and Malaysia were sales or leases. Originally Exxon treated the transactions as leases on its tax returns.
As a lease, Exxon’s income didn’t include the portion of oil and gas revenues it paid to Qatar and Malaysia as royalties. A few years later, Exxon decided it was wrong in its characterization and filed refund claims to take advantage of foreign tax credits.
The determination of whether a taxpayer has a sale or a lease turns on the concept of “economic interest”: the right to share in the profits and losses of a business. For oil and gas, the party entitled to a percentage of profits from oil extraction has an economic interest in the oil. Royalty holders are deemed to have an economic interest in oil on which they are paid a royalty.
The IRS regulations crystalize this understanding. To have an economic interest in minerals in place a person must have:
- An investment in the minerals, and
- Income derived SOLELY from the extraction of minerals.
Exxon’s argument was that its arrangement with the countries secured other benefits in the same bargain, so the arrangement should be treated as a sale. The Court said that if Exxon were right, taxation would depend on how many transactions are cobbled into one contract. Instead, the Court elected to look at the source of the payment obligations in each part of the contract to determine whether it is a sale or a lease. Exxon said that this is “unworkable” “disaggregating” of its agreements.
At the end of the day, without oil and gas production, Qatar and Malaysia would receive no royalties. Supplemental income was irrelevant and is subject to its own tax treatment. Exxon lost its novel argument.
One the bright side for Exxon, it avoided a $200 million dollar penalty. The court said their position was close to crossing the line. But because this is a complex area of the law, like “occult mysteries”, they should be given a break.
Don’t pity Exxon; while it lost its request for a $1.5 Billion refund, it reported colossal profits in Q1 2022.