flL£ CO" DO NOT REMOVE FROM FILE ~~ :\ IN THE WE ST VIRGINIA SUPREME COURT OF APPEALS NO. 18-0 121 I i)) , \l I'j\ 23 2ms II\\ , " ,~ .".",,~.J ~. ~OU;:.TO"""::f.'·' ~ _ ~("ng,,·~~ DAL E W, STEAGER, W EST VIRGINIA STATE TAX COMMISSIONER, Res pondent below , Petitioner \'S. CON SO L ENERGY, INC., DBA CN X GAS COM PANY, LLC, Petitioner below, Res pond ent. REPLY BRI EF OF WEST VIRG INIA STATE TAX DEPARTMENT PATRICK MORRISEY ATTORNEY GENERAL L. WAYNE WILLIAMS (WVSR #43 70) ASSISTANT ATTORNEY GENE RAL Office of the Attorney General 1900 Kanawha Boulevard, East Building 1, Room W-435 Charleston , West Virgin ia 25305 T elephone: (304) 558-2522 Email: I.w av nc.willi ams@ wvago. gov Counsel for Res pondent Dale W. Stcage.-, State Tax Commiss ioner I · ,. TABL E OF CONTENTS I. II. ARGUMENT .......................................................................................... 1 A. THE TAX DEPARTMENT CORRECTLY APPLIED THE LEG ISLATIVE RULE IN VALUING CNX GAS'S PRODUCING OIL AND GAS WELLS CONTRARY TO THE BUSIN ESS COURT DECISION ..... .. .......... ..... ....... I B. THE BUS INESS COURT ERRONEOUSLY CREATED A HYBRID RULE FOR VALUING PROD UCING OIL AND GAS WELLS INSTEAD OF APPLYING THE LEG ISLATIVE RULE ............ ......... ............. ..... ...... .. 9 C. THE LEG ISLATIVE RULE DOES NOT VIOLATE THE EQUAL AND UNI FORM CLAUSE OF Til E WEST VIRGIN IA CONSTITUTION OR THE EQUAL PROTECTION CLAUSE OF THE UNITED STATES CONSTITUTION ........ ............ .. ..... .................... .............. ... .. ... ....... 13 CONCLUS iON ...................................................................................... 14 TABLE OF AUTHOR ITI ES Denex Petroleum Corporation v. Mark Matkovich, West Virginia Slale Tax Commissioner, Civil Act ion No. 16-AA- l , e/ aJ. , Business Court Division, Barbour County Circuit Court ................................. ll , 12 In re Assessment Against American Bituminous Power Partners, L.P., 208 W.Va. 250, 539 S.E.2d 757 (2000) ...................................................... 10, II Lee Trace, LLC v. Raynes, 232 W. Va. 183,751 S. E. 2d 703 (20 13) ........................ 9, I I, 14 Shawnee Bank v. Paige, 200 W. Va. 20, 27, 488 S.E.2d 20, 27 ( 1997) ................ .. ............. 14 Stat ut es W.Va. W.Va. W.Va. W.Va. W.Va. W.Va. Code Code Code Code Code Code § 11·6K·I , ef seq., (2010) ................................................... .. ................ 8 § 11-6K·I(a) (2010) ........................................................................... 2 § 11-13A-2(e)(6)(G) (1995 Replacement Vol.) ............................................ 7 § 11·13A-2(b)(6)(G) (1987 Replacement Vol.) ............ , ..................... .. ........ 7 § 11-1 3A-2(e)(6)(G)(2004) ............................... , . ........ .. .......... , ............ 7 § 11 -2 1-16(a) ...................................................... ..... ....... " ........ ...... 13 Code Code Code Code R. R. R. R. Rules W.Va. W.Va. W.Va. W.Va. § § § § llO-IJ -1.4 ............ ........ ......................................... .... ................ 8 110- IJ·4.3 .................... .. ............................................. ....... ,passim 110·IJ· 4.6 ........................... .. .......... .......................................... 2 11 0·13A·4.8.4 ( 1992) .................................................................... 7 II IN TH E W EST VIRGINIA SUPREME COURT OF APPEALS NO. 18-0121 I DALE W. STEAGER, WEST VIRGINIA STATE TAX COMMI SS ION ER, Respondent below, Petitioner VS. CONSOL ENERGY, INC., DBA CNX GAS COMPANY, LL C, Petitioner below, Respondent. REPLY BRIEF OF WEST VIRGINIA STATE TAX DE I'ARTMENT I. A. ARGUMENT THE TAX DEPARTM ENT CORRECTLY APPLIED THE LEG ISLATIVE RULE IN YALU IN G CNX GAS'S PROD UC IN G OIL AND GAS W ELLS CONTRARY TO T HE BUSIN ESS COURT DECISION. Facts matter. The law matters. Every tax case is dependent on the facts before the Court and the applicable law orlhc particular tax statutes at issue. The Tax Department 's appeal of the five erroneous decisions issued by the Bus iness Court Division is no different. CNX Gas Company, LLC, (hereinafter CNX or CNX Gas) raised severa l objections before the Supreme Court which will be addressed below. Each of CNX's object ions ignores t)oth the material facts and the law. A. 1. !MOl90JaI I! T he Tax Oepartment Performed th e Two Critical Required by th e Legis lat ive Rul e. F~ nctions : Whil e operating a horizontal oil and gas well is a complex undertaking, the valuation process for ad valorem tax purposes is fa irly sim ple. The primary objectL e in valuing natural reso urce properties is set forth by statute. W.Va. Code § 11-6K-I(a) (2010) states in its entirety, "(a) All industrial property and natural resources property shall be assessed annually as of the assessment date at sixty percent of its true and actual value." However, the mechanics of the valuation process are outl ined in the legislative rule. Every individual oi l and gas we I! is valued according to the Yie ld Capita liza tion Model set forth in the legislative rule. See W.Va. Code R. § 110- 1J-4.6. Gross receipts are reduced by the average annual industry operat ing expenses. The legislative ru le requires the Tax Department to det.ermine the standard deduction to be ut il ized in valuing operat ing oil and gas wells every fi ve years. 4.3 . Average industry operati ng expenses. -- The Tax Comm iss ioner shall every five (5) yca rs, detcrmi ne the average annua l industry operating expenses per we ll. T he average a nnu a l indust ry ope r atin g expen ses sha ll be ded ucted fro m working imerest gross receipts to develop an income stream fo r app li cation of a yield capi talization procedure. W.Va. Code R. § llO-IJ-4.3 (emphasis added). T he legislative ru le cannot be clearer. The Tax Department is required to perform two critical functions accordi ng to the legislative rule. First, the Tax Department is requ ired 10 determine Ihe Average ArulUall ndustry Operating Expense every five years for ad valorem tax purposes. In 20 14 the Tax Departme nt circulated a survcy among all oil and gas producers in this Stale and calculated the Average Annual Industry Operating Expense based on the data subm itted by the industry. The data supplied by CNX was incl uded in that calcu lali on. Seco nd, thc Tax Department is requi red to deduct the Average Annual Industry Operating Expense from the gross recei pts in valuing every producing oil and gas ,'Veil in West Vi rginia undcr the Yield Capitalization Model. I M019' lU II 2 The Tax Department perfonned the two critica l functions it is required to perform under the legis lative rule in va luing CNX's producing oil and gas well s. The TL Department valued every producing oil and gas well in West Virg inia lIsing the exact same procedures fo r the 2016 TV as it used in valuing CNX's producing oil and gas wells. A.2. Th e Tax Department Did Not Artificially "Cap" the Average Annual Indu stry Operating Exp ense Contrary to CNX 's Assertions. CNX advanced its appeal in the Business Court by repeatedly stat ing the Average Annual Industry Operating Expense backwards. CNX Gas argues that" ... the Tax Department erroneous ly calculated average operating expenses of 30% of gross receipts with a ' cap' of$5,000 per well for tax year 2016 ... " See CNX's Supreme Court Brief at p. 5. Repeatedl y, CNX argues that the A verage Annual Industry Operating Expense of 30% of gross rece ipts has becn limited to, capped at, or sel at a maximum amount of $5,000 per well by the Tax Department. See e.g, CNX's Supreme Court Brie/at pp. 1,3,4,6,7,17,18, 19,20,2 1, 22, 23, and 25. CNX summarized its entire argument in Footnote S6 of the Supreme Court Brief stating " ... that the cap is unsupported by law as it artificially limits the amount of the operating ex penses allowed per wel1. .. " The Tax Department lIsed the resul ts from the 2014 industry survey, not a "cap". The Tax Department admits that the definition of Average Annua l Industry Operating Expense in the legislative rule does not include the wo rds "cap" or " maximum amount" as argued by CNX. By the same token, the defi nition does not include the wo rds "percentage" or "unlimited deductions" as advocated by CNX. Nor does the legis lative ru le spec ifically Slale that the Tax Department must determine " ... a single average to be app lied as a percentage ... " as ruled by the Business Court. See AR 0006; see also CNX's Supreme Court Brief at p. 16 (single average). CNX's objection regarding any "cap" ignores the testimony presented at (he Board of Assessment Appeals hearings by the Tax Department. Cindi Hoover of the Property Tax Div ision IMOl9'11111 3 testi lied at the Board of Assessment Appeals hearing in October 20 16 l garding the Ave rage Annual Industry Operating Expense as it relates to a percentage to gross rcceipts. At the Lewis Cou nty Board of Assessment Appeals hearing in Octobe r 2016, Cindi Hoover of the Property Tax Div ision test ified that the $5,000 expense fi gure was based on the survey of oil and gas producers from 2014 . See AR VoL III , Trans. at p. 36· 37. On cross-examination, Ms. Hoover stated that al though the legislative rul e does not include the wo rd "cap" or " maximum amount", the rule uses the word "average. " See AR VoL III , Trans. al p. 37. 38. 1 Consequentl y, the Tax Department expressed the Average Annual Industry Operati ng Expcnse as 30% of gross receipts not to exceed $5,000 per well for the 2016 TY because those wcrc the numbers ca lculated from the data supplied by the oil and gas producers in the 2014 survey. The Tax Department has si mply expressed the same calculation in two different ways; 30% of gross receipts not to exceed $5,000 per we ll. In sha ri , I foot equals 12 inches. By fi rst calculating the average of the actual dollar amount of the reported operating expenses based on the survey, the Tax Department was ab le to observe the relationship between reported operat in g expenses and reported gross receipts for the en tire industry as of May and June in 20 14 . The Tax Depa rtment did not "artificially cap" the deduction or se t a maximum amount for the deduction as CNX argues; the deduction of approximately $5,000 per we ll was the average operating expense reported by the industry on the 2014 survey as Cindi Hoover testified in October of 20 16. I The testimony of the witnesses varies among the several Board of Assessment Appeal hearings for the 2016 TV . Ms. Hoover provided better testimony regarding the relationship between the dollar amount of the Average Annual Industry Operating Expense and the percentage deduCiion in the Doddridge County ap~eal for CNX Gas. Ms. Iloover' s testimony is quoted in the Tax Depanment' s Reply brief in the Doddridge CountY. appea l of Sleager v. CNX Gas, Supreme Coun Appeal No. 18-0123, AR Vol. 111,2016 Transcript at p. 54: II - 56 : ISland also p. 65:2 - 24. (~IO l90l l l II 4 This is far more than a semantic issue. By misstating the deduction , CNX has attempted \0 hide the relationship between the dollar amount of reported expenses J er well and the gross receipts per well revealed by the industry data. According to Ms. Iloover 's testimony, the percentage deduct ion utilized by the Tax Department rcOcets the rclationship between the dollar amount of reported operating expenses and the dollar amoun t of gross receipts reported by the ind ustry in 2014. The dollar amount reported for average operating expenses of approximately $5,000 per we ll was also roughly 30% of the gross receipts reported by the oil and gas producers in 2014. Therefore, the Tax Department util ized an Average Annual Industry Operating Expense of30% of gross receipts not to exceed $5,000 per well to va lue every producing oil and gas well . CNX ' s primary objection is that CNX is not satisfied with the Average Annual Industry Operating Expense ofJO% of gross receipts not to exceed $5,000 pe r well fo r the 20 16 TY. Simply put, CNX wants a larger deduction for ad valorem property tax purposes. The logic is obvious from CNX's perspective. If a larger deduct ion is authorized, the valuation of CNX ' s 863 prodllcing oil and gas we lls in Lewis County fo r the 2016 TY ,."iIl be reduced. A reduced va luation wi ll resu lt in CNX Gas paying less in property taxes in Doddridge Coun ty, Lewis County. McDowell County, and every West Virginia County, where CNX operates oil and gas wells. However, CNX cannot claim a deduct ion of greater than $5,000 per well for the 2016 TY because alternative deduct ions arc not authorized under the legislative rule. No producer is au thorized to claim his alleged actual operating expenses. The legislative ru le is clear regarding authorized deductions for ad va lorem tax purposes. In order 10 value producing oil and gas we ll s " ... the average annual industry operating expenses shall be deducted ... " from the working interest gross receipts. W.Va. Code R. § IIO-IJ-4.3. CNX Gas received the Average Annual Industry (MO l~ ' )11 II 5 Operating Expense of 30% of gross receipts not to exceed $5,000 per wel l when the Tax Department valued all ofCNX's oil and gas wells. A.3. I Th e Ad Va lorem Property T ax is a Diffcr ent T ax than th e Sevcr ance Ta x Or the Co rp orat e Net In co me Tax. CNX argues that it should be allowed to deduct its alleged actual o perating expenses incurred to create the gross receipts which must be reported fo r ad valore m property tax valuation purposes. Specifically, CNX" .. contends that use of its actual operating expenses represents the best method to determine the fair market val ue for its producing wells. as required ... " CNX's Supreme Court Brie/at p. 17. CNX repeatedly argues that" .. . any o perating ex penses incurred between the wellhead and the field line point of sale should be used to value the well." See, e.g., CNX's Supreme Cour, Brie/at pp. 13 and Footnote 59. In short, CN X argues that the expenses incurred in getting the gas and oil out of the ground and the transportat ion expenses to get the gas 1U market should be an allowed deduction for ad valorcm tax purposes. The Business Court adopted CNX's rationale and ruled that B ••• this 'cap" undul y restricts the amount of operating cxpenses that should be allowed for each welL .. " Business Court Decision at AR 0006. CNX is attempting to claim dcductio ns under the ad va lorem property tax structure that were created by the Leg islat ure specifically for the Corporate Net Income Tax and the Severance Tax. Different taxes operate differently. Throughout this entire litigation, the Tax Department has taken a strai ght forward approach to the case. The Icgi slative rule on ly authorizes the standard deduction of the Average Annual Industry Operating Expense which is calculated every fi ve years. See W.Va . Code R. § 11 0-IJ -4.3. No alternative deductions are authorized for ad va lorem property tax purposes under the legislative rule or the sta tutory framework. I However, CNX demands a deduction that is not authori zed. In FooJ ote 59 of its Supreme Cour, Brief, CNX references the deductions under the Severance Tax to support its demand IMOI.94)l l II 6 deductions under the ad valorem property tax . However, Footnote 59 actually confinns the Tax Department 's argument that only a standard deduct ion is authorized under tL ad valorem property tax structure at issue in the case before the Supreme Court. The Severance Tax is imposed at the rate of 5% of the "gross value" o f the natural resource produced and measured at the wellhead and the Severance Tax statute expressly excludes transportation and transmission ex penses incurred by the produce rs \0 get the natural resources 10 market. W. Va. Code § ll - 13A-2(e) (6)(G) (2004)' (emphasis added) Slates that producers shall report "gross va lue" as "[fl or natural gas, gross value is the value of the natural gas at the we ll head imm edia tely preceding transpo rtat ion a nd tra nsmiss ion. " CNX Gas spec ifi cally c ited to legislative ru les for the Severance Tax authorizi ng natural gas producers to deduct 15% of the gross proceeds for Severance Tax purposes as a subst itute for actual transmission costs when the natural gas is sold at a poi nt away from the we ll head. 4.8.4. As an a lternati ve to the methods presented al Subsections 4.8.4 [sic] through 4.8.3 supra, the welt-mouth value of such severance and production of natural gas not so ld at th e well-mouth may be detennined by a deduction of transportation and transm ission costs in th e a mount of 15% of th e gross proceeds of the natural gas seve rcd and produced. W. Va. Code R. § 11 0-13AA.8.4 (1992). There is no comparable percentage deduction to be round in the legislative ru le for thc ad valorem property tax. Clearl y, the case before the Supreme Cou rt is an ad valorem property tax case and not a Severance Tax ease or a Corporate Net Income Tax case. Certainly, the West Virginia Legislature could have authorized deductions ror post· product ion expenses including gathering and Z The language in Subsection 2(cX6)(G) is identical to the language found in W. Va. Code § I I -I3A -2(b)(6XG)(1 987 Replacement Votume). The definilions to the Severance Tax were renumbered in 199~; however, the language regard ing the valuation of natural gas at the wellhead immediately prior to transportation a~d transmission is identical with the language originally enacted in 1985. See also W. Va. Code § I I· 13 A-2(c)(6)(G) (1995 Replacement Vol.). 1.\10l94)ll I! 7 com pression, processing, and transmission or transpo rtation costs, as well as a host of additional expenses, in the pro perty tax structure. But, the Legis lature chose not to dd so. The Legislature had two obvious opportuniti es to duplicate the Severance Tax deductions that CNX desires in the property tax structu re . First, the Legislature promulgated the current legi slative rul e for the ad va lorem property tax for produci ng oil and gas we ll s in 2005. See W. Va. Code R. § 11 0- \ J-I.4 (effective date of January 1, 2005). The legislative rul e for the Severance Tax was promulgated by the West Vi rginia Legislature in 1992; th irteen years beforehand. If the Legislature had wanted to authorize similar deductions fo r post-production expenses for ad valorem tax purposes, it would have been a simple matter of co pyi ng the deductions from the statutes or the legislative ru le for the Severance Tax and pasting those deducti ons into the new legislati ve ru les for ad valorem properly taxes. Second, the Legis lature supplemented the general stat utory framework for property taxes by enacting a new article of the tax code solely pertaining to industrial personal property and natural resources. See W. Va. Code § 11-6K-I , ef seq., (2010). Again. it would be a simple exercise to copy the statutory exemptions for transportation and transmission expe nses or any other expenses from the Severance Tax and to paste those deductions into W. Va. Code § 11-6K-J in 2010. But, the Legislature chose not do so. CNX should not be allowed to claim deductions for property tax pu rposes that were spec ifi cally created under the Severance Tax or the Corporate Net Income Tax. The Legis lature could have authorized Ihesc same deductions for the property tax framework, but chose not to do so. Different taxes operate differently. (MOl94)sl I! 8 n. THE BUSINESS COURT ERRONEO US LY CREATED A ,YBRID RULE FOR VALUING PROD UC ING OIL AN D GAS WELLS INSTEAD OF APPLYING THE LEGISLATIVE R ULE. ' B.l. The Busi ness Co urt Created a Hybrid Ilulc. The Tax Department's second assignment of error is that the Business Court created a Hybrid Rule rather than app lying the legislative ru le for producing oil and gas wells. CNX argues: Furthennore, the Tax Department's argument that the Circuit Court created a " hybrid rule" is confusing. Apparently, the Tax Department is basing the characterization on language that this Court used in Lee Trace, LLC v. Raynes, 232 W. Va. 183,751 S. E. 2d 703 (2013). In that case, use of the term "hybrid" was logical, since the Berkeley County Board of Equal ization and Review had required the assesso r to use both the cost approach and the income approach to detenninc the appraised value of an apartmcnt complex. The Circuit Court did no sllch thing in this matter, and instead app lied the Rule as written without all owi ng the unlawful "cap." CNX's Supreme Court Briel at p. 20. CNX has ignored the similarities between the Business Court's Hybrid Rule and thc Lee Trace decision issued by this Court. See Tax Department's Supreme Court Briel at pp. 18-19. Lee Trace clearly states that producers are not pcnnitted to rewrite the valuation methodo logy; the Business Court is not permitted to re-write the applicable legislative ru le and is prohibited from creating a Hybrid Rule. CNX argues that the Bus iness COllrt did not create a Hyb rid Rule but instead determined the fair va lue of CNX's producing oil and gas wells by deducting an unlimit ed 20% of gross receipts. The Business Court's Hybrid Rule adopted CNX ' s argument and rejected the Average Annual Industry Operat ing Expense as determined by the Tax Department. See CNX's Supreme Court Brie! at p. 4-5 and 15, 16, & 19. The Business Court 's Hyb rid Rule re-wrote the leg islative rule stating that the rule " ... contemplates a single average which the Tax Department has calculated as 30 percenl of gross receipts ... " See Busi ness Court Decision at AR 0006. In its Supreme Court Brief, CNX Gas argues (~!019