Administrative Rules of the State of Montana

BEFORE THE DEPARTMENT OF REVENUE

OF THE STATE OF MONTANA

In the matter of the adoption of New Rule I (42.25.1817); II (42.25.1818); III (42.25.1819); IV (42.25.1820); and V (42.25.1816) and amendment of ARM 42.25.1801 relating to oil and gas taxes

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NOTICE OF ADOPTION AND AMENDMENT

TO: All Concerned Persons

1. On August 26, 2010, the department published MAR Notice No. 42-2-844 regarding the proposed adoption and amendment of the above-stated rules at page 1872 of the 2010 Montana Administrative Register, issue no. 16.

2. A public hearing was held on September 20, 2010 to consider the proposed adoption and amendment. Mr. David Galt, Executive Director, Montana Petroleum Association (MPA), and Mr. Patrick Montalbin, Northern Montana Oil and Gas Association (NMOGA), appeared at the hearing. Oral testimony and written comments subsequently received, are summarized as follows along with the response of the department:

COMMENT NO. 1: Mr. Galt testified and provided the following general comments as follows. Due to their concern about inconsistencies with the allowable deductions at the time of audits, the MPA had approached the department a couple of years ago with a request to jointly develop legislation that would provide gas valuation clarity. The department responded that they could do this completely by rule, but Mr. Galt says the MPA did not get the clarity they were seeking through the proposed rule language.

Mr. Galt made the additional general comments that they had submitted examples to the department in seeking clarity and to perhaps establish some parity with other gas-developing states and the federal government, but that he doesn't think these rules provide the clarity needed.

Mr. Galt also added that the MPA is very thankful for the department's efforts, that the rule development has come a long way, and this is very good work that represents the discussions between the industry and the department.

Mr. Galt further commented that they have concerns about the definition of "delivery price adjustments" (DPA), a question about New Rule V related to determining qualifying production and about New Rule I related to defining non-arm's-length situations.

Mr. Galt stated that he would share the hearing comments on proposed New Rule V with the MPA. He further stated that the committee may offer proposed language changes for New Rule V.

He also reiterated that the definition on DPA is a big deal to the industry.

Further, he says the rule continues to foster ambiguity and discretion that will not address the problems that were mutually identified by the industry.

RESPONSE NO. 1: The department appreciates Mr. Galt's comments regarding progress made through the development of these rules. The department does not concur, however, with the comments that suggest that the rules do not provide sufficient clarity at this time. The department notes that if future experience in administering these rules and the applicable tax laws provides evidence that further clarity or specificity is needed, the department is prepared to engage in additional rulemaking for that purpose. The department believes that these rules provide direction to the operators. Specifically, the rules provide direction on what qualifies as an allowable reduction of value in situations where a downstream price must be used. In addition, the examples in the rules provide additional clarity on the types of expenses that may or may not be allowable reductions in total gross value.

The association's comment that the department's rules do not reflect other state's rules is true, in that these rules do not individually list each specific type of expense that is an allowable reduction in total gross value. The department determined that a general category of the types of expenses would better explain what would be allowable reductions in total gross value than would an itemized list. In addition, an itemized list would not be ideal as the list would be voluminous, require constant updates, and would not include all expenses that may be allowable. The itemized list would also be subject to interpretation issues, because not all materials and systems are described using the same terms by all operators.

Please see Comment and Response No. 6 concerning Mr. Galt's statements addressing New Rule V.

COMMENT NO. 2: Mr. Galt further indicated that the MPA finds New Rule I hard to interpret and understand as drafted, and he recommends revising (1) and (2) of that rule.

RESPONSE NO. 2: The department appreciates receiving the association's proposals for further amendments to New Rule I. The department has decided not to adopt the suggested revisions to (1) because the MPA's suggested language, in both instances, does not include the term "arm's-length contract." The purpose of the rule is to arrive at an arm's-length price and the department will not consider a non-arm's-length contract as the basis for total gross value.

The department is amending (2) to incorporate some of the suggested changes from the association. Specifically the department agrees to look for comparable prices in the field before using comparable prices in other fields. However, the department does not agree with the language that confines the review of prices in other fields to be a weighted average. While the department may well use a weighted average price to determine comparable pricing, it must reserve the right to use any appropriate method.

COMMENT NO. 3: Mr. Galt also recommends language revisions for New Rule II as follows:

Section (1), change the last sentence to include that DPA costs must be documented and itemized;

Subsection (2)(a) be expanded to include direct, indirect, and contract labor associated with central facilities and/or applicable lease equipment;

Subsection (2)(b) be expanded to include fuel, power, and utilities, chemicals, safety, and costs of environmental permitting and monitoring, federal or state environmental compliance fees, and overhead directly attributable to the central facility or applicable lease equipment;

Subsection (2)(e) be changed to allow a company to use the price they paid for the equipment and/or facilities and increase the number of years to depreciate the asset to 20 or 25 years; and

Subsection (2)(f) the allowance to take both the depreciation and return on the undepreciated balance be clarified.

He further notes, relative to (3)(d), that overhead is a common expense for facilities allowed by the Council of Petroleum Accountants Societies, Inc. (COPAS) and others, and requests that (b) and (d) be removed.

RESPONSE NO. 3: The department cannot amend the rule to drop the language "increase the value of the gas," in (1) because the purpose of allowing for reductions in total gross value of a downstream price is to compensate for a cost incurred that increases the value of the gas further downstream.

Relative to (2)(a), the department is not amending the rule to include indirect labor or applicable lease equipment as a possible reduction in the total gross value, however, if found to be a direct cost, contract labor will be an allowable reduction of the total gross value.

The department believes the current language in (2)(b) is adequate, and will not amend the rule to allow lease equipment as a reduction in total gross value.

The department believes the ten-year straight-line depreciation schedule to be appropriate as shown in (2)(e) so it will not amend the rule to allow the purchase price of a fully depreciated facility to be a reduction in the total gross value.

The department does agree with the need to clarify (2)(f) and has revised that language.

The department does not allow overhead as a reduction in total gross value and therefore will not amend (3) to remove (b) and (d).

COMMENT NO. 4: Mr. Galt suggests that things like return on investment and depreciation aren't really considered "paid" and that New Rule III is unnecessary and should be deleted.

RESPONSE NO. 4: The department appreciates Mr. Galt's comments but believes that both return on investment and depreciation describe costs that are incurred through the original initial purchase of equipment or a central facility so both of these subsections are necessary in this rule.

COMMENT NO. 5: Mr. Galt recommends that the last sentence in New Rule lV be revised to say "To satisfy the adequate records requirement, the records must be supported by receipts, vouchers, or other documentary evidence."

RESPONSE NO. 5: The department agrees and has amended the rule as shown below to address this concern.

COMMENT NO. 6: Mr. Galt further states that New Rule V has nothing to do with the other rules in this collection and should be deleted. Mr. Montalbin also commented on New Rule V, and requested clarification for this rule because it doesn't make sense to them. He stated that they don't understand the last part of it, because it takes the preceding month off, which therefore takes off one extra month, yet then says the qualifying production time period continues for 12 or 18 contiguous months depending on the wells.

RESPONSE NO. 6: The department believes this rule is necessary but is amending the language to address the concern that the new well incentives are for 12 or 18 months not 11 or 17 months by adding specific dates when the well has a reduced tax rate.

COMMENT NO. 7: Mr. Galt included the following comments about the definitions section:

Section (1), the last sentence needs to be removed;

Section (2), the last sentence in the definition should be changed by inserting "and/or transport" between gather and natural, and by removing "at a point remote" between gas and from; and

Section (4), the language relating to when delivery price adjustments occur is too vague. He proposes the definition language be replaced with ". . . includes all expenses directly incurred and attributable for the operation and maintenance of central facilities and/or lease equipment."

RESPONSE NO. 7: The department believes the last sentence in (1) to be crucial in the distinction between arm's-length and non-arm's-length contracts, so the department has decided to retain this section in the rule.

The department appreciates Mr. Galt's suggestion of adding transport into the definition of central facilities in (2) and is amending the rule to do so.

The department also agrees to drop the following sentence "delivery price adjustments only occur when the department deems it necessary to establish the correct natural gas gross value." in the definition of (4). However, the department does not agree to include lease operating expenses in the definition, because the department has determined that these costs should not be allowable reductions in total gross value.

COMMENT NO. 8: Mr. Montalbin spoke about the economics of the natural gas industry in our state, saying it is the worst it has been in years and today's price makes most of the stripper wells in Montana not economically viable. He further explained that the issue is so serious that their company has had to cut payroll. He thanked the department for bringing this to a head and says it is time to put this issue behind us and try to create good paying jobs in the state.

Mr. Montalbin further commented that NMOGA will always agree with the input MPA provides to the department, and commends the department for coming up with a DPA cost, stating they think it is extremely important for business in the state because it clearly defines what can be deducted. He further stated that NMOGA believes the second sentence in New Rule ll(1), should be described as BTU (British thermal unit), compression, dehydration, and pipeline loss adjustments. He explained that in their business, all of these factors take MCFs (thousand cubic feet) and convert them into dekatherms and, therefore, an operator should be allowed to deduct these through the pricing at the wellhead.

RESPONSE NO. 8: The department appreciates Mr. Montalbin's comments. The department believes the above comments are addressed in the current rules as the department uses the volume derived from the purchase statements, which would address differences in BTU, compression, dehydration, and line loss.

COMMENT NO. 9: Mr. Montalbin testified that another very important part for the small independents of northern Montana is to include in the description the cost of a rental compressor, as there are many operators their size who cannot afford to purchase this high-priced equipment. Because this forces the operator to rent the equipment it is, therefore, a direct cost to deliver natural gas to market. He later added for clarification that there is a cost to operate the compressor and operators will provide written documentation to show BTU compression and dehydration usage, and pipeline loss.

RESPONSE NO. 9: The department agrees and will consider any compression rental costs as reduction in the total gross value in every instance where the compression rental costs are found to not be related to extraction or lease operating costs.

COMMENT NO. 10: Mr. Montalbin commented that, relative to the definitions, NMOGA supports the MPA's position on the description of (1) in ARM 42.25.1801, that the contracts or agreements language should be removed from the definition. He further commented that he believes this is what the industry and department agreed on.

He also stated they do not agree with the definition of DPA, in ARM 42.25.1801, because they don't understand how the proposed language will work. He stated that if we all work together and have very clear adjustments, all this should work. There will be so many cents for BTUs, for compression, for dehydration, and that will have to be for everyone the department has allowed to have pumper cost, etc.

Mr. Montalbin recommends all of the delivery price adjustments language be stricken.

Mr. Montalbin concluded this portion of his comments by saying that the NMOGA feels this is very important for the state of Montana, not just for existing production but to the development of the natural gas industry in the state. NMOGA would like to carry a legislative bill that all parties agree on, in this next legislative session that would alleviate lawsuits in the state and provide good paying jobs.

RESPONSE NO. 10: The department agrees with Mr. Montalbin that if the industry and the department work together value adjustments will be clear and easy to comprehend. The department also believes that the definitions of arm's-length contract and delivery point adjustments are needed because the definitions will assist in providing clarity to both the industry and the employees of the department.

The department further believes that through continued communications and efforts by the department a better understanding of the rules is possible. The department agrees that if it is determined that there is still confusion or concern pertaining to this complex issue, the subject can be revisited to provide further clarification.

Lastly, the department does not believe that the delivery price language should be stricken because delivery price adjustments (DPA) benefit the industry and provide a marketable total gross value for the gas at the well.

3. As a result of the comments received the department adopts New Rule I (42.25.1817); New Rule II (42.25.1818); New Rule IV (42.25.1820); New Rule V (42.25.1816) and amends ARM 42.25.1801 with the following changes:

NEW RULE I (42.25.1817) GROSS VALUE OF NATURAL GAS (1) remains the same.

(2) If natural gas is sold in the absence of a contract the total gross value of the natural gas may be determined by reviewing comparable arm's-length contracts. The department will identify comparable arm's-length contracts utilizing factors including but not limited to; similar time, proximity to the location, similar duration, similar gas quality, and similar quantity of gas sold. Upon conducting a comparable arm's-length study, the department will attempt to identify comparable arm's-length's contracts within the same field of the leases in question prior to using comparable arm's-length contracts from other fields.

(3) If natural gas is sold through a non-arm's-length contract at the well or wells and sold with an arm's-length contract further downstream of the well or wells, the total gross value of the natural gas may be determined at the delivery point with delivery price adjustments.

AUTH: 15-36-322, MCA

IMP: 15-36-305, MCA

NEW RULE II (42.25.1818) DELIVERY PRICE ADJUSTMENT (DPA) COSTS (1) remains the same.

(2) Allowable delivery price adjustment costs include but are not limited to:

(a) Costs of direct labor associated with the central facilities. Direct labor is not meant to include personnel in corporate or headquarter offices who are not directly involved in the actual on-site central facility operations;

(b) Costs of materials, supplies, maintenance, repairs, and utilities directly associated with the central facility;

(d) Liability and casualty insurance directly paid on the central facilities;

(e) Depreciation of the central facility is allowed as a reduction in gross value or a delivery price adjustment. The department will allow the depreciation of the initial capital investment of the central facilities, determined on a straight-line basis for a period of ten consecutive years beginning the year in which the facility first began to operate. The department will also allow additional capital investments made to the central facilities after the initial capital investment determined on a straight-line basis for a period of ten consecutive years beginning the year in which the ~~facility first began to operate~~ additional capital investment was acquired;

(f) A return on investment percentage will be allowed to the operator of the central facility provided a balance of the initial capital investment is available to be depreciated as calculated in accordance with (2)(e). The annual rate of return will consist of the undepreciated balance of the capital investment multiplied by Moody's Baa corporate bond rate. For example assume the following: both Company Y and Company X operate gas wells in Montana, both companies do not have arm's-length wellhead contracts, but rather delivered gas contracts well downstream of the wells, Company Y made an initial capital investment of a central facility asset (a gas processing plant) for $1,000,000 and the initial investment has not been fully depreciated ($~~1,000,000~~ 800,000), Company Y sold the asset to Company X for $200,000 (Moody's Baa corporate rate is 3%), and Company X will be allowed a return on investment reduction of their gas value of 3% of the acquisition cost or 3% * $200,000 or $6,000.

(3) through (3)(f) remain the same.

AUTH: 15-36-322, MCA

IMP: 15-36-305, MCA

NEW RULE IV (42.25.1820) NECESSITY OF PROOF (1) Any delivery price adjustment or reduction in value will be disallowed if the operator does not keep adequate records or other proof to show the amount and purpose for the expense. To satisfy the adequate records requirement, there must be records maintained ~~that were prepared at or near the time of use,~~ and ~~the records must be~~ supported by receipts, vouchers, or other documentary evidence.

AUTH: 15-36-322, MCA

IMP: 15-36-305, MCA

NEW RULE V (42.25.1816) DETERMINING QUALIFYING PRODUCTION

(1) Qualifying production time period begins immediately after the last day of the month preceding the month when production first started. The qualifying production time period continues for 12 or 18 contiguous months, 12 for vertical production or 18 for horizontally completed wells.

(a) Example – A vertical oil or natural gas well first produces May 2010. The well will have a reduced tax rate as illustrated in 15-36-304, MCA for the months May 1, 2010 to April 30, 2011.

(2) remains the same.

AUTH: 15-36-322, MCA

IMP: 15-36-304, MCA

42.25.1801 DEFINITIONS In addition to the definitions found in 15-36-303, MCA, the following definitions apply to terms used in this chapter:

(1) remains the same.

(2) "Central facilities" are installations which are used to cool, heat, separate, dehydrate, compress, sweeten, or gather/transport natural gas at a point remote from the well or wells.

(3) through (13) remain the same.

AUTH: 15-36-322, MCA

IMP: 15-1-101, 15-36-301, 15-36-302, 15-36-303, 15-36-304, 15-36-305, 15-36-309, 15-36-310, 15-36-311, 15-36-312, 15-36-313, 15-36-314, 15-36-315, 15-36-319, 15-36-321, 15-36-326, 82-1-111, MCA

4. Therefore, the department adopts New Rule I (42.25.1817); New Rule II (42.25.1818); New Rule IV (42.25.1820); and New Rule V (42.25.1816) and amends ARM 42.25.1801 with the amendments listed above and adopts New Rule III (42.25.1819) as proposed.

5. An electronic copy of this adoption notice is available through the department's site on the World Wide Web at www.mt.gov/revenue, under "for your reference"; "DOR administrative rules"; and "upcoming events and proposed rule changes." The department strives to make the electronic copy of this adoption notice conform to the official version of the notice, as printed in the Montana Administrative Register, but advises all concerned persons that in the event of a discrepancy between the official printed text of the notice and the electronic version of the notice, only the official printed text will be considered. In addition, although the department strives to keep its web site accessible at all times, concerned persons should be aware that the web site may be unavailable during some periods, due to system maintenance or technical problems.

/s/ Cleo Anderson /s/ Dan R. Bucks

CLEO ANDERSON DAN R. BUCKS

Rule Reviewer Director of Revenue

Certified to Secretary of State October 18, 2010