Trial victory for ExxonMobil in tax litigation

Davis Polk served as lead trial counsel for Exxon Mobil Corporation (ExxonMobil) in litigation concerning the tax treatment of a 2006 transaction with the State of Qatar. After a weeklong trial in April 2024, Chief Judge David C. Godbey of the U.S. District Court for the Northern District of Texas issued a post-trial decision on October 31, 2024, holding that ExxonMobil was lawfully entitled to claim the interest expense deductions that were disallowed by the Internal Revenue Service and that were at issue in the case.

The litigation concerned a partnership between ExxonMobil and the State of Qatar called Al Khaleej Gas. Al Khaleej Gas was formed in 2000 to develop and market valuable minerals in the North Field, the largest non-associated gas field in the world. In 2006, the parties amended their original agreement that governed the partnership to significantly expand its production capacity, making it large enough to generate electricity sufficient to power the equivalent of approximately eight million homes in the United States on an average day.

As part of that amended agreement (and as one of many changes to the partnership), the parties incorporated a production payment. The production payment, which is a form of financing that is commonly used in the petroleum industry, recapitalized the State of Qatar’s equity interest in the partnership. Rather than taking solely a profit share (as was the case under the original agreement), the State of Qatar took a reduced profit share and a production payment. Under the terms of the production payment, the State of Qatar received regular quarterly payments of principal and interest on a fixed schedule and at a market rate of interest – payments that were made out of production and that did not depend on whether the partnership was profitable.

Beginning in 2006, ExxonMobil deducted from its income the interest portion of those payments. The Internal Revenue Service disallowed the interest expense deductions, ruling that the production payment did not qualify for treatment as a mortgage loan under section 636(a) of the Tax Code. ExxonMobil filed suit in March 2022 to recover (among other things) taxes, penalties and interest that were erroneously collected by the government in connection with ExxonMobil’s tax treatment of Al Khaleej Gas for tax years 2010 and 2011.

In its post-trial decision, the Court held that ExxonMobil was entitled to the interest expense deductions for multiple, independent reasons, adopting virtually all of ExxonMobil’s arguments. The Court concluded, among other things, that Al Khaleej Gas satisfied the test for a partnership under federal tax law, and that the production was carved out of the minerals held by the partnership; that the production payment qualified for treatment as debt under section 636(a) of the Tax Code; that there was no basis to invoke judicial doctrines, like the economic substance doctrine and the substance over form doctrine, to disregard the deductions (as the government argued); and that even if judicial doctrines did apply, ExxonMobil proved that the tax deductions should still be respected in any event. The Court observed that, before trial, it was “fully prepared” to find against ExxonMobil, but it ultimately concluded that – “[o]n consideration of the evidence” presented by Davis Polk at trial – “ExxonMobil’s tax treatment of this transaction is correct.”

The Court’s decision resolved all merits issues. The next phase of the case will resolve the amount of the refund to which ExxonMobil is entitled.

The Davis Polk team included partners James P. Rouhandeh, Antonio J. Perez-Marques and Lara Samet Buchwald and associates Sean Stefanik, Kyra Macy Kaufman, Kamali Houston, Kathleen M. Lewis, Alyssa Metcalf and Kaitlin Campanini. Members of the Davis Polk team are based in the New York and Washington DC offices.

Mary McNulty, Lee Meyercord and Meghan McCaig of Holland & Knight LLP served as co-counsel to ExxonMobil.