Highway funding shortchanged — Loophole enhances ‘hot fuel’ profits

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IRS measuring rule allows oil industry to manipulate gasoline and diesel taxes.

The Kansas City Star

Hundreds of millions of dollars in fuel taxes paid by American drivers aren’t going to the government, but instead into the pockets of gas and diesel retailers.

It’s legal, the IRS acknowledges. It’s widespread, according to industry experts. And it’s the latest twist in a controversy involving how the oil industry sells fuel based on temperature fluctuations across the country.

The practice, dubbed “hot fuel,” was exposed by The Kansas City Star in August. The newspaper reported that fuel was often sold at temperatures much hotter than the standard 60 degrees — a standard agreed to nearly a century ago by the industry and regulators, but virtually unknown to the average consumer.

As a liquid, gasoline expands and contracts depending on temperature. At 60 degrees, the 231-cubic-inch U.S. gallon puts out a certain amount of energy. But fuel is often sold at much hotter temperatures, causing the gas to expand and the amount of energy, by volume, to decrease. Yet consumers still get only 231 cubic inches per gallon.

Put simply, selling the hotter, expanded fuel to consumers forces drivers to consume more, making the industry more money. The Star reported that consumers were being overcharged an estimated $2.3 billion annually at then-current prices for gasoline and diesel because of the hot fuel phenomenon. Even with the recent drop in gas prices, hot fuel still amounts to $1.7 billion a year at today’s prices.

But that windfall for the oil industry isn’t just from the fuel. It also includes the handling of some of the taxes paid on that fuel that are supposed to go to build and maintain the nation’s roads and highways.

So how do retailers get to keep some of the taxes that you pay on gas? In part, because the Internal Revenue Service allows station owners to play the hot fuel game with taxes.

Because of an IRS loophole, retailers can switch back and forth on how they measure for federal tax purposes the wholesale fuel they purchase, depending on fuel temperature. Because diesel and gasoline is measured and taxed at wholesale, any amount of taxes a retailer subsequently collects from drivers above that total can be pocketed by the gas station, truck stop or oil company that owns the station.

“It’s a widespread practice and commonplace for fuel taxes to be gamed,” said David Breidenbach, former tax counsel for Marathon Petroleum Co., which owns the third-largest chain of company-owned gas stations in the country.

Breidenbach, who defends the practice, said, “It’s been going on for decades.”

Such tactics affect state fuel tax collections differently depending on differing state policies. But the federal fuel tax, which is 18.4 cents per gallon, is especially vulnerable because of the free hand the IRS gives the industry in how the fuel is measured.

The IRS sought to plug the loophole in 2000, approving a rule that restricted retailers from switching back and forth on how they measured fuel. But the regulation came under industry pressure, and was quietly withdrawn in the early days of the Bush administration.

As a result, the industry continues to use the physics of temperature, mechanics of dispensing and quirks in tax law to curb its fuel taxes while collecting more taxes from consumers.

Even though it’s all legal, it’s still not right, said John Siebert, foundation project manager for the Grain Valley-based Owner-Operator Independent Drivers Association, which has 145,000 members. He said every fuel-tax dollar collected from drivers needed to be used to improve the country’s roads, which truckers find are crumbling.

“The nation’s truckers take fuel-tax issues personally,” Siebert said.

Big bucks

The Star estimated that consumers were annually overcharged at least $360 million in state and federal taxes that did not go for highway projects because of hot fuel. That was based on a nationwide data base of retail fuel temperatures compiled by the National Institute of Standards and Technology and applying the relevant federal and state tax levies.

That amount was included last August in the newspaper’s overall estimate of the $2.3 billion cost to consumers of hot fuel. But the real total is likely much higher.

One reason? Let’s call it “cold fuel.”

For consumers, gas is not temperature-adjusted at the pump, which measures fuel at the standard 231 cubic inches of energy. In Southern states, where the gas is often sold at higher temperatures, consumers get less energy for their money. But in Northern states, where the gas sometimes is cooler, consumers get their money’s worth or, in some cases, a little more.

The Star’s estimate of the cost of hot fuel took into account the winners and losers, with the net effect being the estimated $2.3 billion in losses to American consumers.

Retailers often adjust for temperature when they buy fuel from wholesalers. But the federal rule allowing them to switch methods for tax purposes means they get to benefit when fuel is hot and cold.

In warm states like Florida, Texas, Arizona and California, retailers can buy their fuel at wholesale based on the 60-degree standard, but can usually count on selling fuel at higher temperatures, meaning they get to pocket the extra fuel — and taxes. The Star’s initial estimate included this windfall for the oil industry.

But by being able to switch back and forth in how the fuel is measured, retailers in the cooler Northern states also can calculate gas taxes at wholesale without adjusting for the 60-degree standard. As a result, retailers avoid paying some of the taxes that would be owed at the temperature-adjusted volume.

Compare these examples:

A Southern retailer purchasing 10,000 gallons of gasoline at 80 degrees receives the adjustment for the 60-degree standard. That makes it just 9,861 gallons for the purposes of calculating his taxes. He then sells the hot gas to consumers and keeps the extra revenue — including taxes.

Let’s say a Northern retailer buys the same amount of fuel at 40 degrees. If the retailer adjusts the volume for the 60-degree standard, like his Southern counterpart, he would have to pay taxes on 10,138 gallons. But instead he buys it unadjusted, and pays taxes on only 10,000 gallons. In doing so, he avoids paying taxes on 138 gallons of gas — this time from “cold fuel.”

Thus, by being able to switch measuring methods, the retailer can avoid paying taxes on 139 gallons of fuel in the summer and 138 gallons in the winter. Either way, the retailer saves about $25 in federal fuel tax.

In theory, at least, the system the IRS allows is almost endlessly flexible. Although unlikely, the measuring method used could change by the day or even by the truckload for the federal tax. Computer programs could divide a state into sections to minimize the tax in each part and take advantage of weather patterns.

But the biggest benefit is simply changing with the seasons, especially in middle states, such as Missouri and Kansas, with a wider difference in summer and winter temperatures.

“This is where the greatest opportunity lies,” Breidenbach said.

Some states, such as Kansas, don’t follow the federal rule when measuring fuel for their state fuel taxes. Kansas requires temperature adjustment at wholesale, limiting the ability of retailers to, in essence, have their cake and eat it, too. Some states limit how often switching takes place. But Missouri, like the IRS, allows switching back and forth.

Keith Gast, manager of excise taxes at the Missouri Department of Revenue, said he was not aware that such switching was a problem. The issue has not been studied, but Gast acknowledges that it “makes sense” that it occurs.

The Washington, D.C.-based American Petroleum Institute, which represents the oil industry, said its members followed the law when it came to methods used to calculate the taxable volume of fuel.

Edward Murphy, head of the trade group’s section on downstream operations, questioned the “relative magnitude” of the issue. He noted that the retail price of gasoline was set by a competitive marketplace. And while the oil industry has views on taxes, he scoffed at any suggestion that it dictated tax policy.

“That’s ludicrous,” Murphy said.

IRS officials declined to be interviewed on the topic. In written replies to e-mailed questions, however, they said the agency had done no analysis on the tax consequences of allowing the two measuring methods. They noted that it would be up to Congress to make changes in how federal fuel tax was collected.

“(We) are enforcing the laws as they are written,” said Michael Devine, IRS spokesman.

Thwarted regulation

The federal fuel tax takes in about $39 billion per year. States, which impose their own fuel taxes, raise an additional $35 billion. But an accurate estimate of how much the government is missing out in tax payments from switching isn’t possible because the IRS has not thoroughly investigated the matter and the companies don’t release details about how they figure tax payments.

Breidenbach, who retired from Marathon in June after a 27-year career at the company, said there was nothing wrong with this from the company’s perspective because of its fiduciary responsibility to improve the bottom line for shareholders.

Moreover, he noted, as far as the IRS is concerned, it is not illegal.

“If it’s OK with the government, why wouldn’t it be OK with you?” Breidenbach said.

Critics of the practice counter that any diversion of fuel taxes comes at a bad time for federal and state governments, struggling to cover the rising cost of road construction and improvements.

Greg Cohen, president of the American Highway Users Alliance, a Washington, D.C.-based group advocating highway safety and congestion relief, said funding shortfalls went beyond dollars and cents.

“It means more congestion and more lives lost,” he said.

Former IRS employees and industry executives said the federal government had an opportunity to change the switching regulation, but backed off in the face of industry opposition.

In the mid-1990s, Larry Hecksher, a senior analyst for the IRS’ fuel division, began to receive reports of discrepancies between the amount of fuel taxes collected at the wholesale level and the amount of taxes paid by consumers at the pump. He quickly discovered that companies could consistently pay less fuel tax than collected from consumers at the pump by taking advantage of the seasons and shifting between the two ways to measure the fuel.

To me, it was truly stupid,” Hecksher said, referring to the IRS rule that allowed it.

In 2000, a regulation was written requiring the measurement method to be selected just once a year. Although the regulation’s effectiveness was limited because it still allowed the selection to be made terminal by terminal, it addressed the issue of changing measurement methods as seasons changed.

But the industry lobbied the Department of Treasury’s Office of Tax Policy to have the regulation pulled.

Two weeks before Hecksher retired in 2001, he was told the Treasury Department planned to withdraw the rule limiting switching.

He said there was no one else who wanted to fight the issue.

“I was the only one at national (IRS headquarters) that had the stomach for it,” he said.

Now retired, Hecksher said he had no doubt why the loophole was never closed.

“It’s a profit center for the companies,” he said.

The story so far

In August, The Kansas City Star reported that “hot fuel” was costing U.S. drivers an estimated $2.3 billion a year. That’s because when gas gets hot, it expands, but retail fuel pumps don’t account for the bigger volume, which delivers less energy per gallon.

Today, The Star explores a little-known loophole in federal law that allows the owners of gas stations to choose how they measure wholesale fuel for tax purposes, without passing the savings on to customers.

To read previous stories on this topic, go to www.KansasCity.com.
To reach Steve Everly, call (816) 234-4455 or send e-mail to [email protected]

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