Kentucky’s ‘At The Well’ Rule: Who’s Responsible for Severance Tax Payments?

KENTUCKY’S “AT-THE-WELL” RULE PROHIBITS A
LESSEE UNDER AN OIL AND GAS LEASE FROM DEDUCTING ANY
SEVERANCE TAXES PRIOR TO CALCULATING A ROYALTY VALUE
ABSENT A SPECIFIC LEASE PROVISION APPORTIONING SUCH TAXES.[1]

By:  Michael J. Gartland (Copyright 2016 ©)

In June 2012, I published an article titled:  “So, You Think Severance Taxes Can Be Deducted from Gas Royalties Under Kentucky Law?  Guess Again.”  That article discussed a summary judgment memorandum opinion entered by the Bell Circuit Court on October 25, 2011 in Asher Land and Mineral, Ltd. v. Nami Resources Company, LLC, (“Asher I”), holding that no portion of severance taxes due and payable by a lessee under an oil and gas lease may be deducted from an arm’s-length royalty due the lessor thereunder.  Nami Resources Company, LLC appealed the $4.1 million judgment entered on March 27, 2012 in Asher I, including the severance tax summary judgment entered in favor of Asher Land and Mineral, Ltd.   On August 14, 2015, the Kentucky Court of Appeals entered an opinion affirming the judgment entered in Asher I, including the severance tax summary judgment (“Asher II”).[2]  Six days later the Kentucky Supreme Court issued its opinion in In re: Appalachian Land Company v. EQT Production Company, 468 S.W.3d 841 (Ky. 2015).  The reasoning behind the severance tax rulings in Asher I, Asher II and EQT Production are strikingly similar.  After laying out the facts and procedural history of EQT Production, this article discusses the reasoning of the Kentucky Supreme Court’s severance tax ruling therein.

 

Facts/Procedural History

On December 1, 1994, Robert Williams entered into an oil and gas lease with West Virginia Gas Company.[3]  Thereafter, Appalachian Land Company (“Appalachian”) became Mr. Williams’ successor in interest under the lease and EQT Production Company (“EQT”) became West Virginia Gas Company’s successor in interest and the natural producer thereunder.[4]  The lease required the lessee (EQT) to pay the lessor (Appalachian) a royalty on natural gas extracted from the leased premises “at the rate of one-eighth (1/8) of the market price of gas at the well.”[5]  In 2008, Appalachian filed a class action suit against EQT in the United States District Court for the Eastern District of Kentucky, claiming that EQT underpaid royalties owed to Appalachian under the oil and gas lease.[6]

The dispute in EQT Production arose because natural gas is not sold “at the well,” which required EQT to mathematically work back from the price at the point of sale to arrive at the wellhead price.[7]  The wellhead price for the natural gas was determined by deducting from the sales price all post-production processing costs, transportation costs, and severance taxes, with Appalachian receiving one-eighth of the remainder.[8]

Before the district court, Appalachian argued that in arriving at the “market price” of the natural gas for royalty purposes, EQT should not have deducted the severance taxes, which resulted in an underpayment of royalties.[9]  The district court disagreed and entered judgment on the pleadings in favor of EQT.[10]  Appalachian appealed to the United States Court of Appeals for the Sixth Circuit.[11]  Because the issue of apportionment of natural gas severance taxes had never been directly addressed by the Kentucky Supreme Court, the Sixth Circuit certified the following question to the Kentucky Supreme Court under Rule 76.37(1) of the Kentucky Rules of Civil Procedure:

Does Kentucky’s “at-the-well” rule allow a natural-gas processor to deduct all severance taxes paid at market prior to calculating a contractual royalty payment based on “the market price of gas at the well,” or does the resource’s at-the-well price include a proportionate share [i.e., one-eighth] of the severance taxes owed such that a processor may deduct only that portion of the severance taxes attributable to the gathering, compression, treatment of the resource prior to calculating the appropriate royalty payment?[12]

 

The Kentucky Supreme Court rejected both options in the Sixth Circuit’s certified question, holding that “in the absence of a specific lease provision apportioning severance taxes, lessees may not deduct severance taxes or any portion thereof prior to calculating a royalty value.”[13]

 

Kentucky’s severance tax statute

After natural gas is extracted from the earth, it is cleaned, stored, and subsequently transported through various pipelines, all of which is a capital-intensive process.[14]  Often after additional cleaning, refining and processing, the gas is eventually sold at a hub location.[15]  The severance tax is remitted at this point, with the sales price constituting the “gross value” of the gas for purposes of calculating the severance tax owed to Kentucky under KRS §§ 143A.010-020.[16]

Liability for payment of the natural resources severance and processing tax is governed by KRS § 143A.020, which provides, in relevant part, that:  “For the privilege of severing[17] or processing natural resources in this state, a tax is hereby levied at the rate of four and one-half percent (4.5%) on natural gas[18] and four and one-half percent (4.5%) on all other natural resources, such rates to apply to the gross value of the natural resources severed and processed . . . .”[19]  This severance tax applies to all taxpayers severing and/or processing natural resources in Kentucky, and is in addition to all other taxes imposed by law.[20]  As Kentucky’s severance statute makes clear, only “taxpayers” are liable for payment of severance taxes.[21]  The term “taxpayer” is defined in KRS § 143A.010, which provides:

“Taxpayer” means and includes any individual, partnership, joint venture, association, corporation, receiver, trustee, guardian, executor, administrator, fiduciary, or representative of any kind engaged in the business of severing and/or processing natural resources in this state for sale or use.  In instances where contracts, either oral or written, are entered into whereby persons, organizations or businesses are engaged in the business of severing and/or processing a natural resource but do not obtain title to or do not have an economic interest therein, the party who owns the natural resources or has an economic interest is the taxpayer.[22]

 

Under Kentucky’s severance tax statute, a party who only receives an arm’s-length royalty under an oil and gas lease “shall not be considered as having an economic interest” in the gas severed and produced at the party’s premises.[23]

 

Applying precedent to Kentucky’s severance tax statute

Prior to the enactment of KRS Chapter 143A in 1980, Kentucky did not tax the severance or production of natural gas under any statute or regulation.[24]  The oil and gas leases at issue in Asher and EQT Production antedated the enactment of KRS Chapter 143A by several decades.  Under these circumstances, the original parties to these leases could not have contemplated the apportionment of gas severance taxes.[25]

In reaching its holding in EQT Production, the Kentucky Supreme Court relied primarily on its decision in Burbank v. Sinclair Prairie Oil Co., 202 S.W.2d 420 (1946), which addressed a nearly identical issue under Kentucky’s then oil severance tax statute, which later became KRS § 137.120.[26]  The consideration in the oil lease at issue in Burbank provided that the lessor would receive “the equal of 1/8 part of all oil produced and sold from the leased property.”[27]  Like the lease in EQT Production, the lease in Burbank did not provide for apportionment of severance taxes.[28]  The Burbank court focused its analysis on the original oil severance tax statute that provided, in relevant part, that:

Every person, firm, corporation and association engaged in the business of producing oil in this State, by taking same from the earth, shall, in lieu of all other taxes on the wells producing said oil imposed by law, annually pay a tax for the right or privilege of engaging in such business. . . .[29]

 

Based on the plain language of the oil severance tax at issue in Burbank, the court there held that “the original act as amended cannot be construed as placing any part of the tax in question on one who is simply a royalty owner.”[30]  The facts and holding in Burbank were dispositive of the issue in EQT Production.  Like the royalty owner in Burbank, Appalachian was not engaged in the business of severing or producing natural gas.[31]  The only party that engaged in severing the gas was EQT; it was also the only party involved in bringing the gas to market, and thus processing the gas.[32]  And only the taxpayer “engaged in the business of severing and/or processing natural resources”[33] in Kentucky is liable for severance taxes under KRS § 143A.020(1).  Because Appalachian merely received an arm’s-length royalty under the oil and gas lease at issue in EQT Production, it was not considered as having an “economic interest” in the gas severed and produced at the leased premises, and thus was not a taxpayer within the meaning of KRS § 143A.010(4).

 

Implications of EQT Production

The court in EQT Production held that that “in the absence of a specific lease provision apportioning severance taxes, lessees may not deduct severance taxes or any portion thereof prior to calculating a royalty value.”[34]  Under EQT Production, there could be hundreds, if not thousands, of lessors with severance tax claims against lessees under oil and gas leases governed by Kentucky law.  It is doubtful that any oil and gas lease that was executed prior to 1980—the year that KRS Chapter 143A became effective—would have a specific lease provision apportioning severance taxes, which did not even exist until 1980.  In the aggregate, there could be millions of dollars of unadjudicated severance tax claims against gas lessees.[35]  For this reason, any lessor or royalty owner under a pre-1980 oil and gas lease should consult an attorney as to his, her or its right to recover severance taxes unlawfully deducted from royalties owed thereunder.

 

For more information about this topic or any other litigation matter, please contact Michael J. Gartland at mgartland@dlgfirm.com.

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Footnotes

[1]  This article is a service for friends and clients of DelCotto Law Group PLLC.  The opinions expressed in this article are intended for general guidance only and not as recommendations for specific situations.  As always, readers should consult a qualified attorney for specific legal guidance.
[2]  Asher Land and Mineral, Ltd. v. Nami Res. Co., LLC., — S.W.3d —-, 2015 WL 4776376 (Ky. Ct. App. Aug. 14, 2015).
[3]  EQT Prod., 468 S.W.3d at 842.
[4]  Id.
[5]  Id.
[6]  Id.
[7]  Id.
[8]  Id.
[9]  Id.
[10]  Id.
[11]  Id.
[12]  Id.
[13]  Id. at 842-43.

[14]  Id. at 843.
[15]  Id.
[16]  Id.
[17]  “Severing” or “severed” means “the physical removal of the natural resources from the earth or waters of this state by any means,” but does not include “the removal of natural gas from underground storage facilities into which the natural gas has been mechanically injected following its initial removal from the earth.”  KRS § 143A.010(3).

[18]  “Natural gas” is a “natural resource” within the meaning of KRS § 143A.020(2).
[19]  KRS § 143A.020(1).
[20]  KRS § 143A.020(2).
[21]  Id.
[22]  KRS § 143A.010(4)(a).

[23]  KRS § 143A.010(4)(b).
[24]  EQT Prod., 468 S.W.3d at 846.
[25]  Id.
[26]  EQT Prod., 468 S.W.3d at 843.

[27]  Id. at 844.
[28]  Id.
[29]  Id. (quoting 1917 Ky. Acts Ch. 9, § 1) (emphasis in original).

[30]  Burbank, 202 S.W.2d at 425.
[31]  EQT Prod., 468 S.W.3d at 844.
[32]  Id.
[33]  KRS § 143A.010(4)(a) (emphasis added)

[34]  EQT Prod., 468 S.W.3d at 842-43.
[35]  Such claims might be appropriately litigated in a class-action suit.

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