United States: Kentucky Supreme Court Holds Producer Solely Responsible For Payment Of Severance Tax

On a request for certification of the law from the United States Court of Appeals for the Sixth Circuit, the Supreme Court of Kentucky held that the producer severing natural gas from the earth is solely responsible for payment of the severance tax.  In re: Appalachian Land Co. v. EQT Production Co., 2013-SC-000598-CL (Aug. 20, 2015)(to be published).  The court certified that, absent a specific lease provision apportioning severance taxes between the lessor and lessee, the producer/lessee may not deduct severance taxes or any portion thereof prior to calculating royalties to be paid the lessor.

On December 1, 1944, Robert Williams leased all oil and gas within his property to West Virginia Gas Company for the sole purpose of operating for, producing and marketing oil, gas and gasoline.  Appalachian Land Company ("Appalachian") succeeded Mr. Williams as lessor.  EQT Production Company ("EQT"), a natural gas producer, succeeded West Virginia Gas Company as lessee.  Under the terms of the lease, the lessee, now EQT, is required to pay the lessor, now Appalachian, a royalty interest on natural gas extracted from the land at the rate of 1/8 the market price of gas "at the well".  In 2008, Appalachian filed a class action lawsuit against EQT in the U.S. District Court for the Eastern District of Kentucky, claiming EQT underpaid royalties owed to Appalachian. 

The heart of the dispute centered upon the fact that natural gas is not sold in its raw state "at the well", but rather "downstream" at an interstate pipeline connection after being transported and processed.  Thus, lessees like EQT mathematically work back from the price "downstream" at the point of sale to arrive at the wellhead price, which is then used to calculate royalties owed the lessor.  In the instant case, EQT deducted from the sales price all post-extraction processing costs, transportation costs, and all severance taxes; EQT then paid Appalachian 1/8 of the remainder. 

Appalachian argued EQT should not have deducted severance taxes in arriving at a "market price" for royalty purposes.  The district court disagreed and entered judgment on the pleadings in favor of EQT, also denying Appalachian's motion to alter or amend the judgment.  Appalachian appealed to the Sixth Circuit, which certified the following question to the Supreme Court of Kentucky:

Does Kentucky's "at-the-well" rule allow a natural-gas processor to deduct all severance tax paid at market price 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 of the severance taxes owed such that a processor may deduct only that portion of the severance taxes attributable to the gathering, compression and treatment of the resource prior to calculating the appropriate royalty payment. 1

The Kentucky Supreme Court first stated that Kentucky follows the majority "at the well" rule for determining royalty payments, citing its decision in Baker v. Mangum Hunter Production, Inc., 2013-SC-000497-DG (Aug. 20, 2015) (to be published), rendered the same day.  Under the "at the well" approach, production costs (associated with severing the gas from the earth) are not deducted from the sales price when calculating royalties.  Post-production costs (incurred after the gas is severed and reaches the wellhead) are deducted from the sales price for royalty calculation purposes.

Turning to the specific severance tax provisions at issue, the court noted that KRS 143A.020(1) states that "[f]or the privilege of severing 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 . . . to apply to the gross value of the natural resource."  The tax applies to "all taxpayers severing and/or processing natural resources in this state . . . ."  KRS 143A.020(2). 

The court found Burbank v. Sinclair Prairie Oil Co., 202 S.W.2d 420 (Ky. 1946), a 1946 decision concerning the apportionment of the oil severance tax, to be instructive.  In Burbank, the court held that the act imposing the oil severance tax could not be construed to place any part of the tax on one who is simply a royalty owner.  Likewise, the court found Appalachian was merely a royalty owner and was not involved in either severing or processing the gas.  Indeed, the court stated, "the natural gas tax is assessed for the 'privilege of severing or processing the gas'.  This is a privilege Mr. Williams surrendered over seventy years ago." 

The court found the authorities cited by EQT and Amicus Curaie, the Kentucky Oil and Gas Association, Inc., to be distinguishable because these authorities involved state statutes that specifically provided for the payment of severance taxes by the royalty owner.  In sharp contrast, the court stated, the Kentucky legislature specifically excluded from the definition of taxpayer under KRS Chapter 143A "[a] party . . . who receives an arm's length royalty."  Thus, the court found Appalachian had no statutory liability for the severance tax.

The court also held Appalachian had no contractual liability for the tax.  KRS Chapter 143A was enacted 36 years after the lease in question was executed; therefore, the court stated, the original parties to the lease could not have intended the apportionment of gas severance taxes at the time the lease was executed.  Additionally, because the severance tax does not enhance the value of the gas, the court found it would run contrary to the parties' intent and the purpose of the "at the well" rule for the royalty owner to share in an expense that does nothing to improve the quality of the product beyond the wellhead. 

Finally, the court rejected the argument of Amicus Curaie that imposing the entirety of the severance tax expense on producers would have a devastating impact on small producers that are the backbone of Kentucky's oil and gas industry.  The court reasoned that, as a matter of economics, the severance tax would inevitably be paid by the market participant most willing to endure it.  Furthermore, the court found it immaterial whether its decision ultimately reduces profits to producers to a sum that drives them out of the market, as tax policy is a legislative concern. 

Justice Abramson authored a dissenting opinion, joined by Chief Justice Minton.  The dissent argued the second option proposed by the Sixth Circuit should be adopted, and the producer/lessee should be permitted to deduct the portion of the tax attributable to post-production costs that the processor is allowed to deduct from the sales price prior to calculating the royalty.  The dissent argued such a result would preserve "the parties' contracted for proportionate shares of 'market price at the well'" and be consistent with the legislature's intention to impose the severance tax on "severing" and "processing" the gas.  Under the majority's interpretation, the dissent argued, the producer bears the full brunt of the severance/processing tax.  According to the dissent, the majority's holding ignores the language of KRS Chapter 143A, which focuses both on the severance and processing stages of getting the product to market for the first sale.

Footnote

1. Notably, the Kentucky Supreme Court rejected both options presented by the Sixth Circuit, instead concluding that in the absence of an agreement to the contrary, lessees may not deduct any severance taxes prior to calculating a royalty value.

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