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Hey Producers, Severance Taxes Are All Yours, Kentucky Supreme Court Says

Natural gas producers operating in Kentucky may not deduct severance taxes before calculating the amount of royalties to be paid to landowners, the Kentucky Supreme Court said Thursday.

"Today we certify that the producer severing natural gas from the earth is solely responsible for the payment of the severance tax," the court said in a majorityopinion by Justice Bill Cunningham. "Of course, this rule can be altered through agreement."

The case is Appalachian Land Co. versus EQT Production Co. [2013-SC-000598-CL]. At issue was the fact that natural gas is not sold at the wellhead.

"As such, lessees like EQT must mathematically work back from the price at the point of sale to arrive at the wellhead price. This is the relevant 'market price' for purposes of calculating royalties," the opinion said. "In the present case, this value was obtained by deducting from the sale price all post-extraction processing costs; transportation costs and all severance taxes. EQT then paid Appalachian one-eighth of the remainder," which was its royalty rate.

Appalachian said severance taxes should not be deducted and that doing so yielded an underpayment of royalties. The majority of the court agreed.

"...[T] he law is clear," the majority opinion said. "The severance tax was intended to be a levy for the privilege of severing or processing the gas. Absent statutory or contractual apportionment, the tax is assessed exclusively to the producer/lessee."

In a dissenting opinion joined by Justice John Minton that sought to put another slice in the tax pie, Justice Lisabeth Hughes Abramson wrote that "...where a royalty is based on the market price 'at the well,' the natural gas processor may deduct that portion of the tax attributable to those post-production costs which the processor is allowed to deduct from the sale price prior to calculating the royalty, but it may not deduct the portion of the tax attributable to its initial severing or extraction of the gas. That portion of the tax attributable to severance is a production cost for which the natural gas producer is solely liable under the lease."

The deduction of post-production costs from royalty calculations has been an issue in Pennsylvania, where landowners have lobbied lawmakers for more protections on royalties (see Shale DailyApril 7, 2014).

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