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Severance Tax Increase Will Affect Most Landowners

Krugliak, Wilkins, Griffiths & Dougherty Co., L.P.A.

Many landowners have heard of the recent proposal to increase the oil and gas severance tax due to Ohio’s recent increase in Utica Shale drilling activity.  Currently, Ohio imposes a severance tax on oil and gas production.  The tax is approximately $0.20 per barrel of oil produced and $0.03 on each million cubic feet of gas produced (mcf).  There is no separate tax on natural gas liquids, and the natural gas liquids are treated as natural gas for purposes of taxation under the severance tax. The Governor has proposed increasing the tax to 1.5% during the initial year of production and 4% thereafter.

Under the new proposal, landowners who are oil and gas lessors could pay $4 for every $100 in royalty received.  If the landowner received $25,000 in royalty for one year, then he or she could owe $1,000 in severance taxes under the proposed increase.  It is unclear whether the landowner will still be required to pay state income tax on the entire $25,000 or receive a deduction for the tax already paid. 

Proponents of the tax assert that the increase is a method to reduce Ohioans’ taxes while increasing taxes on foreign out of state companies.  With Ohioans currently being taxed near the top third in the country, a tax decrease is certainly long overdue.

As one would expect, the tax has been adamantly opposed by the oil and gas industry.  However, other organizations, such as the Ohio Farm Bureau Federation have not endorsed the proposed tax increase, likely due to the potential affect the tax increase will have on many of its members. 

Many of the oil and gas leases that were circulated in the recent Utica Shale leasing frenzy required the landowner to pay their proportionate share of all taxes.  This would necessarily include the ad valorem tax in addition to the severance tax which is the subject of the increase. 

It should be pointed out that many Ohioans’ land is already subject to an oil and gas lease, and thus they do not have an opportunity to negotiate a new lease to shift the tax burden.  Oil and gas leases in the last 20-30 years typically state in the royalty provision that the landowner will bear their share of any taxes associated with production.  Older leases are generally silent on the issue.  Unfortunately, silence on the issue does not mean the landowner will not bear this burden.  Rather, in many states when the lease is silent as to the ability to deduct taxes, Courts have concluded that they are appropriate post-production deductions from the landowner’s share of the royalty.  Thus, it is very unlikely that the overwhelming majority of Ohio royalty holders in the Utica Play will be avoiding the severance tax increase. 

The Ohio Oil and Gas Association has issued an extensive fact sheet discussing the potential pitfalls of the severance tax hike which includes a comparison of the tax imposed in other states.  Based upon our neighbors, it appears Ohio seems to be in the middle of the severance tax spectrum, with some states such as Pennsylvania having no severance tax, while others such as Michigan have a much higher severance tax.  However, a recent study commissioned by the Governor’s Office indicates Ohio ranks in the bottom tier of Shale producing states, implicitly supporting the need for a hike.

Industry commentators have raised concerns that significantly increasing the tax in the infancy of the Utica Shale development could stifle further exploration.  While there are less than 400 wells currently permitted and/or drilled in the state, the potential ramp up is expected to be as many as 1,000 wells per year.  Due to a lack of infrastructure, it appears that this ramp up may be slower than many desire.  Thus, it appears accurate that we are still in the initial start up phase of the Utica Shale Play, thus supporting the position of some that a severance tax increase at this point in time is less than prudent. 

On July 26, 2012, a poll released by Magellan Strategies of 597 Ohioans conducted on July 23-24, indicates that approximately 23% agreed with the Governor’s severance tax proposal, while 44% disagreed.  Twenty-nine percent of those responding indicated they strongly disagree with the plan, while only 15% said they strongly agree with the proposed plan.  When asked who ultimately pays for taxes on the energy industry, 72% of the respondents said they believe the energy taxes are simply passed on to consumers, while only 17% of respondents said energy taxes are not passed on to consumers.

There are certainly many more debates to come on the proposed severance tax increase; however, it does appear clear that while there may be a benefit to Ohioans from a income tax decrease, that benefit will be greater for Ohioans outside the Utica Play due to the portion of the severance tax being paid by landowners receiving royalties. 

The Ohio legislature is expected to pick up the debate after the November election. 

NOTE:  This general summary of the law should not be used to solve individual problems since slight changes in the fact situation may require a material variance in the applicable legal advice.

 
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