Monday, August 24, 2015

Kentucky Supreme Court Requires Specific Lease Language for Severance Tax Deduction from Royalty

On August 20, 2015, the Supreme Court of Kentucky held that severance taxes cannot be deducted from royalty payments unless the lease contains a specific provision apportioning severance taxes.

In 2008, Appalachian Land Company (Appalachian) filed a lawsuit against EQT Production Company (EQT) before the U.S. District Court for the Eastern District of Kentucky challenging the measurement of the royalty. The lease at issue provided for a royalty calculated based on the market price of gas at the well. This value was obtained after deducting from the sale price all post-production processing costs, transportation costs, and all severance taxes. Appalachian contended that EQT should have not deducted the severance tax from the royalty payment. The U.S. District Court found for EQT, and Appalachian filed an appeal in August 2013.

The Sixth Circuit Court of Appeals certified a question to the Supreme Court of Kentucky addressing whether “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 whether “the resource’s at-the-well price include a proportionate share of the severance taxes owned 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?”

The Supreme Court rejected the two options presented by the Court of Appeal and reasoned that “the natural gas-lessee may not deduct the severance tax attributable to the initial severing or extraction of the gas because that is a true production cost which the lessee assumes in lease premised on market value 'at the well'.”

Written by Chloe Marie - Research Fellow

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