Articles Posted in Severance Tax

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An article by Jim Malewitz in The Texas Tribune, “As Oil Prices Plunge, Questions about Big Tax Credit,” sheds light on an arcane and technical issue not well understood even by most oil and gas lawyers – classification of wells as “oil wells” or “gas wells” by the Texas Railroad Commission. While most wells produce both oil and gas, under RRC rules a well must be either one or the other. Different rules apply depending on well classification. Why does it matter?

For one thing, oil and gas leases traditionally have allowed larger pooled units for gas wells than oil wells – allowing operators to hold more acreage with a single well. This distinction is based on the theory that gas wells drain a larger area than oil wells – probably true in most conventional reservoirs, where oil and gas migrate through the formation as wells withdraw production. Not so true for new unconventional shale formations, which have very low permeability and porosity, and where oil and gas don’t “flow” through the formation but are produced through artificially induced fractures.

But operators recently are rushing to “reclassify” wells as gas wells that were originally classified as oil wells. According to Malewitz, the RRC granted operator applications to reclassify 844 wells from oil to gas this year – nearly six times the number reclassified in 2013. And Devon Energy has asked the RRC to reclassify more than 200 of its wells from oil to gas. The reason? Tax credits. Continue reading →

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Recently some of my clients have received notices of class action settlements in Coll v. Abaco Operating, LLC, et al., in the U.S. District Court for the Eastern District of Texas, Marshall Division, C.A. No. 2:08-CV-345 TJW. The case reveals a little-known aspect of royalty payments: many companies never reimburse their royalty owners for refunds of severance taxes.

Most royalty owners know little about severance taxes except that they are a deduction that regularly appears on their royalty check stubs. Texas imposes a tax on the value of all oil and gas produced in the state: 7.5% for gas and 4.6% for oil. Most producing states impose similar severance taxes. Pennsylvania has been debating whether to pass a severance tax in light of its budget problems and recent development of the Marcellus Shale in that state. Texas’ severance taxes are paid into its “rainy day fund” that has been much in the news of late.

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Royalty owners should be aware that they are entitled to severance tax refunds on gas wells drilled in certain “tight sand” formations, including the Barnett Shale. If a field is designated as a “tight sand,” Texas law provides for a reduction in severance tax from 7.5% to 2% for a period of ten years, or until the operator has recovered one-half of the well’s drilling and completion costs, whichever comes first. But the operator must apply for this exemption to the Texas State Comptroller’s office after the well has been completed. Until the exemption is granted for the well, the operator pays severance tax at the 7.5% rate, and once the exemption is granted the Comptroller refunds the excess tax paid to the operator. The operator should then pass on to the royalty owners their share of the refund, since the royalty owner bears his/her share of the severance tax. This refund could occur several months after production first commences.

According to Gene Powell’s Barnett Shale Newsletter, there are 1,452 Barnett Shale wells in the “pending file” at the Texas Railroad Commission. Wells in the pending file have not yet been assigned a lease code number. Until a lease number has been assignd by the Railroad Commission, the operator cannot file for a tight sand exemption to the Comptroller. Powell says that the 1,452 pending wells have been producing for an average of eight months, so the operators of those wells are entitled to severance tax refunds of millions of dollars, once the paperwork is done.

Royalty owners should inquire with their lessees as to the status of the lessee’s severance tax exemption. The additional royalty resulting from the exemption should be 5% of the gas royalties previously paid, from date of first production.

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