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Class Action to Force Companies to Reimburse Royalty Owners for Severance Tax Refunds – Coll v. Abaco

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.

Over the past several years, the Texas Legislature, at the behest of producers, has passed various exemptions from the severance tax intended to encourage further exploration and production and avoid abandonment of low-producing wells:

The Enhanced Oil Recovery Incentive (Tex.Tax Code Sections 202.052, 202.054)

The High-Cost Gas Incentive (Tex. Tax Code Section 201.057)

The Two- and Three-year Inactive Well Incentives (Tex. Tax Code Sections 201.053, 301.058, 202.056)

The Incentive for Marginal Gas and Oil Wells (Tex. Tax Code Sections 201.059, 202.058

The Enhanced Efficiency Equipment Severance Tax Credit (Tex. Tax Code Section 202.061)

The Orphaned Well Reductoin Program (Tex. Tax Code Section 202.060)

The Advanced Clean Energy Enhanced Oil Recovery Reduction (Tex. Tax Code Section 202.0545)

The Incremental Production Incentive (Tex. Tax Code Sections 201.058, 202.057)

All of these exemptions serve to eliminate or reduce the severance tax on a particular well that qualifies for the exemption’s requirements. The requirements to qualify for each exemption vary. Some exemptions apply only below certain price thresholds for oil or gas.

One of the most lucrative tax exemptions is the Texas High-Cost Gas Incentive. It reduces the severance tax on natural gas produced from a well that produces from a formation designated by the Texas Railroad Commission as a “tight formation.” This exemption has become much more important with the increase in drilling of horizontal shale wells in the Barnett, Haynesville and Eagle Ford formations. The exemption was originally passed in 1991 and provided an exemption from all gas severance tax for qualified gas wells.  In 1997 the Legislature amended the statute to provide for a reduced tax rate for a limited time, applicable for wells spudded after August 31, 1996. The reduced tax rate is based on a formula and depends on the drilling and completion costs for the well compared to the median cost of all high-cost gas wells drilled in the previous fiscal year. Using the comptroller’s formula, if I completed a high-cost gas well in 2009 for $3 million, my severance tax would be reduced from 7.5% to 2.6%. The reduced tax rate applies for ten years or until the well accumulates tax savings of 50 percent of the actual drilling and completion costs for the well, whichever is first.  The savings for companies (and the loss of severance tax revenue to the State) are huge.

In Texas, the severance tax is a tax on the production and it is borne by all owners of the well, including royalty owners. The law requires the operator or first purchaser to collect the tax and remit payment to the comptroller. Thus, royalty owners see the deduction for severance tax on their royalty check stubs.

The severance tax exemptions require an application process, and it can sometimes be months or years between the first production from a well and the well’s qualification for the exemption. Until the exemption is granted, the producer or first purchaser collects and remits the full amount of the severance tax to the comptroller. Once the exemption has been granted, the comptroller reimburses the operator or first purchaser, either in the form of an actual payment or a credit against future severance taxes owed.

The plaintiffs’ attorneys who filed Coll v. Abaco discovered that, when producers and first purchasers receive a severance tax refund, they do not always pass it on to the royalty owner (and sometimes do not pass it on to other working interest owners in the well). As a result, the operator receives a windfall equal to the amount of the refund that is attributable to the severance tax previously paid on behalf of the royalty owner. According to the pliaintiffs’ complaint in Coll v. Abaco, over the four years 2004-2008 Texas has paid refunds totaling approximately $1.1 billion. If the royalty on those refunds was only 1/8th, there would be $137,500,000 in refunds owed to Texas royalty owners. Apparently, much of that money has never been paid back to the royalty owners.

Suppose that a high-cost gas well is drilled for $5 million and produces $3 million of gas in its first year of production. In year two, the operator applies for and receives a high-cost gas exemption reducing its severance tax on the first $2,500,000 of production equal to 50% of the severance tax paid, or $112,500. If the royalty on that production is 25%, then 25% of that refund, or $28,125, belongs to the royalty owner. If the operator simply pockets this money, then in effect the net reduction in severance tax paid by the operator is 62.5% instead of 50%!

The plaintiffs in Coll v. Abaco sued 117 producers and first purchasers on behalf of all royalty owners who received royalties from those 117 defendants from 2000 to 2008, alleging that the defendants had failed to pay their royalty owners their share of severance tax refunds received by those companies. Since the suit was filed in 2008, many of the defendants have settled, and only about 25 defendants remain. The court has not yet ruled on whether the case can proceed as a class action, but the settling defendants have agreed to refund to their royalty owners a portion of the severance taxes they received. The amounts of the settlements differ for each company, but generally the companies have agreed to pay all or substantially all of the severance tax refunds attributable to production from wells during the four years prior to filing suit, and a percentage (40% in one instance) of the severance tax refunds attributable to production from wells from 2000 to 2004.

All of the defendants, including big producers like Exxon Mobil, Anadarko, Apache, Shell, Newfield, Pioneer, Samson, Devon, BP, EOG, and Forest, and smaller producers like Abaco, Cimarex, Enervest, Noble Energy, and Vintage Petroleum, have vigorously denied that they have any obligation to pay royalty owners any refund. They have also denied that the case can proceed as a class action. (Practically, if the case cannot be brought as a class action, the companies have won, because very few royalty owners have a large enough claim standing alone to justify suing for their refund.) One of the arguments made by the companies is that their leases do not require them to pay the royalty owners any severance tax refund. Certainly, most oil and gas leases do not deal with refunds for severance tax exemptions — many of the leases were written before there were any severance tax exemptions. The companies also insist that they owe no royalties attributable to refunds more than four years prior to the suit, because of the four-year statute of limitations on bringing claims.

In order to protect royalty owners from being denied their share of severance tax refunds, an express provision should be included in their leases, something like the following:

The royalty paid under this lease shall bear its proportionate part of all severance taxes actually paid on production from the leased premises or lands pooled therewith. If Lessee applies for and obtains an exemption from or reduction of severance tax on such production, Lessor shall be entitled to its proportionate part of such exemption or reduction. If as a result of any such exemption or reduction of severance tax, Lessee receives a refund (either in the form of a payment or credit against future taxes) for severance taxes previously paid on such production, then Lessee shall reimburse Lessor for its proportionate share of such refund, including any interest thereon.


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