On the afternoon of February 12, 2014, the Ways and Means Committee of the Ohio House of Representatives was presented with a modified version of the severance tax proposal previously introduced on December 4, 2013 by Rep. Matt Huffman (R-Lima). The modified legislation, known as Substitute House Bill 375 (Sub. HB 375), proposes to: (i) reduce (and for certain periods of time eliminate) the severance tax rate on persons extracting oil and natural gas by means other than horizontal wells (e.g. conventional drilling); (ii) impose a new, higher severance tax on oil and natural gas produced through horizontal wells based on “gross receipts” received at the first point of sale less any costs incurred prior to the point of first sale; (iii) divide the proceeds from the severance tax among the Ohio Department of Natural Resources (ODNR), local governments and the income tax reduction fund; (iv) provide a non-refundable credit against the state income tax equal to the amount of any severance tax paid by a royalty interest owner; and (v) offer an exclusion from the commercial activity tax (CAT) for proceeds of the sale of oil and gas by persons paying the severance tax and subject to the income tax. The most recent version of the bill available is here, and a detailed summary of the as-introduced version is available here.
The Severance Tax: R.C. 5749.02(B)
- Conventional Oil and Gas Wells The current volume-based severance tax in Ohio is set forth in R.C. 5749.02(B), and is levied at a rate of 10 cents per barrel of oil and 2.5 cents per thousand cubic feet (MCF) of natural gas. Sub. HB 375, like the as-introduced version, sets up a two-tiered structure for the severance tax depending on the type of well producing the hydrocarbons (e.g. conventional vs. horizontal) and based on the value (rather than the volume) of the hydrocarbons produced. Specifically, R.C. 5749.02(C)(2) establishes a graduated, value-based severance tax rate for oil and gas produced and sold from conventional wells after October 1, 2014. For the first three years after a conventional well first produces, there is no severance tax. From years four through 20, the severance tax rate equals 0.25 percent of the gross receipts from the first sale of oil or gas; and, for all years thereafter the rate drops to 0.10 percent. For purposes of this proposal, the term “gross receipts” means those receipts “from the point of first sale of oil or gas severed from the soil or water of this state, without deduction for costs incurred after the point of first sale,” while the “point of first sale” is defined to mean the “first point after the production of oil or gas from an owner’s well at which the owner transfers ownership of the oil or gas.” The substitute bill is silent as to whether expenses incurred prior to the point of first sale may be excluded.
- Horizontal Oil and Gas Wells Perhaps most importantly, Sub. HB 375 proposes new language in R.C. 5749.02(C)(1) to establish a different mechanism for calculating the severance tax upon persons who extract oil and gas through the use of a horizontal well. Prior to October 1, 2014, oil and gas produced through a horizontal well remain subject to the existing, volume-based severance tax rates. Beginning October 1, 2014, during the initial two (2) years of production, the severance tax equals one percent (1%) of the gross receipts (as defined above) from the point of first sale of oil or gas, with an increase to two and one-quarter percent (2.25%) of the gross receipts in years two through 20, and back down to one percent (1%) in all subsequent years. Unlike the as-introduced bill, there is no lesser severance tax rate for low-producing wells (e.g., when quarterly production falls below an average of 100 MCF per day of natural gas, or 17 barrels of oil).
Chart Summarizing Ohio Severance Tax
Click here to view table.
NOTE: It is unclear for wells producing as of the effective date of the statute whether Year 1 starts on October 1, 2014, or on the day the well first started producing.
- Owner vs. Severer A new proposal in R.C. 5749.02(C)(3) attempts to link the definition of a well “owner” in R.C. 1509.01 with the concept of severer as used in R.C. 5749.06 for purposes of establishing who is required to pay the severance tax. As such, the owner is obligated to report the gross receipts and quantity of oil and gas sold on the quarterly return, which is required to be filed with the tax commissioner, and to remit the tax that is owed.
- Affiliate Sales Instead of setting up a separate process for addressing first sales between affiliated entities, R.C. 5749.02(C)(3) gives the tax commissioner unlimited discretion to analyze such sales to determine whether the relationship between the well owner/severer and purchaser is such that the price paid at the point of first sale reflects the market price of the oil or gas. If the tax commissioner determines that the price does not reflect the “market price,” the tax commissioner shall determine the price to use for purposes of calculating the severance tax. The bill contains no guidance as to how this determination is to be made, nor does it provide a basis for a taxpayer to contest that determination.
- Record Retention Another new provision in Sub. HB 375, R.C. 5749.13, requires the severer to retain all severance tax-related records for a period of five (5) years.
Elimination of the Regulatory Assessment in R.C. 1509.50
In addition to restructuring the calculation of Ohio’s oil and gas severance tax, Sub. HB 375 (like the as-introduced version) proposes to eliminate the regulatory assessment currently found in R.C. 1509.50. For most well owners, the existing regulatory assessment totals 10 cents per barrel of oil and ½ of one (1) cent per thousand cubic feet (or 1 MCF) of natural gas produced, which goes toward the funding of ODNR’s Division of Oil and Gas Resources.
Oil and Gas Severance Tax Fund: New R.C. 5749.02(D)(6)
Under new language in R.C. 5749.02(D)(6), the General Assembly proposes to create a new oil and gas severance tax fund within the state treasury to manage and distribute the collected severance tax payments. By September 25 of each year, the director of budget and management must transfer: (i) $18 million to ODNR’s oil and gas well fund and $3 million to the geological mapping fund, which are to be proportionately reduced if the amount in the fund totals less than $21 million; (ii) of any remaining balance, 10 percent of the original amount credited to the severance tax fund to the local government reimbursement fund; and (iii) any remaining amount to the income tax reduction fund, which is to be used to provide temporary income tax rate reductions.
Local Government Reimbursement Fund: New R.C. 5747.56
The new local government reimbursement fund is designed to return some of the severance tax money to the areas in Ohio where shale development is actually occurring. The money within this fund will be distributed in various proportions to: (i) the undivided local government fund and public library fund; (ii) the new severance tax infrastructure fund; (iii) the new matching revenue fund (used to match funds from federal or state grants not associated with employee compensation, benefits or other personnel costs); and (iv) the new severance tax trust fund (only for use after 2025 to fund certain projects fostering long-term prosperity and a positive legacy). See e.g., R.C. 190.01-.04, and R.C. 321.50. In addition, Sub. HB 375 establishes certain mechanisms by which these funds are distributed.
Non-Refundable Income Tax Credit for Royalty Interest Owners: New R.C. 5747.63
In R.C. 5747.63, the General Assembly modifies its proposal to establish a nonrefundable income tax credit for certain taxpayers equal to the amount of the severance tax paid for calendar quarters that end during the taxpayer’s taxable year. Unlike the as-introduced version of the bill, Sub. HB 375 provides the income tax credit only to a person with a royalty interest (defined to mean the “fee holder's share in the production from a well”) who is liable for the severance tax (e.g., under the terms of an oil and gas lease). The credit is equal to the severance tax paid by the owner multiplied by the lesser of 12.5 percent or the proportion of the tax that the royalty owner-taxpayer is contractually required to pay to the owner. The royalty interest owner cannot carry the credit forward, and is unable to utilize the credit if it also takes an income tax deduction under R.C. 5747.01(A)(31) (the small business investor deduction). In order to facilitate the royalty interest owner’s use of this credit, Sub. HB 375 also imposes a new obligation on the well owner to provide an annual statement identifying the total amount of the severance tax paid by the person holding the royalty interest. While the original bill based the income tax credit on severance tax paid with respect to oil and gas extracted by means of a horizontal well, the credit in the substitute bill applies to any severance tax paid under R.C. 5749.02(C) with respect to oil and gas extracted by any means.
Exclusion from Commercial Activity Tax (CAT)
A new exclusion from the definition of gross receipts for purposes of the CAT is created in R.C. 5751.01(F)(2)(jj). This provision excludes receipts from the first sale of oil or gas sold after October 1, 2014, if the CAT taxpayer is subject to the personal income tax or is a pass-through entity, the direct or indirect owners of which are subject to the income tax on the income from the sale.