On the afternoon of March 11, 2014, the Kasich administration introduced another new severance tax proposal as part of its Mid-Biennium Budget Review (MBR). The proposal in the MBR, introduced in the Ohio House of Representatives as House Bill 472 (HB 472), proposes to:
- 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 wells);
- impose a new, higher severance tax on oil and natural gas produced through horizontal wells based on true “gross receipts” received at the first point of sale without any accounting for post-production costs or expenses; and
- divide the proceeds from the severance tax among the Ohio Department of Natural Resources (ODNR), local governments and the income tax reduction fund.
A copy of HB 472 is available on the Ohio General Assembly website.
Notably, HB 472 represents the Kasich administration’s alternative to Substitute House Bill 375 (Sub. HB 375), initially introduced as House Bill 375 on December 4, 2013, and for which the substitute bill was introduced on February 12, 2014. For a detailed summary of Sub. HB 375 see our February 13, 2014 article Updated Severance Tax Proposal Presented in Ohio House of Representatives.
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. HB 472, like Sub. HB 375, sets up a two-tiered structure for the severance tax depending on the type of well producing the hydrocarbons (e.g. conventional vs. horizontal). Unlike the structure set forth in Sub. HB 375, however, the severance tax rate for hydrocarbons produced from a conventional well remain tied to the volumes produced (rather than value).
Specifically, R.C. 5749.02(A)(5) increases the current severance tax for oil from a rate of 10 cents per barrel to 20 cents per barrel, while R.C. 5749.02(A)(6) increases the current rate for natural gas from 2.5 cents per thousand cubic feet (equal to 1 MCF) to 3 cents. Of note, the new rate does not actually increase the amounts paid for hydrocarbons produced from such conventional wells, as the MBR also proposes to eliminate the regulatory assessment currently found in R.C. 1509.50. For most well owners, this existing regulatory assessment totals 10 cents per barrel of oil and ½ of one cent per thousand cubic feet (or 1 MCF) of natural gas — the exact amount of the increase in the severance tax applicable to conventional wells.
NOTE: HB 472 provides a broad exemption from payment of the severance tax for “low” producing conventional wells. Specifically, R.C. 5749.03(B) provides a complete exemption from the payment of severance taxes for any gas produced from a conventional well if production is less than 910,000 cubic feet (910 MCF) in a quarter, or less than 3.64 million cubic feet (3,640 MCF) in a year.
- Horizontal Oil and Gas Wells
- The “gross receipts” model
HB 472 imposes a new tax on “the privilege of engaging in the severance oil or gas. . . using a horizontal well.” Unlike the as-introduced version of House Bill 375 or the amended language in Sub. HB 375, the MBR bases the tax on the “gross receipts” from the first sale of the gas or oil produced through the use of a horizontal well on and after July 1, 2014, without any accounting for post-production costs. The tax applicable to hydrocarbons produced from a horizontal well equals 2.75 percent of the gross receipts “from the first sale of oil or gas. . . made at arm’s length regardless of where title passes, including the fair market value of any property and any services received, and any debt transferred or forgiven as consideration.”
b. Affiliate Sales
Instead of setting up a separate process for addressing first sales between affiliated entities, R.C. 5749.01(O) establishes a different method of calculating the value of the gross receipts at the point of first sale when the sale does not involve an “arm’s length” transaction. There is not, however, a definition of the phrase “arm’s length” or a listing of factors to be considered in determining whether a sale is “arm’s length.” To the extent a sale is not arm’s length, the severance tax is calculated based on the average annual spot price of the hydrocarbon (as reported by the Energy Information Administration) for the preceding year, multiplied by the quantity of the hydrocarbon produced (e.g. oil, natural gas, or natural gas liquids).
Chart Comparing Ohio Severance Tax Proposals
Click here to viw the table.
- Definition of Severer
A new proposal in R.C. 5749.01(I) establishes two different definitions of the terms “severer” as used in Chapter 5749 of the Revised Code. This definition is important because the severance tax is imposed on a “severer” under R.C. 5749.02. For purposes of the severance tax applicable to conventional wells, a severer is defined as “the person who actually removes the natural resources from the soil or water in this state.” On the other hand, in the context of a horizontal well, a severer is defined to mean “the person that has the right to sell the oil or gas severed through the use of a horizontal well.” This broader definition of severer could capture a royalty and/or working interest owner (e.g., a non-operating working interest owner) entitled to an in-kind share of the oil and gas to market and sell on its own.
Under new section R.C. 5749.031, the calculation of the severance tax for hydrocarbons produced from a horizontal well is limited during a three-year cost-recovery period. For the first year of production from a horizontal well, the severance tax is only paid on gross receipts exceeding $4 million. For the second year of production from a horizontal well, severance tax is only paid on gross receipts exceeding $3 million. For the first year of production from a horizontal well, severance tax is only paid on gross receipts exceeding $1 million. In all subsequent years of production, severance tax is paid on all gross receipts.
Use of Money in Severance Tax Receipts Fund: New R.C. 5749.02(C)(7)
Under new language in R.C. 5749.02(C)(7), HB 472 establishes how money in the severance tax receipts fund will be managed and distributed. By the 25th day of each month, the director of budget and management must credit: (i) an unidentified amount to the oil and gas well fund and geological mapping fund to be determined in the sole discretion of the director of budget and management based on a balancing of the amounts already appropriated to those funds by the state, the then-available balance in those funds, and anticipated revenue to the funds from sources other than severance tax revenue; (ii) 20 percent of any remaining balance to certain local government initiatives; and (iii) any remaining amount to the general revenue fund.
Three Local Government Funds
The funding of local government initiatives is accomplished through the creation of three specific funds: (i) the county severance tax fund (which will be used to fund local government infrastructure needs); (ii) the severance tax infrastructure fund (which will be used to fund grants to eligible subdivisions to support and supplement investments in those subdivisions); and (iii) the severance tax endowment fund (which will be used to fund certain projects fostering long-term prosperity and a positive legacy). See e.g., R.C. 190.03-.04, and R.C. 5749.02(C)(7)(a)(i).
Effective Date of New Severance Tax
The new tax applicable to oil and gas severed through a horizontal well applies to oil and gas severed on and after July 1, 2014, as do the other provisions of the bill.
Increase in the Commercial Activity Tax (CAT)
In addition to the increased severance tax rates, HB 472 proposes an increase in the rate of the CAT from 0.26 percent of gross receipts to 0.30 percent. Under uncodified section 812.20 of the bill, this provision is not subject to referendum and would become effective immediately upon the bill being signed. Unlike the provisions in HB 375 or Sub. HB 375, there is no new exclusion from the definition of gross receipts for the sale of oil or gas severed through the use of a horizontal well.