Appalachian Land Co. v. EQT Production Co.

CERTIFYING THE LAW

OPINION OF THE COURT BY

JUSTICE CUNNINGHAM

Today we certify that the producer severing natural gas from the earth is solely responsible for the payment of the severance tax. Of course, this rule can be altered through agreement.

On the first day of December, 1944, widower Robert Williams surrendered the privilege of severing oil and gas from his land in Pike County to West Virginia Gas Company. He leased all oil and gas within his property to the gas company “for the sole and only purpose of operating for, producing and marketing oil, gas and gasoline....”

Appalachian Land Company, (“Appalachian”) is Mr. Williams’ successor in interest as the lessor. EQT Production Company, (“EQT”) is a natural gas producer. It is the successor in interest to the original lessee, West Virginia Gas Company. The lease provides that the lessee, now EQT, shall pay the lessor, now Appalachian, a royalty on natural gas extracted from the land “at the rate of one-eighth (1/8) of the market price of gas at the well.” In 2008, Appalachian filed a class action law suit against EQT in the U.S. District Court for the Eastern District of Kentucky. Appalachian claimed that EQT underpaid royalties owed to Appalachian in exchange for natural gas EQT acquired from Appalachian’s land.

The disputed issue arises from the fact that natural gas is not sold “at the well.” As such, lessees like EQT must mathematically work back from the price at the point of sale to arrive at the wellhead price. This is the relevant “market price” for purposes of calculating royalties. In the present case, this value was obtained by deducting from the sale price all post-extraction processing costs; transportation costs; and all severance taxes. EQT then paid Appalachian one-eighth of the remainder.

Appalachian argued before the district court that in arriving at a “market price” for royalty purposes, EQT should not have deducted the severance taxes. Appalachian contends that these allegedly improper deductions resulted in an underpayment of royalties. The court disagreed and entered judgment on the pleadings in favor of EQT. Appalachian moved the court to alter or amend that judgment, which was denied. Appalachian appealed those rulings.

Because the issue of apportionment of natural gas severance taxes has not been directly addressed by this Court, the Sixth Circuit Court of Appeals certified the following question pursuant to CR 76.37(1):

Does 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 does the resource’s at-the-well price include a proportionate share of the severance taxes owed 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?

While we accept the invitation to clarify this important issue, we reject the two options presented. Instead, we conclude *843that in the absence of a specific lease provision apportioning severance taxes, lessees may not deduct severance taxes or any portion thereof prior to calculating a royalty value.

Background

The extraction of natural gas is a capital intensive process involving various technologies and extraction methods. After extraction, the gas is cleaned, stored, and subsequently transported to other sites through various pipelines. Often after additional cleaning, refining, and processing, the gas is eventually sold at a hub location. The severance tax is remitted at this point of the operation. KRS 143A.060(2). The sales price at that location constitutes the gross value of the gas for purposes of calculating the severance tax. KRS 143A.010-020. Royalty payments are calculated based on this sale price.

In Baker v. Magnum Hunter Production, Inc., — S.W.3d-, 2015 WL 4967131 (Ky. August 20, 2015), we recently held that Kentucky follows the majority “at the well” rule for determining royalty payments. Our decision confirms the Sixth Circuit’s interpretation of Kentucky law. Poplar Creek Development Co. v. Chesapeake Appalachia, LLC, 636 F.3d 235 (6th Cir.2011). Under the “at the well” approach, production costs are not deducted from the sale price for royalty calculation purposes. Production costs include bringing the gas to the surface, exploration, drilling, and well-maintenance costs. In other words, production costs are those associated with “severing” the gas from the earth. In contrast, post-production costs are deducted from the sale price when calculating royalty payments. Post-production costs are incurred after the gas is severed and reaches the wellhead. These costs include improving the quality of the gas and transporting it to the point of sale.

Analysis

Although the “at the well” rule is a critical component of our oil and gas jurisprudence, it is not conclusive of the narrow issue currently before this Court — nor are economic considerations determinative here. Rather, we must decide whether Appalachian’s severance tax liability arises under statute or contract. Having reviewed the facts and the law, we conclude that there is no severance tax liability on behalf of Appalachian. We keep in mind that Appalachian is simply the successor to Mr. Williams — the landowner under the 1944 lease — and is not in the business of extracting a profitable mineral from the earth or bringing it to market.

Statutory Liability

KRS 143A.020(1) states that “[flor the privilege of severing or processing natural resources in this state, a tax is hereby levied at the rate of four and one-half percent (4.5%) on natural gas ... to apply to the gross value of the natural resource.” This tax applies to “all taxpayers severing and/or processing natural resources in this state....” KRS 143A.020(2). “Severing” is defined as “the physical removal of the natural resource from the earth or waters of this state by any means.” KRS 143A.010(3). “ ‘Processing’ includes but is not limited to breaking, crushing, cleaning, drying, sizing, or loading or unloading for any purpose.” KRS 143A.010(6). With these provisions in mind, we turn to Burbank v. Sinclair Prairie Oil Co., which addressed a nearly identical issue. 304 Ky. 833, 202 S.W.2d 420 (1946).

Burbank involved a dispute between a lessee and lessor concerning the apportionment of the oil severance tax assessed under the original version of what would become KRS 137.120. The consideration *844provided in the lease at issue in that case was “the equal of 1/8 part of all oil produced and sold from the leased property.” Id. at 421. Similar to the present case, the lease in Burbank did not provide for apportionment of severance taxes.

The Court focused its analysis on the original severance tax statute that provided in pertinent part:

Every person, firm, corporation and association engaged in the business of producing oil in this State, by taking same from the earth, shall, in lieu of all other taxes on the wells producing said oh imposed by law, annually pay a tax for the right or privilege of engaging in such business....1
Id. at 422 (citing 1917 Ky. Acts Chapter 9, Section 1) (emphasis added).

Based on this plain language, the Court held that “the original act as amended cannot be construed as placing any part of the tax in question on one who is simply a royalty owner.” Id. at 425.

The Burbank Court’s determination was well-founded. For example, the Court noted that in “States having similar acts ... the courts have held the tax not to extend.” Id. at 424 (citing State of Oklahoma v. State of Texas, 266 U.S. 298, 300, 45 S.Ct. 101, 69 L.Ed. 296 (1924) (holding that a royalty owner was not liable under a pre-1933 law that taxed all those engaged in “producing” crude oil)). Burbank also relied upon the U.S. Supreme Court’s decision in Oliver Iron Mining Co. v. Lord, 262 U.S. 172, 43 S.Ct. 526, 67 L.Ed. 929 (1923). In that case, the Court considered a Minnesota law that taxed “every person engaged in the business of mining or producing iron ore.... ” Id. In holding that the royalty owner was not liable for the tax or any portion thereof, the Court cogently observed:

[t]he tax in its essence is ... an occupation tax. It is not laid on the land containing the ore, nor on the ore after removal, but on the business of mining the ore....
Id. at 176-77, 43 S.Ct. 526.

Like the royalty owners in Burbank and Oliver, Mr. Williams and his successor, Appalachian, have not engaged in the business of producing natural gas. Burbank, 202 S.W.2d at 423. It is similarly evident that the only party to the lease that engages in seveñng the gas is EQT. Cf. Cimmaron Coal Corp. v. Dep’t of Revenue, 681 S.W.2d 435, 437 (Ky.App.1984) (“A mineral owner who leases his coal to a severer of coal is not ‘engaged in severing’ that coal.”). EQT is also the only party to the lease involved in bringing the gas to market and, thus, processing the gas. See Burbank, 202 S.W.2d at 423 (“There can be no doubt but that the Legislature had in mind that the person, firm, etc., making it his or its business to drill, bring in the oil and put the product on the market, should bear the tax.”) (Emphasis added). Therefore, royalty owners are not involved in severing or processing the gas.

Furthermore, it is critical to our analysis that the natural gas tax is assessed for the “privilege of severing or processing” the gas. This is a privilege Mr. Williams surrendered over seventy years ago. Absent a clear legislative directive to the contrary, the privilege to deplete this non-renewable resource and bring it to market is most logically bestowed upon the producer — not the passive lessor from whose land the resource is being severed.

*845In exchange for a royalty interest in any gas extracted, Mr. Williams conveyed his right to extract the gas to West Virginia Gas Company. Appalachian and EQT succeeded to those respective property rights. In the present case, title to the gas became vested with EQT the moment it brought the gas to the wellhead.2 Therefore, even viewing the severance tax as analogous to a property tax, the owner of the property being taxed is EQT, not Appalachian. As such, whether we interpret the severance tax as a levy on the privilege of producing gas, the business of producing gas, or on the gas itself, the tax burden lies squarely with EQT.

EQT asserts that other “at the well” jurisdictions have reached a contrary determination, thus holding that lessees may deduct severance and processing taxes pri- or to calculating royalties. Unlike the present case, however, the weight of the authority cited by EQT and Amicus Curiae, Kentucky Oil and Gas Association, Inc., involves state statutes that specifically provide for the payment of severance taxes by the royalty owner. E.g., Cartwright v. Cologne Production Co., 182 S.W.3d 438 (Tex.App.2006); Brown v. Shell Oil Co., 128 MichApp. Ill, 339 N.W.2d 709 (1983). These cases are readily distinguishable from the current case.

For example, the statute at issue in Cartwright imposed a tax on each producer of gas that expressly included royalty owners. Cartwright, 182 S.W.3d at 446 (citing TEX. TAX CODE ANN. § 201.001) (defining producer as “a person who owns an interest, including a royalty interest, in gas or its value_”) (Emphasis added). In sharp contrast, the Kentucky General Assembly has specifically excluded from its definition of taxpayer under KRS Chapter 143A “[a] party ... who only receives an arm’s length royalty.” KRS 143A.010(4)(b). Since Appalachian receives only a royalty payment under the lease at issue here, it has no economic interest in the gas for purposes of the severance tax assessed under KRS 143A.020.

If the General Assembly determines that KRS Chapter 143A should be amended to include royalty owners, it may certainly do so in a manner that otherwise comports with state and federal law. For example, after Burbank was rendered, the General Assembly promptly amended KRS 137.120 to impose the tax “ratably upon all persons owning any interest in such oil.” 1948 Ky. Acts Chapter 82, Section 1 (H.B. 297). In the absence of any similar legislative action regarding KRS Chapter 143A, we must read the relevant portions of that Chapter in accordance with their plain meaning and with guidance from Burbank. Accordingly, royalty owners such as Appalachian are not subjected to the severance tax presented in KRS Chapter 143A.

It is critical to note that the dissent concedes the following: 1) Appalachian does not engage in the business of severing or processing the gas; 2) EQT is the “taxpayer” pursuant to the statutory definition; and 3) that royalty owners are specifically excluded from that statutory definition. Therefore we are speaking unanimously on the issue posed by the Sixth Circuit concerning the “intent” of the Kentucky severance tax statute. Yet, the dissent maintains that despite the statute’s clear intent, its “reach” extends 71 years *846into the past in order to imply contractual terms that were never bargained for by the original parties to the lease. Through the lens of equity, the dissent reads KRS Chapter 143A and the lease together, only to arrive at a conclusion that contradicts both.

Contract Liability

KRS Chapter 143A was enacted in 1980, 36 years after the lease was executed. Prior to 1980, the Commonwealth did not tax the severance or production of natural gas under any other statute or regulatory provision. Therefore, the original palsies to the lease could not have intended the apportionment of gas severance taxes at the time the lease was executed.

In this regard, the present case can be distinguished from Burbank, where the oil severance tax statute preceded the lease that was executed by the parties in 1942. See KS 4223c-l. As such, the contracting parties in Burbank would have been aware of the existence of such a tax and may have intended apportionment.

Nevertheless, the Burbank Court concluded that while the 1942 lease created a joint interest in the proceeds resulting from the sale of the oil, the lessor had no say in the “operation and management. ...” Burbank, 202 S.W.2d at 422-23. The Court accordingly held that the lessor/royalty owner was not statutorily liable or contractually liable for the oil severance tax. As previously discussed, the Court based its analysis on a statute and pertinent contractual provisions that are nearly identical to those at issue in the present case. Compare Poplar Creek Development Co., 636 F.3d at 242 n. 5 (where the lease expressly provided that “lessee must pay all taxes on gas produced under the lease, except with respect to the one-eighth royalty paid to the lessor[ ]_”).

However, EQT, Amicus, and the dissent give short shrift to the application of Burbank. They simply argue that the “at the well” rule did not apply in that case. Ami-cus specifically opines that, “[u]nlike gas, oil was and is typically sold at-the-wellhead.” See Burbank, 202 S.W.2d at 422 (citing KS 4223c-3) (“The tax provided by this section shall be imposed and attached when the crude petroleum is first transported from the tanks or other receptacle located at the place of production.”). As previously noted, however, the purpose of that amendment “was merely curative and clarifying as to the method of reaching the quantity and value.... ” Burbank, 202 S.W.2d at 422. This method does not negate application of the “at the well” rule in oil cases such as Burbank.

For example, Cumberland Pipe Line Co. v. Commonwealth specifically applied the “at the well” rule in the context of the oil severance tax statute. 15 S.W.2d 280, 284 (Ky.1929). While addressing the constitutionality of the oil severance tax, the Cumberland Pipe Line Court determined:

[t]he plain mandate of the act of 1918 is that the tax commission shall find the market value at the place of production by taking the actual sales as reported from the pipe line companies, and such other evidence thereof as may be available, and deducting therefrom the carriage charges. The result reached in that way is the market value of the oil at the wells.

Cumberland Pipe Line Co., 15 S.W.2d at 284.

In addition, the Court defined the oil severance tax as one “imposed upon the occupation of producing the oil” and is, therefore, “imposed on the producer alone and for the privilege of engaging in the business of producing crude petroleum from oil wells in this state.” Id at 283. (Emphasis Added). Therefore, the dissent’s representation of the oil severance *847tax as a property tax on oil sold at the well-head directly contradicts the holding in Cumberland Pipe Line.

Critically, the dissent omits any mention of Cumberland Pipe Line whatsoever. This is surprising considering that we recently embraced that case in Baker, to support our unanimous decision that Kentucky has long since applied the “at the well” rule in gas and oil cases. Baker also pays great homage to the authority advanced by the Sixth Circuit in its well-reasoned Poplar Creek decision. Of course, Poplar Creek also relied heavily on Cumberland Pipe Line. See Poplar Creek Development Co., 636 F.3d at 244 (citing Cumberland Pipe Line for the proposition that “[t]here is seldom, if ever, a market at the place of production.”). Therefore, the majority and dissent in the present case— as well as the Sixth Circuit — agree that the “at the well” rule and its accompanying “work-back” method apply to the production of oil as well as gas.

Similarly, the Burbank Court was well aware of the “at the well” rule discussed in Cumberland Pipe Line, and certainly considered that rule when reaching its determination. Burbank, 202 S.W.2d at 422 (citing Cumberland Pipe Line, 15 S.W.2d at 282). Yet, the “at the well” rule did not supersede the plain language of the severance tax statute at issue in Burbank, nor did it imply terms to the lease where there were none.

It is also necessary to address the dissent’s erroneous analogy of taxes and deductable- post-production costs. Post-production costs such as gathering, compression, and transportation actually enhance the value of the gas. In contrast, while the sale of gas is contingent upon payment of the severance tax, the tax does not enhance the value of the gas. Thus, it would run contrary to the parties’ intent — and the purpose of the “at the well” rule — for the royalty owner to share in an expense- that does nothing to improve the quality of the product beyond the well-head. Like administrative and regulatory fees, severance taxes are not á benefit for which the royalty owner bargained. Cf. Hockett v. Trees Oil Company, 292 Kan. 213, 251 P:3d 65, 72 (2011) (holding that state conservation fees assessed downstream against first purchasers did not constitute post-production costs that were required to be shared by the royalty owner.).

The authority cited by EQT on this issue is also unpersuasive. For example, the gas division order that supplemented -the lease at issue in Cartwright contained a provision authorizing the lessee/producer to deduct, “all production and severance taxes required to be paid with respect to the interest of the [lessors]_” Cartwright, 182 S.W.3d at 446. Clearly, the lease now in dispute contains no such provision.

Having considered the authority from other states offered in support of EQT’s argument, we determine that Burbank is controlling and that .its logic remains, sound. Therefore, we hold that absent a specific lease provision apportioning severance taxes, lessees may not deduct severance taxes or any portion thereof prior to calculating a royalty value. Appalachian is not contractually liable for any portion of the gas severance tax,

Economic Considerations

Amicus further contends that assessing the entirety of severance tax expenses to producers “would have a devastating effect on many of the small producers who are the backbone of Kentucky’s $1.1 billion dollar oil and gas industry.” This timeworn tactic has been used by mineral producers for over a century to plague this embattled region of our Commonwealth.

*848It is a fundamental principle of free markets that regardless of regulatory apportionment a tax will be passed along and, thus, in large measure “paid” by the market participant most willing to endure it. For example, a “sin tax” is an excise tax on vice that is remitted by the retailer/supplier but the majority of which is borne by the end user in the form of increased prices. While the government enjoys a considerable amount of additional revenue, the resulting decrease in the quantity demanded for the product subjected to the increased tax is relatively minimal.

In contrast, it is much more complex to calculate the precise change in natural gas production and consumption relative to a slight increase in producers’ severance tax expenses. What is certain, however, is that the severance tax will inevitably be “paid” by the market participant most willing to endure it. That may or may not be the producer.

In any event, whether an increase in producers’ tax expenses reduces profits to a sum that drives them out of the market — or actually reduces profits at all — is a determination ultimately decided by the market, not the Court. Any additional economic analysis is not the domain of this Court and should not instruct our decision. Tax policy is a legislative concern. See Burbank, 202 S.W.2d at 422 (“A fair division of the tax is a matter for the Legislature[ ]_”). We are charged with interpreting and applying the law. Here, the law is clear. The severance tax was intended to be a levy for the privilege of severing or processing the gas. Absent statutory or contractual apportionment, the tax is assessed exclusively to the producer/lessee.

We reach this conclusion having due regard for all.those involved in the mining industry, including producers. However, we cannot ignore the rights and interests of landowners engaged in mineral transactions. In that same vein, this Court recently brought common sense and clarity to our mineral trespass law by affording landowners the same recovery as producers. Harrod Concrete and Stone Company v. B. Todd Crutcher, 458 S.W.3d 290 (Ky.2015). Thus, if we were to weigh the equities in this case, the well-being of the landowner — historically given secondary consideration — deserves equal consideration to the potential economic losses of natural gas producers.

Conclusion

For the forgoing reasons, we certify that: 1) royalty owners are not statutorily liable for the severance tax assessed under KRS Chapter 143A; and 2) absent a specific contractual provision apportioning severance taxes, lessees may not deduct severance taxes or any portion thereof pri- or to calculating a royalty value. Accordingly, Appalachian is not liable for any portion of the natural gas severance tax. The law is hereby certified to the United States Court of Appeals for the Sixth Circuit.

All sitting. Barber, Cunningham, Keller, Noble, and Venters, JJ., concur. Venters, J., concurs with separate opinion in which Noble, J., joins. Abramson, J., dissents by separate opinion in which Minton, C.J., joins.

. In 1918, the legislature reenacted the 1917 Act and amended it to include a provision clarifying how the tax was to be assessed and collected. KS 4223c-3. However, the 1918 Act "did not indicate any change in the purpose of the original act." Burbank, 202 S.W.2d at 422.

. See Mikal C. Watts & Emily C. Jeffcott, Does He Who Owns the "Minerals" Own the Shale Gas? A Guide to Shale Mineral Classification, 8 Tex. J. Oil Gas & Energy L. 27, 36 (2012-2013) ("Kentucky follows the rule of capture, which provides that fugacious minerals, such as oil and gas, cannot be "owned” until produced and possessed.”) (citing Bowles v. Hopkins County Coal, LLC, 347 S.W.3d 59, 65 (Ky.App.2011)).