On December 4, 2013 Ohio House Speaker Rep. William Batchelder, Speaker Pro Tempore Rep. Matt Huffman, Majority Whip Rep. Cheryl Grossman, Finance and Appropriations Committee chair Ron Amstutz, Agriculture and Nature Resources Committee chair Rep. David Hall, and other members of the Ohio House Republican Caucus introduced House Bill 375 (“HB 375”) which includes sweeping proposals to change Ohio’s oil and natural gas tax scheme.  HB 375 repeals the existing Ohio oil and natural gas regulatory cost recovery assessment (the “CRA”) in favor of a horizontal well tax, provides a new credit against Ohio state income tax, and offers a new Ohio commercial activity tax exclusion.

            If enacted as introduced, HB 375 would repeal the CRA currently imposed on all oil and natural gas well owners in Ohio Revised Code section (“R.C.”) 1509.50, and in its place levy a horizontal well tax on owners of horizontal oil and natural gas wells through which oil or natural gas are severed on or after April 1, 2014. For the first twenty quarterly periods after the well begins production, the tax rate would be 1% of the net proceeds of the well. Thereafter, the tax rate generally would be 2% of the net proceeds of the well.  If after the first five years the well is low-producing, the tax rate would remain at 1%.  Specifically, a natural gas well producing an average of less than 100 Mcf/day in a calendar quarter, or an oil well producing an average of less than 17 bbl/day in a calendar quarter, would qualify for the 1% tax rate for that quarter. The tax base, “net proceeds,” is defined as the gross receipts from the severance of oil and natural gas, less any post-production costs – such as the costs of gathering, processing, transporting, fractionation, delivery for sale, and any adjustment for shrinkage.  This structure more closely tracks the economics of horizontal well production activity than the fixed cents-per-unit severance tax in existing R.C. 5749.02(A)(5) and (6).

            In addition to these changes, there are several direct tax-reduction elements in HB 375.  The severance tax rate on natural gas extracted through traditional wells would be reduced under HB 375 from 2.5 cents to 1.5 cents per Mcf, though the existing severance tax rate on oil extracted through traditional wells would remain unchanged.  HB 375 also provides a nonrefundable Ohio state income tax credit for the full amount of the horizontal well tax paid during the taxpayer’s taxable year.  The proposal further provides a commercial activity tax exemption for the receipts from the sale of oil or natural gas by a horizontal well taxpayer, which appears to apply only to receipts from the sale of the specific quantity of oil or natural gas on which the horizontal well tax was paid.  As is the case for most provisions of the bill, the commercial activity tax exemption for horizontal well taxpayers is intended to be effective on April 1, 2014.

            Like the CRA, the new horizontal well tax would be levied on the owner of the well.  However an owner may designate a severer that has a working interest or a royalty interest in the owner’s horizontal well to actually pay the tax and file the return on behalf of the owner.  The bill allows the tax commissioner to pursue either the severer or the owner for any unpaid or underpaid tax.  If a severer is designated as the taxpayer, the owner would not be allowed to claim the Ohio state income tax credit, unless the owner is otherwise designated as a horizontal well taxpayer, or is an investor in a horizontal well taxpayer organized as a pass-through entity.  If the owner is an investor in a pass-through entity horizontal well taxpayer, the owner would be able to claim as a credit its distributive or proportionate share of the horizontal well tax paid.

            Just as the owner of a well may designate the severer of that owner’s well to pay the horizontal well tax on its behalf, a taxpayer authorized to claim the Ohio state income tax credit may designate another person who has been designated a payer of the horizontal well tax to receive all or a part of the credit.   If the credit is designated to another, it could be claimed only for the horizontal well tax paid by the designating person with respect to the calendar quarter for which the designation is made.  Taxpayers who designate their credits for use by others are to consider any contractual arrangement between them that provides for allocation of horizontal well tax liability.  As drafted, it is not clear whether the bill allows a taxpayer to designate the credit to an owner who has not been designated as a taxpayer by another.

            Again paralleling the CRA, when a severer is designated to pay the tax, it may recoup the expense from the well owner, but may do so only to the extent the severer does not recoup the cost by claiming the Ohio state income tax credit.  If the credit exceeds the taxpayer’s Ohio income tax liability in the tax year it first becomes available, the bill allows a seven-year carry forward, provided that the credit is applied against any income tax liability in each of the succeeding years. The effect appears to allow the severer and the owner to share the economic cost of the tax under their existing agreement, and for the income tax credit to serve as a form of insurance for both parties in the event that the well does not produce sufficient income to pay for the tax, while preventing either party from receiving a windfall.

            In terms of use of the revenue generated by the horizontal well tax, the proceeds of the tax would be used for a new horizontal well tax fund.  The bill would require the Ohio Tax Commissioner to calculate the amount of revenue that would have been generated had the oil and natural gas severed by horizontal wells subject to the horizontal well tax been subject to the severance tax as it existed on December 31, 2013.  Ninety percent of the calculated revenue would be paid out of the horizontal well tax fund to the oil and gas well fund and ten percent would be paid to the geological mapping fund.  The oil and natural gas well fund is used to plug idle and orphaned wells, to restore the land surface as required by law, and to correct imminent health and safety risks arising from idle or orphaned wells and wells for which the owner cannot reasonably be contacted.  The geological mapping fund exists to map and make public reports on the geology, geologic hazards and energy and mineral resources of the state.  The remainder of the horizontal well tax fund would go toward income tax reduction for all Ohio taxpayers.

            All indications are that this bill may be a compromise among the various stakeholders in favor of and opposed to a new severance tax.  HB 375 found a warm reception with Ohio Governor John Kasich, and media reports suggest it is likely to pass in one form or another.  News coverage of the proposed legislation can be found here and here, and the full text of the bill is available here.  The BakerHostetler Shale Team will keep you informed as this fast-moving legislation develops.