Mineral Interests and Severance Taxes

July 7, 2011 | Erin Herbold-Swalwell


In Kansas, the royalty owners of mineral interests (coal, oil or gas) bear the severance tax on minerals in accordance with their pro rata shares. Many states have instituted severance taxes- a tax incurred when natural resources are severed.  With respect to natural gas, helium (a component of natural gas) contributes to the gross value of the gas. Thus, helium-making is subject to the Kansas severance tax. Additionally, the operator of a gas gathering system or underground natural gas storage facility is assessed a conservation fee in Kansas. Normally, a royalty owner is not assessed such a fee. If a royalty clause of a natural gas lease provides that the royalty on the gas shall be 1/8 of the proceeds if sold at the well, then the term “proceeds” is defined as the gross sale price between the first purchaser and the producer. Approval of the price is required by the applicable regulatory authority.

Here, a royalty owner of natural gas claimed that the Kansas Department of Revenue (KDOR) improperly collected a severance tax and sued the natural gas company (operator of the well) alleging that the company wrongfully withheld taxes and fees from his royalty payments. The royalty owner owned a 1/8 royalty interest in the production of natural gas from the well. The gas company sold the gas and helium (extracted from the raw gas) separately. Before the purchaser paid for the gas and helium, they deducted the Kansas severance tax from the proceeds. The proceeds were then distributed as net sales proceeds to the royalty owners. 

The royalty owner brought a class action suit against the company on behalf of all royalty owners who were paid royalties from oil or gas produced in Kansas wells. The royalty owner asked the court to order the company to provide an accounting and pay out the underpayment of royalties in the amount of the conservation fee and the severance tax deduction for the helium. The gas company responded, stating that the court should dismiss the suit because the company was merely attempting to comply with Kansas law. The trial court ruled for the company, and held that the severance tax was appropriately charged upon the plaintiff’s royalty share.  The court noted that the Kansas conservation fee is imposed on all participants in an oil and gas venture, including royalty owners.

The Kansas Supreme Court agreed to hear the case.  Before the Court, the plaintiff argued that the statutory language imposing the Kansas severance tax did not specifically mention helium. However, the Court noted that the KDOR had ruled in 1998 that since helium is a component of natural gas and is measured as part of its full volume, it is subject to the severance tax.  Consequently, the Court reasoned that the gas company had no choice but to comply with the statutory provisions and held that instead of suing the gas company for essentially complying with the law as they understood it, the plaintiff should have brought suit against the regulatory agency  - KDOR

The Court also addressed the plaintiff’s claim that, as a royalty owner, he had no legal obligation to share in operational expenses- including the conservation fee.  The Court noted that the conservation fee statute clearly specified that only an “operator” is responsible for paying the conservation fee, and that a royalty owner had no statutory obligation to proportionately share in post-production costs and fees.  But, of course, that obligation can be created via contract.  Here, the lease provided that the royalty owner was entitled to 1/8 of the proceeds received by the oil company. The gas company argued that this meant the proceeds received from the first purchaser, reduced by the conservation fee. The gas company argued that the royalty owner essentially agreed, in writing, to a reduction of the royalties he was statutorily entitled to. The gas company’s definition of “proceeds” included expenses for post-production of the product- i.e. operational costs. The Court did not agree. “Proceeds” was not explicitly defined under the lease and the royalty owner was not the operator.  The Court held that the conservation fee was an operating expense to been borne by the operator.   Hockett v. The Trees Oil Company, 251 P.3d 65 (Kan. Sup. Ct. 2011).