The Pennsylvania Department of Revenue is finalizing and anticipates issuing shortly a Tax Bulletin setting forth the Department’s position on the realty transfer taxation and personal income taxation of oil and gas leases and easements, royalty interests and production payments. The Department’s Office of Chief Counsel circulated the draft for comment and the Tax Policy Office is now reviewing comments and revising the Bulletin for discussion with the newly appointed Secretary of Revenue before publication.
Pennsylvania Realty Transfer Taxation of Oil and Gas Transactions
Oil and Gas Leases
General Rule. The transfer tax statute exempts from tax “[l]eases for the production or extraction of coal, oil, natural gas or minerals and assignments thereof.” The Bulletin confirms that entering into an oil and gas lease incurs no transfer tax, and establishes the Department’s position that the assignment of a lessor’s (but not a lessee’s) interest in an oil and gas lease is subject to transfer tax.
Assignment of Lessee’s Interest in Oil and Gas Lease. The Bulletin confirms that the assignment by a lessee (the oil and gas company) of its interest in an oil and gas lease is exempt from transfer tax.
Assignment of Lessor’s Interest in Oil and Gas Lease. The Bulletin sets forth the Department’s position that the transfer taxation of a lessor’s assignment of its interest in an oil and gas lease depends on whether the interest assigned is a mere right to receive income (exempt from transfer tax) or an actual interest in the oil and gas in place (subject to transfer tax).
Lessor’s Assignment of Income from Oil and Gas Lease. If a lessor (the landowner) assigns only its right to receive royalties or other income under the lease, the assignment is exempt from transfer tax because the royalty right is personal property. Transfer tax is imposed only on the transfer of real property and not on the transfer of personal property. Accordingly, the Bulletin provides that no transfer tax is imposed on the lessor’s assignment of the personal property right to receive royalties or other income under an oil and gas lease.
Lessor’s Assignment of Reserved Interest in Oil and Gas in Place. If a lessor assigns its reserved interest in the oil and gas that remains in place under its land, the Bulletin provides that the assignment is subject to transfer tax because a reserved interest in oil and gas in place constitutes real property. This treatment is appropriate since the assignment of a reserved interest in oil and gas constitutes the transfer of real property, to which transfer tax applies.
Planning Tip. A lessor may be able to transfer the right to receive income from an oil and gas lease together with an option for the assignee to purchase the reserved interest in oil and gas in place for a nominal price once production ceases from the leased interest. Under the Bulletin, the assignment of the right to receive royalty income is exempt from transfer tax. If the assignee exercises its option to purchase the reserved interest after production has ceased, the transaction will be subject to transfer tax but should have little or no value (since production has ceased). This would enable the assignee to obtain 100% of the lessor’s interest — over time — without incurring transfer tax. It’s possible the Department would seek to tax such a transaction using its power to “combine” transactions, but that argument appears weak as there is no certainty the assignee would exercise the option to purchase the reserve interest since it has no value. Instead, the option would be intended only to enable the assignee to obtain 100% of the lessor’s interest, in effect, to clean up title if it so chooses at a point in the indeterminate future when production ceases from the leased interest.
Oil and Gas Easements
General Rule. The transfer tax regulations provide that the transfer of an easement is subject to transfer tax on the actual consideration paid. Under the Bulletin, the Department clarifies its view that easements associated with oil and gas exploration, extraction and production — such as access, pipeline, water line and fracture pond easements — are subject to transfer tax if the term of the easement exceeds thirty years (or is permanent or indefinite). The Bulletin confirms the current rule that transfer tax is imposed on the consideration paid for the easement. If no consideration is paid, the tax is based on the “actual monetary worth” of the easement, determined by appraisal or comparable transactions.
Public Utility Easement Exemption. The transfer tax statute exempts from transfer tax “public utility easements.” The regulations clarify that to qualify as an exempt public utility easement, an easement must be (1) transferred “to a person furnishing public utility service,” and (2) “used in, or useful for, furnishing public utility services.” The draft Bulletin provides the Department’s interpretation that to qualify as a person furnishing public utility service, the easement beneficiary must be regulated by the Pennsylvania Public Utility Commission (PUC), the Federal Energy Regulatory Commission (FERC) or a similar state or federal agency. The Bulletin further indicates that to qualify as an exempt public utility easement, the pipeline must be used to transport oil or gas to end users. Using this framework, the Bulletin concludes that easements granted for production or gathering pipelines are subject to transfer tax (because they transport oil and gas from the well to a transmission facility, rather than to end users), while easements granted to a public utility for transmission or distribution pipelines are exempt from transfer tax (because they transport oil and gas to end users).
Analysis. The Department’s intent to impose transfer tax on production and gathering easements appears to be rooted in the exemption of natural gas gathering facilities from FERC jurisdiction.
The question whether a gatherer qualifies as a public utility under the Pennsylvania Public Utility Code has received renewed attention in the context of Marcellus Shale development. For example, in December 2010, an administrative law judge recommended to the PA PUC that it deny the application of Laser Northeast Gathering — a Marcellus natural gas gatherer — for a Certificate of Public Convenience. The Certificate would give Laser the power of eminent domain to take property needed for gathering pipelines. The PA PUC’s ultimate decision, and potential court appeals, should clarify whether gatherers qualify as Pennsylvania public utilities. The administrative law judge also recommended that the Pennsylvania General Assembly consider expanding the statutory definition of “public utility” to include natural gas gatherers, or otherwise amending the Pennsylvania Public Utility Code, to enable the PA PUC to regulate gatherers for public safety and environmental protection.
The Department’s intent to impose transfer tax on production and gathering easements transferred to public utilities may inject unnecessary uncertainty and an additional inquiry into the transfer taxation of easements. It would be more efficient for the Department to adopt an interpretation that the transfer of an easement to an entity regulated by the PA PUC or FERC as a public utility automatically qualifies for the public utility easement exemption. That would enable the determination of whether or not an entity is a public utility to be made one time, by one state agency — the PA PUC — rather than having the Department of Revenue make a second very similar determination, and would provide the clearest guidance on the transfer taxation of easements for the Department, Pennsylvania landowners and the oil and gas industry. In addition, such an approach would arguably be more consistent with the statutory exemption for public utility easements and the Department’s existing regulation exempting from transfer tax easements transferred to a public utility and used to furnish public utility services.
Practice Tip. The public utility easement exemption is available only for easements transferred to a public utility regulated by the PA PUC, FERC, or similar agency. The exemption may be jeopardized if the easement is granted or transferred to an affiliate of the public utility, if that affiliate is not itself subject to regulation as a public utility.
Pennsylvania Personal Income Taxation of Oil and Gas Transactions
Production Payments. A “production payment” is a share of the value of gas produced by a well, limited by a specified dollar amount, volume of production or period of time. In other words, it is a carved-out portion of royalty income. Production payments may be created in the oil and gas lease in favor of the lessor, or granted by the lessee in favor of a third party.
Federal Tax Treatment. For federal income tax purposes, production payments generally are treated as mortgage loans.
Transfer of Production Payment. For a production payment carved out of a leasehold interest and transferred to a purchaser, the amount paid by the purchaser is treated as a mortgage loan to the seller and therefore is not taxable income to the seller. The production payments are taxable to the seller as ordinary income, subject to depletion (since the seller is treated as having retained ownership of the production payment and mortgaged it). The production payments received by the purchaser are treated as principal and interest on the deemed loan, so the portion of the payment that represents interest is taxable income to the purchaser. This is essentially an income deferral technique for the seller, who receives cash upon the sale of the production payment but defers paying tax on those funds until the actual production payments are received over time.
Reservation of Production Payment in Assignment of Lease. The reservation of a production payment in the assignment of an oil and gas lease is also treated as a mortgage loan from the purchaser to the assignor.
Pennsylvania State Tax Treatment. The Bulletin provides that the Department will treat the sale of a production payment as an “anticipatory assignment of income.”
Seller. In the Department’s view, the seller receives royalty income in the amount of the purchase price. While for federal purposes, the purchase price is treated as a nontaxable loan to the seller (with taxable income later on the production payments), for Pennsylvania personal income tax purposes, the purchase price is treated as taxable royalty income to the seller in the year of receipt (but with no taxable income later on production payments). Thus, income is deferred for federal purposes but not for state purposes.
Purchaser. The purchaser is treated as having purchased the right to future production payments and receives basis in the payments equal to the purchase price. In most cases, each future payment will be treated partially as a non-taxable return of basis and partially as taxably royalty income, in proportion to the ratio of the purchase price to the total anticipated future production payments.
Please call Lafe Metz (412-562-1044) or Carl Staiger (412-562-1624) if you would like to discuss how these potential changes may affect you or your business.