On February 1, 2018, the West Virginia State Tax Department (the “State Tax Department”) filed its annual Administrative Notices with the West Virginia Secretary of State’s Office in order to provide guidance regarding various factors that it uses to value producing oil and natural gas wells for property tax purposes. The Administrative Notices can currently be found on the State Tax Department’s Administrative Notices 2018 webpage. Administrative Notice 2018-02 establishes that the Tax Department primarily relies on the income approach in valuing producing oil and gas, and Administrative Notices 2018-07 and 2018-08 provide background on some of the components that factor into the income based approach to valuation.
Administrative Notice 2018-07 is the “State Tax Commissioner’s Statement for the Determination of Production Decline Rates for Producing Oil and Gas Properties for Property Tax Purposes for Tax Year 2018, Pursuant to § 110 CSR 1J-4.4.” This Administrative Notice reflects the fact that “flush production” occurs in the early years of production for a well, and thereafter the production levels off into “settled production.” The production decline rates are applied to the gross receipts from a well in order to “develop a probable future income series for the respective wells. The income stream from these wells is then discounted to present value.” Use of the production decline rates prevents a large spike in property tax payable in the early years of production, and instead results in property tax payments that are more consistent throughout the life of the well.
The production decline rates for tax year 2018 are the same as the rates used for tax year 2017. Small changes in a production decline rate can result in significant tax savings for producers. If a producer has information to demonstrate that a production decline rate used by the State Tax Department does not reflect the true decline rate for a region, the State Tax Department will consider that information and amend the decline rate if the information is deemed to be accurate.
Administrative Notice 2018-08 is the “State Tax Commissioner’s Statement for the Determination of Oil and Gas Operating Expenses for Property Tax Purposes for Tax Year 2018, Pursuant to § 110 CSR 1J-4.3.” Legislative Rule 110-1J-4.1 establishes the methodology that is used to value producing oil and natural gas property, and states that “value shall be determined through the process of applying a yield capitalization model to the net receipts (gross receipts less royalties paid less operating expenses) for the working interest and a yield capitalization model applied to the gross royalty payments for the royalty interest.” The average annual industry operating expenses are developed by the State Tax Department every five years (and sometimes more frequently) based on surveys received from oil and natural gas producers and other information gathered by the State Tax Department. Surveys were conducted in 2014 and 2017, and based on the responses to the surveys, the State Tax Department established the amounts of average annual industry operating expenses allowed for different well types. The average annual industry operating expense amounts for Tax Year 2017 were amended to account for declining gas prices, with slight changes made to allowances for “typical” producing wells and horizontal wells in the Marcellus and Utica shale regions. Despite the changes, many producers, particularly horizontal well producers in the Marcellus and Utica shale regions, continue to maintain that the average annual industry operating expense amounts used by the State Tax Department are significantly lower than the operating expenses that are actually necessary to produce and sell the natural gas. Steptoe & Johnson is assisting a number of producers in appeals of their property tax valuations based primarily on the issue of the appropriate amount of operating expenses to apply to wells.
Another important change was made to the operating expenses’ Administrative Notice for tax years 2016-18. In past years, the State Tax Department included a paragraph that stated that “[i]n the event a producer’s ordinary expenses, as a direct result of the production, exceeds the stated maximums for oil and gas production, the State Tax Department will accept and review documentation on wells for the previous three years that is provided by the producer. This information must be submitted on or before August 1, the due date for the Oil and Gas Producer/Operator return in order that it may be considered for any given tax year.” This paragraph was omitted from Administrative Notice 2018-08 and the Tax Department now takes the position that it does not have the authority to consider actual operating expense information submitted by producers.