Can a Virginia gas producer deduct transportation and other costs when calculating gross receipts for a local severance tax, and can the commissioner audit the producer?

Plain-English summary

Tazewell County Commissioner of the Revenue Emma Hagy asked two questions about the local license tax on gas severance under § 58.1-3712: can a gas producer deduct production costs and expenses, and how broad is the Commissioner's audit authority?

On deductions: The AG concluded that gas producers not engaged in coal mining can deduct certain costs. Section 58.1-3712 authorizes localities to levy a license tax at up to 1% of "gross receipts" from the sale of coal or gas severed within the county. The trick is that "gross receipts" is defined by statute as the fair market value of the coal or gas measured either (1) when used or sold within the taxing locality, or (2) when placed in transit for shipment from the locality. So the valuation timing matters.

When gas is shipped outside the locality before sale, the fair market value is measured at the time of shipment, not at the time of out-of-state sale. The sale price the producer ultimately receives may reflect added value from later processing, transportation, and marketing. Those post-shipment expenses should be backed out of the gross receipts to get to the in-locality fair market value. The Tax Commissioner has previously ruled to the same effect.

The 2002 General Assembly addressed the issue with an amendment "declaratory of existing law" adding that "no person engaging in the production and operation of severing gases from the earth in connection with coal mining shall be allowed to take deductions, including but not limited to, depreciation, compression, marketing fees, overhead, maintenance, transportation fees, and personal property taxes." The implication: coal-related gas production gets no deductions, but other gas production does. The AG read the amendment as the General Assembly's endorsement of the prior administrative interpretation, plus a new restriction for the coal-mining context.

On audit authority: The AG concluded that commissioners of the revenue can audit producers. Section 58.1-3712(C) authorizes localities to require producers and common carriers to maintain records and file reports, but does not directly address audits. Nothing in that subsection limits the commissioner's ability to audit. The audit authority comes from elsewhere: the commissioner, who is charged with assessing license taxes, is free to audit taxpayers who pay the tax and is directed to require taxpayers "to furnish access to books of account or other papers and records for the purpose of verifying the tax returns of such taxpayers and procuring the information necessary to make complete assessment of any taxpayer's ... license taxes."

A point worth noting: the gross receipts tax under this section is based on fair market value at the statutory measurement time, not necessarily the sale price the producer ultimately receives. A sale price that includes value added by later processing or transportation does not reflect the fair market value at the required measurement time.

Currency note

This opinion was issued in 2011. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here.

Title 58.1 tax statutes are frequently amended. Anyone evaluating a current local severance tax assessment should consult the current text of § 58.1-3712, current Tax Commissioner rulings, and any newer court decisions.

Common questions

Why is gas production "in connection with coal mining" treated differently?
The opinion does not explain the policy reason in detail, but the 2002 amendment is express: coal-bed methane and other gas extracted in connection with coal mining cannot take the deductions that other gas production can take. The General Assembly drew the line itself. The statute is what controls.

What deductions are typically available?
The opinion identifies depreciation, compression, maintenance, transportation fees, and personal property taxes as illustrative deductions. These are not exhaustive. Any cost that adds value to the gas after the measurement point (in-locality use or sale, or placement in transit) is potentially deductible.

Why was the AG relying on the Tax Commissioner's ruling?
Because the Tax Commissioner had already construed this exact statute, and the AG leaned on that construction, reinforced by the 2002 statutory amendment that the General Assembly made declaratory of existing law.

What's the audit risk for a gas producer?
The Commissioner of the Revenue can request books of account and records to verify returns and assess license taxes. A producer claiming deductions should keep good documentation of what costs were incurred where and when, to support the fair-market-value measurement.

Background and statutory framework

The local license tax:

• § 58.1-3712. Authorizes counties and cities to levy a license tax on persons engaged in the business of severing coal or gases from the earth, not exceeding 1% of gross receipts from the sale of coal or gases severed within the locality.
• "Gross receipts" defined as fair market value at the time the coal/gas is used or sold within the locality OR placed in transit for shipment from the locality.
• 2002 amendment (declaratory of existing law): no deductions for coal-mining-related gas production.

Commissioner authority:

• The commissioner is charged with assessing license taxes and is directed to require taxpayers to furnish access to books of account and records to verify returns and make a complete assessment.
• § 58.1-3712(C). Localities may require producers and carriers to maintain records and file reports.

The two-step valuation:

1. Determine whether gas was used or sold within the locality, or placed in transit out of the locality.
2. Measure fair market value at the corresponding point in time. Sale price minus value added afterward equals approximate fair market value at measurement time.

Citations

• Va. Code § 2.2-505
• Va. Code Ann. § 58.1-3712, including subsection (C)

Source

• Landing page: https://www.oag.state.va.us/annual-reports-opinions/official-opinions
• Original PDF: https://www.oag.state.va.us/files/Opinions/2011/10-110-Hagy.pdf

Original opinion text

COMMONWEALTH of VIRGINIA
Office of the Attorney General
Kenneth T. Cuccinelli, II
Attorney General

August 5, 2011

The Honorable Emma N. Hagy
Commissioner of the Revenue for Tazewell County
101 East Main Street
Tazewell, Virginia 24651

Dear Ms. Hagy:

I am responding to your request for an official advisory opinion in accordance with § 2.2-505 of the Code of Virginia.

Issues Presented

You ask whether § 58.1-3712, which authorizes localities to impose a license tax on gas producers, permits a taxpayer to deduct expenses and production costs from the gross receipts upon which the tax is imposed, when the receipts are for gas produced by means not in connection with coal mining. You also inquire regarding the scope of the Commissioner's ability to conduct audits relating to the collection of severance taxes authorized under § 58.1-3712.

Response

It is my opinion that § 15.2-3712 allows persons engaged in the production and operation of severing gas from the earth not in connection with coal mining to take certain deductions when the sale occurs at a point outside the county or city where the gas was extracted and the producer has incurred additional expenses for the gas to reach its destination. Those deductions might include, but are not limited to, depreciation, compression, maintenance, transportation fees, and personal property taxes; however, persons who are engaged in the production and operation of severing gas from the earth in connection with coal mining may not take such deductions. It further is my opinion that Commissioners of the revenue are authorized to perform audits in connection with their duty to assess license taxes.

Applicable Law and Discussion

Section 58.1-3712 provides in relevant part that

[t]he governing body of any county or city may levy a license tax on every person engaging in the business of severing coal or gases from the earth. Such tax shall be at a rate not to exceed one percent of the gross receipts from the sale of coal or gases severed within such county. Such gross receipts shall be the fair market value measured at the time such coal or gases are utilized or sold for utilization in such county or city or at the time they are placed in transit for shipment therefrom .... In calculating the fair market value, no person engaging in the production and operation of severing gases from the earth in connection with coal mining shall be allowed to take deductions, including but not limited to, depreciation, compression, marketing fees, overhead, maintenance, transportation fees, and personal property taxes.

One difficulty in analyzing this statute is that while it calls for a tax upon "gross receipts," the statute further provides that "gross receipts shall be the fair market value measured at the time such coal or gases are utilized or sold for utilization in such county or city or at the time they are placed in transit for shipment therefrom." The statute calls for the gross receipts to be valued "at the time" the gases are used or sold locally, or placed in transit.

This Office has opined that under this section, gross receipts may be measured at "two distinct times." These are either

(1) when the coal [or gas] is used or sold for use within the taxing locality; or (2) when the coal [or gas] is placed in transit for shipment from the taxing locality. The use of the disjunctive indicates that two separate alternatives were intended .... Section 58.1-3712 thus contemplates that coal [or gas] will be either used or sold for use in the taxing locality or exported for sale in another jurisdiction. In the latter event, the fair market value for purposes of determining gross receipts is measured at the time the coal [or gas] is placed in shipment .... and should not include value added by the processing of the coal [or gas] in [another jurisdiction].

Relying on this opinion, the Tax Commissioner has opined that although the term "gross receipts" generally does not contemplate deductions, that is not the case with respect to § 58.1-3712. According to the Tax Commissioner, when the gases "severed by the taxpayer are [not] used or sold for use within the County, they must be valued when they are placed in transit for shipment." Examining gases that were placed in transit for shipment at the wellhead, the Tax Commissioner concluded that the gases should be valued at the wellhead. Clearly, no deductions may be taken for expenses incurred up to that point. As such,

Gross receipts from sale may be used as a starting point when determining the value of the gases at the time they are placed in transit for shipment. Expenditures, however, which represent value added to the gases at, and subsequent to, the time they are placed in transit for shipment must be deducted. Such expenses may include processing, transportation and marketing expenses.

Accordingly, if a sale takes place outside the County, the "gross receipts" received by the gas producer will be attributable in part to certain costs sustained after the point in time designated by the statute for valuation. To illustrate, suppose that gas originating in Virginia is sold in Tennessee. If the gas extractor incurs additional expenses after the gases are placed in transit, those expenses can be deducted.

In 2002, after the opinions of this Office and of the Tax Commissioner had been issued, the General Assembly, in an act "declaratory of existing law[,]" added to § 58.1-3712 language providing that "no person engaging in the production and operation of severing gases from the earth in connection with coal mining shall be allowed to take deductions, including but not limited to, depreciation, compression, marketing fees, overhead, maintenance, transportation fees, and personal property taxes." This enactment suggests that the General Assembly accepted the opinions from the Tax Commissioner and the Attorney General, but further provided that permissible deductions would be limited to those persons who are engaged in the production and operation of severing gases from the earth and who are doing so in a manner not in connection with coal mining.

In sum, persons who are engaged in the production and operation of severing gases from the earth and who do so not in connection with coal mining may take deductions, where appropriate, for among other things, "depreciation, compression, marketing fees, overhead, maintenance, transportation fees, and personal property taxes." Such deductions, however, are available only for expenses incurred after the gas was used or sold for use within the taxing locality or after it is placed in transit for shipment from the taxing locality. The point is to determine what the fair market value of the gas was before it was shipped outside of the locality.

Turning to your inquiry regarding the ability of the Commissioner to conduct audits relating to the collection of severance taxes authorized under § 58.1-3712, I note that, while subsection (C) provides that "[a]ny county or city enacting a license tax under this section may require producers of coal or gas and common carriers to maintain records and file reports showing the quantities of and receipts from coal or gases which they have produced or transported[,]" it does not directly address audits. Neither its plain text nor any implication limits the ability of a Commissioner to perform an audit. Rather, this subsection makes express that a when a locality chooses to levy the license tax on the extraction of coal or gas, the locality may also require companies to maintain records regarding quantities and receipts relating to the production or transportation of the gas or coal.

Nevertheless, the Commissioner, who is charged with assessing license taxes, is free to audit taxpayers who pay the license tax and to seek any necessary documentation in connection with deductions. Indeed, the Commissioner is directed to require taxpayers "to furnish access to books of account or other papers and records for the purpose of verifying the tax returns of such taxpayers and procuring the information necessary to make complete assessment of any taxpayer's ... license taxes[.]"

Conclusion

Accordingly, it is my opinion that § 15.2-3712 allows persons engaged in the production and operation of severing gas from the earth not in connection with coal mining to take certain deductions when the sale occurs at a point outside the county or city where the gas was extracted and the producer has incurred additional expenses for the gas to reach its destination. Those deductions might include, but are not limited to, depreciation, compression, maintenance, transportation fees, and personal property taxes; however, persons who are engaged in the production and operation of severing gas from the earth in connection with coal mining may not take such deductions. It further is my opinion that Commissioners of the revenue are authorized to perform audits in connection with their duty to assess license taxes.

With kindest regards, I am

Very truly yours,

Kenneth T. Cuccinelli, II
Attorney General