Severance Tax Definition

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Severance Tax Definition

What Is Severance Tax?

A severance tax is a state tax levied on the exploitation of nonrenewable natural resources for consumption in other states. Crude oil, condensate and natural gas, coalbed methane, lumber, uranium, and carbon dioxide are examples of natural resources.

Understanding Severance Tax

Severance tax is levied on resource producers or anybody with a working or royalty stake in oil, gas, or mineral activities in the states that levy it. The tax is computed based on the value or volume of output, however states may use a mix of the two. The severance tax is levied to pay governments for the loss or “severance” of a nonrenewable resource, as well as to cover the expenses of extracting these resources. It is, however, only applied when a drilling well produces more than a specific amount of natural resources, as decided by the respective state government.

Key Takeaways

  • A severance tax is a state tax levied on the exploitation of nonrenewable natural resources for the consumption of other states.
  • The purpose of a severance tax is to compensate governments for the loss of nonrenewable resources.

Several tax breaks in the form of credits or reduced tax rates are sometimes given in circumstances when the tax rate is high enough to cause extractors to plug and abandon wells. As a result, certain tax benefits are available to stimulate the production and growth of oil and gas enterprises.

Oil severance taxes must be paid pro rata by royalty owners. This deduction is shown on their royalty owner revenue statement each month. Even if they do not make a net return on their investment, these owners may be subject to severance tax. State severance taxes, on the other hand, are deducted from federal business income tax responsibilities. It is crucial to emphasize that severance tax is not the same as income tax, and royalty owners and producers must still pay all federal and state income taxes on oil and gas earnings in addition to severance tax.

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Based on the quantity produced, some wells may be exempt from severance tax. Different states have their own set of regulations. In Colorado, for example, an oil well producing less than 15 barrels per producing day or a gas well producing less than 90,000 cubic feet per generating day is free from this tax.

Pennsylvania’s Senate approved a budget that includes a severance tax on natural gas generated in the state for the first time. As of 2020, the state is still the only major gas-producing state in the nation that does not tax output. It instead imposes a per-well impact tax, as well as an annual cost on all unconventional (i.e. shale) wells. In contrast to the severance tax, which gas firms pay dependent on how much gas is produced, gas companies pay the impact fee for each well they dig.

Except in a few resource-rich states like North Dakota and Wyoming, severance taxes make for a relatively modest fraction of total government income.

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