What is Severance Tax?

What is Severance Tax?

A State tax charged on the exploitation of non-renewable resources such as crude oil, condensate and natural gas, coal bed methane, timber, uranium, and carbon dioxide that are allocated for other state’s consumption is called a Severance Tax.

Understanding Severance Tax

An enforcing state will charge resource producers or someone that have working or royalty interest in oil, gas, or mineral operations with a severance tax. Either the value or volume of production is used as a basis for the calculation for this tax, however some states often merge the two. The implementation of severance tax aims to indemnify the states for the loss or “severance” of the exhaustible source as well as to compensate the extraction related expenses of these resources. Nevertheless, every state government set a specific level of natural resources a drilling well must produce in order to be charged for a severance tax.

In cases where the tax rate becomes too high and difficult for extractor to pay that might lead them to stop and abandon the wells, extractors are permitted to have several tax incentives in the form of credits or lower tax rates. Hence, these tax splits are offered to foster the production and development of oil and gas operations.

It is the obligation of the royalty owners to give their pro-rata share of oil severance taxes. Every month, this deduction will be recorded in the revenue statement of royalty owners. In spite of not having a net profit in their investments, royalty owners will still be liable to severance tax. But state severance taxes can be used to reduce corporate income tax payables. It is necessary to bear in mind that there is a difference between income tax and severance tax. Moreover, aside from severance tax, royalty owners and producers are still obliged to pay for all federal and state income taxes on oil and gas income.

The production volume of wells will be the basis for the exemption of severance taxes. Take note that each state differs in the provision regarding this matter. For instance, an oil well and gas well in Colorado was exempted from this tax in 2017 because they are producing lower than the average production per day which is equal to 15 barrels of oil and 90 cubic feet of gas.

On the other hand, the senate in Pennsylvania pioneered the approval of a budget that contains a severance tax on natural gas produced inside their territory in the year 2017.  As of 2018, Pennsylvania is the sole major gas-producing states in the country that continues to not impose a tax on its production. Alternatively, all non-traditional wells (i.e shale) are charged with a yearly fee by the state in the form of a per-well impact fee. Contrary to the severance tax that is based on the amount of gas produced, the impact fee is being charged to gas companies for every well they drilled. 

In the total government revenue, Severance taxes covers only minimal percentage, but it is not applicable to North Dakota and Wyoming which are said to be a resource-rich states.

The Revenue Received by State and Local Governments from Severance Taxes

In 2016, approximately $8 billion severance taxes were collected by local governments and states. State taxes were the source of almost the total revenue. In the same year, an incorporated total of $225 million was collected by 12 states that are permitted to local severance tax. 

Also in 2016, it is recorded that severance taxes covers less than 1% of the overall national state and local own-source general revenue. Although some resource-rich states submitted a considerable amount of own-source revenue, like North Dakota and Wyoming which obtain 21% and 10 % respectively.

Alaska, New Mexico, and West Virginia are the next-highest contributors of severance taxes. Through severance taxes, the four states collected a total of 4% state and local own-source revenue. Meanwhile, 30% of national state and local severance tax revenue was recorded for severance taxes in Texas. However, it only covers 1 % of the overall state and local own-source revenue of the country. Take note that there are also states that do not charge severance tax including the 16 states of Columbia District.

Compared to other states, Alaska generally relies on severance tax revenue. But the oil production and its price have declined drastically which also leads to lesser tax revenue of the state. The severance tax revenue of Alaska in 2012 is around $6 billion, which is recorded to be 40 % of the joint general revenue of state and local own-source. Subsequently, again, revenue declined in 2013 to 33% ($4 billion), in 2014 to 23 % ($2 billion), also in 2015 to 8% ($636 million), and 4% ($337 million) in 2016.

It has been emphasized by Alaska that the instability of severance taxes and the issues that the states have which strongly depends on them. This is why these states need to have versatile budgeting provisions or substantial rainy day funds to respond to unexpected adjustments in the flow of severance tax revenue.  

Key takeaways

Severance tax is defined as a state tax charged on the exploitation of non-renewable natural resources that are allocated for other state’s consumption. It is designed to indemnify the loss of the non-renewable resources of the state.

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