DEFINITION of 'Severance Tax'

Severance tax is a state tax imposed on the extraction of non-renewable natural resources that are intended for consumption in other states. These natural resources include such as crude oil, condensate and natural gas, coalbed methane, timber, uranium, and carbon dioxide.

BREAKING DOWN 'Severance Tax'

Severance tax is charged to resource producers, or anyone with a working or royalty interest in oil, gas, or mineral operations in the imposing states. The tax is calculated based on either the value or volume of production, though sometimes states use a combination of both. The severance tax is imposed to compensate the states for the loss or "severance" of the non-renewable source and also to cover the costs associated with extracting these resources. However, it is only imposed when a drilling well can produce above a certain level of natural resources, as determined by the individual state government.

Several tax incentives in the form of credits or lower tax rates are often allowed in situations where the tax rate might be burdensome enough for extractors to plug and abandon the wells. Thus, these tax breaks are provided to encourage the production and expansion of oil and gas operations.

Royalty owners must pay their pro rata share of oil severance taxes. This deduction is captured on their monthly royalty owner revenue statement. These owners may be charged severance tax even if they do not realize a net profit on their investment. However, state severance taxes are deductible against federal corporate income tax liabilities. It is important to note that severance tax is different from income tax, and royalty owners and producers still have to pay all federal and state income taxes on oil and gas income in addition to severance tax.

Certain wells may be exempt from severance tax based on the amount they produce. Different states have different rules. For example, in Colorado, as of 2017, an oil well that produces less than an average of 15 barrels per producing day or a gas well that produces less than an average of 90,000 cubic feet per producing day is exempt from this tax.

In 2017, Pennsylvania’s Senate passed a budget that includes, for the first time, a severance tax on natural gas produced within the state. The state still remains the only major gas-producing state in the country that does not tax production, as of 2018. Instead, it levies a per-well impact fee, charging an annual fee to all unconventional (i.e. shale) wells. Gas companies pay the impact fee for each well they drill, which is unlike the severance tax which gas companies pay based on how much gas is produced.

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