Prior to the Hydraulic Fracturing Tax Act, Illinois was one of the few drilling states not to impose any severance or gross production taxes on the extraction of its minerals.  For oil and gas removed on or after July 1, 2013, Illinois imposes a tax upon the severance and production of oil or gas from a well on a production unit, provided that well is subject to the Hydraulic Fracturing Regulatory Act.

On June 17, 2013, Illinois P.A. 98-0022, consisting of the Hydraulic Fracturing Regulatory Act (225 ILCS 732/1-1 et seq. (2013)) (HFRA) and the Illinois Hydraulic Fracturing Tax Act (35 ILCS 450/2-5 et seq. (2013)) (HF Tax Act), became law.  Originally enrolled as HR 2615, PA 98-0022 was later enrolled as SB 1715 and was passed by the General Assembly on May 29, 2013.  Governor Pat Quinn signed the Act on June 17, 2013.  The Act, which was the result of months of negotiations among industry and some environmental groups, had been stalled since March 2013 after a last-minute amendment added a licensing regime that would have favored water-well drilling contractors, who happen to be largely unionized.  That impasse was resolved when the objectionable well licensing regime was replaced by a local workforce credit against HF Tax Act liability.  This On The Subject discusses the HF Tax Act.  For more information on the HFRA, see McDermott’s White Paper “Illinois Set to Regulate Shale Oil and Gas.”

HF Tax Act

Prior to the HF Tax Act, Illinois was one of the few drilling states not to impose any severance or gross production taxes on the extraction of its minerals.  For oil and gas removed on or after July 1, 2013, Illinois imposes a tax upon the severance and production of oil or gas from a well on a production unit, provided that well is subject to the HFRA.  The liability for the hydraulic fracturing (HF) tax accrues at the time the oil or gas is removed from the production unit.  “Removed” is defined at 35 ILCS 450/2-10(2013) as the physical transportation of oil or gas off of the production unit where severed; and if the oil or gas is used onsite where severed, or if the manufacture or conversion of oil or gas into refined products occurs onsite where severed, the oil or gas is deemed to have been removed on the date such use, manufacture or conversion begins from a well on a production unit that is permitted, or required to be permitted, under the HFRA.  All oil and gas removed is subject to the HF tax unless expressly exempt.  If a well is subject to the HFRA, the HF tax applies regardless of whether an HFRA permit was obtained.  35 ILCS 450/2-15(a)(2013).  The Illinois Department of Revenue (IDOR) administers the HF tax.

HF Tax Rate

For the first 24 months from the date the HFRA well first produces oil or gas, the rate of the HF tax is 3 percent of the value of the oil or gas severed.  After that period, the tax rate depends on production.  For oil, the rate is 3 percent of the value of oil severed for a well where average daily production for any month is fewer than 25 barrels (oil produced from a well where average daily production is 15 barrels or fewer for the 12-month period immediately preceding the production is exempt from HF tax), 4 percent where the average daily production for any month is 25 or more barrels but fewer than 50 barrels, 5 percent where the average daily production for any month is 50 or more barrels but fewer than 100 barrels, and 6 percent where the average daily production for any month is 100 or more barrels.  For gas, the HF tax rate is 6 percent of the value of the gas severed after the 24th month of production.  These rates are reduced, however, by 0.25 percent for the life of the well when a minimum of 50 percent of the total workforce hours on the well site are performed by Illinois construction workers being paid wages equal to or exceeding the general prevailing rate of hourly wages.  When (a) the operator and purchaser are affiliated persons, (b) the sale and purchase of products is not an arm’s length transaction, or (c) the products are severed and removed from a production unit and a value is not established for those products, the IDOR will determine the value of the product for purposes of the HF Tax.

Liability, Withholding, Payment, Tax Lien

The HF tax is upon the producers of such oil or gas in proportion to their respective beneficial interests at the time of severance and is due and payable on or before the last day of the month following the end of the month in which the oil or gas is removed from the production unit.  The first purchaser of any oil or gas sold must collect the amount of the HF tax due from the producers by deducting and withholding such amount from any payments made by the purchaser to the producers, and must remit to the IDOR the collected HF tax (which is deemed held in trust for the State of Illinois until remitted).  Purchasers are required to register with the IDOR. 

A purchaser who pays any HF tax due from a producer is entitled to reimbursement from the producer for the HF tax so paid and may take credit for such amount from any monetary payment to the producer for the value of products.  If a purchaser withholds the HF tax from payments due a producer and fails to remit the amount due to the IDOR, that purchaser will be liable for the tax, and the producer’s interest remains subject to any lien for the HF tax.  A producer is entitled to bring an action against a purchaser to recover the amount of the HF tax so withheld together with penalties and interest that may have accrued by failure to pay the withheld amounts.

The HF tax is a lien on the oil and gas from the time of severance until the tax and all penalties and interest are fully paid.  That lien is on all oil or gas severed from the production unit that is in the hands of the operator, any producer, the first or any subsequent purchaser, or a refiner to secure the payment of the HF tax.  If a lien is filed by the IDOR (pursuant to Section 5b of the Retailers’ Occupation Tax Act (35 ILCS 120/5b)), the purchaser or refiner must withhold from payments due producers or operators the amount of the HF tax, penalty and interest identified in the lien.

Leasing Parties: Check Your Leases

There is no reason a mineral lease, royalty interest reservation or other similar instrument created after the enactment of the HF Tax Act should not clearly provide whether the HF tax is to be deducted from the royalty due the royalty holder. 

For leases or royalty reservations already in place as of the HF tax effective date, what is the result if the instrument fails to clearly provide for allocating severance or gross production taxes (which did not exist in Illinois at the time of formation)?  Case law from other drilling states is split on whether an operator can deduct a royalty holder’s share of severance tax where the instrument is silent (Texas, Heritage Resources, Inc. v. Nationsbank, 939 S.W.2d 118 (1996) (deductible); Kentucky, Asher Land and Mineral, Ltd. v. Nami Resources Company LLC, Bell Circuit Court, Civil Action No. 06-CI-00566 (2011) (non-deductible)).

The HF Tax Act defines “producer” as “any person owning, controlling, managing, or leasing any oil or gas property or well who severs in any manner any oil or gas subject to the HFRA, including any person owning any direct and beneficial interest in any oil or gas produced, whether severed by such person or some other person on their behalf, either by lease, contract, or otherwise, including working interest owners, overriding royalty owners, or royalty owners” (emphasis added).  35 ILCS 450/2-10(2013).  That definition has been persuasive in other drilling states to approve the deduction of the proportionate share of severance taxes from the royalty holder’s share, particularly where the instrument grants the royalty holder the right to take its royalty share in kind (sometimes referred to as royalty oil), in which case the royalty holder is considered the owner of the royalty oil and the producer is selling the product as the royalty holder’s agent (David E. Pierce, Incorporating a Century of Oil and Gas Jurisprudence Into the “Modern” Oil and Gas Lease, 33 Washburn L. J. 786, 818–819 (1994)).  Where, however, the instrument does not provide for that right, the royalty holder may not be deemed the owner of any of the product, so the ultimate resolution of the allocation of HF tax burden in that situation might need to be resolved judicially.

What Is Next

The HF Tax Act requires the IDOR to adopt regulations for determining the value of the severed oil or gas when the counterparties are affiliated; for withholding, payment and collection of the tax; for registration of purchasers of oil and gas; for filing the state’s lien for unpaid severance taxes; and for the IDOR’s inspection of buyer and seller records.  Those regulations are expected to be promulgated within 90 days after enactment of the HF Tax Act. 

The economic impact of the HF Tax Act is uncertain; more exploration of the New Albany Shale is necessary in order to know what production levels are realistic.  One report has estimated the average HF tax revenue for each horizontal hydraulic fractured producing well could be about $1 million over a 10-year period.  Forces opposing Illinois P.A. 98-0022 were critical of the initial 24-month “tax holiday” tax rate (3 percent), which coincides with the typical well’s highest rate of production.  The oil and gas industry countered that the initial 24-month tax rate provides a reasonable incentive for producers of wells with horizontal hydraulic fracturing treatment, who typically face higher exploration and production compared to a conventional oil or gas well.  Considering that Illinois has never imposed a severance tax (conventionally produced oil and gas remains untaxed, as does coal) and the state’s bleak financial condition—its debt has the worst bond rating of all 50 states—any tax revenue would be a welcome sight.