Was an oil-field service company's entire $1.739 million asset sale taxable because 5.4 percent of its receipts came from retail nitrogen sales?

Plain-English summary

An oil-field company used specialized tubing, pumps, and nitrogen systems to inject gas into exploration wells and force oil to the surface. Skilled employees operated the equipment, mostly offshore. The company also made some California retail sales of nitrogen and held a seller's permit for those sales.

During the 17-month audit period from July 1, 1984 through November 30, 1985, taxable nitrogen sales were $210,052.58, or 5.4 percent of total receipts of $3,897,078.80. The company's asset sale was effective November 30, 1985 and produced a protested $1,739,000 measure in its first, close-out audit.

The recommendation treated the main operation as a service enterprise and the nitrogen sales as incidental. Applying Ontario Community Foundation, it recommended taxing only the nitrogen storage tanks used in retail sales and reducing the rest of the protested measure. The district was to calculate the reduction from the tanks' transfer price; the PDF gives no number or final disposition.

Petition record and limits

An unidentified corporation began business in July 1984 and sold its assets to a redacted buyer effective November 30, 1985. It petitioned by August 22, 1986 letter against a state, local, and county liability measured by $1,739,000 of unreported asset sales. Hearing Officer H. L. Cohen held a preliminary hearing in Culver City on October 20, 1987 and signed the Decision and Recommendation on November 6.

The corporation provided oil-exploration services, not services to production wells. When low pressure or viscous oil prevented flow, skilled employees inserted flexible metal tubing and pumped nitrogen into the exploration well. The liquid nitrogen was stored in tanks, dissipated into the atmosphere after injection, and the tubing was recovered and reused. Tubing spools, pumps, tanks, and other specially designed equipment were skid-mounted for transport; most jobs were on exploration ships or drilling platforms outside California waters.

The company also made retail nitrogen sales in California, held a seller's permit for that reason, and reported tax. Over the audit's 17 months, it reported $3,897,078.80 in receipts and $210,052.58 in taxable sales. Regulation 1501's true-object test asked whether the customer sought the service itself or property produced through the service. The recommendation relied on Business Taxes Law Guide Annotation 515.1200 for the conclusion that nitrogen injection for well testing and processing was a service; that service alone would not require a permit.

Retail nitrogen sales required the next question: whether they made all or only part of the asset sale taxable. The hearing officer applied Ontario Community Foundation to isolate assets used in incidental retail sales by a primarily service enterprise. He found the nitrogen sales incidental and said they did nothing to enhance the primary activity, so only the storage tanks were taxable. Unlike the live annotation, the supporting PDF does not call the sales unrelated to the service.

The PDF does not include the August 22 petition, taxpayer or buyer identity, asset-sale agreement, asset inventory or allocation, invoices, nitrogen purchase and sales records, seller's permit, tax returns, job contracts, well records, equipment-use records, California-location evidence, audit workpapers, tax rate or computation, preliminary-hearing transcript or exhibits, nitrogen-tank transfer price, district reduction calculation, redetermination, Board action, payment, appeal, or later outcome. The recommendation says Reduce and Redetermine; it does not establish that either occurred.

The live annotation preserves the service, nitrogen-injection process, permit, incidental-sales characterization, tank-only tax result, other-assets exemption, and November 6, 1987 date. It adds that the nitrogen sales were unrelated to the primary business, a word absent from the supporting analysis. It omits the petition and preliminary-hearing posture, audit period and close-out status, effective sale date, $1.739 million protested measure, receipts and 5.4-percent figures, exploration-only and mostly-offshore facts, equipment and employee details, Regulation 1501, Annotation 515.1200, Ontario, district-calculation instruction, missing records, and absent final Board action.

What this means for you

Service businesses with small product-sales streams

A seller's permit for incidental retail sales did not automatically make every service asset taxable on a business sale.

Accountants and tax professionals

Identify which assets actually support retail sales and whether those sales enhance or integrate with the main service, rather than allocating by permit status alone. This PDF does not supply the tank transfer price or the district's resulting calculation.

Common questions

Q: Why was nitrogen injection treated as a service?
A: Customers sought the skilled well-testing and processing work, while the injected nitrogen dissipated into the atmosphere.

Q: How large were the retail sales?
A: $210,052.58, or 5.4 percent of receipts during the audit period.

Q: Which assets were taxable?
A: The nitrogen storage tanks used in making the retail nitrogen sales.

Q: What happened to the rest of the protested asset value?
A: The recommendation directed the district to reduce the measure to the nitrogen tanks' transfer price, but no calculation or final action appears.

Q: Was the recommendation a final Board decision?

A: No final Board action appears. The document is a hearing officer's recommendation following a preliminary hearing.

Q: Did the source give the tank transfer price?

A: No. It left the reduction calculation to the district.

Citations and references

• California Revenue and Taxation Code §§ 6006.5 and 6367
• California Sales and Use Tax Regulation 1501
• Business Taxes Law Guide Annotation 515.1200 (August 4, 1964)
• Ontario Community Foundation, Inc. v. State Board of Equalization, 35 Cal.3d 811 (1984)
• Petition, asset-sale, equipment, nitrogen, permit, return, service, audit, hearing, valuation, calculation, Board-action, and outcome records — implicated but not included

Verbatim support

From the official November 6, 1987 Decision and Recommendation:

During the seventeen months of the audit period, petitioner reported receipts of $3,897,078.80 and taxable sales of $210,052.58. Taxable sales were 5.4 percent of receipts.

We think the situation here is similar. The primary business of petitioner is the rendition of services. The sales of nitrogen are incidental to this primary business and do nothing to enhance petitioner's primary activity.

Applying Ontario, only the sale of the nitrogen storage tanks should be regarded as taxable.

Reduce the amount subject to tax to the transfer price of the nitrogen tanks. ---District to calculate the reduction. Redetermine without other adjustment.

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Annotation page: Annotation 395.0074.175
• Original supporting opinion: 395.0074.175 PDF

Original ruling text

STATE OF CALIFORNIA
BOARD OF EQUALIZATION

In the Matter of the Petition
for Redetermination Under the
Sales and Use Tax Laws:

Petitioner

)
)
)
)
)
)
)

395.0074.175
11/6/87

DECISION AND RECOMMENDATION
No. ----

The preliminary hearing on the above taxpayer's petition for redetermination was held on October 20, 1987, in Culver City, California. Hearing Officer:

H. L. Cohen

Appearing for Petitioner

Appearing for the Board:

--Protested Items

A petition for redetermination was filed by letter dated August 22, 1986. The protested tax liability for the period July 1, 1984, through November 30, 1985, is measured by: Item

State, Local and County

B. Unreported sale of assets

$1,739,000
Contention

Petitioner contends that the transaction ~n question was an exempt occasional sale. Summary Petitioner is a corporation which was engaged in providing oil field services and in making retail sales of nitrogen. It began in business in July 1984. This first audit was a close-out audit conducted because petitioner sold its assets to --- effective November 30, 1985. Petitioner states that it provides certain services to oil exploration activities. None of its services are performed for production wells. During exploration activities, a well is drilled to evaluate a given zone. In many instances, oil does not flow to the surface because the internal pressure is too low or because the oil is too viscous. The exploration company will then hire petitioner. Petitioner inserts flexible metal tubing into the well and pumps nitrogen gas through the tubing into the well to force oil to the surface. The nitrogen is stored by petitioner in the liquid state. Ultimately, the nitrogen dissipates into the atmosphere. The tubing is pulled back up

and is reused. The equipment, consisting of tubing spools: pumps, nitrogen tanks, etc., is specially designed and is mounted on skids for ease in transportation. The majority of petitioner's jobs are aboard exploration ships or drilling platforms outside California waters. All equipment is operated by petitioner's skilled employees. Petitioner made some retail sales of nitrogen gas inside California. For· that reason, petitioner held a seller's permit and reported tax. During the seventeen months of the audit period, petitioner reported receipts of $3,897,078.80 and taxable sales of $210,052.58. Taxable sales were 5.4 percent of receipts. Petitioner contends that it was engaged in a service business; any sales of tangible personal property were minor and only incidental to the rendition of services. The final sale of assets was therefore an exempt occasional sale. Analysis and Conclusions Section 6367 of the Revenue and Taxation Code exempts occasional sales from tax. Section 6006.5 defines "occasional sale" to include a sale of property not held or used in the course of activities for which a seller's permit is required. If petitioner's activities require the holding of a seller's permit, the exemption does not apply. Sales and Use Tax Regulation 1501 provides that the basic distinction in determining whether a particular transaction involves a sale of tangible personal property or the transfer of tangible personal property incidental to the performance of a service is one of the true object of the contract; that is, is the real object sought by the buyer the service per se or the property produced by the service. We have previously concluded that the injection of nitrogen into oil wells for purposes of testing and processing is a service. See Business Taxes Law Guide, Annotation 515.1200 (August 4, 1964). Petitioner would not be required to hold a seller's permit if this were its only activity. In that case, the occasional sale exemption would apply. Petitioner, however, also made retail sales of nitrogen. The question then is whether the sales of nitrogen result in making all or some part of the sale of equipment taxable. In Ontario Community Foundation, Inc. v. State Board of Equalization, 35 Cal.3d 811, the court held that where an entity which is primarily in the business of furnishing services makes a sale of assets, only receipts from the sale of assets used in making incidental retail sales of tangible personal property will be subject to tax. We think the situation here is similar. The primary business of petitioner is the rendition of services. The sales of nitrogen are incidental to this primary business and do nothing to enhance petitioner's primary activity. Applying Ontario, only the sale of the nitrogen storage tanks should be regarded as taxable. Recommendation Reduce the amount subject to tax to the transfer price of the nitrogen tanks. ---District to calculate the reduction. Redetermine without other adjustment.

11/6/87
H. L. Cohen, Hearing Officer

Date