Was a flat-day-rate horizontal drilling package with specialized equipment and technical personnel taxable in Texas?

Plain-English summary

An oil-and-gas operator hired a horizontal-drilling contractor at a flat daily rate. The contractor supplied extensive downhole and surface equipment plus experts who planned the well, set up and monitored measurement-while-drilling tools, directed the well path, inspected and maintained equipment, and prepared logs and reports. The customer did not control the operators.

The Comptroller treated the package as a nontaxable complex horizontal-drilling service. It was not taxable under either Tax Code Chapter 191 or Chapter 151. Equipment charges were incidental to the service rather than taxable sales or rentals.

The contractor had to pay tax on all materials and equipment used or consumed in providing the service. Charges for lost or damaged equipment, rental-cost reimbursement, or repair-cost reimbursement should be clearly labeled as reimbursements so auditors would not mischaracterize them.

If the contractor actually sold or rented equipment—without the complex advance planning and technical drilling services—it had to collect tax on the sale or rental and on connected service charges.

What this means for you

Horizontal-drilling contractors

The service result rested on the complete factual package: advance planning, skilled operators, continuous monitoring, specialized equipment, and lack of customer control. Supplying equipment with only limited supervision could be treated differently.

Accountants and tax professionals

Invoice wording cannot replace substance, but clear reimbursement labels help show why damage and repair recoveries are not intended as rental or sale charges.

Common questions

Was the flat day rate taxable? No, on the described package.

Were the equipment components separately taxable? No. They were incidental to the service.

Who paid tax on equipment and materials used in the service? The drilling contractor.

What if the contractor merely rented or sold equipment? Those transactions and connected services were taxable.

Citations and references

• Tex. Tax Code Chapter 191 (oil-well service occupation tax)
• Tex. Tax Code Chapter 151 (limited sales, excise, and use tax)
• 34 Tex. Admin. Code Rule 3.324 (oil and gas well services)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9202L1158C02

Original ruling text

February 6, 1992

Dear ***:

Thank you for your recent letter, in which you described
horizontal drilling services provided by your client. According
to your facts:

Company A ("A") is an oil and gas operating company incorporated
and doing business within the state of Texas. Company B ("B") is
a horizontal drilling contractor doing business in the state of
Texas and provides lateral drilling services to "A" on a day work
basis (flat rate per day for services provided). The scope of "B"'s
services is to provide the equipment and technical personnel
necessary to assist a drilling contractor and advise the oil and
gas operating company in the drilling of the horizontal section
of the wellbore from the point of kick-off from the vertical
section to the horizontal section of the wellbore (or curve)
to the total depth of the wellbore. All of these services
are performed inside the wellbore for the purpose of starting or
stimulating production from the well.

"B" provides all equipment necessary to perform the services,
and the equipment remains "B"'s property. "A" is responsible
for repairs resulting from damages, other than ordinary wear
and tear, and for either the purchase cost or lease rate of
additional equipment (such as diamond drilling bits) that
might be required to complete the wellbore path.

"B" supplies "A" with a two-page invoice. Page one contains
the well identification information, a total invoice charge
for both equipment and services, and an invoice description
of "Medium Radius Lateral Drilling Services". Page two contains
daily drilling report information, formation information, and
descriptions of the equipment that may have been required to
perform the described services. You write:

The equipment and personnel services are necessary to provide
location and directional information (Measurement While Drilling)
so that the technicians know the exact location of the
bit and the path it has followed in order to rotate and orient
the drill bit in order for it to turn from vertical, build to
the desired angle and direction, and then change that angle
and direction as desired.

"B" provides the following downhole equipment: angle build
motors, angle hold motors, non-magnetic drill collars, nonmagnetic
flex collars, float subs, orienting subs, measurement
while drilling (MWD) flow subs, MWD downhole tools, drill
string stabilizers, lift subs, crossover subs, float valves,
baffle plates, and magnetic single shot survey kits. "B"
provides the following surface equipment: computers, software,
printers, equipment trailer, and personnel mobile home.

Transportation costs and partial lost-in-hole insurance on
motors, tools, and MWD equipment are also provided. "B"'s
personnel provide the following services:

Services are performed by one or more experts in horizontal
drilling operations (at least one of which is present at the
well site during the entire lateral drilling process from
kickoff point to total depth of well) and include equipment
set-up and rig down, well planning services, horizontal
measurement while drilling requiring constant monitoring,
multishot survey from kick-off point to surface, equipment
inspection services, equipment maintenance and repair services
for normal wear and tear, and preparation of related daily
logs and completion reports.

Personnel subsistence and transportation costs are also provided.

You write also that:

It should be noted that the lateral drilling services
contemplated under the contractual agreement between "A" and
"B" could not be rendered or completed in accordance with "P"'s
contractual obligations and "A"'s expectations under the
agreement without the presence and more importantly the technical
expertise of the personnel provided by "B". The equipment
provided by "B" under the agreement does not setup, operate, and
monitor itself or interpret its own results. The directional
drilling and measurement while drilling technicians provide
integral highly skilled labor necessary to operate, maintain and
complete the services contemplated in the contractual agreement.
Clearly, their duties extend beyond the scope of mere supervisory
services. Additionally, "A" does not exercise any direct control
or supervision over the operator of the equipment in the
performance of his expert services under the contract.

Question: Do the lateral drilling services as described above
being provided by Company "B" constitute a "Nontaxable Well
Service" under Rule 3.324?

Answer: The lateral (horizontal) drilling services described
above do not meet the definition of an "oil well service" under
Chapter 191 (Oil Well Service Occupation Tax) of the Tax Code
and are also not taxable under Chapter 151 (Limited Sales, Excise
and Use Tax) of the Tax Code. Much of the expense of this service
is incurred prior to the arrival of equipment and personnel at
the well site. The charges for equipment used in performing the
described services are incidental to the service transaction and
are not taxable as rentals or sales of equipment.

The service provider ("B") must pay tax on all materials and
equipment used or consumed in the performance of the lateral drilling
services. To avoid confusion, charges to "A" for loss or damage
to equipment or for equipment rental cost reimbursement or repair
cost reimbursement should be clearly labeled as "reimbursement"
charges. Otherwise, they could be mischaracterized in an audit as
taxable sales or rentals.

If "B" does actually rent or sell equipment, with or without a
supervisor, but without all of the complex prior drilling planning
and other technically demanding horizontal drilling services you
have described, then "B" would be responsible for collecting tax
on the rentals and sales, as well as charges for services connected
to those rentals and sales.

However, when "B" performs all of the services you described above,
"B" is performing complex horizontal drilling services rather than
simply furnishing equipment and a supervisor for more generic
horizontal drilling.

This opinion is based on the facts presented. Different facts,
though similar, might lead to different answers. If you have
further questions, feel free to write or call me at 1-800-252-5555,
ext. 3-3889.

Sincerely,

John Christian
Attorney
Tax Administration Division