Were a directional driller's day-rate tools, operators, standby charges, and separately billed equipment taxable rentals?

Plain-English summary

A directional-drilling company designed horizontal well paths and drill assemblies, supplied specialized tools and a measurement-while-drilling unit, and sent trained personnel to direct, calibrate, and monitor the equipment. A separate drilling contractor operated the rig under the company's instructions. Contracts could use a combined day rate or separately state supervision, tools, added equipment, and standby time.

The Comptroller treated the arrangement as a nontaxable well service, not a rental, because the customer did not control either the equipment or its operators and the directional-drilling company planned the well and used the tools to perform its service. The facts rebutted invoice-based rental presumptions under Rules 3.294 and 3.324 even when equipment charges appeared separately.

Standby charges and charges for extra tools also remained part of the nontaxable service when the directional-drilling company used the equipment to perform the work. But if someone other than that company used the equipment, the transaction became a taxable rental.

The company had to pay tax on equipment it used to perform the nontaxable service. The letter also addressed past tax collected on charges mislabeled as rentals: all amounts collected as tax had to be remitted, and the state would refund them only after the company first refunded the customers who paid them, following Rule 3.325.

What this means for you

Oilfield service companies

Separate equipment lines do not automatically turn a controlled well-service package into a rental. The key facts were who planned the well and who exercised control over the equipment and operators.

Accountants and tax professionals

Distinguish equipment the service provider uses from equipment handed over for another person to use. The former stayed inside the nontaxable service on these facts; the latter was a taxable rental.

Common questions

Did a single day-rate charge make the package a nontaxable service? The single charge supported a service presumption, but the Comptroller also relied on the company's planning and control of the equipment and operators.

What if tools and supervision were billed separately? The facts still rebutted the rental presumption because the company used the tools to perform its own well service.

Were standby charges taxable? Not when they related to equipment used as part of the nontaxable service.

When did equipment become a taxable rental? When it was used by someone other than the directional-drilling company.

Could the company recover tax collected in error? Only after refunding that tax to the customers who paid it and then following the refund procedure in Rule 3.325.

Citations and references

• Tex. Tax Code § 151.0101 (taxable services)
• 34 Tex. Admin. Code Rule 3.294 (rental and lease presumptions)
• 34 Tex. Admin. Code Rule 3.324 (oil, gas, and mineral well services)
• 34 Tex. Admin. Code Rule 3.325 (refund procedure)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9203L1165C01

Original ruling text

March 3, 1992

Dear **:

Thank you for your request for a ruling regarding the
application of sales tax to charges connected with
directional or horizontal drilling of an oil well.

Your company, *****, is in the business of manufacturing
oil well drilling tools for sale and rent to the oil drilling
industry. The company also performs directional drilling
services and inspection and repair of oil well drilling tools.

In addition to renting directional drilling tools used
in generic directional drilling to industry, ***
also performs horizontal drilling services which are
more technically demanding.

** has developed a measurement while drilling
(MWD) unit(consisting of an instrument probe and pulser
unit which are part of the bottom hole assembly, and an
above ground receiver unit which analyzes data transmitted
by the equipment at the bottom) which is used in conjunction
with a down-hole motor and other equipment to supply data
regarding the location of the bottom hole assembly, and
allows very precise drilling around or through geological
formations.

** has also created proprietary computer models
which recommend horizontal directional drilling methods,
using the equipment manufactured by the company. *
employs personnel trained in using these computer models
and directional drilling equipment.

Essentially I understand the facts to be as follows: In
a horizontal drilling job ** designs and plans
the well path to interest all desired targets. **
also designs and plans the drilling assembly configuration,
and designs the drill string. The tool assembly designed
is comprised of * tools and equipment rented by
**** from third parties. This part of the service
is not performed at the well site.

At the well site, the general drilling operations are normally
managed by a drilling contractor hired by *'s customer.
(** in not hired by the drilling contractor.)
* personnel ensure the assembly has
arrived intact and calibrates the tools if necessary.
Drilling contractor personnel install the tool assembly in
the drill string under the direction of the *
company supervisor and operate the rig which controls the
drill string while the directional equipment is in the hole.
**** personnel instruct the driller on how to employ
the equipment.

** monitors the performance of the equipment while
in the hole. **** personnel also instruct the drilling
contractor personnel as to the appropriate settings necessary
to direct the drilling angle.

Upon completion of the job, drilling contractor personnel detach
the tool assembly from the drill string, under the supervision
of ** personnel.

Standard contract terms hold customer (not the driller)
responsible for the safety of the equipment. The invoicing
for jobs in the past contained separate charges for
equipment used in the job and for planning, supervisor's
services and other personnel services. The billing could
also include charges for standby time while the tool was at
the rig but not in use.

Recently, the new contractors set out a combined day rate for
a service/rental package which includes planning the
drilling program, directional supervisors, technical support
during drilling, rental of a complete set of horizontal
tools and a MWD unit with operators. An invoice pursuant to
this contract would reflect a single charge for both
personnel and equipment included in the day rate package.
Any equipment used in addition to tools listed in the
contract is separately billed to the customer at standard
rental rates. Stand-by charges apply to the additional
equipment.

The questions you ask and my responses are:

1. Are the services performed by the horizontal drilling
   supervisors and/or the MWD operators (a) nontaxable services
   (b) services taxable pursuant to Law Section 151.0101 as
   interpreted by Section 3.324, or (c) part of the tax base
   as an expense connected with a rental of equipment pursuant
   to Rule Section 3.324 (c) (1)?

Answer: These are non-taxable services. The providing of
equipment with an operator for a single day rate charge is
presumed to be a service. The separate billing for
equipment as a rental from the charge for an operator is
presumed to be a rental with an operator.

In this case, after reviewing the facts you submitted in
your letter, it appears that the customer neither exercises
control over the equipment nor over the operator of the
equipment. (You stated in your letter that your customer
believes the transactions are non-taxable "services" rather
than rentals.) We agree. Instead, the driller or **
and the driller jointly operate some of the equipment (bottom
hole) since both exercise a degree of control over that
**** ground equipment (MWD).

Because ** plans the well, the nature of the transaction is
that * (assisted by the driller) is using equipment in
performing a service (drilling a well) for the customer
rather than renting equipment to the customer and operating
it. Included in the service is any equipment *** uses in
addition to the tools listed in the contract and separately
billed to the customer.

2. Rule 3.294 establishes certain presumptions regarding
   the incidence of tax based on the presentation of
   service and rental charges on the invoice. Please
   explain the application of these rules to the specific
   situations described below.

a. When a customer requests horizontal directional
drilling services with Company equipment and the
invoice states the supervision charge separately
from the tool rental charges, is the Company
obligated to collect tax on the rental receipts
from the customer, or is the presumption of a
rental refuted by the facts outlined above?

Answer: The facts outlined above will sufficiently rebut
the presumption that a rental has occurred. The pertinent
rule is 3.324 (b)(5) which addresses this issue. It holds
that the term "rentals" in many well services billings are
not rentals as addressed in Rule 3.294.

b. When a customer requests MWD services and
equipment and the invoice states the service charge for
the operator separately from the tool rental charges,
is the Company obligated to collect tax on the rental
receipts from the customer, or is the presumption of a
rental rebutted by the facts outlined above?

Answer: Same as for situation a. Rule 3.324 addresses
these questions.

c. If in either of the above situations [(a) or (b)],
it is determined a rental has not occurred, what
is the proper sales tax treatment of stand-by
rental charges for idle tools?

Answer: Rule 3.324 (b) (4) does not allow tax to be
collected on any portion of the charge for a non-taxable
service. This is still the case even though the portion of
the service charge in question is associated with a charge
called a rental.

d. If the invoices described in Question 1 or 2
stated a single charge for both services and
equipment pursuant to the "day-rate contract"
described in the factual discussion, upon whom,
the Company or the customer, does the tax fall?
Would the Company be obligated to collect tax on
separately stated rents for equipment supplied in
addition to the contract tool list?

Answer: Under both Rule 3.294 and Rule 3.324, * would be
required to pay tax on the equipment used to perform a non-taxable
service for a single charge. The charge for equipment supplied in
addition to the contract tool list is considered part of the charge
for the service, if it is also used by ** to perform the
service. However, if the equipment is used by someone other than
***, the transaction is a rental and the charge is taxable.

3. If in prior periods, the Company has treated the
   separate charges for tools in the transactions
   described in Question 2 as taxable equipment rentals
   pursuant to the rule regarding presumptions, will the
   State refund to the Company taxes collected on the
   "rentals" in prior periods if the determination is that
   a rental has not occurred?

Answer: Money collected as tax, whether in error or
correctly, must be remitted to the state. The person who
collected it has no right to keep it. The state will refund
tax to a person who collected it in error only after it has
been refunded to the person from whom it was collected. If
you wish to obtain refunds for your customers who paid the
tax to you, Rule 3.325 (enclosed) addresses the procedure.

This opinion is based on the facts presented. Other facts
though similar may provide a different result.

If you have other questions or need more information please
call or write. The toll-free number is 1-800-531-5441; my
extension is 3-4675. The regular number is (512)463-4675.

Sincerely,

Tom Soto
Tax Administration