When was directional drilling a nontaxable service rather than a taxable equipment rental in Texas?

Plain-English summary

The Comptroller distinguished two directional-drilling arrangements based on who planned and controlled the work.

In the first arrangement, the directional drilling company performed the engineering and planning, quoted a lump-sum price, supplied all necessary equipment and personnel, controlled when specialized equipment was attached to the drill pipe, and monitored compliance with its own drilling guidelines. The Comptroller treated that arrangement as a nontaxable drilling service, not an equipment rental.

The company still owed tax on equipment used to provide the nontaxable service. If the same equipment was also rented in taxable transactions, it could be bought with a resale certificate, but the company then had to accrue tax on the equipment's fair-market rental value while using it in its nontaxable service business.

In the second arrangement, the oil and gas customer created its own drilling plan and hired the directional drilling company only to supply tools and a supervisor who advised the customer and monitored the equipment. The Comptroller treated that arrangement as a taxable equipment rental because the supervisor's role was advisory and the customer had developed the drilling guideline.

What this means for you

Directional drilling companies

The label on the contract was not decisive. The letter looked at the substance of the arrangement: planning the well and controlling the specialized equipment supported service treatment, while supplying tools under the customer's plan with only advisory supervision supported rental treatment.

Accountants and tax professionals

Equipment can move between taxable rentals and nontaxable service use. The letter allowed resale-certificate treatment for dual-use equipment but required tax accrual on fair-market rental value during nontaxable service use.

Common questions

Was the lump-sum integrated drilling arrangement taxable? No. On the stated facts, it was a nontaxable service.

Why was the call-out arrangement taxable? The customer developed the drilling plan, while the directional drilling company supplied equipment and a supervisor only in an advisory role. The Comptroller characterized that as equipment rental.

Who paid tax on equipment used in the nontaxable service? The drilling company had to pay tax when purchasing the equipment, unless it used a resale certificate because the equipment was also rented; in that case it had to accrue tax on fair-market rental value during service use.

Citations and references

The letter cited no specific statute or rule.

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9203L1165D07

Original ruling text

March 4, 1992

Dear ****:

Thank you for your letter of February 12, 1992, concerning
the tax responsibilities of a directional drilling company (DDC).

You stated in your letter, that some DDC's are charging tax
on the entire cost for their services while others are not.

The confusion stems from whether a DDC is providing a
non-taxable service (i.e. drilling an oilwell and providing the
necessary equipment) or providing a taxable rental of equipment
(i.e. rental of drilling equipment without a operator).

You have provided two situations which I have re-stated in
part with response.

Situation 1:

Integrated Engineering Services Drilling -A DDC performs the
engineering and planning required to provide a drilling guideline
for drilling from point A to point B. The DDC provides their client
a lump-sum contract price for completing the drilling within a
specified number of days. The contract provides for a separate
charge per day if extra drilling time is required in excess of the
contracted number of days. The DDC provides all necessary equipment
and personnel for the drilling. The DDC supervisor controls when the
specialized equipment is attached to the drill pipe by the client's
personnel. The DDC supervisor then monitors the progress of the
drilling to ensure compliance with the original DDC drilling guidelines.
Upon completion of the contract, the DDC bills the client the contracted
price plus sales tax.

Question:

Is this type of directional drilling service subject to tax?
Is the DDC providing a service or is the entire charge considered
an equipment rental? The client's intent was to acquire a service.

Response:

This is a non-taxable service. Tax must be paid on the drilling
equipment used to perform this service at the time of purchase.
Equipment that is used to provide a non-taxable drilling service and
is also rented in a taxable manner (see Situation 2) may be purchased
tax free by issuing a resale certificate in lieu of tax. However, tax
must be accrued on the fair market rental value of the equipment when
being used for a non-taxable service.

Because the DDC plans the well, the nature of the transaction is that
the DDC (assisted by the drilling operator) 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 the DDC uses in addition to the tools listed
in the contract and separately billed to the customer.

Situation 2:

Call Out Services -A large oil and gas company has its in-house
engineers prepare the planning and engineering required to perform
directional drilling of their well. This company contacts a DDC
and arranges for a DDC supervisor and DDC tools to be at a specified
well site for a specified period of time to advise the oil and gas
company during the directional or horizontal drilling phase. The DDC
supervisor would also monitor the performance of the DDC equipment to
ensure it is performing in a manner according to the plan developed
by the oil and gas company.

Question:

Is this type of transaction subject to the limited sales tax?

Response:

This is a taxable equipment rental. The supervisor provided with
the equipment is provided only for advisory purposes. The drilling
guideline has been developed by the customer.

This opinion is based on the facts presented. If there are
any additional or different facts, the opinion may change.

If you have any questions or need additional information, you
may call toll free 1-800-252-5555 or the regular Austin number
is 512-463-4600. You may also write to Tax Administration Division.

Sincerely,

Lindey Osborne
Tax Administration Division