Is a drilling contractor's charge for oil/gas well drilling services a taxable equipment rental or a tax-exempt service, and does it matter who physically operates the equipment?

Plain-English summary

An oil and gas operator asked the Commission whether directional/horizontal drilling services on a Utah well are subject to sales tax, in two rounds of correspondence. The first, simpler question: is a drilling contractor's charge (services only, no equipment sold) taxable? The follow-up added a more complex real-world fact pattern: the operator hired one contractor ("Vertical") to drill a vertical bore and a separate, unrelated contractor ("Horizontal") to make the turn from vertical to horizontal partway through -- with Horizontal's own employees attaching their equipment to Vertical's drill stem and directing the turn, while Vertical's crew physically operates the drill stem under Horizontal's direction. Horizontal billed the operator sales tax on its charges; the operator refused to pay, arguing drilling services aren't taxable.

The Commission's rule, refined across both letters:

• If the contractor supplies the equipment but the CUSTOMER supplies (or controls) the operator -- even if the contractor merely sends someone to observe -- the entire charge is a taxable equipment rental.
• If the contractor supplies BOTH the equipment AND an operator/supervisor who exercises EXCLUSIVE CONTROL over the equipment, the contract is a tax-exempt service.
• The dividing line is control of the drilling operation, not who is physically operating the machinery. A customer's supervising employee simply being on-site is itself evidence the customer retained control (pointing toward a taxable rental) -- but if the contractor's employee/supervisor genuinely directs the work, the transaction stays an exempt service even if someone else's hands are literally on the controls.

Applied to the two-contractor horizontal-drilling scenario:

• Operator-to-Vertical: exempt service, so long as Vertical (not the operator) controls and supervises its own drilling.
• Operator-to-Horizontal: this is where it gets interesting. Even though no equipment physically passes between Horizontal and Vertical (Horizontal's gear attaches directly to Vertical's drill stem), if Vertical ends up controlling the overall drilling operation rather than Horizontal directing it, then Horizontal is effectively just renting its equipment to the operator -- a taxable rental, because the Commission found the operative rental relationship runs between Horizontal and the operator, not between Horizontal and Vertical. If instead Horizontal directs and controls the turning operation (even while Vertical's employee physically operates the drill stem under Horizontal's direction), Horizontal is providing a non-taxable service.

The Commission explicitly agreed with the operator's own reasoning that "who is operating the equipment" is not the test -- control and direction of the operation is.

What this means for you

Oil and gas operators structuring drilling contracts

Whether you owe sales tax on a drilling contractor's charges depends on who's actually calling the shots during drilling, not on whose crew's hands are on the equipment. If you want a service contract (nontaxable), make sure the contractor -- not your own on-site supervisor -- retains real control and direction of the operation; having your own employee simply observe on-site can itself be read as evidence you retained control.

Drilling contractors (especially multi-contractor jobs like vertical/horizontal combinations)

Watch who exercises control when your equipment gets attached to or operated alongside another contractor's equipment. Even without any direct equipment transfer between contractors, you can end up as an effective "renter" to the ultimate customer -- and thus liable for tax-collection duties on that transaction -- if the OTHER contractor ends up controlling your equipment's use.

Accountants classifying drilling and similar equipment-plus-labor service contracts

This ruling's control test generalizes beyond drilling to any equipment-plus-operator arrangement: look past who physically runs the machine and identify who directs and supervises the work. That's the same control-based framework worth applying to other Utah equipment-with-operator scenarios.

Common questions

Q: Is a drilling contractor's service charge always taxable in Utah?
A: No, per this ruling -- it's exempt as a service if the contractor supplies both the equipment and an operator/supervisor who exercises exclusive control over it.

Q: Does having my own employee on-site to observe make an otherwise-exempt drilling contract taxable?
A: It can be evidence of taxability, per this ruling -- requiring your supervising employee to be on-site during drilling is cited as evidence that the customer, not the contractor, retained control.

Q: If one contractor's equipment is operated by ANOTHER contractor's crew, who owes the tax?
A: Per this ruling, it depends on who controls the overall operation -- if the operating contractor (not the equipment-owning contractor) ends up directing things, the equipment-owning contractor's charge to the ultimate customer is treated as a taxable rental.

Q: Does it matter whose hands are literally on the drilling equipment?
A: No, per this ruling -- the Commission explicitly agreed that "who is operating the equipment" does not determine taxability; control and direction of the operation does.

Q: Can another multi-contractor drilling arrangement rely on this ruling directly?
A: Not automatically -- it binds the Commission only for the taxpayer and the specific vertical/horizontal drilling facts presented. The Commission advised carefully reviewing the actual agreements and operations in any other case to determine tax liability.

Source

• Landing page: https://tax.utah.gov/commission/rulings/
• Original PDF: https://files.tax.utah.gov/tax/commission/ruling/95-090.pdf

Original ruling text

95-090

Response
July 26 1995 and December 19, 1995

Request

XXXXX

RE: Advisory
Opinion - Applicability of Sales Tax to Drilling Services

Dear
XXXXX

You requested an advisory opinion as
to whether directional drilling services associated with oil and gas wells are
subject to sales tax. Your letter
indicated that the drilling contractor provides drilling services only and does
not sell XXXXX drilling equipment or other tangible personal property.

Our research indicates that drilling
contractors such as XXXXX have been instructed by our Auditing Division that
certain types of drilling contracts amount to taxable equipment rentals The
distinction is as follows

If the contract calls for XXXXX to
provide drilling equipment, but XXXXX provides the equipment operator, the
transaction is deemed as taxable equipment rental. Even if XXXXX provides an employee to observe or supervise the
drilling operation, the entire contract price is taxable.

If the contract calls for XXXXX to
provide drilling equipment and an operator, the contract is viewed as a tax
exempt contract for services.

Your letter does not detail which
type of arrangement XXXXX has with XXXXX, so we cannot determine whether your
contracts are taxable. If you would
like to provide us with more detailed information, we will be happy to issue
you a more specific opinion.

For
the Commission,

Alice
Shearer

Commissioner

Ms.
Alice Shearer

Tax
Commissioner

Utah
State Tax Commission

210
North 1950 West

Salt
Lake City, UT 84134

Re: Advisory
Opinion - Applicability of

Sales Tax to Drilling
Services

XXXXX

Dear
Commissioner Shearer:

I originally thought the advisory
opinion you offered on XXXXX would be sufficient but, as always, new facts have
occurred. Would you please elaborate on
the same theme but with this factual situation:

XXXXX decides it wants a horizontal
well drilled at a certain spot in Utah. (Remember a horizontal well starts out
as a vertical bore, but the bore is turned horizontal after the vertical
drilling is completed.) XXXXX retains a
drilling contractor to drill the well (�Vertical�) and a separate contractor
(�Horizontal�) to make the turn in the bore from vertical to horizontal. �Horizontal� is not a subcontractor for �Vertical.�

XXXXX's employees supervise the
drilling operation but do not operate the drilling equipment. XXXXX does not rent or lease equipment used
in the drilling operation.

�Vertical� and �Horizontal� each own
their equipment brought to the job site.

When the time comes to make the turn
to horizontal, �Horizontal� employees attach their equipment to the drill stem
then monitor the program as �Vertical� operates the drill stem.

�Horizontal� has billed XXXXX for
taxes on its drilling services. XXXXX
has refused to pay the taxes maintaining drilling service is not taxable. �Horizontal� says it has been told its
drilling service is taxable because �Vertical� operated �Horizontal's�
equipment.

My reasoning on non-taxability is
based upon the factual situation: �Vertical� is not renting equipment from
�Horizontal.� The question of who is
�operating� equipment does not determine taxability. Even if it is determined �Vertical� is operating �Horizontal's�
machines, that fact does not render this transaction taxable unless
�Vertical� is renting equipment from �Horizontal.�

As you can imagine, �Vertical� has a
special responsibility. He is operating
a long drill stem several thousand feet into the ground; �Horizontal� does not
want to be responsible for operating that drill stem, only for making the turn
at a designated spot. But �Horizontal�
cannot make the turn without �Vertical� operating the drill stem in a precise
manner as directed by �Horizontal.

Meanwhile, XXXXX watches, hopes to
strike oil, and pays the bills for drilling services. Should it be paying Utah sales taxes on �Horizontal's� charges
when it is not asked to pay sales taxes on �Vertical's� charges?

I would appreciate a prompt
response.

Yours
truly,

XXXXX

XXXXX

RE: Advisory Opinion - Applicability of Sales
Tax to Drilling Services.

Dear XXXXX

We
have received your request for additional information regarding the application
of sales tax to drilling services.
Before answering your most recent questions, we would like to take this
opportunity to clarify our prior response.
Our staff in the Auditing Division expressed concern that our July 26
advisory opinion failed to adequately explain the distinction between taxable
and non-taxable rentals. To restate our
position on your first inquiry

1. If the contract calls for XXXXX to
   provide drilling equipment, but XXXXX provides the equipment operator, the
   transaction is deemed as taxable equipment rental. Even if XXXXX provides an employee to observe the drilling
   operation and the drilling operation is under XXXXX's control, the entire
   contract price is taxable.

2. If the contract calls for XXXXX to
   provide drilling equipment and an operator or supervisor who exercises
   exclusive control over the equipment, the contract is viewed as a tax exempt
   contract for services.

The
distinction between a contract for services and a rental of equipment turns on
who controls the drilling operation.
For instance, if XXXXX's enters an agreement with XXXXX that requires
XXXXX to supply an equipment operator who will work under the exclusive
direction of a XXXXX supervisor or employee, XXXXX is retaining control over
the drilling operation. In that case,
XXXXX is providing a non-taxable service as described in number 2 above. If, on the other hand, XXXXX controls
decisions regarding the equipment, XXXXX is merely renting equipment. Such transaction is taxable, even if XXXXX
supplies an employee to operate the equipment or to observe the work. If XXXXX requires that their supervising
employee be on-site during the drilling operations, that is evidence that XXXXX
has retained control of the operations.

Turning
to your latest request for advisory opinion, we find as follows:

If
XXXXX hires a contractor to drill a vertical well (Vertical), and Vertical
supplies the equipment and operator, the transaction is a non-taxable contract
for service so long as the Vertical, and not XXXXX, exercises control and
supervision over the drilling operation.
If XXXXX directs the drilling operation, the transaction is taxable as
an equipment rental as described in #l above.

If
XXXXX hires a second contractor to drill horizontally (Horizontal), and
Horizontal supplies his own equipment and operator, the same rule applies. However, in the scenario that you describe,
the transaction between XXXXX and Horizontal may be taxable. If Horizontal supplies the equipment, but
Vertical controls the drilling operation, then Horizontal is merely renting its
equipment rather than selling its services.
By your description, if there is a rental transaction, it occurs between
Horizontal and XXXXX -- not Horizontal and Vertical. Therefore, XXXXX is liable for sales tax on the rental
transaction. If, on the other hand,
Horizontal takes control of and directs the operation while its equipment is
attached to Vertical's equipment, Horizontal is providing non-taxable
services. In that case, the transaction
is a non-taxable contract for services, even if Vertical's employee operates
the drill under Horizontal's direction.

As
you can see, we agree with you that taxability does not turn on who is
operating the equipment. It turns on
who is controlling and directing the drilling operation. We advise you to carefully review the
agreements and the actual operations to determine XXXXX's tax liability.

For
the Commission,

Alice
Shearer

Commissioner