United States

Texas: Taxpayer Providing Labor and Materials for Oil Well Construction Entitled to Deduct COGS

Mar 14, 2016
From KPMG TaxWatch

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Recently, a Texas appeals court held that a taxpayer providing data to oil and gas companies was entitled to deduct costs of goods sold (COGS) in computing its Texas franchise tax liability. Under Texas law for the 2008 tax year at issue, a taxpayer’s franchise tax was based on (1) total revenue minus COGS or compensation, or (2) 70 percent of total revenue. Generally, only sellers of goods were allowed to deduct COGS. An exception applied for taxpayers furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance of real property. The taxpayer at issue collected seismic and geophysical data and processed the data to generate images of the earth and sound recordings.  The images and recordings were used by customers for use in producing oil and gas from onshore and offshore locations. After a desk audit, the taxpayer’s COGS deduction was disallowed on the basis that it was a service provider not entitled to deduct COGS. The taxpayer disagreed with the adjustment, arguing that its costs were incurred exclusively for the "construction, repair, or industrial maintenance” of oil and gas wells, which are real property, and were therefore deductible as COGS. Alternatively, the taxpayer argued that the visual images and recordings it sold were “goods” and therefore it was a seller of goods. After a trial court ruled that the taxpayer was entitled to deduct COGS, the Comptroller appealed.

Before the appeals court, the key question was whether the taxpayer was providing “labor and materials” for the construction of oil and gas wells, or was simply providing services to the oil and gas companies. The appeals court noted that in another case addressing the same issue, it had concluded that the legislature intended to permit taxable entities to deduct a wide range of labor expenses, including those associated with activities that might also be described as a "service."  To determine whether a particular "labor cost" is includable as a COGS, it is necessary to examine whether the activity is an essential and direct component of the "project for the construction . . . of real property."  After reviewing the record, the appeals court concluded that the trial court did not err when it held that the taxpayer’s seismic services and products were an "integral, essential, and direct component" of the drilling process. Evidence established that the taxpayer’s seismic data provided a "roadmap" or "blueprint” for oil and gas well construction projects. Specifically, the data and recordings were used to determine where to drill and how deep to drill.  Without the information provided by the taxpayer, an oil and gas exploration and production company could not reasonably go out and drill a well. The court next rejected the Comptroller’s argument that the taxpayer’s activities were too far removed from the actual construction of a well to qualify. In other words, the state argued that because the wells had generally not yet been constructed when the taxpayer provided its data, its “labor” was not directly related to a construction project.  Although the court recognized that at some point a taxpayer’s activities on a particular project may be too far removed to qualify, the state had not tried to distinguish which of the taxpayer’s activities were too distant from an actual construction project. In addition, there was evidence that the taxpayer’s surveying at times took place after a well was drilled. Please contact Doug Maziur at 713-319-3866 with questions on Hegar v. CGG Veritas Services. 

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.