Does a joint development agreement between two unrelated oil-and-gas companies create a separate taxable entity for Texas franchise tax purposes, and can each company still deduct its own cost of goods sold?

Plain-English summary

This is the ruling later cited as STAR Accession No. 201712002L in a separate hospital-district/radiologist joint venture ruling elsewhere in this corpus (STAR 202106021L) as guidance on when a joint development agreement creates a taxable joint venture.

Two unrelated oil-and-gas companies (Company A and Company B, with no ownership stake in each other) entered into a Joint Development Agreement to develop certain oil, gas, and mineral leasehold interests. Company A made an upfront lump-sum payment; in exchange it gets a 75% interest in wells it drills, while Company B keeps a 25% interest. Under an attached Joint Operating Agreement, Company A operates the wells and pays expenses (billing Company B its share), and each company takes its own share of production "in kind" (physically, rather than as cash) and markets it separately. For federal tax purposes, the arrangement created a "tax partnership" that never elected out of federal partnership treatment under IRC § 761(a).

The Comptroller ruled this joint arrangement is a taxable joint venture for Texas franchise tax: the companies are engaged in the joint prosecution of a particular transaction (oil exploration and production in the development area) for mutual profit — the statutory definition of "joint venture" — and because they didn't elect out of federal partnership treatment, they don't qualify for the statutory carve-out that would otherwise exclude certain co-ownership/joint-operating arrangements.

But that didn't leave each company worse off on cost of goods sold: the Comptroller separately ruled that each company can still deduct its own qualifying contribution to the joint venture in its own COGS calculation, since the production is distributed to each company in kind (not sold by the joint venture itself) and each company's contribution funded activities that would otherwise qualify as cost of goods sold.

What this means for you

Oil-and-gas companies structuring joint development/operating agreements

An arrangement where you and an unrelated party jointly develop leasehold interests, share expenses, and each take production in kind is likely to be treated as a separate taxable joint venture under Texas franchise tax — UNLESS you affirmatively elect out of federal partnership treatment under IRC § 761(a) and meet the requirements of Treasury Regulation § 1.761-2(a)(3). Simply calling the arrangement an "operating agreement" rather than a partnership doesn't avoid this result.

Any industry using joint development/cost-sharing structures for production of goods

Even when a joint arrangement is itself a taxable entity, that doesn't strip the individual participants of their own COGS deduction for goods they take in kind — Section 171.1012(c)(13) lets each partner include its qualifying contribution in its own cost of goods sold calculation, so the joint-venture classification and the COGS analysis are separate questions with separate (and here, favorable-to-taxpayer) answers.

Accountants and tax professionals

This ruling is the direct precedent cited in STAR Accession No. 202106021L (also in this corpus) for the "joint development agreement creates a joint venture" analysis — useful to read the two together if a client's arrangement resembles either fact pattern (oil-and-gas production sharing here; a hospital-district/physician revenue-sharing deal there).

Common questions

Q: Does electing out of federal partnership treatment avoid Texas joint-venture classification for a joint development agreement?
A: It can — the statutory carve-out in Section 171.0002(a) excludes joint operating/co-ownership arrangements that meet Treasury Regulation § 1.761-2(a)(3) and elect out of federal partnership treatment under IRC § 761(a). This arrangement didn't make that election, so it didn't qualify for the carve-out.

Q: If a joint venture is itself a separate taxable entity, do the individual participants lose their own COGS deduction?
A: No — this ruling confirms each participant can still deduct its own qualifying contribution to the joint venture as cost of goods sold under Section 171.1012(c)(13), as long as production is distributed to it in kind and its contribution funded qualifying activities.

Q: Is this ruling cited elsewhere in Texas STAR guidance?
A: Yes — it's cited as precedent in STAR Accession No. 202106021L (also in this corpus), a later ruling analyzing whether a hospital district's revenue-sharing agreement with radiologists created a taxable joint venture.

Citations and references

Statutes and rules:

• Tex. Tax Code § 171.001 (Tax Imposed)
• Tex. Tax Code § 171.0002 (Definition of a Taxable Entity)
• Tex. Tax Code § 171.0002(a) (carve-out for co-ownership arrangements electing out of federal partnership treatment)
• Tex. Tax Code § 171.1012(c) (direct costs of acquiring or producing goods)
• Tex. Tax Code § 171.1012(c)(13) (COGS — partner's contribution to a partnership distributing goods in kind)
• 26 U.S.C. § 761(a) (election out of federal partnership treatment)
• 34 Tex. Admin. Code Rule 3.581(b)(10) (Margin: Taxable and Nontaxable Entities — "joint venture" defined)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=MAR
• Opinion: https://star.comptroller.texas.gov/view/201712002L

Original ruling text

December 11, 2017

Re: Private Letter Ruling No. 201010157.

Dear **:

We issue this private letter ruling in accordance with Rule 3.1, Private Letter Rulings and General Information Letters. [ENDNOTE 1] We are responding to your request originally dated May 31, 2013. Detrimental reliance relief is provided in accordance with Rule 3.10, the Taxpayer Bill of Rights.

You requested guidance regarding whether a joint development agreement creates a taxable entity for Texas franchise tax purposes.

Facts Presented

** (COMPANY A) and ** (COMPANY B) are not affiliates or related parties. Neither owns an interest in the other.

COMPANY A and COMPANY B entered into a Joint Development Agreement (JDA) that provides the terms for the development of certain oil, gas, and mineral leasehold interests maintained by COMPANY B . Under the terms of the JDA, COMPANY A made an initial lump sum payment to COMPANY B from which COMPANY B agreed to maintain certain current leases (the Development Area). COMPANY A receives a 75% interest in any wells it drills in the Development Area, while COMPANY B maintains a 25% interest.

Exhibit C to the JDA is a Model Form Operating Agreement (JOA) entered into between COMPANY A and COMPANY B . Under the JOA, COMPANY A is the operator and COMPANY B is the non-operator. Several exhibits to the JOA are relevant to this PLR, including: Exhibit C, Accounting Procedure Joint Operations; Exhibit E, Gas Storage and Balancing Agreement; and Exhibit F, Tax Partnership Provisions.

As the operator, COMPANY A is responsible for paying all expenses. COMPANY A then charges COMPANY B for its respective share of the total expenses. For federal tax purposes, the parties’ contributions for expenses are treated as capital contributions.

Under the JOA, COMPANY A and COMPANY B take their proportionate shares of the oil and gas produced in kind and then market it separately. The Gas Storage and Balancing Agreement states that if any party fails to take in kind or separately dispose of its proportionate share of the oil or gas produced, COMPANY A can purchase the product or sell it to others on behalf of the non-taking party.

For federal income tax purposes, the JDA creates a tax partnership, described as the COMPANY A-B Tax Partnership. See Exhibit F, Tax Partnership Provisions. The COMPANY A-B Tax Partnership did not elect out of federal partnership treatment, as provided by Internal Revenue Code, Section 761(a).

The COMPANY A-B tax partnership reports no revenue on its federal Internal Revenue Service Form 1065, U.S. Return of Partnership Income, because COMPANY A and COMPANY B take production from wells in the Development Area in kind.

Questions, Rulings, and Analysis

Our restatements of your questions are shown below, followed by our responses and analysis.

Question One: Does the joint operating agreement and tax partnership entered into by COMPANY A and COMPANY B create a taxable entity for Texas franchise tax purposes?

Ruling: Yes. The COMPANY A-B Tax Partnership created by the joint operating agreement between COMPANY A and COMPANY B is a taxable entity for Texas franchise tax purposes.

Analysis:

The franchise tax applies to each taxable entity doing business in Texas or organized in Texas. Section 171.001 (Tax Imposed). Section 171.0002 (Definition of a Taxable Entity) identifies all entities that are considered “taxable entities” and specifically includes a “joint venture.”

The term joint venture is not defined within Chapter 171 of the Texas Tax Code. Rule 3.581(b)(10) (Margin: Taxable and Nontaxable Entities), defines “joint venture” to mean a “partnership engaged in the joint prosecution of a particular transaction for mutual profit.”

Section 171.0002(a) provides additional guidance as to what will not be considered a joint venture for franchise tax purposes:

A joint venture does not include joint operating or co-ownership arrangements meeting the requirements of Treasury Regulation Section 1.761-2(a)(3) that elect out of federal partnership treatment as provided by Section 761(a), Internal Revenue Code.

Under the terms of the JOA, COMPANY A and COMPANY B are engaged in the joint prosecution of a particular transaction – oil exploration and production in the Development Area – for mutual profit. The COMPANY A-B Tax Partnership is therefore a joint venture under Rule 3.581(b)(10). Further, the COMPANY A-B Tax Partnership did not elect out of federal partnership treatment, as provided by Internal Revenue Code, Section 761(a), so it does not meet the exclusion set out in Section 171.0002(a).

Question Two: If the joint operating agreement and tax partnership does create a taxable entity for Texas franchise tax purposes, are COMPANY A and COMPANY B each entitled to deduct the portion of the costs of goods sold associated with the production that each takes in kind?

Ruling: COMPANY A and COMPANY B can each include the amounts of its contribution to the joint venture that would qualify as cost of goods sold as provided in Section 171.1012(c)(13) (Determination of Cost of Goods Sold).

Analysis:

A taxable entity’s cost of goods sold includes all of the direct costs of acquiring or producing the goods. Section 171.1012(c). In the case of a partnership, each partner may include its partnership contributions in its own cost of goods sold calculation if: (i) the partnership uses the partner’s contribution to fund activities that would qualify as a cost of goods sold for the partnership; (ii) the goods produced by the partnership are distributed to the partner as goods-in- kind in the ordinary course of production activities; and (iii) the activities funded by the partner’s contribution relate to the goods distributed to the partner.

The COMPANY A-B Tax Partnership produces oil and natural gas, which are distributed to COMPANY A and COMPANY B in-kind in the ordinary course of business. Therefore, Section 171.1012(c)(13) applies and COMPANY A and COMPANY B may each deduct eligible costs identified in that provision.

The Texas Tax Code and Texas Administrative Code are accessible at www.comptroller.texas.gov/taxes.

If you have questions about this private letter ruling, please email us through our website at https://comptroller.texas.gov/web-forms/tax-help and reference Private Letter Ruling No. 201010157.

Sincerely,

Tax Policy Division

State Comptroller of Public Accounts

ENDNOTE

1. Unless otherwise indicated, all references herein to “Section” are to the Texas Tax Code, and all references to“Rule” to the Texas Administrative Code.