Can an oil-and-gas well-servicing consulting company exclude from its Texas franchise (margin) tax total revenue the payments it passes through to subcontractors?

Plain-English summary

A company that supplies contract field consultants to supervise oil-and-gas drilling and workover rigs asked whether the payments it passes through to its subcontractors (the consultants who do most of the actual on-site work) can be excluded from its Texas franchise tax total revenue. The Comptroller ruled yes, for supervision of well completions and workovers — but drew a line at production-related work.

Texas franchise tax lets a business exclude "flow-through funds" from total revenue when a payment: (1) is a subcontracting payment — money paid to another entity to do work the taxpayer itself is obligated to provide its customer; (2) is a flow-through fund, meaning the taxpayer's own customer is effectively paying for the subcontractor's work; (3) is mandated by a contract or subcontract; and (4) relates to construction, remodeling, remediation, or repair of improvements to real property (more than just a tangential connection, though the work doesn't need to physically or materially change the property itself).

Relying on two court decisions (Titan Transportation and Hegar v. Gulf Copper), the Comptroller found all four elements met here: the taxpayer's contracts obligate it to pay its subcontractors, its customers are the ones ultimately paying for the subcontractors' work, and — critically — drilling an oil or gas well counts as an improvement to real property under Texas case law. So payments for supervising well completions and workovers qualify for the exclusion.

But the ruling drew a limit: payments tied to supervising ongoing production activities (as opposed to completions/workovers) don't qualify, because production work isn't considered "improving" real property the way drilling and workover activity is.

What this means for you

Oilfield services and consulting companies using subcontractors

If your company passes through payments to subcontractors for well drilling, completion, or workover supervision under a contract that obligates you to pay them, and your customer is the one economically funding that work, you may be able to exclude those pass-through payments from total revenue — reducing your franchise tax base. But split out any subcontractor payments tied to production-phase work, since those don't qualify under this ruling's reasoning.

Businesses in other industries using subcontractors on construction-adjacent projects

The four-part test here (subcontracting payment, flow-through, contractually mandated, tied to real-property improvement) applies beyond oil and gas to any business that passes revenue through to subcontractors on real-property construction, remodeling, remediation, or repair work. The "real property improvement" element doesn't require the subcontractor's work to physically alter the property — courts have read it fairly broadly (as illustrated by treating well-drilling as an improvement).

Accountants and tax professionals

This ruling applies and extends the Section 171.1011(g)(3) flow-through-funds exclusion using the Titan Transportation and Hegar v. Gulf Copper framework, and is useful precedent for the completions/workovers-versus-production distinction in oilfield services specifically — a distinction that isn't obvious from the statute's text alone.

Common questions

Q: Does the subcontractor's work have to physically change the property to qualify for the exclusion?
A: No. Per Gulf Copper, the connection to construction/remodeling/remediation/repair of real property improvements must be more than tangential, but the work doesn't need to cause a material or physical change to the property.

Q: Are payments for supervising ongoing production activities excludable too?
A: No — this ruling specifically found that production-related supervision doesn't count as "improving" real property, so pass-through payments tied to production work stay in total revenue.

Q: Can any oilfield services company rely on this ruling to exclude its own subcontractor payments?
A: Not directly — a private letter ruling binds the Comptroller only for the taxpayer and facts in the request. A company should confirm its own contracts satisfy all four elements (subcontracting payment, flow-through, contractual mandate, and real-property-improvement connection) before relying on this result.

Citations and references

Statutes:

• Tex. Tax Code § 171.1011(c) (Determination of Total Revenue from Entire Business)
• Tex. Tax Code § 171.1011(g)(3) (exclusion for flow-through subcontracting payments tied to real property improvements)

Cited case law:

• Titan Transp., LP v. Combs, 433 S.W.3d (Tex. App.—Austin 2014, pet. denied)
• Hegar v. Gulf Copper & Mfg. Corp., 601 S.W.3d (Tex. 2020)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=MAR
• Opinion: https://star.comptroller.texas.gov/view/202407025L

Original ruling text

July 24, 2024

RE: Private Letter Ruling No. PLR20230712120955

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 dated July 10, 2023. Detrimental reliance relief is provided in accordance with Rule 3.10, Taxpayer Bill of Rights.

You asked if certain subcontracting payments are eligible to be excluded from total revenue under Section 171.1011(g)(3) (Determination of Total Revenue from Entire Business).

Facts Presented

The relevant facts are based on the following documents provided for review by ** (Taxpayer):

Taxpayer’s Request for a Private Letter Ruling dated July 12, 2023; and

COMPANY A Master Service Agreement.

Taxpayer provides contract field operation consultants on oil and gas drilling and workover rigs. Specifically, Taxpayer provides direct on-site consulting and supervision services for completions, workovers, and contract lease operators on oil and gas drilling and workover rigs.

Supervision work is handled by either INDIVIDUAL A (50 percent owner of Taxpayer), INDIVIDUAL B (50 percent owner of Taxpayer), or subcontracted consultants. In each contract signed by the customer, the use of subcontractors is specified, and subcontractors perform the majority of the work. Taxpayer handles initial placement of subcontractors with customers; thereafter, Taxpayer’s interaction with the subcontractor is limited to receiving expense sheets and issuing the required payments.

Question, Ruling, and Analysis

Our restatement of your question is shown below, followed by our response and analysis.

Question: Do Taxpayer’s subcontracting payments qualify for exclusion from total revenue under Section 171.1011(g)(3)?

Ruling: Taxpayer may exclude from total revenue subcontracting payments made for consulting and supervision services for completions and workovers of oil and gas drilling and workover rigs under Section 171.1011(g)(3).

Analysis: Total revenue for franchise tax purposes is based on the amounts reportable on various lines of the taxable entity’s federal income tax return less statutorily allowed exclusions. Section 171.1011(c).

Under Section 171.1011(g)(3), a taxable entity shall exclude from its total revenue, to the extent included, flow-through funds that are subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements on real property or the location of the boundaries of real property and that are mandated by contract or subcontract to be distributed to other entities.

Based on the courts’ analysis in Titan [ENDNOTE 2] and Gulf Copper[ENDNOTE 3], a payment to a third party qualifies for the revenue exclusion in Section 171.1011(g)(3) where:

The payment is a subcontracting payment, meaning the payments the taxpayer makes to another entity to do work or provide materials that the taxpayer is in turn obligated to provide its customer and for which that customer is compensating the taxpayer;

The payment is a flow-through fund, meaning that the taxpayer’s customer is compensating the taxpayer for the subcontractor’s work;

The payment is mandated by contract or subcontract, meaning that the taxpayer has a contractual obligation (in the contract or subcontract) to pay its subcontractor; and

The payment is in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements to real property, which requires more than a tangential or incidental relationship between these activities and the services, labor, or materials for which the subcontractors receive payment. However, it does not require that the activity of the taxpayer’s subcontractor affect a material or physical change to the property.

In this case, Taxpayer provides contract field operation consultants (subcontractors) to its customers. The subcontractors are paid to supervise completions; workovers; and contract lease operators on oil and gas drilling and workover rigs. Taxpayer’s contract with its customer is sufficient to establish that Taxpayer’s payments to subcontractors are mandated by contract. As discussed in Gulf Copper, “mandated by contract” in this context simply means that the taxable entity’s obligation to pay its subcontractor is a contractual one.

The payments are also “flow-through” as Taxpayer’s customer is compensating Taxpayer for the work performed by the subcontractors. Additionally, the payments are subcontracting payments as Taxpayer makes the payments to another entity to perform the work that Taxpayer is in turn obligated to provide its customer and for which the customer is compensating Taxpayer.

In Gulf Copper, the comptroller agreed that drilling an oil or gas well is an improvement to real property. Therefore, the payments for direct on-site consulting and supervision services for completions and workovers of an oil and gas drilling and workover rig are in connection with the construction, remodeling, remediation, or repair of improvements to real property.

Taxpayer may exclude from total revenue the subcontracting payments made for direct on-site consulting and supervision services on completions and workovers of oil and gas drilling and workover rigs as the services are in connection with the construction, remodeling, remediation, or repair of improvements on real property. However, any activity related to production is not considered to “improve real property” and Taxpayer may not exclude from total revenue any subcontracting payments for consulting or supervision services of production activities.

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. PLR20230712120955.

Sincerely,

Tax Policy Division – Direct Taxes

Texas Comptroller of Public Accounts

ENDNOTES

1 Unless otherwise indicated, all references to “Section” are to the Texas Tax Code, and all references to “Rule” are to Title 34 of the Texas Administrative Code.

2 Titan Transp., LP v. Combs, 433 S.W.3d (Tex.App.—Austin 2014, pet. denied).

3 Hegar v. Gulf Copper & Mfg. Corp., 601 S.W.3d (Tex. 2020).