Are down-hole labor charges performed in conjunction with drilling a new oil or gas well subject to Texas sales tax if they occur a short time after the well's Railroad Commission (RRC) completion date?

Plain-English summary

An oil and gas company asked the Comptroller's Tax Policy Division about the taxability of down-hole services performed after the Texas Railroad Commission (RRC) certifies a new well completed. The company explained that it uses an AFE (Authorized for Expenditure) system that captures all costs of drilling a new well — including down-hole labor charges that occur within the first few weeks of initial production — under a single AFE. The company argued that all such down-hole labor charges should be treated as part of the overall completion of the well (new construction) and therefore not taxable, regardless of when the RRC certifies the well completed.

The Comptroller disagreed. Down-hole new construction is considered complete once the RRC certifies the well completed and production begins. Any down-hole labor charges performed after that certification — even a short time later — are nonresidential remodeling of already-completed real property, not new construction, and remodeling charges are taxable.

The Comptroller used the taxpayer's own building analogy to explain this: a finished, occupied building that later has changes made to the finished portion (like carpet replacing tile) is remodeling, not new construction. Down-hole work is the same — once the RRC certifies the well as ready for production, any further changes made down hole are remodeling of a completed improvement, so the charges are taxable. This is distinguished from a true "finish-out" situation, such as a partially finished building where an unfinished floor is later completed for the first time, or a well bore drilled through multiple zones where an unprepared zone is later finished out for production for the first time — those situations are new construction.

What this means for you

Oil and gas operators and well owners

Don't assume that all down-hole labor charges tied to a single AFE for drilling a new well are automatically exempt as new construction. Once the RRC certifies the well completed, the clock resets: any further down-hole work is treated as remodeling of a finished improvement and is taxable, even if it happens only weeks after certification and even if the cost is captured under the same AFE as the original drilling.

Accountants and tax professionals preparing AFE-based cost allocations

The taxability line is the RRC completion certification date, not the AFE cost boundary. Down-hole labor performed before RRC certification is new construction; down-hole labor performed after RRC certification is nonresidential remodeling, regardless of how the company's internal capital-cost tracking groups the charges.

Well service companies performing down-hole work shortly after completion

If you're asked to perform down-hole labor shortly after a well's RRC completion date, that work is analogous to remodeling a finished building (e.g., replacing carpet with tile) rather than finishing out an unfinished portion for the first time — so sales tax applies to those charges.

Common questions

Q: Are down-hole labor charges on a new well taxable if they occur shortly after the RRC certifies the well completed?
A: Yes. Down-hole new construction is complete once the RRC certifies the well completed for production, so any down-hole labor charges after that point are nonresidential remodeling and are taxable.

Q: Does it matter that all the costs are captured under one AFE covering the whole drilling project?
A: No. The AFE is an internal cost-tracking mechanism; it doesn't change the tax treatment. The dividing line is the RRC completion certification, not how the company groups its capital expenditure costs.

Q: What if a portion of the well (an unfinished production zone) is finished out for the first time after certification?
A: That's different — finishing out a previously unprepared zone or unfinished part of the structure for the first time is new construction, comparable to finishing a rough second floor of a building that was never previously completed.

Q: What's the building analogy the Comptroller used?
A: A building that is finished-out and ready for occupancy, which then has changes made to the already-finished portion (like carpet replacing tile), is nonresidential remodeling — taxable. Down-hole work completed and certified by the RRC, followed by further down-hole changes, is treated the same way.

Q: Can this company rely on this letter if its facts are slightly different?
A: No. The opinion is based on the facts presented, and if there are additional or different facts, the opinion may change.

Citations and references

• 34 TAC Section 3.357 (referenced in the letter regarding the definition of new construction versus nonresidential repair, remodeling, etc.)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9606L1419G10

Original ruling text

June 13, 1996

Dear *****:

Your letter written to Tom Soto has been forwarded to me for response. You
were asking about the taxability of down-hole services performed after the
Texas Railroad Commission certifies the well completed.

You explained most oil and gas companies utilize an AFE (Authorized for
Expenditure) system in order to capture costs associated with major capital
improvements. All costs associated with drilling a new well are captured under
a single AFE. You feel that all labor charges associated with down-hole
services for a new well are not taxable, regardless of the date the Texas
Railroad Commission (RRC) certifies the well completed. After a well begins
producing, there may be several labor charges which occur downhole within the
first few weeks of initial production. You feel that these charges should be
treated as part of the overall improvement of real property (completion) and
are not taxable by using the definition of new construction in 34 TAC Section
3.357 regarding nonresidential repair, remodeling, etc.

You asked, "Are down-hole labor charges performed in conjunction with the
drilling of a new well subject to sales tax if they occur a short time after
the well's RRC completion date?"

Response: As I understand the process, the company performing the
completion is responsible for notifying the RRC that down-hole work is
completed and requests the certification. The RRC issues the certification and
production begins. Down-hole new construction is completed once the RRC
certifies the well completed for production to begin.

You compared the work at the well site to the building example in the ruling.
I will do the same. A building or portion of a building that is finished-out
and ready for occupancy (completed), that has changes made to the finished
portion (such as carpet replacing tile) is analogous to the down-hole
construction being completed and certified by the RRC as ready for production
then changes are made down hole. Each situation in the previous sentence is
nonresidential remodeling; the charges are taxable.

The information stating initial finish out is treated as new construction
refers to a situation where a building has had all the structural components
finished; some of the usable space is finished and used (i.e., a 3 story
building has the first floor finished and leased). Later the second floor
(previously only roughed-in) is finished. This compares to a well bore being
drilled through multiple production zones with only one zone being prepared for
immediate production. The other zones are sealed off. Later, one or more of
the multiple zones are "finished-out" for production. Again, in both
situations, this finish-out is new construction.

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

Sincerely,

Tax Policy Division

NOTE: Previous Accession Number 9606366L