Texas Taxes Natural Gas Severance Tax

NATURAL GAS SEVERANCE TAXES
AUDIT POLICY ON MARKETING COSTS

This document originated as an attachment to Audit Policy #56.

Section 201.101 of the Tax Code states "The market value of gas is its value at the mouth of the well from which it is produced." Rule 3.15, Gas Marketing Costs, states "The "market value at the mouth of the well" shall be determined by ascertaining the producer's actual marketing costs and subtracting those costs from the producer's gross cash receipts from the sale of the gas." Market value has been further discussed in the court case Mobil v. Calvert, 451 SW 2d 889 (Tex 1970).

The purpose of the marketing cost deduction is not to cause the taxable value to be a "net income" tax. It simply equalizes the tax burden for those selling at or near the point of production with those who have to treat the gas and send it further away to market. Where there is no compression, sweetening, dehydration or transportation to the market, there will be no marketing costs. (The one exception is for costs on the sales meter or a necessary allocation meter. See "Meters" for more information on this subject.)

If a marketing facility is being used for gas lift, pressure maintenance or handling gas for outside parties, those volumes must also be included to calculate a "per mcf" value for the marketing cost deduction. The volumes for gas that qualify for one of the exemptions from tax (i.e., high cost gas) must also be used in the calculation of a "per mcf" cost.

Marketing costs may not reduce the taxable value of gas well gas below the minimum value of $0.010756 per mcf. The taxable value of casinghead gas may not be reduced below zero. Marketing costs may not be carried forward.

Three general rules:

(1)	Marketing costs do not begin until the natural gas and oil or condensate have been separated.
(2)	The cost must be necessary and essential to marketing the gas.
(3)	The cost should be directly related to the physical handling of the gas.

General Concepts:

(1)	Only the lease operator can take marketing cost deductions. (a) What if other interest owners have paid their own share of the taxes? Can they then take their own share of the costs? No, but the operator taking the costs should reimburse the other interest owners for their share of the costs. Exception: If the producer puts in writing that they will tell the other parties the amount of the costs, and agree to make supporting records available if necessary, the non-operator can take marketing cost deductions. (b) What if the gas purchaser is paying the tax? Can the producer tell the purchaser how much the costs were so that the purchaser can enter them on the tax return? No. The purchaser can only take costs that are built into the contract. (c) What if the gas purchaser has paid the tax? Can the producer and/or operator get an assignment letter from the purchaser and file for a refund on their costs? Yes. They may file the costs on a schedule rather than on amended returns since they have zero reported value.
(2)	Amended returns need to be filed for all refund requests. Amended returns are required to provide a good audit trail for costs taken. If additional costs are submitted as part of a refund request and are to be incorporated in an audit and/or filed on a schedule, the taxpayer must first obtain approval from Account Maintenance Division and from Tax Policy.
(3)	Taxpayers can compute costs on an annual basis and use a rate per MCF for reporting, then go back at the end of the year and compute the actual costs and rate. Then if the rate used was too high or too low, the rate for the next year must be adjusted accordingly. Actual costs must be used for audits and refund requests.
(4)	A reasonable amount is allowed for overhead, at a rate of 6% of the appropriate accounts. The "overhead" accounts from which the 6% is taken are the accounts that are billed to the joint interest owners as overhead. Joint interest billings can be used to determine these amounts if necessary.
(5)	Costs can be allocated between sales and gas lift systems by using a ratio of gas sales to the total gas produced or compressed.
(6)	Costs can be allocated between gas and condensate systems by: (a) dollar value basis (b) liquids to gas method (c) gas to liquids method
(7)	Typical depreciation and return on investment calculation: Purchase price = $100,000 Salvage value = $ 10,000 Useful life = 10 years Depreciation per year = $100,000 - $10,000 = $90,000 / 10 yrs = $9,000 per yr Return on investment: Undepreciated balance at beginning of year = $ 100,000 Undepreciated balance at end of year = 91,000 --------- Subtotal $ 191,000 Divided by 2 = $ 95,500 Less: salvage value - 10,000 --------- Average undepreciated balance $ 85,500 Multiplied by 6% rate .06 --------- Return on Investment per year $ 5,130 Notes: (a) Useful life and depreciation rate: Ten years useful life and a depreciation rate of 10% per year is normally used. However, a different term can be used if the situation calls for it, based upon documentation in the taxpayer's records. Useful life must be the lesser of the expected life of the equipment, or the life of the field. Straight line depreciation is the preferred and recommended depreciation method. If another method is used, the taxpayer should be ready to support why that particular method is appropriate for the situation. (b) There are times when the taxpayer wants to use a zero salvage value, i.e. on pipelines they claim will not be recovered when the lease is abandoned. Generally we have seen that the land owners do want these pipelines removed, so a 10% salvage value should be used unless there is good evidence and documentation to support a different treatment, including specifications in lease agreements. (c) In cases where one company acquires another, it is best to use the value placed on the new owner's books. If the new owners place no value on the equipment, valuing only the reserves, the company should not be allowed to depreciate the equipment. (d) If equipment that has been fully depreciated is sold for more than the salvage value, the additional "profit" is subject to severance tax. Auditors should assess this in audits. (e) If fully depreciated equipment continues in use by the taxpayer, they can continue to deduct the return on investment amount on the salvage value.
(8)	Lease schematics appropriate to the relevant time period and signed by a company engineer should be provided for all audits or refund requests. If not available, a written description, including a listing of equipment, signed by a company engineer, may be provided.

The following lists present various costs by category as "Allowable" or "Disallowed" as marketing costs. The exact answer as to whether the cost is deductible or not often depends upon exactly how the item is used. Also, if the cost is deductible, it must be determined whether the item should be expensed or depreciated.

Item	Allowable	Disallowed	Comments
Wellhead and Downhole Equipment/Operations			These items all relate to either the drilling of the well or well servicing activities. None are deductible as marketing costs.
Acidizing		X
Casing		X
Cementing		X
Drill Pipe		X
Fishing/fishing tools		X
Fracturing		X
Hot oiling/hot oil treatment		X
Injecting baroid		X
Logging		X
Packers/setting packers		X
Paraffin removal		X
Perforating		X
Swabbing		X
Tubing		X
Well Service		X
Wire line service		X

Item	Allowable	Disallowed	Comments
Production equipment/ operations			These items are all involved with the production of oil and gas, not marketing the gas. Therefore, none are allowable as marketing costs.
Christmas tree		X
Compressors: wellhead/suction/vacuum		X	This type of compressor sits on top of the well bore and is used to suction out the oil and gas.
Corrosion inhibiting chemicals	*	X	Most of these chemicals are used downhole and are not allowable. If the chemical is used in pipelines that are part of the marketing function, that portion may be allowed.*
Downhole separation		X
Electricity to run pumping unit		X
Lease use gas to run pumping unit		X
Pumping unit		X
Replacement valves/parts for Christmas tree		X
Rods/ pulling rods		X
Submersible pumps		X
Tanks		X
Tank and Vessel cleaning		X

Item	Allowable	Disallowed	Comments
Lease Equipment After the Wellhead
Air compressors used to start lease equipment		X	Not allowable unless used to start equipment that otherwise qualifies as marketing equipment.
Break out of heater and removal; set new heater and start hook-up.		X	Not allowable unless this refers to a qualifying line heater.
Cathodic protection		X
Chrome/stainless steel piping for handling gas with high H2S content.	X*		*Depends on if the piping qualifies as allowable, based on location of the piping and its function. The "chrome/stainless steel" element is irrelevant.
Clean contacts on coffing	X		See "coffing for compressor"
Coffing for compressor building	X		Coffing is used like a crane to lift and move the compressor.
Compressor installation charges	X		If compressor is owned, may be included in depreciable base.
Compressors/parts and service for compressors - gas lift systems		X
Compressors/parts and service for compressors - to return gas to leases		X
Compressors/parts and service for compressors - to get gas up to required sales pressure. Compressors owned rather than rented.	X		If compressors perform a dual purpose, the costs can be allocated between allowable and not allowable marketing costs. Must be depreciated over useful life, and return on investment may be calculated.
Compressors - rented sales compressors	X		Deducted as a monthly expense.
Compressors- at central facility (compressor stations)	X		Same as above for all compressors.
Compressors- transmission line		X	Not allowable unless it occurs before the sale has been made.
Compression charge on settlement statement	X*		*Allowable if not already deducted from the reported price.
Compressor fuel for gas lift compressors		X
Concrete slab for compressor	X		If compressor is owned, cost of slab may be included in depreciable base.
Concrete pad around compressor to collect oil and drainage, to reduce environmental clean-up in the future.		X
Cost reimbursement from gas purchaser for compression		X	Should be included in gross taxable value, and actual marketing costs deducted by the producer.
Dehydrators	X		Takes the water content out of the gas stream.
Demulsification chemicals		X	Used to break down oil emulsions, usually in a heater treater.
Fence around compressor		X
Filters	X*		*Allowable if used on a piece of equipment that qualifies as a marketing cost deduction.
Fin Fans	X		Used to cool the gas after it has been compressed.
Flow lines from separator to purchaser's transmission line	X
Glycol for use in dehydrators	X		See "dehydrators"
Heater treater		X	Used to treat oil, not gas.
Hydrogen sulfide monitoring		X
Insurance on compressor		X
LACT Units		X	These measure crude oil being sold.
Lease chiller	X*		*Costs of the chiller are allowable if tax is paid on the products obtained at 7.5% tax rate. If the taxpayer defines the liquids obtained as condensate and pays tax at 4.6% tax rate, no marketing costs are allowed.
Lease separators		X
Line heaters	X*		*Allowable if the heater is located after the separator. Not allowable if heater is located before the first separator.
LTX Unit	X*		*Allowable if the producer is paying gas tax on the liquids that are obtained from the unit.
Methanol for gas line	X		Used in preventing freeze-ups.
Oil/condensate storage tanks		X
Painting dehydrator and sales compressor building	X
Painting separators		X
Paint storage tanks to prevent rusting		X
Pig socks used around oil storage tanks & compressor		X	Used to clean oil spills.
Pigs and pigging equipment		X
Pipeline between wellhead and separator		X
Pipeline between wellhead and central separation facility		X
Pipeline between wellhead and sales line if there is no lease separation and no separation prior to sale.	*	*	*Allocate costs of this line between gas and condensate. Marketing costs are allowable on portion of line allocated to gas, and not allowable on the portion allocated to condensate.
Pipeline between wellhead and plant if there is no lease separation and gas is going full well stream to the plant for processing	*	*	*Allocate costs of this line between gas and condensate. Marketing costs are allowable on portion of line allocated to gas, and not allowable on the portion allocated to condensate.
Pipeline after first separator	X		Between separator and sales line.
Purchase and installation of compressor to increase capacity due to tight sands drilling program		X	A vacuum type compressor being used to increase production.
Removal of contaminated soil, back-fill new dirt		X
Repair handrails on vessels at tank battery		X
Repair water leg on heater treater		X
Security alarm on compressor		X	Not necessary and essential.
Separators at central facility		X
Shed/cover over sales compressor	X
Skid mounting of sales compressor	X		Skid mounting of gas lift compressor not allowable.
Stack packs/ production units		X	Basically separators that contain a heat source. There may also be lease use gas consumed on these.
Sweetening chemicals	X		Used to remove hydrogen sulfide from gas.
Vapor recovery units		X	Recovering additional vapors is a production function, not marketing.

Item	Allowable	Disallowed	Comments
Other Lease related items
Ad valorem taxes	X*		*Allowable on value of marketing equipment only. If there is no breakdown between marketing equipment vs other equipment, taxes are not allowable.
Building or trailer rental		X
Cattle guards around lease equipment or on lease roads		X
Clean out dumpsters, trash barrels at lease facility		X
Cleaning agents	X*		*Deductibility depends on purpose for which they are being used. Costs are allowable if used on allowable marketing equipment.
Construction/installation of lease road		X
Cost to acquire pipeline right of way		X
Fence around lease facility		X
Fire ant treatment around lease, including compressor		X
Fire extinguishers		X
Heat sensing devices on leases		X
Hydrostatic testing	X*		*Usually refers to testing pressure and amount of water in pipelines. Deductibility depends on which pipelines are being tested. Testing after separation is allowable.
Miscellaneous parts, valves, fittings, plugs, duct tape, lubricants, tools, etc.	X*		*Deductibility depends on purpose for which they are being used. Costs are allowable if used on allowable marketing equipment.
Motor freight & hauling	X*		*Deductibility depends on purpose of freight and hauling. Costs are allowable if for allowable marketing equipment.
Mowing, weeding around lease equipment		X
Mowing, weeding pipeline right of way		X
Repairing fire wall		X
Repair and maintenance on lease roads		X
Salt water disposal expenses, including wells or hauling		X

Item	Allowable	Disallowed	Comments
LABOR EXPENSES
Cellular phone in pumper's truck, radios, CBs, etc.	X*		*Include in overhead. Allow at 6% rate.
Company labor expenses if there is contract labor on the same lease		X	Company labor should not be allowed when the company has hired contractors to work on the marketing equipment. The contract labor expenses can be claimed on marketing equipment. If the contractors work only on specific equipment, i.e., the compressor, then an appropriate percentage of company labor can be allowed for time spent working on other marketing equipment.
Contract labor	X*		See "Company labor expenses"
Cost to operate district office building, warehouses, shops, garages, etc.		X
Cost of secretary in district office		X	Does not work on equipment which is physically handling gas.
Field supervisor cost	X*		*Include in overhead and allow at 6% rate.
Gauger salaries	X		Gaugers normally refer to employees who measure volumes in storage tanks. If this is the case, the gauger's salary would not be deductible. However, the use of this term differs from company to company. Some gaugers are actually doing the work of a pumper. The determining factor as it relates to marketing costs is exactly what the job duties entail.
Hand tools used by pumper/gauger		X
Meals/food expenses for pumper/gauger	X*		*Include in overhead and allow at 6% rate.
Meals/food expenses for other district office personnel		X
Pumper/gauger benefit costs	X*		*Allow the same percentage as for pumper's salary and benefits.
Pumper salaries/benefits	X*		*The percentage of salary attributable to pumper's time spent working on marketing equipment is allowable. The percentage of salary attributable to other duties, i.e. production, is not allowable. A standard percentage is often used, i.e., 50% of the salary charged to gas wells and 25% charged to oil wells. Each situation should be evaluated independently to determine appropriate percentages. If the only meter on the lease is an allowable marketing meter, and no other marketing equipment, only 10% of the salary is deductible.
Safety clothing/equipment		X	Required by OSHA or EPA
Thawing gas lines	X*		*Allowable if the lines being thawed are after initial separation.
Transportation expenses for pumpers/gaugers (trucks)	X*		*Include in overhead and allow at the 6% rate.

Item	Allowable	Disallowed	Comments
METERS
Gas analysis expenses	X		To make sure contract requirements are met.
Meters - sales	X		Meter on which payment is based. If sales meter is owned by producer, the cost of the meter (depreciation plus monthly maintenance expense) is deductible.
Meter- allocation meter	X		Allowable if more than one well or lease is paid from a single purchaser meter. If the sales meter is owned by the purchaser, the producer is allowed to take the cost of lease allocation meters (since we require lease level reporting).
Meters- check		X	Used to verify sales volumes; usually located next to the purchaser's sales meter.
Meter to measure lease use gas		X
Meter calibration services	X*		*For sales or allocation meters only.
Pens for meters: graphic red pen, graphic green pen, black static pen	X		Allowable if used in an allowable meter only.

Item	Allowable	Disallowed	Comments
ELECTRICITY
Central separation/compression facility	X*		*Partially allowable. Allocate electricity costs based on how much is used in each function of the facility.
District office building		X
Electronic gate		X
Gas lift compressor		X
Gas sales compressor		X
Generators	X*		*Depends upon use. If used for allowable equipment, it is allowable.
Lease security light		X
Maintenance shop		X
Oil pumps		X
Pumping unit		X
Storage building		X

Item	Allowable	Disallowed	Comments
PLANTS			In general, costs cannot be taken on a plant if the producer is receiving settlement based on a product/residue plant split (getting a percentage of the proceeds). In the examples below, assume that revenue was paid at 100% so that costs are eligible to be taken.
Compressors- inlet	X
Compressors - tailgate	X*		*Compressors handling sales gas before the sales meter are allowable. Compressors handling gas being returned to leases for gas lift, injection or lease use, or transmission, are NOT allowable.
Control room computers	X
De-methanization expenses	X
Electricity for office building, storage buildings, and control room		X
Installing breaker in control room	X
Janitorial expenses for office building, storage buildings, and control room		X
Painting of plant piping and other facilities	X
Propane compressors	X		Before the sales meter
Scrubbers	X
Water chilling expenses	X

A situation being seen more frequently is where a company has always reported taxes based upon a percentage of the plant revenues and not taken any marketing costs. Now the taxpayer wants to go back and take 100% of the costs and pay tax on 100% of the product and residue value. This is allowable IF they are the sole owner of the plant and IF they are processing only their own gas.

If a taxpayer claims 100% of the marketing costs on a plant, the additional costs must be offset by the amount of tax that will be due on 100% of the revenue. In other words, if a taxpayer deducts marketing costs in lieu of reporting revenue on a percentage basis, then they must also report 100% of the revenue.

If the plant is processing gas for unrelated parties, and those parties are paid based on a contractual revenue split, 100% of the costs cannot be taken. Likewise, if the plant operator has other interest owners sending gas to the plant and who pay taxes based on a split, 100% of the costs cannot be taken. If a majority (>50%) of gas is being processed for unrelated parties, then the operator's share should be valued using the same method for the unrelated parties' gas.

If a taxpayer changes to a 100% revenue/ 100% cost method as a result of a refund request, they should continue to report using that method on the future monthly tax returns. They cannot switch back and forth on the method used.

Item	Allowable	Disallowed	Comments
OFFSHORE LEASES
Boats - crew boats	X*		*Used for taking personnel to and from platform. Allow as part of overhead at the 6% rate.
Boats - crew boats	X*		*Used for taking personnel to and from platform. Allow as part of overhead at the 6% rate.
Boats - used to deliver supplies to production platforms	X*		*Partially allowable, depending upon what is being delivered. If supplies being delivered are related to marketing costs, i.e. glycol or parts for sales compressors, the cost is allowable.
Boats - used for surveillance around platforms (maintenance and security)		X
Boats - used for surveillance around platforms (maintenance and security)		X
Boat or barge to transport condensate from platform to shore		X	The cost of transporting crude oil to shore is allowable as a trucking cost for crude oil, but no part of the cost is allowable as a marketing cost.
Compressors	X*		*Allowable if compressing gas for sale. If the compressor is located on the platform and it compresses gas for transport to shore for sale, and if condensate is also placed in the pipeline, compressor costs must be allocated. The portion attributable to condensate is not allowable.
Compressors - gas lift		X
Condensate sent to shore via pipeline		X
Food for platform personnel	X*		*Allowable as overhead at the 6% rate.
Helicopter expense for transporting personnel to and from platform	X*		*Allowable as overhead at the 6% rate.
Housing facilities for platform personnel	X*		*Part of the platform cost and treated the same as "Production platform."
Pipeline - from platform to shore (gas only line)	X*		*Allowable if there has been separation on the platform.
Pipeline - from platform to shore (both gas and condensate in line)	X*		*Allocate as described under "Compressors."
Pipeline - from satellite wells to central platform		X
Production platform	X*		*An allocation of costs can be made between sales and production IF gas is being separated and sold on the platform. If gas is being separated for measurement purposes and then recombined with condensate for shipment to shore for sale, platform costs are not allowable.
Separators on platform		X
Separators on shore		X

Item	Allowable	Disallowed	Comments
Miscellaneous Issues
Accounting department salaries		X	Recording revenue from leases and reporting taxes
Ad valorem taxes on marketing facilities or equipment	X
Carbon dioxide recovery projects		X*	*These projects are normally used to enhance production of crude oil. Only an allocation of expenses may be allowed as a marketing cost. Allocation should be based upon a study of schematics for each individual situation.
Cost on leases where there is no marketing equipment		X*	*If the lease has a qualifying meter, a small portion (10%) of the labor would be allowable.
Exempt leases		X	Marketing costs are not allowable on leases which are exempt from taxes.
Insurance premiums on any equipment or facilities		X
Legal department salaries and expenses		X	Legal department prepares contracts for marketing gas.

Minimum Tax: Auditors approving marketing costs must remember that costs cannot reduce the final taxable value less than the minimum taxable value on gas wells.