Attention To State, Local Taxes Can Save Producers Money

Robert K. Eggett
Price Waterhouse LLP
Houston

• Nonfederal tax considerations for independents [89,832 bytes]

A constant challenge for independent oil and gas producers in the U.S. is taxes. While the federal income tax code undergoes periodic revision, with much sound and fury attached to congressional and presidential action, state and local taxes are constantly being revised with little fanfare and little publicity.

As an independent producer, you should pay close attention to these taxes because, in the aggregate, businesses pay considerably more to state and local jurisdictions in income, sales and use, and property taxes than they pay to the federal government in income tax.

More than 85,000 taxing jurisdictions in the U.S. impose a variety of taxes in a variety of ways, and your company's operations may span a number of them. In most jurisdictions, you are responsible for payroll taxes, excise taxes, and severance taxes.

Yet you probably know more about federal taxes than you do about the more-local taxes affecting your income.

At the federal level, for example, you are aware that the differences between financial reporting and tax reporting often require your company to maintain more than one set of accounting books and records. Intangible drilling and development costs, depreciation, depletion and amortization, among other exploration and production expenditures, are often treated differently under financial accounting standards and the Internal Revenue code. This knowledge allows you to efficiently administer your compliance activities and effectively plan for your anticipated federal tax burden.

A similar knowledge of state and local taxes will allow you to bring similar benefits to your bottom line: better, more efficient compliance and the opportunity to minimize your total state and local tax burden. The goal is to lower your overall effective rate-the percentage of your income you are paying to state and local governments.

This article will explore some of the issues raised by the major taxes for which you are responsible.

State income taxes

With few exceptions, most states imposing a tax on or measured by net income begin with federal taxable income modified for state-specific additions and subtractions. The major exceptions are Texas and Ohio, which use an alternative net worth/income calculation, and Michigan, which uses a form of value-added tax.

While the use of net income as a starting point may lead you to believe that state income taxes mirror the federal income tax, the effects are quite different due to the need for any given state to determine the portion of a multistate company's overall income attributable to its specific jurisdiction. This is generally done by a formula.

The most common formula computes the ratio of in-state property, payroll, and sales to property, payroll, and sales everywhere and multiplies the result by the income deemed to be substantially connected to the company's in-state business activities. The dollar amount resulting from this calculation is multiplied by the state's tax rate.

At least four aspects of this methodology determine the tax due a particular state:

• The determination of whether the entity is subject to the state's jurisdiction because it has enough presence in the state to satisfy the U.S. Constitution's commerce clause and due process clause restrictions.
• Whether the particular stream of income received by the entity has sufficient connection with the activity performed in the state by the entity to meet constitutional restrictions.
• The particular formula employed by the state: for example, equally weighted factors, double-weighted sales factor, or single factor determined by receipts or a measure other than receipts.
• The state's tax rate.

Businesses obviously have many opportunities to structure their operations so as to take advantage of each of these measures in a manner most beneficial to them.

An example of how apportionment provisions can affect the liability of an oil and gas company for state income taxes is the Texaco-Cities Service Pipeline (Texaco) case in Illinois.

The company was in the business of transporting crude oil and petroleum products by pipeline. Illinois employs a single revenue-miles factor on all transportation companies. For businesses such as Texaco's the formula is pipeline barrel-miles traveled in Illinois over total pipeline barrel-miles.

In 1983, Texaco sold 90% of its pipeline assets and underlying real estate, including all of the pipeline and associated real estate located in Illinois. While the lower court had determined that the gain on the sale should be apportioned through use of the standard three-factor formula, the Illinois Appellate Court held the gain to be properly apportioned under the single revenue-miles formula on the basis that the special formula applies to the taxpayer in the transportation industry and not to the specific activity giving rise to the income.

Similarly, you, as an independent producer, should remain aware of how differing interpretations of apportionment provisions can affect your state income tax liability.

Affiliated corporations

Another major difference between state income taxes and federal income taxes is treatment of affiliated corporations.

At the federal level an affiliated group of corporations may elect to file a consolidated return based on ownership requirements. States are divided on the subject. Some do not allow such a filing (separate-entity filing states). And some permit and require companies to file consolidated or combined returns.

Consolidated returns generally are based on ownership and taxability in the state and are similar in nature to the federal return provisions. Combined returns bring in a concept known as the unitary principle. Companies may run the business as a single entity through various divisions or form subsidiaries to perform the separate operations that are dependent upon and contribute to the business as a whole.

In the latter circumstance, the group of corporations is considered to form a single business, a unitary business, and the income and factors of all the members of the unitary group will be taken into consideration in calculating the income due the state. The theory underlying this method of taxation is substance over form; whether a business enterprise chooses a single form over a multiple form, the result, from a state tax perspective, should be the same.

These differing state methodologies offer independent producers opportunities to minimize their tax burdens.

If, for example, a producer has plant and equipment in State A but sells most of its production in States B, C, and D, it may wish to divide its production and sales activities between separate entities. Assuming State A employs unitary combined reporting, there will be no change in the tax paid to that state. But if States B, C, and D are separate-entity reporting states, only the sales income will be subject to taxation, and the production income will be free from tax in those states.

On the same basis, if the company chooses to charge its subsidiaries a management fee, the income and expenses of the separate entities will result in a wash in the unitary reporting state but reduce taxable income for the subsidiaries in the separate-entity reporting states.

When the company decides to expand its production operations, its choice of state should be made not only on the basis of the rate imposed on taxable income but also on whether the state gives a benefit to such expansion by providing lower percentages for the property and payroll factors than for the sales factor. Decision-making based on knowledge of the states' income tax systems can lead to increased benefits to the business as a whole.

Sales and use taxes

Sales and use taxes, imposed by both states and their political subdivisions, are based on transactions rather than income.

The sales tax is imposed on either the seller of tangible personal property and selected services or on the consumer; in either case it is borne by the consumer. The use tax is a complementary tax imposed on the consumer in situations, generally interstate in character, where the state cannot tax the actual seller. The base of the tax is the price charged by the retailer, or the price paid by the consumer.

It is vital for a producer to know when tax applies and when it doesn't. If, for example, sales tax is not charged to a customer when it should have been, the business will become responsible for paying the tax to the state itself. In the same manner, a customer who has not self-assessed and paid the use tax to the state on an item purchased from an out-of-state seller tax-free will be responsible not only for the tax when audited but also for interest and penalties.

However, far more than the income tax, sales and use taxes are rife with exemptions. These exemptions may be based on the nature of the sale (e.g., a sale for resale), the nature of the customer (e.g., sales to tax-exempt entities), the nature of the product, (i.e., machinery and equipment used in manufacturing or fabrication), or the location of the business purchasing the goods or services (e.g., enterprise zones).

In this area, perhaps more than in any other, businesses must become aware of available benefits in order to save hundreds of thousands of dollars over time and to obtain or maintain a competitive advantage.

Some of the rules are changing due to the nature of federal deregulation. An illustration of this point is the Ohio scheme recently upheld by the U.S. Supreme Court in the General Motors (GM) case. Ohio imposes its general sales and use taxes on natural gas purchases from all sellers, whether in or out of state, except regulated public utilities that meet Ohio's statutory definition of a natural gas company.

Non-local distribution companies, such as producers and independent marketers, cannot meet this definition because they do not own or control any physical assets in the state needed for distribution. GM purchased virtually all of the natural gas for its Ohio plants from out-of-state marketers and was, therefore, obliged to pay sales and use tax on its purchases.

The company argued that the exemption from sales and use tax for purchases from in-state natural gas utilities amounted to discrimination in violation of the commerce clause of the U.S. Constitution. The U.S. Supreme Court held there to be no violation because Ohio natural gas utilities were subject to a variety of state-imposed requirements and protections and because the gas and services offered by the marketers were subject to no such restraints.

The conflict for states rests on the desire to provide lower prices for in-state users of gas and oil and to protect in-state utilities. This is an area that independent oil and gas companies should watch closely.

Property taxes

While property taxes make up approximately one third of the revenues flowing to states and their political subdivisions, they are generally overlooked by business decision-makers. This is partly because property taxes are administered at the local level rather than at the state level and decisions are often left to those in the field.

Yet property taxes are most often the beneficiaries of credits and incentives, and a full understanding of these incentives can help independent producers save money.

Most often, taxes are imposed on real and personal property, based on location of the property at the time of the assessment.

An example of how this works is the Diamond Shamrock Refining & Marketing Co. (DS) case in Texas. DS imported crude oil that it off-loaded in Nueces County, Tex., and held in tanks for 12-25 days. From there the oil moved by pipeline to DS's refinery in Three Rivers, Live Oak County, Tex.

Nueces County assessed property tax on the crude oil. DS protested the assessment under both the commerce and import-export clauses of the U.S. Constitution on the basis that the oil was in transit.

The Texas Supreme Court, overruling the lower court, held that the county provided services to DS and to the crude oil while it was present in the jurisdiction and that, since the oil remained in its crude form while in the county, it could not be considered to be in transit. The court declined to broaden its ruling to goods that may be merely passing through the state on their way to a foreign country or another state. And it did not apply its ruling to goods that may arrive in Texas from another state. Rather, the court restricted its decision to the facts presented in DS's scenario.

It is clear, therefore, that a careful reading of the laws of each state in which an oil and gas company does business is necessary to protect the company from unnecessary taxes, or from unexpected assessments.

Assessing the burden

Other state and local taxes, such as severance taxes and imposts on the removal of natural resources from their location, may have great effect on independent oil and gas companies.

The purpose here is to alert producers to how general state and local taxes affect profits of any business operating in more than one jurisdiction. Once the complexity and significance of these taxes are understood, your company can begin the process of planning to minimize your overall state and local tax burden-and increasing your cash flow and earnings per share.