Why the oil and gas industry is underutilizing the R&D tax credit

%{[ data-embed-type="image" data-embed-id="5d086d8ff6d5f267eec841ed" data-embed-element="aside" data-embed-align="right" data-embed-alt="Fvi Flame" data-embed-src="https://img.ogj.com/files/base/ebm/ogj/image/2018/08/fvi_flame.png?auto=format&h=640&w=640" data-embed-caption="" ]}%

Rizwan Virani
alliantgroup
Houston

It's a common course of action for people to shy away from things they don't understand. That may be acceptable for an individual or company that is not affected by their lack of knowledge. In the case of the R&D tax credit, however, businesses need to become educated and develop an interest in the matter to ensure they are claiming every dollar to which they are entitled.

Let's take a cementing company with annual revenue of $19 million engaged in numerous projects to develop engineering designs for oil well cementing. During the implementation of projects, the company addressed numerous uncertainties, including the ultimate cementing mix design to provide the most effective viscosity and water content of cement slurries, pumping and thickening time, compressive strength, quality of mixing water, compatibility with drilling fluid, density, and loss of circulation and filtration control.

As with all projects that are considered R&D, this company utilized physics, chemistry, engineering, and materials science to make improvements. They utilized structural engineering and materials science in determining the compressive strength of its cement slurries. The company relied on hard sciences to develop and improve its processes and was able to capture $60,000 in federal R&D tax credits that increased cash flow. As a result, the company was able to reinvest in itself and its future R&D activities.

The oil and gas industry is, without a doubt, the backbone of the global economy and acts as the driving force in the continued rapid development of our world today. Beyond the use of oil and gas for energy purposes, refined and finished petroleum products have been instrumental in crafting the lifestyle, technological, and scientific feats. The petroleum industry has continued to allocate significant resources for the effective engagement of research and development at the upstream, midstream, and downstream levels.

Despite this, the oil industry continues to underutilize and even ignore the benefits made available by the R&D tax credit. The credit for increasing research activities was first introduced by Congress in 1981. In 2001, the tax code language was expanded to include R&D activities that were not necessarily new to the world, but were new to a given business. This does not just apply to conventional lab coat R&D, but also entails projects involving new and custom designs, prototypes, and improvements to existing business components.

The only reference to the petroleum industry made in this portion of the tax code states that this credit does not apply for "the purpose of ascertaining the existence, location, extent, or quality of any" petroleum deposit. This is quite explicit, and despite excluding activities, such as the drilling of wildcat wells, it leaves a large potential for projects involving proven reserves, as well as processes and products related to the oil sector.

Many firms fail to take advantage of the R&D credit because they lack information and fear the unknown, or do not realize that many of their activities entitle them to generous tax incentives. Oil and gas companies spend a considerable amount of time and effort developing more efficient and effective ways to explore for oil and gas, produce it, transport it, refine it, develop cleaner or more efficient fuels, and hundreds of other activities. This applies to the thousands of smaller companies that provide services and materials to the oil and gas industry, as well as the big energy giants. While many of these activities do not occur in traditional laboratories or settings usually thought of as "research," these activities require time and money that may be captured as qualified research expenditures leading to significant tax benefits.

Too many small and medium businesses think that the R&D tax credit is only for the big companies. "While the big guys, with their armies of tax lawyers, are all over the R&D tax credit, too often small and medium businesses act as if there were a velvet rope barring them from taking the R&D tax credit. The R&D tax credit is available for small and medium businesses, but you do need to show up and apply to get it. The IRS isn't simply handing out credits," Dean Zerbe, former senior tax counsel to the Senate Finance Committee and alliantgroup's national managing director, said.

There are three major sectors or operations components of the petroleum industry: upstream, midstream, and downstream. The upstream sector, involves the exploration for and extraction of petroleum crude oil and natural gas. The midstream involves storing, marketing, and transporting petroleum crude oil, natural gas, natural gas liquids and byproduct sulfur. The downstream sector involves the refining of petroleum crude oil and the processing of raw natural gas, including the selling and distribution of processed natural gas and the products derived from petroleum crude oil. This sector includes petroleum refineries, petroleum product distribution, retail outlets, and natural gas distribution companies. Many companies do not realize that each of these sectors takes part in activities that would be defined as R&D, and therefore, would likely qualify for thousands to hundreds of thousands of credit dollars.

The list of eligible activities for this credit in the oil and gas industry is quite extensive. It includes design, fabrication, and implementation of drill rigs, pipeline, separators and compressors, gas processing facilities, downhole tools, and surface machinery and equipment. The credit applies to work conducted on plug and abandonment jobs, frac jobs, drilling and completion designs, and workover projects. Additionally, the engineering of surfactants, drill bits, and microseismic technology are all eligible for governmental and state R&D tax credit benefits.

"Businesses that looked at the credit in the past and determined that they didn't qualify may now realize significant benefits due to the credit's broader applicability," Mark Everson, alliantgroup vice chairman and former IRS Commissioner, said. "I can certainly attest to the complexity of the tax code, and the requirements for the R&D tax credit are no exception. That having been said, at almost $10 billion a year, the R&D credit is one of the most generous tax benefits established by Congress."

Sadly, it remains the case that one of the biggest roadblocks for businesses taking the R&D tax credit is self-censorship. It was recently reported in The Wall Street Journal that 19 out of 20 small- and medium sized-businesses that are eligible for tax incentives, such as the R&D tax credit, fail to take advantage.

A smaller company with annual revenue of $1.5 million set out to improve the quality of oil production processes and resolve operational problems. To accomplish this goal, the company developed methodologies to eliminate or reduce paraffin buildup and pipe corrosion. As wells produce oil, wax adhered to and plugged pumps and tubing. This resulted in a need to pull and clean pipes and tubing frequently, which was costly, time consuming, and unsafe. .As a result of the company's willingness to test and improve its products and processes, they received approximately $80,000 in state R&D tax credits, resulting in permanent tax savings and refunds.

While the R&D tax credit can provide the funds for oil and gas companies to hire new employees, improve current products, develop and implement new strategies, and overall increase their bottom line, this incentive is also complex, and fully identifying the proper substantiation for capturing the credit requires a deep understanding of the tax code.

"The oil industry is fundamental to our way of life. Every day, new and improved technologies are being developed, and it is time that companies start taking advantage of the lucrative, government-endorsed incentives that can help grow and strengthen their firms," Zerbe said.

Don't allow fear of the complicated tax code to hold you back from claiming the money you deserve.

About the author

%{[ data-embed-type="image" data-embed-id="5d086d8ff6d5f267eec841ef" data-embed-element="aside" data-embed-align="right" data-embed-alt="Fvi Rizwan Virani" data-embed-src="https://img.ogj.com/files/base/ebm/ogj/image/2018/08/fvi_rizwan_virani.png?auto=format&h=640&w=640" data-embed-caption="" ]}%

Rizwan Virani is a managing director at alliantgroup, a provider of specialty tax services with headquarters in Houston and offices across the country. The company works with accountants and their clients to ensure they receive the full benefits of all available federal and state government-sponsored tax credit and incentive programs.

Fear of the unknown

In order to access this content, you must be logged-in and have an active subscription to the OGJ Premium Archive