Many activities within the oil and gas industry qualify for the R&D tax credit, and this significant tax incentive is often overlooked within the industry. The R&D tax credit was originally enacted as part of the Economic Recovery Tax Act of 1981. For a company to qualify for the credit, a company needed to discover something new to its industry or its particular field of science or engineering.
However, in December 2003, the IRS replaced the “Discovery Test” with a “Four-Part Test” to qualify for the credit. This change opened up the types of activities that are eligible for the credit and greatly enhanced this opportunity for the oil and gas industry.
The Four-Part Test
For a company to qualify for the R&D tax credit, it now needs to perform activities within the United States that meet the following “Four-Part Test” criteria.
First, the company needs to be trying to (these do not need to be successful endeavors) develop a new or improved “business component.” As defined in IRS regulations, the business components include a product, process, technique, invention, formula or software.
Second, the activity needs to be technological; in other words, it needs to involve the hard sciences, like engineering, physics, biology, computer science or chemistry.
Third, there needs to be some uncertainty at the onset when the company is trying to develop a new or improved business component. However, there only needs to be uncertainty regarding one of three things: can they do it, how would they do it, or the ultimate or appropriate design of what they are trying to develop.
And, finally, the company needs to be evaluating different alternatives when it is trying to develop the new or improved business component. Examples of this include systematic trial and error, modeling and simulation.
Qualifying Activities for Oil and Gas Industries
Several activities within the oil and gas industry involve the development of new or improved products, processes or techniques that would qualify for the R&D tax credit. These include:
- Improvements made to a drilling process and its design
- Developing fracking techniques
- Improving methods to refine or transport oil and gas more efficiently
- Developing plug and abandonment solutions
- Offshore structure design
- Design of a plant, including considerations made to pollution control and safety
- Wastewater solution design
- Improvements made to wells and other field equipment
Costs That Qualify For The CreditR&D expenditures used to calculate the R&D tax credit include the wages paid to employees for engaging in qualifying R&D activity within the US, including direct supervision and direct support of such activities. Also, up to 65% of outside contractor costs associated with qualifying R&D activities can count towards the credit calculation as well, as long as the contractors are based in the US.
Very Meaningful Federal And State Tax Credit
The federal R&D tax credit typically comes out to about 5% to 7% of the above R&D spend. Most states have an R&D tax credit as well. Texas, for example, has a state R&D tax credit that comes out to about 2/3 of the federal credit and can be used to offset up to 50% of the Texas franchise taxes paid by a company each year.
The Benefit To Oil and Gas Companies
These dollar-for-dollar federal and state tax credits can significantly reduce the tax burden for oil and gas companies. In this very competitive industry, these tax savings can be used for further investments in technological advancements and also to finance additional projects and to hire more employees.