The Texas Legislature recently passed House Bill 500, which reforms many aspects of the Texas franchise tax. Governor Perry is expected to sign the legislation. Among other things, the legislation expands availability of the cost of goods sold deduction for certain pipeline entities. Specifically, section nine of the legislation amends Texas Tax Code § 171.1012 to allow certain pipeline entities to deduct depreciation, operations, and maintenance costs as costs of goods sold if the costs are related to providing certain services with respect to products owned by other parties. As explained below the legislation is ambiguous, but it appears to apply to costs to provide gathering, processing, storage, and transportation services.

This new provision applies only to a pipeline entity that:

  • owns or leases and operates the pipeline by which the product is transported for others and only to that portion of the product to which the entity does not own title, and
  • is primarily engaged in gathering, storing, transporting, or processing crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids, except for a refinery installation that manufactures finished petroleum products from crude oil.

For purposes of the latter test, “processing” is defined as “the physical or mechanical removal, separation, or treatment of crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids after those materials are produced from the Earth. The term does not include the chemical or biological transformation of those materials.”

While this legislation is beneficial to pipeline entities, the ambiguous drafting raises a number of issues that pipeline companies will need to consider, including:

  • Whether the deduction is available when a pipeline company transports both its own products and products of others (i.e., whether the deduction is lost or simply prorated);
  • For which services the deduction is allowed (i.e., does the deduction apply only to costs to provide transportation and ancillary storage and processing services, or does it also apply to stand-alone storage and processing services provided without transportation services—in other words, what constitutes a service “related to the product” within the meaning of the new statutory provision);
  • The delineation between “processing” and “transformation”;
  • Establishing accounting procedures for calculating cost of goods sold under the Texas franchise tax’s unique rules;
  • Whether qualifying as a “pipeline entity” requires anything more than meeting the activity requirements of the new provision; and
  • What it means to be “primarily engaged” in the required activities.

This state tax update is intended only to provide a general summary of the legislation. If you have any questions about the legislation, please contact any Baker Botts state tax lawyer, including the authors of this update listed above.

The full text of the new provision, codified as Texas Tax Code § 171.1012(k-2) and (k-3) is as follows:

* * * *

SECTION 9.

Section 171.1012, Tax Code, is amended by adding Subsections (k-2) and (k-3) to read as follows:

(k-2) This subsection applies only to a pipeline entity: (1) that owns or leases and operates the pipeline by which the product is transported for others and only to that portion of the product to which the entity does not own title; and (2) that is primarily engaged in gathering, storing, transporting, or processing crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids, except for a refinery installation that manufactures finished petroleum products from crude oil. Notwithstanding Subsection (e)(3) or (i), a pipeline entity providing services for others related to the product that the pipeline does not own and to which this subsection applies may subtract as a cost of goods sold its depreciation, operations, and maintenance costs allowed by this section related to the services provided.

(k-3) For purposes of Subsection (k-2), "processing" means the physical or mechanical removal, separation, or treatment of crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids after those materials are produced from the earth. The term does not include the chemical or biological transformation of those materials.