[author: James L. Fritz]

With the rush to develop the Marcellus Shale natural gas fields, the Pennsylvania Department of Revenue has been issuing guidance right and left to address the treatment of gas development activities under the sales and use tax and other state taxes. We have summarized below sales and use tax guidance from a recently-published bulletin, various Q&A's published on the Department's website, and several unpublished letter rulings and informal advisories.  These supplement the Department's formal regulations which pre-date the Marcellus Shale "fracking" activity.  Companies should keep in mind that while regulations have the force of law, published letter rulings are not binding as to anyone other than the company to which the letter was issued and other forms of published and unpublished advice are not binding at all.  We can assist companies to obtain formal letter rulings on which the company may rely.

Gas recovery activities qualify as mining

Starting with basics, the Department has made clear that extracting natural gas is an excluded mining activity:

The law defines mining to include exploring for, drilling, extracting and refining of natural resources such as natural gas.  The Department considers the actual mining process to begin with the drilling of the wellbore and ends with the last physical change of the gas prior to being sold and transferred by the miner to another.

PA Rev. Dept. Q & A (4/17/2012).

The Department has cited the following examples of gas recovery activities considered to be mining activities:

• Drilling
• Cementing (pumping cement slurry to bond casing or piping to the wall of the  bore hole)

•  Fracking (the use of a fluid, a mixture of water and chemicals, to crack the rock formation and the injection of proppants such as sand and ceramic materials into cracks in the formation to open channels through which the gas flows)
• Acidizing (the injection of acid below rock fractures to create flow channels within the rock formation)
• Extraction of gas from underground
• Removal of water and hydrocarbons from gas prior to its transfer from a miner to its customers

Id.

Taxable Pre-Mining, Post-Mining, Materials Storage and Other Non-Exempt Activities

Pennsylvania's mining exclusion applies only to tangible personal property and certain services directly used in excluded activities.  Pre-production, post-production and other remote activities do not qualify.

Site Preparation.  Machinery, equipment and other tangible personal property or services used to remove trees and clear ground in preparation for extraction activities is not considered to be directly used in mining.  61 Pa. Code § 32.35(a)(3)(i).  Property used to build access roads also is taxable.  Sales and Use Tax Bulletin 2012-01 (4/16/2012).

Examples of taxable site preparation equipment and materials include:

• Bull dozer
• Backhoe-front loader
• Stone, except stone directly under exempt equipment
• Road fabric
• Sluice pipe
• Security fencing
• Bridges and bridge construction materials

PA Rev. Dept. Q&A (4/17/2012).

Water and Other Materials Storage.  The construction of water holding ponds and other facilities for storage of materials is not considered part of the mining process.  Equipment used in fabricating such facilities, and materials consumed in the fabrication or incorporated into such facilities are not considered to be directly used in mining.  Sales and Use Tax Bulletin 2012-01 (4/16/2012).

Examples of taxable storage facilities:

• Pipe racks/pipe boats for pipe storage
• Fuel storage units
• Sand or gravel storage units
• Oil storage tank connected to the wellhead through a pipe.  Both the storage tank and the connecting pipe from the wellhead to the tank are taxable.
• Water storage ponds used to store water prior to being used in the drilling operations, including construction materials and rubber liner.
• Water transportation system pumping water from the river or creek to the water storage pond.

PA Rev. Dept. Q&A (4/17/2012).

Production Recording.  Equipment and supplies used to record the volume and pressure of gas flowing from the wellhead is not directly used in mining because there is no "active causal relationship" to the production of the gas.  Taxable items would include the chart recorder, batteries powering the chart recorder, charts, chart labels, pens, pen tips, pen arms and ink for the chart recorder.  House and farm tap meters used to measure gas used by the property owner also would be taxable if used by the mining company (but would be exempt under the Public Utility Exclusion if used by a public utility).  Unpublished Revenue Dept. Letter Ruling.

Exempt Mining Equipment.

Natural Gas Drilling Equipment qualifies for exclusion.

• Extracting natural gas qualifies as mining for sales and use tax purposes.  Property such as drilling equipment is considered directly used in a natural gas extraction operation.
• The mining exclusion, like all business exclusions (manufacturing, processing, public utility operations, etc.), is a limited exclusion.  Section 201(k)(8)(A) of the Tax Reform Code of 1971 provides that the exclusion may only be claimed by a purchaser who uses or consumes the property directly in a mining operation.

PA Rev. Dept. Q & A (4/2/2012).

Examples of exempt mining equipment and supplies in gas recovery activities.

• Drilling rig unit and all repair parts
• Drilling head
• Cutting bits
• Drilling extensions
• Fuel used to run the drilling unit
• Casing
• Cement to encase the casing
• A frack unit (affixed to the back of a truck chassis) and all repair parts and fuel used in running the frack unit
• Pump (placed at the bottom of the well)
• Pump rod (connected to the pump)
• Sucker pipe (pipe that allows oil to flow to the surface)
• Cap (affixed to the top of wellhead)
• Pump jack (provides upward and downward movement to the pump rod directly resulting in the operation of the pump)
• Electricity and off-road fuel used to run the pump jack
• Fishing or extraction tools used exclusively to retrieve and remove objects from drilled hole
• Gathering lines connecting wellhead to the last fluids and hydrocarbons removal system prior to miner selling and transferring gas
• Pit liner used in the sludge holding pond
• Silt fence and stakes

PA Rev. Dept. Q&A (4/17/2012).

Gyroscope Services.  A contractor qualified for the mining exclusion for his wireline equipment used to lower a gyroscope into an oil well to determine that the well was being drilled in the proper direction.  However the contractor's truck, as a registered vehicle, was not eligible for exemption.  Since the operator of the equipment was under the direction of the customer, the charge for the operator was for a taxable "help supply" service.  Unpublished Revenue Dept. Letter Ruling.

Foundations for Mining Equipment.  As a general rule, property and services used in the "construction, reconstruc­tion, alteration, remodeling, servicing, repairing, maintenance or improvement of real estate" are not covered by the mining exclusion.  However, materials incorporated into a foundation for exempt drilling equipment are excluded from tax.  Dozers, backhoes and other equipment used to construct the foundation would not be excluded.  Sand, stone and other materials incorporated into a rigging pad are examples of excluded materials.  See, Sales and Use Tax Bulletin 2012-1 (4/16/2012).

Compression Equipment.  Equipment and supplies are excluded from tax where used to compress natural gas at or near the gas mining site.  The compression qualifies as a continuation of the manufacturing/mining process.  This activity would be exempt whether performed by the mine operator or by a contractor working for the operator.  Unpublished Revenue Dept. Advisory Letter.

Electricity to Pump Oil or Natural Gas.  Electricity used to pump oil out of the earth is excluded from tax because it is directly used in manufacture/mining.  Electricity used to pump oil or natural gas from the well to a second location where the same company refines the oil or gas would also be directly used because the tax statute treats both extraction and refining as parts of manufac­ture/mining.  However, if the purchaser of the electricity does not perform a second excluded operation after extraction, tax would apply to electricity used in the transportation or storage of oil or gas after extraction.  Unpublished Revenue Dept. Letter Ruling.

Pollution Control and Abatement.  Property "used for waste handling and disposal of pollutants other than in the course of production operations is taxable unless the equipment, machinery and supplies are designed and used to control, abate or prevent air, water or noise pollution generated in the mining operation."  Sales and Use Tax Bulletin 2012-01 (4/16/2012).

"Ponds used to control or abate pollution generated in the mining operation … are excluded from tax.  Therefore, although equipment used to build such ponds is taxable, any materials used in that construction, such as liners, sand and gravel, would be excluded from tax."

Sales and Use Tax Bulletin 2012-1 (4/16/2012).

Containment.  Geotechnical products used to contain contaminated fracking water, erosion control products such as silt fences and stakes, and backup containment systems are exempt when used as pollution abatement systems.  Products used to hold clean water for use in drilling are considered to be taxable pre-production products.  Unpublished Revenue Dept. Letter ruling.

Gas Gathering Pipelines.  Company which limited its activities to construction and operation of underground pipelines linking natural gas producer's wells to producer's processing plant was entitled to claim mining exclusion on dehydrators (remove water and vapors to stabilize gas), pipes and materials used as foundations under the pipes.  Construction equipment used to build pipelines was taxable since not directly used in mining.  Unpublished Revenue Dept. Letter Ruling.

Distribution Storage Facility - Mining & Public Utility Exclusions

The Department of Revenue has issued an unpublished, informal advisory letter addressing the taxability of machinery, equipment and supplies to be used in operating an underground natural gas storage facility (a converted natural gas reservoir which had been depleted).  Although the facility's rates and service will be regulated by the Federal Energy Regulatory Commission, the Department did not characterize the facility, itself, as a public utility.  The facility's customers, however, included local gas distribution companies and pipeline companies (which are recognized utilities) as well as non-utilities such as natural gas marketers.

The Department indicated that machinery, equipment and supplies used to withdraw natural gas from the underground storage facility would qualify for the manufacture/mining exclusion because the statutory exclusion includes "extracting from the earth or from waste or stock piles … any natural resources …."  72 P.S. § 7201(c)(3).

Machinery, equipment and supplies used to compress and inject gas into the underground storage facility would not qualify for the manufacturing/mining exclusion, but could qualify for the Public Utility Exclusion if the majority of the storage was for companies constituting recognized public utilities.  Unpublished Revenue Dept. Advisory Letter.  (NOTE: If less than a majority of the storage was used by com­panies otherwise recognized as public utilities, we could suggest that such a storage facility further explore whether the facility itself should be characterized as a public utility.)

Miscellaneous.

Equipment Rental.  Provision of an operator with the rental of non-excluded equipment may be treated as two transactions:

Generally, when charges are billed separately for the equipment rental and the operator's time, the charges are taxable as taxable rental of equipment and taxable help supply service respectively.

PA Rev. Dept. Q & A (4/17/2012).

Compression Services.  Contractor provided a non­taxable service where compressor operator installed and operated compressor "based on conditions and specifications outlined in the service agreement," the operator was not on-site at all times and compensation was on a monthly lump-sum basis.  The contractor's compressor, lubricants, parts and supplies were considered exempt as directly used in mining.  Unpublished Revenue Department Letter Ruling.

Truck Chassis.  Tax applies to a "truck chassis to which drilling unit, frack unit, or service rig is affixed and repair parts."  Pa. Rev. Dept. Q&A (4/17/212).

Compression Services and Stripper Plant.  Tax applies to a "stripper plant that strips various hydrocarbons contained within the natural gas into byproducts for sale" and to "compression services alone without removal of fluids and hydrocarbons."  Pa. Rev. Dept. Q& A (4/17/2012).