This article was updated on January 8, 2024.
The oil and gas industry is no stranger to innovation, and substantial tax incentives are available to help support this activity. The R&D tax credit is available to companies developing new or improved products, processes, techniques, formulas, inventions, and software.
What Is the R&D Tax Credit?
The R&D tax credit is a dollar-for-dollar tax savings that directly reduces a company’s tax liability. There’s no limitation on the amount of expenses and credit that can be claimed each year. If the R&D credit can’t be used immediately or completely, any unused credit can be carried forward for up to 20 years. Previously filed tax returns can typically be amended for up to three years to claim the R&D credit, retrospectively, providing an avenue to recoup previously paid taxes.
The R&D tax credit is available both at the federal and state level, with several states in prominent oil and gas producing areas offering an R&D credit to offset state tax liability. State credits may also be carried forward for a length of time as determined by the state.
How Much Can a Company Save with R&D Tax Credits?
There’s no limit, but several factors can impact savings. Some clients save a few thousand dollars and others save millions of dollars each year. Generally, the more a company spends to innovate, the more they can potentially save. Companies can typically save up to 10% of annual R&D costs for federal purposes and much more when state credits are considered.
Start-up companies and small businesses may be eligible to apply their federal R&D credit to offset the company’s portion of payroll taxes of up to $250,000 per year for five years, which is $1.25 million in potential savings.
When Does the R&D Credit Apply?
This often underutilized opportunity to reduce a company’s income tax burden offers significant tax savings to those that participate in qualifying activities by allowing them to include certain expenses directly connected to qualified research.
Examples of Qualified Costs
- Taxable wages paid to employees for performing qualified R&D activities, which includes direct R&D, as well as first line managers and personnel who directly support the R&D projects
- Supplies and raw materials consumed during the R&D process such as developing prototype parts or components, pilot models, and destructive testing
- Contractor expenses paid for qualified R&D activities performed on behalf of the company
Examples of Qualified Personnel
- Petroleum engineers developing new field designs
- Well-spacing and field design during the drilling and production of oil and gas
- Mechanical, facility, industrial or industrial distribution engineers designing new facilities and tools
- Electrical engineers designing electrical systems
- Pipeline engineers designing and constructing new pipelines
- Welders and skilled fabricators supporting construction and design efforts
- Computer-aided design (CAD) modelers and designers who design facilities and equipment
What Activities in the Oil and Gas Industry Qualify for the R&D Credit?
To qualify for the credit, companies must prove they’re engaging in qualified R&D activities. Here are some examples of qualified activities companies might be engaging in at each stage of the petroleum production lifecycle.
Upstream
- Development of new well configurations and production designs that are new to a specific operator
- Experimentation of new drilling processes or completion designs. These processes could include new fracking technologies or fluids, drilling designs to enhance overall recovery, the experimentation of new technologies to increase efficiency, and overall quality of the wellbore
Midstream
- New or improved facility and pipeline design and development
- Cathodic protection design
- Lease automatic custody transfer (LACT) system design
- Metering system development
- Electrical and instrumentation engineering
Downstream
- Processing facility design
- Pilot plant design and development
Services
- Compressor design
- Downhole tool design
- Drilling rig design
- Auxiliary equipment design
- Development of new or improved frac or drilling chemicals
- Development of software for fracture design, drilling software, modeling, etc.
What Are the Steps to Apply for R&D Credits?
Assess whether activities qualify and how many credits are available. Once the scope of the potential credit is outlined and the required supporting documentation is submitted, schedule the interviews and site visits needed to help secure the credit.
Significant tax planning should go into this process because capital improvement projects can sometimes utilize different credits and deductions that impact tax liability when combined with carryforward limits. There’s a certain level of documentation required to successfully claim the credit, and there are penalties if done incorrectly.
Four-Part Test
R&D activities must meet each of the following IRS criteria, known as the four-part test, and be performed in the United States. There’s no distinction between a project’s success or failure as long as the following criteria are met for R&D purposes. The four parts include:
- Qualified purpose
- Technological in nature
- Technical uncertainty
- Process of experimentation
Qualified Purpose
The goal of the research must be to create a new or improved product or process that results in increased performance, function, reliability, or quality.
Technological in Nature
The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
Technical Uncertainty
The activity needs to be intended to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the design.
Process of Experimentation
This includes any activities undertaken to eliminate or resolve technical uncertainty, and requires evaluating alternative solutions or approaches through modeling, simulation, numerical analysis, systematic trial and error, or other methods.
State R&D Credits
In addition to federal R&D credits, there are state credits available nationwide. Some notable states that have oil and gas activity are:
- Texas
- California
- Colorado
- Pennsylvania
- New Mexico
- North Dakota
Specific tax benefits may vary from state to state, but the above listed, as well as others, can be quite valuable to taxpayers for additional tax savings during the tax year.
Internal Revenue Code (IRC) Section 174 and the R&D Credit
The Tax Cuts and Jobs Act of 2017 (TCJA) made significant changes to the way businesses can deduct research and experimental (R&E) expenses. Beginning in the 2022 tax year, businesses are required to capitalize and amortize R&E expenses over five years for domestic costs and 15 years for foreign costs. This change means that businesses must now capitalize R&E expenses, including any software development costs.
Capitalization of R&E expenses doesn’t affect the amount of expenses that can be claimed for the R&D tax credit. The R&D tax credit is still calculated based on qualified research expenses (QRE), which are a subset of R&E expenses that meet certain criteria. This means oil and gas and other energy companies may still be able to claim the R&D tax credit.
We’re Here to Help
To learn more about R&D tax credits, please reach out to your Moss Adams professional. You could also request a complimentary credit benefit estimate to see how much your company could save.
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