Texas Supreme Court Affirms That Use of Oil & Gas Downhole Equipment Is Not Manufacturing

Thoughtware Alert Published: Jul 07, 2016
Oil Field

On June 17, 2016, the Texas Supreme Court (Court) issued the long-awaited decision in Southwest Royalties, Inc. v. Hegar, No. 14-0743. The Court denied the manufacturing exemption for casing, tubing, pumps and other downhole equipment used in oil and gas production. The Court held that downhole equipment doesn’t cause a direct physical or chemical change to the product and that such changes occur naturally while the equipment merely transports the hydrocarbons during the extraction process.

Southwest Royalties, Inc. is an oil and gas exploration and production company that purchased and paid sales taxes on equipment, materials and associated services used in oil and gas production. In 2009, Southwest Royalties filed a sales and use tax refund claim with the Texas Comptroller of Public Accounts (Comptroller) seeking a manufacturing exemption for casing, tubing, pumps and other downhole equipment used in oil and gas production. Pursuant to Texas Tax Code §151.318, Property Used in Manufacturing, tangible personal property directly used or consumed in or during the actual manufacturing, processing or fabrication of tangible personal property for ultimate sale is exempt from sales and use tax if the use or consumption of the property is necessary or essential to the manufacturing or processing and directly makes or causes a chemical or physical change to the product for sale.

Southwest Royalties argued that the downhole equipment used in the oil and gas extraction process separated the hydrocarbons into components and brought them to the surface and, therefore, was necessary and essential to the extraction process and made a physical and chemical change to the product. The Comptroller denied the claim, asserting the downhole equipment was used for transportation purposes, not manufacturing. In turn, Southwest Royalties filed suit.

After the oral hearings, the trial court judge initially indicated he agreed with the taxpayer on the equipment qualifying for the exemption. However, after the Comptroller announced a taxpayer victory would cost the state more than $4.4 billion in tax refunds and lost revenue, the judge sided with the Comptroller in the Court’s written opinion. The appellate court affirmed the lower court decision; however, the judge used a different reasoning and found the manufacturing exemption statute ambiguous.

The case made its way to the Texas Supreme Court, which didn’t find the manufacturing exemption statute ambiguous but actually rooted in the dictionary definitions of manufacturing and processing. According to the Court, the legislature intended “processing” to mean the application of materials and labor necessary to modify or change characteristics of tangible personal property. The Court didn’t dispute whether physical and chemical changes occur to hydrocarbons during the extraction process; however, it stated these occur naturally due to temperature and pressure changes, not the taxpayer’s equipment. According to the Court, the downhole equipment simply transports the hydrocarbons to the surface. Under the Texas statute, transportation and handling equipment doesn’t qualify for a manufacturing exemption because it doesn’t directly cause a physical or chemical change—even if it’s necessary to the process. Therefore, the Court found that the downhole equipment didn’t qualify for the manufacturing exemption, siding with both the trial court and court of appeals. The finality of this decision depends on whether the taxpayer files a motion for rehearing in the next few days.

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