Texas Supreme Court Denies Manufacturing Exemptions for Equipment and Services Used "Downhole" During Production of Oil and Gas

Southwest Royalties, Inc. ("Southwest") requested a refund of Texas sales and use taxes paid on casing, tubing, pumps, related parts, and associated services used in oil and gas production. Southwest contended that the items are exempt under Tex. Tax Code section 151.318 because they extract and separate the mixture into its components of oil, gas, condensate, and water. Therefore, these items are directly used in the actual manufacturing or processing of oil, gas, and other products and directly make a chemical or physical change to the products. Furthermore, Southwest demonstrated that casing contains the products during production, and the equipment alters and regulates the pressure of the products during production. This prevents escape, spills, and contamination of groundwater. Therefore, it is necessary or essential to control pollution that can result from oil and gas production and to comply with federal, state, or local laws related to public health. 

In opposition, the Comptroller pressed the Court to hold that extraction of minerals from the earth is not manufacturing or processing for sales tax purposes and that no processing can occur "underground." The Court declined to make such sweeping determinations and instead focused on the narrow issue of whether Southwest proved that the downhole equipment "acted upon the hydrocarbons to modify or change their characteristics." The Court applied the Comptroller's definition of "processing" in 34 Tex. Admin. Code section 3.300(a)(10):  "The physical application of the materials and labor necessary to modify or to change the characteristics of tangible personal property." 

Relying on this definition and the trial court's findings of fact, the Court concluded that although physical and chemical changes occur in the oil, gas, and hydrocarbons during production, these changes occur naturally due to pressure and temperature changes. Therefore, the downhole equipment was not used in the "actual" physical application of materials and labor to the hydrocarbons necessary to cause a physical change in them. 

This decision appears to leave intact the Comptroller's previous determinations to grant manufacturing and processing exemptions to other types of equipment and materials used in oil, gas, and mineral production and extraction. In other words, the Court redirected the Comptroller's focus to whether a piece of equipment, chemical, etc., actively causes a physical or chemical change in the product being processed.

The Court did not address the taxpayer's remaining contentions that the downhole equipment qualified for the pollution control and public health exemptions. Likewise, the Court did not distinguish between items purchased before and after October 1, 1997. (Effective October 1, 1997, the Legislature modified Tex. Tax Code section 151.318 significantly, introducing the new requirement of a "chemical or physical change" and completely rewriting the remainder of the law.)

It was not known at press time whether the taxpayer would request a rehearing from the Court.

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