Court of Appeals Hears Argument Regarding Texas Sales Tax Exemption for Oil and Gas Equipment

The Texas Third Court of Appeals heard oral argument today in Southwest Royalties, Inc. v. Combs, No. 03-12-00511-CV.  The case addresses whether oil and gas operators may claim the Texas sales and use tax manufacturing exemption on their purchases of certain above-ground and downhole production equipment.  An ultimate win for the taxpayer here could mean Texas sales and use tax refunds for many other Texas oil and gas operators.

The court below denied the taxpayer’s Texas sales and use tax refund claim, and the taxpayer appealed.  However, the lower court judge verbally ruled in the taxpayer’s favor after trial, only to reverse his decision in his later written judgment.

In this article, I’ll briefly explain the legal basis for the taxpayer’s Texas sales and use tax refund claim, then discuss the issues of particular interest to the Third Court of Appeals today.

Texas Sales and Use Tax Manufacturing Exemption Background

Texas law exempts from sales and use tax certain items used in manufacturing and processing tangible personal property for sale to customers.  Some of these items exempt from Texas sales and use tax under the manufacturing exemption include items that actually cause a chemical or physical change to the item to be sold, as well as items used in manufacturing to control pollution or comply with public health laws.

The taxpayer contends that oil and gas extraction constitutes processing of tangible personal property for sale.  The taxpayer also argues that the above-ground and downhole production equipment in question causes a physical change to the oil and gas produced, because during the extraction process, some of the oil becomes gas (casinghead gas) and some of the gas becomes oil (condensate).  The taxpayer further argues that much of the above-ground and downhole production equipment is necessary to control pollution and/or comply with public health laws.

On the other hand, the state asserts that the extraction of oil and gas is not manufacturing and processing and that the above-ground and downhole production equipment in question does not cause a chemical or physical change to the oil and gas.  The state also asserts that the oil and gas is not tangible personal property, but real property.  Only items used in the manufacturing or processing of tangible personal property qualify for the manufacturing exemption.

Issues of Interest to the Third Court of Appeals

The Third Court of Appeals questions centered on three issues.  First, the Court asked about the definition of manufacturing or processing.  In particular, the Court was interested in whether the lower court actually found that the taxpayer engaged in manufacturing or processing.  The lower court found that a chemical or physical change occurred, but did not state directly whether the taxpayer engaged in manufacturing or processing.  The question remains whether that causing a chemical or physical change to a product alone constitutes manufacturing.

The Court also asked whether oil and gas constituted tangible personal property, and if so, when.  While it’s clear that Texas law considers oil and gas to be real property when it’s in the ground unextracted, the taxpayer and the state differed on when during the extraction process that oil and gas becomes tangible personal property.

Finally, the Court asked how it should determine when an item directly causes a chemical or physical change.  The taxpayer and the state seemed to conflict on whether the test was but-for causation (the change would not have occurred but for the item) or a higher standard.

Taxpayers should have an answer to these questions from the Third Court of Appeals sometime in the next few months.  However, because of the importance of the issue, there is a good chance that whoever loses will appeal to the Texas Supreme Court, meaning that a final answer for taxpayers is still a ways off.  In the meantime, however, oil and gas producers and other similarly-situated taxpayers may consider the possibility of filing protective refund claims.  A Texas tax professional, such as a Texas tax attorney, may be able to assist taxpayers in determining whether such protective refund claims are necessary.

 

 


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