Today, the Texas Supreme Court released its long-awaited opinion in Southwest Royalties, Inc. v. Hegar. It held that oil and gas above-ground and downhole production equipment doesn’t qualify for the manufacturing exemption from Texas sales and use tax, affirming the ruling of both the Third Court of Appeals and the trial court. This case has drawn some attention due to the large potential financial impact it would have had on the State of Texas if the taxpayers ultimately prevailed — after a trial court judge initially stated after an oral hearing that he was inclined to side with the taxpayers, the Texas Comptroller announced her estimate that a taxpayer win could cost Texas as much as $4.4 billion in tax refunds and lost revenue. (After another hearing, that trial court judge sided with the Texas Comptroller in his written opinion.) This blog post discusses the Texas Supreme Court’s opinion and its possible implications in more detail.
Background on Manufacturing Exemption
Texas law exempts from sales and use tax various items used in manufacturing and processing tangible personal property for sale to customers. Generally, the items exempt from Texas sales and use tax under the manufacturing exemption are items that actually cause a chemical or physical change to the item being sold, though there are some other categories of exemption.
In Southwest Royalties, the taxpayer contended that extraction of oil and gas constitutes processing of tangible personal property for sale. Further, the taxpayer argued that the equipment at issue 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).
On the other hand, the Texas Comptroller asserted 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 Texas Comptroller also argues 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. The Texas Comptroller argued that it was his long-standing policy not to classify the extraction of oil and gas as manufacturing.
The Southwest Royalties Opinion
The Texas Supreme Court affirmed the Third Court of Appeals’ decision that the taxpayer didn’t qualify for the manufacturing exemption from Texas sales and use tax on oil and gas above-ground and downhole production equipment. However, the Texas Supreme Court used different reasoning than the Third Court of Appeals to come to this conclusion. While the Third Court of Appeals deferred to the Texas Comptroller’s interpretation of the statute because it found the manufacturing exemption statute ambiguous, the Texas Supreme Court found that the manufacturing exemption statute was unambiguous. The Texas Supreme Court looked to the dictionary definitions of “manufacturing” and “processing” and found the question it needed to answer was “whether the equipment for which Southwest is seeking an exemption was used in the actual physical application of materials and labor to the hydrocarbons that was necessary to cause, and caused, a physical change to them.” The Texas Supreme Court found that it did not. According to the Texas Supreme Court, any changes to the hydrocarbons were caused by natural temperature and pressure changes, not the taxpayer’s equipment. The Texas Supreme Court said that the taxpayer’s equipment only served to transport the hydrocarbons to the surface. Accordingly, the Texas Supreme Court found that the taxpayer did not qualify for the manufacturing exemption from Texas sales and use tax.
While the Texas Supreme Court did not find for the taxpayer in Southwest Royalties, it is interesting that the Texas Supreme Court diverged from the Third Court of Appeals’ reasoning. The Third Court of Appeals’ opinion seemed unusually deferential to Texas Comptroller policy, in light of other recent Third Court of Appeals and Texas Supreme Court decisions that have generally been far less deferential to Texas Comptroller policy. Therefore, while the Texas Comptroller won this case, it weakens its possible use of the Third Court of Appeals’ highly deferential opinion as a tool in other cases when the Texas Comptroller seeks deference to his administrative policies.
Note that this decision is not yet final, as the parties have 15 days from the date of the decision to file a motion for rehearing. We will update this blog if either party files such a motion.
In the wake of this decision, taxpayers who find themselves uncertain of their Texas sales tax obligations may wish to seek the advice of a Texas tax professional, such as a Texas tax attorney, in order to clarify their obligations.