Third Court of Appeals Defers to Comptroller on Manufacturing Exemption for Oil & Gas

As we reported earlier, the Third Court of Appeals ruled in Southwest Royalties, Inc. v. Combs that oil and gas above-ground and downhole production equipment doesn’t qualify for the Texas sales tax manufacturing exemption.  This case has drawn a fair amount of attention due to the large potential financial impact on the State of Texas should the taxpayers ultimately prevail — 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.  The Third Court of Appeals affirmed that decision.  This blog post discusses that Third Court of Appeals opinion and its potential implications in more detail.

Note that this opinion isn’t the end of the road for Southwest Royalties.  They may still file a Petition for Review with the Texas Supreme Court, and during a presentation at the Texas Society of CPAs’ State Tax Conference, an attorney for Southwest Royalties indicated that Southwest Royalties would be filing a Petition for Review.  The deadline for Southwest Royalties to file that Petition for Review is Monday, September 29, 2014, unless Southwest Royalties files a Motion for Rehearing (due August 28, 2014), in which case Southwest Royalties would have until 45 days after the Third Court of Appeals rules on that Motion for Rehearing to file a Petition for Review with the Texas Supreme Court.

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 argues 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 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 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 her long-standing policy not to classify the extraction of oil and gas as manufacturing.

The Southwest Royalties Opinion

The Third Court of Appeals sided with the Texas Comptroller, finding that the extraction of oil and gas didn’t constitute manufacturing.  In doing so, the Third Court of Appeals stated that the statute was ambiguous as to whether oil and gas extraction constituted manufacturing for the purpose of the manufacturing sales tax exemption.  As a result, the Third Court of Appeals applied the general administrative law principle that an agency’s construction of an ambiguous statute that it is charged with enforcing will be accorded deference if the construction is reasonable and does not contradict the plain language of the statute.  The Third Court deferred to the Comptroller’s construction and rejected Southwest Royalties’ arguments that the Third Court should not defer to the construction, which the Comptroller espoused in recent administrative hearings on the issue, because it (1) contradicted earlier Comptroller policy statements on the issue; (2) undermined a taxpayer’s ability to get a trial de novo (meaning, a trial in court on a clean slate without consideration of a prior administrative decision against a taxpayer on an issue); and (3) concerned a matter (oil and gas extraction) that was outside the Comptroller’s expertise.


In finding in the Texas Comptroller’s favor on the issue of whether the oil and gas equipment at issue qualified for the manufacturing exemption from Texas sales tax, the Third Court of Appeals was quite deferential to the Comptroller’s policy constructions.  However, in other recent cases, both the Third Court of Appeals and the Texas Supreme Court have been far less deferential to the Comptroller.  It remains to be seen whether the Texas Supreme Court will take this case up and, if so, whether the Court will take a less deferential approach to the Comptroller.  In the meantime, taxpayers should keep an eye on this case, particularly those in the oil and gas extraction industry.  Those oil and gas taxpayers who have not yet determined whether they would qualify for a refund if the taxpayer prevailed in Southwest Royalties should consult with a Texas tax professional, such as a Texas tax lawyer, to determine whether it may be appropriate for them to file protective refund claims while this litigation is ongoing.

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