United States

Texas: Supreme Court Holds That an Oil and Gas Producer Did Not Qualify for the Manufacturing Exemption

Jun 27, 2016
From KPMG TaxWatch

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On June 17, 2016, the Texas Supreme Court held that an oil and gas producer was not entitled to claim a manufacturing exemption on certain types of machinery and equipment and services used in the oil production and extraction process.  In 2009, the taxpayer, Southwest Royalties, filed a refund claim contending that certain purchases of oil and gas well equipment, including casings, tubings, wellhead and pumping equipment, and associated services, were exempt from sales and use tax under Texas’ manufacturing equipment exemption. The taxpayer’s primary argument was that the oil and gas well equipment was exempt because of the activities that occurred downhole or below the ground surface before the oil or gas was extracted. Specifically, the taxpayer asserted that hydrocarbons (oil, gas and associated substances) extracted from an underground reservoir had to be separated into their component parts to produce saleable products. Thus, the equipment for which it sought refunds was used in “processing” the hydrocarbons as they were  extracted from the reservoir, separated, and brought to the surface. The taxpayer also argued that because the downhole activity was “processing” other equipment was exempt as tangible personal property used in processing that was necessary and essential to the pollution control process, and that certain chemicals consumed during the processing were likewise exempt.

The taxpayer’s refund claim was denied by the Comptroller’s office and the matter eventually went to district court. The district court judge originally held in the taxpayer’s favor in an oral ruling; however, on reconsideration the judge ruled in favor of the Comptroller’s office. The Texas Court of Appeals later affirmed that ruling. The taxpayer subsequently appealed to the Texas Supreme Court.

The court first determined that the term “processing” was not ambiguous and meant the application of materials and labor necessary to modify or change the characteristics of tangible personal property. All three tax code sections under which the taxpayer sought an exemption all required that the property at issue be used in “processing.” It was undisputed that the hydrocarbons underwent physical changes as they moved from underground reservoirs to the surface. However, the question was whether the taxpayer’s equipment created those changes. The court concluded that it did not. In the court’s view, there was no evidence that the equipment acted on the hydrocarbons to modify or change their characteristics. Instead, the changes in the substances were caused by the natural pressure and temperature changes that occurred as the hydrocarbons traveled from the reservoir through the casing and tubing to the surface. Please contact Shawn McDermott at 713-319-2472 with questions on Southwest Royalties Inc. v. Hegar. 

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.