On June 17, 2016, the Texas Supreme Court ruled that an oil and gas producer (“Southwest”) was not entitled to a statutory exemption from sales taxes on its purchases of casing, tubing and pumps used in the production of oil and gas (the “Equipment”).

At issue in Southwest Royalties, Inc. v. Hegar was whether the Equipment qualifies under the so-called “manufacturing exemption” found in Section 111.104(a)(2) of the Texas Tax Code,  which exempts:

tangible personal property directly used or consumed in or during the actual manufacturing, processing, or fabrication of tangible personal property for ultimate sale if the use or consumption of the property is necessary or essential to the manufacturing, processing, or fabrication operation and directly makes or causes a chemical or physical change to:

(A) the product being manufactured, processed, or fabricated for ultimate sale; or

(B) any intermediate or preliminary product that will become an ingredient or component part of the product being manufactured, processed, or fabricated for ultimate sale[.]

Upon being denied a tax refund, Southwest sued the Comptroller and the Attorney General (the “State”), asserting that the Equipment qualified for the exemption because it is necessary or essential to the “processing” of hydrocarbons as they are extracted from the reservoir and brought to the surface.  Specifically, Southwest contended that it processed the hydrocarbons by creating pressure and temperature changes as it brought the minerals to the surface, which resulted in the hydrocarbons being converted from a liquid to a gaseous state and vice versa.  The State contended that bringing minerals to the surface does not constitute “manufacturing,” and put on evidence to show that the phase changes identified by Southwest were the result of natural changes in pressure in temperature and were not caused by Southwest’s equipment.  In other words, it was “undisputed that hydrocarbons undergo physical changes as they move from underground reservoirs to the surface; the disagreement [was] about the role [the Equipment] play[ed] in those changes.”

The trial court ruled for the State upon finding that, while physical changes do occur to hydrocarbons while they are extracted from the ground and lifted to the surface, those changes were directly caused by temperature and pressure changes as the hydrocarbons moved upward toward the surface, rather than by the Equipment, which was an indirect cause of, and merely incidental to, those physical changes.  Therefore, the Equipment did not qualify for the exemption.

The Texas Supreme Court rejected the State’s request for deference to the Comptroller’s interpretation of Section 111.104(a)(2), confirming that agency deference is appropriate only in the case of ambiguous statutes.  In finding the statute unambiguous, the Court sided with Southwest in holding that the term “‘processing’ includes matters outside the confines of ‘manufacturing,’” and is not merely “encompassed within ‘manufacturing,’” as the State argued.  Thus, the Court found the exemption applicable to non-manufacturing activities that otherwise meet the definition of “processing” or “fabrication.”  Nevertheless, the Court did adopt the Comptroller’s definition of “processing” as found in 34 Tex. Admin. Code § 3.300(a)(10):  “The physical application of the materials and labor necessary to modify or change the characteristics of tangible personal property.”

The Court ultimately found the exemption inapplicable to Southwest’s Equipment on the grounds that the Equipment did not “process” the hydrocarbons (i.e., did not “modify or change the characteristics” of the hydrocarbons).  In so ruling, the Court expressly noted that Southwest did “not challenge any of the trial court’s findings of fact” or “the evidence supporting those findings,” which showed that the phases changes resulted from pressure and temperature changes.  According to the Court, “[n]o evidence identified any way Southwest’s equipment acted upon the hydrocarbons to cause a modification or change other than by being the vehicle through which they exited the underground formation and traveled to the surface.”  Instead, “[t]he changes in the substances were caused not by the application of equipment and materials to them, but by the natural pressure changes that occurred as the hydrocarbons traveled from the reservoir through the casing and tubing to the surface.”  Thus, because the Equipment was not used to “process” or directly cause the changes to the hydrocarbons, Southwest was not entitled to the exemption.

Liskow & Lewis attorneys Butch Marseglia and Jillian Marullo submitted an amicus brief in Southwest Royalties on behalf of EOG Resources, Inc.

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