Texas sales tax ruling disallows exemption for extraction equipment

July 1, 2012
In recent months the application of Texas sales tax to oil and gas extraction equipment has become a high stakes question for both oil and gas production companies as well as the state of Texas.

Elizabeth L. McGinley, Bracewell & Giuliani LLP, New York
R. Joe Hull, Bracewell & Giuliani LLP, Austin
Alexander W. Jones, Bracewell & Giuliani LLP, New York

In recent months the application of Texas sales tax to oil and gas extraction equipment has become a high stakes question for both oil and gas production companies as well as the state of Texas. If decided in favor of producers, Texas could lose more than $4 billion of sales tax revenues, creating a significant budget gap. Alternatively, if the state prevails, and the sale of oil and gas extraction equipment continues to be subject to state tax, the higher cost of oil and gas production in Texas could drive business to states where the tax incentives for production are greater.

At the center of this debate is the Southwest Royalties case in Travis County (Austin). State District Court Judge John K. Dietz first ruled in favor of the taxpayer, exempting certain oil and gas extraction equipment from the Texas sales tax. But then, after further consideration, he reversed his own ruling and determined that no exemption from sales tax is available for the sale of oil and gas extraction equipment.

This article considers the rationale for these decisions as well as the significant economic impact of this issue to producers and the state of Texas.

Texas imposes a sales tax, at a rate of 6.25%, on each item of property sold in the state not specifically exempt from such tax. One sales tax exemption, the "manufacturing exemption," applies to property used or consumed in or during the actual manufacturing, processing, or fabrication of tangible personal property for ultimate sale if such property is necessary or essential to the manufacturing, processing, or fabrication operation, and directly causes a chemical or physical change to the product manufactured or processed.

In Southwest Royalties, Inc. v. Combs, Case D-1-GNU-09-004282 (Travis County 250th Dist. Ct.), the taxpayer, Southwest, claimed that, pursuant to Texas common law, taxpayers may rely upon the plain meaning of the law, and the plain meaning of the manufacturing exemption would exclude from sales tax well equipment used to process oil and gas that directly causes a chemical or physical change to the oil and gas.

Although "processing" is not statutorily defined, the state comptroller has defined "processing" to mean the physical application of the materials and labor necessary to modify or change the characteristics of tangible personal property. Southwest asserted that the component parts of producing oil or gas wells and the ancillary support equipment qualify for the manufacturing exemption from sales tax because the property is necessary for processing oil and gas and the use of the property changes the oil and gas processed.

In support of its position, Southwest demonstrated that the well, including the pumps, creates a difference in pressure between the reservoir and the wellbore, which causes fluids to flow into the wellbore. This difference in pressure causes a thermodynamic physical change to oil or gas in the wellbore.

Southwest stated that the state comptroller previously had exempted from sales tax property causing a similar change including surface separating equipment such as gun barrels and separators that cause similar thermodynamic changes at the surface. Southwest argued that many of the items of tangible personal property that it acquired for use in the extraction process from January 1, 1997 to April 30, 2001, including casing, tubing, wellhead, and pumping equipment, thus should be exempt from Texas sales tax because the items were used to effect such a physical change.

The comptroller responded that pursuant to its longstanding policy dating back to the 1960s, oil and gas exploration and production companies are not manufacturers or processors, thus well equipment was never intended to qualify for the manufacturing exemption. The comptroller also contended that, even if oil and gas extraction was properly treated as a production activity, the equipment purchased by Southwest does not cause a chemical or physical change to the oil and gas extracted from a well and therefore is not eligible for the manufacturing exemption.

At the conclusion of the trial, Judge Dietz announced from the bench that he agreed with Southwest that the well equipment is essential to the oil and gas production process and caused a physical change of the hydrocarbons in the wellbore. On rehearing, however, Dietz expressed concern that the physical change that occurs in the oil and gas well is merely incidental to the process of bringing the oil and gas to the surface and is not caused by the wellbore. The judge concluded that Southwest had not satisfied its burden of proof that the equipment used to extract oil and gas directly causes a physical change in the oil and gas extracted.

In his final signed judgment, Dietz agreed with the comptroller, reversed his prior ruling, and held the equipment that Southwest purchased for use in the extraction process is not exempt from Texas sales tax. Southwest said it intends to appeal his final judgment.

Unless Judge Dietz's latest ruling is overturned on appeal, Texas may be at a competitive disadvantage to other states in attracting oil and gas development. Other states that provide targeted tax advantages related to oil and gas exploration may be better able to encourage development in their state.

Natural gas rich New York, Ohio, and Pennsylvania, for example, provide a sales tax exemption for equipment used directly in the oil and gas extraction process, reducing the cost of production. Texas's closest oil and gas producing neighbors, Oklahoma and Louisiana, however, generally do subject equipment used in the oil and gas extraction process to sales tax, but at lower rates than Texas. Accordingly, Texas must determine whether the competitive benefits it could derive from expanding its sales tax exemption to include equipment used in oil and gas production would be greater than the potential loss of $4 billion in sales tax revenue.

About the authors:

Elizabeth McGinley is a partner and head of the tax practice at Bracewell & Giuliani LLP. She represents a variety of clients in the oil and gas and electric power industries, including private equity firms investing in oil and gas exploration, production and infrastructure, and is based in New York.
Joe Hull is a partner in the tax practice at the firm. He has substantial experience representing clients in federal, state and local tax matters in many industries, including oil, gas and petrochemical; equipment leasing; financial institutions and public finance. He is based in Austin, Tx.
Alexander W. Jones is an associate in the firm's tax practice where he focuses on the federal income taxation of corporations, partnerships and limited liability companies, as well as state and local tax matters. He is based in New York.
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