Although taxes are not commonly thought of as an interesting topic, in March of this year, the Texas Supreme Court heard oral argument on a case that should be fascinating to all Texas operators. If the Court sides with Southwest Royalties, Inc., and against the Texas Comptroller, operators may see huge refunds and large future sales tax exemptions.
This case began when Southwest applied for a refund of sales and use taxes in 2009 for downhole oil and gas equipment. The Comptroller denied the claim, and Southwest filed suit. The three exemptions that Southwest claimed applied are as follows:
• § 151.318(a)(2): Equipment directly used or consumed in or during the actual processing of tangible personal property for ultimate sale if the use or consumption of the equipment is necessary or essential to the processing operation and directly makes or causes a physical change to the product being processed;
• § 151.318(a)(5): Equipment used or consumed in the actual processing of tangible personal property for ultimate sale if the use or consumption of the equipment is necessary and essential to a pollution control process; [and]
• § 151.318(a)(10): Equipment used or consumed in the actual processing of tangible personal property for ultimate sale if the use or consumption of the equipment is necessary and essential to comply with federal, state, or local laws or rules that establish requirements related to public health.
Southwest argues that not only does the downhole equipment ensure there is no water pollution, as required by the Texas Railroad Commission, but that it also “directly caused and controlled physical changes in the crude hydrocarbons, separating them into oil, gas, and condensates (including contaminates) for separate sale.” Therefore, Southwest claims, the downhole equipment falls squarely into the exemptions allowed.
The Comptroller, on the other hand, contends that the “hydrocarbons would experience phase change regardless of the presence of Southwest’s casing or equipment.” Thus, the downhole equipment could not be considered to be necessary or essential to the processing of the oil and gas, and did not directly make or cause a physical change. The lower court agreed with the Comptroller, and ruled against Southwest.
Southwest appealed, but the appellate court affirmed the lower court’s decision. The appellate court found that “the extraction of oil and gas from the ground would not seem to qualify as manufacturing.” The appellate court, in making its decision, noted that “processing” is merely a subset of manufacturing. Southwest appealed to the Texas Supreme Court.
In its appeal to the Texas Supreme Court, Southwest vehemently argued that processing is a separate and distinct activity from manufacturing. “Processing and manufacturing are not synonymous, even though these activities might sometimes occur together. The refund should be based not just on manufacturing—not when the statute uses the disjunctive or in the phrase ‘manufacturing, processing, or fabrication.’”
In a second point, the Comptroller claimed that even if the Court agreed with Southwest that the downhole equipment actually processed the oil and gas, and that processing was sufficient under the tax code, “minerals underground are not ‘tangible personal property’” and thus downhole equipment ‘processing’ oil and gas cannot qualify for the exemption. The Comptroller noted that “[i]t has always been the law in Texas that minerals are part of the real estate until they are removed from the ground.”
In response, Southwest pointed out that:
[s]evered hydrocarbons do amount to tangible personal property: there is an age-old principle that petroleum severed from real property becomes personal property when removed from its reservoir. One hundred years ago, this Court cited learned authorities in its opinion in Texas Company v. Daugherty. In that tax case, the Court explained that minerals are real property as long as they ‘remain in the ground, outside of an artificial receptacle at least, as the casing of a well or pipe line.’ Once captured and trapped in the well’s casing or pipeline, they become personal property.
We have to wait until the Texas Supreme Court makes a decision before filing for those refunds, but it’s an interesting wait. And ultimately, even if Southwest is successful, the legislature may jump into the fray and rewrite the Code to ensure the exemption does not apply to downhole equipment. For now, though, I intend to keep a close watch on this case because it is indeed captivating, even though it’s centered around one of the most tedious of topics.