More quickly than I expected, the Texas Supreme Court recently issued an opinion in the tax case appeal filed by Southwest Royalties, Inc. The facts and arguments of this case were covered in a previous article, but a quick refresher is necessary.
In 2009, 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. All three of the exemptions that Southwest claimed applied required that any equipment must be used or consumed in or during the actual processing of tangible personal property, and that the equipment directly make or cause a physical change to the product.
Southwest argued that the downhole equipment “directly caused and controlled physical changes in the crude hydrocarbons, separating them into oil, gas, and condensates (including contaminates) for separate sale.” Therefore, the downhole equipment fell squarely into the exemptions allowed.
The Comptroller, on the other hand, maintained 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. Therefore, the appellate court found that Southwest did not qualify for the exemption. Southwest appealed to the Texas Supreme Court.
In its appeal to the Texas Supreme Court, Southwest 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.’”
Although there were other issues argued by the parties at the Texas Supreme Court level, the Court focused on the use of the word “processing” in the statute. The Court agreed with Southwest, holding that “[w]hile manufacturing may well include types of ‘processing,’ the use of the separate term ‘processing’ in the statute indicates the Legislature understood and intended that ‘processing’ includes matters outside the confines of ‘manufacturing.’”
Unfortunately for Southwest, and other operators that were possibly pulling out those old tax returns, the Court sided with the Comptroller on the issue of whether the downhole equipment actually processed the hydrocarbons, i.e. directly caused physical changes. The Court found that:
[n]o evidence identified any way Southwest’s equipment acted upon the hydrocarbons to cause a modification or change in them other than by being the vehicle through which they exited the underground formation and traveled to the surface. […] While the equipment unquestionably was both used in and necessary to the efficient recovery of hydrocarbons from their reservoirs, there is no evidence that the equipment acted upon the hydrocarbons to modify or change their characteristics. The changes in the substances were caused not by the application of equipment and materials to them, but by the natural pressure and temperature changes that occurred as the hydrocarbons traveled from the reservoir through the casing and tubing to the surface.
Therefore, the exemptions could not apply to the downhole equipment. Because the decision was made on these issues, the Court did not address any of the other claims in the case. So, the State gets to keep the money they got from those taxes, and the operators will continue to pay them. But don’t lose heart! In these slow economic times, it’s possible another operator will start digging into a different exemption and try again.