On Aug. 21, 2014, the Multistate Tax Update addressed a Colorado case ruling in favor of a natural gas company in a sales tax exemption dispute. Here, we address a Texas case that dealt with a somewhat similar sales tax exemption statute, but held that equipment used in extracting oil and natural gas failed to qualify for the exemption.
In Southwest Royalties, Inc. v. Susan Combs, et al., No. 03-12-00511-CV (Tex. Ct. App. 2014), Southwest Royalties, Inc. (Southwest), filed a refund claim with the State of Texas Comptroller for taxes that it paid from Jan. 1, 1997 through April 30, 2001 on equipment used in the extraction of oil and natural gas. Southwest alleged that such equipment qualified for manufacturing exemptions in Tex. Tax Code § 151.318(a)(2), (5), and (10).
The pertinent Texas manufacturing exemptions are:
(2) 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
(5), (10) tangible personal property used or consumed in the actual manufacturing, processing, or fabrication of tangible personal property for ultimate sale if the use or consumption of the property is necessary and essential to: (5) a pollution control process [and] (10) comply with federal, state, or local laws or rules that establish requirements related to public health.
The equipment Southwest sought exemptions for consisted of “casing, tubing, pumps, and related parts” in addition to services related to the equipment purchases. Southwest contended that “the equipment was used in or during the actual processing of product to extract and separate the mixture into its components of oil, gas, and water, and is necessary and essential to that process”, and caused a direct physical change to the products. Furthermore, Southwest contended that the equipment “was necessary and essential to a pollution control process and to comply with public health regulations” pursuant to the exemption statutes.
The court held that the extraction of oil and gas from the ground does not qualify as manufacturing. The fact that the term “extraction” was not specifically enumerated in the statute appeared to be the deciding factor for the court. The court in Southwest placed great emphasis on narrowly interpreting exemptions from taxation, and providing deference to the Comptroller’s interpretation. The court noted that “[s]tatutory exemptions are strictly construed because they undermine both uniformity and equality of taxation by imposing a heavier burden on some taxpayers instead of imposing the burden equally on all taxpayers.”
The court determined that the phrase “manufacturing, processing, or fabrication” in the exemption statutes does not include extraction. The court stated that the legislature’s distinguishing of manufacturing from extracting in other contexts lends support for their conclusion. The court agreed with the Comptroller that extraction is more like an act “in preparation for production” as opposed to an act of manufacturing. Furthermore, extracting was not processing because processing means “the physical application of the materials and labor necessary to modify or to change the characteristics of personal property” and to assemble or “make tangible personal property work in a new or different manner.” 34 Tex. Admin. Tax Code § 3.300(a) (5), (10).
Finally, the court agreed with the Comptroller that if it were to accept Southwest’s arguments that the manufacturing exemption includes equipment and services used in the extraction of oil and gas, then it would effectively make other provisions of Texas’ tax code unnecessary. For example, section 151.324 of the Texas Tax Code exempts certain equipment used for mineral exploration or production. In addition, one subsection of section 151.317 of the Texas Tax Code exempts gas and electricity sold for use in powering equipment exempted under the manufacturing exemption and used in a certain manner and another subsection exempts gas and electricity used “directly in exploring for, producing, or transporting, a material extracted from the earth.”
Pioneer v. Southwest
The Pioneer and Southwest cases deal with a somewhat similar set of facts and statutes, but the analysis and outcomes sharply contrast one another. While both cases claim to follow a plain meaning approach to analyzing the statutes, the Pioneer court was much more willing to stretch the meaning to exempt the property at issue. In that case, one of the manufacturing exemptions did include the term “extraction” but the equipment at issue was used for a gas gathering system, which the Pioneer court noted is not exactly the same as extraction. However, the Pioneer court determined that the gas gathering system was part of the manufacturing process and qualified for certain manufacturing exemptions.
The Southwest court, on the other hand, determined that when the boundaries of the manufacturing exemption were not clear from the statute, it was required to defer to the Comptroller’s interpretation of the statute unless it was plainly erroneous or inconsistent with the statutory language. Therefore, the Southwest court granted more deference to the taxing authority than the Pioneer court.
These two cases illustrate why a business should involve tax practitioners to assist them in determining whether certain activities of the business may qualify for exemptions from taxes when such activities do not clearly fall within or outside of such exemptions.