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On June 17, 2016, the Texas Supreme Court decided the case Southwest Royalties, Inc. v. Hegar. In so doing, it affirmed two decisions that concluded that Southwest Royalties, Inc., an oil and gas exploration and production company, was not entitled to a refund on the sales tax it paid on well equipment and associated services from January 1, 1997 to April 30, 2001.

Southwest uses the equipment at issue during the process of extracting hydrocarbons from underground mineral reservoirs, separating them into their component substances, and bringing them to the surface. The company filed a tax refund claim with the state’s comptroller in 2009, relying on a Texas statute providing that certain items are exempt from taxes if “sold, leased, or rented to, or stored, used, or consumed by a manufacturer.” Relevant to Southwest were the provisions exempting tangible personal property if:
  1. [The] tangible personal property [is] 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.
  2. Its use is necessary to a pollution control process.
  3. Its use is necessary to comply with federal, state, or local laws or rules that establish requirements related to public health.
The basis of Southwest’s argument was that it uses the equipment to process the hydrocarbons – separating them into their component parts – as they are extracted from the reservoir, in order to produce saleable products. 

The Texas comptroller denied the exemption, reasoning that oil and gas companies are not considered to be manufacturers. Additionally, it relied on a previous determination that the equipment was used for transportation; extracting minerals from the ground and bringing them to the surface is not manufacturing, the comptroller declared. 

The appeals

On appeal, the court opined that because the statute was ambiguous regarding what qualifies as property or services used during actual manufacturing, processing or fabrication, it would defer to the comptroller’s interpretation. Thus, Southwest’s multi-part argument in the Supreme Court consisted of the following:
  1. Hydrocarbons are tangible personal property once they are severed from the reservoir and pass into the casing in the wellbore. 
  2. The equipment is used for processing because it separated the hydrocarbons into their component parts.
  3. The statute is not ambiguous so deferral to the Comptroller’s interpretation is not appropriate. 
  4. The equipment is essential for controlling pollution and complying with public health laws.  
The Supreme Court declared part of its job to be resolution of the seemingly simple question of whether the statute’s use of the term “processing” was ambiguous, even though neither side argued that it was.  

Determining the statute was not ambiguous, the Supreme Court then turned to the question of whether the equipment at issue was used in processing.  Scrutinizing the definitions of terms like “used” and “actual,” the Supreme Court asserted that the changes were caused not by the application of equipment and materials, but by natural pressure and temperature changes that occurred while the hydrocarbons travel from reservoir to the surface. For these reasons, the Supreme Court concluded that Southwest’s equipment was not used in the “actual manufacturing, processing, or fabrication” within the meaning of the statute.  Thus, it was not entitled to a tax refund.

The state’s budget surplus remains intact

The Supreme Court’s opinion gave no hint of the dollars at issue. But the Texas Tribune reported that although Southwest sought a refund of less than $500,000, billions of dollars were at stake. The paper noted that a ruling in the company’s favor could have prompted up to $4.4 billion in refund filings for 2017 alone.  It also pointed to the comptroller’s  warning that a decision against his office could “trigger a flood of refunds that would wipe out the state’s projected $4 billion budget surplus.”

The Texas Oil & Gas Association issued a statement in response to the ruling expressing its disappointment, contending that “[i]t is undeniable that oil and natural gas exploration and production today is more and more a manufacturing process.”  The organization vowed to continue discussing equitable tax treatment.

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