In Southwest Royalties, Inc. v. Hegar, the Texas Supreme Court addressed whether downhole oil & gas equipment – such as tubing, casing, and pumps – qualified for the manufacturing exemption from the Texas sales and use tax. The Court ultimately concluded that Southwest Royalties failed to prove its entitlement to the exemption by clear and convincing evidence.

In seeking a refund of sales tax paid on downhole equipment, Southwest Royalties relied upon three subsections of the Texas Tax Code, which exempt from tax:

• tangible personal property directly used or consumed in or during the actual manufacturing, processing, or fabrication process if the property is necessary or essential and directly makes or causes a chemical or physical change to the product;
• tangible personal property used or consumed in the actual manufacturing, processing, or fabrication process if the property is necessary and essential to the pollution control process; or
• tangible personal property used or consumed in the actual manufacturing, processing, or fabrication process if the property is necessary and essential to comply with federal, state, or local rules that establish public health requirements.

See Tex. Tax Code §§ 151.318(a)(2), (5), and (10). Southwest Royalties argued that the downhole equipment was directly used, necessary, and essential to the processing of oil and gas because it separated the hydrocarbons into their component parts (oil, gas, and water). In contrast, the Comptroller argued that the extraction of oil and gas was not processing within the meaning of the exemption, and, even if it were, the changes to the hydrocarbons during their movement to the surface were directly caused by natural pressure and temperature changes – not by Southwest Royalties’ equipment.

The Texas Supreme Court first determined the meaning of “processing” for purposes of the manufacturing exemption, looking to the Comptroller’s rule and defining processing to mean “the application of materials and labor necessary to modify or change characteristics of tangible personal property.” Then, the Court turned to the question of whether the equipment for which Southwest Royalties sought the manufacturing exemption satisfied the definition of processing. In other words, was the equipment “used in the actual physical application of materials and labor to the hydrocarbons necessary to cause, and caused, a physical change to them?” Looking to testimony provided by engineers for both Southwest Royalties and the Comptroller, the Court concluded that there was no evidence that Southwest Royalties’ “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.” Rather, the changes were caused “by the natural pressure and temperature changes that occurred as the hydrocarbons traveled from the reservoir through the casing and tubing to the surface.” As expressly noted by the Court, the decision did not turn on the fact that the alleged processing occurred underground as contrasted with above-ground.

The Comptroller predicts that the ruling saves the state over $4 billion. In contrast, the Court’s decision is a great disappointment to those in the oil and gas industry hoping for sales tax refunds based upon the manufacturing exemption to help reduce the economic pinch of the slump in oil and gas production.

Note: The Southwest Royalties opinion does not entirely foreclose manufacturing exemption refunds for the oil and gas industry. A case-by-case analysis is necessary. Purchases of other equipment may satisfy either the court’s definition of processing or other statutory language outlined in the manufacturing exemption.