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Texas Ruling Could Expand the Scope of the Manufacturing Exemption from Sales or Use Tax to Equipment Used in Oil and Gas Extraction

In a recent Texas bench ruling, in the case of Southwest Royalties, Inc. v. Combs, Case D-1-GNU-09-004282 (Travis County 250th Dist. Ct.), the court expanded the Texas sales or use tax exemption for manufacturing property to include certain items of tangible personal property such as well casing and certain “down-hole” equipment used to extract oil and gas from wells.  

Texas imposes a sales or use tax upon all items of tangible personal property sold or used in Texas unless an exemption applies. One such exemption applies to the purchase of equipment used for manufacturing. The “manufacturing exemption,” applies, in relevant part, to

property 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 the product being manufactured or processed for ultimate sale or to any intermediate or preliminary product that will become an ingredient or component part of the product being manufactured or processed for ultimate sale. (Texas Tax Code section 151.318(a)(2)).

The Texas Comptroller has a long-standing policy of excluding extraction equipment used in the oil and gas drilling and production process from the manufacturing exemption from sales or use tax. The Comptroller determined that such equipment was not used in manufacturing and even if it were, it did not cause a chemical or physical change to the oil and gas extracted from a well. The taxpayer in Southwest Royalties challenged the policy and claimed that the well casing and “down-hole” equipment it purchased to extract oil and gas from wells was used to directly cause a physical change to a product or an intermediate or preliminary product. The taxpayer in Southwest Royalties claimed that approximately 50 items of tangible personal property that it acquired for use in the extraction process were exempt from Texas sales tax. These items included casing, tubing, wellhead, and pumping equipment.

After trial, the judge in Southwest Royalties announced from the bench for the taxpayer that he agreed that the equipment was essential to the oil and gas extraction process and was used to cause a physical change in the hydrocarbons and the wellbore. Until the written opinion of the court is issued, however, it is unclear whether the court’s decision applies to each item of equipment listed by the taxpayer. No final judgment has been entered yet, and the court still has plenary power to change its decision in any manner.

The Texas Comptroller has claimed that the application of the Southwest Royalties decision could give rise to a $2 billion refund liability and a significant future loss of sales tax revenue. Thus, it is expected that the Comptroller will appeal the court’s decision. Accordingly, until a final judgment is entered by the court and the appeals are exhausted, it is unclear whether oil and gas equipment used in the extraction process will be exempt from Texas sales tax. Oil and gas companies that paid sales tax upon the acquisition of such equipment should nonetheless consider timely filing protective claims for refunds to preserve their claims because Texas provides for a four-year period to claim a refund for sales taxes paid and the appeals process may not be completed in that time. 

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Notice: This client alert is for general information purposes only.

IRS Circular 230 Notice: To ensure compliance with requirements imposed by the U.S. Internal Revenue Service, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein.

© 2020 Bracewell LLPNational Law Review, Volume II, Number 127

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About this Author

Elizabeth McGinley, Energy, Tax, Attorney, Bracewell law firm
Partner

Elizabeth McGinley is the head of the firm's tax practice. She represents a variety of clients in the oil and gas and electric power industries, including private equity firms investing in oil and gas exploration, production and infrastructure. Her experience includes complex debt and equity financing, joint ventures and project finance, as well as experience with volumetric production payment (VPP) transactions. 

In addition, Elizabeth has experience in partnership and corporate transactions including mergers and acquisitions and spin-off...

212-508-6173
Joe Hull, tax, attorney, Bracewell, law firm
Partner

With more than four decades of experience, Joe Hull's legal practice concentrates on federal, state and local taxation, including both planning and controversy work. Mr. Hull has substantial experience representing clients in tax matters in many industries, including real estate; oil, gas and petrochemical; financial; aerospace; equipment leasing; public finance; and high tech and telecommunications. Mr. Hull’s additional areas of practice are real estate development and finance, transactions, syndications and REITs; equipment leasing; partnerships and...

512-494-3611