On June 17, 2016, the Texas Supreme Court ruled that an oil and gas exploration and production company, Southwest Royalties, Inc. (“Southwest”), is not exempt from a sales tax on casing, tubing, and other well equipment (“Equipment”).

Facts and Procedural Background

Southwest purchased Equipment used for oil and gas production operations, and paid sales tax thereon.  Southwest filed a tax refund claim with the Comptroller pursuant to Section 111.104(a)(2) for Equipment that Southwest used in separating hydrocarbons into their component substances and bringing them to the surface.  The Comptroller denied Southwest’s claim, stating that the Equipment was used for transportation, not “manufacturing.”  Southwest filed a motion for rehearing, which the Comptroller denied.  Subsequently, Southwest sued the Comptroller and the State.

The trial court ruled in favor of the Comptroller and Southwest appealed the trial court’s decision.  The court of appeals found the tax exemption statute to be ambiguous.  Because of the ambiguity, the court of appeals deferred to the agency’s interpretation of the statute and ultimately ruled in favor of the Comptroller. Southwest appealed to the Texas Supreme Court.

The Texas Supreme Court’s opinion addressed two issues: (1) the tax exemption statute’s ambiguity, and (2) the use of Southwest’s Equipment in “processing” hydrocarbons. 

The Statute’s Ambiguity

While addressing the first issue, the Court recognized that the statute does not define “processing,” and that when a statute contains an undefined term, the term is given its ordinary meaning. 

Southwest argued that “processing” involves a physical change in a tangible physical property, and “processing” hydrocarbons does not have to mean “manufacturing” hydrocarbons to be exempted.  The Court agreed with Southwest because using “manufacturing” and “processing” as separate terms evidences the Legislature’s intent of the term “processing” including other matters outside of “manufacturing.” 

The Equipment’s Role in “Processing” Hydrocarbons

The second issue that the Court addressed centered on the parties’ disagreement over whether Southwest’s Equipment was responsible for hydrocarbons undergoing physical changes when moving to the surface.  Southwest argued that the casing and tubing system continues the “processing of hydrocarbons into separate substances of oil, gas, and condensates.”  The Court disagreed. 

Because Southwest did not prove that its Equipment was used in the “manufacturing, processing, or fabricating” of hydrocarbons, the Court ruled in favor of the Comptroller. 

What This Means For You

The Texas Supreme Court set forth its interpretation of the “manufacturing exemption,” holding that well equipment that does not physically alter hydrocarbons are not tax exempt.  As a result, oil and gas exploration and production companies cannot apply for a tax exemption from sales tax on casing, tubing, and other well equipment.

Special thanks to Steptoe & Johnson Summer Associate Leah Homan for her valuable assistance on this alert.