Sales Tax Slice: Texas High Court Saves State from Processing $4 Billion Refund

While the rest of the country celebrates paying less at the gas pump, the oil industry and states like Texas face the darker side of slumping oil prices. Profits are down, likely affecting tax revenues for states dependent on the oil industry. Fortunately for Texas, the state just netted a gigantic win to the tune of $4.4 billion, as reported by Laurel Brubaker Calkins in Bloomberg BNA’s Daily Tax Report.

The Texas Supreme Court’s unanimous June 17 decision rejected Southwest Royalties’ claim to a manufacturing exemption for equipment the company used during the extraction of hyrdocarbons. That’s industry-speak for the collection of oil, gas, and other stuff coming out of ground. Had Southwest Royalties, a Texas gas and oil exploration and production company, won its case, state officials would have had to find a way to refund billions in sales taxes to the state’s entire oil industry. The popular story surrounding this case is the big savings for Texas. Indeed, before the Texas Supreme Court even heard oral arguments, Texas Comptroller Glenn Hegar warned that a favorable decision for the oil company could eliminate a projected budget surplus for the state.

Beyond the fiscal impact, however, the Southwest Royalties, Inc. v. Hager, case serves as a reminder of the highly-nuanced nature of applying the sales tax exemption for manufacturing equipment. Few areas are as frustrating in sales and use tax as the manufacturing exemption because determining what qualifies as exempt manufacturing equipment often feels like trying to slice a shadow.[1]

The issue in the Texas case turned on whether the steel pipes for which Southwest Royalties claimed the manufacturing exemption were actually used in “processing,” one of the necessary requirements under Texas’ exemption statute. The company claimed its steel casing and tubing was used to separate the hyrdocarbons being extracted into oil, gas, and condensates, thereby “processing” the hydrocarbons by causing a physical change to them. But the Texas high court agreed with a lower court’s findings that the direct causes of the separation of the hydrocarbons into different substances were pressure and temperature changes that occur naturally during extraction. Southwest Royalties’ equipment was just an indirect cause of the physical change to the hydrocarbons, and thus, did not qualify for the manufacturing exemption allowed for equipment used in “processing.”

Consider a recent case out of Arkansas’ Supreme Court – another illustration of how vexatious analyzing the manufacturing exemption can be. In Walther v. Carrothers Constr. Co. of Ark., LLC, the Arkansas high court denied an exemption for a company that used a three-part process to turn raw surface water into potable drinking water. The company’s process of removing trash from the raw water, then chemically treating the water, then purifying the water did not convince the Arkansas court that the water treatment process constituted manufacturing eligible for a sales tax exemption. The court stated, “[i]t was water in the beginning, and it was water in the end.”

State legislatures favor sales tax exemptions for manufacturing, processing, fabricating, and the like because those exemptions encourage the location of new businesses in the state or the expansion or upgrading of existing businesses. Nevertheless, one sometimes wonders if the incentive is worth all the analytical effort. For Texas, at least this time around, the reasoning worked out in the state’s favor.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: How do you assess the significant differences in the states’ application of the sales tax exemption for manufacturing equipment?

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By René Y. Blocker

[1] Tax practitioners may recall the U. S. Supreme Court’s statement in Container Corp. v. Franchise Tax Board, likening allocating income among various states to “slicing a shadow.”