Texas High Court Hears Argument in Oil and Gas Case

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By Paul Stinson

March 10 — Metal pipes, tubing and other equipment used in oil and gas production should be exempt from sales tax, an attorney on behalf of a Texas energy company argued before the Texas Supreme Court.

Central to the tax-refund case is whether a producer of oil and gas can be considered exempted from paying sales tax for below-ground equipment used in the service of extracting minerals.

In February, the state’s chief tax collector and treasurer told Bloomberg BNA that a ruling in favor of the Texas oil and gas company seeking a tax refund would expose the state to a financial liability large enough to wipe out the state’s projected budget surplus .

David Keltner of Kelly Hart & Hallman LLP, who is representing Southwest Royalties, told the court that among the questions at issue is language in Tex. Tax Code Section 151.318, specifically the phrase “manufacturing, processing or fabricating” and whether or not it is “clear on its face, or is it ambiguous?”

Addressing the justices, Keltner said the second question before the court is that if that phrase is ambiguous, “whether the comptroller’s interpretation…of the word ‘processing’ has no meaning at all outside the manufacturing purview and whether it can never be used as part of the oil and gas industry is entitled to deference.”

“We believe the answer to that is clearly no,” he said. “The court of appeals held the phrase manufacturing processing or fabricating to have uncertain boundaries and based on that bowed to the comptroller’s interpretation,” he said. “That rush to ambiguity is the basis of our appeal.”

Midland, Texas-based Southwest Royalties Inc. filed suit in late 2015 following the comptroller's denial of the tax-refund claim for purchases for “downhole” equipment under a provision exempting sales tax on equipment used or consumed during “actual manufacturing, processing or fabrication,” according to a Texas Supreme Court overview .

In a December 2015 brief, the Midland, Texas-based subsidiary of Clayton Williams Energy Inc. asserted that the plain-meaning construction of “processing” in Tex. Tax Code Section 151.318 doesn't depend on the statutory language in Section 151.324, which governs sales tax exemption for equipment used in mineral exploration or production.

Further, Southwest Royalties contends that a traditional plain-language interpretation of Section 151.317 distinguishes it as a stand-alone activity, even when manufacturing sometimes includes processing.

A trial court ruled in favor of Southwest, but upon reconsideration sided with the state, finding that below-ground equipment didn't meet the manufacturing sales tax exemption requirement of causing a physical or chemical change in the extracted hydrocarbons, according to the high court's summary of the case.

In its review, an appeals court affirmed that decision, holding that the comptroller's statutory interpretation isn't “plainly erroneous or inconsistent” with statutory language establishing the exemption, according to the overview.

Mineral Extraction is Not ‘Processing.'

“Southwest’s claim fails because its mineral extraction is not ‘processing’ under manufacturing exemption for at least three reasons,” Michael Murphy of the attorney general's office told the court.

Murphy argued that in the context of the manufacturing exemption, the term “processing” refers to an activity during the course of manufacturing.

“Adopting a broad definition of ‘processing’ would violate both the rule that terms must be interpreted according to their statutory context as well as the rule that tax exemptions are narrowly construed in favor of taxation,” Murphy said.

The state argued further that mineral extraction equipment “like Southwest” is expressly covered by another tax exemption, provided that use is offshore and out of state.

“Adopting a broad definition of processing would not only render that statute redundant, it would destroy the Legislature’s express limitation of that exemption to offshore or out-of-state use,” he said.

Murphy reiterated the state's view that minerals underground aren't tangible personal property as the manufacturing exemption requires.

“For any of these reasons, the court should affirm,” he said.

The state’s chief tax collector and treasurer told Bloomberg BNA “it was never the intent” of the Legislature for a sales tax exemption to apply to the equipment at issue when used in Texas.

“In fact, the statute specifically calls for the exemption to apply only when used offshore and not in Texas,” Texas Comptroller Glenn Hegar (R) told Bloomberg BNA March 10.

“The Legislature could have included production in Texas, but chose not to,” said Hegar. “We have a strong case and the facts are on our side.”

To contact the reporter on this story: By Paul Stinson in Austin, Texas, at pstinson@bna.com

To contact the editor responsible for this story: Ryan Tuck at rtuck@bna.com

For More Information

For additional discussion of the manufacturing exemption in Texas, see Sales and Use Tax Navigator, at Texas 8.3.1.

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