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Texas Third District Court of Appeals Denies Manufacturing Exemptions for Equipment and Services Used "Downhole" During Production of Oil and Gas

Tax Development Aug 15, 2014

On August 14, 2014, the Third District Court of Appeals (the “Court”) in Austin denied manufacturing exemptions for equipment and services used “downhole” during production of oil and gas. Ryan anticipates that the decision will be appealed to the Texas Supreme Court.

Southwest Royalties, Inc. (“Southwest”) requested a refund of Texas sales and use taxes paid on casing, tubing, pumps, related parts, and associated services used in oil and gas production. Southwest contended that the items are exempt under Tex. Tax Code § 151.318 because they extract and separate the mixture into its components of oil, gas, condensate, and water. Therefore, these items are directly used in the actual manufacturing or processing of oil, gas, and other products and directly make a chemical or physical change to the products. Furthermore, Southwest demonstrated that casing contains the products during production, and the equipment alters and regulates the pressure of the products during production. This prevents escape, spills, and contamination of groundwater. Therefore, it is necessary or essential to control pollution that can result from oil and gas production and to comply with federal, state, or local laws related to public health.

The Court adopted the Comptroller’s argument that extracting oil and gas from the ground is not “manufacturing.” The Court found the terms “manufacturing,” “processing,” and “fabrication” to be ambiguous. Therefore, the Court decided to defer to the Comptroller’s construction of the underlying statutes. Because the Comptroller’s interpretation was “not plainly erroneous or inconsistent” with the statute, the Court considered itself bound by the Comptroller’s representation that oil and gas extraction are not “manufacturing.”

Ryan believes the Court erred in deferring to the Comptroller’s interpretation of the law. The plain meaning of the terms “manufacturing” and “processing” encompasses the activities associated with separating, pressurizing, and extracting oil, gas, and water during production. These terms are not “ambiguous” and do not, therefore, require agency guidance for the courts to interpret. In addition, the Comptroller lacks specialized knowledge or expertise in the field of oil and gas production that would lend any weight to its interpretation of the relevant terms. Furthermore, the Comptroller has a long history of treating various oil and gas extraction activities as “processing.” In fact, the Comptroller previously ruled in an administrative hearing that the Legislature did not intend to draw a bright line between “mining activities” and “manufacturing.” The Texas courts have held that an agency interpretation is entitled to deference if it is “long-standing and applied uniformly.” The Comptroller’s interpretation of the exemption is of recent vintage and is inconsistent with the agency’s prior interpretation of the law. Because the statutes are unambiguous and the Comptroller’s interpretation thereof is neither long-standing nor applied uniformly, the Comptroller was not entitled to the deference shown by the Court.

Ryan also believes the Court erred significantly in asserting that the “pollution control” and “public health” exemptions depend on whether an item causes a physical or chemical change in the manufactured product. Tex. Tax Code § 151.318 is actually a series of self-contained exemptions. Therefore, although subsection (a)(2) is limited to machinery or equipment that “directly makes or causes a chemical or physical change” to the manufactured product, this requirement does not appear in subsection (a)(5) (pollution control) or (a)(10) (public health). The Court conflated the different requirements of subsections (a)(2), (a)(5), and (a)(10) in its decision.

Finally, Ryan believes the Court erred by failing to distinguish between items purchased before and after October 1, 1997. Effective October 1, 1997, the Legislature modified Tex. Tax Code § 151.318 significantly, introducing the new requirement of a “chemical or physical change” and completely rewriting the remainder of the law. Southwest’s refund claim for periods prior to October 1, 1997 should have been judged based on the law in effect at that time.

Because of the numerous errors in the Court’s decision, Ryan anticipates that Southwest will appeal the decision to the Texas Supreme Court. In recent cases, the Supreme Court has taken a strong stand in favor of strictly construing unambiguous statutes and rejecting unreasonable or unsupported agency interpretations of the law. TracFone Wireless, Inc. vs. Com’n on State Emergency Communications, No. 11-0473 (Tex. – April 5, 2013). Also, taxpayers have prevailed at the Texas Supreme Court multiple times after losing at both the trial and intermediate appellate levels. See Fleming Foods of Texas, Inc. vs. Rylander, 6 S.W.3d 278 (Tex. 1999); R Communications vs. Sharp, 875 S.W.2d 314 (Tex. 1994); and Day & Zimmermann, Inc. vs. Calvert, 519 S.W.2d 106 (Tex. 1975).


Damon Chronis