Texas Supreme Court rules against multibillion dollar tax refund to oil & gas drillers

Texas Supreme Court rules against multibillion dollar tax refund to oil and gas drillers by Jeffrey Weiss, June 17, 2016, Dallas News
Texans could have been faced with billions of dollars in new taxes or lost services, had the Texas Supreme Court ruled differently Friday. The case turned on whether oil and gas companies can claim state sales tax exemptions for drilling equipment.

Midland-based Southwest Royalties argued it could. The state comptroller argued it couldn’t. The court unanimously agreed with the comptroller.

Southwest Royalties, a subsidiary of Clayton Williams Energy, was asking for a $500,000 refund for equipment bought between 1997 and 2001. But Comptroller Glen Hegar estimated the impact could be as much at $4.4 billion next year in refunds and lost tax revenue, and another $500 million every year in lost taxes.

The original case was filed in 2009. Southwest had lost at the trial court and appeals court level before it got to the state supreme court.

The argument was whether the stuff used to bring gas and oil to the surface qualifies as manufacturing, processing or fabrication equipment. That’s exempt from Texas sales taxes. To qualify, the statute says equipment “directly makes or causes a chemical or physical change” to the materials.

Southwest argued that because oil and gas in the ground change in form as they’re brought to the surface through the pipes, that qualifies. Some changes from liquid to gas as it rises. Some changes from gas to liquid. The pipes and casing help to separate the liquid from the gas. And none of the changing would happen if not for for the drilling.

But the comptroller’s office said that’s not manufacturing. It said the changes are due to pressure and temperature differences between the deep ground and the surface, and the pipes don’t directly cause those changes.

Pipes, the state said, are basically a form of transportation and not a manufacturing process or system.

A trial court, and now the state supreme court, agreed that the comptroller’s position is a reasonable interpretation of the tax code.

“While the equipment unquestionably was both used in and necessary to the efficient recovery of hydrocarbons from their reservoirs, there is no evidence that the equipment acted upon the hydrocarbons to modify or change their characteristics,” Friday’s opinion says.

In the opinion, however, the court noted that other materials used in drilling do qualify for the exemption: The explosives used in fracking, for instance. Materials send down the pipe in a fracking operation to help get the oil and gas out of the rocks are also exempt.

The bottom line in this case, for the court:

“Southwest did not prove that the equipment for which it sought a tax exemption was used in ‘actual manufacturing, processing, or fabricating’ of hydrocarbons within the meaning of” the tax code.

The Texas Oil and Gas Association issued a statement in response:

“We are disappointed in the Court’s decision. It is undeniable that oil and natural gas exploration and production today is more and more a manufacturing process. For a healthy oil and natural gas industry, our operators, who compete globally, need equitable tax treatment. We look forward to an ongoing discussion on the best overall tax policy to bring jobs and investment to Texas and to enhance our state’s economic competitiveness.”

At least two states do offer a sales tax exemption to some of the drilling equipment discussed in this case.

Pennsylvania exempts a long list of digging and extracting equipment, machinery, and tools directly used in what the state calls “gas mining.” The list specifically includes pipe casing and other associated materials.

The Arizona tax code specifically exempts “machinery or equipment used directly to drill for oil or gas or used directly in the process of extracting oil or gas from the earth for commercial purposes.”

Despite the loss of this case, Texas oil and gas companies were left with room for future challenges, said Zachary Jones, a tax attorney in the Dallas office of Gardere Wynne Sewell LLP. The state asked that the court rule that oil and gas drillers were not engaged in manufacturing, and therefore had no right to claim “processing” exemptions, he said.

That didn’t happen.

“The Supreme Court did not agree that ‘the extraction of oil and gas’ cannot be an activity that qualifies for the exemption.” Jones said.

The ruling means oil and gas companies “may still qualify for the exemption for other types of equipment, or even the same equipment that was the object of this case if different evidence were presented to demonstrate how the equipment was used to process,” Jones said. [Emphasis added]

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