© 2016 The Texas Lawbook.
By Janet Elliott
AUSTIN (June 19) – In a ruling that turned on the role that pipes and tubes play in the physical changes of oil and gas moving from underground to the surface, the Texas Supreme Court said such drilling equipment is not exempt from the state sales tax.
The unanimous ruling by the state’s highest court dashed the hopes of drillers, concrete providers, business groups and limited government advocates, which all supported Southwest Royalties Inc. in the high profile tax dispute. At the same time, it relieved state budget writers from potential tax refunds of up to $4 billion.
The justices agreed with the Texas comptroller that state law does not exempt pipes, tubing and well equipment used in oil and gas extraction from the state sales tax. The court said the company owned by Clayton Williams Energy Inc. did not prove that the equipment was used in “actual manufacturing, processing, or fabricating” of hydrocarbons.
Certain items used in manufacturing, processing or fabrication are exempt from the sales tax. The law exempts tangible personal property that “directly makes or causes a chemical or physical change” in the product being manufactured or processed.
The court, in an opinion by Justice Phil Johnson, said it is undisputed that hydrocarbons undergo physical changes as they move from underground reservoirs to the surface. The disagreement was about role steel pipe inserted into a borehole and tubing that hangs inside the pipe plays in those changes, said Johnson.
The court explained that most of the hydrocarbon fluids flow to the surface through the tubing while gas separated from the fluids moves into and up the space between the tubing and the casing. Changing pressure and temperature results in the hydrocarbons separating into gas and liquids.
“The changes in the substances were caused not by the application of equipment and materials to them, but by the natural pressure and temperature changes that occurred as the hydrocarbons traveled from the reservoir though the casing and tubing to the surface,” Johnson said.
Texas Attorney General Ken Paxton said in a statement that the law is clear and the ruling saves taxpayers more than $4 billion.
Todd Staples, president of the Texas Oil & Gas Association, issued a statement expressing disappointment in the decision.
“It is undeniable that oil and natural gas exploration and production today is more and more a manufacturing process,” said Staples. “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.”
An economic study released days before the ruling disputed the $4 billion tax hit and said the short-term impact to the state would be about $2.2 billion in tax refunds. The study prepared by The Perryman Group for the Texas Association of Business said a ruling exempting the drilling equipment would provide an economic stimulus.
For example, the study said, had the exemption been available between 2001 and 2016, state and local governments would have seen a net dynamic gain (in constant 2016 dollars) of $834.6 million in tax revenues and $359.4 million in royalties.
A tax attorney who has been following the case said the decision could have been worse for the oil and gas industry.
“This decision is not a flat rejection of an oil and gas company claiming a sales tax exemption,” said Zachary Jones, a tax attorney in the Dallas office of Gardere Wynne Sewell. “The court stopped short of declaring that the equipment at issue is not entitled to an exemption as a matter of law. The decision actually provides Texas oil and gas companies with some favorable authority for future cases.”
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