tooth fairyA fight over the Texas sales tax drew industry-wide attention when the trial judge commented from the bench that he was inclined to exempt purchases of casing, tubing, pumps and related services from Texas state sales tax. His actual ruling denied the relief sought by the taxpayer. In Southwest Royalties v. Hegar, the Texas Supreme Court agreed.

You will want to study this case if you are a tax lawyer, or if you expected the judiciary, channeling the tooth fairy, to redirect to producers millions of dollars in badly-needed state sales tax revenues. Otherwise, proceed directly to the musical interlude. (Tea Party: No micro-aggression here; I acknowledge your sincerely-held belief that no governmental unit, especially the Godless ones, really needs or deserves tax revenues.)

The Tax Code says

The tubulars would be exempt if:

  • They are sold to a manufacturer and directly used or consumed in or during the actual manufacturing, processing, or fabrication of tangible personal property if the use or consumption is necessary or essential to the processing operation and directly makes or causes a chemical or physical change to the product being manufactured, processed or fabricated for ultimate sale;
  • They are used or consumed in actual manufacturing, processing or fabrication of tangible personal property for ultimate sale if the use or consumption of the property is necessary and essential to a pollution control process; or
  • The use or the consumption of the property is necessary and essential to comply with laws or rules that establish requirements related to public health.

Bored yet? Read on. The worst is over.

Southwest said

Hydrocarbons are tangible personal property once they are severed.  The equipment was used for processing because it was used in or during the process of extracting hydrocarbons from underground reservoirs, separating them into their component parts and bringing them to the surface. Thus, the equipment was used in “processing” the hydrocarbons as they were extracted.

Another point: The equipment was used in processing and is essential for controlling pollution.

The State said

The manufacturing exemption must be construed narrowly, which yields a conclusion that mineral extraction is not manufacturing, processing or fabrication. Construing the statute otherwise is inconsistent with the other provisions of the Tax Code.

Another point: Minerals below the surface are real property and not tangible personal property.

The trial court findings of fact

Physical changes occur in hydrocarbons when they are extracted and lifted, but the equipment was not the direct cause of the changes.  Rather, the changes were directly caused by temperature and pressure changes as the hydrocarbons moved up toward the surface. Southwest did not challenge these findings.

The Supreme Court declared

The court pondered the notion of ambiguity, and gave “processing” its ordinary meaning. Southwest did not prove that the equipment was used in actual processing of hydrocarbons within the meaning of the Tax Code.

There was no evidence that the equipment was applied to cause changes to the characteristics of the hydrocarbons. The change was caused by natural pressure and temperature changes as the hydrocarbons were moved to the surface.This is different from, say, pumps that send superheated water into sulphur formations, causing a physical or chemical change in the sulphur.

Ralph Stanley, RIP.

Take a listen before writing off this tune or this one as whiney vocals and tinny hillbilly banjo noise.

taxesThis is to be expected in these dark days of diminished cash flow. Imagine:  You are the operator and the non-ops have given you their share of ad valorem taxes, expecting you to pay them to the taxing authority at the right time. Things are a little tight, if you know what I mean, so you divert “borrow” the funds for more pressing obligations. You intend, of course, to replace the money “when things get better”.  Time passes; “things” don’t get better; your entity – a corporation, LLC, whatever – collapses. Not to worry; your personal assets are protected because that’s what corporations are for, right?  Wrong, at least in Texas.

The Texas Tax Code imposes personal liability upon any person who receives or collects an ad valorem tax from another person. The recipient holds the funds in trust for the benefit of the taxing unit and is liable to the taxing unit for the full amount collected plus penalties and interest.

Who is the ”responsible individual”?

It’s not just the entity that is liable:

“ … [A]n individual who controls or supervises the collection of tax or money from another person, or an individual who controls or supervises the accounting for and paying over of the tax or money, and who willfully fails to pay or cause to be paid the tax or money is liable as a responsible individual for an amount equal to the tax or money, plus all interest, penalties, and costs, not paid or caused to be paid.”

Lest there be doubt, the Code defines a ”responsible individual” for us:

“A  ‘responsible individual’ includes an officer, manager, director, or employee or a corporation, association, or limited liability company or a member of a partnership who, as an officer, manager, director, employee, or member, is under a duty to perform an act with respect to the collection, accounting, or payment of a tax or money … “.

If you are “robbing” Peter to pay Paul, make sure Peter isn’t a governmental entity.

The other side of the coin

Non-operator, do you know what your operator is doing with the tax money being collected from you?

Musical interlude

Where to start! RIP David Bowie and Glenn Frey.

Co-author Matthew Wheatley

The owner of 33 BCF of gas cant’ just stuff it in his pocket and move it county-to-county to avoid taxes. So, the question: Is gas in storage subject to ad valorem tax on personal property?  taxThe Harris County Appraisal District thought so. The taxman prevailed in ETC Marketing v. Harris County Appraisal District.

The gas was stored in a depleted oil reservoir. The storage agreement between ETC – owner of the gas – and affiliate Houston Pipeline – transporter – enabled ETC to hold the gas for delivery to other states when demand is higher. ETC contended the gas was exempt from taxation because it is in interstate commerce.

When is Personal Property Taxable?

Tangible personal property is appropriate for taxation if it is located in the jurisdiction “for longer than a temporary period.” Property is immune from taxation if the owner can prove the tax:

  • applies to activity lacking a substantial nexus to the taxing state,
  • is not fairly apportioned,
  • discriminates against interstate commerce, or
  • is not fairly related to services provided by the state.

(Notice who has the burden of proof.)

Why Was the Stored Gas Taxable?

There was a substantial nexus between the activity and Texas. The gas was purchased, transported, and stored in Texas, and ETC had facilities and employees in Texas. Houston Pipeline’s facilities are also located entirely within the state.

The tax is fairly apportioned because it is “internally and externally consistent.” It is internally consistent because it is “structured so that if every state were to impose an identical tax, no multiple taxation would result.” The gas was stored in Texas “for longer than a temporary period” and ETC did not attempt to store the gas in any other state at the same time.

The tax is externally consistent because “the state has taxed only that portion of the revenues from the interstate activity which reasonably reflects the in-state component of the activity being taxed” … the entire volume of gas.

The tax did not discriminate against interstate commerce because it “places no greater burden upon interstate commerce than the state places upon competing intrastate commerce of like character.”  Even if the gas was in interstate commerce, it could be taxed when stored for the business purpose of selling at a later time of the owner’s choosing.  HCAD taxed only that quantity stored in Harris County on the date of taxation and as to which ETC acknowledged ownership.

The tax was fairly related to services provided by the state. ETC enjoys the benefit of police and fire protection and other public services which facilitate gas storage.

Not Everyone Agreed

A dissent made these points:

  • The tax imposes a burden on working gas in interstate trade that is “clearly excessive in relation to the… local benefits.”It threatens the free movement of commerce by placing a financial barrier by imposing a tax not levied by taxing authorities in other jurisdictions.
  • Local law enforcement, fire, and other public services serve the facility itself, which ETC pays substantial property taxes on, in addition to the taxes paid on cushion gas it permanently stores at the facility. The tax is thus not fairly related to state-provided services.

What is it about Kern County?

Two things: It produces 75 percent of all California onshore oil. And it’s home of the “Bakersfield Sound”. Examples:

Buck Owens

Buck disciple Dwight Yoakum

Flatterers