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.