Oilfield Tax Exemptions: Lessons from Southwest Royalties, Inc. v. Hegar

Oil and gas drillers across Texas had their hopes of a multi-million dollar tax break dashed this summer, as the Texas Supreme Court held in Southwest Royalties, Inc. v. Hegar,[1] that downhole equipment such as casing and tubing was not exempt from state sales taxes.  However, the court left the door open for future tax disputes involving more advanced extraction equipment and may offer opportunities for exploration, production, and processing companies seeking tax benefits under Texas law.Midland-based Southwest Royalties filed its initial suit in 2009, seeking a refund for sales taxes paid on the casing, tubing, and pumps used by its oil and gas exploration division.  The company cited Texas Tax Code § 151.318, which provides a tax exemption for equipment “used or consumed” in “the actual manufacturing, processing, or fabrication of tangible personal property for ultimate sale.”[2]  Southwest Royalties sought refunds of less than $500,000, but a win for the company could have forced the Comptroller to issue billions of dollars in refunds industry-wide.[3]The dispute centered largely on the meaning of “processing” in Texas Tax Code § 151.318. The court concluded that “processing” included any equipment used to “modify or change the characteristics of tangible personal property,” including hydrocarbons.[4]  The key question analyzed by the court was whether the casing, tubing, and pumps used by Southwest Royalties caused any physical or chemical change to minerals after they were extracted.  While minerals undergo various phase changes during extraction, the court concluded that these phase changes were the result of natural shifts in pressure and temperature that occurred during the extraction process. Although equipment plays a vital role in transporting hydrocarbons to the surface, it is only a “conduit” by which the minerals moved from the reservoir and thus fails to qualify as processing under the exemption.[5] The ruling is not all bad news for the industry, however.  The Texas Supreme Court rejected the Comptroller’s attempt to categorically exclude all extraction and processing equipment from sales tax exemptions, and the court’s detailed analysis of drilling operations offers a road-map for future, case-by-case disputes involving tax exemptions for other types of oilfield equipment.  Thus, for example, oilfield extraction or production equipment that “processes” (i.e., changes the physical characteristics of) hydrocarbons now is potentially subject to the exemption in Texas Tax Code § 151.318. As a result, exploration and production companies looking to reduce their tax bill may find relief in this summer’s decision. Thompson & Knight LLPConrad Hester & Brett Rector[1] No. 14-0743, 2016 WL 3382151 (Tex. June 17, 2016).  The Texas Supreme Court issued a revised opinion on October 21, 2016, clarifying that in most cases “artificial means” are needed to move oil & gas from its reservoir into the wellbore.  The revised opinion can be found here.[2] Tex. Tax Code § 151.318(a)(2), (5), (10). [3] Jim Malewitz, Texas Budget Spared in Court Ruling on Drilling Tax Case, Texas Tribune, June 17, 2016.[4]Southwest Royalties, 2016 WL 3382151, at *5–6.[5]Id.