Face Challenges Confidently

624 Sw. Royalties, Inc. v. Hegar, 500 S.W.3d 400 (Tex. 2016)

Wednesday, February 14th, 2018

Richard F. Brown

The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.

Southwest Royalties, Inc. v. Hegar Sw. Royalties, Inc. v. Hegar, 500 S.W.3d 400 (Tex. 2016) (Sales tax exemption for downhole equipment), held that the sales tax exemption for equipment used in processing was not applicable to downhole equipment such as casing, tubing, and pumps. The sales tax exemption applied to “tangible personal property directly used or consumed in or during the actual . . . processing . . . of tangible personal property for ultimate sale if the use or consumption of the property is necessary or essential to the . . . processing . . . operation and directly makes or causes a chemical or physical change to . . . the product being . . . processed . . . for ultimate sale . . . .”

Southwest’s argument was “that hydrocarbons extracted from an underground reservoir must be separated into their component parts to produce saleable products, and the equipment for which it sought refunds was used in ‘processing’ the hydrocarbons as they were extracted from the reservoir. . . .” The trial court ruled against Southwest because Southwest’s equipment did not directly cause the change in the hydrocarbons. The appeals court also ruled against Southwest, because it found the use of the word “processing” in the statute to be ambiguous and the Comptroller’s interpretation was not plainly erroneous or inconsistent. The issue before the Supreme Court of Texas was whether Southwest’s equipment was used for “processing” and if so, whether Southwest’s processing was the actual and direct cause of the chemical or physical change in the hydrocarbons.

The court first interpreted the tax statute. Because “processing” was not defined, the court gave the word its ordinary meaning. It essentially adopted the Comptroller’s definition and held that the term “processing” meant “the application of materials and labor necessary to modify or change characteristics of tangible personal property.”

“[I]t is undisputed that hydrocarbons undergo physical changes as they move from underground reservoirs to the surface; the disagreement is about the role Southwest’s equipment plays in those changes.” Expert testimony for the State established that phase changes in the oil and gas were a “natural, physical process that occurs from the reservoir to the top of a well, and whether casing was in the well was only incidental to the changes,” because “the casing and tubing were essentially only conduits through which the hydrocarbons exit the reservoir and proceed to the surface.” Thus, the court narrowed its inquiry to “whether the equipment . . . was used in the actual physical application of materials and labor to the hydrocarbons that was necessary to cause, and caused, a physical change to them”(emphasis added). The court reasoned that the changes in the substances were natural changes, and 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.”

“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 Tax Code [sections] 151.318[(a)](2), (5), or (10),” and was therefore not entitled to a tax exemption.

Phase changes in hydrocarbons from the reservoir to the surface are the result of changes in temperature and pressure, and not the result of casing, tubing, and pumps. The significance of the case is the holding that the downhole equipment is not exempt from sales tax because only equipment used in processing the hydrocarbons is exempt. “Processing” in this context means changing the characteristics of tangible personal property.