State & Local Tax Alert

Transcription

1 State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP Texas Supreme Court Holds Oil and Gas Exploration and Production Equipment Subject to Sales Tax The Texas Supreme Court has affirmed the Texas Third District Court of Appeals ruling that an oil and gas exploration and production company s purchases of casing, tubing and downhole equipment did not qualify for the manufacturing exemptions from Texas sales and use tax. 1 In doing so, the Supreme Court determined that while hydrocarbons such as oil and gas undergo physical changes as they rise to the surface, these changes result from natural pressure and temperature changes, not from application of the equipment. Background The taxpayer, an oil and gas exploration and production company, paid sales and use tax on its purchases of downhole equipment, including casing, tubing and similar items. In 2009, the taxpayer filed a refund claim, contending the purchases qualified for the manufacturing exemptions because the activities caused a physical or chemical change to the oil and gas when they were being extracted from the ground. Specifically, the taxpayer maintained that the purchases and use of the goods and services satisfied: (i) the general manufacturing exemption; (ii) a pollution control exemption relating to manufacturing; and (iii) a public health exemption relating to manufacturing. After the Texas Comptroller of Public Accounts rejected the taxpayer s refund claim and motion for rehearing, the taxpayer pursued litigation, asserting that the equipment was used in processing the hydrocarbons as they were extracted from the ground and brought to the surface. In response, the state argued that the taxpayer was not entitled to the exemptions because oil and gas exploration companies are not manufacturers and because extracting materials and bringing them to the surface is not manufacturing. The trial court rendered judgment for the state, holding that the taxpayer failed to meet its burden to prove that the exemptions applied. According to the trial court, the physical changes occurred in the hydrocarbons as they were extracted and lifted to the surface, but the taxpayer s equipment did not directly cause the changes. Rather, the trial court concluded that the changes were directly caused by temperature and pressure changes as the hydrocarbons moved toward the surface. The taxpayer appealed this decision to the Texas Third District Court of Appeals. Release date July 13, 2016 States Texas Issue/Topic Sales and Use Tax Contact details John LaBorde Houston T E john.laborde@us.gt.com Pat McCown T E pat.mccown@us.gt.com David Rohlmeier T E david.rohlmeier@us.gt.com Tracy Watts Houston T E tracy.watts@us.gt.com Robbie Blacketer T E robbie.blacketer@us.gt.com Jamie C. Yesnowitz Washington, DC T E jamie.yesnowitz@us.gt.com Chuck Jones Chicago T E chuck.jones@us.gt.com Lori Stolly Cincinnati T E lori.stolly@us.gt.com Priya D. Nair Washington, DC T E priya.nair@us.gt.com 1 Southwest Royalties, Inc. v. Hegar, Texas Supreme Court, No , June 17,

2 Grant Thornton LLP - 2 In affirming the trial court, the Court of Appeals first determined that the manufacturing exemptions statute was ambiguous regarding what qualifies as property or services used during actual manufacturing, processing, or fabrication. 2 Because of the statute s ambiguity, the Court of Appeals deferred to the Comptroller s interpretation that the manufacturing exemptions did not apply to the extraction of oil and gas. The Court of Appeals concluded that the Comptroller s interpretation was not plainly erroneous or inconsistent with the statutory language. The Texas Supreme Court agreed to consider the taxpayer s appeal of this decision. Exemptions for Property Used in Manufacturing Texas law provides a sales and use tax exemption, in relevant part, to manufacturers for: [T]angible personal property directly used or consumed in or during the actual manufacturing, processing, or fabrication of tangible personal property for ultimate sale if the use or consumption of the property is necessary or essential to the manufacturing, processing, or fabrication operation and directly makes or causes a chemical or physical change to: (A) the product being manufactured, processed, or fabricated for ultimate sale; or (B) any intermediate or preliminary product that will become an ingredient or component part of the product being manufactured, processed or fabricated for ultimate sale. 3 An exemption is also available for tangible personal property used or consumed in the 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. 4 Finally, an exemption applies to tangible personal property used or consumed in the 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 comply with federal, state, or local laws or rules that establish requirements related to public health. 5 An administrative rule defines the term processing for purposes of these exemptions as [t]he physical application of the materials and labor necessary to modify or change the characteristics of tangible personal property. 6 Supreme Court Holds Exemptions Did Not Apply The Texas Supreme Court affirmed the Court of Appeals and held that the taxpayer failed to prove that the equipment was used in actual manufacturing, processing, or fabricating of hydrocarbons within the meaning of the manufacturing exemptions statute. Therefore, the taxpayer was not entitled to an exemption from paying sales tax on the purchases of the equipment. 2 Southwest Royalties, Inc. v. Combs, Texas Court of Appeals, Third District, at Austin, No CV, Aug. 13, TEX. TAX. CODE ANN (a)(2). 4 TEX. TAX. CODE ANN (a)(5). 5 TEX. TAX. CODE ANN (a)(10) TEX. ADMIN. CODE 3.300(a)(10).

3 Grant Thornton LLP - 3 The taxpayer made the following arguments before the Texas Supreme Court: Hydrocarbons are tangible personal property once they are severed from the reservoir and pass into the casing in the wellbore; Its equipment was used for processing because it was used to separate the hydrocarbons into component parts; The statute is unambiguous and the Court should not defer to the Comptroller s interpretation regarding what qualifies as manufacturing; and The exemption applies because the equipment is used in processing and is essential for controlling pollution and for compliance with public health laws. In response, the state argued that: The manufacturing exemption must be construed narrowly with any doubts resolved against the taxpayer; Construing the exemption narrowly yields the conclusion that mineral extractions are not manufacturing, processing, or fabrication; Construing the statute otherwise is inconsistent with other provisions of the Tax Code; If extraction is processing, the changes the hydrocarbons undergo are directly caused by natural pressure and temperature changes, not by the taxpayer s equipment; and The exemption is inapplicable because the minerals below the surface are real property rather than tangible personal property. Statutory Language Not Ambiguous As a first step in its analysis, the Texas Supreme Court addressed whether the manufacturing exemption statute was ambiguous regarding the term processing given the conflict between the lower courts on this issue. The Court noted that while the Comptroller s construction of a statute may be taken into consideration by courts when interpreting a statute, deference to the Comptroller s construction is appropriate only when the statutory language is ambiguous. Focusing on the plain meaning of the words in the statute that evidenced the Texas legislature s intent, 7 the Court concluded that the term processing was something different from manufacturing and fabrication. Specifically, the term processing as used in the statute involves creating or inducing a physical change in the tangible personal property being processed. In the case of hydrocarbons, processing does not need to be manufacturing to be included within the exemption. Further, the definition of processing in the Comptroller s regulation as [t]he physical application of the materials and labor necessary to modify or to change the characteristics of tangible personal property 8 was consistent with other text in the statute, and such guidance could be considered by the Court. Therefore, the Court concluded that the relevant statutory language was not ambiguous. 7 Citing Greater Houston Partnership v. Paxton, 468 S.W.3d 51, 58 (Tex. 2015) TEX. ADMIN. CODE 3.300(a)(10).

4 Grant Thornton LLP - 4 Equipment Not Used in Processing The exemptions that the taxpayer asserted required the equipment to be used in actual processing, 9 defined in the Comptroller s regulation as [t]he physical application of the materials and labor necessary to modify or to change the characteristics of tangible personal property. 10 There was no dispute that the hydrocarbons undergo physical changes as they move from underground to the surface. The disagreement between the taxpayer and the Comptroller concerned the role that the equipment played in making the changes. The Court held that there was no evidence that the equipment acted upon the hydrocarbons to change their characteristics. Instead, the equipment was a vehicle through which the hydrocarbons exited the underground formation and traveled to the surface. Thus, the equipment was not used in processing because it did not cause the change in the hydrocarbons. Commentary The Texas Supreme Court s decision clarifies the application of the manufacturing sales tax exemptions to oil and gas exploration and production companies. Because the Texas Supreme Court affirmed the lower courts judgment and denied the exemptions, the decision was not surprising. While the taxpayer did not receive the outcome that it sought, there are some aspects of this ruling that may be favorable to taxpayers. First, the Texas Supreme Court made it clear that a business does not have to be a manufacturer to qualify for the manufacturing exemptions. Processing and fabrication are activities that enable taxpayers to benefit from the manufacturing exemptions without independently meeting the definition of a manufacturer. Additionally, the Court continues to take a relatively narrow stance on what constitutes an ambiguous statute that requires a level of deference to the Comptroller s interpretation. As the Court stated, [w]hether statutory language is ambiguous is a matter of law for courts to decide, and language is ambiguous only if the words yield more than one reasonable interpretation. Relying on precedent that the Comptroller s interpretation of a statute should only be controlling when the statutory language is ambiguous, 11 the decision further weakens the Comptroller s reliance on the Third District Court of Appeals in cases where the Comptroller seeks deference to its administrative policies. 12 The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific 9 TEX. TAX CODE ANN (a)(2), (5), (10) TEX. ADMIN CODE (a)(10). 11 See Texas Department of Insurance v. American National Insurance Co., 410 S.W.3d 843, (Tex. 2011); Thompson v. Texas Department of Licensing & Regulation, 455 S.W.3d 569, 572 (Tex. 2014). 12 See Railroad Commission of Texas v. Texas Citizens for a Safe Future & Clean Water, 336 S.W.3d 619, 625 (Tex. 2001).

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