Texas Oil & Gas -Southwest Royalties, Inc. vs. Susan Combs Most Likely Heading to Supreme Court

The issue concerning whether tangible personal property placed inside a well (i.e., “downhole”) qualifies for the manufacturing exemption has been pending in the Texas court system for several years. The trial judge ruled in favor of the Comptroller on April 30, 2012, and the Third Court of Appeals heard oral arguments on September 25, 2013. After considering the issue for almost 11 months, the Third Court of Appeals issued an opinion on August 13, 2014, affirming the trial court’s judgment for the Comptroller.

Texas Oil & Gas -Southwest Royalties, Inc. v. Susan Combs - Most Likely Heading to Supreme Court

Texas Oil & Gas – Southwest Royalties, Inc. vs. Susan Combs Most Likely Heading to Supreme Court

Texas exempts a taxable item purchased by a manufacturer if the purchase falls within one of the specific exemption provisions provided by Texas Tax Code §151.318. This manufacturing exemption statute, as administered by the Comptroller, is not limited to taxpayers that are classified within the manufacturing sector. The Comptroller has permitted mining and oil/gas companies to claim the manufacturing exemption for activities performed after the extraction phase because they are manufacturing, processing, or fabricating tangible personal property for ultimate sale. Past tax issues have involved questions of when the manufacturing process begins for the purpose of claiming the exemption and what items that are used during the manufacturing process qualify for the manufacturing exemption. The Comptroller has rejected attempts by taxpayers to extend the manufacturing exemption provided by Texas Tax Code §151.318 to items used to lift and extract minerals (including oil and gas) from realty. The Comptroller’s distinction between the extraction stage and the surface stage for purposes of the manufacturing exemption is the subject matter of Southwest Royalties, Inc. v. Combs.

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The court of appeals held that the phrase “manufacturing, processing, or fabrication” in Texas Tax Code §151.318 does not plainly include the extraction of oil and gas. To the extent an exemption statute is ambiguous, the court considered other provisions in Chapter 151, Texas Tax Code, to reach the conclusion that the legislature made a distinction between manufacturing and mining activities. The court then resolved the dispute by relying on the rule of statutory construction that a tax exemption should be strictly construed in favor of taxation and by giving deference to the Comptroller’s interpretation of an ambiguous statute.

Before the issuance of the court of appeals’ opinion, the staff of the Comptroller publicly stated the agency’s intent to amend various rules, including Rule 3.300 (relating to manufacturing), to conform them to the agency’s position in Southwest Royalties v. Combs that activities to extract materials from realty are not manufacturing activities. The Comptroller’s stated position could have applicability to other operations involving extraction of materials from the earth, such as quarries, coal, silca, and uranium. Looks like this is going to head to the Texas Supreme Court.

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