Are Sand Separators Exempt from Taxation?

The Texas Tax Code under section 151.318 exempts equipment and chemicals used in a processing operation to cause a chemical or physical change to a product that will be sold.  The exemption as it relates to oil and gas production is explained in Policy Letter 9609L1435A12 and applies to equipment such as:
  • gun barrel
  • firetube
  • weighted float
  • dehydrators
  • heater treater
  • water leg
  • separators
  • water knockout
  • scrubbers
However, the exemption as interpreted by the Comptroller only applies to above-ground equipment, as the general policy (with one limited exception relating to carbon dioxide injection as constituting processing) is that processing does not occur below ground. A fairly recent court case was Southwest Royalties, v. Hegar. Here the Texas Supreme Court addressed whether downhole oil and gas equipment, such as tubing, casing, and pumps, qualified for the manufacturing exemption from the Texas sales and use tax. The Court concluded that Southwest Royalties failed to prove that it was entitled to the exemption by clear and convincing evidence in seeking a refund of sales taxes paid on the downhole equipment. Southwest Royalties argued that
  • tangible personal property directly used or consumed in or during the actual manufacturing, processing, or fabrication process if the property is necessary or essential and directly makes or causes a chemical or physical change to the product;
  • tangible personal property used or consumed in the actual manufacturing, processing, or fabrication process if the property is necessary and essential to the pollution control process; or
  • tangible personal property used or consumed in the actual manufacturing, processing, or fabrication process if the property is necessary and essential to comply with federal, state, or local rules that establish public health requirements.
Southwest Royalties argued that the downhole equipment was directly used, necessary, and essential to the processing of oil and gas because it separated the hydrocarbons into their component parts (oil, gas, and water). The Comptroller argued that the extraction of oil and gas was not processed within the meaning of the exemption, and, even if it were, the changes to the hydrocarbons during their movement to the surface were directly caused by natural pressure and temperature changes – not by Southwest Royalties’ equipment.  The Court sided with the Comptroller.

Policy Letter on Downhole Separator

An additional Policy letter addressing a sand separator concluded that the separator was used to provide a service and was taxable to the service provider. See below… 200208347L [Tax Type: Sales] [Document Type: Letter/Memo]

200208347L August 12, 2002

Subject: Sand Separator

Question: Taxpayer is a service company working for oil and gas exploration firms. Upon the completion of a new well, the Taxpayer is called in to separate out sand and other drilling residuals from the oil or gas. Until sand is separated out, oil and gas cannot be oil and gas cannot be transferred to a gathering line for further processing and eventual sale. The taxpayer has treated its service as a non-taxable service.  Because oil or gas cannot be transferred to the gathering line and thereby cannot be eventually sold without the removal of the sand, the Taxpayer contends that the removal of impurities from a product to be sold is processing and is claiming the manufacturing exemption on its purchases of sand separators and parts. Do these items qualify for the manufacturing exemption?

Answer: It is the agency’s understanding that the primary purpose of a sand separator is to clean the well after a frac job, but prior to the actual processing of oil or gas. The description that the agency found on the Internet indicates that after a well is opened after a frac, the flow is directed through a sand separator where the clean gas is routed back to a sales line inlet and onto and through the production equipment. All solids and liquids are dumped from the sand separator into the flow back tank, which allows the producer to sell gas while cleaning the well.  This description indicates that Taxpayer is providing a nontaxable service of removing impurities (sand, drill mud, prop, boxite or other abrasives, etc.,) that were injected downhole by the Taxpayer or others during the initial drilling of the well or during a workover of the well. The removal of impurities in this situation is not a processing operation. Therefore, the sand separator used by Taxpayer is not eligible for the manufacturing exemptions under Texas Tax Code 151.318. This conclusion is consistent with Rule 3.324 (relating to Oil, Gas, and Related Well Service) that states the removal of impurities from the product being removed is a non-taxable service. Non-taxable service providers must pay tax on equipment, supplies, and chemicals used to perform their service.

Additionally, Hearing NO. 39,572 addressed downhole submersible pumps and separators and held them to be taxable. The relative facts are restated below:


Claimant, **************, is an oil and gas exploration and production company with operations in Texas and elsewhere in the United States, as well as in offshore areas and overseas.

Claimant holds a direct payment permit duly issued by the Comptroller, pursuant to which Claimant routinely makes purchases of taxable as well as nontaxable services and tangible personal property.

Separate refund claims were filed by Claimant for the periods January 1, 1990, through December 31, 1995, and January 1, 1996, through December 31, 1998, which were granted in part and otherwise denied.  Timely filed requests for refund hearings relating to both claims resulted in these hearings, which were consolidated due to the common issues of fact and law presented by the claims.

Downhole submersible pumps, separators, valves, couplings, motors, and other tangible personal property referred to generically by Claimant as “below-ground equipment,” were purchased during the relevant periods, used to maintain pressure and facilitate the flow of oil and gas toward ultimate recovery.  The “below-ground” equipment and parts under review are not materially different from those items considered for exemption in Comptroller’s Decision No. 39,936 (2003).

Gas separators are used downhole to promote oil and gas separation and emulsion breakers/demulsifiers are so used in connection with the separation of water from the oil.  Paraffin inhibitors are also used downhole to modify the crystal structure ultimately to prevent paraffin deposits that may inhibit production. Carbon dioxide injection affects the viscosity of, and displaces, the crude oil and is used downhole to enhance its mobility.


The claimant’s first contention should be denied.

As here pertinent, throughout the relevant periods’ Section, 151.318 exempted from Texas sales and use tax tangible personal property 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. Section 151.318(a)(2). Section 151.318(g) provided entitlement to credits for exempt machinery, equipment, replacement parts, or accessories with a useful life in excess of six months and Section 151.318(h) provided the percentage amount of the credit, which depended on the date of purchase.

Section 151.318(c)(2), as it existed prior to October 1, 1997, expressly excluded from the exemption intraplant transportation used incidentally in a manufacturing operation.

By its first contention, Claimant asserts that the below-ground equipment employed downhole at the well is exempt because it is used in or during processing performed by the gas separators and by carbon dioxide injection, the emulsion breakers and the paraffin inhibitors, all of which act to effect physical and chemical modifications to oil and gas.  Accession 8307L0524E01 (July 29, 1983) is specifically relied on by Claimant as holding that carbon dioxide injection constitutes processing.  Claimant asserts that the entirety of the below-ground equipment is exempt because all equipment that “acts upon” the product once processing starts is within the exemption, whether or not each item of equipment is engaged in processing.  Essentially, Claimant contends that processing activities “begin when the oil is removed from its natural state from the pores of the reservoir rock formation underground.”

In Comptroller’s Decision No. 39,936 (2003), the Comptroller considered the exempt status of downhole equipment of the exact type and nature here involved under the law as it existed during the periods at issue here, expressly addressing Accession 8307L0524E01 (July 29, 1983) and other prior hearing decisions.  Comptroller’s Decision No. 39,936 (2003) affirmed the Comptroller’s long-standing policy that the “act of bringing oil to the surface of the earth is not processing, fabrication or manufacturing” and held downhole equipment as here involved to be excluded from Section 151.318 manufacturing exemption. The taxpayer there asserted as the basis for the exemption the same arguments made here, namely that the downhole equipment maintains the pressure inside the wellbore as the mixture of oil, gas, and water is forced through the formation and physical and chemical modifications to the oil and gas occur due to changes in pressure, temperature changes and agitation of the product brought about by injection of carbon dioxide, and the treatment of the product with emulsion breakers and paraffin inhibitors.

Comptroller’s Decision No. 39,936 (2003) is determinative of Claimant’s first contention.  While Claimant disagrees with the holding and urges that it is erroneous, no evidence has been presented that distinguishes this case from Comptroller’s Decision No. 39,936 (2003).  In accordance therewith, Claimant’s first contention should be denied.


Based on the foregoing research, we believe that the Comptroller would hold that the downhole sand separator does not qualify for the exemption allowed for processing equipment under Tax Code Section 151.318 and Comptroller Rule 3.300.

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