A recent Texas district court ruling in a tax case regarding the applicability of sales tax collections on the sale of machinery and equipment used to extract oil and gas could lead the state to make billions in tax refunds, future annual tax losses of $500 million, and a legislative battle in 2013.

A Travis County judge in Southwest Royalties, Inc. v. Combs (D-1-GN-09-004284) ruled from the bench last week that changes in pressure and temperature used in the extraction process met the statutory criteria to be considered manufacturing and thus, the machinery and equipment used in the process was not subject to sales tax.

The equipment at issue includes component parts of producing oil or gas wells and their ancillary support equipment that qualify for exemption under Texas Tax Code §151.318 (the manufacturing and processing exemption). The items include casing, tubing, well-head, and pumping equipment.

The plaintiffs were instructed to submit a draft order to the court. A judgment will not be adopted until the court issues a written ruling in the next several weeks. The state is expected to appeal the ruling. The Texas Comptroller of Public Accounts will collect the tax until all appeals are exhausted.

Companies that have paid the tax should consider applying for refunds soon in order to protect refund claims from expiring under the general four-year statute of limitations while the decision is being appealed.

While the courts seek to resolve the matter, we expect the Texas Legislature to attempt to amend the sales tax exemption for manufacturing next session to ensure that the statutes do require sales tax to be collected on the sale of equipment, supplies, and services for producing wells. This would prevent the state from losing the $500 million paid annually on the sale of the equipment at issue in the case.

In addition, the Legislature may need to seek a new funding stream to cover the $2 billion in refunds it may owe to business in the oil and gas industry.

When such tax statutes are considered for adoption or amendment, industries that could be impacted — via intended or unintended consequences — should closely monitor such legislative activity. Some entities may use the opportunity to seek minor changes in the statutes to benefit their interests. Others may attempt to exclude themselves from new tax liability.