Travis County District Judge John Dietz has ruled that drilling equipment, including well casing and “down-hole” equipment used to extract oil and gas, does not qualify for the Texas sales tax exemption for manufacturing property, reversing a ruling he handed down just last month.

The tax exemption, applicable to manufacturing, fabricating and processing equipment was enacted in Texas in 1987 (Texas Tax Code Sec. 151.318). The legislative intent was to attract manufacturing companies by keeping Texas competitive with other states that have a similar tax exemption. The state law is silent on whether the exemption applies to oil and gas equipment, giving the Court’s interpretation a significant impact on State tax revenue.

In the case, Southwest Royalties, Inc. v. Combs, Case D-1-GNU-09-004282 (Travis County 250th Dist. Ct.), the plaintiff argued that the exemption applies because the drilling equipment causes a change when petroleum is brought to the surface and separates into natural gas, oil and other liquids. Southwest Royalties presented evidence that the oil and gas wells directly caused the physical changes to the hydrocarbon products without any intervening forces required. The State’s attorneys asserted that the separation is simply a natural process stemming from a drop in pressure and temperature and not a direct result of the equipment. 

Judge Dietz initially ruled that the exemption applied. Dietz reheard the case last week and agreed with the State’s argument that the physical change in the petroleum is merely incidental to the process and not directly tied to the equipment. 

The state comptroller estimated that if the exemption had been extended to drilling equipment, it could have cost the state $2 billion in refunds and about $500 million in lost tax revenue each year, with the potential for a staggering $4.4 billion drop in state revenues through 2017.

An appeal of the ruling is expected.