In a recent a trial court ruling from the bench in Southwest Royalties Inc. vs. Combs, Cause D-1-GNU-09- 004284 (Travis County 250th Dist. Ct.), Judge John Dietz overturned longstanding Texas Comptroller policy and expanded the sales and use tax manufacturing exemption to include certain items used to extract oil and gas from wells. See Locke Lord QuickStudy, “New Texas Case Creates Possible Sales Tax Refund Opportunities for Oil and Gas Exploration and Production Companies.” The judge’s ruling generated substantial publicity and attention, not least because the Texas Comptroller’s Office estimated that the ruling could result in $2 billion in tax refunds and prospective losses of roughly $500 million annually. Explicitly due to the potential impact of his ruling, Judge Dietz ordered a rehearing held on April 26, to allow the parties an opportunity to reargue their positions as to whether the exemption applied. On April 30, Judge Dietz issued a written decision in the case, reversing the outcome of his ruling from the bench and denying any refund to the taxpayer.

Section 151.318 of the Texas Tax Code provides a sales tax exemption for equipment that, among other requirements, “directly makes or causes a chemical or physical change” to a product being manufactured or processed for sale. In his original ruling, the judge concluded that the process of extracting the product from the wellbore caused the necessary physical change to support exemption for the equipment. After the rehearing, however, the judge concluded that although the extraction process caused a physical change to the product, the taxpayer had failed to prove that the equipment at issue (e.g., tubing) directly caused such change. Instead, the judge concluded that the physical changes during the extraction process resulted from pressure and temperature differences between the subsurface formation and the surface. The taxpayer’s equipment that brought the product to the surface therefore was only an indirect cause of the physical change, which is insufficient to support an exemption. Because the court was able to decide the case on this basis, the court declined to rule on the State’s alternative position that the exemption per se does not apply to oil and gas extraction because such activities are mining rather than manufacturing.

While Judge Dietz’s decision on rehearing deals a blow to oil and gas companies hoping for refunds for taxes paid on prior equipment purchases, the issue remains in play through a possible appeal of the Southwest Royalties decision or through two other similar cases pending in Travis County (Apache Corp, cause number D-1-GN-09-004344, and Leoncito Plant, L.L.C., cause number D-1-GN-11-001116).