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Case Study: Southwest Royalties v. Glenn Hegar, Comptroller of Public Accounts – Texas

Posted 6:30 AM, March, 1st 2016 by Manning Wolfe & filed under Case Studies, Legal

Introduction: Texas faces possible Billions in tax refunds in an oil driller’s lawsuit, as energy companies are hoping for a huge windfall from the Texas Supreme Court. The state’s highest civil court last week agreed to hear a case hinging on whether metal pipes, tubing and other equipment used in oil and gas production should be exempt from sales taxes. Texas Comptroller Glenn Hegar is sounding the alarm that a ruling favoring the industry could force the state to issue tax refunds of as much as $4.4 billion. Oral arguments are scheduled for March 8, 2016.


Background: Southwest Royalties, a subsidiary of Midland based Clayton Williams Energy, sued the state in 2009, just before the drilling boom, for refunds on purchases dating back to 1997. Susan McCombs, Hegar's predecessor, rejected the claim. Over the years, the case has wound its way through the court system to the Supreme Court.


Issue: Texas Supreme Court justices are set to weigh the company’s appeal of a lower court’s ruling amid concerns that a prolonged drilling slowdown might hurt Texas’ bottom line. The oral arguments will require the justices to parse the language of a sales tax exemption for goods and services used in the “actual manufacturing, processing, or fabrication of tangible personal property,” and debate how that description relates to the mechanics of petroleum extraction.

The case hinges on whether certain extraction equipment, such as casing, pipes, tubing and pumps, fits the definition cited in the exemption. Southwest Royalties says it does. The equipment, it argues, “processes” West Texas crude by separating it into marketable oil and gas. The Texas Oil and Gas Association backs the position.

The state counters that the equipment does not fit the exemption's definition since underground minerals are not “tangible personal property.” They assert that natural pressure and temperature changes, not the equipment itself, transforms crude as it rises to the surface.

Texas also warns that granting the exemption would spread far beyond the Southwest Royalties case and “impose a severe financial penalty on Texas taxpayers” amounting to $4.4 billion in 2017, and $500 million each year after that as companies around the state seek to cash in, according to estimates compiled in 2012. Texas would stand to lose up to $1.5 billion a year, and $6 billion in initial refunds, if it loses a separate legal challenge involving the franchise tax levied on businesses, Hegar warned.


Appeals Court:  An appeals court in Travis County upheld the lower court’s written decision, backing the comptroller’s interpretation due to “a lack of clarity” in the way lawmakers wrote the exemption. Hegar cited those earlier rulings in expressing confidence that Texas would ultimately prevail.


Collateral law:  In April, Texas' 3rd Court of Appeals sided with AMC movie theatres in a parallel case by widening the definition of "tangible personal property" under the state's tax code to include more of the theater chain's expenses. AMC argued that screening movies fits under the “perceptible to the senses” definition in the code, meaning it should be able to use its costs for theater space to offset revenue when calculating taxes. Hegar fears that most any product could fit that definition, leading to a flood of refunds. The state is asking the appeals court to reconsider the AMC decision, and will then appeal to the Supreme Court if necessary.


Bottom Line:  “It is hardly likely that the Legislature intended such an expansive and costly interpretation of the manufacturing exemption,” Texas’ attorneys say. Southwest Royalties disagrees, and says the financial impact has no bearing on who has correctly interpreted the policy. Ideally, judges decide such cases only on their merits, but when a judge is informed that the comptroller thinks that the ramification of these things is huge, they may approach them much more cautiously.


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