A version of this piece can be read on Law360, here.
In October, in Hegar v. Texas Westmoreland Coal Co., the Texas Court of Appeals for the Third District handed taxpayers a win in confirming that mineral extraction equipment may qualify for the Texas sales tax manufacturing exemption.1
Westmoreland is important not only for its specific holding, but also for its analysis that might support a more expansive reading of the exemption under other facts.
As discussed below, Westmoreland builds on another recent decision that rejected the comptroller's narrow interpretation of the exemption. In so doing, it signals that taxpayers may have further opportunities to expand the exemption.
In June 2016, the Texas attorney general and Texas comptroller touted a Texas Supreme Court victory for the state in the now widely cited Southwest Royalties Inc. v. Hegar.2
In that case, the Texas Supreme Court denied the sales tax manufacturing exemption to Southwest Royalties, an oil and gas exploration and production company, because it had failed to prove that the equipment for which it sought an exemption was used in actual manufacturing, processing or fabricating within the meaning of the tax code.3
At the time, we observed in a Law360 guest article that the Southwest Royalties holding was not the whole story because, despite winning the overall dispute, the state lost important ground in its ongoing battle over the scope of the manufacturing exemption.4
More specifically, although the court denied the manufacturing exemption because the equipment did not directly cause a physical or chemical change to the hydrocarbons, the court rejected the comptroller's argument that processing and fabrication are simply steps in the manufacturing process, such that manufacturing must have already begun for a taxpayer to claim the manufacturing exemption.5
The court's construction of the manufacturing exemption signaled that taxpayers in multiple industries might eventually qualify for the exemption despite past denials.
As applied specifically to extraction, we demonstrated that Southwest Royalties cast doubt on the comptroller's argument that equipment used in extraction is per se ineligible for the manufacturing exemption, and we predicted that taxpayers might succeed if they could demonstrate that extraction equipment was used for processing as defined in the tax code.6
In Westmoreland, the taxpayer made that demonstration successfully.
Westmoreland Coal Co. sought the manufacturing exemption for tax paid on excavation equipment it used to extract and break apart lignite coal. In a seamless process, Westmoreland operators used excavators to drag their buckets' teeth through the exposed coal formation, breaking it apart while filling the buckets with pieces of coal, which were then dumped into trucks 10 to 12 feet below, breaking it apart further.7
This process turned the coal from a lignite formation in the earth into small pieces ranging in size from a pea to a soccer ball, which Westmoreland then sold to NRG Energy Corp.8
Westmoreland sought a refund for the sales tax paid on the excavators, prorated based on the percentage of time that the excavators were used to break apart the coal.9
The comptroller denied the refund, and Westmoreland filed a protest suit. After a bench trial, the Travis County District Court rendered judgment for Westmoreland, concluding that the excavators "were used in exempt processing by directly causing physical changes to lignite coal."10
On appeal, the comptroller argued that the exemption was unavailable to Westmoreland because "processing," as defined in the statute, "does not encompass extracting minerals from the earth," and because the coal was "real property, not personal property, when the excavators first dug into the ... formation."11
Although presented as two arguments, the Third Court of Appeals properly treated them as a single issue of statutory construction: What is required for the manufacturing exemption in Texas Tax Code Section 151.318(a)(2)(A) to apply?
Like the Texas Supreme Court in Southwest Royalties, the Westmoreland court held that the statute is unambiguous.12
The court observed that there was no dispute regarding the manufacturing exemption's requirements, namely: (1) the ultimate product must be tangible personal property, (2) the item for which the exemption is sought must be tangible personal property, and (3) the item must directly cause a chemical or physical change to the end product being sold.13
The court then addressed the core dispositive question: "Does an input in the production process have to be tangible personal property itself?"14
Finding no express requirement in the statute about the nature of the inputs or raw materials, the court held that both the statute's grammar and its structure indicate that the focus is on the end product, not the inputs.15
In so holding, the court cleared the way for mineral extraction to be treated as processing under certain circumstances.
The court then supported its holding with Southwest Royalties, noting that the exemption was denied there not because the inputs were hydrocarbons in the ground, but because the equipment did not directly process the hydrocarbons.16
The Westmoreland court found it significant that the Texas Supreme Court mentioned — but did not adopt — the comptroller's argument that the taxpayer was not processing personal property because the hydrocarbons were real property while they remained underground.17
The Westmoreland court also found it relevant that the Supreme Court in Southwest Royalties cited with approval three earlier comptroller decisions that otherwise supported Westmoreland Coal Co.'s position — namely, that the comptroller has allowed the exemption for equipment used to "shatter limestone formations to be processed into cement," for explosives used to "blast rock and sandstone formations to be processed into gravel and sand," and for dynamite used to "blast rock out of earth to be processed into gravel."18
Interpreting the Supreme Court's favorable citation to those comptroller decisions as an indication of how it saw the distinction between real property personal property as inputs, the Westmoreland court saw Southwest Royalties as support for its conclusion that "exempt processing can include the severance of minerals."19
The comptroller filed a petition for review on Nov. 22, arguing that the Westmoreland court had read too much into Southwest Royalties.
According to the comptroller, the Texas Supreme Court's refusal to adopt his position that the manufacturing exemption does not apply if inputs are not personal property — and the Supreme Court's favorable citation of the three comptroller decisions allowing the exemption even when the inputs were minerals in the ground — are irrelevant because they were not critical to the Southwest Royalties holding.
It remains to be seen whether this argument gains further traction with other Texas courts, including the Supreme Court.
As of this writing, Westmoreland has waived a voluntary response to the comptroller's petition, and the court has not yet requested one.
If the court denies the petition, it will — as we anticipated — widen the opening created by Southwest Royalties for taxpayers to push back on comptroller positions that have little statutory support, but that the state has been using for years to deny the manufacturing exemption to taxpayers across a range of industries.20
For example, activities such as cutting metal into pieces for processing21 or using chemicals to neutralize acid prior to manufacturing have failed to qualify under the comptroller's narrow reading,22 but are ripe for reevaluation following Southwest Royalties and Westmoreland. And a number of other activities broadly analogous to these that occur prior to, or ancillary to, a core manufacturing process might now be reconsidered.
At a minimum, unless the Texas Supreme Court overturns Westmoreland, the comptroller will find it more difficult to categorically deny the exemption for processing or fabrication that occurs prior to manufacturing, i.e., as premanufacturing.
And more broadly, Westmoreland — building on Southwest Royalties — could pave the way for arguments about general categories of activities related to manufacturing, such as transportation.23
Westmoreland, in sum, may not be the last instance in which the comptroller's purported win in Southwest Royalties yields opportunities for taxpayers to qualify property for the manufacturing exemption that has historically been denied.
Baker Botts state and local tax section chair Renn Neilson contributed to this article.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
1Hegar v. Texas Westmoreland Coal Co., No. 03-20-00406-CV, --- S.W.3d --- (Tex. App.—Austin Oct. 7, 2021, pet. filed).
2Southwest Royalties, Inc. v. Hegar, 500 S.W.3d 400 (Tex. 2016).
3Id. at 409.
4Larsen & Young et al, Extracting Taxpayer Opportunities From Texas Supreme Court "Win," Law360 (Aug. 12, 2016) available at https://www.law360.com/articles/818727.
5See Sw. Royalties, 500 S.W.3d at 405-06.
7Id. at 2.
9Id. at 3 n.2.
10Id. at 4.
12Id. at 5.
14Id. at 6.
15Id. at 8.
16Id. at 9.
17See id. at 10.
18Id. at 11.
20Larsen & Young, supra n.1 at 1.
21See Texas Comptroller's Letter 9704455L (April 11, 1997) (denying the manufacturing exemption for crane operated shears that cut scrap metal to size for processing, in part, because the processes were "in preparation for production.").
22See Texas Comptroller's Hearing 8,012 (1977) (denying the manufacturing exemption for ammonia used to neutralize battery acid, in part, because the "act of neutralizing sulphuric acid is the initial step before the actual processing…").
23For a more detailed discussion of potential manufacturing exemption opportunities related to transportation and other ancillary activities following Southwest Royalties which have gained additional traction with Westmoreland, see Larsen & Young.
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