In opposition, the Comptroller pressed the Court to hold that extraction of minerals from the earth is not manufacturing or processing for sales tax purposes and that no processing can occur "underground." The Court declined to make such sweeping determinations and instead focused on the narrow issue of whether Southwest proved that the downhole equipment "acted upon the hydrocarbons to modify or change their characteristics." The Court applied the Comptroller's definition of "processing" in 34 Tex. Admin. Code section 3.300(a)(10): "The physical application of the materials and labor necessary to modify or to change the characteristics of tangible personal property."
Relying on this definition and the trial court's findings of fact, the Court concluded that although physical and chemical changes occur in the oil, gas, and hydrocarbons during production, these changes occur naturally due to pressure and temperature changes. Therefore, the downhole equipment was not used in the "actual" physical application of materials and labor to the hydrocarbons necessary to cause a physical change in them.
This decision appears to leave intact the Comptroller's previous determinations to grant manufacturing and processing exemptions to other types of equipment and materials used in oil, gas, and mineral production and extraction. In other words, the Court redirected the Comptroller's focus to whether a piece of equipment, chemical, etc., actively causes a physical or chemical change in the product being processed.
The Court did not address the taxpayer's remaining contentions that the downhole equipment qualified for the pollution control and public health exemptions. Likewise, the Court did not distinguish between items purchased before and after October 1, 1997. (Effective October 1, 1997, the Legislature modified Tex. Tax Code section 151.318 significantly, introducing the new requirement of a "chemical or physical change" and completely rewriting the remainder of the law.)
It was not known at press time whether the taxpayer would request a rehearing from the Court.
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