States vary in how a sales or use tax exemption for materials and equipment is applied when used in conjunction with the manufacturing process. This murky water is no more apparent than during an audit or refund application.
Manufacturing is an industry with its own complex set of exemptions. Even the most seasoned tax manager can get hung up on exempt use when it comes to manufacturing equipment. And it usually comes down to the state's interpretation and application of the ever familiar term "used in the manufacturing process".
Texas Case Tests the Waters
A recent Texas Supreme Court case is a good example. A Texas company, Southwest Royalties, Inc., an oil and gas production company, applied for a sales tax refund based on a manufacturing exemption provided for in the Texas State Tax Code. The company purchased and paid tax on equipment such as casings, tubing, pumps and associated services. They later applied for a refund of the tax paid for the period January 1, 1997 through April 30, 2001 based on the Texas manufacturing exemption for equipment used in the manufacturing process. It was up to Southwest Royalties to prove that the equipment in question was indeed used in the manufacturing process. The Comptroller denied the refund application and this case eventually made its way to the Texas Supreme Court.
Explanation of Texas Ruling
A Texas exemption statute states that a manufacturing exemption can be applied if the equipment is actually used in processing. The court went on to determine that the equipment in question did not meet this standard because it did not actually cause the separation of the hydrocarbons (processing). The pipes were used to bring the materials to the surface from underground but did not separate the hydrocarbons into its components. The Court determined that Southwest Royalties did not meet their burden to prove that the exemption applied.
It should also be noted that the Comptroller's decision was based on a previous determination that this type of equipment was used for transporting, and not manufacturing.
So, as you can see, this manufacturing exemption in Tax Code section 151.318(2), (5), or (10). had two different and distinct interpretations of what the manufacturing process included. One by the taxpayer and one by the State.
Southwest believed that the manufacturing process included removing the gas and oil from the ground and that the equipment should be exempt. The Court stated that even though there is some ambiguity in this statute related to the term processing, it was narrowly interpreted to mean that the statute did not intend to include the extraction of gas and oil from the ground. And the meaning of processing as it appears in this statute is the application of labor and materials to change or modify the composition of tangible personal property. It was determined that oil and gas in the ground are real property and not tangible personal property.
The Supreme Court upheld the Decision of the Comptroller and the Appeals Court and denied the refund application. As previously stated, Southwest Royalties, Inc. did not meet the burden of proof required relating to the equipment in question being part of the manufacturing process.
Exemptions Open to Interpretation
This case is a very interesting read and lifts up the intricacies of interpreting manufacturing exemptions. It's apparent in this case that the Comptroller and the courts looked beyond the definition of processing and applied other known gas and oil industry factors in their decision making process.
There's a lesson to be learned here. Navigating the waters of manufacturing sales and use tax exemptions begins with knowing your industry and the challenges you face in managing the sales tax function. Don't just rely on the statutory definition of any industry term. There are exceptions to every rule.
SOUTHWEST ROYALTIES, INC., PETITIONER, v. GLENN HEGAR, COMPTROLLER OF PUBLIC ACCOUNTS OF THE STATE OF TEXAS, AND KEN PAXTON, ATTORNEY GENERAL OF THE STATE OF TEXAS, RESPONDENTS Case No. 14-0743, June 17, 2016, Supreme Court of the State of Texas
Have you been denied a sales tax exemption by your state? What were the circumstances?
How do you keep up with sales and use tax regulations in your state?
Other recent “Manufacturing & Distribution” posts by Lauren Stinson, CMI:
- Manufacturing Purchases: 5 Sales-Use Tax Basics for Purchasers and A/P
- Manufacturing Exemption Misconception: Everything is Tax Exempt!
- Manufacturers’ Utility Studies: 5 Approaches to Utility Exemptions
- Manufacturing Sales & Use Exemptions: Open to Interpretation
- Use Tax Exemptions Case: Non-Traditional Manufacturer in Missouri