Texas Supreme Court Grapples With Billion-Dollar Tax Question

^{Editor's note: This story has been corrected and updated.}

With billions of dollars at stake, the Texas Supreme Court heard arguments Tuesday in a tax showdown whose outcome could shake up the next legislative session while straining the historically friendly relationship between state lawmakers and the iconic oil and gas sector.

Throughout a spirited debate over arcane accounting rules and oil-tinged science, the justices offered few clues as to how they might rule. 

“They’re all great poker faces,” said James LeBas, an economist with the Texas Oil & Gas Association and a former chief revenue estimator for Texas, following arguments.

The case ultimately focuses on a single question: Are metal pipes, tubing and other equipment used in oil and gas extraction exempt from sales taxes?

Texas Comptroller Glenn Hegar has warned state lawmakers that a yes to that question, brought by Midland-based Southwest Royalties in an appeal of a lower court’s ruling, could trigger a flood of refunds that would wipe out the state’s projected $4 billion budget surplus. 

“This one’s as big as they come,” the Republican said ahead of the arguments.

In the courtroom Tuesday, Hegar watched as the justices parsed the language of a sales tax exemption for goods and services used in the “actual manufacturing, processing, or fabrication of tangible personal property” and considered how that description relates to the mechanics of petroleum extraction.

The case hinges on whether certain extraction equipment — like casing, pipes, tubing and pumps — fits the definition cited in the exemption.

Though Southwest Royalties, a subsidiary of Clayton Williams Energy, seeks to recoup less than $500,000 from purchases between 1997 and 2001, the stakes are far higher. 

A Texas loss could spur up to $4.4 billion in refund filings for 2017 alone, Hegar’s office estimates, and $500 million each subsequent year that the exemption remains in place.

That high price tag drew no mention in Tuesday’s arguments, which lasted less than an hour and stuck to the highly technical merits of the case.

David Keltner, an attorney representing Southwest Royalties, argued that certain extraction equipment clearly fits the exemption’s definition.

The company’s equipment “processes” West Texas crude by separating it into marketable oil and gas, he argued, at times pointing to a chart that displayed the various stages of petroleum extraction. Once the crude is brought up from the ground, it is no longer part of a mineral owner’s estate, he said.

“It is tangible personal property. People own it,” Keltner said. “If you were to hold otherwise, there would be serious consequences.”

Among the consequences he named: Texas regulators would struggle to hold drillers accountable for the oil they extract.

Arguing for the state, Texas assistant solicitor general Michael Murphy disagreed, arguing that minerals are not “tangible personal property,” and that Southwest’s equipment was not necessarily responsible for transforming the crude.

“Southwest’s mineral extraction is really like gathering raw materials,” he said, dubbing the mechanics “pre-production or pre-processing.”

“Until that oil and gas bubbles out of the ground, it’s part of the [real estate]."

Justice Phil Johnson, questioned that interpretation.

“It’s not personal property in the tubing, when it’s coming up, it’s still realty?” he asked. “Even though it’s outside the ground, outside the natural environment?”

Justice Debra Lehrmann wondered how Texans could determine the precise moment the crude changes phases. “But how would we know when?” she asked.

Keltner, the driller’s attorney, said that instrumentation on the surface would reveal that information. Murphy disagreed.

Murphy also pointed to a separate tax exemption on the books for purchases of some of the same equipment in question — if it’s used for offshore drilling outside of Texas. Texas lawmakers, he said, would not likely intend to consruct overlapping exemptions.

He also argued that the court must revert to a narrow interpretation of the tax code — siding with the state — if a rule is deemed ambiguous.

But Keltner argued that the wording clearly supported the driller’s side, and that denying the exemption was unfair. He listed several other purchases that Hegar’s office has allowed companies to write off under the policy — including equipment that speeds the ripening of bananas.

“Our concern here is that we have a new stance applied to the oil and gas industry differently,” he said. “A banana is going to ripen anyway. That is inevitable.”

Southwest Royalties originally filed its lawsuit in 2009, just before improved technology unleashed a surge of oil production that transformed the U.S. energy landscape. Susan Combs, Hegar’s predecessor, was named in the original challenge, which has wound through the court system for years.

Lower courts have sided with the state, prompting the company's appeal. 

Though the suit’s potential price tag did not factor into Tuesday’s arguments, it may have played a role in the case’s earlier stages. 

At a hearing in 2012, Travis County District Judge John Dietz said he would rule in favor of Southwest Royalties, only to later reverse his position in a written decision.

The driller suggested that a Wall Street Journal article quoting dire warnings from Combs swayed the judge.

An appeals court in Travis County upheld Dietz's written decision, backing the comptroller’s interpretation due to “a lack of clarity” in the way lawmakers wrote the exemption. 

With an estimated $4 billion budget surplus and a separate Rainy Day Fund projected to top $10 billion in 2017, Texas is well positioned to weather any financial havoc wrought by a Supreme Court loss.

But that outcome would undoubtedly shrink the state’s budget cushion and play a major factor in the 2017 legislative session. It would give lawmakers less money to work with and force those friendly to the industry to consider reversing a policy viewed favorably by the oil sector. 

Disclosure: The Texas Oil & Gas Association is a corporate sponsor of The Texas Tribune. A complete list of Tribune donors and sponsors can be viewed here.