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Barring Appeal, Tax Exemption Ruling Could Cost Texas $4.4B

Texas could lose an estimated $4.4 billion in revenue from oil and gas sales taxes, depending on how a district court judge tailors his ruling on exempting oil and gas companies from paying the state sales taxes on extraction equipment.

Travis County District Court Judge John Dietz issued a bench ruling last Thursday in favor of Southwest Royalties Inc., a subsidiary of Clayton Williams Energy Inc. (CWEI). Dietz said he agreed with the company's argument that its oil and gas production equipment should qualify for the state's sales tax exemption for manufacturing equipment.

An official in the clerk's office said a written ruling in the case could be issued within weeks.

According to media reports, Texas Comptroller Susan Combs' office said the state would have to refund $2 billion in sales tax revenue to oil and gas companies, plus interest, if the judge's ruling stands. The comptroller added that the state would lose additional tax revenue in the years ahead, as much as $400 million in 2013 and $580 million by 2017.

"This is going to be appealed," Alex Mills, president of the Texas Alliance of Energy Producers, told NGI's Shale Daily on Tuesday. "If the court's ruling is even similar to what we now believe to be the truth, the state is going to appeal. And we feel certain that the legislature will take this up when they come back in 2013."

In a statement Friday, law firm Locke Lord LLP also predicted that the state will appeal the case and that the legislature will revisit the tax exemption for manufacturing equipment, which is Texas Tax Code Section 151.318(a)(2).

"The case definitely will be appealed, and there is considerable uncertainty about the outcome of the appeals process," Locke Lord said. " During the trial, [Combs] not only argued that the [state's] 'chemical or physical change' requirement had not been satisfied, but also argued strenuously that as a matter of law the manufacturing exemption does not apply to the exploration and production of minerals. We expect the comptroller to pursue both positions as well as other arguments on appeal."

Debbie Hastings, executive vice president of the Texas Oil & Gas Association (TXOGA), said the industry was surprised by Dietz's ruling.

"We understand there may be potential implications of this decision to our companies, the state of Texas, and local taxing entities," Hastings said Friday. "We are waiting for the written decision and an analysis of the case to fully understand those implications. While this case is making its way through the appeals process, TXOGA will work cooperatively with state and local officials to discuss any potential impacts."

Hastings said the oil and gas industry in Texas paid $7.8 billion in state and local taxes, plus $1.5 billion in royalties, during fiscal year 2011. She added that the "vast majority" of state and local revenue would be unaffected by Dietz's ruling.

"From the industry's point of view, it was something that was not really on our radar screen," Mills said. "But now that it's happened, we have to deal with it and wait and see what the judge's opinion is and what the state of Texas does to appeal.

"I think Southwest did a great job in making their arguments -- that even though this is not manufacturing widgets, it certainly is a process that is used to find and extract hydrocarbons from miles beneath the earth. It's very early in the ballgame, but Southwest did hit a home run."

The case is Southwest Royalties Inc. v. Combs et al. (Cause No. D-1-GN-09-004284).

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