Amended Texas Private Letter Ruling: Is converting pipeline-quality natural gas into liquefied natural gas (LNG) at a new Texas LNG plant exempt manufacturing 'processing,' or is it all just excluded 'transportation' activity because the gas is being prepared for overseas shipment?

Plain-English summary

This is an amended ruling, reissued to fix typos in an earlier December 19, 2014 version — the substance is unchanged.

A company planning a new LNG plant in Texas asked a question of first impression: does converting pipeline-quality natural gas into liquefied natural gas (LNG) count as exempt manufacturing "processing," or is the whole operation excluded as taxable "transportation" activity under § 151.318(c), since the entire point of liquefying the gas is to make it economical to ship overseas?

The plant's process: incoming pipeline gas passes through scrubbers and amine treaters to remove contaminants and acid gases, then a dryer and molecular sieve remove water, then a mercury-removal bed filters out mercury — all needed to meet customer specs and protect the equipment. The purified gas then runs through three refrigerant loops (propane, ethylene, methane) that progressively cool it to about -215°F, turning it liquid; it's then pumped into storage tanks where a pressure drop cools it further to about -260°F for stable storage.

The Comptroller held that at least some of these activities — specifically, compressing the gas to the pressure needed to convert it to liquid — constitute "processing" that happens during manufacturing, even though the ultimate business reason for liquefying is easier transportation. The ruling reasoned that the "purpose is transportation" argument doesn't automatically exclude an activity from the processing exemption; what matters is whether the activity itself directly makes a chemical or physical change to the product (here, turning gas into liquid), which liquefaction plainly does.

Two important limits on this holding: (1) Texas does not treat an entire integrated plant as one unified, all-exempt manufacturing process — each individual piece of equipment used in the facility must independently qualify for the § 151.318 exemption (the ruling cites a 2011 Comptroller hearing holding that a group of machines operating together isn't a "single item of manufacturing equipment," and notes the old case law suggesting otherwise has mostly been superseded by later legislation). (2) The ruling makes NO determination about the taxability of any specific piece of equipment at the facility — it only establishes that liquefaction, as a category of activity, isn't automatically excluded as mere transportation.

What this means for you

LNG producers and gas processing facilities

Don't assume that "we're liquefying gas so it can be transported" automatically pulls your whole operation out of the manufacturing exemption — processing that changes the gas's physical state (like compression to liquefy it) can still qualify as exempt manufacturing processing, even when transportation is your ultimate business purpose.

Anyone claiming a manufacturing exemption for equipment in a large integrated plant

This ruling is a clear reminder that Texas evaluates equipment item-by-item, not the plant as a whole — securing a favorable ruling on the general nature of your process (like this one) does not by itself establish that any particular piece of equipment qualifies for the exemption. You still need to show each item directly causes a chemical or physical change and meets § 151.318's other requirements.

Related rulings

This 2015 ruling appears to be an early, foundational LNG liquefaction ruling establishing the general processing-vs-transportation principle. Later same-corpus rulings (a same-day pair from February 2016) apply this same processing conclusion to more specific LNG liquefaction fact patterns, including a tolling arrangement where the liquefier never owns the gas.

Common questions

Q: If a company liquefies natural gas purely to make it cheaper to ship, does that make the whole activity a nonexempt "transportation" activity?
A: Not per this ruling — the Comptroller held that liquefaction processing can qualify as exempt manufacturing even where the underlying business purpose is transportation, because what matters is whether the activity itself causes a physical/chemical change to the product.

Q: Does this ruling mean all the equipment in an LNG facility is tax-exempt?
A: No — per this ruling, Texas doesn't treat an integrated plant as one unified exempt process; each piece of equipment must separately qualify, and this ruling doesn't decide the taxability of any specific equipment.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.318 (Property Used in Manufacturing)
• Tex. Tax Code § 151.318(a)(2) (exempt property causing a chemical/physical change to the product)
• Tex. Tax Code § 151.318(c)(3) (transportation/distribution equipment excluded from the exemption)
• Tex. Tax Code § 151.318(d) (beginning/ending points of manufacturing)
• Tex. Tax Code § 151.318(f) (integrated equipment groups not a single manufacturing item)
• Tex. Tax Code § 151.318(r) (taxpayer's burden of proof)
• 34 Tex. Admin. Code Rule 3.300(a)(9)-(10) (manufacturing and processing definitions)

Cited prior guidance:

• Hearing No. 101,650 (2011), STAR # 201103022H — an integrated group of manufacturing/processing machines isn't a single item of manufacturing equipment; discusses Sharp v. Chevron Chemical Co., 924 S.W.2d 429 (Tex. App.—Austin 1996), as largely superseded by later legislation

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201501032L

Original ruling text

January 27, 2015

RE: Private Letter Ruling # 142340831

Dear ****:

We issue this amended private letter ruling to correct typographical errors in
our previous ruling dated December 19, 2014.

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request dated February 7, 2014 and further clarified by a letter dated
August 18, 2014. In addition, we spoke with you about your request on July 8,
2014 and July 18, 2014. Detrimental reliance is provided in accordance with
Rule 3.10, the Taxpayer Bill of Rights.

Your client, COMPANY A, will build a new Liquefied Natural Gas (LNG) plant in
Texas (“the Facility”). We issue this private letter ruling for the sole
purpose of addressing a question of first impression: whether any of the
activities that occur within the Facility constitute exempt processing
operations or whether all the activities constitute a taxable transportation
activity excluded from exemption in Section 151.318(c). [ENDNOTE 1]

FACTS PRESENTED
We understand that the Facility is in the development stages. We issue this
private letter ruling based on the facts presented and without any independent
verification of the terms used or activities described and assume they present
an accurate description of the activities that will occur at the Facility.
According to Rule 3.1(d)(2), this ruling is not binding on the Comptroller “if
there has been a misstatement or omission of material facts in the request” or
“the facts subsequently developed are materially different from the facts on
which the private letter ruling was based.”

We understand that COMPANY A will purchase pipeline quality natural gas that
will be delivered to the Facility by pipeline. At the Facility, COMPANY A will
convert the pipeline quality natural gas it owns into LNG. COMPANY A will then
sell the LNG with possession and title passage at the flange connecting to the
ship that will export the LNG.

Once in the Facility, the pipeline quality natural gas is sent through an inlet
feed facility where inlet scrubbers remove contaminants such as solid particles
and liquid droplets that could harm Facility equipment if not removed. Next,
amine treaters/absorbers absorb and remove acid gases, such as carbon dioxide
and hydrogen sulfide, from the natural gas by using a liquid amine solution,
heated by a hot oil circulating system. A dryer feed knockout drum further
purifies the natural gas by separating condensed hydrocarbons and water from
the natural gas and a molecular sieve dehydrator physically filters out water
vapor not previously removed. A mercury removal bed then removes mercury by
filtering the natural gas through an activated carbon filter. Purification to
remove each component (carbon dioxide, hydrogen sulfide, water and mercury) is
required to meet customer specifications; furthermore, the removed components
may damage the equipment if still present in the natural gas when it reaches
cryogenic temperatures.

After the natural gas has been purified, it begins to be cooled by running
through three separate refrigerant units. LNG is produced using the three
refrigerant loops, with propane, ethylene, and methane serving as refrigerants.

At the Facility, the natural gas begins cooling by flowing into the propane
heat exchangers which reduce the temperature of the natural gas in stages as a
result of the refrigerant cycle. The natural gas completes its first
refrigerant cycle when it reaches the end of the propane refrigerant loop,
where it is cooled to approximately -25 degrees Fahrenheit (“F”).

Next, the natural gas flows into the ethylene cold box, which further reduces
the temperature of natural gas in stages by means of the second refrigerant
cycle. When the natural gas completes this second refrigerant cycle at the end
of the ethylene refrigerant loop, it is cooled to approximately -130 degrees F.

The natural gas is next sent to the heavies removal unit where trace amounts of
heavier natural gas liquids ("NGLs") are removed, leaving behind primarily
methane. These NGLs must be removed before the natural gas enters the methane
refrigeration loop because they solidify before methane liquefies. If they are
not removed, they will form ice crystals in the LNG that could damage Facility
equipment.

From the heavies removal unit the natural gas is next sent to its final
refrigerant cycle in the methane cold box, which further reduces its
temperature in stages. When the natural gas reaches the end of the methane
refrigerant loop, it is cooled to - 215 degrees F and is now a liquid that is
LNG.

Next, the LNG is pumped into LNG storage tanks using LNG transfer pumps. When
the LNG exits the methane refrigerant cycle, its pressure is approximately 100
pounds per square inch (“PSI”) as it is contained in the confined space of the pipe;
however, once the LNG enters the LNG storage tank, the pressurization is
instantly reduced to approximately 1.5 PSI, which further reduces the
temperature of the LNG to -260 degrees F. Because the volumes of LNG will
naturally dissipate and convert to boil-off gas at temperatures above -260
degrees F, the temperature drop attained when the LNG enters the tank is an
important step in the liquefaction process.

You also stated, “LNG is natural gas that, through a refrigeration process, has
been reduced to a liquid state that occupies approximately 1/600th of its
gaseous volume. Liquefying natural gas allows it to be economically transported
from areas of the world where natural gas is abundant and inexpensive to areas
where natural gas production and other imports are insufficient to meet demand.
LNG is transported from liquefaction terminals to regasification facilities
using oceangoing LNG tankers specifically constructed for this purpose.”

RELEVANT AUTHORITIES
Section 151.318, Property Used in Manufacturing, provides guidance on the
Legislature’s intent regarding items that can and cannot be purchased tax free
by persons engaged in manufacturing activities. Rule 3.300, Manufacturing;
Custom Manufacturing; Fabricating; Processing, provides further guidance.

Section 151.318(a)(2) states that the following items are exempt if sold,
leased, or rented to, or stored, used, or consumed by a manufacturer:

(2) tangible personal property directly used or consumed in or during the
actual manufacturing, processing, or fabrication of tangible personal property
for ultimate sale if the use or consumption of the property is necessary or
essential to the manufacturing, processing, or fabrication operation and
directly makes or causes a chemical or physical change to:

(A) the product being manufactured, processed, or fabricated for ultimate sale;
or

(B) any intermediate or preliminary product that will become an ingredient or
component part of the product being manufactured, processed, or fabricated for
ultimate sale;

Section 151.318(c)(3) provides that manufacturing exemptions do not apply to
equipment or supplies used in distribution or transportation activities.

Section 151.318(d) defines the beginning and ending points of any manufacturing
activity as “each operation beginning with the first stage in the production of
tangible personal property and ending with the completion of tangible personal
property having the physical properties (including packaging, if any) that it
has when transferred by the manufacturer to another.”

Section 151.318(f) states that for purposes of subsection (c)(1), piping
through which material is transported forward from one single item of
manufacturing equipment and its ancillary support equipment to another single
item of manufacturing equipment and its ancillary support equipment is not
considered a component part of a single item of manufacturing equipment and is
not exempt. An integrated group of manufacturing and processing machines and
ancillary equipment that operate together to create or produce the product or
an intermediate or preliminary product that will become an ingredient or
component part of the product is not a single item of manufacturing equipment.

Section 151.318(r) states that a “taxpayer claiming an exemption under [Section
151.318] has the burden of proof that the exemption is applicable and that no
exclusion under Subsection (c) applies.”

Rule 3.300(a)(9) defines manufacturing as follows:

Manufacturing--Each operation beginning with the first stage in the production
of tangible personal property and ending with the completion of tangible
personal property. The first production stage means the first act of
production, and it shall not include those acts in preparation for production…:

(A) Completion of production means the tangible personal property has all the
physical properties, including packaging, if any, that it has when transferred
by the manufacturer to another. For example, a manufacturer of raw rubber has
completed production when the raw rubber is ready to be transferred to a
manufacturer of rubber goods.

(B) Processing and fabrication are two activities that are performed during
manufacturing. For example, the person who takes raw steel and makes pipe is
engaged in fabrication. The workers who coat or thread the pipe are engaged in
processing.

Rule 3.300(a)(10) provides in relevant part that processing means “[t]he
physical application of the materials and labor necessary to modify or to
change the characteristics of tangible personal property.”

RULING AND ANALYSIS
You do not ask for guidance regarding specific items of tangible personal
property that will be purchased and used at the Facility. However, we must
consult Section 151.318 and Rule 3.300, and related authorities, in order to
determine if any of the activities engaged in at the Facility qualify as
manufacturing.

Based on the relevant authorities as applied to the facts presented, we
conclude that at least some of the activities that will occur within the
Facility to convert natural gas into LNG constitute processing, which is an
activity that occurs during manufacturing. See Rule 3.300(a)(9)(B).
Specifically, compressing the gas to a pressure required to convert the gas
into a liquid within the Facility constitutes “actual manufacturing” under
Section 151.318(a)(2) and is considered processing performed by a manufacturer
as defined in Rule 3.300(a)(10). Further, the production of liquefied natural
gas under Rule 3.300(a)(9)(B) begins after natural gas enters the Facility.

The purpose of COMPANY A liquefying natural gas is so it can ultimately be sold
as LNG and then transported overseas. Although the conversion to LNG is done
for transportation purposes, we conclude that the conversion of pipeline
quality natural gas into LNG at the Facility is a manufacturing process.

Texas does not recognize a self-contained, unified manufacturing process in
large integrated plants as being all-inclusive for tax purposes. See, for
example, Hearing No. 101,650 (2011), STAR # 201103022H (explaining that an
integrated group of manufacturing and processing machines and ancillary
equipment that together operate to produce a product are not a single item of
manufacturing equipment and that the case of SHARP V. CHEVRON CHEMICAL COMPANY,

924. S.W.2d 429 (Tex. App. – Austin 1996, writ denied) was for the most part
     superseded by subsequent acts of the Legislature).

As you noted in your request for this private letter ruling, each piece of
equipment used in the Facility’s operation must stand on its own and meet the
qualifications for exemption under Section 151.318. There are many items of
tangible personal property that will be purchased and used at the Facility for
which we make no determination as to taxability. We only conclude that based on
the facts presented, some processing as contemplated by Section 151.318 and
Rule 3.300 will occur at the Facility.

If you have questions about this private letter ruling, please email us at
https://www.window.state.tx.us/taxhelp/ and reference Private Letter Ruling No.
142340831.

Sincerely,

Tax Policy Division

ENDNOTES:

1. Unless otherwise indicated, all references herein to “Section” are to TEX.
   TAX CODE ANN. (Vernon 2008 and Supp. 2013) and all references to “Rule” are to
   Title 34, Texas Administrative Code.