I bought subsurface pumps for my gas/oil wells to remove water so gas can flow to the surface -- do they qualify for the sales tax manufacturing exemption?

Subject

Oil/Gas Production Vs. Manufacturing Production

Plain-English summary

A company bought two subsurface pumps for two gas wells it operates and asked whether the pumps qualify for the sales tax manufacturing exemption. The company argued the pumps were doing far more than "transporting" a product: they remove water from the well bore, which reduces pressure on the gas-producing formation and lets gas (and a small amount of condensate -- less than 5% of the fluids removed) flow up the well bore. The company described the well bore, casing, tubing, and subsurface pump as effectively a "preliminary two-phase separator," separating gas from a liquid phase (mostly water, plus condensate) before that liquid is pumped to a surface separator for final processing. In the company's view, the "manufacturing" or "production" process wasn't complete until this final separation happened at the surface, so the subsurface pump should count as part of manufacturing, not as equipment that merely transports a product to market. The same basic argument applied to oil wells, where the pump removes an oil-and-water mixture (plus some casinghead gas) from the well bore for further separation at the surface.

The Comptroller disagreed and ruled the pumps are taxable. The response is direct: "Bringing oil or gas to the surface is not processing, fabrication, or manufacturing." The ruling explains the source of the confusion -- the oil and gas industry commonly uses the word "production" to mean bringing oil or gas up to the surface, while the same word is also used elsewhere to mean manufacturing an item of tangible personal property. But the statutory exemption in Tax Code 151.318 is written in terms of "manufacturing, processing, or fabrication," and it has been determined that an oilfield producer is not manufacturing or fabricating. The ruling also rejects the idea that moving oil from below ground to the surface is "processing." Because none of the three exempt terms (manufacturing, processing, fabrication) covers the mere act of "production" as the industry uses that word, the subsurface pumps -- which facilitate production by removing waste water and oil from the well bore -- are production equipment, not manufacturing or processing equipment, and do not qualify for the exemption.

What this means for you

Oil and gas producers/operators

Subsurface pumps used to lift water, oil, or gas out of the well bore are treated as production equipment, not manufacturing equipment, no matter how essential they are to getting the well to flow. Under this ruling, that means they are not eligible for the Section 151.318 manufacturing exemption, so tax applies to their purchase.

Anyone deciding where "production" ends and "manufacturing" begins in this industry

The dividing line the Comptroller draws is the well bore itself: bringing oil or gas up from underground to the surface is production, and production is not one of the three exempt activities (manufacturing, processing, fabrication) under 151.318 -- regardless of how the equipment is described (e.g., as a "two-phase separator") or how integral it is to the overall process.

Businesses evaluating exemption claims based on how "integral" equipment is to a process

This ruling shows that being an essential, even indispensable, step in getting a marketable product ready is not by itself enough to qualify for the manufacturing exemption -- the activity has to fit within the statutory categories of manufacturing, processing, or fabrication, and simply moving oil or gas from underground to the surface does not.

Common questions

Q: Are subsurface pumps used to remove water from gas or oil wells exempt from Texas sales tax as manufacturing equipment?
A: No. The Comptroller ruled that these pumps facilitate production, not manufacturing, processing, or fabrication, so they don't qualify for the exemption under Tax Code 151.318 and are taxable.

Q: Does it matter that the taxpayer described the well bore and pump as acting like a "preliminary two-phase separator"?
A: No. The ruling didn't dispute the mechanics described but held that bringing oil or gas to the surface is production, not manufacturing, processing, or fabrication -- regardless of how the equipment functions.

Q: Why does the ruling say there's confusion in this area?
A: Because the oil and gas industry commonly calls the activity of bringing oil or gas to the surface "production," while the same word can also describe manufacturing tangible personal property elsewhere. The statute's exemption, however, only covers "manufacturing, processing, or fabrication" -- not production in the industry sense.

Q: Does the same result apply to oil wells as well as gas wells?
A: Yes. The ruling states the oil well analysis "is not quite as clear but is essentially the same" -- the pump removes an oil-and-water mixture (and casinghead gas) from the well bore, which is still production, not manufacturing.

Q: Where does the Comptroller say the "manufacturing" or "production" process ends?
A: The ruling doesn't need to fix that boundary for exemption purposes, because it holds bringing oil/gas to the surface is not manufacturing, processing, or fabrication at all -- so the subsurface pump is production equipment regardless of where later separation happens.

Citations and references

Statutes and rules:

• Tax Code 151.318 (manufacturing, processing, or fabrication exemption; construed to exclude mere "production" of oil or gas)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9611770L

Original ruling text

November 26, 1996

Dear *****:

This is in response to your request for a ruling on the
taxability of two subsurface pumps purchased by your company that you feel
should qualify for the manufacturing exemption. Your fact situation and
discussion are restated below, followed by my response:

FACTS

This company recently purchased two subsurface pumps for two
gas wells that it operates. I spoke with someone in your office about an
exemption for sales tax for these items because they are used in a
manufacturing or production operation. The person seemed to feel that these
pumps were involved in transporting a product rather than manufacturing it,
and, thus, there was no exemption. However, the person was not sure on this
point. I am writing for a clarification.

Both of these wells are classified as gas wells. A minimal
amount of condensate is produced by the wells (considered liquefied natural gas
by the Texas Railroad Commission). The purpose of the subsurface pumps is to
remove water from the well bore so that pressure on the gas producing formation
will be reduced, thus allowing gas to flow out of the formation and up the well
bore. The water is not a salable product that we are transporting. Probably
less than 5% of the total fluids removed from the well bore would be condensate
(condensed natural gas, if you will). The casing, tubing and subsurface pump
are, in effect, serving the purpose of a preliminary two phase separator. The
gas phase product is being separated in the well bore from a liquid phase
consisting of more than 95% water and the balance condensate. The liquid phase
is sent by the subsurface pump to be processed again on the surface (sometimes
with the gas phase recombined with it and sometimes not) in a two phase
separator which extracts the last traces of gas dissolved in the liquid water
and condensate. The production, or manufacturing phase ends when this final
separation of the phases takes place in the surface separator and the gas is
sent down the pipeline and the water and condensate are sent by gas pressure
(not a pump) to a storage tank.

To me it requires a real stretch of the imagination to consider that the
subsurface pump is not part of the manufacturing (production) process but
is transporting a product to market. It is removing a waste product (salt
water) from the well bore which otherwise would prevent the whole manufacturing
(production) process from taking place. It is anintegral and essential part
of the manufacturing (production) process. Essentially, the manufacturing
(production) process is not over until the components leave the surface
separator. Moving fluids around from one part of the processing equipment
to another surely should not be considered as transporting one of the products
to market especiallywhen the fluid being moved is mostly water and not a
salable product. In any case, moving components around in the production
process should not be considered transporting them to market. Look at the
absurdity this could lead to by imagining a small pump circulating fluid from
the bottom of the surface separator and injecting it as a spray in the top end
of the separator for some imagined purpose. Would this be considered
transportation of the product? I don't see how anyone could call it such. The
pump would be an integral part of the manufacturing process.

In the case of wells classified as oil wells by the Texas Railroad Commission,
the case is not quite as clear but is essentially the same. The pump is
removing an oil and water mixture from the well bore to reduce the pressure
on the formation so that this oil and water mixture and some gas (called
casinghead gas when produced from an oil well) will continue to flow into the
well bore. The liquid phase (an oil and water mixture) is again sent to a
surface separator by the subsurface pump, to separate out any dissolved gas
that may come out of solution in the oil and water mixture. Hence, this pump
is also a part ofthe manufacturing (production) process, which is not complete
until the last traces of casinghead gas are separated from the oil and water
mixture in the surface separator, the gas sent down the pipeline and the oil
and water mixture sent to storage tanks using gas pressure.

To me the essential question is, "Where does the manufacturing process end"?
And the answer can only be, "It ends when the last separation of the products
is terminated in the surface separator and the gas is sent down the pipeline,
while water and condensate or oil is sent to storage tanks. All operations
up until this point are part of the manufacturing process."

RESPONSE: Bringing oil or gas to the surface is not
processing, fabrication, or manufacturing. Some confusion exists in this area
because the term "production" is generally used in your industry to refer to
the activity of bringing oil or gas to the surface of the earth, and that term
is also used by some in the context of manufacturing an item of tangible
personal property. However, the statutory language in 151.318 is
"manufacturing, processing, or fabrication" and it has been determined that the
oilfield producer is not manufacturing or fabricating. Nor is the act of
moving the oil or transporting it from its subsurface location to the surface,
processing. Thus, the three terms used in the scope of the exemption are not
applicable to the mere act of "production".

The subsurface pumps in question, by removing the waste oil and water from the
wellbore, facilitate the production of the gas or casinghead gas and are thus
production equipment and not manufacturing or processing equipment.

This opinion is based on the facts presented. Other facts though similar may
provide a different result.

You may call me toll-free at 1-800-531-5441, extension 3-4502. The direct
line is 512/463-4502. You may also write to Tax Policy Division, Comptroller
of Public Accounts. My Internet address is: [email protected].

Sincerely,

Gilbert Zamora
Tax Policy Division