Texas Court Rules That Excavation Equipment Qualifies for Sales Tax Exemption

By: Tina Chunn, SALT Senior Manager

At a glance

• The main takeaway: Manufacturers who are paying sales tax on machinery or equipment related to their production process may be entitled to a sales tax refund.
• How to reap the benefits: Below, we unpack a recent opinion out of Texas that could help shed light on how other states may handle these types of sales tax exemptions.
• Take the next step: Contact Aprio’s State and Local Tax (SALT) team to find out whether or not your manufacturing business qualifies.

Schedule a free consultation today to learn more!

The full story:

Most states generally provide a full sales tax exemption for the purchase of machinery and equipment (and related parts) used in manufacturing or processing tangible personal property for sale. However, the scope of that exemption can vary among the states.

For example, what constitutes manufacturing or processing? When does that process start and when does it end? These are the issues over which states and taxpayers argue, and there is a lot of money at stake, since machinery and equipment are very expensive. Therefore, the sales tax on these items can be substantial.

Recently, the Texas Third Court of Appeals issued an opinion in favor of a coal company that mined and processed coal for sale, allowing a refund of sales taxes paid on equipment used in processing the coal.[1] Below, we unpack the case and explain how it may set a precedent for other businesses.

The case in question

The taxpayer in this case owned a lignite coal mine in Texas, and it used heavy equipment to produce lignite coal that it sold to an energy company. The initial step in the process involved removing a layer of dirt called “overburden” to expose the lignite coal formation. Then, the taxpayer used three excavators “to crack, break apart and reduce the size of the lignite coal,” since the energy company could not handle large pieces of coal.

The taxpayer leased the excavators and purchased component parts for them, and it paid sales and use taxes on the leases and parts. Subsequently, the taxpayer petitioned the Texas Comptroller for a sales tax refund of the sales tax related to the excavator leases and parts, which the Comptroller denied.

Like many states, Texas provides a sales tax exemption for purchases of tangible personal property used in manufacturing or processing. Specifically, the statute provides an exemption for:

“… [T]angible 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 … the product being manufactured, processed or fabricated for ultimate sale[.]”

The taxpayer and Comptroller both agreed that the ultimate product (i.e., the coal) was tangible personal property, the excavators were tangible personal property, and the excavators were directly used in the production of the coal and directly caused physical change to the coal during the production process. However, the Comptroller argued that one additional requirement was not met; namely that the excavators were not processing tangible personal property because the lignite coal formation constituted real property at the moment that the excavators first dug into it. In other words, the Comptroller was interpreting the phrase “manufacturing, processing or fabrication of tangible personal property” to mean not only that the output of the process be tangible personal property, but that the inputs being processed are also tangible personal property.

The Court reviewed the language of the statute, noting that there is no mention of inputs or raw materials, and that the plain language provides an exemption for the excavators to the extent they were used in the “the actual manufacturing, processing or fabrication of tangible personal property for ultimate sale.” In addition, the Court concluded that the statute’s grammatical structure did not support the Comptroller’s interpretation, explaining that the preposition “of” in the phrase above can only be reasonably read to indicate the end product of the production process as opposed to the inputs.

In addition, the Court noted a 2016 Texas Supreme Court opinion that cited three prior Comptroller decisions that support the taxpayer:

1. Comptroller Letter Ruling 9506L1351F01 (1995) (finding that equipment used to break apart the ground and shatter the underlying limestone and shale into pieces to be processed into cement qualified as manufacturing equipment)
2. Comptroller Hearing 27,940 (1992) (concluding that explosives used to blast rock and sandstone formations were used in processing gravel and sand)
3. Comptroller Hearing 23,055 (1988) (determining that dynamite used to blast rock out of the earth and start reducing the size of large boulders to gravel was exempt)[3]

The bottom line

Is it possible that your business paid sales tax on items that would qualify for a state’s manufacturing exemption, and is therefore due a sales tax refund?

Aprio’s SALT team is experienced with analyzing these types of transactions and identifying and claiming potential sales tax refunds to put cash back into your business. We will also work with your team to develop a process to identify exempt purchases at the time of the transaction so that you do not have to constantly be claiming refunds.

We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Tina Chunn, SALT Senior Manager, at tina.chunn@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This content was featured in the November/December 2021 SALT Newsletter.

[1] Hegar v. Tex. Westmoreland Coal Co., No. 03-20-00406-CV, 2021 BL 384349 (Tex. App.-Austin Oct. 07, 2021), Court Opinion.

[2] Texas Tax Code § 151.318(a)(2)(A).

[3] See Southwest Royalties, Inc. v. Hegar, 500 S.W.3d 400, 409 (Tex. 2016).

Disclosure

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.