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The Texas Supreme Court has denied review in Citgo Petroleum Corp. v. Hegar (holding that receipts from the sale of certain mark-to-market securities are included in the franchise tax apportionment factor on a net basis rather than gross) and in Hegar v. Texas Westmoreland Coal (holding that excavators used to extract and break coal to proper size for sale qualify for the sales and use tax manufacturing exemption). Now that the Texas Supreme Court has denied review in these cases, taxpayers with receipts from the sale of securities and taxpayers with Texas mining operations should evaluate the potential impact of the intermediate appellate court decisions on their Texas tax liability.

In Citgo, the Texas Third Court of Appeals held that receipts from the sale of non-inventory securities, which the taxpayer elected to be treated as inventory using mark-to-market accounting for federal tax purposes under I.R.C. §475(e) and 475(f), were properly included in the company’s franchise tax apportionment factor at net rather than at gross. Generally, Texas law requires a taxpayer to include receipts from the sale of securities at net. However, Texas’s statute provides an exception for receipts for the sale of a security that “is treated as inventory of the seller for federal income tax purposes.” For these sales, the gross proceeds of the sale are included in the taxpayer’s apportionment factor.

The taxpayer in Citgo did not argue that its securities were actually inventory for federal tax purposes, but rather argued that, due to its mark-to-market elections, its securities were treated as inventory for federal income tax purposes. The Court of Appeals rejected this argument, holding that only receipts from the sale of securities that are actually inventory for federal income tax purposes (i.e., held for sale to customers in the ordinary course of business) may be included in the apportionment factor on a gross basis. The taxpayer petitioned the Texas Supreme Court for review of the Court of Appeals’ decision, which the Texas Supreme Court denied on September 30, 2022.

Although the Texas Supreme Court denied review in Citgo, that does not necessarily mean the issue is over. Another recent case, Conagra, presents a similar interpretation question regarding the treatment of non-inventory securities. Just as in Citgo, the Court of Appeals held that only receipts from the sale of actual inventory securities are included in the apportionment factor at gross. The taxpayer in Conagra has until November 9, 2022 to file its petition for review. If the taxpayer does file a petition, it may attempt to distinguish its case from Citgo on factual grounds or highlight the significance of the legal question.

One point that not fully addressed by Citgo is how to distinguish between inventory and non-inventory securities. In a footnote, the Court of Appeals suggested that a taxpayer with both securities dealing activities and securities trading activities that were the subject of a mark-to-market election would need to treat the receipts from dealing at gross and the receipts from trading at net, but the Court did not explain how to distinguish between the two activities because the taxpayer in Citgo had not disputed that the receipts at issue were from the sale of non-inventory securities.

Summary of Texas Westmoreland Coal

In Texas Westmoreland Coal, the Texas Third Court of Appeals held that purchases of coal mining excavators used by a taxpayer to extract and then break coal into a saleable size were exempt from sales and use tax as manufacturing equipment. Texas’s manufacturing exemption only applies to the production of tangible personal property, and the Comptroller had argued that the taxpayer’s excavators did not qualify because the coal was real property when excavated from the ground.

The Court of Appeals rejected the Comptroller’s argument, and explained that, under Texas’s common law governing mineral extraction, the coal became tangible personal property upon severance; thus, the excavators were processing tangible personal property ultimately held for sale. Moreover, the court emphasized, the manufacturing statute does not require that manufacturing inputs or raw materials start as tangible personal property, so long as the end product manufactured qualifies as tangible personal property.

The Comptroller petitioned the Texas Supreme Court for review, which the Court denied on September 30, 2022.

Takeaways from Texas Westmoreland Coal

The logic of Texas Westmoreland Coal seems to allow a significant amount of property used in mineral extraction to qualify for the manufacturing exemption from sales and use tax. Taxpayers should evaluate their purchases to determine whether there is a potential for refunds. Important facts to consider include whether purchased property is acting directly on extracted natural resources, whether the natural resources undergo chemical or physical changes, and whether the manufacturing process results in the sale of tangible personal property.

Given the Comptroller’s strong opposition to the scope of the manufacturing exemption, as defined by the Court of Appeals’ opinion, taxpayers should anticipate the Comptroller will narrowly construe and apply the decision, in a manner similar to the Comptroller’s narrow application of the Checkfree data processing case. Thus, taxpayers that claim refunds for property used in mineral extraction under Texas Westmoreland Coal may need to prepare for further litigation to secure the refunds to which they are entitled.

The Comptroller could also advocate for a legislative amendment when the Texas Legislature convenes in January 2023, as seen in the wake of prior litigation argued to have judicially expanded the scope of the exemption beyond that contemplated by the legislature. Any such amendment should be applied prospectively, though the legislature does sometimes mark amendments as clarifications of existing law, which can muddy the waters regarding their effective date.

One other point to consider is that the Court of Appeals’ reasoning in Texas Westmoreland Coal is not necessarily limited to Texas law. Taxpayers should consider whether they may be entitled to claim the manufacturing exemption for property used in mineral extraction in other states that provide a manufacturing exemption similar to Texas’s.

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