Is converting natural gas into liquefied natural gas (LNG) for overseas shipment 'processing' eligible for Texas's manufacturing exemption, or is it just a taxable transportation-related activity?

Plain-English summary

Note posted with this ruling: the Comptroller later provided subsequent clarification to this same taxpayer in a separate ruling, STAR 201902009L — check that ruling if you're relying on this one, since it may update or refine this analysis.

Two related companies are building new natural gas liquefaction facilities in Texas — a companion fact pattern to the toll-processing question addressed in a same-day ruling (STAR 201602747L). Here, the companies will never own the gas they liquefy; they convert customers' pipeline-quality natural gas into liquefied natural gas (LNG) so it can be shipped overseas, regasified, and sold as natural gas abroad. The facilities have two parts working as a single "liquefaction train": pretreatment facilities that change the gas's chemical composition to meet liquefaction specifications, and liquefaction facilities that actually convert it to liquid. The companies asked the Comptroller to confirm that specific compressors and other detailed equipment they described qualify for the Texas manufacturing exemption (Section 151.318(a)(2) and (4)), or whether the whole operation is instead just an excluded "transportation" activity (Section 151.318(c)(3)).

The Comptroller ruled that liquefaction is processing, not transportation — even though the ultimate business purpose is to make the gas easier to ship, the actual activities (altering chemical composition, compressing to liquefaction pressure) constitute "processing" under Rule 3.300(a)(9)(B), a category expressly encompassed within "actual manufacturing." The Comptroller also rejected treating the whole integrated liquefaction train as one giant unified manufacturing unit for tax purposes, citing prior authority that Texas doesn't recognize large integrated plants as all-inclusive single manufacturing units (Comptroller's Decision No. 101,650, noting a 1996 court of appeals case on this point was later legislatively superseded).

Importantly, the Comptroller stopped short of ruling on the specific compressors and equipment identified in the request. It only confirmed that some processing occurs at the facility, meaning Section 151.318's item-by-item framework will apply: equipment that powers, supplies, supports, or controls exempt processing equipment is itself exempt (Section 151.318(a)(4)), but equipment used to maintain the LNG at required pressure/temperature during storage, or the storage tanks themselves, is specifically excluded (Section 151.318(c)(4)) even at a facility that otherwise qualifies.

What this means for you

LNG producers and gas-processing facility operators

Liquefaction (chemically and physically converting gas to a liquid state) qualifies as "processing" for manufacturing exemption purposes, even where the underlying commercial motivation is easier transport — don't assume the "transportation exclusion" defeats your claim just because shipping is the end goal. But get a specific ruling or detailed item-by-item analysis for your equipment; a general "processing occurs here" finding doesn't automatically exempt every piece of hardware at the facility.

Businesses purchasing compressors, pretreatment, or refrigeration equipment for gas processing plants

Expect the exemption analysis to turn on function, not just location within the plant: equipment that powers/supports/controls the actual chemical/physical-change processing step is exempt; equipment whose role is storage or maintenance of the finished product is not, per Section 151.318(c)(4).

Accountants and tax professionals

Watch for STAR 201902009L, the follow-up ruling to this same taxpayer flagged directly on this ruling's posting — it may narrow, expand, or otherwise clarify how this framework applies to the actual equipment list, which this ruling deliberately declined to address.

Common questions

Q: Is LNG liquefaction always treated as processing rather than transportation in Texas?
A: This ruling holds that changing natural gas's chemical composition and compressing/cooling it into a liquid state constitutes "processing" under Rule 3.300(a)(9)(B), even though the business purpose is to facilitate transport — but always check for subsequent guidance, since the same facts here were followed up on in STAR 201902009L.

Q: Does this ruling tell me whether my specific compressors qualify for exemption?
A: No. The Comptroller explicitly declined to rule on the taxability of the specific compressors and equipment identified in the request, beyond confirming that some processing occurs at the facility.

Q: Are storage tanks for the finished LNG exempt?
A: No. Machinery and equipment used to maintain the LNG at required pressure/temperature during storage, and the storage tanks themselves, are excluded from the manufacturing exemption under Section 151.318(c)(4).

Q: Can another LNG facility operator rely on this ruling?
A: No. This is a private letter ruling binding only on the Comptroller as to these taxpayers and these facts, and cannot be relied upon by any other taxpayer — and even for this taxpayer, check the later STAR 201902009L clarification.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.318(a)(2), (4) (manufacturing exemption)
• Tex. Tax Code § 151.318(c)(3) (distribution/transportation exclusion)
• Tex. Tax Code § 151.318(c)(4) (maintenance/storage exclusion)
• Tex. Tax Code § 151.318(d) (beginning/ending points of manufacturing)
• Tex. Tax Code § 151.318(f) (integrated group of machines not a single item)
• Tex. Tax Code § 151.318(r) (taxpayer's burden of proof)
• 34 Tex. Admin. Code Rule 3.300(a)(9) (manufacturing definition)
• 34 Tex. Admin. Code Rule 3.300(a)(10) (processing definition)
• 34 Tex. Admin. Code Rule 3.1 (Private Letter Rulings and General Information Letters)
• 34 Tex. Admin. Code Rule 3.10 (Taxpayer Bill of Rights; detrimental reliance)

Prior authority discussed:

• Comptroller's Decision No. 101,650 (2011) (integrated plant equipment not a single manufacturing unit)
• Sharp v. Chevron Chemical Co., 924 S.W.2d 429 (Tex. App.—Austin 1996, writ denied) (noted as legislatively superseded in relevant part)
• STAR 201902009L (subsequent clarification to this same taxpayer)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201602740L

Original ruling text

NOTE: Subsequent clarification was provided to this taxpayer in STAR 201902009L.

February 22, 2016

RE: Private Letter Ruling #140900961

Dear *****:

We issue this private letter ruling in accordance with Rule 3.1, Private Letter Rulings and General Information Letters, [ENDNOTE 1] in response to your initial request dated March 18, 2014, which you supplemented on August 12, 2014. Detrimental reliance relief is provided in accordance with Rule 3.10, Taxpayer Bill of Rights.

Your clients, ** and **, (collectively, COMPANY 1 & 2) are building new natural gas liquefaction facilities in Texas. We issue this private letter ruling to address whether any of the activities that occur within the liquefaction facilities constitute exempt processing or whether all the activities constitute a taxable transportation activity excluded from exemption in Section 151.318(c).

We understand that the liquefaction facilities are 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.

Facts Presented

Liquefied natural gas (LNG) is natural gas that, through a cooling process, is reduced to a liquid state. Liquefying natural gas allows it to be transported overseas, regasified, and then sold as natural gas.

COMPANY 1 & 2 are building new LNG facilities where they will convert customers’ pipeline quality gas to LNG (the Liquefaction Facilities). COMPANY 1 & 2 will never own the gas they liquefy.

The Liquefaction Facilities consists of pretreatment facilities (PF), which change the chemical composition of the gas to meet the specifications required for liquefaction, and the liquefaction facilities (LQF), which convert the gas to a liquid state. The PF and LQF operate together as one liquefaction train. The LQF will be located on Island A and the PF will be located on the mainland contiguous to the island, near CITY, Texas.

In the private letter ruling request, you identified several compressors and other items of equipment that COMPANY 1 & 2 intend to purchase, and you have provided a very detailed technical description of how each piece of equipment is to be used. You have asked for confirmation that the purchase of the equipment is exempt from Texas sales tax under Section 151.318(a)(2) and (4).

Relevant Authorities

Section 151.318(a)(2) and (4) states in part 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; …

(4) actuators, steam production equipment and its fuel, in-process flow through tanks, cooling towers, generators, heat exchangers, transformers and the switches, breakers, capacitor banks, regulators, relays, reclosers, fuses, interruptors, reactors, arrestors, resistors, insulators, instrument transformers, and telemetry units that are related to the transformers, electronic control room equipment, computerized control units, pumps, compressors, and hydraulic units, that are used to power, supply, support, or control equipment that qualifies for exemption under Subdivision (2) or (5) or to generate electricity, chilled water, or steam for ultimate sale; transformers located at an electric generating Facilities that increase the voltage of electricity generated for ultimate sale, the electrical cable that carries the electricity from the electric generating equipment to the step-up transformers, and the switches, breakers, capacitor banks, regulators, relays, reclosers, fuses, interruptors, reactors, arrestors, resistors, insulators, instrument transformers, and telemetry units that are related to the step-up transformers; and transformers that decrease the voltage of electricity generated for ultimate sale and the switches, breakers, capacitor banks, regulators, relays, reclosers, fuses, interruptors, reactors, arrestors, resistors, insulators, instrument transformers, and telemetry units that are related to the step-down transformers.

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

Section 151.318(c)(4) states that manufacturing exemptions do not apply to machinery and equipment or supplies used to maintain or store tangible personal property.

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 in part that 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) provides 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.”

Analysis and Ruling

At the Liquefaction Facilities, COMPANY 1 & 2 will liquefy natural gas owned by others so that the LNG can be transported overseas, regasified and ultimately sold in a foreign country as natural gas. Although the conversion from natural gas to LNG is done to make the natural gas easier to transport, it is not itself transportation. Specific activities at the Liquefaction Facilities, such as altering the chemical composition of the natural gas and compressing the gas to a pressure required to convert the gas into a liquid, are considered to be processing that occurs during “actual manufacturing.” See Section 151.318(a)(2) and Rule 3.300(a)(9)(B).

Texas does not recognize a self-contained, unified manufacturing process in large integrated plants as being all-inclusive for tax purposes. See, e.g., Comptroller’s Decision No. 101,650 (2011) (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 Co., 924 S.W.2d 429 (Tex. App. – Austin 1996, writ denied) was, in relevant part, superseded by subsequent acts of the Legislature).

For purposes of this ruling, we conclude only that some processing, as contemplated by Section 151.318 and Rule 3.300, will occur at the Liquefaction Facilities based on the facts presented. We do not provide a ruling regarding the taxability of the items of tangible personal property that will be purchased and used at the Liquefaction Facilities, including the compressors you identified. However, because we determine that some processing will occur at the Liquefaction Facilities, we also accept that the provisions of Section 151.318, Rule 3.300 and other relevant authorities will apply to determine the taxability of the specific items of tangible personal property purchased and used at the Liquefaction Facilities. For example, if any of the compressors you identified are used to “power, supply, support, or control equipment that qualifies for exemption under [Section 151.318(a)(2)],” then that property is exempt from sales and use tax. See Section 151.318(a)(4). Likewise, certain exclusions from the manufacturing exemption will apply. For example, machinery and equipment used to maintain the LNG at the required pressure or temperature during storage and the tanks used to store the LNG before export do not qualify for the manufacturing exemption. See Tax Code, 151.318(c)(4) (“The exemption does not include…. machinery and equipment or supplies... used to maintain or store tangible personal property…”).

If you have questions about this private letter ruling, please email us through our website at https://www.window.state.tx.us/taxhelp/ and reference Private Letter Ruling # 140900961.

Sincerely,

Tax Policy Division

ENDNOTE:

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.