In re Tax Appeals of Edmiston Oil Co. (updated January 18, 2012)

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No. 104,950

IN THE COURT OF APPEALS OF THE STATE OF KANSAS

IN THE MATTER OF THE APPEALS OF
EDMISTON OIL COMPANY, INC., et al., FROM ORDERS OF
THE DIVISION OF TAXATION ON
APPLICATIONS FOR REFUND OF SALES/USE TAX.

SYLLABUS BY THE COURT

1.
When courts are called upon to interpret statutes, they begin with the fundamental
rule that they must give effect to the intent that the legislature expressed through the plain
language of the statutes, when that language is plain and unambiguous. An appellate
court's first task is to ascertain the legislature's intent through the statutory language it
employs, giving ordinary words their ordinary meaning.

2.
Statutes imposing a tax must be interpreted strictly in favor of the taxpayer. Tax
exemption statutes, however, are interpreted strictly in favor of imposing the tax and
against allowing an exemption for a taxpayer's property that does not clearly qualify.
Strict construction of an exemption provision does not, however, warrant unreasonable
construction.

3.
As amended in 2000, K.S.A. 2010 Supp. 79-3606(kk) does not change the fact
there are dual threshold requirements for the sales and use tax exemption of machinery
and equipment used in a processing operation: To be eligible for exemption, the subject
machinery and equipment must be both used (a) as an integral or essential part of an
integrated production operation, and (b) by a manufacturing or processing plant or
facility. The amended statute, however, has additional requirements: (1) The integrated
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production operation must be engaged in at a manufacturing or processing plant or
facility that meets the statutory definition, and (2) that plant or facility must be owned or
controlled by a manufacturing or processing business that also meets the statutory
definition for such an operation. The definition of processing business includes
operations at an oil or gas well where the oil or gas extracted from the earth is subject to
certain listed treatments or preparations.

4.
Giving ordinary words their ordinary meaning, it is undeniable that in the case of
oil and gas wells, extraction does not stop at the bottom of the well bore but must also
include withdrawing the fluids to the surface. Movement or migration of fluids occurs in
the subsurface rock formation, but those fluids have not yet been extracted from the earth
until they reach the surface.

5.
In qualifying for a sales and use tax exemption under K.S.A. 2010 Supp. 79-
3606(kk)(1), as to the listed treatments, processes, or preparations required by K.S.A.
2010 Supp. 79-3606(kk)(2)(D)(i) to be performed to meet the statutory definition of a
processing operation, none of these occur at the bottom of the well bore. Although some
apparently natural separation may occur in the tubing, the uncontroverted facts establish
that the primary purpose of the tubing is to convey the oil to the surface so that it can be
separated with surface equipment. Under the facts of this case, there are no
uncontroverted facts to suggest that fluids are otherwise—at the bottom of the well bore
or within that well bore—cleaned, separated, crushed, ground, milled, screened, washed,
or otherwise treated or prepared by any of the subject machinery or equipment as
required by the exemption scheme in K.S.A. 2010 Supp. 79-3606(kk). When the primary
use of the equipment is for a nonproduction purpose, the equipment does not qualify for
exemption under K.S.A. 2010 Supp. 79-3606(kk)(2)(F) and (6).

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6.
Comparing the sales and use tax exemption and mineral severance tax statutory
schemes, the severance tax statute, K.S.A. 2010 Supp. 79-4216(l), equates the severing of
oil with extraction or withdrawal from below the surface of the soil or water, and the
severing of gas is equated with extraction or withdrawal from below the surface of the
earth or water. The sales and use tax exemption statute for machinery and equipment
used in integrated processing operations, K.S.A. 2010 Supp. 79-3606(kk)(2)(D)(i), that
employs the phrase "extracted from the earth" is thus not materially different from the
severance tax scheme. Both statutes seem to clearly measure severance and extraction at
the earth's surface. Moreover, severance tax is generally defined as a tax imposed on the
value of oil, gas, timber or other natural resources extracted from the earth.

7.
The plain language of the statutory subsection in K.S.A. 2010 Supp. 79-3606(kk)
requires that the substance in question be extracted from the earth before examining the
nature of the treatments or preparations that may be performed on such an extracted
hydrocarbon stream.

8.
All definitional and explanatory subsections of K.S.A. 2010 Supp. 79-3606(kk)
must be read within the context of the entire statute and do not constitute separate and
independent avenues to exemption.

Appeal from Court of Tax Appeals. Opinion filed January 13, 2012. Affirmed.

Jeffrey A. Wietharn and S. Lucky DeFries, of Coffman, DeFries & Nothern, of Topeka, for
appellants.

John Michael Hale, of Legal Services Bureau, Kansas Department of Revenue, for appellee.

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Before GREENE, C.J., ATCHESON, J., and BRAZIL, S.J.

GREENE, C.J.: Edmiston Oil Company and a host of other oil and gas producers
(Taxpayers) appeal the decision of the Kansas Court of Tax Appeals (COTA) that denied
them a sales and use tax exemption on down-hole machinery and equipment, as well as
surface pumping equipment, under K.S.A. 2010 Supp. 79-3606(kk). Concluding that the
subject machinery and equipment is not used as an integral part of integrated production
operations by a processing plant or facility operated by a processing business where the
oil or gas that has been extracted from the earth is then treated or prepared before its
transmission to a refinery or wholesale distribution as contemplated by the applicable
statute, we affirm COTA in denying the tax exemption for the purchases of such
machinery and equipment.

FACTUAL AND PROCEDURAL BACKGROUND

Taxpayers applied to the Director of Taxation for a refund of sales and use taxes
paid in Kansas for the purchases of certain oilfield machinery and equipment after the
legislature substantially amended K.S.A. 79-3606(kk) in the 2000 session. See L. 2000,
ch. 123, sec. 1; K.S.A. 2010 Supp. 79-3606(kk). Specifically, their claims remaining in
this appeal include requests for sales and use tax refunds on purchases of pumping and
down-hole machinery and equipment, including gas compressors and lines; surface
pumping units, engines, and motors; down-hole pumps, rods, tubing, tubing strings,
production casing strings, and cathodic protection; valves and fittings; and electrical
equipment. Taxpayers essentially claimed these purchases were for machinery and
equipment used as an integral part of an integrated production operation by a processing
plant owned by a processing business, and thus eligible for exemption under K.S.A. 2010
Supp. 79-3606(kk).

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After the Director of Taxation denied these refund applications and that denial was
upheld by the Secretary of Revenue, Taxpayers appealed the matters to COTA. COTA's
small claims division upheld the denial of refunds, and Taxpayers then petitioned COTA
for an evidentiary hearing. COTA resolved the claims on two rounds of summary
judgment proceedings, based on uncontroverted facts as follows:

"6. Oil and gas is contained in rock formations, or [in] the earth. Oil and gas is
free to move through rock formations over time, so [it] must accumulate in traps to pool
sufficient quantities to warrant drilling, equipping and producing the oil or gas.
"7. Traps can be structural in nature in which the oil and gas accumulate in the
upper part of rock folds or in faults and fractures. Traps can be stratigraphic in nature
where oil and gas accumulates in the upper part of the changes in rock types that prevent
the further migration of the oil and gas. Traps can be a combination of structural and
stratigraphic traps. To remove oil and gas from the earth, wells are drilled to locate and
extract the oil and gas from the rock and out of the earth and then deliver it to the surface
where it can be sold.
"8. After a successful well is drilled to the total depth, casing pipe is run into the
well and cemented in place. This prevents the rock formations from collapsing and
closing up the hole. The casing in the well bore then becomes the equivalent of a mine
shaft for extracting the oil and gas from the earth or rock formation. Without the casing in
the well, over time, the well would fall in or collapse on itself, plugging off the well.
"9. After the production casing is cemented in the hole, a perforating 'gun' is
lowered inside the casing to the depth where the oil or gas was identified during drilling.
The 'gun' is set off, firing individual focused charges that burn a hole through the casing
and cement into the rock formation. This opens channels into the rock or earth for the oil,
gas, condensate and water to migrate to the well bore.
"10. The perforated interval will require additional treatment before the rock will
allow the fluids to flow properly. Acid is pumped into the perforated interval to dissolve
the cement and the rock around the perforations, to provide better channels for flow.
"11. In some rock formations, the oil, gas, condensate, and water is trapped in the
rock because the pore spaces are not well connected, or lack permeability. Such wells
require more than perforations and acid to cause the fluids to migrate to the well bore. In
those cases, the rock formation is given a frac treatment which involves pumping a gelled
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fluid, or an inert gas like nitrogen or carbon dioxide, along with sand at high pressure into
the rock. The pressures generated by this treatment create small cracks or fractures in the
rock that get filled with the sand. When the frac treatment ends, the pressure slowly
dissipates and the rock formation relaxes and begins to close the artificial fractures that
were created. The sand that was pumped along with the fluids fills the newly created
artificial fractures, leaving a channel for the oil, gas, condensate and water to migrate to
the well bore.
"12. Originally, oil and gas is trapped in the rock formations under considerable
pressure. The well bore created by drilling into the rock creates a low pressure point. The
oil and gas migrates through the rock to the low pressure point in an effort to equalize the
pressure in the formation. This migration to the well bore is the primary method of
extracting oil, gas, condensate and water from the earth. It would not happen without the
construction of the well to provide the means for the fluids to leave the rock formation.
"13. Once the pressure in the formation has depleted sufficiently, there is no
longer enough pressure to carry the fluids to the surface. At this point, fluid migration or
extraction of the fluids from the rock ceases to happen as the reservoir finds a new
pressure equilibrium. To overcome this new equilibrium point, pumping equipment is
installed, known in the industry as 'artificial lift.'
"14. The most common type of mechanical assistance or 'artificial lift' is the rod
pump operated by the pumping unit. In all cases, the purpose of the artificial lift is to
mechanically lower the hydrostatic pressure of the fluids in the well bore by pumping the
fluids to the surface. If the hydrostatic pressure is not relieved, the fluids will reach an
equilibrium point and will not migrate to the well bore and extraction of the fluids from
the rock cannot take place."

COTA also adopted the following additional facts:

"In some cases, due to lowering of the pressure in the tubing or well bore, some
separation may occur in the tubing on the way to the surface. The primary purpose of the
tubing is to convey the oil to the surface so that it can be separated from the gas and
water that produced along with oil. The majority of separation is done using surface
equipment. [Parties' stipulation.]
. . . .
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"Generally, the pumping unit is connected to the rods, the rods are connected to
the pump, the pump is connected to the tubing, the tubing is connected to the wellhead,
the wellhead is connected to the flow (lead) lines, and the flow lines are connected to the
tank battery.
"The pumping and down-hole machinery and equipment are an integral or
essential part of oil and gas well operations. Without such machinery/equipment, the oil
and gas are not able to reach the surface, particularly after the formation pressure is
depleted. The pumping and down-hole machinery and equipment is dedicated to the
oil/gas wells where the same is located and cannot be easily (if at all) moved or applied to
tasks away from the oil/gas well."

COTA's first order on the summary judgment motions found that the phrase
"extracted from the earth" was "reasonably interpreted to mean the operations occurring
after the oil or gas has been extracted from the surface of the earth." COTA granted the
Kansas Department of Revenue's (KDR) motion for summary judgment in part and
denied Taxpayers' motion for summary judgment. Following that order, Taxpayers filed a
second motion for summary judgment, arguing the machinery and equipment qualified
for a tax exemption under K.S.A. 2010 Supp. 79-3606(kk)(1)(A) and (2)(A), as well as
K.S.A. 2010 Supp. 79-3606(kk)(3). COTA then denied Taxpayers' second motion for
summary judgment. Taxpayers filed a motion for reconsideration of both orders issued by
COTA, which COTA denied. Taxpayers timely appeal.

STANDARDS OF REVIEW

COTA orders are subject to appellate review under the Kansas Judicial Review
Act, K.S.A. 77-601 et seq. Whether certain property is exempt from ad valorem or sales
and use taxation is a question of law if the facts are not in dispute, but it is a mixed
question of law and fact if the facts are controverted. "This court's review of statutory
interpretation in tax appeal matters is unlimited, and an appellate court applies the same
general rules that are applied in other contexts." In re Tax Appeals of Genesis Health
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Clubs, 42 Kan. App. 2d 239, 242, 210 P.3d 663 (2009), rev. denied 290 Kan. 1094
(2010).

Interpretation of a statute is a question of law over which appellate courts have
unlimited review. Unruh v. Purina Mills, 289 Kan. 1185, 1193, 221 P.3d 1130 (2009).
Kansas appellate courts no longer give deference to an agency's interpretation of a statute
and, therefore, have unlimited review. Saylor v. Westar Energy, Inc., 292 Kan. 610, 614,
256 P.3d 828 (2011); Cochran v. Kansas Dept. of Agriculture, 291 Kan. 898, 904, 249
P.3d 434 (2011); Kansas Dept. of Revenue v. Powell, 290 Kan. 564, 567, 232 P.3d 856
(2010); Ft. Hays St. Univ. v. University Ch., Am. Ass'n of Univ. Profs., 290 Kan. 446, Syl.
¶ 2, 228 P.3d 403 (2010); In re Tax Exemption Application of Kouri Place, 44 Kan. App.
2d 467, 471, 239 P.3d 96 (2010).

"When courts are called upon to interpret statutes, they begin with the fundamental rule
that they must give effect to the intent that the legislature expressed through the plain
language of the statutes, when that language is plain and unambiguous. See State v.
Valladarez, 288 Kan. 671, 675-76, 206 P.3d 879 (2009). An appellate court's first task is
to ascertain the legislature's intent through the statutory language it employs, giving
ordinary words their ordinary meaning. State v. Gracey, 288 Kan. 252, 257, 200 P.3d
1275 (2009). Only if the statutory language is not plain and unambiguous are the courts
called upon to resort to canons of statutory construction or consult legislative history. See
Valladarez, 288 Kan. at 675-76." In re Tax Exemption Application of Mental Health
Ass'n of the Heartland, 289 Kan. 1209, 1211, 221 P.3d 580 (2009).


In construing tax exemption statutes, we strictly but reasonably construe the
statutory language against exemption and in favor of taxation.

"Statutes imposing a tax must be interpreted strictly in favor of the taxpayer.
However, tax exemption statutes are interpreted strictly in favor of imposing the tax and
against allowing an exemption for one that does not clearly qualify. In re Tax Appeal of
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Western Resources, Inc., 281 Kan. 572, 575, 132 P.3d 950 (2006). Strict construction of
an exemption provision does not, however, warrant unreasonable construction. In re Tax
Application of Lietz Constr. Co., 273 Kan. 890, Syl. ¶ 7, 47 P.3d 1275 (2002)." Mental
Health Ass'n of the Heartland, 289 Kan. at 1211.

See also In re Tax Appeal of Western Resources, Inc., 281 Kan. 572, Syl. ¶ 4, 132 P.3d
950 (2006) (K.S.A. 79-3606[kk] must be interpreted strictly because it is a tax exemption
statute.).

OVERVIEW OF APPLICABLE EXEMPTION STATUTE

Taxpayers argue their machinery and equipment purchases were exempt under
five separate provisions of K.S.A. 2010 Supp. 79-3606(kk). Although we must consider
the entire statute in pari materia, the five provisions relied upon by Taxpayers provide as
follows:

"(kk)(1)(A) all sales of machinery and equipment which are used in this state as
an integral or essential part of an integrated production operation by a manufacturing or
processing plant or facility;
. . . .
"(2) For purposes of this subsection:
"(A) 'Integrated production operation' means an integrated series of operations
engaged in at a manufacturing or processing plant or facility to process, transform or
convert tangible personal property by physical, chemical or other means into a different
form, composition or character from that in which it originally existed. Integrated
production operations shall include: (i) Production line operations, including packaging
operations; (ii) preproduction operations to handle, store and treat raw materials; (iii) post
production handling, storage, warehousing and distribution operations; and (iv) waste,
pollution and environmental control operations, if any;
. . . .
"(C) 'manufacturing or processing plant or facility' means a single, fixed location
owned or controlled by a manufacturing or processing business that consists of one or
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more structures or buildings in a contiguous area where integrated production operations
are conducted to manufacture or process tangible personal property to be ultimately sold
at retail. Such term shall not include any facility primarily operated for the purpose of
conveying or assisting in the conveyance of natural gas, electricity, oil or water. A
business may operate one or more manufacturing or processing plants or facilities at
different locations to manufacture or process a single product of tangible personal
property to be ultimately sold at retail;
"(D) 'manufacturing or processing business' means a business that utilizes an
integrated production operation to manufacture, process, fabricate, finish, or assemble
items for wholesale and retail distribution as part of what is commonly regarded by the
general public as an industrial manufacturing or processing operation or an agricultural
commodity processing operation. (i) Industrial manufacturing or processing operations
include, by way of illustration but not of limitation, the fabrication of automobiles,
airplanes, machinery or transportation equipment, the fabrication of metal, plastic, wood,
or paper products, electricity power generation, water treatment, petroleum refining,
chemical production, wholesale bottling, newspaper printing, ready mixed concrete
production, and the remanufacturing of used parts for wholesale or retail sale. Such
processing operations shall include operations at an oil well, gas well, mine or other
excavation site where the oil, gas, minerals, coal, clay, stone, sand or gravel that has been
extracted from the earth is cleaned, separated, crushed, ground, milled, screened, washed,
or otherwise treated or prepared before its transmission to a refinery or before any other
wholesale or retail distribution. . . .
. . . .
"(3) For purposes of this subsection, machinery and equipment shall be deemed
to be used as an integral or essential part of an integrated production operation when
used:
"(A) To receive, transport, convey, handle, treat or store raw materials in
preparation of its placement on the production line;
. . . .
"(5) Machinery and equipment used as an integral or essential part of an
integrated production operation shall not include:
"(A) Machinery and equipment used for nonproduction purposes, including, but
not limited to, machinery and equipment used for plant security, fire prevention, first aid,
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accounting, administration, record keeping, advertising, marketing, sales or other related
activities, plant cleaning, plant communications, and employee work scheduling;
"(B) machinery, equipment and tools used primarily in maintaining and repairing
any type of machinery and equipment or the building and plant;
"(C) transportation, transmission and distribution equipment not primarily used
in a production, warehousing or material handling operation at the plant or facility,
including the means of conveyance of natural gas, electricity, oil or water, and equipment
related thereto, located outside the plant or facility;
"(D) office machines and equipment including computers and related peripheral
equipment not used directly and primarily to control or measure the manufacturing
process;
"(E) furniture and other furnishings;
"(F) buildings, other than exempt machinery and equipment that is permanently
affixed to or becomes a physical part of the building, and any other part of real estate that
is not otherwise exempt;
"(G) building fixtures that are not integral to the manufacturing operation, such
as utility systems for heating, ventilation, air conditioning, communications, plumbing or
electrical;
"(H) machinery and equipment used for general plant heating, cooling and
lighting;
"(I) motor vehicles that are registered for operation on public highways; or
"(J) employee apparel, except safety and protective apparel that is purchased by
an employer and furnished gratuitously to employees who are involved in production or
research activities." K.S.A. 2010 Supp. 79-3606(kk).

Prior to the 2000 amendments to this statute, the first paragraph of the statutory
exemption provided the general requirements for sales of machinery and equipment to
qualify for exemption from sales and use tax:

"[A]ll sales of machinery and equipment used directly and primarily for the purposes of
manufacturing, assembling, processing, finishing, storing, warehousing or distributing
articles of tangible personal property in this state intended for resale by a manufacturing
or processing plant or facility or a storage, warehousing or distribution facility, and all
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sales of repair and replacement parts and accessories purchased for such machinery and
equipment." K.S.A. 1999 Supp. 79-3606(kk).

Our Supreme Court noted that the former version of section (kk) had two
requirements to qualify for the exemption: "[T]he machinery and equipment must be (1)
used directly and primarily for one of the listed purposes, and (2) used by one of the
listed plants or facilities." 281 Kan. at 576.

After amendment, the first portion of the statutory subsection now states:

"The following shall be exempt from the tax imposed by this act:
. . . .
"(kk)(1)(A) all sales of machinery and equipment which are used in this state as
an integral or essential part of an integrated production operation by a manufacturing or
processing plant or facility." K.S.A. 2010 Supp. 79-3606(kk)(1)(A).

We note at the outset of our analysis that the legislature has not changed the fact
there are dual threshold requirements for exemption: To be eligible for exemption, the
subject machinery and equipment must be both (a) used as an integral or essential part of
an integrated production operation, and (b) used by a manufacturing or processing plant
or facility. The amended statute, however, has additional requirements: (1) The integrated
production operation must be engaged in at a manufacturing or processing plant or
facility that meets the statutory definition, and (2) that plant or facility must be owned or
controlled by a manufacturing or processing business that also meets the statutory
definition for such an operation. The definition of "processing business" includes
operations at an oil or gas well where the oil or gas extracted from the earth is subject to
certain listed treatments or preparations.

We must now apply this backdrop of the rather complex statutory exemption
scheme to the uncontroverted facts before us.
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DID COTA ERR IN CONCLUDING THAT THE POSTEXTRACTION LIMITATION OF K.S.A.
2010 SUPP. 79-3606(kk)(2)(D)(i) PROVIDES A COMPLETE BASIS FOR DENYING
EXEMPTION ELIGIBILITY TO TAXPAYERS?

Taxpayers argue that the term "extracted from the earth" in K.S.A. 2010 Supp. 79-
3606(kk)(2)(D)(i) is properly interpreted to mean "extracted from the natural formation"
or "extracted from the naturally occurring state" and nothing within the statute requires
that the minerals also be brought up to and out of the surface of the earth. The KDR
argues that its long-established, bright-line test is the correct interpretation of the statute.
The KDR's test "1) exempt[s] services and equipment used in processing after the oil and
gas has emerged above the surface of the earth; and 2) tax[es] services and equipment
used below the crust of the earth." The KDR emphasized before COTA that the
legislature used the past tense of the word "extract," which the KDR argued creates a line
of demarcation and that the KDR's bright-line test gives effect to that purpose.

The Uncontroverted Facts Fail to Establish that Taxpayers' Equipment is Used in
Processing or Treatment of Oil that Has Been Extracted From the Earth

At the outset of our analysis, we note that K.S.A. 2010 Supp. 79-3606(kk)(2)(D)(i)
includes within "processing operations" by a "processing business" certain listed
operations at an oil or gas well. But the statute includes as such processing only those
operations where the oil or gas "that has been extracted from the earth" is subjected to
such listed treatments or preparations. Our scrutiny of the uncontroverted facts fails to
convince us that oil or gas "has been extracted" before it reaches the earth's surface, or
that any of the listed treatments occur prior to the oil or gas actually reaching the surface.
Thus, we conclude that the down-hole machinery and equipment, together with the
pumping unit and related accessories, fail to satisfy the statutory exemption scheme.

First, as to the phrase "has been extracted from the earth," we reject the notion that
extraction occurs when the oil or gas has merely migrated to the well bore. A common
dictionary definition of "earth" is "the fragmental material composing part of the surface
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of the globe," and its alternative dictionary definitions or synonyms include "soil," or
"ground" or "soil for cultivating." See Webster's Third New International Dictionary of
the English Language 714 (1993). Thus, giving ordinary words their ordinary meaning, it
is undeniable that, in the case of oil and gas wells, extraction does not stop at the bottom
of the well bore but must also include withdrawing the fluids to the surface. The
uncontroverted facts substantiate this belief, suggesting that "[t]o remove oil and gas from
the earth, wells are drilled to locate and extract the oil and gas from the rock and out of
the earth and then deliver it to the surface where it can be sold." (Emphasis added.)

Taxpayers emphasize that movement or migration of fluids occurs in the sub-
surface rock formation, but those fluids have not yet been extracted from the earth until
they reach the surface. None of the uncontroverted facts suggest that fluids have been
extracted from the earth upon mere arrival at the well bore.

Second, as to the listed treatments or processes or preparations, none of these
occur at the bottom of the well bore. Although "some [apparently natural] separation may
occur in the tubing," the facts establish that "the primary purpose of the tubing is to
convey the oil to the surface so that it can be separated" with surface equipment.
(Emphasis added.) There are no uncontroverted facts to suggest that fluids are
otherwise—at the bottom of the well bore or within that well bore—"cleaned, separated,
crushed, ground, milled, screened, washed, or otherwise treated or prepared" by any of
the subject machinery or equipment as required by the exemption scheme in K.S.A. 2010
Supp. 79-3606(kk). When the primary use of the equipment is for a nonproduction
purpose, the equipment does not qualify for exemption under K.S.A. 2010 Supp. 79-
3606(kk)(2)(F) and (6).

Our conclusion here is consistent with that reached by COTA, which found that
the Taxpayers' interpretation would lead to an unreasonable and absurd result.
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"The Taxpayers argue that extraction is complete as soon as the oil or gas enters the well
bore. Only an expert with significantly more knowledge of the intricacies of the oil and
gas drilling process than the ordinary person could contemplate arguing that extraction
from the earth ends when the oil or gas flows into the well bore. . . . While man's control
over the oil or gas may begin when the oil or gas enters the well bore, the oil or gas has
not yet been extracted from earth in ordinary terms as required by the statute. It gives
ordinary meaning to the past tense to find that extraction process ends when the oil or gas
reaches the surface of the earth. [COTA] is not persuaded that the Taxpayers'
interpretation gives ordinary words their ordinary meaning in the context of oil and gas
operations."

We agree. The essential requirements of the exemption scheme have not been
satisfied by the uncontroverted facts in the record when the statutory scheme is read
giving ordinary words their ordinary meaning.

Distinctions Between the Sales and Use Tax Exemption Scheme and the Mineral
Severance Tax Act Do Not Support Taxpayers' Position.

Taxpayers argue that the legislature, in drafting K.S.A. 2010 Supp. 79-3606(kk),
chose not to use the same terms or definitions contained in the Mineral Severance Tax
Act, K.S.A. 79-4216 et seq. They contend that if the legislature intended to require that
oil and gas be brought up from below the surface of the earth to qualify under K.S.A.
2010 Supp. 79-3606(kk), the legislature would have used the term "sever," but it chose
instead to use the word "extract."A close look at the definition of "sever" or "severed"
contained in K.S.A. 79-4216 et seq., however, defeats Taxpayers' argument. The K.S.A.
2010 Supp. 79-4216 definitions include the following:

"(l) 'Severed' or 'severing' means: (1) The production of oil through extraction or
withdrawal of the same from below the surface of the soil or water, whether such
extraction or withdrawal shall be by natural flow, mechanical flow, forced flow, pumping
or any other means employed to get the oil from below the surface of the soil or water
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and shall include the withdrawal by any means whatsoever of oil upon which the tax has
not been paid, from any surface reservoir, natural or artificial, or from a water surface; (2)
the production of gas through the extraction or withdrawal of the same by any means
whatsoever, from below the surface of the earth or water." (Emphasis added.) K.S.A.
2010 Supp. 79-4216(l).

Comparing the two statutory schemes, the severance tax statute, K.S.A. 2010
Supp. 79-4216(l), equates "severing" of oil with "extraction or withdrawal from below
the surface of the soil or water," the "severing" of gas is equated with "extraction or
withdrawal from below the surface of the earth or water." The sales and use tax
exemption statute for machinery and equipment used in integrated processing operations,
K.S.A. 2010 Supp. 79-3606(kk)(2)(D)(i), that employs of the phrase "extracted from the
earth" is thus not materially different from the severance tax scheme. Both statutes seem
to clearly measure severance and extraction at the earth's surface. Moreover, "severance
tax" is generally defined as "[a] tax imposed on the value of oil, gas, timber or other
natural resources extracted from the earth." (Emphasis added.) Black's Law Dictionary
1597 (9th ed. 2009).Taxpayers' argument fails given this commonality between the tax
schemes.

Remaining Arguments of Taxpayers are Rejected


Taxpayers argue that COTA's articulation of certain factual premises somehow
undermines the legal conclusions arrived at by that court. We are not impressed with
these arguments. Our analysis on appeal is based upon an application of the statutory
scheme to the actual uncontroverted facts before us. To the extent COTA may have
articulated these facts in some other fashion, we need not be concerned so long as we
have been faithful on appeal to the actual and unadulterated uncontroverted facts in
reaching our own legal conclusions. This we have done, and we thus reject any
arguments based on COTA's regurgitation of certain factual premises.

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Taxpayers also argue that COTA erroneously and unreasonably interprets the
phrase "where the oil [or] gas . . . that has been extracted from the earth is . . . treated or
prepared before its transmission" (emphasis added) in subsection (kk)(2)(D)(i) to
effectively replace "where" with "after," suggesting that "the language [of the statute] is
not discussing timing or a point in the process, but rather location." This argument,
however, overlooks the past tense of "extract" used by the legislature in the statute, which
clearly indicates legislative intent regarding timing. The statutory phrase indicates that
processing operations include those where oil or gas "that has been extracted from the
earth" is subject to the listed treatments or preparations. The plain language of the
statutory subsection in K.S.A. 2010 Supp. 79-3606(kk) requires that the substance in
question be extracted from the earth before examining the nature of the treatments or
preparations that may be performed on such an extracted hydrocarbon stream. Taxpayers'
argument must be rejected.

Taxpayers finally argue that an above/below ground distinction ignores the actual
purpose or use of the equipment. They contend that the above/below ground distinction is
not rationally related to the intent of the legislature. In Western, however, our Supreme
Court, interpreting the pre-2000 version of K.S.A. 79-3606(kk), looked to the location
where the equipment was used, finding that the "legislature specifically limited the
exemption to transportation and distribution equipment used 'at the plant or facility.'"
Western, 281 Kan. 580. The court found that, as a tax exemption statute, K.S.A. 79-
3606(kk) must be strictly interpreted and, "under such an interpretation, if the
manufacturing process takes place at a location other than the plant or facility, the sale of
machinery and equipment which performs that process is not exempt from sales tax." 281
Kan. at 581. Similarly, in this case, the statute must be strictly interpreted and it states
that processing operations may be eligible for exemption where they occur "at an oil well,
gas well, mine or other excavation site where the oil, gas, minerals, coal, clay, stone, sand
or gravel that has been extracted from the earth is cleaned, separated, crushed, ground,
milled, screened, washed, or otherwise treated or prepared before its transmission to a
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refinery or before any other wholesale or retail distribution." K.S.A. 2010 Supp. 79-
3606(kk)(2)(D)(i). Here, the plain language used by the legislature shows that if the
process takes place before the substance is extracted from the earth, it is not exempt.

Further, the function of the equipment here is to extract the oil or gas from the
earth. The Taxpayers point to a case where the KDR granted an exemption for a scoop or
shovel used to scoop gypsum. In that case, however, the KDR noted that the "equipment
[was] used to transport raw material during the production or processing operations, and
[was] not used in any extraction activity." (Emphasis added.) In contrast, here the subject
equipment was completely devoted to the extraction activity.

We have attempted to address each and every argument suggested by Taxpayers,
but we consistently arrive at the same conclusion: Taxpayers' equipment simply does not
satisfy the clear statutory exemption scheme provided and defined at K.S.A. 2010 Supp.
79-3606(kk)(2)(D)(i) and is therefore not exempt from sales and use taxes.

DID COTA ERR IN REJECTING TAXPAYERS' ARGUMENTS FOR AN EXEMPTION UNDER
K.S.A. 2010 SUPP. 79-3606(kk)(3)(A)?

Taxpayers next argue that COTA erred in rejecting their independent contention
that their equipment purchases qualify for exemption under K.S.A. 2010 Supp. 79-
3606(kk)(3)(A), which deems equipment to be used as an integral or essential part of an
integrated production operation "when used to receive, transport, convey, handle, treat or
store raw material in preparation of its placement on the production line." They contend
"the below ground tubing and equipment can be likened to a conveyor belt," which
together with the pumping machinery "transport[s] the raw materials and place[s] them
on the assembly or production line."

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Initially, we disagree with Taxpayers' contention that K.S.A. 2010 Supp. 79-
3606(kk)(3)(A) is an independent avenue to qualify for a tax exemption. This sub-section
is an extension or clarification of K.S.A. 2010 Supp. 79-3606(kk)(1)(A) and (2)(A), both
of which reference an "integrated production operation." Thus, subsection (3)(A) relates
to the first threshold requirement to qualify for an exemption: whether the machinery and
equipment is used as an integral part of an integrated production operation under K.S.A.
2010 Supp. 79-3606(kk).

Taxpayers argue that they meet the exemption in K.S.A. 2010 Supp. 79-
3606(kk)(3)(A) based on COTA's decision in In re LaFarge Midwest/Martin Tractor Co.,
Inc., No. 2006-8532-DT, dated June 4, 2009; COTA's decision was appealed, and
LaFarge was transferred to the Supreme Court pursuant to K.S.A. 20-3018(c). The court
heard oral arguments on September 1, 2011, and no opinion has been released as of this
date. Also, this court is not bound by COTA's decision in LaFarge, as this court is not
bound by COTA's interpretation of a statute.

Moreover, we do not find COTA's decision in LaFarge to be applicable here.
There, the precise issue was "whether the Caterpillar loaders and haulers . . . are exempt
machinery and equipment under K.S.A. [2010 Supp.] 79-3606(kk) in view of where the
machinery and equipment is used at the premises." LaFarge, COTA Order, p. 4. In
LaFarge, COTA found that "[KDR] has failed to show that the loaders and haulers are
not used in 'preproduction operations' to 'receive, transport, convey, handle, treat or store
raw materials in preparation of its placement on the production line.' See K.S.A. [2010
Supp.] 79-3606(kk)(2)(A)(ii) and K.S.A. [2010 Supp.] 79-3606(kk)(3)(A)." LaFarge,
COTA Order, p. 6. In deciding Taxpayers' case, COTA listed many factual distinctions
between the present facts and LaFarge, including the finding in LaFarge that "the post-
extraction operations in question—though occurring at an excavation site—were still
intra-plant operations to receive, handle and transport raw materials to a manufacturing
production line." (Emphasis added.) Obviously, we have already concluded that the
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machinery and equipment in question here is not used in postextraction operations, but
rather it fails to meet that aspect of the statutory scheme.

We are not convinced that K.S.A. 2010 Supp. 79-3606(kk)(3)(A) provides any
avenue for the exemption of Taxpayers' down-hole and pumping equipment.

DID COTA ERR IN REJECTING TAXPAYERS' ARGUMENT THAT THE OMISSION OF ITS
EQUIPMENT FROM K.S.A. 2010 SUPP. 79-3606(KK)(5) IMPLIES ITS EXEMPT STATUS?

Taxpayers next argue that because K.S.A. 2010 Supp. 79-3606(kk)(5) expressly
itemizes examples of machinery and equipment that do not qualify for exemption, and the
machinery and equipment at issue in this case is not enumerated in that subsection, the
legislature intended for all the below-ground and pumping equipment located at the well
to be covered by subsection (kk).

We disagree. K.S.A. 2010 Supp. 79-3606(kk)(5) is not an exclusive listing of
machinery and equipment that does not qualify for the exemption. This is expressly
clarified by K.S.A. 2010 Supp. 79-3606(kk)(6), which states in material part that
"Subsections (3) and (5) shall not be construed as exclusive listings of the machinery and
equipment that qualify or do not qualify as an integral or essential part of an integrated
production operation." The mere omission of equipment such as that of Taxpayers from
the list in subsection (kk)(5) suggests nothing of legal significance.

DID COTA ERR IN REJECTING TAXPAYERS' ARGUMENT THAT ITS EQUIPMENT IS USED IN
PREPRODUCTION OPERATIONS AND THEREFORE EXEMPT UNDER K.S.A. 2010 SUPP. 79-
3606(kk)(1)(A) AND (2)(A)

Taxpayers next argue that the subject machinery and equipment should be exempt
under the provisions of K.S.A. 2010 Supp. 79-3606(kk)(1)(A) and (2)(A) because if
production does not start until the oil or gas reaches the earth's surface, this necessarily
means the down-hole and pumping activities must be considered "preproduction
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operations," and the equipment used is expressly recognized as includable within
machinery and equipment used in an "integrated production operation," as defined in
subsection (kk)(2)(A).

Taxpayers' argument ignores the language of subsection K.S.A. 2010 Supp. 79-
3606(kk)(2)(D)(i), which limits "processing business" for oil and gas operations in a
manner already construed and applied above to exclude such equipment. There is no
reason to reiterate or elaborate on that analysis. If the oil or gas has not yet been extracted
from the earth, the machinery and equipment used for that extraction are not considered
to be used in or by a processing business, and that disqualification prevents eligibility for
the tax exemption.

DID COTA ERR IN REJECTING TAXPAYERS' ARGUMENT THAT ITS ABOVE-GROUND
EQUIPMENT SHOULD QUALIFY FOR EXEMPTION UNDER THE STATUTORY SCHEME?

Finally, Taxpayers argue that at a minimum, the machinery and equipment located
above the ground should be exempt under K.S.A. 2010 Supp. 79-3606(kk)(2)(A) because
integrated production operations include preproduction operations to handle, store, and
treat raw materials, and the pumping unit "provide[s] the energy required to operate the
movement of the raw material through the pre-processing and/or processing parts of the
facility." Again, we disagree.

Taxpayers' argument ignores the language of subsection K.S.A. 2010 Supp. 79-
3606(kk)(2)(D)(i), which limits "processing business" for oil and gas operations (in the
manner already construed and applied above) to exclude such machinery and equipment.
There is no reason to reiterate or elaborate on that analysis. We agree with attorney
Thomas E. Hatten, of the Office of Policy and Research at the KDR, who stated that
"[s]ales of pumps and derricks to extract oil are also subject to tax since these are
extraction operations rather than 'production' operations as those terms are used in
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House Bill 2011." (Emphasis added.) KDR Opinion Letter 0-2001-003, dated January 3,
2001, p. 3. Again, if the oil or gas has not yet been extracted from the earth, the
machinery and equipment used for extraction is not considered part of a processing
business, and that disqualification prevents the exemption.

Affirmed.