Widely held partnerships are a significant source of funding for oil, gas and certain natural resources projects, but the publicly traded partnership (“PTP”) rules can cause such partnerships to be treated as corporations for U.S. tax purposes, which results in their earnings being subject to a double layer of tax. However, a PTP will not be treated as a corporation if at least 90% of its gross income is “qualifying income,” as defined in Code Section 7704(d) (such a PTP is commonly referred to as a master limited partnership, or MLP). Qualifying income is comprised of “passive” investment income, such as dividends and interest, and also active income derived from certain activities with respect to minerals or natural resources pursuant to Section 7704(d)(1)(E) of the Internal Revenue Code (the “Code”). The scope of the activities described in Section 7704(d)(1)(E) has historically been unclear. On May 6, 2015, the IRS issued proposed regulations on qualifying income under Section 7701(d)(1)(E) (“Proposed Regulations”) which seek to clarify the types of minerals or natural resources related activities that give rise to qualifying income. The Proposed Regulations benefit certain sectors within the oil, gas and natural resources industry and harm others, although a 10-year transition period eases the negative impact of the Proposed Regulations on any adversely-impacted businesses.
Generally, activities that give rise to qualifying income under Section 7704(d)(1)(E) include the exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource. In the past several years the IRS issued numerous private letter rulings ("PLRs") which expanded the scope of activities which give rise to qualifying income beyond those explicitly covered by Section 7704(d)(1)(E) to include activities which are integral to those listed explicitly in the Code. Examples of activities that were determined to be integral in these rulings included: acquiring seismic data and licensing it to oil and gas producers (PLR 200909006), and providing services to customers engaged in the extraction of natural gas through hydraulic fracturing, including removing and treating waste products generated by the fracturing process (PLR 201227002). While these PLRs could only be relied on by the taxpayer requesting the ruling, they had nonetheless been a source of helpful guidance.
Beginning in 2014, the IRS temporarily stopped issuing new PLRs on PTP qualifying income. Several commentators attributed this pause to concern within the agency that it lacked a consistent and systematic approach to determining which activities give rise to qualifying income, especially with regard to activities not explicitly listed in Section 7704(d)(1)(E). On March 6, 2015, the IRS resumed issuing PLRs on PTP qualifying income. The IRS also announced that it had made “significant progress” on regulations to clarify the scope of Section 7704(d)(1)(E), including with respect to income earned by oilfield service companies, which was an area in which practitioners had been seeking additional guidance.
On May 6, 2015 the IRS issued new Proposed Regulations on qualifying income under Section 7701(d)(1)(E). The Proposed Regulations separately addressed activities explicitly listed in Section 7704(d)(1)(E) (so-called “qualifying activities”) and activities deemed integral to those activities (so-called “intrinsic activities”), both of which give rise to qualifying income.
The IRS appears to acknowledge that the Proposed Regulations are not entirely consistent with its past ruling practice under Section 7704(d)(1)(E). For example, a statement released by the IRS notes that the Proposed Regulations are “largely consistent with the rulings the IRS has issued in the past, with some exceptions” and that “[w]here the new guidance interprets the law more narrowly than in the past, Treasury and the IRS believe the regulations more accurately reflect Congressional intent.”
As an example of a possible inconsistency with past ruling practice, the Proposed Regulations provide that “processing or refining” (with certain limited exceptions) does not include any activity that causes a “substantial physical or chemical change in a mineral or natural resource, or transforms the extracted mineral or natural resource into new or different mineral products, including manufactured products.” This standard appears to be more strict than the criteria applied in PLR 201241004, which found that processing ethane and propane into olefins through a cracking process gave rise to qualifying income. As a second example, the Proposed Regulations provide that an activity which involves adding “chemicals or other foreign substances” to timber to manipulate its physical properties does not give rise to qualifying income, which appears to be at odds with the IRS's determination in PLRs 9008035 (extracting wood pulp from timber and selling the wood pulp gives rise to qualifying income).
Qualifying activities listed in Section 7704(d)(1)(E) include the exploration, development, mining or production, processing or refining, transportation, and marketing of minerals or natural resources. The Proposed Regulations define and clarify the application of each of the activities listed above. The preamble to the Proposed Regulations notes that the IRS expects qualifying activities to be undertaken only by an exploration and development company, a mining or production company, a refiner or processor, or a transporter or marketer of a mineral or natural resource. Providing services to these types of businesses generally will not be a qualifying activity, although it may qualify as an intrinsic activity.
Noteworthy limitations on qualifying activities in the Proposed Regulations include the exclusion from “transportation” of any transportation of oil or gas (or related products) to a business that sells to retail customers; and the exclusion from “marketing” of any expenses incurred in facilitating retail sales. According to the preamble to the Proposed Regulations, both of these limitations are consistent with Congressional intent, as evidenced by legislative history.
In general, intrinsic activities are supporting activities which, although not listed in Section 7704(d)(1)(E), are considered integral to a Section 7704(d)(1)(E) activities. Under the Proposed Regulations, an activity must satisfy a three-part test to be considered an intrinsic activity. Specifically, the activity must:
- be specialized to support a Section 7704(d)(1)(E) activity;
- be essential to the completion of the Section 7704(d)(1)(E) activity; and
- require provision of significant services to support the Section 7704(d)(1)(E) activity.
For the first prong, an activity is considered specialized to support a Section 7704(d)(1)(E) activity if both the personnel performing the activity, as well as any property used in the activity or sold to the customer performing the Section 7701(d)(1)(E) activity, are specialized. Personnel are specialized if they have received special training unique to the mineral or natural resource industries that is of limited utility other than to perform or support a Section 7704(d)(1)(E) activity. Property is considered specialized if it is used only in connection with Section 7704(d)(1)(E) activities, is of limited use outside of those activities, and cannot easily be converted for use outside of those activities.
Second, an activity will be considered essential to the completion of a Section 7704(d)(1)(E) activity if it is necessary to physically complete the Section 7704(d)(1)(E) activity or to comply with applicable law regulating the Section 7704(d)(1)(E) activity.
Finally, a partnership will be deemed to provide significant services to support a Section 7701(d)(1)(E) activity (the third requirement) if its personnel have an ongoing or frequent presence at the site of the Section 7704(d)(1)(E) activity and if the presence of those personnel is necessary for the partnership to provide its services or support. The Proposed Regulations provide that services performed offsite may satisfy this requirement.
Certain Industries Fare Better than Others
One activity treated favorably under the Proposed Regulations is the provision of services to producers of natural gas who use hydraulic fracturing, including providing water for use in hydraulic fracturing. However, examples in the Proposed Regulations make it clear that a partnership which provides water for use in hydraulic fracturing must also collect and clean, recycle, or otherwise properly dispose of such water in order to earn qualifying income.
Conversely, two activities generally not treated by the Proposed Regulations as giving rise to qualifying income are the creation of olefins from a cracking furnace and the production of pulp and paper products, which in each case appear to be a departure from the IRS’s previous ruling practice in these areas, as noted above.
Effective and Applicability Dates and Transition Rules
The Proposed Regulations, if finalized, will apply on a prospective basis, although a partnership may rely on the Proposed Regulations prior to their finalization in treating an activity as giving rise to qualifying income. There is also a 10-year transition period that begins after the Proposed Regulations are finalized during which a partnership can continue to rely on any favorable PLR on qualifying income that it previously received, even if the final regulations reach a contrary result. Furthermore, where a partnership had treated an activity as giving rise to qualifying income prior to May 5, 2015, and where the partnership’s treatment of that activity was a reasonable interpretation of Section 7701(d)(1)(E) prior to the issuance of the proposed regulations, the partnership will be allowed to continue to treat the activity as giving rise to qualifying income during the transition period. The IRS noted in a statement that it will not issue rulings on application of the transition rules.
Comments Requested on Certain Issues
Lastly, the IRS requested comments on certain additional issues not addressed in the Proposed Regulations, including:
- the transportation or storage of certain fuel mixtures, activities with respect to industrial source carbon dioxide, and certain alcohol and biodiesel fuels;
- additional activities that should be included in the list of Section 7704(d)(1)(E) activities;
- activities relating the fertilizer; and
- a possible objective standard for whether activities are ongoing or frequent.
Comments and requests for a public hearing will be due 90 days after the Proposed Regulations are published in the Federal Register.
The recently issued Proposed Regulations clarify which activities with respect to minerals or natural resources give rise to qualifying income under Section 7701(d)(1)(E). Certain sectors within the oil, gas and natural resources industry benefit from the proposed regulations, whereas others likely will be adversely impacted, although that adverse impact will be softened by a 10-year transition period. It remains to be seen whether the Proposed Regulations will be finalized, and if so whether any changes to the Proposed Regulations will be made prior to their finalization.
Read the Proposed Regulations here.