On May 5, 2015, the Treasury Department and the Internal Revenue Service (IRS) issued proposed regulations regarding the definition of natural resources-related “qualifying income” for publicly traded partnerships, including publicly traded entities frequently referred to as Master Limited Partnerships (MLPs).1 The proposed regulations (the “Proposed Regulations”) provide clarifications regarding the types of income that qualify, but also break with prior IRS ruling practice in some ways that are adverse to taxpayers, and introduce a new standard for “intrinsic” supporting activities that generate qualifying income. The Proposed Regulations, which will become effective after publication as final regulations, are likely to attract substantial comment, especially with respect to the divergences from the IRS’s ruling practice, and the proposed ten-year “grandfathering” of existing operations may be considered insufficient for currently traded MLPs that relied on prior IRS rulings or ruling practices.
Background A publicly traded partnership must generate at least 90 percent of its gross income each year from qualifying activities, or the partnership will be treated as an association taxable as a corporation for federal income tax purposes. One of the major benefits of satisfying this income test, and operating in publicly traded partnership form, is the absence of corporate-level taxes. In general, qualifying income includes “passive” income, such as dividends, interest, rents, royalties and gains from the disposition of assets that generate such income. Under a special rule contained in Section 7704(d)(1)(E) of the Internal Revenue Code, however, qualifying income also includes certain income generated from natural resource activities, such as the “exploration, development, mining or production, processing, refining, transportation . . . or the marketing of any [depletable] mineral or natural resource.” Prior to the Proposed Regulations, there was little formal guidance regarding the meaning of the quoted phrase. Instead, taxpayers frequently called upon the IRS to issue private letter rulings, confirming that the income they generated fell within the statutory boundaries. Private letter rulings were especially useful to MLPs, which market their equity interests to public investors by affirmatively representing that they generate qualifying income. In recent years, the number of requests for private letter rulings has grown, and the IRS has issued a number of favorable rulings to partnerships that provide—in effect—outsourced or support functions relating to activities that clearly generate qualifying income. The recipients of these rulings included partnerships that provided water used in hydraulic fracturing of oil and gas wells or otherwise performed support functions without which exploration, development or production could not occur. Nonetheless, the IRS and some practitioners had expressed concern that the IRS’s ruling standards had started down a “slippery slope” and that the logic used to justify the rulings could permit a wide array of support services to qualify. As a result of these concerns, last year, the IRS stopped issuing rulings in order to study the area more carefully. The Proposed Regulations are the result of this study. The Proposed Regulations distill a number of concepts from existing private letter rulings and therefore would eliminate the need to obtain rulings with respect to certain matters. The Proposed Regulations break with the IRS’s ruling policy in a number of respects, however, and set forth new rules for determining when supporting activities are considered “intrinsic” to qualifying activities such that they may generate qualifying income. Codification of Prior Ruling Policy The Proposed Regulations would codify the IRS’s ruling practice in a number of respects. For example, the Proposed Regulations define non-qualifying “retail” sales of minerals and natural resources (i.e.
, sales that are not within the intended scope of the favored term “marketing” in Section 7704(d)(1)(E)) only to include “sales made in small quantities directly to end users.” This approach is consistent with the IRS’s recent private letter rulings and, therefore, would treat bulk sales of aircraft fuel to governmental or airline users as generating qualifying income without the need for a ruling. Further, the Proposed Regulations confirm that “transportation” of natural resources encompasses terminalling and storage activities, which are necessary components of transportation activities,2 and indicate that “marketing” includes blending additives into fuels, which had been the subject of a relatively large number of private rulings.
Change in Direction In other respects, the Proposed Regulations break with the IRS’s ruling practice. For example, the Proposed Regulations conclude that “processing” timber does not include “activities that add chemicals or other foreign substances to timber to manipulate its physical or chemical properties, such as using a digester to produce pulp.” The IRS had previously issued a private letter ruling concluding that pulpmaking generates qualifying income, and it had also concluded that the production of medium-density fiberboard and engineered wood products generated qualifying income. Although currently there are no publicly traded partnerships in the pulpmaking business, these earlier rulings led taxpayers to conclude that pulpmaking would qualify, and resulted in a well-publicized effort by activist shareholders to pressure pulpmakers to move their operations into MLPs. The Proposed Regulations eliminate the possibility that pulpmaking may serve as the foundation for an MLP. Also, surprisingly, the Proposed Regulations indicate that the production of olefins, other than by physical separation or as part of certain refinery activities, does not generate qualifying income.3 The IRS had previously issued rulings that concluded that a broader category of olefins production activities were qualifying, and the change in course puts pressure on the effective date of the new regulations with respect to publicly traded partnerships that received these rulings or otherwise concluded that their olefins activities generated qualifying income.4 In addition, while confirming that certain “gas to liquids” activities generate qualifying income, the Proposed Regulations provide that in order to qualify the activity must occur “in one integrated conversion into liquid fuels that are otherwise produced from petroleum.” Therefore, contrary to a private ruling that had been issued in 2013, the production and sale of methanol would not be a qualifying activity, “because methanol is not a liquid fuel otherwise produced from the processing of crude oil.”5 New Framework for “Intrinsic Activities” The heart of the Proposed Regulations is the introduction of a new standard for determining when certain supporting activities are “intrinsic” to a qualifying activity and, therefore, may be treated as generating qualifying income. The Proposed Regulations set forth a three-part test that must be satisfied for such activities to qualify.
- Specialized. First, the relevant activities must be “specialized,” requiring special training of personnel or the use of property that has limited utility other than for use in a qualifying activity. Pursuant to an exception, the provision of water may qualify under this standard (i.e., to the extent it is used for hydraulic fracturing), but only if the taxpayer also collects and cleans, recycles or otherwise disposes of the water. Thus, the IRS would no longer issue rulings to publicly traded partnerships that simply supply water to exploration and production companies.
- Essential. The relevant activities at issue must be “essential” to an otherwise qualifying activity. For example, the activities must make the qualifying activity economically viable or in compliance with applicable regulations. Moreover, the activities cannot be “too attenuated” to accomplish the qualifying activities, such as legal or accounting services.
- Significant. Finally, the tested activities must be “significant.” Under this standard, the regulations generally require that the publicly traded partnership’s activities be “ongoing or frequent” (e.g., the partnership’s employees are onsite or its offsite services are ongoing and frequent and offered exclusively to businesses engaged in qualifying activities), and the temporary provision of property (such as renting tools or other equipment) generally will not qualify.6
Effective Date The Proposed Regulations are expected to be effective for taxable years beginning on or after they are issued as final regulations (but may be relied upon prior to that date by publicly traded partnerships). A partnership that has obtained a private letter ruling inconsistent with the regulations may continue to treat the income described in the ruling as qualifying until the end of the tenth year after the regulations are finalized. Similarly, a publicly traded partnership engaged in an activity that it treated as qualifying under a “reasonable” interpretation of Section 7704(d)(1)(E) prior to May 6, 2015 may continue to treat that income as qualifying until the end of the tenth year after the regulations are finalized. It is expected the commentators will seek clarification of the meaning of “reasonable” in this context. Comments The Proposed Regulations appear designed to establish uniform and balanced standards for determining qualification across various types of activities, while remaining true to the directives of the legislative history to the enactment of Section 7704(d)(1)(E). Nonetheless, perhaps constrained by the legislative history, the Proposed Regulations reflect a substantial amount of arbitrariness in the application of the announced standards, and set forth industry-specific applications of these standards. The resulting line-drawing may be subject to challenge—especially by publicly traded partnerships that received rulings that would be invalidated under the Proposed Regulations. Those partnerships may rightly complain that the IRS’s prior interpretations of the statute in their private letter rulings were justified and, without some direction from Congress to the contrary, should not be changed.