The Treasury Department (Treasury) and the Internal Revenue Service (Service) have issued proposed tax regulations (Proposed Regulations) that provide guidance on, and significantly scale back, the types of activities relating to minerals and natural resources that generate “qualifying income” under section 7704 of the Internal Revenue Code of 1986, as amended.
In general, a publicly traded partnership (commonly known as a master limited partnership or MLP) is treated as a corporation for U.S. federal income tax purposes. Section 7704(c), however, provides an exception to that general rule if 90% or more of the MLP’s gross income is “qualifying income.” The term “qualifying income” generally is defined to include passive-type income (e.g., interest, dividends and rent). Importantly, under section 7704(d)(1)(E), qualifying income also includes “income and gains derived from the exploration, development, mining or production, processing, refining, transportation . . . or the marketing of any mineral or natural resource . . . .” The term mineral or natural resource (which includes fertilizer, geothermal energy and timber) generally is defined as any product for which a deduction for depletion is allowed other than, for example, soil, sod, water or minerals from certain inexhaustible sources.
While prior tax regulations have addressed certain issues involving publicly traded partnerships, such as whether a partnership is regarded as “publicly traded,” the Proposed Regulations represent the first effort to provide published guidance under section 7704(d)(1)(E) upon which the MLP industry may rely. Until now, in the absence of formal guidance, questions regarding qualifying activities generally have been resolved by IRS private letter rulings or by opinions of counsel. According to the preamble to the Proposed Regulations (Preamble), the increasing burden of the rulings process on the Service is what led to the issuance of the Proposed Regulations.
The Proposed Regulations, which the MLP industry has long awaited, are notable in that they exclude from the section 7704(d)(1)(E) qualifying income exception some activities previously considered, even by the Service, to constitute qualifying activities. Given that the Proposed Regulations upset some previously accepted notions of what are considered qualifying activities, and the gravity of the consequences for any MLP that relied upon those previously accepted notions, transition rules are provided allowing partnerships that would no longer meet the qualifying income exception a period to unwind.
Under the Proposed Regulations, the term “qualifying activities” is used to describe activities relating to minerals or natural resources that generate qualifying income under section 7704(d)(1(E). As discussed in more detail below, qualifying activities include “section 7704(d)(1)(E) activities” and “intrinsic activities.”
Section 7704(d)(1)(E) Activities
The Proposed Regulations provide an exclusive list of “section 7704(d)(1)(E) activities,” which represent different stages in the extraction of minerals and natural resources and the eventual offering of products for sale, including (i) exploration, (ii) development, (iii) mining or production, (iv) processing or refining, (v) transportation, and (vi) marketing. The enumerated list, which may be expanded by published guidance, is intended to set forth only those activities that would be undertaken 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. Importantly, services provided to, for example, an exploration company, are not section 7701(d)(1)(E) activities, although such services may constitute “intrinsic activities,” as discussed below.
The Preamble also describes activities that now would be considered outside of the scope of the qualifying income exception. For example, although processing and refining activities (which activities include purification, separation and elimination of impurities) generate qualifying income, the Proposed Regulations provide that processing or refining does not include activities that cause a substantial physical or chemical change in a mineral or natural resource, or that transform the extracted mineral or natural resource into new or different mineral products, including manufactured products.
The production of plastics and similar petroleum derivatives is specifically called out for exclusion, as are products such as heat, steam or electricity produced by the refining process. Timber activities receive special mention, as well. In that regard, processing, to the extent it merely modifies the physical form of timber, such as by the application of heat or pressure qualifies; but, processing that includes the use of chemicals to “manipulate” the physical or chemical properties of timber are excluded. Thus, lines are drawn between processing that results in wood chips or sawdust, and processing that results in pulp, treated lumber and plywood.
In scaling back the types of qualifying activities considered incident to, for example, exploration and development activities, the Proposed Regulations set forth three requirements for an activity to qualify as an “intrinsic activity.” More specifically, an activity will qualify as an intrinsic activity only if (i) the activity is specialized to support the section 7704(d)(1)(E) activity, (ii) is essential to the completion of the section 7704(d)(1)(E) activity, and (iii) requires the provision of significant services to support the section 7704(d)(1)(E) activity. Each of these requirements is summarized below.
- Specialized. The personnel performing the activity and any property used in the activity or sold to the customer performing the section 7704(d)(1)(E) activity must be specialized. Personnel are specialized if they have received training unique to the relevant mineral or natural resource industry that is of limited utility other than to perform or support a section 7704(d)(1)(E) activity.
- Essential. The activity must be essential to a section 7704(d)(1)(E) activity. An activity is essential if it is necessary to (i) physically complete the section 7704(d)(1)(E) activity (including in a cost effective manner in order to make the activity economically viable), or (ii) comply with federal, state or local law regulating the section 7704(d)(1)(E) activity. Legal, financial, consulting, accounting, insurance, and other similar services are considered not to be essential to a section 7704(d)(1)(E) activity.
- Significant Services. An activity must include the provision of significant services, whereby personnel have an ongoing or frequent presence at the site of the section 7704(d)(1)(E) activity and the activities of those personnel are necessary to support the section 7704(d)(1)(E) activity. In cases where the same services are provided to multiple clients, this test may be satisfied if the services are performed through a rotating presence at multiple sites. Moreover, services may be conducted offsite if the services are performed on an ongoing or frequent basis and are offered exclusively to those engaged in one or more section 7704(d)(1)(E) activities.
Requests for Comments
The Proposed Regulations include requests for comments on the following issues:
- The Proposed Regulations provide guidance on whether income from activities with respect to minerals or natural resources as defined in section 7704(d)(1) is qualifying income. The Proposed Regulations do not, however, address the transportation or storage of any fuel described in sections 6426(b), (c), (d) or (e), or activities with respect to industrial source carbon dioxide, any alcohol fuel defined in section 6426(b)(4)(A), or any biodiesel fuel as defined in section 40A(d)(1), each of which is referenced in section 7704(d)(1)(E). Comments are requested concerning whether guidance is also needed with respect to these activities and, if so, the specific issues such guidance should address.
- Comments are requested concerning whether additional activities should be included in the exclusive list of section 7704(d)(1)(E) activities.
- The Proposed Regulations reserve on the types of activities that are included in the processing or refining of fertilizer. Comments are requested on what activities should be included.
- With respect to intrinsic activities, the significant services requirement provides that services must be ongoing or frequent. For this purpose, determining whether services are ongoing or frequent is determined under all facts and circumstances, including recognized best practices in the relevant industry. Comments are requested on whether and how this requirement could be set forth as an objective standard.
Effective Date and Transition Rules
In general, the Proposed Regulations are proposed to apply to income earned by a partnership in a taxable year beginning on or after the date the regulations are published as final regulations in the Federal Register. The Proposed Regulations also provide for a transition period, which ends, generally speaking, 10 years after the date that these regulations are published as final regulations in the Federal Register.
The Proposed Regulations provide that a partnership may treat income from an activity as qualifying income during the transition period if the partnership received a private letter ruling from the Service holding that income from the activity is qualifying income. In addition, a partnership may treat income from an activity as qualifying income during the transition period if, prior to May 6, 2015, the partnership was publicly traded, engaged in the activity, and treated the activity as giving rise to qualifying income under section 7704(d)(1)(E), and that income was qualifying income under the statute as reasonably interpreted prior to the issuance of the Proposed Regulations. In determining whether an interpretation was reasonable, the legislative history and interpretations applied by the Service prior to the issuance of the Proposed Regulations are taken into account. For this purpose, an interpretation will not be considered reasonable merely because a partnership had a reasonable basis for that position.
A partnership that is publicly traded and engages in an activity after May 6, 2015, but before the date the Proposed Regulations are published as final regulations in the Federal Register, may treat income from that activity as qualifying income during the transition period if the income from that activity is qualifying income under the Proposed Regulations.