On January 19, 2017, the Department of the Treasury and the Internal Revenue Service (IRS) issued final regulations (available here) on the scope of qualifying income under section 7704(d)(1)(E) of the Internal Revenue Code for master limited partnerships (MLPs) engaged in activities with respect to minerals or natural resources. The final regulations include significant changes to the proposed regulations that were issued on May 5, 2015.
Highlights from the Final Regulations
The discussion below highlights the manner in which the final regulations address some of the issues in the proposed regulations that have generated the most discussion over the past year.
No More “Exclusive List.” The final regulations abandon the rule in the proposed regulations that the regulations constitute an “exclusive list” of all activities that can qualify. This will provide much greater flexibility to MLPs in evaluating the qualifying nature of activities not specifically listed in the regulations.
Ethylene from Steam Crackers Qualifies. The final regulations provide that ethylene, propylene and similar products are qualifying, regardless of whether they are produced in a refinery, a steam cracker, or elsewhere.
Simplified Analysis of Oil and Gas Products. The final regulations greatly simplify the analysis of the extent to which production, transportation and marketing of products derived from oil and gas produce qualifying income. In general, those products produce qualifying income if they are products of a type typically produced at refineries or gas field facilities, without regard to where the MLP’s products are actually produced. The limitations contained in the proposed regulations regarding the manner in which the taxpayer classifies the property used in the activity under the MACRS depreciation rules, the existence of a chemical change to the product or the nature of the activity as a “manufacturing activity” are eliminated.
Greater Clarity on Qualifying Nature of Some Activities. The final regulations clarify that a variety of activities as to which the proposed regulations contained no express provisions qualify, such as
- LNG liquefaction and regasification
- Transportation of propane to retail customers
- Pipeline compression services
- Sales of excess renewable identification numbers (RINs)
- Income from passive interests in oil and gas properties, such as royalties, net profits interests and lease bonus payments
- Many blending and additization activities as to qualifying products.
Oilfield Services Still Qualify. The final regulations retain, and slightly liberalize, the rules in the proposed regulations allowing oilfield services and similar activities to qualify as “intrinsic activities”
No Guidance on Hedging Activities. The final regulations reserve on the important issue of hedging commodity price risks with respect to volumes of mineral or natural resource products (such as oil and gas), but the preamble to the final regulations implies that future guidance will likely be favorable.
Like the proposed regulations, the final regulations set forth detailed rules with respect to “qualifying activities”—activities relating to “minerals or natural resources” that generate qualifying income. Qualifying activities include both the activities specifically enumerated in section 7704(d)(1)(E)—exploration, development, mining or production, processing, refining, transportation and marketing of minerals and natural resources (section 7704(d)(1)(E) activities)—and certain support activities that are “intrinsic” to the section 7704(d)(1)(E) activities (intrinsic activities).
Mineral or Natural Resource
Minerals and natural resources include any product for which a depletion deduction is allowable, except soil, sod, dirt, turf, water, mosses, minerals from sea water, the air, or other similar inexhaustible sources.
Section 7704(d)(1)(E) Activities
Section 7704(d)(1)(E) activities include the exploration, development, mining or production, processing, refining, transportation and marketing of minerals and natural resources. The final regulations provide a definition of each activity and in some cases a non-exclusive list of operations that comprise each activity.
Exploration. An activity constitutes exploration if it is performed to ascertain the existence, location, extent, or quality of any deposit of minerals or natural resources before the beginning of the development stage of the natural resource deposit including by:
- drilling an exploratory or stratigraphic type test well;
- conducting drill stem and production flow tests to verify commerciality of the deposit;
- conducting or interpreting data from geological or geophysical surveys; or
- for minerals, certain activities described in prior IRS guidance with respect to exploration expenses conducted prior to development of the minerals (e.g., testpitting, trenching, drilling, driving of exploration tunnels and adits).
Development. An activity constitutes development if it is performed to make accessible minerals or natural resources including by:
- drilling wells to access deposits of minerals or natural resources;
- constructing and installing drilling, production, or dual purpose platforms in marine locations, or any similar supporting structures necessary for extraordinary non-marine terrain (such as swamps or tundra);
- completing wells, including by installing lease and well equipment, such as pumps, flow lines, separators, and storage tanks, so that wells are capable of producing oil and gas, and the production can be removed from the premises;
- performing a development technique such as fracturing for oil and natural gas or stripping, benching and terracing, dredging by dragline, stoping and caving or room-and-pillar excavation for minerals; or
- constructing and installing gathering systems and custody transfer stations.
Mining or production. An activity constitutes mining or production if it is performed:
- to extract minerals or other natural resources from the ground including by operating equipment to extract natural resources from mines and wells; or
- to extract minerals or natural resources from the waste or residue of prior mining or production (but not the recycling of scrap or salvaged metals or minerals from previously manufactured products or manufacturing processes).
Processing. Generally, an activity is processing if it is performed to convert raw mined or harvested products or raw well effluent to substances that can be readily transported or stored.
Industry-specific rules are given for the following industries: natural gas, petroleum, ores and minerals and timber.
- Natural gas processing consists of activities performed to purify natural gas, including by removal of oil, condensate, water or non-hydrocarbon gases, and separate natural gas into its gaseous (methane and ethane) or liquid (propane, butane, pentane and heavier streams) constituents.
- Crude oil processing consists of activities performed to separate produced fluids by passing crude oil through mechanical separators to remove gas, placing crude oil in settling tanks to recover basic sediment and water, dehydrating crude oil, and operating heater-treaters that separate raw oil well effluent into crude oil, natural gas and water.
- Ores and minerals processing includes an activity that is a “mining process” under the percentage depletion regulations. Under these rules, mining processes include a long list of specific activities (and the processes necessary or incidental thereto) carried out on specific minerals. For example, in the case of coal, mining includes the cleaning, breaking, sizing, dust allaying, treating to prevent freezing, and loading for shipment.
- Timber processing includes activities performed to modify the physical form of timber, including by application of heat or pressure to timber, without adding any foreign substances. Specific examples are provided of products that meet this standard (such as wood chips, wood bark, wood pellets, veneers, rough poles and rough lumber) and products that do not (such as pulp, paper and paper products, treated lumber, oriented strand board/plywood and treated poles).
Refining. The final regulations provide no general definition of “refining,” but they do provide industry-specific rules with respect to refining for the following industries: natural gas and crude oil, ores and minerals and timber.
Natural gas and crude oil refining is principally defined by a broad list of oil and gas products typically produced at natural gas processing facilities and refineries. There is no limit on the types of physical, chemical, separation or blending processes that may occur, so long as the activity begins and ends with the right types of products.
Permitted inputs are oil, gas, products resulting from natural gas processing, any hydrocarbon component of a natural gas processing stream and any product on the refined products list below. Permitted outputs are methane, ethane, propane, butane, pentane and heavier natural gas products and any product on the refined products list below.
The refined product list includes ethane, ethylene, propane, propylene, normal butane, butylene, isobutane, isobutene, isobutylene, pentanes plus, unfinished naphtha, unfinished kerosene and light gas oils, unfinished heavy gas oils, unfinished residuum, reformulated gasoline with fuel ethanol, reformulated other motor gasoline, conventional gasoline with fuel ethanol – Ed55 and lower gasoline, conventional gasoline with fuel ethanol – greater than Ed55 gasoline, conventional gasoline with fuel ethanol – other conventional finished gasoline, reformulated blendstock for oxygenate (RBOB), conventional blendstock for oxygenate (CBOB), gasoline treated as blendstock (GTAB), certain other motor gasoline blending components defined as gasoline blendstocks, finished aviation gasoline and blending components, special naphthas (solvents), kerosene-type jet fuel, kerosene, distillate fuel oil (heating oils, diesel fuel, and ultra-low sulfur diesel fuel), residual fuel oil, lubricants (lubricating base oils), asphalt and road oil (atmospheric or vacuum tower bottom), waxes, petroleum coke, still gas, naphtha less than 401°F end-point, and other products of a refinery that the Commissioner may identify through published guidance.
Heat, steam or electricity produced by the refining processes, and products obtained for use in the refinery (such as hydrogen) if excess amounts are sold, are not products obtained from qualifying refining activities. Any product that results from further chemical change of the listed product that does not result in the same or another listed product does not qualify (production of petroleum coke from heavy residuum qualifies, but any upgrading of petroleum coke—such as to calcined coke—does not qualify because it is further chemically changed). The end product must not be plastics or similar petroleum derivatives.
Ore and mineral refining includes an activity if it is one of the various processes performed subsequent to mining processes to eliminate impurities or foreign matter and which are necessary steps in achieving a high degree of purity from metallic ores and minerals which are not customarily sold in the form of the crude mineral product (that is, lead, zinc, copper, gold, silver and other metallic ores under IRS guidance). Qualifying activities include fine pulverization, electrowinning, electrolytic deposition, roasting, thermal or electric smelting, or substantially equivalent processes, such as the smelting of concentrates to produce Doré bars or refining of blister copper. Refining does not include the introduction of additives that remain in the metal, e.g., gold alloy manufacturing.
Transportation. Transportation activities are performed to move minerals or natural resources and refined and processed products, including by pipeline, marine vessel, rail, or truck. They do not include transportation (other than LPG transporation) directly to retail customers or, except by pipeline, to a place that sells or dispenses to retail customers (excluding a person who acquires oil or gas for refining or processing, or a utility). The movement of LPG (including propane) via trucks, rail cars, or pipeline to a place that sells to retail customers or directly to retail customers also constitutes qualifying transportation. Transportation includes (i) providing storage services; (ii) providing terminalling services, including blending and additization and selling excess RINs acquired as part of additization services to comply with environmental regulations; (iii) moving or carrying products via pipelines, gathering systems and custody transfer stations; (iv) operating marine vessels, railcars or trucks; (v) providing compression services to a pipeline; and (vi) liquefying or regasifying natural gas.
Marketing. Marketing activities include the bulk sale of minerals or natural resources and refined and processed products but not retail sales (that is, small quantity sales directly to end users). Marketing also includes retail sales of LPG (including propane) and certain activities that facilitate sales (e.g., packaging, qualifying blending and additization).
Additional Activities. The final regulations also include specific rules clarifying that a variety of activities related to the Section 7704(d)(1)(E) activities set forth above also qualify. These additional qualifying items include
- Reimbursements for costs in performing Section 7704(d)(1)(E) activities, such as cost of designing, constructing, installing, inspecting maintaining, metering, monitoring or relocating an asset, or providing office functions necessary to the operation of the Section 7704(d)(1)(E) activity (e.g., staffing, purchasing supplies, accounting), whether the cost is imbedded in the rate the MLP charges or separately itemized;
- Passive interests in oil and gas minerals, such as production royalties, net profits interests, and non-operating interests, and delay rentals and lease bonus payments;
- Blending of component parts of the same mineral or natural resource;
- Additization activities, if the additives aid in the transportation of the product, enhance or protect the intrinsic properties of the product or are necessary as required by law (e.g., environmental standards), but only if the additives do not create a new product; qualifying additives include
- Natural gas and crude oil additives constituting less than 5 percent (or, in the case of ethanol or biodiesel, 20 percent) of the total volume when added by the terminal operator or upstream of the terminal operator;
- In the case of ores and other minerals, incidental amounts of additives such as paper dots to identify shipments, anti-freeze to aid in shipping or compounds to allay dust as required by law or reduce losses in shipping:
- In the case of timber, incidental additization to comply with governmental regulations, to the extent the additization does not create a new product.
Services provided to companies engaged in section 7704(d)(1)(E) activities are not themselves section 7704(d)(1)(E) activities, but such services may generate qualifying income if they qualify as intrinsic activities. The IRS intends that intrinsic activities include active support of section 7704(d)(1)(E) activities, not merely the supply of goods for use in section 7704(d)(1)(E) activities.
An activity is an “intrinsic activity” if:
- The activity is “specialized” to support a section 7704(d)(1)(E) activity;
- The activity is “essential” to the completion of the section 7704(d)(1)(E) activity; and
- The activity requires the provision of “significant services” to support the section 7704(d)(1)(E) activity.
An activity is “specialized” if the personnel performing the activity on behalf of the MLP have received 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. In addition, if an activity involves the sale, provision or use of property, then the property also must qualify as specialized. Specialized property includes water and lubricants that are used as injectants in hydraulic fracturing only if the MLP is also in the trade or business of collecting and cleaning, recycling, or otherwise disposing of the injectants after use in accordance with federal, state or local regulations governing such waste products (and only where the MLP provides the injectant delivery and disposal services in the same geographic area).
An activity is “essential” to a section 7704(d)(1)(E) activity if the activity is required to either physically complete the section 7704(d)(1)(E) activity (including completion in a cost effective manner, such as by making the activity economically viable) or comply with laws that regulate the section 7704(d)(1)(E) activity. The rule excludes legal, financial, consulting, accounting, insurance, and other similar services, because the connection to completion of such an activity is too attenuated.
Finally, an activity requires the provision of “significant services” if the MLP’s personnel have an ongoing or frequent presence at the site or sites of the section 7704(d)(1)(E) activity. Alternatively, the services may be conducted offsite if the services are performed on an ongoing or frequent basis and offered for (and in the case of monitoring, exclusively for) those engaged in one or more section 7704(d)(1)(E) activities. Personnel perform significant services only if those services are necessary for the MLP to perform an activity that is essential to support the section 7704(d)(1)(E) activity. An activity does not constitute significant services with respect to a section 7704(d)(1)(E) activity if the activity principally involves the design, construction, manufacturing, repair, maintenance, lease, rent, or temporary provision of property.
Under the final regulations, it is clear that MLP personnel include subcontractors and affiliates.
The final regulations will apply to income earned in a taxable year that begins on or after January 19, 2017. However, the regulations provide for a 10-year transition period ending in an MLP’s taxable year that includes January 19, 2027. During such transition period, an MLP may continue to treat income from an activity as qualifying income if: (a) the MLP received a PLR from the IRS concluding that the income from such activity is qualifying income; (b) prior to May 6, 2015, the MLP was engaged in the activity and treated the activity as giving rise to qualifying income under section 7704(d)(1)(E), provided that such income constitutes qualifying income under section 7704(d)(1)(E) as reasonably interpreted prior to May 6, 2015; (c) prior to May 6, 2015, the MLP had entered into a binding agreement for the construction of assets that would give rise to qualifying income as then reasonably interpreted; or (d) the MLP engaged in such activity after May 6, 2015 but prior to January 19, 2017, and the income from that activity was qualifying income under the proposed regulations.
The regulations incorporate many of the IRS’ views from past private letter rulings and many of the comments to the proposed regulations. Existing MLPs and companies planning to form MLPs should review their current activities and make sure they fit within the definitions of section 7704(d)(1)(E) activities or intrinsic activities. Companies using processes not described in the final regulations or developing new technologies may wish to consider seeking a private letter ruling.