On May 6, 2015, the Internal Revenue Service (IRS) published proposed regulations [REG-132634-14], which if finalized would clarify that income from certain oil and natural gas fracturing (“fracking”) services is “qualifying income” for purposes of determining whether a master limited partnership (MLP) qualifies for favorable “passthrough” federal tax status.
Generally, an MLP qualifies for passthrough tax status if 90 percent or more of the MLP’s gross income for the year is qualifying income, which includes certain income from natural resource-related activities, including income from the exploration, development, mining and production, processing, refining, transportation, and marketing of minerals and natural resources. If an MLP does not satisfy the 90 percent threshold, the IRS could treat it as a taxable corporation, meaning that its income could be subject to two levels of tax – corporate income tax at the level of the MLP and additional tax at the level of the partners in the MLP at the time the income is distributed.
In recent years, the IRS has issued a number of private rulings concluding that certain natural resource-related income was qualifying income, but these rulings technically could be relied on only by the particular MLPs that received the rulings. In early 2014, the IRS suspended issuing such private rulings, announcing its intent to issue generally applicable guidance (that suspension was lifted in March 2015). The proposed regulations contain such broad guidance and would apply to all natural resource-related MLPs. The proposed regulations would apply to income earned by an MLP on or after final regulations are issued. They also provide for a special 10-year transition period beginning when final regulations are issued, as described below.
Although the proposed regulations provide detailed guidance relevant to fracking service providers, it could prove challenging to apply the rules in practice. Under the proposed regulations, income from providing fracking services is qualifying income only if the services represent an “intrinsic activity,” which involves a three-part test. First, the services must be “specialized” to support a natural resource-related activity described in section 7704(d)(1)(E) and the proposed regulations (a “development” activity), such as oil or natural gas fracking. Second, the services must be essential to the development activity. Third, the services must be “significant.”
The “specialized” requirement is satisfied only if the service personnel have training unique to the development activity. That is, the training must be of limited utility other than with respect to the development activity. Also, if the services include the sale or use of property, either (i) the property must be specialized and have limited use other than with respect to the development activity (i.e., must not easily be converted to another use), or (ii) the property must be an “injectant” (such as water, lubricants, or sand) and the MLP must collect and dispose of the injectant in compliance with applicable federal, state, or local law.
The “essential” requirement is satisfied if the services are necessary to complete the development activity physically, to make the activity economically viable, or to comply with applicable law that regulates the activity.
The “significant” requirement is satisfied if personnel of the MLP have an ongoing or frequent presence at the site of the development activity, such as the drilling site. An MLP that provides services to multiple clients may satisfy this requirement by having its personnel rotate between sites. Also, the requirement may be satisfied by services conducted off-site if the services are performed on an ongoing and frequent basis and are offered exclusively for oil and natural gas developers. The proposed regulations indicate, however, that the design, manufacturing, or leasing of assets is insufficient.
The proposed regulations provide much-needed guidance and confirm that certain fracking services give rise to qualifying income. The proposed regulations, however, arguably heighten the requirements for income from fracking services to be treated as qualifying income. For example, the proposed regulations indicate that income from water delivery and recovery and recycling of flowback for fracking natural gas developers is qualifying income. In contrast, however, income from mere water delivery is not qualifying income because water delivery does not satisfy the “specialized” requirement. Furthermore, the IRS acknowledged that although the proposed regulations largely are consistent with past IRS rulings, the new guidance may narrow the range of permitted activities.
The proposed regulations provide a generous 10-year transition period beginning on the date final regulations are published. During this transition period, an MLP would be permitted to treat fracking services income as qualifying income if it met one of three conditions:
- The MLP received a private ruling from the IRS concluding that the income was qualifying income;
- Prior to May 6, 2015, the MLP was publicly traded, conducted the relevant activity, and treated the activity as giving rise to qualifying income under a reasonable interpretation of the law prior to the issuance of the proposed regulations (this requirement might involve considerable legal judgment, as it would be necessary to establish that the MLP’s position was “reasonable”); or
- The MLP was publicly traded and conducted the activity on or after May 6, 2015, but prior to the date final regulations were published and the income qualified under the proposed regulations.
The IRS has requested comments on all aspects of the proposed regulations. A copy of the proposed regulations can be found here.