Locke Lord QuickStudy: Proposed Regulations Issued on MLP Qualifying Income

The Internal Revenue Service (IRS) recently issued proposed regulations addressing master limited partnership (MLP) qualifying income under Section 7704(d)(1)(E) of the Internal Revenue Code. This Locke Lord QuickStudy briefly summarizes the proposed regulations. 

Background
Section 7704 generally provides that an MLP—a special form of limited partnership that is publicly traded on a national securities exchange—is exempt from the corporate income tax so long as it derives at least ninety percent of its gross income from qualifying sources such as natural resources, real estate, or commodities. Historically, the definition of qualifying income has not kept pace with the ever-evolving energy industry. As a result, many MLPs questioned whether certain activities generated qualifying income and, until the beginning of the 2014 moratorium, frequently submitted private letter rulings (PLRs) to the IRS for clarity. The IRS announced in March 2015 that the agency would resume issuing PLRs concerning qualifying income. Although many MLPs welcomed this announcement, the PLR process is not an ideal mechanism for resolving qualifying income questions because it is a time consuming and expensive process. The proposed regulations should alleviate this problem and help MLPs more easily determine if they are generating qualifying income.

Proposed Regulations
The proposed regulations provide that qualifying income relating to minerals and natural resources includes only income and gains from “qualifying activities” with respect to minerals or natural resources. The proposed regulations establish two categories of qualifying activities: (1) “Section 7704(d)(1)(E) activities” and (2) “intrinsic activities” (i.e., those activities that support Section 7704(d)(1)(E) activities). 

Section 7704(d)(1)(E) Activities: The proposed regulations provide an exclusive list of six MLP operations that constitute Section 7704(d)(1)(E) activities: (i) exploration, (ii) development, (iii) mining or production, (iv) processing or refining, (v) transportation, and (vi) marketing. These activities represent different stages in the extraction of minerals or natural resources and the eventual offering of products for sale. Although the IRS intends for this list to be an exclusive one, the Agency recognizes that it may need to expand the list by published guidance. The table below highlights how the proposed regulations define each Section 7704(d)(1)(E) activity:

MLP Activity	General Definition	Points of Interest
Exploration	An activity performed to ascertain the existence, location, extent, or quality of any deposit of mineral or natural resource before the beginning of the development stage of the natural deposit.	An MLP is engaged in exploration if the MLP: (i) drills an exploratory or stratigraphic type test well; (ii) conducts drill stem and production flow tests to verify commerciality of the deposit; (iii) conducts geological or geophysical surveys; or (iv) interprets data obtained from geological or geophysical surveys.
Development	An activity performed to make minerals or natural resources accessible.	An MLP is engaged in development if the MLP: (i) drills wells to access deposits of mineral or natural resources; (ii) constructs and installs 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); (iii) completes 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; (iv) performs a development technique (for example, fracturing for oil and natural gas, or, with respect to minerals, stripping, benching and terracing, dredging by dragline, stoping, and caving or room-and-pillar excavation); or (vi) constructs and installs gathering systems and custody transfer stations.
Mining or Production	An activity performed to extract minerals or other natural resources from the ground.	An MLP is engaged in mining or production if the MLP: (i) operates equipment to extract natural resources from mines and wells; or (ii) operates equipment to convert raw mined products or raw well effluent to substances that can be readily transported or stored.
Processing or Refining	An activity done to purify, separate, or eliminate impurities.	The proposed regulations provide industry specific-rules concerning natural gas, petroleum, ores and minerals, and timber (the proposed regulations reserve a section for fertilizer, but provide no guidance on the subject). The proposed regulations exclude from the definition of processing or refining those 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 or manufactured products.
Transportation	The movement of minerals or natural resources and products produced from mining, production, processing or refining, including by pipeline, barge, rail, or truck.	The following activities qualify as transportation: (i) providing storage services; (ii) terminalling; (iii) operating gathering systems and custody transfer stations; (iv) operating pipelines, barges, rail, or trucks; and (v) construction of a pipeline only to the extent that a pipe is run to connect a producer or refiner to a preexisting interstate or intrastate line owned by the MLP.
Marketing	Activities undertaken to facilitate sale of minerals or natural resources, or products produced from mining, production, processing or refining.	Marketing may include blending additives into fuels. Marketing does not include retail sales (sales made in small quantities directly to end users), but it is intended to cover bulk and wholesale sales made to end users.

Intrinsic Activities: The proposed regulations provide that certain activities that support Section 7704(d)(1)(E) activities give rise to qualifying income because this income is “derived from” the Section 7704(d)(1)(E) activities. An intrinsic activity is one that (i) is specialized to support a Section 7704(d)(1)(E) activity, (ii) is essential to the completion of that activity, and (iii) requires the provision of significant services to the activity. The proposed regulations define each of these elements as follows:

• Specialization—an activity is specialized if the MLP provides personnel to perform or support the Section 7704(d)(1)(E) activity and those personnel have received training unique to the mineral or natural resource industry that is of otherwise limited use. If the activity also involves the sale, provision, or use of property, then the property must be (i) used only in connection with a Section 7704(d)(1)(E) activity and have limited use outside of that activity, or (ii) used as an injectant to perform a Section 7704(d)(1)(E) activity and, as part of that activity, the MLP must collect and clean, recycle, or otherwise dispose of the injectant in accordance with applicable law.
• Essential—an activity is essential if it is necessary to (i) physically complete the Section 7704(d)(1)(E) activity or (ii) comply with the applicable laws regulating the Section 7704(d)(1)(E) activity.
• Significant Services—an MLP provides significant services if its 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 for the MLP to provide its services or to support the Section 7704(d)(1)(E) activity.

The proposed regulations include a ten-year transition period for MLPs that received a PLR from the IRS holding that the income from the activity is qualifying income or took a reasonable position under the statute, and prior to the issuance of the proposed regulations, that their activities generated qualifying income. 

Takeaways
The proposed regulations represent a much needed modernization of the qualifying income definition and present MLPs with a clearer framework for determining whether or not their operations generate qualified income. The proposed regulations will not be universally welcomed, however, and may force some firms to substantially reorganize their operations. In fact, the proposed regulations may actually terminate the MLP status of several firms, particularly those involved in the processing of petrochemicals. For instance, Westlake Chemical Partners LP may lose its MLP status at the end of the regulatory transition period despite having obtained a favorable PLR from the IRS in 2012. According to a Westlake Chemical Partners LP press release, the proposed regulations “would make it difficult or impossible for the [company’s] production, transportation and marketing of ethylene and its co-products to continue to qualify as ‘qualifying income’ after the proposed ten-year transition period.” The proposed regulations also close the door on the paper industries’ recent attempts to form MLPs for their operations.

The IRS is accepting comments and public hearing requests until August 4, 2015. MLPs should carefully review the proposed regulations with their tax advisors. It is also worth noting that the proposed regulations contain detailed examples that demonstrate the application of the principles discussed in this QuickStudy. We will continue to closely monitor this issue and will provide future client updates once the final regulations are published. 

For more information on the matters discussed in this Locke Lord QuickStudy or if you are interested in submitting a comment to the IRS, please contact the authors.