On January 24, 2017, the Internal Revenue Service (IRS) issued final regulations addressing master limited partnership (MLP) qualifying income under Section 7704(d)(1)(E) of the Internal Revenue Code (the Code). The regulations are effective January 19, 2017 and, as a result, are not subject to the regulatory freeze that the White House imposed on January 20, 2017. This Locke Lord QuickStudy briefly summarizes the final regulations.
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 a 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. In May 2015, the IRS issued proposed regulations addressing qualifying income under Section 7704. A prior QuickStudy
reviewed the proposed regulations. The final regulations largely adopt the proposed regulations, albeit with some potentially significant modifications. The clarifications offered by the final regulations should be welcomed by many MLPs.
The regulations are divided into seven parts. The first part establishes the basic rule that qualifying income includes income and gains from qualifying activities with respect to minerals or natural resources. Similar to the proposed regulations, the final regulations establish two categories of qualifying activities: (i) “Section 7704(d)(1)(E) activities” and (2) “intrinsic activities” (i.e., those activities that support Section 7704(d)(1)(E) activities). The second part defines “mineral or natural resource” consistent with the definition set forth in Section 7704(d)(1) of the Code. The third part defines and identifies the specific component activities that are included in each of the Section 7704(d)(1)(E) activities. The fourth part provides rules for whether activities are intrinsic activities. The fifth and sixth parts provide, respectively, a rule regarding the interpretation of Sections 611 and 613 of the Code (dealing with depletion of minerals and natural resources) in relation to the final regulations and examples illustrating the provisions of the regulations. Finally, the seventh part provides that the regulations apply to income received by an MLP in a taxable year beginning on or after January 19, 2017 and includes a ten year transition period for certain MLPs. This QuickStudy
focuses its review on the definitions of (i) Section 7704(d)(1)(E) activities and (ii) intrinsic activities.
Section 7704(d)(1)(E) Activities.
The proposed regulations provided an exclusive list of operations that comprised Section 7704(d)(1)(E) activities: (i) exploration, (ii) development, (iii) mining or production, (iv) processing or refining, (v) transportation, and (vi) marketing. As a result of various comments objecting to the use of an exclusive activity list, the final regulations provide a general definition of each of the listed active terms in Section 7704(d)(1)(E) followed by a non-exclusive list of examples of each activity. Also in response to commentary on the proposed regulations, the IRS modified the final regulations to provide for separate definitions of processing and refining. The table below highlights how the regulations define each Section 7704(d)(1)(E) activity.
|| General Definition
An activity constitutes exploration if it is 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 including by
(i) drilling an exploratory or stratigraphic type test well;
(ii) conducting drill stem and production flow tests to verify commerciality of the deposit;
(iii) conducting geological or geophysical surveys;
(iv) interpreting data obtained from geological or geophysical surveys; or
(v) for minerals, testpitting, trenching, drilling, driving of exploration tunnels and adits, and similar types of activities described in Rev. Rul. 70-287 if conducted prior to development activities with respect to the minerals.
||An activity constitutes development if it is performed to make accessible minerals or natural resources, including by:
(i) drilling wells to access deposits of minerals or natural resources;
(ii) 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);
(iii) 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;
(iv) performing a development technique such as, for minerals other than oil and natural gas, stripping, benching and terracing, dredging by dragline, stoping, and caving or room-and-pillar excavation, and for oil and natural gas, fracturing; or
(v) 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 natural resources from the ground including by operating equipment to extract minerals or natural resources from mines and wells, or to extract minerals or natural resources from the waste or residue of prior mining or production allowable under this section. The recycling of scrap or salvaged metals or minerals from previously manufactured products or manufacturing processes is not considered to be the extraction of ores or minerals from waste or residue.
||An activity constitutes 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. The regulations also provide descriptions of the processing of: (i) natural gas; (ii) crude oil; (iii) ores and minerals other than natural gas or crude oils; and (iv) timber.
||The regulations do not provide a general definition of refining, but instead set forth activities that qualify as refining activities under the specific rules for the different categories of natural resources (i.e., (i) natural gas and crude oil; and (ii) ores and minerals other than natural gas or crude oil).
With respect to natural gas and crude oil, the regulations provide a comprehensive list of products that are deemed to be produced in a petroleum refinery or natural gas processing plant and are thus deemed the result of refining activities.
||An activity constitutes transportation if it is performed to move minerals or natural resources, and products under mining or production, processing, or refining activities, including by pipeline, marine vessel, rail, or truck. In general, transportation does not include the movement of minerals or natural resources, and products produced under mining or production, processing, or refining activities, directly to retail customers or to a place that sells or dispenses to retail customers. Retail customers do not include a person who acquires oil or gas for refining or processing, or a utility. The regulations also clarify that transportation includes the movement of liquefied petroleum (e.g., propane) via trucks, rail cars, or pipeline to a place that sells to retail customers or directly to retail customers.
Transportation includes the following activities:
(i) providing storage services;
(ii) providing terminalling services, including the following: receiving products from pipelines, marine vessels, railcars, or trucks; storing products; loading products to pipelines, marine vessels, railcars, or trucks for distribution; testing and treating, as well as, in certain circumstances, blending and additization; and separating and selling excess renewable identification numbers acquired as part of additization services to comply with environmental regulations;
(iii) moving or carrying (whether by owner or operator) products via pipelines, gathering systems, and custody transfer stations;
(iv) operating marine vessels (including time charters), railcars, or trucks;
(v) providing compression services to a pipeline; and
(vi) liquefying or regasifying natural gas.
||An activity constitutes marketing if it is the bulk sale of minerals or natural resources, and products under mining or production, processing, or refining activities. In general, marketing does not include retail sales (sales made in small quantities directly to end users), which includes the operation of gasoline service stations, home heating oil delivery services, and local natural gas delivery services. Retail sales of liquefied petroleum gas are included in marketing. The regulations also note that marketing can include certain activities that facilitate sales that constitute marketing.
| Additional Activities
||The regulations provide that income generated from the following activities will be considered Section 7704(d)(1)(E) activities: (i) certain cost reimbursements (related to the performance of Section 7704(d)(1)(E) activities); (ii) certain passive interests (e.g., production royalties, minimum annual royalties, net profits interests, delay rentals and lease bonus payments); (iii) certain blending activities (provided that the blending concerns products that are component parts of the same mineral or natural resource; provided further that products of oil and natural gas are considered being from the same natural resource) and (iv) and certain additization activities (provided that additives comprise less than 5%, or 20% in the case of ethanol or biodiesel, of the total volume for products of natural gas and crude oil).
Intrinsic Activities. Similar to the proposed regulations, the final 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) activity. 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 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, provided, that, the MLP must also be in the trade or business of collecting, recycling, or otherwise disposing of injectants in accordance with applicable law in the same geographic area the MLP delivers the injectant.
- 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. Legal, financial, consulting, accounting, insurance, and other similar services do not qualify as being essential to a 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. Services may be conducted offsite if the services are performed on an ongoing or frequent basis and are offered to those engaged in one or more Section 7704(d)(1)(E) activities. If the services are monitoring, those services must be offered exclusively to those engaged in one or more Section 7704(d)(1)(E) activities. Whether services are conducted on an ongoing or frequent basis is determined based on all the facts and circumstances, including recognized best practices in the relevant industry. The regulations provide that an MLP can satisfy the significant services when they are performed by the MLP directly or through an affiliate or subscontractor.
The regulations include a ten-year transition period for MLPs that (i) received a PLR from the IRS holding that the income from the activity is qualifying income, (ii) took a reasonable position under the statute, and prior to the issuance of the proposed regulations, that their activities generated qualifying income, (iii) prior to the issuance of the proposed regulations, entered into a binding agreement for the construction of assets to be used in an activity that would give rise to qualifying income as reasonably interpreted under the statute, or (iv) the MLP engaged in the activity after the issuance of the proposed regulations but before the publication of the final regulations and the income from such activity is qualifying income under the proposed regulations. The IRS rejected comments requesting that the IRS permanently allows MLPs with PLRs that are contrary to the final regulations to continue to rely on them on the grounds that the IRS has the authority to revoke a PLR that is found to be in error or not in accord with the current views of the IRS. Moreover, the IRS thought that ten years was a sufficient time period in which an MLP could rearrange its affairs to comply with the final regulations. The final regulations clarify that a technical termination (i.e., a transfer of 50% or more of the outstanding interests in an MLP during a 12-month period) will not end the ten year transition period.
The final regulations represent a much needed modernization of the definition of qualifying income and significantly improve upon the proposed regulations. Similar to the proposed regulations, however, the final regulations will not be universally welcomed as several MLPs will need to substantially reorganize their operations to generate qualifying income (at least after the ten year transition period expires). For example, SunCoke Energy Partners, L.P., an MLP that manufactures coke, must analyze whether its activities fall within the ten year transaction period because the final regulations exclude cokemaking as a qualifying income activity. Similar to proposed regulations, the final regulations also close the door on the paper industries’ recent attempts to form MLPs for their operations. The final regulations include reserved paragraphs for fertilizer and hedging, which the IRS plans to address in the future.
For more information on the matters discussed in this Locke Lord QuickStudy,
please contact the authors.