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May 2015
Master limitedpartnership alert
IRS releases guidance defining which activities of master limited partnerships generate qualifying income
On 5 May 2015, the Internal Revenue Service (the IRS) issued highly anticipated proposed Treasury regulations that define which activities of master limited partnerships (MLP) will be treated as generating “qualifying income” with respect to minerals or natural resources. The proposed regulations address certain activities that generate income derived from the exploration, development, mining or production, processing, refining, transportation or marketing of minerals or other natural resources (the Section 7704(d)(1)(E) Activities), as well as certain limited support activities that are intrinsic to Section 7704(d)(1)(E) Activities (the Intrinsic Activities) and therefore generate qualifying income under Section 7704(d)(1)(E).
The proposed regulations, if enacted in the current form, could significantly impact companies with non-traditional types of income that may have wanted to access the MLP market, as well as certain activities held in currently traded MLPs.
BackgroundAn MLP, a type of publicly traded partnership, is a partnership whose interests are traded on an established securities market or are readily tradable on a secondary market or its substantial equivalent. Section 7704(a) generally requires an MLP to be classified as a corporation (and thus distributions may be subject to double taxation) for tax purposes. An exemption to corporate taxation exists if 90% or more of the partnership’s gross income for all tax years is “qualifying income” — generally passive-type income.
Section 7704(d)(1)(E) provides, in part, that qualifying income includes income derived from the exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource (including fertilizer, geothermal energy and timber). The IRS and the Treasury Department had not previously issued regulations as to what activities generate qualifying income under Section 7704(d)(1)(E); rather, the specific application of the rules was generally resolved by taxpayers seeking a PLR.
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As the number of PLR requests on this issue had increased from five or fewer requests per year for most years before 2008 to more than 30 requests received in 2013, the IRS and the Treasury Department issued the proposed regulations in response to the increased interest in the application of Section 7704(d)(1)(E). The release of these proposed regulations come on the heels of the end of a PLR “pause” with respect to Section 7704(d)(1)(E)-related activities.
Proposed regulationsThe proposed regulations offer previously promised guidance on what constitutes qualifying income derived from certain activities with respect to minerals or natural resources as defined in Section 7704(d)(1)(E). Under the proposed regulations, income from “qualifying activities” generates qualifying income for MLP purposes. Qualifying activities include (a) the Section 7704(d)(1)(E) Activities and (b) the Intrinsic Activities.
Section 7704(d)(1)(E) Activities
The Section 7704(d)(1)(E) Activities represent different stages in the extraction of minerals or natural resources and the eventual offering of products for sale. These stages include the following:
1. Exploration
2. Development
3. Mining or production
4. Processing
5. Refining
6. Transportation (including pipelines transporting gas, oil or products thereof)
7. Marketing of any mineral or natural resource (including fertilizer, geothermal energy and timber)
The proposed regulations define each stage and provide an exclusive list of activities that constitute Section 7704(d)(1)(E) Activities. This list may be expanded by published guidance, and the IRS and the Treasury Department have stated that the list represents 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. Services provided to those businesses are not Section 7704(d)(1)(E) Activities under the proposed regulations (although, as discussed below, could be Intrinsic Activities).
Intrinsic ActivitiesThe proposed regulations list and define three requirements for a support activity to be intrinsic to Section 7704(d)(1)(E) Activities so that it would be an Intrinsic Activity that generates qualifying income. An activity will qualify as an Intrinsic Activity only if the activity:
1. Is specialized to support the Section 7704(d)(1)(E) Activity
2. Is essential to the completion of the Section 7704(d)(1)(E) Activity
3. Requires the provision of significant services to support the Section 7704(d)(1)(E) Activity
SpecializedAn activity meets the “specialized” requirement if both 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 are specialized.
EssentialAn activity is “essential” if it is necessary to physically complete the Section 7704(d)(1)(E) Activity (including in a cost-effective manner in order to make the activity economically viable) or to comply with federal, state or local law regulating the Section 7704(d)(1)(E) Activity. The proposed regulations state that water delivery and disposal services are essential when provided for use in fracturing, for example.
SignificantA partnership provides “significant” services if its personnel have an ongoing or frequent presence at the site of a Section 7704(d)(1)(E) Activity, and the activities of those personnel are necessary for the partnership to provide its services or to support the Section 7704(d)(1)(E) Activity.
Comments requestedIn the proposed regulations, the IRS requests comments concerning whether additional activities should be included in the list of Section 7704(d)(1)(E) Activities. While the proposed regulations do not address the transportation or storage of any fuel described in Section 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), the IRS and the Treasury Department also request comments on whether guidance is needed on those activities. The proposed regulations reserve the provisions relating to fertilizer.
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Transition rulesThe regulations are proposed to be effective for income earned by a partnership in a tax year beginning on or after the regulations are finalized. Additionally, the proposed regulations include transition rules. The transition rules end on the last day of the partnership’s tax year that includes the date that is 10 years after the date that the final regulations are adopted.
Under the transition rules, even after these regulations are finalized, certain income that is no longer qualifying income under the final regulations can continue to be considered qualifying income during the 10-year period if:
1. The partnership received a PLR holding that the income from that activity is qualifying income
2. Prior to official publication of the proposed regulations (5 May 2015), the partnership was publicly traded and engaged in an activity that it considered to generate qualifying income under a reasonable interpretation of the statute
3. The partnership is publicly traded and engages in an activity that generates qualifying income under the proposed regulations after 5 May 2015, but before the adoption of final regulations
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ImplicationsThe proposed regulations are significant in the sense that they (a) define what type of activities generate qualifying income for MLP purposes; (b) change the way in which Section 7704(d)(1)(E) has been administratively handled; and (c) would generally disqualify certain types of income, if enacted in the current form (i.e., such income would no longer be considered “qualifying income”) that had previously been qualifying income under prior PLR.
As discussed earlier, while the proposed regulations include a 10-year transition period, the transition period is sub-optimal relief for a partnership that has been relying on a PLR or an opinion from counsel regarding the qualifying income status of an activity. The proposed regulations will generate significant comments. In that regard, the final regulations, when adopted, could be significantly more favorable than the proposed regulations on what constitutes qualifying income under Section 7704(d)(1)(E).
For companies (or existing MLPs) with more of the traditional upstream, midstream and certain downstream activities, the proposed regulations are not expected to have a significant impact on a go-forward basis. For companies with activities that generate qualifying income, the MLP structure is expected to continue to be an accretive structure for sponsors of MLPs as well as for the public. Offering the benefits of flow-through taxation and growth to unitholders, the MLP structure as a whole is expected to continue to thrive, despite the language in the proposed regulations.
For companies that focus on providing services to traditional MLP-type activities, the proposed regulations provide a framework for what types of income would be qualifying income under the IRS’s and Treasury Department’s current interpretation.
For companies with non-traditional activities, the proposed regulations may present an obstacle to accessing the structure and will require additional consideration and thought as to how to maintain and/or grow under the guidance.
