The US Internal Revenue Service has issued long-awaited proposed Treasury Regulations (Proposed Regulations) on “qualifying income” of publicly traded partnerships (PTPs) generated by activities related to minerals and natural resources, including new rules covering the fracking industry. The Proposed Regulations are the culmination of a US Department of Treasury guidance project and effectively end the IRS’ 13-month-long suspension on issuance of private letter rulings regarding PTPs in the natural resources sector.
PTPs are generally treated as corporations for US federal income tax purposes. However, if 90 percent of a PTP’s gross income is so-called “qualifying income,” then the PTP is treated as a partnership for US federal income tax purposes and is not itself subject to US federal income tax. Rather, the partnership’s income is allocated to, and taken into account by, its partners, thus resulting in a single level of US federal income tax. Qualifying income includes interest, dividends, and rents or gains from the sale of real property; income from the exploration, development, mining, production, refining or transportation of a natural resource, including gain on the sale of property used in such business; or income from the marketing of any mineral or natural resource (including fertilizer, geothermal energy and timber) or industrial source carbon dioxide; or from the transportation or storage of any biodiesel fuel.
The PTP structure has grown in popularity as a tax-efficient investment vehicle. A PTP combines the liquidity of trading on a national stock exchange with a single layer of US federal income tax incurred by the investors on their allocable share of the PTP’s taxable income, as noted above. Such favorable partnership tax treatment is predicated on the PTP satisfying the qualifying income test. If a PTP fails to meet the qualifying income test, it will lose its status as a partnership and be taxed as a corporation, thus resulting in two levels of US federal income tax—one at the PTP level, and a second, on investors, when the income is distributed.
Due to the uncertainty in determining whether certain activities generate qualifying income, taxpayers traditionally have submitted private letter ruling requests to the IRS prior to adopting a PTP structure. Between March 2014 and April 2015, the IRS temporarily suspended the issuance of such private letter rulings while it studied the definition of qualifying income. The Proposed Regulations were issued in response to the increased interest in the PTP structure and are intended to provide guidance on whether income from activities with respect to minerals or natural resources is qualifying income.
Under the Proposed Regulations, activities relating to minerals or natural resources that generate qualifying income are broken down into two separate categories:
- Exploration, development, mining or production, processing, refining, transportation, and marketing of minerals or natural resources (section 7704(d)(1)(E) activities), and
- Certain limited support activities that are intrinsic to section 7704(d)(1)(E) activities (intrinsic activities).
Section 7704(d)(1)(E) Activities
Section 7704(d)(1)(E) activities are further subdivided according to the different stages in the process of extracting the minerals or natural resources and eventually offering the products for sale. These stages are: (1) exploration, (2) development, (3) mining or production, (4) processing or refining, (5) transportation, and (6) marketing. Under the Proposed Regulations, this is intended to be the exclusive list of operations that comprise section 7704(d)(1)(E) activities.
- Exploration is defined as 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. Examples of exploratory activities include conducting geological or geophysical surveys and drilling exploratory wells and tunnels.
- Development is defined as an activity performed to make minerals or natural resources accessible. Examples of development activities include drilling wells to access deposits of mineral or natural resources, constructing and installing drilling, production or dual purpose platforms in marine locations, and constructing and installing gathering systems.
- Mining or production is defined as an activity performed to extract minerals or other natural resources from the ground. Examples of mining or production activities include operating equipment to extract natural resources from mines or wells, operating equipment to convert raw mined products into substances that can be readily transported or stored and dehydrating crude oil.
- Processing or refining generally is defined as an activity conducted to purify, separate or eliminate impurities from minerals or natural resources. The Proposed Regulations contain industry-specific rules with respect to processing or refining of crude oil, natural gas, ore and minerals, and timber. Notably, the production of plastics and similar petroleum derivatives is specifically excluded from activities giving rise to qualifying income. In addition, the processing of timber into pulp, paper, and paper products is specifically excluded from qualifying timber-processing activities.
- Transportation is defined as the movement of minerals or natural resources and products produced from processing and refining, including by pipeline, barge, rail or truck. Transportation also includes providing storage services, operating custody transfer stations and gathering systems, and constructing a pipeline, but only to the extent that a pipe is run to connect a client to a pre-existing line owned by the PTP.
- Marketing is defined as an activity undertaken to facilitate the sale of minerals or natural resources, or products produced from processing and refining. Marketing may also include some additive blending into fuels provided to a customer’s specification. Marketing does not include retail sales (sales made in small quantities directly to end users) but can include bulk and wholesale sales made to end users.
Under the Proposed Regulations, certain limited support activities intrinsic to section 7704(d)(1)(E) activities also give rise to qualifying income because the income is considered to be “derived from” section 7704(d)(1)(E) activities. An activity qualifies as an intrinsic activity only if: (1) the activity is specialized to support the section 7704(d)(1)(E) activity, (2) it is essential to the completion of the section 7704(d)(1)(E) activity, and (3) requires the provision of significant services to support the section 7704(d)(1)(E) activity.
If each of these requirements is met, the activity is an intrinsic activity, and any income received from the activity is qualifying income.
- An activity is specialized if employees must have unique training that is of limited value other than to perform support for the exploration and production of minerals and natural resources. For example, catering services are not intrinsic because they do not require skills specific to resource production.
If a support activity involves the sale or use of property, the property also must be specialized and not easily convertible for another use. The Proposed Regulations specifically provide that injectants such as water, sand and lubricants qualify as specialized as long as the PTP providing the injectants also collects and cleans, recycles, or otherwise disposes of the injectant after use in accordance with federal, state or local regulations.
- An activity is essential if it is necessary to: (1) physically complete the section 7704(d)(1)(E) activity (including in a cost-effective manner in order to make the activity economically viable) or (2) comply with federal, state or local law regulating the section 7704(d)(1)(E) activity. For example, water delivery and disposal services are essential when provided for use in fracturing because water must be used to complete the drilling operations in a cost-efficient manner.
- A PTP 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 PTP to provide its services or to support the activity. Services conducted offsite also will be considered substantial if the services are performed on an ongoing or frequent basis and offered exclusively for those engaged in one or more section 7704(d)(1)(E) activities.
Effective Date and Transition Period
The Proposed Regulations are expected to apply from and after the date they are published as final Treasury Regulations. Moreover, PTPs may rely on the Proposed Regulations with respect to activities conducted after May 6, 2015 but before the date on which final regulations, are published. The Proposed Regulations provide for a 10-year transition period during which certain PTPs that either obtained a favorable private letter ruling or treated certain income under a reasonable interpretation of the statute as qualifying income may continue to treat such income as qualifying income.
The Proposed Regulations provide much-needed guidance on which mineral and natural resource-related activities give rise to qualifying income. However, although the Proposed Regulations do contain bright line rules, such as with respect to the provision of injectants, they would also raise novel ambiguities, particularly vis-à-vis the three-part “intrinsic activity” test. Further, the fact that the Proposed Regulations contain an exclusive list of mineral and natural resource-related activities that generate qualifying income may limit the availability of the PTP structure for companies that develop new activities, approaches and methods, unless additional guidance is provided.
The Proposed Regulations would significantly impact current PTPs, their partners and any sponsor that may consider adopting a PTP structure for its mineral or natural resource operations. As such, even before final regulations are promulgated, PTPs, their partners and potential PTPs should consult their tax advisors and carefully consider the potential impact of the Proposed Regulations on planned or completed transactions in order to ensure that the PTP’s partnership tax treatment is not jeopardized.
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