Service Issues Proposed Regs on "Qualifying Income" for MLPs

The Service has issued newly proposed regs under Code Sec. 7704(d)(1)(E) that would clarify when income from exploration, development, mining or production, processing, refining, transportation, and marketing of minerals or natural resources, as well as from certain other related activities, would be considered "qualifying income" to a publicly traded partnership (PTP). Code Sec. 7704(c) excepts a PTP from treatment as a corporation if at least 90% of its gross income is qualifying income.

The proposed regs, out less than a day, have already generated unhappy responses from taxpayers in the containerboard and chemical processing industries.

The proposed regs use the term "qualifying activities," and set out requirements under which an activity would be treated as "qualifying," to describe activities relating to minerals or natural resources that would generate qualifying income. The regs would break up qualifying activities into the following two groups: (i) "Code Sec. 7704(d)(1)(E) activities," referring to the exploration, development, mining or production, processing, refining, transportation, or marketing of minerals or natural resources; and (ii) "intrinsic activities," meaning certain limited support activities that are intrinsic to Code Sec. 7704(d)(1)(E) activities.

"Code Sec. 7704(d)(1)(E) activities" represent different stages (see below) in the extraction of minerals or natural resources and the eventual offering of products for sale, each of which involves various types of operations. The proposed regs would provide an exclusive list of operations that comprise the Code Sec. 7704(d)(1)(E) activities for purposes of Code Sec. 7704. The stages would include:

  • Exploration, i.e., an activity performed to ascertain the existence, location, etc. of any deposit of mineral or natural resource;

  • Development, referring to an activity performed to make the minerals or natural resources accessible;

  • Mining or production, i.e., an activity performed to extract the minerals or other natural resources from the ground;

  • Processing or refining, the activities for which vary with respect to different minerals or natural resources (and lists of qualifying activities are broken down accordingly), but which generally refer to something that is done to purify, separate, or eliminate impurities. The proposed regs would further require that, for an activity to be treated as processing or refining, the partnership's position that an activity constitutes processing or refining must be consistent with its designation of an appropriate MACRS class life for assets used in the activity;

  • Transportation, defined as the movement of minerals or natural resources and products produced from processing and refining, including by way of pipeline, barge, rail, truck, etc. The proposed regs would provide more specific rules for when construction of a pipeline is included, as well as for the treatment of transportation of oil or gas to a place that sells or dispenses to retail customers; and

  • Marketing, i.e., activities undertaken to facilitate larger sales (not retail sales) of minerals or natural resources or products produced from processing and refining.

"Intrinsic activities" would also give rise to qualifying income because the income is "derived from" the Code Sec. 7704(d)(1)(E) activities. For a support activity to be considered intrinsic, it would have to:

  • Be specialized, referring to both the personnel performing the activity (in general, personnel who have received training unique to the mineral or natural resource industries that is of limited utility other than to perform or support a Code Sec. 7704(d)(1)(E) activity) and any property used in the activity or sold to the customer performing the Code Sec. 7704(d)(1)(E) activity. For the property to qualify as specialized, it would have to either be used only in connection with Code Sec. 7704(d)(1)(E) activities and have limited use outside of those activities (and not be easily converted to another use), or, if the property could be used for other purposes, it could nonetheless qualify as specialized to the extent that it is used as an injectant to perform a Code Sec. 7704(d)(1)(E) activity and certain requirements as to its disposal, etc. are met;

  • Be essential, meaning that the activity is necessary either to (i) physically complete the Code Sec. 7704(d)(1)(E) activity (including in a cost effective manner in order to make the activity economically viable), or (ii) comply with federal, state, or local law regarding the activity; and

  • Include the provision of significant services, which generally means that the partnership's personnel would have an ongoing or frequent presence at the site of the Code Sec. 7704(d)(1)(E) activity and that the activities of those personnel are necessary for the partnership to provide its services or to support the Code Sec. 7704(d)(1)(E) activity. In addition, services performed offsite may also qualify if they are performed on an ongoing or frequent basis and offered exclusively for those engaged in one or more Code Sec. 7704(d)(1)(E) activities.

The proposed regs would apply to income earned by a partnership in a tax year beginning on or after the date they are published as final. The proposed regs also provide for a transition period, ending on the last day of the partnership's tax year that includes the date that is ten years after May 6, 2015 (i.e., the publication date for the proposed regs), during which a partnership may treat income from an activity as qualifying income if the partnership received a PLR to that effect.

In addition, a partnership would be able to treat income from an activity as qualifying income during the transition period if, before May 6, 2015, the partnership was publicly traded, engaged in the activity, and treated the activity as giving rise to qualifying income under Code Sec. 7704(d)(1)(E), and that income was qualifying income under the statute as reasonably interpreted prior to May 6, 2015. A partnership that is publicly traded and engages in an activity after May 6, 2015, but before the regs are published as final, may treat income from that activity as qualifying income during the transition period if the income from that activity would be qualifying income under the proposed regs.