27 January 2017 Final regulations released on MLP qualifying income under Section 7704(d)(1)(E) On January 19, 2017, the Internal Revenue Service (IRS) and the Treasury Department released final regulations (TD 9817) on what constitutes qualifying income under Section 7704(d)(1)(E) for master limited partnerships (MLPs). The final regulations define and describe mineral-related or natural resource-related activities that generate qualifying income (the Section 7704(d)(1)(E) Activities), as well as provide a framework for certain "intrinsic activities" (Intrinsic Activities) that support qualifying Section 7704(d)(1)(E) Activities that also generate qualifying income. There is some uncertainty, however, regarding the effectiveness of the final regulations given that they were published in the Federal Register after January 20, 2017, and could be subject to a memo issued by the Trump White House. In a memo dated January 20, 2017, the White House instructed heads of executive departments and agencies to withdraw regulations from the Federal Register that had not been published as of noon January 20 until President Trump's appointees or designees could review them. If the final regulations are effective as described in the released and published version of such regulations, then the final regulations ought to apply to income received by an MLP in any tax year beginning on or after January 19, 2017 (subject to the application of the Transition Period, as defined and described later). Overall, the final regulations contain a number of provisions that create a more flexible approach in determining qualifying income status for purposes of Section 7704(d)(1)(E). Some of the noteworthy changes or improvements are as follows: — The final regulations abandoned the "exclusive" list of qualifying activities that were reflected in the proposed regulations (see Tax Alert 2015-865). For each Section 7704(d)(1)(E) Activity, the final regulations contain a general definition and a non-exhaustive and non-exclusive list of examples of such activities. The final regulations, in certain circumstances, provide examples of activities that qualify, as well as certain activities that do not qualify, as a Section 7704(d)(1)(E) Activity. — The final regulations address and define "processing" and "refining" separately, as compared to the combined approach in the proposed regulations. By addressing each activity separately, the final regulations provide a more straight-forward and simple approach to determining the qualification for many oil and gas activities as a Section 7704(d)(1)(E) Activity. Additionally, under the final regulations, the conversion of ethane and propane into ethylene and propylene through use of a steam cracker can generate qualifying income for purposes of Section 7704(d)(1)(E). — The final regulations also specifically address a number of activities that were either omitted or not clearly addressed in the proposed regulations. For example, the final regulations include as qualifying Section 7704(d)(1)(E) Activities income from certain passive, non-operating interests in minerals and natural resources, the sale of renewable identification numbers, certain cost reimbursement amounts, the marketing and sale of propane to retail customers, the liquefaction or regasification of natural gas, compression services to pipelines, certain blending and additization activities, among others. An MLP, a type of publicly traded partnership, is a partnership whose interests are normally traded on an established securities market. Section 7704(a) generally requires an MLP to be classified as a corporation for tax purposes. Section 7704(c)(1) exempts an MLP from corporation classification, however, if 90% or more of the partnership's gross income for all tax years consists of "qualifying income" (generally passive-type income). Section 7704(d)(1) lists certain activities the income of which ought to be classified as "qualifying income," including the items enumerated in Section 7704(d)(1)(E). Section 7704(d)(1)(E) states, 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), as well as gross income derived from certain other types of activities. With a lack of issued regulations under Section 7704(d)(1)(E), questions about the specific application of Section 7704(d)(1)(E) were generally resolved by private letter ruling (PLR). The IRS announced a pause on issuing PLRs early in March 2014, effectively placing MLP qualifying income PLR requests in limbo until it provided further guidance. See Tax Alert 2014-645. In March 2015, the IRS informally announced the end of the pause and cautioned taxpayers that PLR requests on file would be processed, but that some time may be required to process all requests. In May 2015, the IRS issued the highly anticipated proposed regulations (REG-132634-14) that defined which MLP activities would be treated as generating qualifying income under Section 7704(d)(1)(E)). The proposed regulations also defined certain limited support activities that are intrinsic to those qualifying activities and therefore generate qualifying income under Section 7704(d)(1)(E). Numerous comment letters were submitted to the IRS and Treasury on certain aspects of the proposed regulations, and the IRS held a public hearing at which several interested parties raised issues with and recommended changes to the proposed regulations. The final regulations adopted a number (but not all) of the suggestions and comments that companies, advisors and other key stakeholders submitted as potential improvements to the proposed regulations. In the preamble to the final regulations, the IRS spent a considerable amount of effort discussing the legislative history, intent and the rationale for either adopting or not adopting a number of comments. Certain, key changes from the proposed regulations are discussed in this Alert. As discussed, the final regulations offer a general definition of each of the eight listed active terms in Section 7704(d)(1)(E), followed by a non-exhaustive and non-exclusive list of examples. This general framework is a clear and helpful departure from the "exclusive" list approach that the proposed regulations had adopted in defining qualifying activities. Regarding the definition of "mineral or natural resource," the final regulations adopt, almost verbatim, the same definition as in the proposed regulations, but expand the definition to include fertilizer, geothermal energy, and timber. Further, the final regulations do not list liquefied natural gas (LNG) and liquefied petroleum gas (LPG) as natural resources since they are not a mineral or natural resource by Congress. Rather, liquefying or regasifying natural gas is listed as a qualifying transportation activity, and the sale of LPG (propane) is listed as a qualifying marketing activity. In addressing control or ownership of the property in the definition of a resource, the IRS noted that Congress intended to specify the type of asset involved, not the ownership structure. Accordingly, the final regulations state that continual ownership or control of the depletable asset from extraction through each of the listed active terms is not required, but that qualifying activities can take place at different points along that progression of activities described by the active terms by those who purchase, take control of or merely perform Section 7704(d)(1)(E) Activities with respect to partially processed or refined minerals or natural resources. The final regulations follow the proposed regulations' approach to exploration and development activities, but insert the term "including" before examples to ensure that the list of examples is not an exclusive list. The final regulations clarify the proposed regulations' definition of mining or production activities to include only extraction activities, and treat activities that convert raw mined products or raw well effluent into products that can be readily transported or stored as qualifying processing activities. The final regulations also extend mining or production to include the extraction of minerals or natural resources from the waste deposits or residue of prior mining or production. The recycling of scrap or salvaged metals or minerals from previously manufactured products or manufacturing processes, however, does not give rise to qualifying income. While certain mining processes would not necessarily fall under the final regulations' definition of "mining," the final regulations address such activities under the definition of "processing." With certain post-extraction activities effectively moved to the "processing" category of qualifying income, the IRS and Treasury state in the preamble that they believe that Section 7704(d)(1)(E) encompasses a broader category of income with a different endpoint as compared to the depletion rules applicable to mining. The final regulations define processing as an activity performed to convert raw mined or harvested products or raw well effluent to substances that can be readily transported or stored. The intent of this definition was to capture processing activities that are generally performed at the wellhead, mine, field facilities or other location where mining processes are generally applied. The final regulations contain separate provisions for processing natural gas, crude oil, other ores and minerals, and timber. For natural gas, certain purification and separation processes are included. For crude oil, certain separation processes are included, in keeping with the IRS's stated intent. For other ores and minerals, income is included (qualified) if the activity meets the definition of mining processes under Treas. Reg. Section 1.613-4(f)(1)(ii), without regard to whether the taxpayer owns the property. Finally, the final regulations describe limited timber-related activities that are included in the term "processing" (e.g., wood chips, saw dust, rough lumber), but such activities do not include pulping and other activities that produce paper products, treated lumber, and certain other products (which are activities that the IRS views more properly as manufacturing-type activities for this purpose). For an activity to be considered "processing" under the final regulations, taxpayers no longer have to satisfy the Modified Accelerated Cost Recovery System requirement that was included in the proposed regulations. Additionally, the IRS and Treasury contemplate that "processing" may cause a substantial physical or chemical change, thus eliminating the prior limitation on creating such a chemical change. Consistent throughout the final regulations and the preamble, the IRS reiterated the initial and continued intent to not include certain activities that are more properly classified as manufacturing activities as activities that can generate qualifying income under Section 7704(d)(1)(E). The final regulations do not provide a general definition of refining, but instead set forth an extensive list of activities that qualify as refining activities for this purpose. In general, refining includes the further physical or chemical conversion or separation processes of products resulting from certain activities, and the blending of petroleum hydrocarbons, to the extent such activities give rise to specified, listed products. As an additional departure from the proposed regulations, regarding the refining of natural gas or crude oil, the final regulations list 35 specific products that are of a type produced in a petroleum refinery or natural gas processing plant, based, in part, on the list of products produced by a refinery as compiled by the US Energy Information Association (EIA) (although the final regulations modify the EIA's list slightly). Of note, however, is that methanol is not included as a listed product. Overall, the final regulations no longer differentiate between the refining of natural gas and the refining of crude oil, particularly for the creation of olefins and certain liquid fuels. Further, the final regulations appear to abandon a perceived bias toward fuel-related products or activities. For ores and minerals other than natural gas or crude oil, the final regulations include an activity if the activity is one of the various, specified processes performed subsequent to a defined mining process to eliminate impurities or foreign matter and is a necessary step in achieving a high degree of purity from certain, specified metallic ores and minerals. The rules for refining other ores and minerals apply only to lead, zinc, copper, gold, silver, and any other ores that the Commissioner may identify through "published" guidance. The final regulations specify that qualifying income is income derived from an activity performed to move minerals or natural resources, and certain mined, developed, processed, or refined products, including by pipeline, marine vessel, rail, or truck. The term "transportation" also includes compression services to a pipeline, liquefying or regasifying natural gas, providing terminalling services, storage services, the movement or carry of qualified items via pipelines and gathering systems, and the sale of renewable identification numbers, among others. Additionally, certain bulk transportation activities can qualify as "transportation." Transportation does not include the movement of minerals, natural resources or qualified products directly to retail customers or to a place that sells or dispenses to retail customers, with two primary exceptions. First, transportation includes the movement of items via pipeline directly to a place that sells to retail customers (but not directly to the retail customer). Second, transportation includes the movement of LPG (propane) via trucks, rail cars, or pipeline to a place that sells to retail customers or directly to retail customers. The final regulations define marketing as the bulk sale of minerals or natural resources, and products produced through processing or refining, and includes activities that facilitate sales (such as packaging), but generally does not include retail sales. Retail sales of LPG (propane), however, are included in the definition of "marketing." The final regulations include certain activities that will be considered "derived from" a Section 7704(d)(1)(E) Activity. For certain cost reimbursements, the final regulations provide that operating income (including from construction and back-office functions) constitutes qualifying income so long as the activities are part of the partnership's business of performing the Section 7704(d)(1)(E) Activity, regardless of whether the cost is billed separately or added to overhead. The final regulations also clarify that certain passive interests in qualified minerals or natural resources are considered "derived from" a Section 7704(d)(1)(E) activity, including production royalties, minimum annual royalties, net profits interests, delay rentals and lease-bonus payments. Payments with respect to production payments properly characterized as such under Section 636, however, do not fall within the scope of (or are not derived from) a qualifying Section 7704 (d)(1)(E) Activity. The final regulations also include certain blending and additization activities. Income from the blending of the same mineral or natural resource, or products thereof may be part of processing, refining, transportation or marketing. The final regulations do not, however, include as qualifying activities the combination of different minerals or natural resources. Some additization services may be qualifying activities, such as certain additization in order to safely transport a product. Additives generally must constitute less than 5% of the total volume for products of natural gas and crude oil (however, additives for ethanol and biodiesel may constitute up to 20% of the total volume). The IRS intends to issue proposed regulations dealing with fertilizer. Further, the IRS and Treasury have requested comments on the appropriate methods to treat hedging income, gains and losses for purposes of Section 7704(d)(1)(E). Generally, Intrinsic Activities are intended to constitute active support of Section 7704(d)(1)(E) Activities, and not merely the supply of goods. As under the proposed regulations, the final regulations specify that an activity is an Intrinsic Activity only if the activity is: (a) specialized to support a Section 7704(d)(1)(E) Activity, (b) essential to the completion of the Section 7704(d)(1)(E) Activity, and (c) requires the provision of significant services to support the Section 7704(d)(1)(E) Activity. The final regulations adopt the "essential" prong of the intrinsic activities test with no changes. Further, the final regulations also clarify that the "significant services requirement" can be met through affiliates or subcontractors, in addition to the MLP's own employees, as long as they are being compensated by the MLP. For the "specialized requirement," and particularly related to water services, the final regulations reiterate that the mere delivery of water is insufficient to meet the Intrinsic Activities requirements. Rather, the provision of water for use as an injectant in a Section 7704(d)(1)(E) Activity is specialized to that activity only if the partnership: (a) provides the water exclusively to those engaged in Section 7704(d)(1)(E) Activities, (b) is also in the trade or business of cleaning, recycling, or otherwise disposing of water after use in accordance with federal, state or local regulations concerning waste products from mining or production activities, and (c) operates these disposal services within the same geographic area as that in which it delivers water (adopting a "basin-by-basin" approach, as opposed to a "well-by-well" approach). The final regulations as published in the Federal Register on January 24, 2017, state that they apply to income earned by a partnership in a tax year beginning on or after January 19, 2017. A transition period exists, however, until the period that ends on the last day of the partnership's tax year that includes the date that is 10 years after January 19, 2017 (the Transition Period). The Transition Period operates in substance in a very similar manner to that described in the proposed regulations; helpfully, the IRS and Treasury clarified that a technical termination of a partnership would not terminate the Transition Period for an affected partnership. Overall, the final regulations represent a marked improvement over the proposed regulations in many (but not all) respects. The final regulations appear to provide a workable and flexible framework for companies and advisors to evaluate whether certain activities would generate qualifying income under Section 7704(d)(1)(E). In the final regulations, the IRS and Treasury adopted many (but not all) of the proposed changes or clarifications that companies, advisors, and other interested parties submitted during the comment period for the proposed regulations. For existing MLPs with mineral-related or natural resource-related income-producing assets that do not produce "qualifying income" under the final regulations, the Transition Period provides temporary relief. Companies that are not yet publicly traded but aspire to become publicly traded MLPs in the future would generally need to meet the requirements set forth in the final regulations. As noted, the publication of the final regulations after the January 20, 2017 Trump White House Memo instructed executive department and agency heads to withdraw unpublished regulations from the Federal Register raises some uncertainty about the regulations' effectiveness.
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