Final regulations issued on publicly traded partnership minerals or natural resources qualified income

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Robert Watkins
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Tax Insights from the National MLP Practice Final regulations issued on publicly traded partnership minerals or natural resources qualified income February 2, 2017 On January 20, 2017, President

1 Tax Insights from the National MLP Practice Final regulations issued on publicly traded partnership minerals or natural resources qualified income February 2, 2017 On January 20, 2017, President Trump s Chief of Staff, Reince Priebus, sent a regulatory freeze to the heads of Executive Departments and Agencies, ordering in part that any regulations that were sent to the Office of the Federal Register that had not yet been published were to be immediately withdrawn for review and approval by a "department or agency head appointed or designated by the President after noon on January 20, 2017." The final qualifying income regulations, described below, were not yet published and presumed by many to be subject to the freeze. Nonetheless, the final qualifying income regulations were published in the Federal Register on January 24. We note that some commentators have questioned the validity of the regulations in light of the order. In brief On January 19, 2017, the IRS issued final regulations under Section 7704(d)(1)(E) (final regulations) addressing qualified income derived from minerals or natural resources by a publicly traded partnership (PTP). The final regulations adopt many of the provisions of the proposed regulations issued on May 5, 2015 with several significant modifications. The final regulations will apply to income earned by a partnership in taxable years beginning on or after January 19, 2017 subject to additional transition rules described below. Thus, for practical purposes, the regulations generally will apply to PTPs for tax years beginning on January 1, In detail The final regulations are divided into seven parts: (1) Basic rules establishing income and gains from Section 7704(d)(1)(E) and intrinsic activities as qualifying income; (2) Definition of mineral or natural resource; (3) Definition of exploration, development, mining or production, processing, refining, transportation, and marketing including specific identification of component activities; (4) Rules for determining intrinsic activities, (5) Rules interpreting Section 611 with respect to examples in the final regulations; (6) Rules interpreting Section 613 with respect to examples in the final regulations, and; (7) The effective date of the final regulations and the transition period. The first part of the final regulations establishes the basic rule that qualifying income includes income and gains from qualifying activities. Qualifying activities are defined in the final regulations as Section 7704(d)(1)(E) activities or intrinsic activities which are defined below. PwC 1

2 Definition of Mineral or Natural Resource Section 7704(d)(1) defines a mineral or natural resource as any product of a character with respect to which a deduction for depletion is allowable excluding soil, sod, dirt, turf, water, mosses, and minerals from sea water, the air, or other similar inexhaustible sources. The final regulations also clarify that qualifying activities with respect to a mineral or natural resource can occur regardless of whether the activity is conducted by the party whom extracted the mineral or natural resource. Therefore, there is no requirement for continual ownership of the mineral or natural resource from extraction through the conduct of the qualifying activities. However, Treasury and the IRS declined to expand the definition of mineral or natural resource to include products thereof, stating that an expansion would imply that a mineral or natural resource could be processed or refined without limitation. Section 7704(d)(1)(E) enumerated activities In response to comments, the final regulations remove the proposed exclusive list of qualifying activities in favor of providing general definitions of the Section 7704(d)(1)(E) activities. Nonetheless, the final regulations state that they are not intended to be interpreted or applied in an expansive manner. Instead, the IRS stated that the regulations should be interpreted in a manner consistent with their plain meaning and Congressional intent in providing for an exception to section 7704(a) for these activities related to minerals and natural resources. Observation: Although the final regulations do not include the proposed regulations exclusive list of qualifying activities, the IRS is putting taxpayers on notice that it intends to interpret final regulations definitions narrowly. Therefore, we expect that a private letter ruling would be necessary with respect to any activity not included on the list of examples of qualifying activities to confirm application of the rules in a particular situation. Exploration The final regulations define exploration 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. Development The proposed regulations define development as an activity performed to make minerals or natural resources accessible. Mining or production: The final regulations define mining or production as an activity performed to extract minerals or other natural resources from the ground. In addition, the definition of mining or production in the final regulations includes extraction of minerals or natural resources from the waste deposits or residue of prior mining or production. Processing and Refining The final regulations substantially change the definitions of processing and refining that were set forth in the proposed regulations. The proposed regulations provided a combined definition of processing and refining. In response to comments, the final regulations provide for separate definitions of processing and refining activities. The final regulations provide general definitions of processing activities for PwC 2

3 various natural resources; however, general definitions are not provided for refining activities. Instead, the final regulations address the activities that qualify as refining activities. The manufacturing limitation implemented by the proposed regulations has been removed. Instead, the final regulations include in the definitions of processing and refining only those activities that are performed at field facilities and petroleum refineries, or those that produce products typically found at field facilities and petroleum refineries. The proposed regulations contained a requirement that property used in a processing and refining activity must be consistently classified as processing and refining under the MACRS asset classes provided in Rev. Proc In response to a number of comments, the final regulations state that MACRS class lives are not comprehensive, and therefore, the final regulations removed the MACRS consistency requirement introduced in the proposed regulations. The NAICS codes reference provided in the proposed regulation s definitions of processing and refining were also removed. Acknowledging that processing and refining can cause a substantial physical or chemical change to natural resources, the IRS also removed the general physical or chemical change limitation that appeared in the proposed regulations. 1. Processing Under the final regulations, qualifying processing activities are those activities that convert raw mined or harvested products or raw well effluent into substances that can be readily transported or stored. Similar to the proposed regulations, the final regulations provide specific definitions of processing for different types of natural resources. With respect to natural gas, processing or refining processes are qualifying only if the activity purifies natural gas or separates natural gas into its gaseous and liquid components. While the proposed regulations also treated the conversion of methane in one integrated conversation into liquid fuels that are otherwise produced from petroleum as processing, the final regulations remove this activity from the qualified processing of natural gas. Under the final regulations, processing of crude oil only includes those activities performed to separate produced fluids by passing crude oil through mechanical separators, placing crude oil in settling tanks, dehydration, and certain separation processes common in the operation of heatertreaters. The final regulations add specific definitions of processing with respect to ores and minerals as well as timber. With respect to ores and minerals, certain mining processes defined in regulations under Section 613 are included as processing of ores and minerals for purposes of Section With respect to timber, qualifying activities that constitute the processing of timber are those activities that modify the physical form of the timber. Such activities include the application of heat or pressure to timber. Products which result from the processing of timber include wood chips, sawdust, and wood pellets. The final regulations specifically state certain products that do not result from the processing of timber, including (but not exclusively) pulp, paper, treated lumber, and paper products. 2. Refining The final regulations do not provide a general definition of refining activities with respect to natural gas and crude oil, instead, the regulations provide a list of qualifying products. This list is generally derived, with some modifications, from information provided by the US Energy Information Administration which lists products produced by a refinery. Qualifying refining activities include the further physical or chemical conversion or separation processes of these listed products. Additionally, the blending of petroleum hydrocarbons to the extent such blending gives rise to a listed product or products generally produced in a refinery or blending of listed products themselves give rise to qualified refining activities. PwC 3

4 OBSERVATION: In contrast to the proposed regulations, the final regulations do not differentiate between products derived from natural gas and crude oil. For example, under the proposed regulations, refining activities which derived olefins (e.g., ethylene and propylene) from the component parts of crude oil were considered qualifying activities while the refining activities which derived olefins from natural gas were excluded. The final regulations also clarify that certain products are specifically excluded from the definition of refining. These include heat, steam, or electricity and any products that result from further chemical change of a qualified refinery product. The final regulations define refining of ores and minerals to include any process performed subsequent to a mining process which eliminates impurities or foreign matter and which are necessary to achieve a high degree of purity from ores and minerals which are not generally sold in the form of the raw material. The final regulations identify these ores and minerals as lead, zinc, copper, gold, silver, and any other ores or minerals the Commissioner may identify in future guidance. Transportation The final regulations define transportation as activities performed to move minerals or natural resources, and the products of qualifying processing and refining activities, including by pipeline, marine vessel, rail, or truck. Transportation also includes: Terminalling; Providing storage services; Separating and selling excess RINs acquired as part of additization services Operating marine vessels; Providing compression services to a pipeline; Operating gathering systems and custody transfer stations; Liquefying or regasifying natural gas; and, Qualified blending and additization services. Transportation includes the movement of minerals or natural resources, and products included under mining, processing and refining via pipeline to a place that sells to retail customers. Transportation also includes the movement of liquefied petroleum gas via trucks, rail cars, or pipeline to a place that sells to retail customers or directly to retail customers. Marketing Marketing is defined under the final regulation as the activities undertaken to facilitate the sale of minerals or natural resources, or products produced from processing and refining, including bulk and wholesale sales made to end users. The regulations provide that other than bulk and wholesale sales, marketing does not include retail sales. Fertilizer The final regulations reserve on the definition of fertilizer. Additional activities The final regulations also address certain activities that are not exclusive to any one qualifying activity otherwise listed in the final regulations. PwC 4

5 1. Cost reimbursements Reimbursement of costs, whether separately stated or included in rates, will constitute qualifying income if the costs were incurred in performing a qualified activity listed in the final regulations. These costs include the cost of designing, constructing, installing, inspecting, maintaining, metering, monitoring, or relocating an asset used in the qualifying activity or providing back office services necessary to the qualifying activity. 2. Hedging Several comments in response to the proposed regulations requested guidance on whether income and gains derived from hedging transactions entered into in the normal course of business which manage the PTPs commodity price exposure should be included as qualifying income. The preamble to the final regulations states that the IRS generally agrees that hedging income as well as the deductions and losses derived from a section 7704(d)(1)(E) activity should give rise to qualifying income. Nevertheless, the final regulations reserve on the issue, and the IRS has requested additional comments on the appropriate manner to account for the income and gains as well as the deductions and losses with respect to hedges. 3. Passive Interests Income and gains from a passive interest or non-operating interest in a mineral or natural resource are qualifying income. Non-operating interests include royalties, net profits interests, and leasebonus payments. However, production payments are not included as qualifying income if the payments are treated as loan payments. 4. Blending The final regulations include income and gains from blending activities or services with respect to products that are qualified mining, processing, or refining products as qualifying income. The products blended must be component parts of the same mineral or natural resource oil and natural gas are considered as part of the same natural resource. The activity of blending different minerals or natural resources (or products thereof) together is excluded from the definition of qualified blending activities. 5. Additization Under the final regulations, income and gains from certain additization services constitutes qualifying income if the additives aid in the transportation of a product, enhance or protect the intrinsic properties of a product, or are necessary under applicable law. The enumerated additization services include: a. Addition by the terminal operator or a person upstream of the terminal operator of additives to products of natural gas and crude oil, provided that the additives are less than 5% of the total volume of the natural gas and crude oil products (20% for ethanol or biodiesel); b. Addition of incidental amounts of material to aid in transportation of ores and minerals; and c. Addition of incidental amounts of material to comply with government regulations with respect to timber. In all cases, the final regulations make clear that the addition of the additives must not create a new product. Intrinsic Activities Under the final regulations, income from qualifying intrinsic activities, is qualifying income. For certain oilfield services, the final regulations adopt the three-prong test of the proposed regulations on an activity-by-activity basis. To be considered a qualifying intrinsic activity, an oilfield service must satisfy each of the three requirements described below. PwC 5

6 Specialized personnel and property First, the personnel performing and the property used in the service must be specialized to support the qualifying Section 7704(d)(1)(E) activity. Personnel performing the activity must have received training unique to the industry and that training must have limited applicability outside the industry. The final regulations clarify that personnel includes employees of the partnership, an affiliate, subcontractor, or independent contractor performing work on behalf of the partnership. Property used in the performance of the service is specialized if it is used only in connection with the qualifying activity, has limited use outside the industry application, and is not easily converted into nonspecialized property. However, the use of non-specialized property that is typically used in the industry to perform incidental services will not cause the partnership to fail this prong of the intrinsic activity test. The final regulations provide a specific exception for injectants (such as water) which may have general uses outside the industry as long as the PTP both delivers and collects/disposes of the waste product, the injectant is provided exclusively for the use in qualifying activities, and the injectant delivery and disposal services are conducted in the same geographic area. Essential, necessary or required for completion of the activity Second, the service must be essential to the completion of a qualifying Section 7704(d)(1)(E) activity. A service is essential if it is necessary to physically complete the qualifying Section 7704(d)(1)(E) activity or is required to comply with federal, state, or local laws regarding the qualifying Section 7704(d)(1)(E) activity. Provision of significant services required Third, the qualifying Section 7704(d)(1)(E) activity for which the services are being provided must require the provision of significant services to support the qualifying activity. In order to satisfy the significant services requirement of the final regulations, the personnel providing the services must have an ongoing or frequent presence at the site of the qualifying Section 7704(d)(1)(E) activity. This determination is made based on all of the facts and circumstances. However, the final regulations provide an exception for certain services performed offsite. For example, monitoring services may be performed offsite, provided that those services are provided exclusively to a partnership engaged in qualifying activities. The final regulations specifically exclude services that principally involve the design, construction, manufacturing, repair, maintenance, lease, or rental of property from the definition of significant services. Effective Date and Transition Rules The final regulations will apply to income earned by a partnership in a taxable year beginning on or after January 19, Additionally, the final regulations provide for a transition period to treat income earned by a PTP as qualifying income, even if such income does not qualify under the final regulations, on a prospective basis for a ten year period which ends January 19, Furthermore, the final regulations clarify that the ten year transition period is not ended by a technical termination of a partnership Observation: Any publicly traded partnership with a private letter ruling that is in conflict with the final regulations must restructure its businesses during the 10 year transition period. Conclusion The final regulations address a number of comments on the proposed regulations received from the PTP industry and its representatives while retaining the overall format. While the removal of the exclusive list from the final regulations provides relief from the restrictive nature of the proposed regulations, the current list of qualifying activities should not be construed broadly. The final regulations also PwC 6

7 acknowledge that similar products derived from crude oil and natural gas should not be treated differently, a major source of concern that arose from the proposed regulations. Additionally, the IRS s separation of refining and processing activities better aligns with activities common in the PTP space. Next Steps PTPs with extensive hedging activities should consider submitting comments to Treasury and the IRS to address various types of hedging activities, including commodity hedges, price and interest rate risk hedges, which could give rise to qualifying income in certain situations. The final regulations reserve on fertilizer, therefore, PTPs producing fertilizer and similar products should consider submitting comments to Treasury and the IRS to address industry specific activities that should give rise to qualifying activities. Let s talk For more information, please contact: Mergers & Acquisitions Audrey Ellis Michael Hauswirth Managing Director Director audrey.ellis@pwc.com michael.j.hauswirth@pwc.com Master Limited ships Robert Baldwin Timothy Watkins robert.baldwin@pwc.com timothy.r.watkins@pwc.com Michael Moreland Scott Dillow michael.w.moreland@pwc.com scott.r.dillow@pwc.com Christopher LaGrone Director christopher.s.lagrone@pwc.com This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility of duly care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers ("PwC") refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity PwC 7

Background and timeline

Background and timeline Oil & Gas alert Final regulations released on MLP qualifying income under Section 7704(d)(1)(E) for MLPs engaged in mineral or natural resource-related activities On 19 January 2017, the Internal Revenue