Chapter 5 Master Limited Partnerships

Transcription

1 CITE AS 28 Energy & Min. L. Inst. ch. 5 (2008) Chapter 5 Master Limited Partnerships Patrick W. Mattingly Wyatt, Tarrant & Combs, LLP Louisville, Kentucky Synopsis Overview [1] Introduction [2] Structure [3] The 90 Percent Gross Income Requirement [4] Mineral and Energy Industry [5] Oil and Gas Activities [a] Introduction [b] Transportation [c] Other Oil and Gas Activities [6] Determination of Publicly Traded Partnership Status [7] Established Securities Markets [8] Readily Tradeable on a Secondary Market [9] Origin [10] Legislative History [11] Governance Advantages and Disadvantages [1] Advantages [a] Taxation [b] Control [c] Retail Interest [d] Advantage Per Type [2] Disadvantages [a] Interest Rate Risk [b] Cumbersome Administrative Requirements [c] Governance [d] Disincentive to Accumulate Capital [e] Loss of Certain Market of Investors Regulatory Environment and Potential Litigation Issues for MLPs [1] Introduction [2] FERC Litigation Involving Tax Allowance for MLPs Recent Legislation Applicable to MLPs [1] American Jobs Creation Act of [2] State Efforts to Incorporate MLPs into Their Laws...137

2 5.01 ENERGY & MINERAL LAW INSTITUTE [a] Texas [b] Kentucky [c] Oklahoma [d] Pennsylvania [e] Louisiana [f] Oregon Tax Treatment [1] Introduction [2] Partnership Qualification [3] Income and Gains from Minerals and Natural Resources [4] Inadvertent Terminations [5] Effect of Termination of Partnership Status [6] Tax Advantages to Investors [7] Additional Federal Tax Considerations [a] Application of Passive Loss Rules [b] Tax-Exempt Organizations [c] Mutual Funds [8] State Tax Matters Investment Characteristics Recent Developments Conclusion Overview. [1] Introduction. A master limited partnership (MLP) is a domestic or foreign business entity taxable as a partnership under the Internal Revenue Code of 1986, as amended (the Code), the interests in which are readily tradeable on (a) an established securities market or (b) a secondary securities market (or the substantial equivalent of a secondary securities market). 1 MLPs are also referred to as publicly traded partnerships (PTPs) and throughout this article the terms will be used interchangeably. For federal income tax purposes, the term partnership as used in Section 7704 of the Code is a tax concept as opposed to a state law concept. A partnership interest includes: 1. any interest in the capital or profits of the partnership (including the right to partnership distributions); and 1 Treas. Reg (a) (1995). 118

3 MASTER LIMITED PARTNERSHIPS any financial instrument or contract the value of which is determined in whole or in part by reference to the partnership (including the amount of partnership distributions, the value of partnership assets, or the results of partnership operations). 2 Thus, although referred to as partnerships from a tax perspective, an MLP can take the form of a variety of legal entities created under state law, such as partnerships, limited liability companies and other unincorporated entities. The determinative factor is whether the applicable legal entity falls within the definition of a partnership for federal tax purposes. In accordance with Section 7704 s general rule, absent an exception, MLPs are taxed as corporations under Subchapter C of the Code. 3 This exception allows an MLP to be taxed as a partnership under Subchapter K of the Code if 90 percent or more of its gross annual income consists of qualifying income. 4 [2] Structure. MLPs are typically formed as limited partnerships under the Delaware Revised Uniform Limited Partnership Act. The general partner is a separate entity which typically owns two percent interest in the MLP and manages its day-to-day operations. The MLP can be capitalized through the sale of limited partnership interests (typically referred to as common units ) to outside investors via private and/or public offerings. The general partner interests are held by a separate entity that may or may not be a publicly traded company. Depending upon the circumstances, this entity is sometimes referred to as the MLP s sponsor. [3] The 90 Percent Gross Income Requirement. In order to qualify for partnership-type, flow-through tax treatment, a partnership with publicly traded interests must receive not less than 90 2 Id (a)(2)(i). 3 I.R.C. 7704(a) (2004). 4 Id. 7704(c). 119

4 5.01 ENERGY & MINERAL LAW INSTITUTE percent of its gross annual income in the form of qualifying income. 5 In general, qualifying income consists of the following: 1. dividends; 2. rents; 3. realized real estate gains; 4. mineral and energy income and gains; 5. realized capital asset gains; and 6. income and gains from commodities trading (including the purchase and sale of options, futures, or forward purchase contracts on commodities). [4] Mineral and Energy Industry. With respect to the mineral and energy industry, qualifying income means income and gains derived from exploration, development, mining, production, processing, refining, transportation (including pipelines, transporting gas, oil, or products thereof) or marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber). 6 For these purposes, minerals and natural resources include any product of a character with respect to which a deduction for depletion is allowable under Section 611 of the Code. 7 The following products are not considered minerals or natural resources for these purposes: 1. dirt; 2. sod; 3. mosses; 4. turf; 5. water; or 6. minerals from sea water, the air, or similar inexhaustible sources. 5 Id. 7704(d). 6 Id. 7704(d)(1)(E). 7 Id. 7704(d)(1)(last sentence). 120

5 MASTER LIMITED PARTNERSHIPS 5.01 [5] Oil and Gas Activities. [a] Introduction. Oil and gas operations are generally broken down into the following three broad categories: 1. Upstream Assets Upstream assets are assets used in the exploration for, or in the development and marketing of, crude oil, natural gas liquids, etc. This category often includes oil and natural gas reserves, rigs, drilling, and production assets Midstream Assets Midstream assets are those used in the refining of crude oil, or the transportation, distribution, and marketing of refined oil and natural gas products. This includes treatment facilities, pipelines, distribution terminals, storage facilities, and other transportation and refining assets Downstream Assets Downstream assets generally consist of assets such as refineries, storage facilities, local distribution companies that market and sell oil and gas products to retail and wholesale customers and other large end users. 10 [b] Transportation. In general, income generated by the bulk transportation of oil and gas (and products derived therefrom) constitutes qualifying income for purposes of the MLP rules. This status applies regardless of whether the method of transportation involves barge, rail, truck or pipeline. Furthermore, in the case of pipeline transportation, this general rule applies regardless of whether or not the end recipient is a retail customer. In the case of other (i.e., non-pipeline) modes of transporting oil and gas (and other products derived therefrom), any income generated from such activities will be not be qualified 8 David Alexander, Fact and Fiction of Master Limited Partnerships, RMA J., Nov Id. 10 Gabe Moreen et al., Merrill Lynch, Natural Gas Pipelines, An Investor Guide to Energy MLPs (Nov. 21, 2006). 121

6 5.01 ENERGY & MINERAL LAW INSTITUTE if the transportation is to a site from which the products transported are sold to retail customers (as opposed to refiners or processors). 11 Thus, the operation of retail gas stations would not generate qualifying income. [c] Other Oil and Gas Activities. Qualifying income can be generated by such diverse activities as marketing oil and gas in connection with exploration, development, processing or refining; buying and selling derivative products to hedge against price risks; borrowing money to develop the borrower s reserves; and storing oil and gas resources and their products. [6] Determination of Publicly Traded Partnership Status. Unless grandfathered, in order to avoid being taxed as a corporation, an MLP must meet the 90 percent qualified income test for each of its taxable years beginning with its first taxable year that ends after December 31, For purposes of making this determination, if a private partnership becomes publicly traded, it will only be held accountable to the 90 percent qualified income standard beginning with its first taxable year ending after its conversion to publicly traded partnership status (i.e., there are no lookback provisions). An inadvertent failure to meet the 90 percent gross income requirement can be waived by the IRS upon its determination that such failure was indeed inadvertent if (i) the partnership acts to rectify the situation within a reasonable time after learning thereof, and (ii) the partnership agrees to make any adjustments or pay such amounts as required by the IRS. 12 [7] Established Securities Markets. Established securities markets include the following: 1. recognized national securities exchanges such as the New York Stock Exchange, the American Stock Exchange and NASDAQ; 11 H.R. Rep. No. 1104, 100th Cong., 2d Sess. II-17 to II-18 (1988), C.B. 473, , as reprinted in 1988 U.S.C.C.A.N. 5048, I.R.C. 7704(e) (2004). 122

7 MASTER LIMITED PARTNERSHIPS regional/local stock exchanges such as the Boston Stock Exchange, the Cincinnati Stock Exchange, the Pacific Stock Exchange and the Philadelphia Stock Exchange; 3. certain recognized foreign stock exchanges such as the London International Financial Futures Exchange, the Marche a Terme International de France, the International Stock Exchange of the United Kingdom and the Republic of Ireland, Limited, the Frankfurt Stock Exchange, and the Tokyo Stock Exchange; and 4. an interdealer quotation system that regularly disseminates firm buy and sell quotations by identified brokers or dealers by electronic means or otherwise. [8] Readily Tradeable on a Secondary Market. The general rule is that an MLP is considered readily tradeable on a secondary market (or the substantial equivalent thereof) if, taking into account all of the facts and circumstances, the owners of the partnership interests are readily able to purchase, sell, or exchange such interests in a manner that is comparable, economically, to purchasing, selling or exchanging such interests on an established securities market. 13 Examples of this general rule with respect to partnership interests include the following situations: 1. a broker or dealer makes a market in the partnership interests and provides regular price quotes with respect thereto; and 2. one or more persons provide bid and offer quotes and stand ready to purchase or sell such partnership interests at the quoted prices. Partnership interests that are otherwise tradeable by means of an interdealer quotation system or on a secondary market (or the substantial equivalent thereof) will not be deemed to be publicly traded if the partnership 13 Treas. Reg (c)(1). 123

8 5.01 ENERGY & MINERAL LAW INSTITUTE does not acquiesce to the inclusion of its interests therein or refuses to redeem such partnership interests or recognize the transferees as partners. 14 [9] Origin. The first MLPs were created in the early 1980s when several limited partnerships opted to issue their shares publicly through a public offering of their limited partnership interests, which they generally referred to as common units and which were typically listed on a national stock exchange. By the time of enactment of Section 7704 in 1987, approximately 120 master limited partnerships had been formed. While the range of businesses formed as MLPs varies greatly, the vast majority of MLPs are in the mineral and energy and real estate industry segments. Congress enacted Section 7704 out of concern that the rising popularity of master limited partnerships would result in a long-term erosion of America s corporate tax base. Specifically, if enough corporations converted to master limited partnerships, corporate tax revenues might be materially adversely affected. By taxing publicly traded partnerships as corporations in general, Congress sought to prevent the conversion into MLPs by businesses producing active income (as opposed to passive income) driven primarily by tax-avoidance desires. Another reason Congress enacted Section 7704 was its view that the freely tradeable nature of publicly offered limited partnership units created such a lack of identity between the issuer thereof and the holders thereof so as to justify taxing the partnership as an entity separate from its owners. [10] Legislative History. The tax rules governing publicly traded partnerships were added to the Internal Revenue Code as Section 7704 by section 10211(a) of the Omnibus Budget Reconciliation Act of The final regulations grandfathered 14 Id., (d). 15 Omnibus Budget Reconciliation Act of 1987, Pub. L. No , 101 Stat. 1330, 10211(a), as amended by the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No , 102 Stat. 3772, 2004(f)(1)-(5). 124

9 MASTER LIMITED PARTNERSHIPS 5.01 existing MLPs which were engaged in active business operations prior to December 4, 1995, such that unless they added a substantial new line of business, they would be exempt from such regulations for 10 years (i.e., until their tax years ended after December 31, 2005). Businesses that added a substantial new line of business during such interim period became subject to the regulations for their taxable years beginning on or after such addition. For these purposes, a substantial new line of business is any business activity that is not closely related to a pre-existing business of the partnership that generates non-qualifying income and that generates more than 15 percent of the partnership s gross annual income or as to which the partnership directly deploys greater than 15 percent of its total assets. 16 [11] Governance. Most MLPs are formed as limited partnerships under the Delaware Revised Uniform Limited Partnership Act (DRULPA). 17 DRULPA has as its stated policy giving maximum effect to the principle of freedom of contract and the enforceability of partnership agreements governed by its provisions. 18 Accordingly, forming an MLP under DRULPA provides the general partner a significant amount of control over the partnership while at the same time allowing it to contractually limit or eliminate most of its potential liability to the limited partners for breach of fiduciary duty. Specifically, under DRULPA, a general partner can limit or eliminate some or all of its liabilities to the limited partners for breach of contract and/or fiduciary duties, provided that the partnership agreement may not limit or eliminate liability for a bad faith violation of the implied contractual covenant of good faith and fair dealing. 19 Thus, the governance structure of a typical master limited partnership is more contractual than legislative in nature. 16 Treas. Reg Delaware Revised Uniform Limited Partnership Act, 6 Del. Code Ann , et seq. (2006). 18 Id., (c). 19 Id., (f). 125

10 5.02 ENERGY & MINERAL LAW INSTITUTE Notwithstanding these state law considerations, the governance of master limited partnerships that are traded on a national stock exchange, such as the New York Stock Exchange (the NYSE) or the National Association of Securities Dealers Automated Quotation system (NASDAQ), will be affected by the governance rules of such exchange. For example, in order to maintain a listing on NASDAQ, the general partner of a master limited partnership must, among other things, comply with certain specific requirements including specifications as to: 1. the maintenance of audit committees; and 2. an independent review of potential material conflicts of interest situations where appropriate Advantages and Disadvantages. MLPs are attractive investment tools because they combine the tax benefits of a partnership with the liquidity of publicly traded securities. Following is a summary of some of the commonly cited advantages and disadvantages of MLPs. [1] Advantages. In general, investors like MLPs for the stability of the cash flows that are not taxed at the entity level. The combination of high current return, lower volatility in relation to other classes and high overall returns makes this investment vehicle appealing. Generally a company decides to be a MLP to avoid double taxation of dividends and because they are able to maintain control over the business. The MLP structure offers advantages for companies that want to grow because the new capital is used to acquire new assets that in turn increase the value of the MLP to the investors. [a] Taxation. There are several tax benefits to MLPs. First, in contrast to the earnings of most publicly traded corporations, which are taxed twice once at the 20 See NASD Manual, NASD Rule

11 MASTER LIMITED PARTNERSHIPS 5.02 corporate level and once at the shareholder level an MLP s earnings are taxed only once at the unitholder level. Consequently, the MLP can pay out significantly more of its cash flow to the unitholders than a corporation. Second, the non-cash expenses of the MLP, such as depreciation, depletion and other business deductions, directly benefit the unitholders since such expenses diminish the taxable income passed through to the unitholders. Third, almost all of the revenue passed through to the unitholders is classified as return of capital so it is not subject to income tax. Distributions are generally 80 percent to 90 percent tax deferred until the unit is sold. As a result, yearly income tax applied to MLP distributions will be less than the tax applied to an equity dividend that offers similar pretax yield. Taxes on the deferred portion of the distribution will be taxed as ordinary income, but the majority of these taxes are paid when the unit is sold rather than in the years in which distributions are received. When the unit is sold much of the gain is taxed as capital gain. [b] Control. The MLP provides the sponsor more control than in a corporate model where a large shareholder may limit power. Further, from an investor standpoint, MLPs have an incentive to maintain a good governance model because they have to continually convince investors that the MLP is a good investment to keep receiving capital. [c] Retail Interest. There is a strong retail interest in MLPs because institutions do not dominate MLPs as they do the overall market. MLPs offer investors a security free, to some extent, from the volatility that large institutional holdings cause for common stock. MLPs generally create income which is taxable to taxexempt entities such as pension and profit-sharing plans, IRAs and charities. MLPs sometimes substitute what are known as i-units or i-shares that make distributions in stock rather than cash to avoid the potential tax issue in IRAs and pension accounts. These units can be held in IRAs without penalty. Affiliates of Kinder Morgan and Enbridge have issued such units, but the i-units are complex securities and appear to be falling out of favor. 127

12 5.02 ENERGY & MINERAL LAW INSTITUTE In the past, mutual funds were not active with MLPs because they could lose their status as a non-tax paying entity if they had too much (more than 10 percent) non-qualified income. This was changed by the American Jobs Creation Act of 2004, which considers income from MLPs one of the sources of qualifying income for mutual funds. [d] Advantages Per Type. Drop-down MLPs are typically used to increase unitholder value by focusing public attention on undervalued assets, to enhance takeover defense strategies, to provide a low-cost financing tool and to improve balance sheet presentation of debt with equity. Roll-up MLPs are used to increase overall financial strength, promote administrative efficiency by consolidating programs, offer liquidity and provide an acquisition vehicle for future operations. Liquidation MLPs are used to increase current after-tax cash flow available for distribution and to move appreciation outside the range of corporate taxation. [2] Disadvantages. While there are many advantages to MLPs there are also several disadvantages. Additionally, several of the advantages from the investor perspective are disadvantages from the company perspective and vice versa. [a] Interest Rate Risk. MLPs can experience flat to negative returns as interest rates increase. MLPs can offset some of the decline by raising their distributions. The ability to do this, however, is at least in part dependent upon energy prices remaining strong. MLPs may be less sensitive to rising interest rates than other highyield investments, like junk bonds and Real Estate Investment Trusts. [b] Cumbersome Administrative Requirements. MLPs are subject to various reporting requirements in states in which the MLP operates. Additionally, the preparation of tax returns for unit holders is more difficult because investors receive a K-1 as opposed to a Also, 128

13 MASTER LIMITED PARTNERSHIPS 5.03 an investor may be required to pay his or her allocable share of state taxes in the states in which the MLP does business. [c] Governance. An investor has little say in the corporate governance even if it owns a large portion of the LP units unless the investor is also the general partner. While most MLPs have a board of directors, the board is comprised of the directors of the general partner. Further, most MLP agreements provide that the general partner has full control over all activities of the partnership. [d] Disincentive to Accumulate Capital. Due to the pass-through characteristics of the MLP, industries that require large capital outlays may not find the structure attractive unless those outlays can be financed by new equity or debt financing. [e] Loss of Certain Market of Investors. While individual investors may find it appealing for the MLP to have primarily individual unitholders instead of institutions, the companies may find this a disadvantage because a whole group of investors is unavailable. Further, foreign investors typically are not interested in MLPs as they are at a disadvantage. Foreign investors are treated as engaged in the activities of the MLP so they must file a United States tax return and pay United States taxes Regulatory Environment and Potential Litigation Issues for MLPs. [1] Introduction. Oil, gas, and coal companies are subject to a myriad of regulatory agencies, including federal and state environmental agencies. This section does not confront all of the agencies that regulate oil, gas, and coal companies. Instead, this section highlights those regulatory agencies that may impact an entity s decision to become an MLP. For instance, when forming an MLP, an entity may choose to partially or completely merge with an existing MLP. If the entity is engaged prior to the 129

14 5.03 ENERGY & MINERAL LAW INSTITUTE merger in the transportation and sale of natural gas in interstate commerce, the entity must obtain permission from the Federal Energy Regulatory Commission (FERC or the Commission) under the Natural Gas Act (NGA). 21 FERC also regulates rates for natural gas and oil companies. 22 The rates that are set are reviewed by FERC to ensure that they are just and reasonable. 23 Factored into the determination of just and reasonable rates are costs, which include federal income taxes. Several issues have arisen concerning whether an MLP may be allocated cost of income taxes because, unlike a corporation, an MLP is a pass-through entity. [2] FERC Litigation Involving Tax Allocation for MLPs. FERC employs cost of service ratemaking, wherein the Commission ensures that rates are just and reasonable while also ensuring that the rates yield sufficient revenue to cover all proper costs, and provide an appropriate return on capital. 24 The general rule is that taxes are recoverable from ratepayers as costs. 25 Where an entity is part of a consolidated group and only a portion is regulated, the general rule is complicated. Two tests arose to calculate tax costs for a utility that is part of a group. Under the flow-through test, the Commission derive[d] an effective tax rate by determining the ratio of each [regulated] pipeline s taxable income to the total taxable income of all affiliates, multipl[ied] this fraction by the group s consolidated tax liability, and divided this figure by the pipeline s taxable income. 26 Under the stand-alone test, the Commission segregate[ed] the regulated entity, then determine[d] the taxable income and deductions [that 21 Natural Gas Act, 15 U.S.C. 717 et seq. (2005); Energy Policy Act, 42 U.S.C (1994) U.S.C. 7172; 15 U.S.C. 717c et seq U.S.C. 717c. 24 BP West Coast Prods., LLC v. FERC, 374 F.3d 1263, 1286 (D.C. Cir. 2004)(quoting City of Charlottesville v. FERC, 774 F.2d 1205 (D.C. Cir. 1985)). 25 Id. 26 Id. at 1286 (quoting City of Charlottesville, 774 F.2d at 1207). 130

15 MASTER LIMITED PARTNERSHIPS 5.03 were] specifically attributable to the utility s jurisdictional activities. 27 Then, the statutory tax rate was applied to the tax base, which yielded the tax allowance. 28 In BP West Coast Products, LLC v. Federal Energy Regulatory Commission, 29 the D.C. Circuit Court affirmed and remanded in part the Commission s ratemaking orders for SFPP, L.P. (SFPP), an entity whose operations include several oil pipelines. 30 Several parties intervened and protested FERC s ratemaking decision. Of particular interest to MLPs is the court s ruling reversing the Commission s decision that SFPP was entitled to a 42.7 percent income tax allowance in the cost of service allowable to SFPP. All parties to the appeal had claimed FERC s percentage was error. The shippers, and intervenors supporting the shippers, argued that no tax allowance should be included, while SFPP argued that a full income tax allowance should have been included in the rate calculation. 31 The D.C. Circuit noted that the complication of the income tax allowance for SFPP stemmed from the fact that SFPP was an MLP, so neither the flowthrough or stand-alone methodologies, which were used on corporations, were necessarily applicable, as MLPs incur no tax liability. 32 In its ruling below, FERC relied on its Lakehead Policy as authority to allocate a percentage of tax liability to SFPP. In the Lakehead Policy, FERC stated that if a regulated pipeline operated as a non-taxable partnership, then the tax allowance for corporations was not permitted, but that if the partnership had corporate partners, then it would treat the partnership as being in essence a division of each of its corporate partners for purposes of determining an income tax component in the partnership s cost of service computation. 33 SFPP, Inc., a C corporation, owned a 42.7 percent interest 27 Id. (quoting City of Charlottesville, 774 F.2d at 1207). 28 Id. 29 BP West Coast Prods., LLC v. FERC, 374 F.3d 1263 (D.C. Cir. 2004). 30 Id. 31 Id. at Id. at Id. at 1287 (quoting Lakehead Policy, 71 F.E.R.C. P 61,338, 62, 315 (1995)). 131

16 5.03 ENERGY & MINERAL LAW INSTITUTE in SFPP, L.P., so FERC concluded that under Lakehead, the partnership was entitled to the same percentage of taxation allowance. The Lakehead Policy had never been reviewed by a court, so the D.C. Circuit confronted an issue of first impression. The shippers argued that no tax allowance was permitted because no income taxes were paid by the partnership on partnership income. Thus, they argued, if an allowance were permitted, it would constitute an allowance for phantom taxes. SFPP, on the other hand, argued that FERC should use the stand-alone test which would treat the regulated entity as if it alone were responsible for taxes which would have been incurred on the same income had the jurisdictional pipeline been a taxable corporation. 34 The D.C. Circuit agreed with the shippers and concluded that on the record... SFPP is entitled to no allowance for the phantom taxes it did not pay. 35 The court held that the Commission s decision to permit an income tax allowance for the tax paid on partnership income by its corporate partners, but not permitting a tax allowance for partnership income held by individual interests who do not pay a corporate tax was not reasoned because there was no explanation for the different treatment of partnership income. 36 The court noted that the Commission was supposed to set rates in such a fashion that the regulated entity yields returns for its investors commensurate with returns expected from an enterprise of like risks. 37 Because a corporate investor would expect dual taxation in an unregulated investment, the court held that there should be no difference in expectations in a regulated investment. Thus, the court held, the regulator cannot create a phantom tax in order to create an allowance to pass through to the rate payer. 38 The court explained its reasoning by the following example: The regulated pipeline generates many costs, for example bookkeeping expenses. Presumably those bookkeeping expenses are 34 Id. at Id. 36 Id. at Id. 38 Id. at

17 MASTER LIMITED PARTNERSHIPS 5.03 recoverable in its rates. Its corporate unit holders, if any, presumably also have bookkeeping expenses. The bookkeeping expenses of the corporate unit holders are not recoverable in the rates of the pipeline, even though the corporation and its shareholders each may independently be paying bookkeepers and accountants unlike individual unit holders who pay only for their own accounting. All of this makes sense. It makes equal sense when applied to income taxes. 39 The court noted that while the Commission may have been trying to change the risk analysis of investors that were doubled taxed, the end result of the Commission s ruling was that these investors also bore the rate change that resulted from the allowance, which would change the profit margin for all investors, regardless of their corporate status. SFPP argued this reason justified including the tax liability of its non-corporate members (i.e., creating an allowance of 100 percent). The court agreed that if an allowance was permitted at all, it probably should have been across the board. However, the court stopped at the first step and held that no allowance was proper. 40 Over SFPP s argument to the contrary, the court held that previous case law did not suggest that it is the business of the Commission to create tax liability when neither an actual nor estimated tax is ever going to be paid or incurred on the income of the utility in the ratemaking proceeding. 41 Finally, the court rejected SFPP s argument that not permitting a tax allowance for pass-through partnerships would frustrate Congress s intent in excluding oil and gas publicly traded partnerships from taxation in order to facilitate investment in these enterprises. The court held that Congress s intent in Section 7704 of the Code was exhausted when the pipeline limited partnership was exempted from corporate taxation. 42 The court, thus, 39 Id. 40 Id. 41 Id. at Id. at

18 5.03 ENERGY & MINERAL LAW INSTITUTE reversed the Commission s order regarding use of the Lakehead Policy for tax allocation and remanded the matter to FERC. 43 In response to the BP West Coast decision, FERC issued the Policy Statement on Income Tax Allowances. 44 After public comment, the Commission concluded that an income tax allowance for partnerships or similar pass-through entities that hold interests in a regulated public utility... should be permitted on all partnership interests, or similar legal interests, if the owner of that interest has an actual or potential income tax liability on the public utility income earned through the interest. 45 The Commission asked for public comment before responding to the remand order because it was unsure whether the ruling was specific to the facts of the SFPP or was meant to apply to partnerships with other capital structures and other entities with pass through forms of ownership. The Commission noted that comments were sought because it was concerned that the denial of a tax allowance would create a reduction in expected returns that functioned as the basis of a person s investment in an oil or gas entity. 46 The specific issue was under what circumstances, if any, an income tax allowance should be permitted on... public utility income earned by various public utilities regulated by the Commission. 47 The Commission found that there were four options: (1) provide an income tax allowance only to corporations, but not partnerships; (2) give an income tax allowance to both corporations and partnerships; (3) permit an allowance for partnerships owned only by corporations; and (4) eliminate all income tax allowances and set rates based on a pre-tax rate of return. 48 After receiving comments, the Commission chose to return to pre- Lakehead Policy and permit an allowance, regardless of form, if an entity 43 Id. at Policy Statement on Income Tax Allowances, 111 F.E.R.C. P 61,139 (2005). 45 Id. at 61, Id. at 61, Id. at 71, Id. at 61,

19 MASTER LIMITED PARTNERSHIPS 5.03 or individual has an actual or potential income tax liability to be paid on that income from those assets. 49 The Commission agreed with the D.C. Circuit that Lakehead s distinction between corporate unit members and non-taxable unit members was unfounded because it improperly focused on who pays income taxes instead of focusing on what income taxes could be attributed to the regulated service. 50 To remedy this issue, the Commission held that a tax allowance would be provided to a tax-paying corporation, a partnership, a limited liability corporation, or other pass-through entity... on the income imputed to the corporation, or to the partners or the members of pass through entities, provided that the corporation or the partners or the members, have an actual or potential income tax liability on that public utility income. 51 Though the pass-through entity itself does not pay taxes, the members do, which the Commission held was just as much a cost of acquiring and operating the assets of that entity as if the utility assets were owned by a corporation. 52 The Commission reasoned that otherwise, denial of the allowance for pass-through entities would be a disincentive for use of this form because the return to the members of a pass-through entity would be less than that of a corporation and income taxes to corporations investing in this form would increase as they could not file consolidated tax returns. 53 The Commission held that this ruling would not result in an allowance for a phantom tax, because the income of pass-through entities is attributable directly to the owners of such entities and the owners have an actual or potential income tax liability on that income. 54 The Commission noted that the D.C. Circuit s concern with over-recovery of individual members would not be implicated by this policy statement because the allowance was limited to actual or potential tax liability Id. 50 Id. at 61, Id. at 61, Id. 53 Id. at 61, Id. at 61, Id. at 61,

20 5.03 ENERGY & MINERAL LAW INSTITUTE Finally, the Commission stated that the amount of any tax allowance would be made in individual rate proceedings wherein a regulated entity would be required to show the tax status of its owners, or if there is more than one level of pass-through entities, where the ultimate tax liability lies and the character of the tax incurred. 56 The Policy Statement was incorporated in full in FERC s order on remand in the consolidated appeals dealt with in BP West Coast. 57 As to the implication of the new Policy Statement, the Commission ordered a hearing to determine the actual or potential tax liability. 58 The Order following applied the tax allowance analysis formed in the Policy Statement and refined the procedure for proving a tax allowance was applicable. FERC rejected arguments that the Policy Statement and June 1, 2005 Order were inconsistent with BP West Coast. The Commission held that regardless of deductions or losses from partnership income in a particular year, if a partner is required to file a Form 1040 or Form 1120 return that includes a partnership income or loss[,] then that partner has an actual or potential tax liability. Among the other issues discussed in this Order were the marginal tax bracket to be applied, the effect of multiple levels of ownership, and the flow of the tax allowance benefits among the partners. 59 The BP West Coast decision and the FERC decisions thereafter have fueled a debate as to whether FERC s actions were consistent with the D.C. Circuit. In fact, Administrative Law Judge H. Peter Young held in a related case, SFPP, L.P., 60 that the Policy Statement was inconsistent with BP West Coast in two main respects. First, the ALJ held that the decision was inconsistent because it permitted a tax allowance at the non-utility level; and, second, that the Policy Statement did not ensure that the tax allowance reflected actual and equivalent income tax payments (i.e., actual cost) Id. 57 SFPP, L.P. v. Mobil Oil Corp., 111 F.E.R.C. P 61,334 (2005). 58 Id. at 62, Id. at 62, SFPP, L.P., 116 F.E.R.C. P 63,059, available at 2006 WL 273,0763 (2006). 61 Id. at *

21 MASTER LIMITED PARTNERSHIPS 5.04 Parties in unrelated cases also argued that FERC s Policy Statement on income tax allocation for MLPs was inconsistent with BP West Coast. 62 For instance, after the issuance of the Policy Statement, the Canadian Producers and the Missouri Public Service Commission sought clarification and rehearing of the statement. Their motions were denied because the Commission held that it would reserve further discussions of the issues contained [within the Policy Statement] for specific proceedings in which the policy is applied Recent Legislation Applicable to MLPs. Due in part to the increase in entities choosing the MLP form, there are several relatively recent pieces of legislation that are of note. [1] American Jobs Creation Act of The American Jobs Creation Act made it possible for mutual funds to invest in MLPs up to 25 percent of their capital in MLPs and up to 10 percent in one MLP. Qualifying income is now defined to include energy MLPs. Prior to the Act, mutual funds were reluctant to invest in MLPs because they would lose their tax advantaged status if more than 10 percent of its total income was received from an MLP or any other non-qualifying source of income. Eventually, this change providing that an MLP is a source of qualifying income to a mutual fund may result in increased participation of mutual funds investing in MLPs. [2] State Efforts to Incorporate MLPs into Their Laws. States have also begun to incorporate MLPs into their laws in various ways. For instance: 62 See Foster Natural Gas Report, Canadian Producers and Missouri Public Service Commission Cite Flaws in FERC s Tax Allowance Policy Statement, Issue 25,444 (June 9, 2005). 63 Inquiry Regarding Income Tax Allowance, 112 F.E.R.C. P 61203, available at 2005 WL , *1 (Aug. 19, 2005). 64 American Jobs Creation Act of 2004, Pub. L. No , 118 Stat. 1418, 331(a). 137

22 5.04 ENERGY & MINERAL LAW INSTITUTE [a] Texas. In 2003, Texas amended the definition of corporation to include master limited partnerships for gas and electric companies subject to the Utility Code. 65 [b] Kentucky. Kentucky specifically defines MLPs the same as the definition provided in the Code. 66 [c] Oklahoma. Oklahoma includes MLPs as a person subject to state laws regulating oil and gas. 67 [d] Pennsylvania. Pennsylvania excludes MLPs from paying state withholding tax on income attributed to nonresident partners. 68 [e] Louisiana. Louisiana law provides that MLPs may request an exemption from the composite payment requirements for nonresident partners. 69 [f] Oregon. In Oregon, [p]ersons carrying on business as partners in a publicly traded partnership are not subject to tax under O.R.S. chapter 316, 317 or 318 on their distributive shares of partnership income, but the publicly traded partnership is taxable as a corporation under O.R.S. chapter 317 or 318 as provided under O.R.S. chapter 317 or Tex. Code. Ann (West 2007). 66 Ky. Rev. Stat. Ann (West 2006). 67 Okla. Stat. Ann. titl. 52, 24.4 (West 2004) Pa. Stat (2001). 69 La. Rev. Stat. Ann. 47:201.1 (2002). 70 Or. Rev. Stat (1989). 138

23 MASTER LIMITED PARTNERSHIPS Tax Treatment. [1] Introduction. As a rule, a domestic or foreign entity that constitutes a publicly traded partnership is treated as a C corporation for federal income tax purposes. 71 This is true whether the entity is formed under state or other relevant law as a general partnership, limited partnership, limited liability company or other form of unincorporated organization. If a publicly traded partnership, or PTP, is taxed as a C corporation, its income will be subject to two levels of income tax, once to the PTP as the income is earned, and a second time to the PTP s owners as the PTP s earnings are distributed. If at least 90 percent of the gross income of a PTP is qualifying income, the PTP will be taxed as a partnership for federal income tax purposes. In general, qualifying income includes passive-type income, such as interest, dividends and real property rentals, as well as potentially more active-type income, such as income and gains from mineral and natural resources mining and production. 72 If a PTP is taxed as a partnership for federal income tax purposes, the tax treatment of the PTP and its partners is determined by the rules that govern the federal tax treatment of partnerships and partners. Thus, the PTP itself is not subject to tax, and its partners are taxed as the PTP generates income, whether or not that income is distributed. Distributions by the PTP to a partner are tax-free to the extent of the tax basis of the partner s interest in the PTP. Depending on state law, a PTP that is taxed as a partnership for federal tax purposes usually will be taxed as a partnership for state income tax purposes. Accordingly, such a PTP will rarely be subject to state income taxes. Instead, its partners will be taxed directly by the states in which the PTP operates based on their respective shares of the PTP s income apportioned to those states. This is one reason the typical PTP structure involves a parent PTP, or master limited partnership (MLP), whose 71 I.R.C. 7704(a) and (b) (2004). 72 Id. 7704(d)(1). 139

24 5.05 ENERGY & MINERAL LAW INSTITUTE interests are publicly traded and a subsidiary operating entity that acts as the income-generating vehicle. [2] Partnership Qualification. Section 7704(a) of the Code provides the general rule that a PTP is treated as a corporation for federal income tax purposes. The general rule does not apply for any taxable year in which at least 90 percent of the gross income of the PTP consists of qualifying income. 73 The gross income requirement applies only in and after the first tax year in which the entity (or a predecessor) constitutes a PTP. 74 For example, if a limited partnership commences business on October 15, 2006, but does not become a PTP until its tax year beginning January 1, 2008, the 90 percent test need be met only on and after January 1, 2008 for the PTP to escape taxation as a corporation after December 31, Once the entity becomes a PTP, it will be taxed as a C corporation unless at least 90 percent of its gross income consists of qualifying income. This rule applies for each and every taxable year of the PTP commencing after December 31, Thus, if a PTP taxed as a partnership wishes to expand its activities to include those not clearly within the statutory scope, the PTP will always want to seek an advance ruling from the IRS that the intended activity will generate qualifying income. Otherwise, if it is later determined that the new income source is not qualifying income, partnership tax treatment could be lost forever. Section 7704(d) of the Code lists the various types of income that constitute qualifying income. The list includes: interest; dividends; real property rents; gains from sales or other dispositions of real property; 73 Id. 7704(b). 74 Id. 7704(c)(1). 75 See id. 7707(c)(1). 140

25 MASTER LIMITED PARTNERSHIPS 5.05 income and gains from minerals and natural resources; any gains from sales or other dispositions of capital assets held for the production of income described in the preceding paragraphs; and in the case of any partnership whose principal activity is the buying and selling of commodities or options, futures with respect to commodities, income and gains from such activities. As can be seen, most types of income that qualify as qualifying income, such as interest and dividends, are the type that an investor can achieve acting alone. The theory in granting widely-held organizations whose income is of this nature flow-through status is that, if a PTP s income is from sources that are commonly considered to be passive investments, there is little reason to treat the PTP as a corporation, either because investors could earn such income directly or because it is already subject to corporate-level tax. 76 Of course, this theory does not account for the favorable treatment of real estate activities and activities involving minerals and natural resources. The justification expressed by the Congress in 1987 for treating these activities favorably was that they had commonly or typically been conducted in partnership form, and disrupting those practices in light of economic conditions existing at the time the statute was enacted was thought inadvisable. 77 On the other hand, there was no intent to tax the benefits from such activities more favorably than they had been, but it was thought inappropriate to subject such activities to the two-level corporate tax regime. 78 [3] Income and Gains from Minerals and Natural Resources. Income and gains from minerals and natural resources represents perhaps the broadest category of qualifying income for purposes of the provisions 76 See H.R. Rep. No. 391 (II), at 1066 (1987), as reprinted in 1987 U.S.C.C.A.N See id. at (1987), as reprinted in 1987 U.S.C.C.A.N Id. 141

26 5.05 ENERGY & MINERAL LAW INSTITUTE governing PTPs. The determination whether income or gains come within this category requires a two-pronged analysis: first, does the item in question constitute a mineral or natural resource, and, second, what income-producing activities associated with that item generate qualifying income? For purposes of this provision, the last sentence of Section 7704(d)(1) of the Code provides that the term mineral or natural resource means any product of a character with respect to which a deduction for depletion is allowable under Section 611, other than soil, sod, dirt, turf, water or mosses, or minerals from sea water, the air, or similar inexhaustible sources. 79 This sentence did not appear in the statute as it was enacted in 1987, but was added by the Technical and Miscellaneous Revenue Act of The legislative history to the 1988 Act states that the intent of the limiting language is to identify only what constitutes minerals and natural resources, not what income from them constitutes qualifying income. 81 Consequently, whether income is taken into account for depletion purposes does not necessarily determine whether it is qualifying income for purposes of I.R.C. Section 7704(d)(1). 82 Income and gains from minerals and natural resources include income and gains derived from the exploration, development, mining, production, processing, refining, transportation or marketing of any mineral or natural resource, including fertilizer, geothermal energy and timber. 83 Such term is not intended to include income from fishing, farming (including the cultivation of fruits or nuts), or from hydroelectric, solar, wind or nuclear power production. 84 Transportation for this purpose specifically includes the transportation of gas or oil or products thereof by pipeline. 85 According to the legislative 79 I.R.C 7704(d)(1)(last sentence). 80 Pub. L , 102 Stat. 3808, 2004(f)(4). 81 S. Rep. No. 100, at 424 (1988), as reprinted in 1988 U.S.C.C.A.N Id. 83 I.R.C. 7704(d)(1)(E). 84 S. Rep. No. 100, at I.R.C. 7704(d)(1)(E). 142

27 MASTER LIMITED PARTNERSHIPS 5.05 history of Section 7704(d)(1)(E), income from any transportation of oil or gas or products thereof by pipeline is qualifying income, as is the income from transportation of such products to a bulk distribution center such as a terminal or a refinery, whether by pipeline, truck, barge or rail. 86 Except in the case of transportation by pipeline, however, transportation of oil or gas or products thereof to a place from which it is dispensed or sold to retail customers is generally not intended to be treated as qualifying income. 87 The Internal Revenue Service has issued an array of private letter rulings that have considered whether revenues derived from mineral and natural resources activities conducted by PTPs constitute qualifying income. In one recent ruling, the Service considered the situation of X, a limited partnership that was engaged in the storage, transportation and distribution of crude oil and refined petroleum products and the acquisition and marketing of crude oil to refiners or resellers through pipeline and terminal facilities owned by X. The ruling stipulated that X made no retail sales. X received fees for receiving refined products into its terminals and transferring them from the terminals to third-party transportation facilities ( terminal fees ); for injecting additives into refined products ( injecting fees ); for blending ethanol with refined products ( blending fees ); and for transporting petroleum products and crude oil through its pipelines ( pipeline fees ). X requested rulings that its injecting fees, its blending fees and its pipeline fees were qualifying income under Section 7704(d)(1)(E). The IRS ruled that all of the foregoing fees constitute qualifying income under Section 7704(d)(1)(E). 88 A private letter ruling issued by the IRS can be relied upon only by the taxpayer to whom the ruling was issued. 89 Nevertheless, this ruling illustrates the broad scope of mineral and natural resource activities that may give rise to qualifying income. 86 S. Rep. No. 100, at Id. 88 See I.R.S. Priv. Ltr. Rul (Sept. 22, 2006). 89 I.R.C. 6110(k)(3). 143