On Wednesday (May 6th, 2015), the Treasury Department published proposed regulations under Section 7704(d)(1)(E) of the Internal Revenue Code that define qualifying activities of publicly-traded partnerships with respect to minerals and other natural resources. (See here)
The proposed regulations provide two categories of activities that may produce “qualifying income” for purposes of the 90% qualifying income test and permit certain publicly-traded partnerships to avoid becoming subject to the corporate income tax. The first category of “qualifying income” is defined as “Section 7704(d)(1)(E) Activities,” and includes activities that have a direct relationship to natural resources. The second category is defined as “Intrinsic Activities,” which are support services provided in furtherance of the “Section 7704(d)(1)(E) Activities.”
Section 7704(d)(1)(E) Activities include: (a) exploration; (b) development; (c) mining and production; (d) processing and refining; (e) transportation; and (f) marketing, all with respect to minerals and other natural resources. Intrinsic Activities are activities that satisfy a three part test pursuant to which an activity must (i) be specialized and require specialized training to carry out; (ii) be essential to the underlying Section 7704(d)(1)(E) Activity to which it relates; and (iii) consist of significant services performed at the applicable site. Examples contained in the proposed regulations help illustrate the application of these rules.
In general, the proposed regulations are consistent with the past IRS ruling practice, with a few exceptions. For example, no mention was made in the proposed regulations as to whether income from sales of LNG would continue to qualify as “qualifying income” under Section 7704(d)(1)(E). The IRS ruled in Private Letter Ruling 201224023 (June 15, 2012) that such income constituted “qualifying income” because liquefaction activities were bona fide natural resource activities. It is unclear whether the analysis in that ruling will survive the proposed regulations.
The proposed regulations are scheduled to become effective for income earned by a partnership in a taxable year beginning on or after the date final regulations are published. Transition rules are proposed for partnerships that have received private letter rulings from the IRS with respect to their qualifying income or that have taken a position based on a reasonable interpretation of the law prior to publication of the regulations.
The Treasury Department has asked taxpayers to comment on the proposed regulations within 90 days. A public hearing will be scheduled if requested in writing by any person that timely submits written comments.
These proposed regulations, once finalized, will have an enormous impact on how the energy industry, from upstream to downstream, is owned and financed. Any private equity fund or developer considering a new project from the standpoint of possible exit strategies or liquidity events should review the proposed regulations carefully. Existing MLPs should be careful that asset or partnership acquisitions meet these new requirements.