© 2017 The Texas Lawbook.
By Mike Bresson and Richard Husseini of Baker Botts
(Feb. 4) – On Inauguration Day, the Trump administration placed a broad freeze on the issuance of new regulations. Among the items suspended by the freeze are new final regulations defining master limited partnership qualifying income.
Once the new administration reviews the regulations, they may be approved, changed or rejected. The administration has not stated a timetable for review.
The importance of qualifying income to MLPs
MLPs do not pay federal income taxes. Like other partnerships, they allocate their income or loss to their partners, who take the income or loss into account in determining their own tax liabilities. By contrast, a corporation must pay tax on its own income, then its shareholders are taxed on dividends paid by the corporation – a “double tax.”
Prior to the issuance of proposed regulations under that section in May 2015, most MLPs relied on the opinions of tax counsel or private letter rulings from the Internal Revenue Service that their income met the definition of qualifying income. As the MLP industry boomed, so did the volume of MLP requests for private letter rulings.
The IRS issued favorable private letter rulings regarding a wide variety of natural resource-related activities, including
- the production of ethylene at a steam cracker
- the production of methanol using a steam reformer
- the hedging of price risks with respect to natural resources owned by the MLP
- the provision or transportation of fresh water or sand for use in fracking activities
- the disposal of wastewater from fracking activities, and
- numerous transportation and storage activities with respect to oil, refined products, gas and natural gas liquids.
In March 2014, the IRS publicly announced a “pause” in the issuance of private letter rulings for qualifying income while it evaluated its policy in issuing those rulings.
The proposed regulations
On May 5, 2015, the Department of the Treasury and the IRS issued proposed regulations defining qualifying income under section 7704(d)(1)(E). The proposed regulations provided definitions of “mineral or natural resource” and each of the eight activities with respect to minerals or natural resources that can produce qualifying income.
The proposed regulations took a much more restrictive view of the scope of the activities that can produce “qualifying income” than the IRS had applied prior to the pause.
Exclusive list. The proposed regulations provided a detailed list of activities that it viewed as qualifying, and stated that this constituted an exclusive list of all activities that could qualify. This “exclusive list” concept was perhaps the most controversial aspect of the proposed regulations, as MLPs and their representatives argued that it would be impossible to compile a comprehensive list of all current industry activities that satisfy the definition, much less future industry activities that might develop in time.
Orphaned activities. The proposed regulations specifically treated as nonqualifying a number of activities that had been the subject of prior favorable private letter rulings, including the production of ethylene outside of a refinery and the production of methanol.
Overly restrictive definitions. The proposed regulations adopted overly restrictive definitions of several qualifying activities, particularly “processing” and “refining.” In the case of “refining,” they imposed restrictions regarding the manner in which the taxpayer classified the property used in the activity under the Modified Accelerated Cost Recovery System depreciation rules, the existence of a chemical change to the feedstock and the nature of the activity as a “manufacturing activity.” This restrictive definition had ripple effects on the types of products that could produce qualifying income from transportation and marketing activities.
Oilfield services. The proposed regulations allowed certain activities to qualify as “intrinsic activities” even if they were not one of the eight qualifying activities named in the statute. These activities were required to be “specialized,” “essential” and “significant” with respect to one of the qualifying activities. Under these rules, providing extraction site wastewater disposal services qualified, but providing fresh water for fracking did not qualify unless the MLP also provided wastewater removal services at the site.
Limited grandfather relief. The proposed regulations provided a 10-year grandfather period to existing MLPs for certain historic activities that did not qualify under the proposed regulations, including those for which the MLP had previously received a favorable private letter ruling or a reasonable opinion of counsel.
The final regulations
On Jan. 19, 2017, the Department of the Treasury and IRS issued final regulations defining the scope of qualifying income under section 7704(d)(1)(E). While they are a significant improvement over the proposed regulations, they still reflect a more restrictive view of the scope of MLP qualifying income than prevailed in the IRS and the MLP industry prior to May 2015.
No “Exclusive List.” The final regulations abandon the rule in the proposed regulations that the regulations constitute an “exclusive list” of all activities that can qualify. This will provide much greater flexibility to MLPs in evaluating the qualifying nature of activities not specifically listed.
Ethylene from steam crackers qualifies. The final regulations provide that ethylene, propylene and similar products are qualifying, regardless of whether they are produced in a refinery, a steam cracker or elsewhere.
Simplified analysis of oil and gas products. The final regulations greatly simplify the analysis of the extent to which processing, refining, transportation and marketing of products derived from oil and gas produce qualifying income. In general, those products produce qualifying income if they are products of a type typically produced at refineries or gas field facilities, without regard to where the MLP’s products are actually produced. The limitations in the proposed regulations regarding the manner in which the taxpayer classifies the property used in the activity under the MACRS depreciation rules, the existence of a chemical change to the product or the nature of the activity as a “manufacturing activity” are eliminated.
Greater clarity on qualifying nature of some activities. The final regulations clarify that a variety of activities which the proposed regulations contained no express provisions qualify, such as
- Natural gas liquefaction and regasification
- Transportation of propane to retail customers
- Pipeline compression services
- Sales of excess renewable identification numbers
- Income from passive interests in oil and gas properties, such as royalties, net profits interests and lease bonus payments, and
- Many blending and additization activities as to qualifying products.
Oilfield services still qualify. The final regulations retain, and slightly liberalize, the rules in the proposed regulations allowing oilfield services and similar activities to qualify as “intrinsic activities.”
No guidance on hedging activities. The final regulations do not address hedging commodity price risks with respect to volumes of mineral or natural resource products such as oil and gas, but the preamble to the final regulations implies that future guidance will likely be favorable.
Grandfather rules. The final regulations will apply to income earned in a taxable year that begins on or after Jan. 19, 2017. However, the regulations provide a 10-year grandfather period, similar to that provided in the proposed regulations, ending in an MLP’s taxable year that includes Jan. 19, 2027.
The freeze
On January 20, 2017, President Trump’s chief of staff, Reince Priebus, issued a memo to the heads of all executive departments and agencies placing a freeze on the issuance of new administrative guidance, including items that had not yet been published in the Federal Register.
This freeze is similar to freezes imposed by former Presidents Reagan, Clinton, George W. Bush and Obama upon taking office. Freezes of this type are intended to give the new President and Cabinet time to review any new or pending rules.
The tax regulations affected by the freeze include the final MLP qualifying income regulations, proposed regulations regarding the new partnership audit rules, and final and temporary regulations regarding dividend-equivalent payments. Those regulation packages were released to the public late last week but had not yet been formally published in the Federal Register when the freeze went into effect.
It is not clear if or when the regulations subject to the freeze will be issued. For example, original issue discount regulations that were subject to the Clinton freeze in 1993 were not reissued for nearly two years, and in substantially different form. It is possible that the Trump administration will view the new qualifying income regulations as requiring significant further review.
Conclusion
While the final MLP qualifying income regulations are a significant improvement over the proposed regulations issued in May 2015, they still reflect a more restrictive view of the scope of MLP qualifying income than prevailed in the IRS and the industry prior to May 2015. The fate of the regulations in the wake of the Trump’s freeze is unclear.
Mike Bresson is a partner in the Houston office of Baker Botts, where he specializes in federal tax law. Richard Husseini is the chair of Baker Botts’ tax law department. He also offices in Houston.
© 2017 The Texas Lawbook. Content of The Texas Lawbook is controlled and protected by specific licensing agreements with our subscribers and under federal copyright laws. Any distribution of this content without the consent of The Texas Lawbook is prohibited.
If you see any inaccuracy in any article in The Texas Lawbook, please contact us. Our goal is content that is 100% true and accurate. Thank you.