The Internal Revenue Service (IRS) has released seven private letter rulings (PLRs) and — for the first time — issued a revenue procedure regarding qualifying income for publicly traded partnerships (MLPs) in the first half of 2012. The PLRs already match last year's record number of qualifying income PLRs for a single year. This year's guidance reaffirms prior IRS positions, strengthens concepts from prior PLRs, clarifies potential areas of ambiguity and identifies new activities that generate qualifying income for MLPs.
The Internal Revenue Code generally treats an MLP as a corporation, rather than a partnership, for federal income tax purposes, unless 90 percent or more of the MLP's gross income for every taxable year consists of "qualifying income." For this purpose, qualifying income includes income derived from the exploration, development, mining, production, processing, refining, transportation, or marketing of minerals, natural resources or industrial source carbon dioxide and the transportation and storage of certain renewable fuels. Other types of qualifying income include dividends, interest (other than interest generated by a financial or insurance business) and certain income that would be qualifying to a real estate investment trust (REIT) or a regulated investment company (RIC). This update describes the IRS's conclusions in the guidance released in the first half of 2012. The revenue procedure described below is an official statement of IRS procedure and may generally be relied upon by taxpayers in determining their tax consequences. On the other hand, only the taxpayer who receives a PLR may rely upon its holding. However, PLRs do provide valuable guidance with respect to the IRS's interpretation of the boundaries of qualifying income.
Safe Harbor for Cancellation of Indebtedness Income
In Revenue Procedure 2012-28 (June 15, 2012), the IRS provided long-awaited guidance regarding the treatment of cancellation of indebtedness (COD) income for MLPs. The revenue procedure establishes a safe harbor, whereby the IRS will not challenge an MLP's determination that its COD income is qualifying income if the discharged debt was incurred in direct connection with such MLP's activities that generate qualifying income. An MLP may use any reasonable method to demonstrate the direct connection, including tracing the proceeds of the debt generating COD income to qualifying activities. Generally, a method that allocates COD income solely on the ratio of qualifying gross income to total gross income will not be considered reasonable. The revenue procedure provides that the IRS may consider PLR requests on whether a method is reasonable. A number of MLPs sought guidance on this issue over the last several years, but were told to wait for public guidance. In the event of a protracted economic downturn, this safe harbor may provide valuable guidance for the MLP community and prevent the need for multiple PLRs regarding the treatment of COD income.
Extractive Logistics and Refined Products Blending Services
In PLR 201226018 (June 29, 2012), the IRS treats as qualifying income a partnership's income from the provision of "extractive logistics," including the delivery and sale of refined petroleum products and other chemicals to customers engaged in drilling, exploration and production, and mining activities, and the provision of additional on-site services and equipment with respect to the proper use, storage, and disposal of its products and other fluids and non-hazardous waste from drilling and mining sites. The IRS also concludes that the partnership's refined products blending and sale of automotive lubricants and related products to non-end users generates qualifying income. In connection with extractive logistics, this PLR expands upon previous rulings with respect to activities that are integral to another qualifying activity (e.g., fluid handling and refinery services), concluding in this context that the integral activity generates qualifying income notwithstanding the involvement of certain products that are not natural resources and end-user sales and transportation of refined products.
LNG Liquefaction and Regasification Activities
In PLR 201224023 (June 15, 2012), the IRS treats income from the liquefaction, transportation, and regasification of natural gas as qualifying income. The MLP owns and operates a liquefied natural gas, or "LNG," terminal undergoing capital improvements to enable liquefaction of natural gas. The MLP will acquire and process domestic natural gas into LNG, transport it to marine docks for shipping, and sell the LNG to customers obligated to resell it to third parties. The conclusion of this PLR is not unexpected, but the PLR is a sign of the times, when the domestic natural gas industry is for the first time seriously considering the exportation of domestic natural gas, and indicates that MLPs may play a role in financing, constructing, and operating the necessary infrastructure.
Oilfield Services — Petroleum-Water Mix Services
In PLR 201222029 (June 1, 2012), the IRS continues to issue guidance with respect to activities provided to oil and gas producers that generate qualifying income. The IRS has released three prior rulings with respect to fracturing fluid services, concluding that the supply, transportation, treatment, disposal, storage, and heating of fracturing fluids, flow back, produced water, and other production fluids generate qualifying income. In this ruling, the IRS concludes that the partnership's income from the transportation, storage, and disposal of petroleum-water mix derived from oil and natural gas wells, as well as associated wholesale petroleum condensate sales, is qualifying income. The partnership also performs fluid treatment and recycling operations to allow the petroleum water to be re-used in drilling operations. This PLR illustrates the IRS's somewhat expanded view of qualifying income as it relates to oilfield services that are integral to the exploration, development, and production of oil and gas for purposes of the qualifying income rule.
Hydrogen Sales as a By-Product of Fertilizer Production
In PLR 201216022 (April 20, 2012), the IRS treats income from the sale of hydrogen produced as a by-product of fertilizer manufacturing as qualifying income. Fertilizer is (rather strangely) treated by the Internal Revenue Code as a natural resource for qualifying income purposes. The MLP's primary business is the production of fertilizer utilizing a petroleum coke gasification process that often results in excess hydrogen. Any excess hydrogen is sold to an adjacent refinery. This the second ruling to address the sale of a by-product from the production of fertilizer — the first being the sale of nitric acid and carbon dioxide addressed by PLR 9339014 (June 28, 1993).
Interest Rate Locks and Swaps
In PLR 201208021 (February 24, 2012), the IRS concludes that income derived from an MLP's treasury locks, interest rate swaps, and forward-start interest rate swaps is qualifying income. The MLP is engaged in the transportation, storage, and marketing of refined petroleum products and natural gas, and periodically issues debt. The MLP enters into various economic arrangements to mitigate interest rate risk. This is the fourth qualifying income PLR addressing interest rate hedging; however, it is the first of these PLRs to address forward-start interest rate swaps. It illustrates a consistent position by the IRS — first seen in PLR 200635008 (May 23, 2006) — that income from common and routine financial transactions used to manage interest rate risk associated with activities that generate qualifying income should also be treated as qualifying income for an MLP.
Refined Product Terminal Blending and Additization Services
In PLR 201206004 (February 10, 2012), the IRS reaffirms three previous terminal blending and additization services rulings and concludes that certain fuel additization and ethanol blending services generate qualifying income. The MLP owns refined products terminals that receive petroleum products from refineries, major common-carrier pipelines, or other vessels. The MLP receives fees for the injection of various additives into fuels at its terminals. The MLP also receives fees for blending, storing and transporting ethanol. While these additives are non-natural resources, efficient distribution of fuel and other refined products (qualifying natural resources) in satisfaction of environmental regulations and customer specifications requires that terminal operators conduct these activities.
Redacted Natural Resource Activities
In PLR 201201002 (January 6, 2012), the IRS treats income from the processing of a redacted natural resource into a redacted product and the transportation, storage, marketing, and distribution of one or more redacted natural resources as qualifying income. The PLR is heavily redacted to protect the identification of the taxpayer and its intended transactions, but the PLR may be an indication that the IRS is willing to expand its view of qualifying income in terms of the natural resources (and materials derived from those natural resources) that generate qualifying income, or that the taxpayer has identified an innovative application of the qualifying income rules.
The first half of 2012 was active for guidance addressing MLP qualifying income, and the IRS's willingness to issue the revenue procedure and PLRs described in this update is a positive sign for MLPs that are considering whether to expand into new or different business activities.
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