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Income from Providing Hydraulic Fracturing Services is “Qualifying Income” for Master Limited Partnerships

21 October 2013
Mayer Brown Article

Background

A Master Limited Partnership or MLP (sometimes called a publicly traded partnership or PTP), is an attractive business entity because it is treated as a partnership for federal income tax purposes even though the ownership interests in the MLP are publicly traded. Thus, the income of the MLP is subject to a single level of tax at the partner level; moreover, ordinary business deductions flow through the MLP and reduce the partners’ taxable income from the MLP. By contrast, income of a corporation (other than an S corporation) is subject to tax at the corporate level, and the net after-tax income of the corporation is subject to a second level of tax when distributed as dividends to its shareholders.

In order to obtain this favorable tax treatment, the MLP must meet certain requirements, one of which is that 90% or more of the MLP’s gross income for each taxable year must consist of “qualifying income.” Failure to meet this requirement could result in treatment of the MLP as a corporation for federal income tax purposes. Qualifying income generally includes passive income such as interest, dividends, and real property rents. However, with respect to natural resources, qualifying income also includes income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber); this is sometimes referred to as the “natural resource exception.” The Internal Revenue Service has issued a number of favorable private letter rulings to the effect that income from various sources qualifies for the natural resource exception, including several recent private letter rulings dealing with income from the provision of hydraulic fracturing services or other income related to hydraulic fracturing. These recent private letter rulings are discussed in greater detail below.

Income from the Provision of Hydraulic Fracturing Services

In Private Letter Ruling 201322024 (released May 31, 2013), the IRS addressed the income of an MLP that (as successor to the business operations of its sponsor) provides well stimulation services to the oil and gas industry. Specifically, the MLP (itself or through affiliated operating entities treated as partnerships or disregarded entities for federal income tax purposes) provides high-pressure hydraulic fracturing services to exploration and production companies in order to enhance the production of oil and natural gas from unconventional oil and natural gas basins (i.e., geologic formations such as shale and other tight formation reservoirs where natural flow is restricted). To provide these services, the MLP uses mobile hydraulic fracturing units and associated heavy equipment that are owned by the MLP and operated by its employees and independent contractors. This hydraulic fracturing equipment is specifically designed to pump specially formulated fracturing fluid into a perforated well casing or tubing under high pressure.

The ruling describes the fracturing process as completed in multiple stages, or horizontal zones. Sand, bauxite, resin-coated sand, or ceramic particles, each referred to as a proppant or propping agent, are suspended in the fracturing fluid and prop open the cracks created by the fracturing process in the underground formation. This propping causes the underground formation to crack or fracture, thereby allowing the hydrocarbons to flow more freely into the wellbore. As part of the ruling process, the MLP represented to the IRS that these hydraulic fracturing services are integral to the production of oil and natural gas from wells drilled in shale and other tight formation reservoirs, because the production of such oil and natural gas would be significantly curtailed in the absence of such services.

The MLP entered into a contract with an independent exploration and production company (the “E&P Company”) engaged in the acquisition, development, and production of unconventional natural gas resources in the United States. Under the contract, the MLP will provide hydraulic fracturing services to the E&P Company in a specific geographic location over a 24-month period. The contract requires the MLP to provide an initial fleet of a specified number of pumps, and to perform a minimum number of stages per day for a number of days per month, that result in a minimum number of fracturing stages per quarter. The MLP’s fees for providing these hydraulic fracturing services consist of (i) mobilization fees based on mileage from the location of the MLP’s hydraulic fracturing fleet, charged at the initial stage of each job; (ii) operating stage/well/day rates; (iii) standby times rates and downtime rates in circumstances where the E&P Company does not provide the MLP with the minimum number of quarterly stages through no fault of the MLP; (iv) force majeure payment rates and payments in the event a governmental body or regulatory agency issues a mandate that either makes it impossible for the MLP to continue operations or causes an increase in the MLP’s rate; and (v) reimbursable costs with respect to hydraulic fracturing-related material, equipment, work, or services that are to be furnished by the MLP at the E&P Company’s request, plus a percentage of such costs for handling.

The MLP represented to the IRS that the contract with the E&P Company is illustrative of the contractual relationships that the MLP expects to have with other exploration and production companies. The fee structure of these additional contracts is expected to be similar to the fees charged in the contract with the E&P Company. In certain instances, the MLP may also source chemicals and proppants that are consumed during the fracturing process and charge its exploration and production customers a fee for providing such materials. Such charges for materials generally will reflect the cost of the materials plus a markup and will be based on the actual quantity of materials used in the fracturing process. Finally, the MLP may charge its other exploration and production customers a handling fee for chemicals and proppants supplied by the customer.

Based on the facts submitted and representations made, the IRS ruled that the gross income that the MLP derives from providing hydraulic fracturing services will be qualifying income.

Other Income Related to Hydraulic Fracturing

In Private Letter Ruling 201234005 (released August 24, 2012), an MLP was engaged in the transportation and processing of natural gas within the United States through affiliated operating subsidiaries treated as partnerships or disregarded entities for federal income tax purposes. To facilitate its transportation and processing activities, the MLP owns natural gas gathering pipelines, natural gas processing systems, and the natural gas pipeline rights-of-way associated with each pipeline.

The MLP’s customers are natural gas producers that use hydraulic fracturing to extract natural gas from geologic formations. Hydraulic fracturing involves the injection of fluids, primarily water mixed with a proppant, into an oil or gas well at high pressure to fracture geologic formations and open pathways for the oil or gas to flow. The fracturing process requires very large volumes of water.

To meet the water needs of the MLP’s customers, the MLP formed a subsidiary operating limited partnership (the “OLP”) to develop, construct, own, and operate a water delivery pipeline system (the “Pipeline”) for the purpose of supplying fresh water to the MLP’s customers and other natural gas producers for use in the production of natural gas through hydraulic fracturing. The Pipeline will run primarily parallel to the trunk-line of the MLP’s natural gas gathering pipelines and will share the MLP’s existing rights-of-way. The OLP will earn income from long-term pipeline capacity and supply agreements with the MLP’s customers. The OLP expects to enter into additional long-term pipeline capacity and supply agreements with other natural gas producers in the region. Under these agreements, natural gas producers will pay the OLP for the pipeline supply and transportation of fresh water to water impoundment ponds designated by the natural gas producers.

As part of the ruling process, the MLP represented to the IRS that the supply and transportation of fresh water to natural gas producers for use in hydraulic fracturing is integral to the exploration and production of natural gas from shale formations and the preservation and growth of the MLP’s existing activity of natural gas transportation. The MLP, through the OLP, is uniquely situated to supply fresh water efficiently through a pipeline due to its existing rights-of-way and expertise in pipeline transportation. The OLP intends to provide the water supply solely to natural gas producers operating in proximity to the MLP’s natural gas gathering assets, many of whom are either current customers or prospective customers of the MLP’s natural gas gathering services.

Based on the facts submitted and representations made, the IRS ruled that the MLP’s distributive share of the gross income derived by the OLP from the supply and transportation of water to oil and gas producers for use in the exploration, development, and production of oil or natural gas is qualifying income.

In Private Letter Ruling 201233009 (released August 17, 2012), modified by Private Letter Ruling 201316005 (released April 19, 2013), the IRS ruled that income derived by an MLP from the mining and marketing of silica for sale to oil field service companies for injection as a proppant in the production of crude oil and natural gas constitutes qualifying income.

Conclusion

It should be noted that a private letter ruling may be relied upon only by the taxpayer that obtained the ruling. Nonetheless, private letter rulings can provide a valuable insight into the IRS’ analysis of the issue addressed. Given the IRS’ favorable disposition toward the natural resource exception, and the dire tax consequences of failing the qualifying income requirement, MLPs engaged in or considering the types of activities described above should consider with their tax advisors the desirability of obtaining their own private letter rulings confirming that the income from those activities will indeed constitute qualifying income.

Authors

  • Jeffrey G. Davis
    T +1 202 263 3390
  • Shawn R. O'Brien
    T +1 713 238 2848
  • Edward C. Osterberg Jr.
    T +1 713 238 2666

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