On April 21, the Trump administration issued an executive order that requires the Department of the Treasury to review all “significant” tax regulations issued after 2015. Any reviewed regulations that are deemed unduly complex or burdensome, or to exceed the authority of the Internal Revenue Service (IRS), may be modified or rescinded, or have their effective date delayed or suspended.

Treasury is required to issue an interim report by June 20 identifying all significant regulations that may be the subject of further action, and to submit a report to the president by Sept. 18 recommending specific further actions as to the identified regulations.

It is not clear whether the order will require a review of the final regulations defining “qualifying income” issued in January 2017. Treasury previously determined that those regulations were not “significant,” but the new executive order provides that earlier determinations are not controlling for this purpose.

The Importance of Qualifying Income to MLPs

MLPs do not pay federal income taxes. Instead, 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 the corporation’s shareholders are taxed on dividends paid by the corporation—a double tax.

For an MLP to maintain its favorable tax status and avoid the double tax, at least 90% of its gross income each year must be “qualifying income” under section 7704 of the Internal Revenue Code. Most MLPs earn the bulk of their qualifying income from one of eight qualifying activities—exploration, development, mining, production, mining or production, processing, refining, transportation and marketing—with respect to minerals or natural resources.

The MLP World Before ‘the Pause’

Before March 2014, most MLPs relied upon opinions of their tax counsel or private letter rulings from the IRS 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 from the IRS.

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 NGL.

In March 2014, the IRS publicly announced a “pause” in the issuance of private letter rulings regarding the eight qualifying activities with respect to minerals or natural resources while it evaluated its policy in issuing those rulings.

The May 2015 Proposed Regulations

On May 6, 2015, Treasury and the IRS issued proposed regulations defining “mineral or natural resource” and each of the eight qualifying activities with respect to them 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.”

Most controversially, the proposed regulations:

  • Purported to provide an “exclusive list” of all natural resource-related activities that could produce qualifying income;
  • Defined “processing and refining” in a manner that made it difficult for many natural gas products and non-fuel crude oil products to qualify;
  • Treated as nonqualifying a number of activities that had been the subject of prior favorable IRS private letter rulings, including:
    • The production of ethylene outside of a refinery; and
    • The production of methanol; and
  • Granted only 10 years of grandfather relief to taxpayers that had received prior favorable private letter rulings or opinions of counsel as to activities that did not qualify under the proposed regulations.

The proposed regulations also provided “intrinsic activity” rules under which activities such as 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.

The Final Regulations

On Jan. 19, Treasury and the IRS issued final qualifying income regulations. While they are a significant improvement over the proposed regulations, they still in many respects 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.

The final regulations:

  • Abandon the controversial “exclusive list” concept of the proposed regulations, and instead provide general definitions and specific examples of each qualifying activity;
  • Define “processing and refining” much more broadly than did the proposed regulations, but more restrictively than their pre-February 2014 private letter ruling practice;
  • Treat production of ethylene outside of a refinery as qualifying (a reversal of the proposed regulations);
  • Treat production of methanol as nonqualifying (consistent with the proposed regulations);
  • Retain the 10-year limit on grandfather relief to taxpayers that had received prior favorable private letter rulings or opinions of counsel;
  • Slightly expand the rules allowing MLPs to provide fracking water (no longer requiring them to collect water at each well site to which water is provided, but only in each basin in which water is provided); and
  • Correct and clarify errors and omissions in the proposed regulations.

The Freeze

The qualifying income regulations were publicly released by the Obama administration on Jan. 19, effective for tax years beginning on or after Jan. 19 and scheduled for publication in the Federal Register on Jan. 24. On Jan. 20, the Trump administration imposed a freeze on the issuance of new administrative guidance, including items that had not yet been published in the Federal Register, subject to exceptions allowed by the Office of Management and Budget (OMB). The final qualifying income regulations were published in the Federal Register on Jan. 24, apparently on the basis of an exception granted by OMB.

Conclusion

While the final MLP qualifying income regulations are a significant improvement over the proposed regulations on that topic 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 new executive order is unclear.

Mike Bresson is a tax partner at Baker Botts LLP. He can be reached at michael.bresson@bakerbotts.com.