Working With Uncle Sam

In June, the Alerian MLP Infrastructure Index (AMZI) rose 2.5% on a total return basis, compared to the S&P 500, which rose 4.1%. Top performers this month were Regency Energy Partners LP gaining 10.5% and Buckeye Pipeline Partners LP, which gained 9.8%. Despite the bump in the road, master limited partnerships (MLPs) are gaining in popularity as, this year, the U.S. government began an expansion of designated resources that can qualify to be held in the low-tax, high-yield business structure.

After Congress (a fickle beast subject to the whims of political fancy), the two governmental agencies which have the most influence on MLPs are the Internal Revenue Service (IRS) and the Federal Energy Regulatory Commission (FERC). The IRS establishes and affirms the preferential tax treatment (no corporate taxes) afforded to MLPs and the FERC regulates both petroleum and natural gas interstate pipelines, which includes setting the tariffs for interstate liquids pipelines.

In order to be treated as an MLP for tax purposes, 90% or more of a company’s gross income must come from qualifying sources. Traditionally and historically, these sources have been the exploration, production, transportation, processing and storage of natural resources and minerals as defined in Section 7704(d) of the IRS. To address ambiguities in the code and request clarification, a taxpayer may request a private letter ruling (PLR) to further define, explain and expand upon the IRS’ interpretation of qualifying sources. In the first half of 2012, the IRS issued seven PLRs, as many as it had issued during all of 2011.

In February, the IRS reaffirmed that terminal blending and fuel-additive processes generate qualified income. These additives, such as corn-based ethanol, are not considered natural resources, but because their use is required by environmental regulations related to natural resources, the income qualifies.

Also, in April, the IRS indicated that the sale of hydrogen produced as a byproduct of fertilizer manufacturing is qualifying income. Fertilizer is already considered a natural resource. In June alone, four PLRs were issued for that industry.

With the discovery of its new shale plays, America is quickly becoming the Saudi Arabia of natural gas, and the Energy Information Administration (EIA) projects that the U.S. will be a net exporter of liquefied natural gas by 2016. As the IRS continues to expand the definition of qualifying income to include the complementary natural resource businesses in the U.S., MLPs will continue to act as the cornerstone for the build-out of U.S. energy infrastructure.

Meanwhile, current FERC rate-methodology mandates that interstate liquids pipeline tariffs increase by the producer price index plus 2.65% every July 1, until the next review period in 2015. This July 1 rates increased by 8.7% reflecting the rising cost of steel and materials, and the FERC’s understanding that MLPs and other pipeline companies are dealing with increased environmental regulations and increased voluntary maintenance and safety costs. About half the pipelines owned by MLPs in the AMZI are long-haul interstate liquids pipelines able to take advantage of this built-in inflation hedge.

The FERC has repeatedly shown itself to be a benign, overarching regulatory organization interested in maintaining and promoting a national energy-pipeline network as a matter of national security. The IRS, more recently, has been active in extending and expanding favorable MLP tax treatment not only to those companies that keep the pipeline network full, but also to those companies that provide support to drillers and other companies at the vanguard of America’s energy independence.