Days after the Internal Revenue Service filed a notice of proposed rulemaking to develop standard guidance regarding MLP-qualifying income, analysts and legal experts are unraveling implications for the energy industry.

In a recent note from Raymond James, Darren Horowitz and J.R. Weston described the most significant changes: the decision that “certain limited support activities that are ‘intrinsic’ to qualified activities”—but are not qualified activities themselves—would qualify for MLP status; and ethane and propane “chemically converted into refinery grade olefins byproducts” would likely not qualify for MLP status.

Regarding oilfield support services, tax lawyer Barbara S. de Marigny with McGuireWoods LLP told Midstream Business the question has always been, “'How far away from the wellhead can you get and still have it be related to the exploration and production of oil and gas?

“What these rules do … is they set up this whole new category of qualifying income—other services to the oil and gas drillers that are considered to be ‘intrinsic.’”

The proposed rules establish a “three-part test” for determining whether an activity is intrinsic, she said. The test examines: whether the activities are specialized to oil and gas; whether the activities are essential, or necessary to the completion of oil and gas activity; and whether the activity is significant. Regarding the significant standard, de Marigny said the thought process behind the standard was that, “in connection with this income from this activity, there has to be a substantial services component.”

“What they’re trying to get at is this situation where somebody goes out to the wellhead and just sells drill bits, for example,” she said. “Well, that’s essential to the drilling, that’s specialized to the drilling, but there’s no service involved in it. They’re just selling a product.”

As for the rule and its relation to olefin production, a recent McGuireWoods note said, “In general, the proposed rules bless products that are byproducts of natural resource processing but exclude products derived by adding or mixing other substances into the product.”

Examples listed in the notice of proposed rulemaking clarified that an MLP that chemically converts ethane and propane into ethylene and propylene via a steam cracker would not be allowed to consider income from the sale of the resulting olefins as qualifying income.

“Basically, what they’re saying is if you are merely purifying the natural resource, so you’re separating things out of it, then the result of that process is going to be good processing activity,” producing qualifying income, de Marigny said. “But if you cause a chemical change, their general view is that chemical conversion in the course of this processing is not going to be qualifying, unless one or more of the products of the conversion are recombined with other physically separated components of the crude oil in the production of gasoline or other fuels.

“I think the people at the Treasury and IRS would acknowledge that the rules have kind of a bias in favor of vertical integration,” she said, noting that byproducts of gas or fuel production will generate qualifying income. “But if it’s not in that process of producing gas or fuel, it’s just a separate undertaking that this business has taken, then under the way they’ve proposed to write these rules, I think you’ve got an issue.”

Need For Guidance

The purpose of the guidance was to clarify the criteria related to “qualifying income from exploration, development, mining or production, processing, refining, transportation, and marketing of minerals or natural resources,” Horowitz and Weston explained in the Raymond James note. To maintain MLP status and the tax advantages that come with it, 90% of a partnership’s income must qualify under the guidelines for MLPs.

Typically, when legislation gives such broad guidelines, the IRS will follow up with more extensive regulations giving detailed guidance, de Marigny said. However, “in this area for whatever reason, the IRS never put out regulations that described in detail their view of what exactly was meant” by the original 1987 legislative provision, she said.

Instead, the IRS depended on companies seeking MLP status to approach the IRS individually and obtain a private-letter ruling (PLR) based on each company’s individual activity. When oil and gas production was less complicated, this process seemed acceptable.

“If things had just stayed like that, where people were getting comfortable with what worked and what didn’t work, this new development maybe wouldn’t have happened,” de Marigny said. “What did happen was there were all these new kinds of activities around oil and gas development and production and processing” to the extent that the IRS “decided that it would be better to publish a set of regulations.”

Looking Ahead

As to what MLPs currently cracking ethane or propane into ethylene or propylene might do with their cracking assets, de Marigny emphasized that those companies have plenty of time to make a decision, since at this stage, the guidelines have only been proposed.

“If the process goes according to the way it usually does, they propose regulations, which are by no means set in stone, and then there’s a lot of back-and-forth with a lot of taxpayer and industry commentary. And then they go back and they reconsider, they revise, and only then will they be published in final form, so there is definitely an opportunity for taxpayer and industry input in the final outcome.”

Even when the rules do go into effect, there is a provision in the current notice of proposed rulemaking allowing all MLPs with PLRs to continue current approved operations for 10 years from the date the rules go into effect, so “It’s not like any of this is going to change things overnight,” de Marigny said.

“A taxpayer that received a PLR that their ethylene was good processing activity income can rest on that PLR for the next 10 years. I don’t think the IRS intended for there to be any sort of huge overnight drama about this.”

In the meantime, it’s possible that this notice will give companies the sense of certainty they’ve been looking for to launch their MLP IPOs. In a recent “Baird Equity Research Note,” Ethan Bellamy and Jason Ball advised, “Now that we have guidance and a framework, however unclear, expect IPO filings and M&A activity to accelerate.”

Contact the author, Caryn Livingston, at clivingston@hartenergy.com.