The IRS recently issued proposed regulations ( REG-132634-14) providing guidance on the scope of qualifying income under Section 7704(d)(1)(E) for publicly traded partnerships (PTPs) engaged in mineral and natural resource activities.
Generally, an entity that is a PTP is classified as a corporation for U.S. federal income tax purposes under Section 7704. However, Congress provided an exception from this rule if 90% or more of the partnership's gross income is "qualifying income." Qualifying income is generally passive-type income, such as interest, dividends and rent. Section 7704(d)(1)(E), however, provides that qualifying income also includes income and gains derived from the exploration, development, mining or production, processing, refining, transportation, or marketing of mineral or natural resources.
Over the past several years, there has been a proliferation in the number of private letter rulings (PLRs) concluding that income from certain activities in the natural resources area met the qualifying income definition. In light of such proliferation in PLRs, the IRS announced in February 2014 that it would put a pause on the PLR process and that it was conducting a study on tax issues related to public partnerships.
On March 6, 2015, the IRS announced that it would resume reviewing pending PLR requests concerning PTP natural resources qualifying income and indicated that proposed regulations would be issued soon. Then, on May 5, the IRS and Treasury Department released the proposed regulations.
The proposed regulations provide a new term, "qualifying activities," to define activities that generally result in qualifying income under Section 7704(d)(1)(E). The two broad types of qualifying activities are "Section 7704(d)(1)(E) activities" and "intrinsic activities." Section 7704(d)(1)(E) activities represent different stages in the extraction of minerals or natural resources and the eventual offering of products for sale.
The IRS explained that Section 7704(d)(1)(E) activities represent only those activities that would be undertaken by an exploration and development company, a mining or production company, a refiner or processor, or a transporter or marketer of a mineral or natural resource. The proposed regulations provide an exclusive list of operations that comprise each Section 7704(d)(1)(E) activity. The IRS requested comments on whether additional activities should be included. For an activity to be an intrinsic activity, it must be "specialized" to support a Section 7704(d)(1)(E) activity, be "essential" to the completion of the Section 7704(d)(1)(E) activity and require the provision of "significant services."
Several type of activities would not qualify under the proposed regulations, such as the production of plastics and similar petroleum derivatives, and using chemicals or other foreign substances to manipulate timber's physical or chemical properties, such as using a digester to produce pulp. The government appears to be making a distinction between processing and manufacturing, which according to the government would not qualify pursuant to the interpretation of legislative history.
The proposed regulations would be effective for income of a partnership earned in a tax year beginning on or after the date of publication of final regulations. The proposed regulations also contain a 10-year transition period during which any partnership that received a favorable PTP qualifying income PLR from the IRS, or any PTP that before May 6, 2015, was engaged in an activity that it thought gave rise to qualifying income "under the statute as reasonably interpreted," can continue to treat the income as qualifying.
Additionally, a partnership that engages in activity after the issuance of the proposed regulations, but prior to publication of final regulations, may treat income from that activity as qualifying income during the 10-year transition period if the income from that activity is qualifying income under these proposed regulations.
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