Monday Mailbag: Method to My Madness

The cat is out of the bag and they’ve spilled the beans: the IRS has issued the proposed regulations clarifying what is considered qualifying income in relation to Section 7704(d)(1)(E) of the US Code. We’ve been waiting on these bad boys since early March and we’re glad to get some clarity straight from the horse’s mouth.

If you’re wondering why I’m using so many expressions, it’s because I’ve been hypnotized by the staggering amount of sources using the phrase “straight down the middle of the fairway” to explain that the new regulations won’t affect the assets that are (and have always been) obviously qualifying. As a challenge to myself and to make this post more exciting, I’m going to see how many expressions I can reasonably include. You’re welcome in advance.

The Federal Register published the proposed regulations on May 6th, and while some believe the IRS hit the nail on the head with the new rules, others are playing devil’s advocate. To make a long story short, when it comes to what constitutes a mineral or natural resource, the definition is old hat. Exploration, development, mining, and production all are defined in a manner consistent with previous Private Letter Rulings (PLRs) and are more or less what experts like the lawyers at Baker Botts would expect. These same experts do warn, however, that the proposed regulations are purported to be an “exclusive list” of activities. They strongly advise MLPs involved in the E&P business to check the list and ensure their qualifying income activities are listed. If not, this is not a time to beat around the bush, cut corners, or let sleeping dogs lie. It is imperative that these MLPs submit comments to the IRS where appropriate or they might miss the boat. However, management teams must remember that it takes two to tango, and just because comments are submitted, doesn’t mean the IRS will take them to heart.

Under the processing and refining section, there are a couple of items worth examining. First, the IRS made a distinction in regards to activities that involve equipment. If the equipment used in a certain process is not depreciated under MACRS Class 13.3 or 49.23 rules, then the activity doesn’t generate qualifying income. Also noteworthy, chemical conversions are very restrictive. Ethylene and propylene production from ethane and propane is not qualifying. Activities that make a mineral or natural resource into something else entirely are not qualifying. Timber processing is qualifying to the extent that they merely modify the timber; no foreign substances can be added. Paper companies like International Paper (IP), KapStone Paper and Packaging (KS), Packaging Corporation of America (PKG), and Rock-Tenn (RKT) didn’t make the cut and it’s probably safe to say the IRS stole their thunder. Fertilizer is qualifying, but the Treasury Department and IRS are requesting comments on exactly which fertilizer-related activities should be included.

The most highly anticipated portion of the proposed regulations centers around intrinsic activities, or those that are considered to be on the fringe. Many companies have considered jumping on the MLP bandwagon in recent years. From food service trucks to water supply companies, a variety of business owners began looking for a piece of the pass-through action. The proposed regulations state that a company’s activities must be specialized, essential, and significant in order to generate qualifying income. This means that in order for the income from Ashley P’s Water Supply Co. to be eligible, its services must be limited and specific to companies that generate otherwise qualifying income. In addition, the activities must be required for the successful completion of qualifying activities, and frequent in nature. Basically, Ashley P’s must have all its eggs in one basket. Luckily for Ben H’s Frac Sand Co. , the income from its operations would qualify under these definitions.

In order to gain an understanding of the general sentiment surrounding the proposed regulations, we visited the online comments page. It’s clear that stakeholders are taking their sweet time and carefully crafting their responses, as there is only one comment to date. The sole commenter doesn’t beat around the bush in voicing his displeasure over the fact that companies who are grandfathered in only have a decade long grace period. Since the commenter is a Westlake Chemical Partners (WLKP) investor, this dissatisfaction is understandable. Especially since, to add insult to injury, Westlake received a favorable PLR before its August 2014 IPO that ethylene production from ethane was qualifying. WLKP is standing its ground and plans to leave no stone unturned in regards to encouraging the IRS to revise the proposed regulations.

Remember, stakeholders, the ball is in your court and you have until August 4th to give the IRS a piece of your mind.

It will be interesting to see how the comments affect the final ruling, but as to what could change, your guess is as good as mine, and we’ll just cross that bridge when we come to it. In the end, we know everyone won’t see eye to eye, but we believe that all’s well that ends well.

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