Years after the MLP game began the U.S. government’s decision to introduce rules has jolted players, but attorneys from Baker Botts LLP were reassuring during a recent webinar that explained the proposed regulations that determine qualifying income.

“Don’t panic,” advised Houston-based partner Michael Bresson. “There’s a 10-year transition rule that applies to most people.”

The 10-year period does not begin until the regulations are published as final, and the four attorneys involved in the webinar were clear that the initial draft released in May raises questions that need to be addressed before the rules are good to go.

Since 1987, MLPs have operated under congressionally imposed limitations in section 7704 of title 26 of the U.S. Internal Revenue Code. That limited guidance was supplemented by legal opinions and, when doubts lingered, with private letter rulings (PLRs) from the Internal Revenue Service (IRS).

The shale boom in 2008 triggered its own boom in requests for PLRs. Finally, in 2014, the IRS declared a moratorium on the letters in favor of developing a comprehensive set of regulations.

Transition Period

Even the rules governing the transition period raise questions. A three-part rule determines whether income from an activity can be treated as qualifying income during the 10-year period. Basically, if an MLP already has a PLR stating that, the company is golden.

It’s the second part of the rule, applying to partnerships that lack a PLR, where things get tricky. Baker Botts partner James Chenoweth found plenty to examine in this area.

“First, the question of how you treat an activity as qualifying or not could raise some issues,” he said. “If you’re a large-enough MLP that has an activity that might not be treated as qualifying under the proposed regs, but it was a small enough portion of your income that you had no reason to treat it as qualifying or not because it fit within your 10% bucket, if that activity grows during the transition period, it’s unclear whether you were ‘treating it as qualifying.’”

If the MLP is engaged in a joint venture, more questions pop up.

“If you’ve got lower-tier JVs, you could have an issue with a new MLP entering into that lower-tier JV,” Chenoweth said. “Are they going to be able to include income as qualifying that maybe some other MLPs in a lower-tier JV might have been able to?”

Questions About Coverage

There is also the matter of what the IRS intends the rules to mean when they don’t refer specifically to an issue, for example, the transportation and storage of carbon dioxide, alcohol, fuels and biodiesel.

“Those items were added to the list of qualifying products in 2008 and are part of the code,” said Dallas-based Baker Botts partner Steve Marcus. “The reason the regs don’t say anything about them is that the regulations simply aren’t intended to address those items. It doesn’t mean that those items are now excluded; they continue to be qualifying under the code provision at least to the extent that they are transported or stored.”

The proposed regulations apply to two kinds of activities: those already included in the code like E&P, processing or refining, transportation and marketing, and those referred to as intrinsic activities. Intrinsic activities, Marcus said, are those that the IRS had found itself handling with numerous PLRs, such as fracking.

The Processing Process

Processing gets particular attention in the proposal, including rules that affect equipment depreciation governed by the Modified Accelerated Cost Recovery System (MACRS) that is used to recover the basis of most business and investment property placed in service after 1986.

“Importantly, the IRS made a distinction about activities that are done with equipment that is not being depreciated consistently with the MACRS classes for petroleum refining or for natural gas production processing,” Chenoweth said. “If you have an activity that would otherwise be treated as purifying or eliminating impurities, but you’re doing it with equipment that’s not being depreciated under one of these classes that’s consistent with what the IRS feels is necessary for refining or processing, then the activity is not covered by the proposed regulation.”

The regulations note that activities that cause a substantial physical or chemical change, or otherwise transform the extracted mineral into something new or different, do not qualify as processing. Marcus noted that the chemical conversion rules are fairly restrictive. Recombination of one or more products of a chemical conversion from processing or refining must result in the cost-effective production of gasoline or other fuels.

“A midstream company might have to know what the depreciable elections were of the refiner or the processor because those are technical rules to be within those prior activities,” Chenoweth said.

For example, he noted that the new regulations raise questions about issues like liquefaction or compression, elements that are necessary for the transportation of LNG or natural gas but are not specifically listed. Chenoweth suspects that these activities would be covered under the intrinsic label, but he would like more guidance from Treasury.

Another example involves pipelines for interconnects.

“The pipeline needs to be owned by publicly traded partnership,” he said. “An interconnect to a lease pipeline doesn’t appear to meet the definition. It might be another oversight that could get fixed in the final regs.”

Contact the author, Joseph Markman, at jmarkman@hartenergy.com.