IRS treats pipeline water-delivery income as qualifying partnership income

Plain-English summary

The IRS ruled that a publicly traded partnership's distributive share of income from a related partnership's water-delivery pipeline would be qualifying income under section 7704(d)(1)(E). The pipeline would supply fresh water to oil and gas producers for hydraulic fracturing and other natural-gas exploration, development, and production activities. The ruling treated that supply and transportation activity as connected to the transportation of a natural resource. It did not rule on whether the partnership met the separate 90 percent gross-income test or whether the pipeline had other commercial uses.

Ruling snapshot

• Question: Whether a publicly traded partnership's share of income from supplying and transporting water to oil and gas producers is qualifying income.
• Outcome: Approved, subject to the stated limitations.
• Key authorities: IRC § 7704(d)(1)(E), with the 90 percent requirement in § 7704(c)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201234005 Third Party Communication: None
Release Date: 8/24/2012 Date of Communication: Not Applicable
Person To Contact:
Index Number: 7704.03-00 ----------------------, ID No. -----------------
Telephone Number:
--------------------
------------------------- Refer Reply To:
-------------------------------------------------- CC:PSI:02
-------------------------------------------------- PLR-103554-12
---------------------------------------- Date:
------------- May 11, 2012

                                                   LEGEND

                       --------------------------------------------------

X =
----------------------------

                       --------------------------------------------

Y =
----------------------------

Z = -------------------------

State = -------------

Dear -------------:

   This letter responds to a letter from X’s authorized representatives dated January

13, 2012, submitted on behalf of X, requesting a ruling concerning the qualifying income
exception to the publicly traded partnership rules of § 7704 of the Internal Revenue
Code (the Code).

    According to the information submitted and representations made, X is a limited

partnership organized under the laws of State and publicly traded within the meaning of
§ 7704(b). Among other activities, X engages in the transportation and processing of
natural gas within the United States through affiliated operating subsidiaries treated as
partnerships and disregarded entities for federal income tax purposes. To facilitate its
transportation and processing activities, X owns natural gas gathering pipelines, natural
PLR-103554-12 2

gas processing systems, and the natural gas pipeline rights-of-way associated with
each pipeline.

    X’s customers are natural gas producers that use hydraulic fracturing to extract

natural gas from geologic formations. Hydraulic fracturing involves the injection of
fluids, primarily water mixed with a proppant, into an oil or gas well at high pressure to
fracture geologic formations and open pathways for the oil or gas to flow. The fracturing
process requires very large volumes of water.

   To meet the water needs of X’s customers, X and Z formed Y, a limited liability

company taxed as a partnership for federal income tax purposes, under the laws of
State. Y will develop, construct, own, and operate a water delivery pipeline system
(“Pipeline”) for the purpose of supplying fresh water to X’s customers and other natural
gas producers for use in the production of natural gas through hydraulic fracturing. The
Pipeline will primarily run parallel to the trunk-line of X’s natural gas gathering pipelines
and share X’s existing rights-of-way. Y will earn income from long-term pipeline
capacity and supply agreements with X’s customers. Y expects to enter into additional
long-term pipeline capacity and supply agreements with other natural gas producers in
the region. Under the agreements, natural gas producers will pay Y for the pipeline
supply and transportation of fresh water to water impoundment ponds designated by the
natural gas producers.

    X further represents that the supply and transportation of fresh water to natural

gas producers for use in hydraulic fracturing is integral to the exploration and production
of natural gas from shale formations and the preservation and growth of X’s existing
activity of natural gas transportation. X, through Y, is uniquely situated to efficiently
supply fresh water through a pipeline due to its existing rights-of-way and expertise in
pipeline transportation. Y intends to provide the water supply solely to natural gas
producers operating in proximity to X’s natural gas gathering assets, many of whom are
either current customers or prospective customers of X’s natural gas gathering services.

   Section 7704(a) provides generally that a publicly traded partnership shall be

treated as a corporation.

  Section 7704(b) provides that the term “publicly traded partnership” means any

partnership if (1) interests in that partnership are traded on an established securities
market, or (2) interest in that partnership are readily tradable on a secondary market (or
substantial equivalent thereof).

   Section 7704(c)(1) provides that § 7701(a) shall not apply to any publicly traded

partnership for any taxable year if such partnership met the gross income requirements
of § 7704(c)(2) for such taxable year and each preceding taxable year beginning after
December 31, 1987, during which the partnership (or any predecessor) was in
existence.
PLR-103554-12 3

   Section 7704(c)(2) explains that a partnership meets the gross income

requirements of § 7704(c)(2) for any taxable year if 90 percent or more of the gross
income of such partnership for such taxable year is qualifying income.

   Section 7704(d)(1)(E) provides that the term “qualifying income” means income

or gains derived from the exploration, development, mining or production, processing,
refining, transportation (including pipelines transporting gas, oil, or products thereof), or
the marketing of any mineral or natural resource (including fertilizer, geothermal energy,
or timber).

   Based solely on the facts submitted and representations made, we conclude that

X’s distributive share of the gross income derived by Y from the supply and
transportation of water to oil and gas producers for use in the exploration, development,
and production of oil or natural gas is qualifying income within the meaning of
§ 7704(d)(1)(E).

    Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. In particular, no opinion is expressed as to whether X meets
the 90 percent gross income requirement of § 7704(c)(1) in any taxable year for which
this ruling may apply. In addition, this office has not verified or determined whether any
other commercial use may exist for the water delivery pipeline system developed,
constructed, owned, and operated by Y. To the extent that other commercial uses may
exist for the water delivery pipeline system, this letter ruling will not apply in determining
whether X’s distributive share of any gross income that may be derived from such other
uses constitutes qualifying income under § 7704(d)(1)(E).

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of
the material submitted in support of the request for rulings, it is subject to verification on
examination.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent.
PLR-103554-12 4

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

                                   Sincerely,



                                   Bradford R. Poston
                                   Senior Counsel, Branch 2
                                   (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes

cc: