PLR 1322024: IRS treats hydraulic fracturing service income as qualifying income

Plain-English summary

The IRS ruled that gross income from providing hydraulic fracturing services would qualify as income from the development or production of a mineral or natural resource under § 7704(d)(1)(E). The taxpayer planned to operate as a publicly traded partnership providing high-pressure fracturing services to oil and gas producers. Its expected fees included mobilization, operating, standby, downtime, force majeure, and reimbursed material costs. The ruling did not decide whether the taxpayer would satisfy the separate 90 percent gross-income requirement or whether its ownership structures would be partnerships for federal tax purposes.

Ruling snapshot

• Question: Would income from the taxpayer's hydraulic fracturing services be qualifying income under the publicly traded partnership rules?
• Outcome: Approved
• Key authorities: IRC §§ 708, 7704, and 6110(k)(3).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201322024 Third Party Communication: None
Release Date: 5/31/2013 Date of Communication: Not Applicable
Person To Contact:
Index Number: 7704.00-00, 7704.03-00 -------------------------, ID No. ------------------
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-------------------------------------------------- Telephone Number:
--------------------------------- ----------------------
-------------------------------------------------- Refer Reply To:
------------------------------- CC:PSI:B02
PLR-138320-12
Date:
January 31, 2013

Legend

X = --------

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

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

Date1 = --------------------------

Date2 = --------------------

a = ----

b = --

c = ----

d = -----

e = ----

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

This responds to your letter dated August 31, 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.
PLR-138320-12 2

Facts

X is a limited liability company formed under the laws of State on Date1 and is treated
as a partnership for federal income tax purposes. X represents that it intends to form a
“publicly traded partnership” within the meaning of § 7704(b). After the initial public
offering, the publicly traded partnership (itself or through affiliated operating limited
partnerships, limited liability companies or disregarded entities) will carry on X’s current
business as described below.

X is an oilfield service company that provides well stimulation services to the oil and gas
industry. Specifically, X provides high-pressure hydraulic fracturing services to
exploration and production companies in order to enhance the production of oil and
natural gas from unconventional oil and natural gas basins (geologic formations such as
shale and other tight formation reservoirs where natural flow is restricted). To provide
these services, X uses mobile hydraulic fracturing units and associated heavy
equipment that are owned by X and operated by X’s employees and independent
contractors. This hydraulic fracturing equipment is specifically designed to pump
specially formulated fluid (“fracturing fluid”) into a perforated well casing or tubing under
high pressure.

The fracturing process is completed in multiple “stages,” or horizontal zones. Sand,
bauxite, resin-coated sand or ceramic particles, each referred to as a proppant or
propping agent, are suspended in the fracturing fluid and prop open the cracks created
by the fracturing process in the underground formation. This causes the underground
formation to crack or fracture, thereby allowing the hydrocarbons to flow more freely into
the wellbore. X represents that these hydraulic fracturing services are integral to the
production of oil and natural gas from wells drilled in shale and other tight formation
reservoirs, because the production of such oil and natural gas would be significantly
curtailed in the absence of such services.

X entered into a contract with Y to provide hydraulic fracturing services to Y in a specific
geographic location. Y is an independent exploration and production company engaged
in the acquisition, development and production of unconventional natural gas resources
in the United States. The contract requires X to provide hydraulic fracturing services to
Y over a 24-month period commencing on Date2. The contract requires X to provide an
initial fleet of a pumps, and to perform a minimum of b stages per day for c days per
month, resulting in a minimum of d fracturing stages per quarter. Under the contract,
X’s fees for providing hydraulic fracturing services to Y consists of: 1) mobilization fees
based on mileage from the location of X’s hydraulic fracturing fleet, charged at the initial
stage of each job; 2) operating stage/well/day rates; 3) standby times rates and down-
time rates in circumstances where Y does not provide X with the minimum d quarterly
stages through no fault of X; 4) force majeure payment rates and payments in the event
PLR-138320-12 3

a governmental body or regulatory agency issues a mandate that either makes it
impossible for X to continue operations or causes an increase in X’s rate; and 5)
reimbursable costs with respect to hydraulic fracturing related material, equipment, work
or services that are to be furnished by X at Y’s request, plus e% for such cost of
handling.

X represents that the contract with Y is illustrative of the contractual relationships that X
expects to have with other exploration and production companies. The fee structure of
these additional contracts is expected to be similar to the fees charged in the contract
with Y. In certain instances, X may also source chemicals and proppants that are
consumed during the fracturing process and charge its exploration and production
customers a fee for providing such materials. Such charges for materials will generally
reflect the cost of the materials plus a markup and will be based on the actual quantity
of materials used in the fracturing process. Finally, X may charge its other exploration
and production customers a handling fee for chemicals and proppants supplied by the
customer.

X has requested a ruling that the gross income it derives from hydraulic fracturing
services is qualifying income within the meaning of § 7704(d)(1)(E).

Law and Analysis

Section 7704(a) provides 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) interests in that partnership are readily tradable on a secondary market
(or substantial equivalent thereof).

Section 7704(c)(1) provides that section 7701(a) shall not apply to any publicly traded
partnership for any taxable year if such partnership met the gross income requirements
of section 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.

Section 7704(c)(2) explains that a partnership meets the gross income requirements of
section 7704(c) 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).
PLR-138320-12 4

Conclusion

Based solely on the facts submitted and representations made, we conclude that the
gross income that X derives from providing hydraulic fracturing services will be
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, including 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, no opinion
is expressed or implied concerning whether any of the ownership structures discussed
or referenced in this letter constitute partnerships for federal tax purposes.

This ruling is directed only to the taxpayer requesting it. However, in the event of a
technical termination of X under § 708(b)(1)(B), the resulting partnership may continue
to rely on this ruling in determining its qualifying income under § 7704(d)(1)(E). Section
6110(k)(3) of the Code provides that this ruling may not be used or cited as precedent.

Temporary or final regulations pertaining to one or more of the issues addressed in this
ruling have not yet been adopted. Therefore, this ruling will be modified or revoked by
the adoption of temporary or final regulations, to the extent the regulations are
inconsistent with any conclusion in the letter ruling. See § 11.04 of Rev. Proc. 2012-1,
2012-1 I.R.B. 1, 50. However, when the criteria in § 11.06 of Rev. Proc. 2012-1, 2012-1
I.R.B. 1, 50 are satisfied, a ruling is not revoked or modified retroactively except in rare
or unusual circumstances.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

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.
PLR-138320-12 5

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,



                                   Melissa C. Liquerman
                                   Branch Chief, Branch 2
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

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

cc: