Integrated fracking-water services produce qualifying income

Plain-English summary

A publicly traded partnership planned to acquire a business that supplied water for hydraulic fracturing and handled the resulting waste fluids. The operations used specialized equipment and personnel to deliver and monitor high-volume water flows, then collect, transport, treat, recycle, or dispose of flowback and produced water. The taxpayers represented that these services were essential to commercially viable oil and gas production. The IRS ruled that income from the integrated water-delivery and post-use fluid-handling services was qualifying income under section 7704(d)(1)(E). The ruling does not apply to water delivered to affiliates or third parties when the partnership does not also collect and clean, recycle, or otherwise dispose of that water after use.

Ruling snapshot

• Question: Does income from integrated hydraulic-fracturing water and waste-fluid services qualify under section 7704?
• Outcome: Approved
• Key authorities: IRC §§ 7704(c), 7704(d)(1)(E)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201545002 Third Party Communication: None
Release Date: 11/6/2015 Date of Communication: Not Applicable
Index Number: 7704.03-00
Person To Contact:
---------------- ----------------------, ID No. ------------------
-------------------------------------------------- Telephone Number:
-------------------------------------- ----------------------
--------------------------- Refer Reply To:
-------------------------------------- CC:PSI:B01
PLR-130812-14
Date:
August 5, 2015

Legend

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

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

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

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

Date = ---------------------------

n1 = ----------

n2 = ----------

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

This responds to your letter dated August 13, 2014, and subsequent correspondence,
submitted on behalf of X, requesting a ruling under section 7704(d)(1)(E) of the Internal
Revenue Code (Code).

                                                 FACTS

According to the information submitted, X is a limited partnership organized under the
laws of State. Y is a publicly traded corporation formed in State. Y is an independent
oil and gas company engaged in the acquisition, exploration and development of natural
gas and oil products. Y developed midstream operations consisting of (1) gathering and
PLR-130812-14 2

transportation system for its natural gas, NGL, and oil production and (2) water
provision and delivery for hydraulic fracturing operations. Y conducts its water provision
and delivery services through two wholly owned subsidiaries collectively known as Z.
On Date, X completed an initial public offering (IPO) pursuant to which Y contributed its
natural gas gathering and compression assets to X in exchange for limited partnership
interests in X. X also received a right of first offer to purchase Y’s water-related assets
and associated fluids services business. X intends to exercise this right.

Z provides fluid delivery, handling, treatment, processing, and disposal services to Y
pursuant to various Services Agreements. Z also has the right to provide these services
to other oil and gas producers. These services are rendered in all three phases of the
exploration and production of oil and gas: upstream of the well site, at the well site, and
downstream of the well site.

As part of its upstream services, Z uses pumps operated by Z personnel to withdraw
water from local rivers, streams, and other sources. The water is then transported
through a system of above and below ground pipelines, water storage facilities including
impoundments and above ground tanks and pumping stations, for use in hydraulic
fracturing (“fracking”).

Fracking stimulates production of natural gas and oil from dense subsurface rock
formations. Fracking involves the injection of fluids, primarily water, sand, and
chemicals under pressure through a cased and cemented wellbore into targeted
subsurface formations to fracture the surrounding rock and stimulate production,
requiring very large volumes of water.

At the well site, Z typically installs pipelines and high-speed pumps to connect the
applicable impoundment to the wellsite. After the infrastructure is in place, Z supplies
water to the well site and stores it in above-ground storage tanks (ASTs) with a capacity
of n1 to n2 barrels of water. Personnel of Z must be present at the well site during all
active fracking operations to ensure equipment is functioning properly and maintain
proper flow rates. Maintaining proper flow rate is essential to the success of the drilling
operation because water being removed from above-ground storage tanks may exceed
the rate at which water is entering the tanks. Personnel must monitor hoses and pumps
and make adjustments as necessary to ensure that the tanks do not overflow while
transferring water at a rate that most efficiently compensates for the asymmetrical flow
rates at which the tanks are filled and emptied. The provision of high-rate transfer
services is specialized and requires skilled employees or contractors to coordinate
closely with the fracking contractor and other onsite personnel.

Z, utilizing its personnel or by hiring independent contractors, also transports, stores,
processes, treats, and disposes of waste fluids associated with the exploration and
production of oil and gas through hydraulic fracturing. Flowback and produced water
are picked up by tank trunks and transported to a water treatment or disposal facility.
PLR-130812-14 3

Waste fluids are then processed to allow the resulting water to be discharged back into
surface water sources, processed to allow the resulting water to be reused in fracking
operations, or disposed of by injecting the fluids into secure underground formations,
including salt water disposal wells.

X and Y make the following representations:

1. The services provided by Z require substantial assets and equipment that are
  dedicated exclusively to use in the exploration and production of oil and gas.
2. The services provided by Z require personnel with specialized knowledge,
  training, and experience.
3. The production of oil and gas using the hydraulic fracturing process would not be
  commercially viable without fluid handling services.

                                LAW & ANALYSIS

Section 7704(a) provides that, except as provided in section 7704(c), a publicly traded
partnership will 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 the substantial equivalent thereof).

Section 7704(c)(1) provides that section 7704(a) does not apply to a publicly traded
partnership for any taxable year if such partnership meets the gross income
requirements of section 7704(c)(2) for the 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) provides, in relevant part, that a partnership meets the gross income
requirements of section 7704(c)(2) for any taxable year if 90 percent or more of the
gross income of the partnership for the taxable year consists of qualifying income.

Section 7704(d)(1)(E) provides that the term “qualifying income” includes income and
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,
and timber).
PLR-130812-14 4

                                  CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
gross income derived by X from the delivery of water and the collection, treatment, and
transport of flowback, produced water, and other fluids will constitute qualifying income
for purposes of section 7704(d)(1)(E). This ruling is not applicable to any income
derived by X from the delivery of water, including recycled produced water, to affiliates
or third parties where X does not also collect and clean, recycle, or otherwise dispose of
the delivered water after use.

Except as expressly provided herein, no opinion is expressed or implied concerning the
federal 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.

The ruling contained in this letter is 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 ruling, it is subject to verification on examination.

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 letter may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representatives.

                                   Sincerely,


                                   Laura C. Fields
                                   Laura C. Fields
                                   Senior Technician Reviewer, Branch 1
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

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