Oilfield service income qualifies for partnership exception

Plain-English summary

A corporation formed a limited partnership to own and finance oil and gas midstream activities before a planned public offering. The partnership would provide freshwater distribution, produced-water transportation and disposal, recycling, pressure pumping, production support, and limited mineral marketing services. The IRS ruled that income from the described services would be qualifying income under IRC § 7704(d)(1)(E). The ruling does not cover water or injectant delivery when the partnership does not also collect and clean, recycle, or dispose of the resulting produced water.

Ruling snapshot

• Question: Would income from the partnership's described oilfield fluid-handling, pressure-pumping, support, and mineral-marketing services qualify under IRC § 7704(d)(1)(E)?
• Outcome: Approved for the described services, subject to the stated produced-water limitation.
• Key authorities: IRC §§ 7704(a), 7704(b), 7704(c), and 7704(d)(1)(E)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201611017                                              Third Party Communication: None
Release Date: 3/11/2016                                        Date of Communication: Not Applicable
Index Number: 7704.03-00
                                                               Person To Contact:
-------------------------------                                ----------------------, ID No. -----------------
------------------------------------------------------------   Telephone Number:
---------------------------                                    ---------------------
-----------                                                    Refer Reply To:
------------------------------------                           CC:PSI:B01
 --------------------------------                              PLR-131150-14
                                                               Date:
                                                               December 2, 2015

Legend

X=                 ----------------
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Y=                 --------------------------------
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State =           -------------

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

This responds to your letter dated August 12, 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. Through direct and indirect subsidiaries, Y conducts midstream
activities including the construction and operation of freshwater distribution pipeline
systems, saltwater disposal systems, gas gathering and processing facilities, and oil
gathering facilities. Y also conducts pressure pumping services. Y formed X to own,
operate, and separately finance some or all of its midstream activities. As part of an
initial public offering (IPO) of X, Y intends to contribute assets related to its midstream

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activities to X. After completion of the IPO, X will be a publicly traded partnership within
the meaning of § 7704(b).

X, directly or through subsidiaries, will provide fluid delivery, handling, treatment,
processing, recycling and disposal services to oil and gas producers. X will also provide
freshwater distribution to exploration and production operators through pipelines
between freshwater delivery points and oil and gas producing wells and future drill sites.
Pipelines may also deliver water into storage ponds operated by X. Personnel of X will
work closely with the operator’s production and planning teams and will conduct
detailed hydraulic analysis before designing, creating, and installing pipelines that can
meet the flow rates demanded by specific groups of oil and gas wells. After the system
is operational, X personnel will optimize, monitor, and maintain the system in order to
ensure that water is delivered to the desired location at required flow rates.

X, utilizing its personnel or by hiring independent contractors, will also transport, store,
process, treat, and dispose of waste fluids associated with the exploration and
production of oil and gas. X will install, maintain, and operate pipelines to transport
produced water and flowback to salt water disposal wells (SWDs) owned and operated
by X. Where pipelines are not available, waste fluids will be picked up by tank trunks
and transported to a SWD for processing and disposal. ------------------------------------------
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Recycling facilities would be connected to X’s produced water pipelines. Treated water
would be re-delivered to well sites via (i) recycling the treated water into X’s freshwater
distribution systems, (ii) separate pipelines, or (iii) trucking water to the site.

X, directly or through subsidiaries, will also provide pressure pumping services to oil and
gas producers. Pressure pumping services include the activity of conducting the
completion of the well and pumping water, sand, and chemicals down the well with
sufficient pressure to fracture the underlying rock formation to release the crude oil and
natural gas. In conjunction with pressure pumping services, X personnel will provide
production support services including working with vendors to procure, store, and
deliver proppants and chemicals that are injected into wells. At each site, an inventory
control assistant will provide 24/7 support to the fracturing crew including (i) recording
the quantity of products used, (ii) monitoring the type and amount of chemicals used
downhole, (iii) ensuring a steady supply of chemicals, and (iv) consulting with the well-
site supervisor regarding the chemical supply and effectiveness. ------------------------------
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------------ On occasion, X may provide production support services for wells at which a
third party is providing the pressure pumping services. In such a case, X will provide
produced water disposal services for the well in question, including the filtering of
flowback and produced water to eliminate the chemicals supplied as part of the
production support services.

PLR-131150-14                                 3

X and Y make the following representations:

1. The services to be provided by X will require substantial assets and equipment that
   are dedicated exclusively to use in the exploration and production of oil and gas.
2. The services to be provided by X will 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.
4. For each well that X provides freshwater sourcing and distribution as a qualifying
   activity, X will also provide produced water transportation and recycling or disposal
   activities.
5. For each well that X provides production support services where a third party is
   providing pressure pumping services, X will also provide produced water
   transportation and recycling or disposal activities.

                                    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).

                                      CONCLUSION

PLR-131150-14                                  4

Based solely on the facts submitted and the representations made, we conclude that
gross income derived by X from freshwater sourcing and distribution services; produced
water transportation, recycling, and disposal services; marketing of skim oil and other
recoverable minerals other than to end users at the retail level; pressure pumping
services; and production support services as described herein 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 or other injectants, including recycled
produced water, to affiliates or third parties where X does not also collect and clean,
recycle, or otherwise dispose of the resulting produced 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