Pipeline, water-service, and interest-rate hedge income qualifies

Plain-English summary

A publicly traded partnership provided crude-oil and natural-gas gathering, transportation, storage, and interconnection services. It also transported produced water, planned integrated fresh-water and chemical delivery with wastewater collection and disposal, and used interest-rate swaps, caps, and Treasury locks to manage borrowing costs. The IRS ruled that the listed pipeline, parking, interconnection, produced-water, and integrated water-service income was qualifying income under section 7704(d)(1)(E). It also ruled that income from the interest-rate hedging transactions was qualifying income under section 7704(d)(1) and the regulations for notional principal contracts and similar routine investments. The IRS did not decide whether the hedges could be integrated with related debt, whether certain instruments were notional principal contracts, or whether the partnership met the overall 90 percent gross-income test.

Ruling snapshot

• Question: Did the partnership's energy transportation, water services, and borrowing-related hedges produce qualifying income?
• Outcome: Approved for the activities and hedging income described, with the partnership's overall 90 percent test left undecided.
• Key authorities: IRC § 7704(c), (d); Treas. Reg. §§ 1.446-3 and 1.7704-3

Full text (IRS public release)

Internal Revenue Service                                          Department of the Treasury
                                                                  Washington, DC 20224

Number: 201614004                                                 Third Party Communication: None
Release Date: 4/1/2016                                            Date of Communication: Not Applicable
Index Number: 7704.00-00, 7704.03-00
                                                                  Person To Contact:
-------------------------------------------------                 --------------------------, ID No. ----------------
-----------------------------------------                         -----------------
--------------------------------                                  Telephone Number:
--------------------------------------                            ---------------------
------------                                                      Refer Reply To:
--------------------------------------------------                CC:PSI:B01
                                                                  PLR-120297-15
                                                                  Date:
                                                                  December 10, 2015




Legend

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

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

         Year                       =        ------

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

         Agreement 1                =        -------------------------------------

         Agreement 2                =        -------------------------------------------

         Agreement 3                =        ---------------------------------



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

This responds to your letter dated June 11, 2015, and subsequent correspondence,
submitted on behalf of X, requesting a ruling under §§ 7704(d)(1) and 7704(d)(1)(E) of
the Internal Revenue Code (the “Code”).

                                                      Facts

According to the information submitted, X is a limited partnership under the laws of
State. X effected an initial public offering on Date and is a publicly traded partnership
PLR-120297-15                                  2

under § 7704(b). X provides crude oil gathering services and natural gas gathering and
processing services for customers as well as transportation and storage for oil and
natural gas customers. In addition, X engages in interest rate swap, interest rate cap,
and Treasury lock transactions (“Hedging Income”).

As part of its transportation services, X derives income from providing pipeline
transportation and gathering services of crude oil, natural gas and other products
thereof. Under Agreement 1, X receives volumes of crude oil into X’s gathering system
at various receipt points and then redelivers the crude oil at various destination points.
The customer pays a per barrel rate for volumes gathered by X. The customer is further
obligated to meet an annual volume commitment and must pay X a shortfall amount to
the extent the customer fails to reach the minimum volume amount. Under Agreement
2, X provides the customer capacity in X’s pipeline system for delivery at the customer’s
pipeline system. The customer is obligated to pay a monthly demand charge based on
the amount of reserved capacity on X’s pipeline system and in some cases, a
commodity charge based on the actual quantity of gas shipped on the system. Pursuant
to the transportation services under Agreement 3, X collects a fee for gathering natural
gas produced by the customer. Under Agreement 1, Agreement 2, and Agreement 3, X
constructs, owns and operates the pipeline and gathering systems.

X also derives income pursuant to parking agreements where X’s customers are
charged a usage fee based on the quantities of natural gas stored (“parked”) at X’s
facilities. Parking consists of (i) the receipt of gas by X for the customer’s accounts, (ii)
the retention of such gas by X, and (iii) the subsequent removal of such gas for the
customer’s account at the agreed upon time. In some cases, X will also engage in
“cycling” agreements with customers. A cycling agreement is a parking activity that has
an upper limit for the amount of natural gas that can be parked during a given time
period.

X also derives transportation income from construction, maintenance and operation of
lateral pipelines and new points of connection to X’s pipeline system
(“interconnections”).

As part of its downstream services, X derives income from the transportation of
“produced water” from crude oil and natural gas wells of its gathering system clients.
The produced water consists of both natural occurring water and flowback fluids used
for hydraulic fracturing. This water is high in salt content as well as various organic and
inorganic compounds and small amounts of radiation and the only viable disposal option
is transportation to a disposal well or injecting the water back down the well bore. X
represents that the produced water pipelines have limited use outside of disposing of
waste flowback and cannot easily be converted to another use other than supporting or
performing oil or gas production or transportation activities under § 7704(d)(1)(E). X’s
employees receive specialized training to operate and maintain the produced water
pipelines. In the future, X intends to expand its water transportation services to include
PLR-120297-15                                 3

produced water transportation services to non-gathering clients, transportation of
produced water that is not naturally occurring but is water flooded into a well to
stimulate production, and transportation of produced water by truck rather than pipeline.

X also intends to deliver fresh water, chemicals and other solutions to well sites for use
in fracturing. With respect to the water delivery services, X will also collect, clean,
recycle and otherwise dispose of the water in accordance with federal, state or local
regulations concerning waste products. In connection with the provision of these
services, X’s employees will receive specialized training and will provide services on an
ongoing and frequent basis.

Hedging Income

In order to finance asset acquisitions and conduct the operations of its business, X
periodically (a) incurs debt with a floating interest rate and enters into interest rate swap
agreements effectively converting its obligation on a portion of that debt into fixed rate
debt; (b) incurs debt with a fixed interest rate and enters into interest rate swap
agreements effectively converting its obligation on portion of that debt into floating rate
debt; (c) enters into interest rate cap agreements; and (d) enters into Treasury lock
agreements in anticipation of a future borrowing transaction.

In some cases, the financial transactions entered into by X are integrated with the
related debt instruments under § 1.1275-6 of the Income Tax Regulations. X is
requesting a ruling only on financial transactions that are not integrated.

Interest Rate Swaps

To manage the risk of interest rate movements on X’s borrowings, X may enter into
interest rate swap transactions with an unrelated party (the “Swap Counterparty”).
These swap arrangements include: (i) floating-to-fixed swaps; (ii) fixed-to-floating
swaps; and (iii) forward-start swaps.

Floating-to-fixed swaps. Under a floating-to-fixed swap, X agrees to pay the Swap
Counterparty a fixed interest rate on a notional principal amount. In return, the Swap
Counterparty agrees to pay X a floating interest rate (determined by reference to an
established index, usually the London Interbank Offered Rate, or “LIBOR”) on the
notional amount. If the floating rate for a given month exceeds the fixed rate, the Swap
Counterparty will owe X an amount equal to the difference between the two rates
multiplied by the notional principal amount. If the fixed rate exceeds the floating rate in a
month, X will owe the Swap Counterparty an amount equal to the difference between
the two rates multiplied by the notional principal amount. Amounts owing will be netted,
with net monthly settlements occurring during the swap’s term.
PLR-120297-15                                 4

Fixed-to-floating swaps. Under a fixed-to-floating swap, X agrees to pay the Swap
Counterparty a floating interest rate on a notional principal amount. In return, the Swap
Counterparty agrees to pay X a fixed interest rate. The terms of a fixed-to-floating swap
are otherwise similar to those of a floating-to-fixed swap described above but they result
in an opposite net income effect as the floating rate changes.

Forward-start swaps. To lock in a spot interest rate for a period prior to the issuance of
its fixed-debt securities (a forward lock), X will agree to pay the Swap Counterparty a
fixed interest rate on a notional principal amount. The Swap Counterparty agrees to pay
X an amount equal to a floating index rate, determined by reference to some
established index, multiplied by the notional principal amount for a fixed period that
begins on the date of the anticipated debt issuance. If the index rate exceeds the fixed
interest rate on the date of issuance of the debt securities, the Swap Counterparty owes
X an amount equal to the excess of the index interest rate over the fixed interest rate
multiplied by the notional principal amount over the term of the forward lock. On the
other hand, if the fixed interest rate exceeds the floating index rate on the date of
issuance of the debt securities, X will owe the Swap Counterparty the excess of the
fixed rate over the floating index rate multiplied by the notional principal amount over the
term of the forward lock. The amounts the parties owe to each other over the term of the
forward lock are calculated and netted on the anticipated date of issuance of the debt
securities.

Interest Rate Caps

In an interest rate cap, X will pay a counterparty an upfront fixed payment. The
counterparty agrees to pay X an amount equal to a floating index rate, determined by
reference to some established index, multiplied by a notional principal amount if, and
only if, the floating index rate exceeds a specified cap rate on a specified payment date.

Treasury Locks

In a Treasury lock agreement an unrelated party (the “Lock Counterparty”) notionally
agrees to purchase Treasury bonds from X at a contract price that values the Treasury
bonds using an interest rate equal to the prevailing interest rate on Treasury bonds in
effect on the date of the agreement. If the prevailing interest rate on Treasury bonds
increased during the agreement period, X will be entitled to receive a payment from the
Lock Counterparty that is effectively equal to the excess of the contract price over the
lower market price at which X could purchase Treasury bonds as a result of the
increase in prevailing Treasury bond interest rates. The payment offsets X’s increased
cost of issuing its debt resulting from the increase in prevailing Treasury bond interest
rates. If the prevailing interest rate on Treasury bonds decreases during the agreement
period, X will be required to pay the Lock Counterparty an amount effectively equal to
the excess of the higher market price at which X would have to purchase Treasury
bonds as a result of the decrease in prevailing Treasury bond interest rates over the
PLR-120297-15                                 5

contract price. That payment offsets X’s decreased cost of issuing its debt resulting
from the decrease in prevailing Treasury bond interest rates.

                                     Law and Analysis

Section 7704(a) provides that, except as provided in § 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 § 7704(a) does not apply to a publicly traded
partnership for any taxable year if such partnership meets the gross income
requirements of § 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 § 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).

Section 7704(d)(1)(A) provides that, except as otherwise provided in § 7704(d), the term
“qualifying income” includes interest.

Section 7704(d)(2) provides that interest shall not be treated as qualifying income if (A)
such interest is derived in the conduct of a financial or insurance business, or (B) such
interest would be excluded from the term “interest” under § 856(f).

Section 1.7704-3(a)(1) provides, in part, that for purposes of § 7704(d)(1), qualifying
income includes income from notional principal contracts (as defined in § 1.446-3) and
other substantially similar income from ordinary and routine investments to the extent
determined by the Commissioner. Income from a notional principal contract is included
in qualifying income only if the property, income, or cash flow that measures the
amounts to which the partnership is entitled under the contract would give rise to
qualifying income if held or received directly by the partnership. Section 1.7704-3(a)(2)
PLR-120297-15                                  6

provides, in part, that qualifying income described in § 1.7704-3(a)(1) does not include
income derived in the ordinary course of a trade or business.

Section 1.446-3(c)(1) defines a notional principal contract as a financial instrument that
provides for the payment of amounts by one party to another at specified intervals
calculated by reference to a specified index upon a notional principal amount in
exchange for specified consideration or a promise to pay similar amounts. Section
1.446-3(c)(1) further provides that this definition of a notional principal contract includes
interest rate swaps and interest rate caps.

Payments due under an interest rate swap are not interest. There is no borrowing and,
hence, no compensation for use of forbearance of money. However, such payments are
measured by reference to an interest rate or interest rate index and have a cash flow
that would not be excluded under § 856(f) if received as interest by X.

X’s treasury locks and forward-start interest rate swaps are common and routine
transactions and, like X’s interest rate swaps, they are entered into for the purpose of
managing the risk of interest rate movements on X’s borrowings. Under § 1.7704-
3(a)(1), the Commissioner may determine the extent to which income from ordinary and
routine investments substantially similar to income from a notional principal contract is
included in qualifying income.

                                         Conclusion

Based solely on the facts submitted and the representations made, we conclude that
income derived by X, directly or indirectly, from the following activities will constitute
qualifying income under § 7704(d)(1)(E):

      Transportation of crude oil and natural gas pursuant to Agreement 1, Agreement
       2, and Agreement 3;
      Natural gas parking activities including income from parking and cycling
       agreements to the extent parking income is separated from loaning income;
      Interconnect activities which enable customer’s product to enter X’s pipeline
       system;
      Transportation of produced water; and
      The delivery of fresh water and injectants where X will also collect, clean, recycle
       and dispose of such water.

Based solely on the facts and representations submitted, we also conclude that the
income X derives from Hedging Income is qualifying income within the meaning of
§ 7704(d)(1) and § 1.7704-3(a)(1).

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
PLR-120297-15                                  7

referenced in this letter. In particular, no opinion is expressed as to whether X’s Hedging
Income can be integrated with the related debt instruments under § 1.1275-6, as well as
to whether X is taxable as a partnership for federal tax purposes. We also express or
imply no opinion as to whether the Forward-Start Interest Rate Swaps or the Treasury
Locks meet the definition of a notional principal contract in § 1.446-3. Finally, no opinion
is expressed or implied 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.

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



cc: