Oilfield water services produced qualifying partnership income

Plain-English summary

A limited partnership planned to provide oil and gas producers with services for collecting, treating, recycling, disposing of, transporting, and storing water used or produced in drilling and hydraulic fracturing. The services required specialized personnel and dedicated equipment, were needed to make production commercially viable, and included fresh-water delivery only to producers engaged in qualifying natural-resource activities. The IRS ruled that income from the described petroleum-water and fresh-water services would be qualifying income under section 7704(d)(1)(E). The ruling did not cover fluid delivery when the partnership did not also collect and clean, recycle, or dispose of produced water and drilling waste in the same geographic area. It also did not decide whether the partnership met the overall 90 percent gross-income test.

Ruling snapshot

• Question: Would income from the partnership's oilfield water handling and distribution services qualify under section 7704(d)(1)(E)?
• Outcome: approved, subject to the stated same-area collection and disposal limitation
• Key authorities: IRC §§ 7704(c), 7704(d)(1)(E); Treas. Reg. § 1.7704-4

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 201732006                                            Third Party Communication: None
Release Date: 8/11/2017                                      Date of Communication: Not Applicable
Index Number: 7704.03-00
                                                             Person To Contact:
----------------------------------------                     ----------------------, ID No. ------------------
---------------------------------------------                Telephone Number:
---------------------------------                            --------------------
--------------------------------                             Refer Reply To:
                                                             CC:PSI:B03
                                                             PLR-107068-15
                                                             Date:
                                                             May 16, 2017

                                                  LEGEND

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

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

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

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

       This letter responds to a letter dated February 12, 2015, and subsequent
correspondence, submitted on behalf of X by its authorized representatives, requesting
a ruling under section 7704(d)(1)(E) of the Internal Revenue Code (Code).

                                                   FACTS

        X is a limited partnership formed under State law on Date. X intends to be a
publicly traded partnership, and will provide a broad range of services to working
interest owners engaged in the exploration, development, and production of oil and
natural gas (the Producers). Services to the Producers will include delivery, handling,
treatment, recycling and disposal of petroleum-water mix produced as part of a
Producers’ oil and gas production (the Petroleum-Water Mix Services), and the
transportation and storage of fluids for Producers’ use in drilling and completing wells
(the Fresh Water Distribution Services). X will provide the services through affiliated
entities using employees of X or other contracted third parties.

        In particular, as part of the Petroleum-Water Mix Services, X will collect the
produced petroleum-water mix through X’s combined liquids pipeline and transport the
petroleum-water mix to X’s central processing facility where the oil and petroleum-water
mix will be separated, stored, and conditioned or treated before the petroleum-water mix
is delivered to third parties contracted by X for either further treatment and recycling for
PLR-107068-15                                2

reuse in future drilling operations, or disposal in underground formations via injection
wells in accordance with applicable state and Federal environmental regulations.
Depending on the area of production, X may alternatively collect and transport the
petroleum-water mix through pipelines or trucks directly to a salt water disposal well for
disposal. In other areas, X may instead collect the petroleum-water mix through
temporary pipelines and transport the petroleum-water mix to mobile on-site recycling
skids where the petroleum-water mix will be cleaned and treated to remove
hydrocarbons, toxic materials, particulates, and dissolved solids to meet specific water
quality specifications. The solids will be continuously collected, removed, and disposed
of in an approved solid waste facility. The treated water will be recycled at the site and
returned to the Producer-owned tanks to be stored for reuse in the hydraulic fracturing
process. X will receive a variable service fee for its Petroleum-Water Mix Services
based on the volume of petroleum-water mix received to handle.

       As part of the Fresh Water Distribution Services, X will provide fresh water (from
recycling facilities and other sources) to Producers in the same geographic area as its
Petroleum-Water Mix Services, using a combination of permanent buried pipelines,
portable surface pipelines, fresh water storage facilities, and pumping stations. X will
receive a monthly fee for its Fresh Water Distribution Services for each month that its
services are provided.

      X makes the following representations:

      1. The services provided by X 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 X require personnel with specialized knowledge,
training, and experience. Such personnel will operate, maintain, and monitor the assets
and equipment on an ongoing basis.

      3. The production of oil and gas using the hydraulic fracturing process would not
be commercially viable without X’s fluid handling services.

     4. X will provide its Fresh Water Distribution Services exclusively to those
engaged in section 7704(d)(1)(E) 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
PLR-107068-15                                  3

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).

        Section 1.7704-4(a) of the Income Tax Regulations provides that, for purposes of
§ 7704(d)(1)(E), qualifying income is income and gains from qualifying activities with
respect to minerals or natural resources as defined in § 1.7704-4(b). Qualifying
activities are section 7704(d)(1)(E) activities (as described in § 1.7704-4(c)) and intrinsic
activities (as described in § 1.7704-4(d)).

        Section 1.7704-4(d)(1) provides that an activity is an intrinsic activity only if the
activity is specialized to support a section 7704(d)(1)(E) activity, is essential to the
completion of the section 7704(d)(1)(E) activity, and requires the provision of significant
services to support the section 7704(d)(1)(E) activity. Whether an activity is an intrinsic
activity is determined on an activity-by-activity basis.

       Section 1.7704-4(d)(2)(i) provides that an activity is a specialized activity if the
partnership provides personnel (including employees of the partnership, an affiliate,
subcontractor, or independent contractor performing work on behalf of the partnership)
to support a section 7704(d)(1)(E) activity and those personnel have received training in
order to support the section 7704(d)(1)(E) activity that is unique to the mineral or natural
resource industry and of limited utility other than to perform or support a section
7704(d)(1)(E) activity.

       In addition, to the extent that the activity involves the sale, provision, or use of
specific property, § 1.7704-4(d)(2)(ii) requires that, in order for the activity to be a
specialized activity, either (A) the property is primarily tangible property that is dedicated
to, and has limited utility outside of, section 7704(d)(1)(E) activities and is not easily
converted (as determined based on all the facts and circumstances, including the cost
PLR-107068-15                                 4

to convert the property) to another use other than supporting or performing the section
7704(d)(1)(E) activities (except that the use of non-specialized property typically used
incidentally in operating a business will not cause a partnership to fail § 1.7704-
4(d)(2)(ii)(A)); or (B) If the property is used as an injectant to perform a section
7704(d)(1)(E) activity that is also commonly used outside of section 7704(d)(1)(E)
activities (such as water and lubricants), the partnership provides the injectants
exclusively to those engaged in section 7704(d)(1)(E) activities; the partnership is also
in the trade or business of collecting, cleaning, recycling, or otherwise disposing of
injectants after use in accordance with Federal, state, or local regulations concerning
waste products from mining or production activities; and the partnership operates its
injectant delivery and disposal services within the same geographic area.

        Section 1.7704-4(d)(3)(i) provides that an activity is essential to the section
7704(d)(1)(E) activity if it is required to (A) physically complete a section 7704(d)(1)(E)
activity (including in a cost-effective manner, such as by making the activity
economically viable), or (B) comply with Federal, state, or local law regulating the
section 7704(d)(1)(E) activity. Section 1.7704-4(d)(3)(ii) provides that legal, financial,
consulting, accounting, insurance, and other similar services do not qualify as essential
to a section 7704(d)(1)(E) activity.

       Section 1.7704-4(d)(4)(i) provides that an activity requires significant services to
support the section 7704(d)(1)(E) activity if those services must be conducted on an
ongoing or frequent basis by the partnership’s personnel at the site or sites of the
section 7704(d)(1)(E) activities. Alternatively, those services may be conducted offsite if
the services are performed on an ongoing or frequent basis and are offered to those
engaged in one or more section 7704(d)(1)(E) activities. If the services are monitoring,
those services must be offered exclusively to those engaged in one or more section
7704(d)(1)(E) activities. Whether services are conducted on an ongoing or frequent
basis is determined based on all the facts and circumstances, including recognized best
practices in the relevant industry.

        Section 1.7704-4(d)(4)(ii) provides that personnel perform significant services
only if those services are necessary for the partnership to perform an activity that is
essential to the section 7704(d)(1)(E) activity, or to support the section 7704(d)(1)(E)
activity. Personnel include employees of the partnership, an affiliate, subcontractor, or
independent contractor performing work on behalf of the partnership. Section 1.7704-
4(d)(4)(iii) provides that services are not significant services with respect to a section
7704(d)(1)(E) activity if the services principally involve the design, construction,
manufacturing, repair, maintenance, lease, rent, or temporary provision of property.

                                      CONCLUSION

       Based solely on the facts submitted and the representations made, we conclude
that gross income derived by X from its Petroleum-Water Mix Services and Fresh Water
PLR-107068-15                                   5

Distribution Services will constitute qualifying income within the meaning of
§ 7704(d)(1)(E). This ruling is not applicable to any income derived by X from the
delivery and transfer of fluids, including recycled produced water, where X does not also
collect and clean, recycle, or otherwise dispose of produced water and drilling
production waste after use within the same geographic area.

       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,

                                          /s/

                                      Holly Porter
                                      Chief, Branch 3
                                      Office of the Associate Chief Counsel
                                      (Passthroughs and Special Industries)


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