[Federal Register Volume 80, Number 87 (Wednesday, May 6, 2015)]
[Proposed Rules]
[Pages 25970-25977]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-10592]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-132634-14]
RIN 1545-BM43


Qualifying Income From Activities of Publicly Traded Partnerships 
With Respect to Minerals or Natural Resources

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under section 
7704(d)(1)(E) of the Internal Revenue Code (Code) relating to 
qualifying income from exploration, development, mining or production, 
processing, refining, transportation, and marketing of minerals or 
natural resources. The proposed regulations affect publicly traded 
partnerships and their partners.

DATES: Comments and requests for a public hearing must be received by 
August 4, 2015.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-132634-14), Room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
132634-14), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at www.regulations.gov (IRS REG-132634-14).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Caroline E. Hay at (202) 317-5279; concerning the submissions of 
comments and requests for a public

[[Page 25971]]

hearing, Regina Johnson at (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) under section 7704(d)(1)(E) regarding 
qualifying income from certain activities with respect to minerals or 
natural resources.
    Congress enacted section 7704 in the Omnibus Budget Reconciliation 
Act of 1987, Public Law 100-203 (101 Stat. 1330 (1987)), due to 
concerns that the rapid growth of certain publicly traded partnerships 
was eroding the corporate tax base. See H.R. Rep. No. 100-391, at 1065 
(1987). Section 7704(a) provides that, as a general rule, publicly 
traded partnerships will be treated as corporations. In section 
7704(c), Congress provided an exception from this rule if 90 percent or 
more of the partnership's gross income is ``qualifying income.'' 
Qualifying income is generally passive-type income, such as interest, 
dividends, and rent. Section 7704(d)(1)(E) provides, however, that 
qualifying income also includes income and gains derived from the 
exploration, development, mining or production, processing, refining, 
transportation, or marketing of minerals or natural resources. Section 
7704(d)(1) defines the term ``mineral or natural resource'' as any 
product for which a deduction for depletion is allowed under section 
611, except soil, sod, dirt, turf, water, mosses, or minerals from sea 
water, the air, or other similar inexhaustible sources.
    Regulations have been published providing guidance on (1) when a 
partnership is publicly traded (Sec.  1.7704-1), (2) transition rules 
for partnerships in existence prior to the effective date of section 
7704 (Sec.  1.7704-2), and (3) qualifying income from certain financial 
products (Sec.  1.7704-3). No regulations have been issued under 
section 7704(d)(1)(E). Instead, questions about the specific 
application of section 7704(d)(1)(E) generally have been resolved by 
private letter ruling. However, the number of private letter ruling 
requests received has increased steadily from five or fewer requests 
per year for most years before 2008 to more than 30 requests received 
in 2013. Many of these requests seek rulings that income from support 
services provided to businesses engaged in the section 7704(d)(1)(E) 
activities is qualifying income for purposes of section 7704. The 
Treasury Department and the IRS are issuing these proposed regulations 
in response to this increased interest in the application of section 
7704(d)(1)(E).
    These proposed regulations provide guidance on whether income from 
activities with respect to minerals or natural resources as defined in 
section 7704(d)(1) is qualifying income. These regulations do not 
address the transportation or storage of any fuel described in section 
6426(b), (c), (d), or (e), or activities with respect to industrial 
source carbon dioxide, any alcohol fuel defined in section 
6426(b)(4)(A), or any biodiesel fuel as defined in section 40A(d)(1). 
The Treasury Department and the IRS request comments concerning whether 
guidance is also needed with respect to those activities and, if so, 
the specific issues such guidance should address.

Explanation of Provisions

    These proposed regulations use the term ``qualifying activities'' 
to describe activities relating to minerals or natural resources that 
generate qualifying income. Qualifying activities include: (1) The 
exploration, development, mining or production, processing, refining, 
transportation, or marketing of minerals or natural resources (section 
7704(d)(1)(E) activities), and (2) certain limited support activities 
that are intrinsic to section 7704(d)(1)(E) activities (an ``intrinsic 
activity''). These proposed regulations set forth the requirements 
under which an activity is a qualifying activity.

1. Section 7704(d)(1)(E) Activities

    Section 7704(d)(1)(E) activities represent different stages in the 
extraction of minerals or natural resources and the eventual offering 
of products for sale. These stages include exploration, development, 
mining or production, processing, refining, transportation (including 
pipelines transporting gas, oil, or products thereof), and marketing of 
any mineral or natural resource (including fertilizer, geothermal 
energy, and timber). Each of these stages involves various types of 
operations. Based in part on discussions with IRS engineers 
specializing in the various oil and natural resource fields, the 
proposed regulations provide an exclusive list of operations that 
comprise the section 7704(d)(1)(E) activities for purposes of section 
7704. This list may be expanded by published guidance. The Treasury 
Department and the IRS intend that this list represents only those 
activities that would be undertaken by an exploration and development 
company, a mining or production company, a refiner or processor, or a 
transporter or marketer of a mineral or natural resource. Services 
provided to those businesses are not section 7704(d)(1)(E) activities, 
although they may qualify as intrinsic activities. The Treasury 
Department and the IRS request comments concerning whether additional 
activities should be included in the list of section 7704(d)(1)(E) 
activities.
A. Exploration
    These proposed regulations define exploration as an activity 
performed to ascertain the existence, location, extent, or quality of 
any deposit of mineral or natural resource before the beginning of the 
development stage of the natural deposit. A partnership is engaged in 
exploration if the partnership: (i) Drills an exploratory or 
stratigraphic type test well; (ii) conducts drill stem and production 
flow tests to verify commerciality of the deposit; (iii) conducts 
geological or geophysical surveys; or (iv) interprets data obtained 
from geological or geophysical surveys. For minerals, exploration also 
includes testpitting, trenching, drilling, driving of exploration 
tunnels and adits, and similar types of activities described in Rev. 
Rul. 70-287 (1970-1 CB 146) if conducted prior to development 
activities with respect to the minerals.
B. Development
    These proposed regulations define development as an activity 
performed to make minerals or natural resources accessible. A 
partnership is engaged in development if the partnership: (i) Drills 
wells to access deposits of mineral or natural resources; (ii) 
constructs and installs drilling, production, or dual purpose platforms 
in marine locations (or constructs and installs any similar supporting 
structures necessary for extraordinary non-marine terrain such as 
swamps or tundra); (iii) completes wells including by installing lease 
and well equipment (such as pumps, flow lines, separators, and storage 
tanks) so that wells are capable of producing oil and gas, and the 
production can be removed from the premises; (iv) performs a 
development technique (for example, fracturing for oil and natural gas, 
or, with respect to minerals, stripping, benching and terracing, 
dredging by dragline, stoping, and caving or room-and-pillar 
excavation); or (v) constructs and installs gathering systems and 
custody transfer stations.
C. Mining or Production
    These proposed regulations define mining or production as an 
activity performed to extract minerals or other natural resources from 
the ground. A partnership is engaged in mining or production if the 
partnership: (i)

[[Page 25972]]

Operates equipment to extract natural resources from mines or wells, or 
(ii) operates equipment to convert raw mined products or raw well 
effluent to substances that can be readily transported or stored 
(including by passing crude oil through mechanical separators to remove 
gas, placing crude oil in settling tanks to recover basic sediment and 
water, dehydrating crude oil, and operating heater-treaters that 
separate raw oil well effluent into crude oil, natural gas, and salt 
water).
D. Processing or Refining
    Because processing and refining activities vary with respect to 
different minerals or natural resources, these proposed regulations 
provide industry-specific rules (described herein) for when an activity 
qualifies as processing or refining. In general, however, these 
proposed regulations provide that an activity is processing or refining 
if it is done to purify, separate, or eliminate impurities. These 
proposed regulations further require that, for an activity to be 
treated as processing or refining, the partnership's position that an 
activity is processing or refining for purposes of section 7704 must be 
consistent with the partnership's designation of an appropriate 
Modified Accelerated Cost Recovery System (MACRS) class life for assets 
used in the activity in accordance with Rev. Rul. 87-56 (1987-2 CB 27) 
(for example, MACRS asset class 13.3 for petroleum refining 
facilities). In addition, except as specifically provided otherwise, 
processing or refining does not include activities that cause a 
substantial physical or chemical change in a mineral or natural 
resource, or that transform the extracted mineral or natural resource 
into new or different mineral products, including manufactured 
products. The Treasury Department and the IRS believe that this rule is 
consistent with definitions found elsewhere in the Code and 
regulations. See, for example, Sec.  1.613-4(g)(5).
    With respect to natural gas, an activity is processing or refining 
only if the activity purifies natural gas, including by removal of oil 
or condensate, water, and non-hydrocarbon gases (including carbon 
dioxide, hydrogen sulfide, nitrogen, and helium), or separates natural 
gas into its constituents which are normally recovered in a gaseous 
phase (for example, methane and ethane) and those which are normally 
recovered in a liquid phase (for example, propane and butane, pentane 
and gas condensate). It is generally anticipated that activities that 
create the products listed in the 2012 version (the most recent version 
as of the date of publication of these proposed regulations) of North 
American Industry Classification System (NAICS) code 211112 concerning 
natural gas liquid extraction will be qualifying activities. Processing 
will also include converting methane in one integrated conversion into 
liquid fuels that are otherwise produced from the processing of crude 
oil, as described in the following paragraph.
    With respect to crude oil, an activity is processing or refining if 
the activity is performed to physically separate crude oil into its 
component parts, including, but not limited to, naphtha, gasoline, 
kerosene, fuel oil, lubricating base oils, waxes, and similar products. 
An activity that chemically converts the physically separated 
components is processing or refining of crude oil only if one or more 
of the products of the conversion are recombined with other physically 
separated components of crude oil in a manner that is necessary to the 
cost-effective production of gasoline or other fuels (for example, gas 
oil converted to naphtha through a cracking process that is 
hydrotreated and combined into gasoline). It is generally anticipated 
that activities within a refinery that create the products that are 
listed in the 2012 version (the most recent version as of the date of 
publication of these proposed regulations) of NAICS code 324110 
concerning petroleum refineries will be qualifying activities, if those 
products are refinery grade products that are obtained in the steps 
required to make fuels, lubricating base oils, waxes, and similar 
products. Additionally, physically separating any product that is 
itself generated by the processing or refining of crude oil is a 
qualifying activity for purposes of section 7704(d)(1)(E).
    The production of plastics and similar petroleum derivatives does 
not give rise to qualifying income derived from processing or refining. 
See H.R. Rep. No. 100-495, at 947 (1987) (Conf. Rep.). The following 
products are also not qualifying products under this standard: (1) 
Heat, steam, or electricity produced by the refining processes; (2) 
products that are obtained from third parties or produced onsite for 
use in the refinery, such as hydrogen, if excess amounts are sold; and 
(3) any product that results from further chemical change of the 
product produced from the separation of the crude oil if it is not 
combined with other products separated from the crude oil (for example, 
production of petroleum coke from heavy (refinery) residuum qualifies, 
but any upgrading of petroleum coke (such as to anode-grade coke) does 
not qualify because it is further chemically changed).
    With respect to ores and minerals, an activity is processing or 
refining if the activity is listed in Treasury Regulation Sec.  1.613-
4(f)(1)(ii) or (g)(6)(iii). Generally, refining of ores and minerals is 
any activity that eliminates impurities or foreign matter from smelted 
or partially processed metallic and nonmetallic ores and minerals, as 
for example, the refining of blister copper.
    With respect to timber, an activity is processing if it merely 
modifies the physical form of timber. Processing includes the 
application of heat or pressure to timber without adding any foreign 
substances. Processing of timber does not include activities that use 
chemicals or other foreign substances to manipulate timber's physical 
or chemical properties, such as using a digester to produce pulp. 
Products that result from timber processing include wood chips, 
sawdust, untreated lumber, veneers (unless a foreign substance is 
added), wood pellets, wood bark, and rough poles. Products that are not 
the result of timber processing include pulp, paper, paper products, 
treated lumber, oriented strand board, plywood, and treated poles.
    These proposed regulations reserve the provisions relating to 
fertilizer. The Treasury Department and the IRS request comments on 
what activities should be included.
E. Transportation
    These proposed regulations define transportation as the movement of 
minerals or natural resources and products produced from processing and 
refining, including by pipeline, barge, rail, or truck. Transportation 
also includes terminalling, providing storage services, and operating 
custody transfer stations and gathering systems. Transportation 
includes the construction of a pipeline only to the extent that a pipe 
is run to connect a client to a preexisting interstate or intrastate 
line owned by the publicly traded partnership (interconnect agreement). 
Transportation (except for pipeline transportation) does not include 
transportation of oil or gas (or oil or gas products) to a place that 
sells or dispenses to retail customers. See H.R. Rep. No. 100-795, at 
401 (1988). The legislative history accompanying section 7704 clarifies 
that ``a retail customer does not include a person who acquires the oil 
or gas for refining or processing, or partially refined or processed 
products thereof for further refining or processing, . . . [or a] 
utility providing power to customers.'' See H. R. Rep. No. 100-1104, 
vol. 2, at 18 (1988) (Conf. Rep.). By contrast, ``transporting refined 
petroleum

[[Page 25973]]

products by truck to retail customers is not a qualifying activity.'' 
Id. However, transportation includes bulk transportation, so long as 
the transportation is not to a place that sells or dispenses oil and 
gas (or oil and gas products) to retail customers. See S. Rep. No. 100-
445, at 424 (1988).
F. Marketing
    These proposed regulations define marketing as the activities 
undertaken to facilitate sale of minerals or natural resources, or 
products produced from processing and refining. Marketing may also 
include some additive blending into fuels provided to a customer's 
specification. The legislative history of section 7704 provides that 
marketing does not include activities and assets involved primarily in 
sales ``to end users at the retail level.'' S. Rep. No. 100-445, at 424 
(1988). Therefore, marketing does not include retail sales (sales made 
in small quantities directly to end users). For example, gas station 
operations are not included in marketing for purposes of section 
7704(d)(1)(E). Id. However, marketing includes bulk and wholesale sales 
made to end users. See, for example, H.R. Rep. 100-1104, at 18 (1988) 
(Conf. Rep.) (with respect to fertilizer) and incorporating in footnote 
1, 133 Cong. Rec. 37957 (December 22, 1987) (statement of Sen. Bentsen 
with respect to propane).

2. Intrinsic Activities

    The Treasury Department and the IRS believe that certain limited 
support activities intrinsic to section 7704(d)(1)(E) activities also 
give rise to qualifying income because the income is ``derived from'' 
the section 7704(d)(1)(E) activities. The proposed regulations set 
forth three requirements for a support activity to be intrinsic to 
section 7704(d)(1)(E) activities. An activity will qualify as an 
intrinsic activity only if the activity is specialized to support the 
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. If 
each of these requirements is met, the activity is an intrinsic 
activity, and any income received from the activity is qualifying 
income. The Treasury Department and IRS intend that intrinsic 
activities constitute active support of section 7704(d)(1)(E) 
activities, and not merely the supply of goods.
A. Specialized
    An activity meets the first requirement of the intrinsic test if 
both the personnel performing the activity and any property used in the 
activity or sold to the customer performing the section 7704(d)(1)(E) 
activity are specialized. Personnel are specialized if they have 
received training unique to the mineral or natural resource industries 
that is of limited utility other than to perform or support a section 
7704(d)(1)(E) activity. An activity cannot be an intrinsic activity 
without specialized service personnel because all intrinsic activities 
require the provision of significant services (as described in part 3.C 
of the Explanation of Provisions section of this Preamble). For 
example, catering services provided to employees at a drilling site 
would not give rise to qualifying income because catering services do 
not require skills (or equipment as explained below) limited to 
supporting a section 7704(d)(1)(E) activity. As such, catering services 
are not intrinsic activities and any income from those services is not 
qualifying income for purposes of section 7704(c).
    If an activity also involves the sale, provision, or use of 
property, then the property must qualify as specialized for the 
activity to be an intrinsic activity. The proposed regulations provide 
two alternative tests under which that property can qualify as 
specialized. Under the first test, property is specialized if it is 
used only in connection with section 7704(d)(1)(E) activities and has 
limited use outside of those activities. That property must also not be 
easily converted to a use other than performing or supporting a section 
7704(d)(1)(E) activity. Whether property is easily converted is 
determined based on all facts and circumstances, including the cost to 
convert the property.
    Under the second test, property that can be used for purposes other 
than to perform or support a section 7704(d)(1)(E) activity will 
qualify as specialized to the extent that the property is used as an 
injectant to perform a section 7704(d)(1)(E) activity, and, as part of 
the activity, the partnership also collects and cleans, recycles, or 
otherwise disposes of the injectant after use in accordance with 
federal, state, or local regulations concerning waste products from 
mining or production activities. Injectants under this definition 
include, for example, water, lubricants, and sand used in connection 
with section 7704(d)(1)(E) activities.
B. Essential
    An activity meets the second requirement of the intrinsic test if 
the activity is essential to a section 7704(d)(1)(E) activity. An 
activity is essential if it is necessary to (a) physically complete the 
section 7704(d)(1)(E) activity (including in a cost effective manner in 
order to make the activity economically viable), or (b) comply with 
federal, state or local law regulating the section 7704(d)(1)(E) 
activity. For example, water delivery and disposal services are 
essential when provided for use in fracturing because the water must be 
used to complete the drilling operations (a development activity under 
section 7704(d)(1)(E)) and because the water disposal services must be 
performed to comply with federal, state, or local law regulating 
drilling and fracturing. Legal, financial, consulting, accounting, 
insurance, and other similar services are not essential to a section 
7704(d)(1)(E) activity because the connection to completion of the 
section 7704(d)(1)(E) activity is too attenuated.
C. Significant Services
    An activity meets the third requirement of the intrinsic test if 
the activity includes the provision of significant services. A 
partnership provides significant services if its personnel have an 
ongoing or frequent presence at the site of the section 7704(d)(1)(E) 
activity and the activities of those personnel are necessary for the 
partnership to provide its services or to support the section 
7704(d)(1)(E) activity. A partnership that provides the same services 
to multiple clients may satisfy this test by performing the activity 
through a rotating presence at multiple sites. For this purpose, 
determining whether services are ongoing or frequent is determined 
under all facts and circumstances, including recognized best practices 
in the relevant industry. The Treasury Department and the IRS request 
comments on whether and how this requirement could be set forth as an 
objective standard.
    In addition, the proposed regulations acknowledge that a qualifying 
activity in which the partnership engages could require extensive 
offsite services. Therefore, these proposed regulations provide that 
the services may be conducted offsite if the services are performed on 
an ongoing or frequent basis and offered exclusively for those engaged 
in one or more section 7704(d)(1)(E) activities. For example, 
monitoring services will satisfy the significant services requirement 
if the monitoring is done on an ongoing or frequent basis only to 
support persons engaged in one or more section 7704(d)(1)(E) 
activities.
    The proposed regulations also identify certain activities that do 
not qualify as significant services because

[[Page 25974]]

they involve the manufacture and sale or temporary provision of a good. 
Thus, the design, construction, manufacturing, repair, maintenance, 
lease, rent, or temporary provision of assets is not taken into account 
when determining whether a partnership has provided significant 
services.

Proposed Effective/Applicability Date and Transition Rules

    Except for rules concerning the Transition Period, these 
regulations are proposed to apply to income earned by a partnership in 
a taxable year beginning on or after the date these regulations are 
published as final regulations in the Federal Register. These 
regulations also provide for a Transition Period, which ends on the 
last day of the partnership's taxable year that includes the date that 
is ten years after the date that these regulations are published as 
final regulations in the Federal Register.
    The proposed regulations provide that a partnership may treat 
income from an activity as qualifying income during the Transition 
Period if the partnership received a private letter ruling from the IRS 
holding that income from the activity is qualifying income. In 
addition, a partnership may treat income from an activity as qualifying 
income during the Transition Period if, prior to May 6, 2015, the 
partnership was publicly traded, engaged in the activity, and treated 
the activity as giving rise to qualifying income under section 
7704(d)(1)(E), and that income was qualifying income under the statute 
as reasonably interpreted prior to the issuance of these proposed 
regulations. In determining whether an interpretation was reasonable, 
the legislative history and interpretations applied by the IRS prior to 
the issuance of these proposed regulations are taken into account. An 
interpretation was not reasonable merely because a partnership had a 
reasonable basis for that position. With respect to an activity 
undertaken prior to May 6, 2015, no inference is intended that an 
activity that is not described in these proposed regulations as a 
qualifying activity did or did not produce qualifying income under the 
statute and legislative history.
    A partnership that is publicly traded and engages in an activity 
after May 6, 2015, but before the date these regulations are published 
as final regulations in the Federal Register may treat income from that 
activity as qualifying income during the Transition Period if the 
income from that activity is qualifying income under these proposed 
regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13563. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to these proposed regulations. Because these proposed 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking has been submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the Addresses heading. 
The IRS and the Treasury Department request comments on all aspects of 
the proposed rules. All comments will be available at 
www.regulations.gov or upon request. A public hearing will be scheduled 
if requested in writing by any person that timely submits written 
comments. If a public hearing is scheduled, notice of the date, time, 
and place for the public hearing will be published in the Federal 
Register.

Drafting Information

    The principal author of these proposed regulations is Caroline E. 
Hay, Office of the Associate Chief Counsel (Passthroughs and Special 
Industries). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Par. 2. Section 1.7704-4 is added to read as follows:


Sec.  1.7704-4  Qualifying income--mineral and natural resources.

    (a) In general. For purposes of section 7704(d)(1)(E), qualifying 
income includes only income and gains from qualifying activities with 
respect to minerals or natural resources as defined in paragraph (b) of 
this section. For purposes of section 7704(d)(1)(E), qualifying 
activities include section 7704(d)(1)(E) activities (as described in 
paragraph (c) of this section) and intrinsic activities (as described 
in paragraph (d) of this section).
    (b) Mineral or natural resource. The term mineral or natural 
resource (including fertilizer, geothermal energy, and timber) means 
any product of a character with respect to which a deduction for 
depletion is allowable under section 611, except that such term does 
not include any product described in section 613(b)(7)(A) or (B) (soil, 
sod, dirt, turf, water, mosses, minerals from sea water, the air, or 
other similar inexhaustible sources). For purposes of this section, the 
term mineral or natural resource does not include industrial source 
carbon dioxide, fuels described in section 6426(b) through (e), any 
alcohol fuel defined in section 6426(b)(4)(A), or any biodiesel fuel as 
defined in section 40A(d)(1).
    (c) Section 7704(d)(1)(E) activities--(1) Definition. Section 
7704(d)(1)(E) activities include the exploration, development, mining 
or production, processing, refining, transportation, or marketing of 
any mineral or natural resource as limited to those activities 
described in this paragraph (c) or as provided by the Commissioner by 
notice or in other forms of published guidance. No other activities 
qualify as section 7704(d)(1)(E) activities.
    (2) Exploration. An activity constitutes exploration if it is 
performed to ascertain the existence, location, extent, or quality of 
any deposit of mineral or natural resource before the beginning of the 
development stage of the natural deposit by:
    (i) Drilling an exploratory or stratigraphic type test well;
    (ii) Conducting drill stem and production flow tests to verify 
commerciality of the deposit;
    (iii) Conducting geological or geophysical surveys;
    (iv) Interpreting data obtained from geological or geophysical 
surveys; or
    (v) For minerals, testpitting, trenching, drilling, driving of 
exploration tunnels and adits, and similar types of activities 
described in Rev. Rul. 70-287 (1970-1 CB 146), (see

[[Page 25975]]

Sec.  601.601(d)(2)(ii)(b) of this chapter) if conducted prior to 
development activities with respect to the minerals.
    (3) Development. An activity constitutes development if it is 
performed to make accessible minerals or natural resources by:
    (i) Drilling wells to access deposits of mineral or natural 
resources;
    (ii) Constructing and installing drilling, production, or dual 
purpose platforms in marine locations, or any similar supporting 
structures necessary for extraordinary non-marine terrain (such as 
swamps or tundra);
    (iii) Completing wells, including by installing lease and well 
equipment, such as pumps, flow lines, separators, and storage tanks, so 
that wells are capable of producing oil and gas, and the production can 
be removed from the premises;
    (iv) Performing a development technique such as, for minerals, 
stripping, benching and terracing, dredging by dragline, stoping, and 
caving or room-and-pillar excavation, and for oil and natural gas, 
fracturing; or
    (vi) Constructing and installing gathering systems and custody 
transfer stations.
    (4) Mining or production. An activity constitutes mining or 
production if it is performed to extract minerals or other natural 
resources from the ground by:
    (i) Operating equipment to extract natural resources from mines and 
wells; or
    (ii) Operating equipment to convert raw mined products or raw well 
effluent to substances that can be readily transported or stored (for 
example, passing crude oil through mechanical separators to remove gas, 
placing crude oil in settling tanks to recover basic sediment and 
water, dehydrating crude oil, and operating heater-treaters that 
separate raw oil well effluent into crude oil, natural gas, and salt 
water).
    (5) Processing or refining--(i) In general. Except as otherwise 
provided in paragraph (c)(5) of this section, an activity is processing 
or refining if it is done to purify, separate, or eliminate impurities. 
For an activity to be treated as processing or refining for purposes of 
this section, the partnership's position that an activity is processing 
or refining for purposes of this section must be consistent with the 
partnership's designation of an appropriate Modified Accelerated Cost 
Recovery System (MACRS) class life for assets used in the activity in 
accordance with Rev. Rul. 87-56, 1987-2 CB 27 (see Sec.  
601.601(d)(2)(ii)(b) of this chapter). For example, for an activity to 
be processing or refining of crude oil under paragraph (c)(5)(iii) of 
this section, the assets used in that process must also have a MACRS 
class life of 13.3, Petroleum Refining. Unless otherwise provided in 
this paragraph (c)(5), an activity will not qualify as processing or 
refining if the activity causes a substantial physical or chemical 
change in a mineral or natural resource, or transforms the extracted 
mineral or natural resource into new or different mineral products or 
into manufactured products.
    (ii) Natural Gas. An activity constitutes processing of natural gas 
if it is performed to:
    (A) Purify natural gas, including by removal of oil or condensate, 
water, or non-hydrocarbon gases (including carbon dioxide, hydrogen 
sulfide, nitrogen, and helium);
    (B) Separate natural gas into its constituents which are normally 
recovered in a gaseous phase (methane and ethane) and those which are 
normally recovered in a liquid phase (propane, butane, pentane, and gas 
condensate); or
    (C) Convert methane in one integrated conversion into liquid fuels 
that are otherwise produced from petroleum.
    (iii) Petroleum--(A) Qualifying activities. An activity constitutes 
processing or refining of petroleum if the end products of these 
processes are not plastics or similar petroleum derivatives and the 
activity is performed to:
    (1) Physically separate crude oil into its component parts, 
including, but not limited to, naphtha, gasoline, kerosene, fuel oil, 
lubricating base oils, waxes and similar products;
    (2) Chemically convert the physically separated components if one 
or more of the products of the conversion are recombined with other 
physically separated components of crude oil in a manner that is 
necessary to the cost effective production of gasoline or other fuels 
(for example, gas oil converted to naphtha through a cracking process 
that is hydrotreated and combined into gasoline); or
    (3) Physically separate products created through activities 
described in paragraph (c)(5)(iii)(A)(1) or (2) of this section.
    (B) Non-qualifying activities. For purposes of this section, the 
following products are not obtained through processing of petroleum:
    (1) Heat, steam, or electricity produced by the refining processes;
    (2) Products that are obtained from third parties or produced 
onsite for use in the refinery, such as hydrogen, if excess amounts are 
sold; and
    (3) Any product that results from further chemical change of the 
product produced from the separation of the crude oil if it is not 
combined with other products separated from the crude oil (for example, 
production of petroleum coke from heavy (refinery) residuum qualifies, 
but any upgrading of petroleum coke (such as to anode-grade coke) does 
not qualify because it is further chemically changed).
    (iv) Ores and minerals. An activity constitutes processing or 
refining of ores and minerals if it meets the definition of mining 
processes under Sec.  1.613-4(f)(1)(ii) or refining under Sec.  1.613-
4(g)(6)(iii). Generally, refining of ores and minerals is any activity 
that eliminates impurities or foreign matter from smelted or partially 
processed metallic and nonmetallic ores and minerals, as for example 
the refining of blister copper.
    (v) Timber. An activity constitutes processing of timber if it is 
performed to modify the physical form of timber, including by the 
application of heat or pressure to timber, without adding any foreign 
substances. Processing of timber does not include activities that add 
chemicals or other foreign substances to timber to manipulate its 
physical or chemical properties, such as using a digester to produce 
pulp. Products that result from timber processing include wood chips, 
sawdust, rough lumber, kiln-dried lumber, veneers, wood pellets, wood 
bark, and rough poles. Products that are not the result of timber 
processing include pulp, paper, paper products, treated lumber, 
oriented strand board/plywood, and treated poles.
    (vi) Fertilizer. [Reserved]
    (6) Transportation. Transportation is the movement of minerals or 
natural resources and products produced under paragraph (c)(4) or (5) 
of this section, including by pipeline, barge, rail, or truck, except 
for transportation (not including pipeline transportation) to a place 
that sells or dispenses to retail customers. Retail customers do not 
include a person who acquires oil or gas for refining or processing, or 
a utility. The following activities qualify as transportation--
    (i) Providing storage services;
    (ii) Terminalling;
    (iii) Operating gathering systems and custody transfer stations;
    (iv) Operating pipelines, barges, rail, or trucks; and
    (v) Construction of a pipeline only to the extent that a pipe is 
run to connect a producer or refiner to a preexisting interstate or 
intrastate line owned by the publicly traded partnership (interconnect 
agreements).

[[Page 25976]]

    (7) Marketing. An activity constitutes marketing if it is performed 
to facilitate sale of minerals or natural resources and products 
produced under paragraph (c)(4) or (5) of this section, including 
blending additives into fuels. Marketing does not include activities 
and assets involved primarily in retail sales (sales made in small 
quantities directly to end users), which includes, but is not limited 
to, operation of gasoline service stations, home heating oil delivery 
services, and local gas delivery services.
    (d) Intrinsic activities--(1) General requirements. 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.
    (2) Specialization. An activity is a specialized activity if:
    (i) The partnership provides personnel to perform or support a 
section 7704(d)(1)(E) activity and those personnel have received 
training unique to the mineral or natural resource industry that is of 
limited utility other than to perform or support a section 
7704(d)(1)(E) activity; and
    (ii) To the extent that the activity includes the sale, provision, 
or use of property, 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 (based on all the facts and 
circumstances, including the cost to convert the property) to another 
use other than supporting or performing the section 7704(d)(1)(E) 
activities; or
    (B) 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, lubricants, and sand) and, as 
part of the activity, the partnership also collects and cleans, 
recycles, or otherwise disposes of the injectant after use in 
accordance with federal, state, or local regulations concerning waste 
products from mining or production activities.
    (3) Essential--(i) 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.
    (ii) Legal, financial, consulting, accounting, insurance, and other 
similar services do not qualify as essential to a section 7704(d)(1)(E) 
activity.
    (4) Significant services--(i) An activity requires significant 
services to support the section 7704(d)(1)(E) activity if it 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 
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.
    (ii) Partnership 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.
    (iii) An activity does not constitute significant services with 
respect to a section 7704(d)(1)(E) activity if the activity principally 
involves the design, construction, manufacturing, repair, maintenance, 
lease, rent, or temporary provision of property.
    (e) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. Petrochemical products sourced from an oil and gas 
well. (i) Z, a publicly traded partnership, chemically converts a 
mixture of ethane and propane (obtained from physical separation of 
natural gas) into ethylene, propylene, and other gases through use 
of a steam cracker.
    (ii) Z's activities chemically convert physically separated 
components of natural gas. The chemical conversion of physically 
separated components of natural gas (ethane and propane) is not an 
activity that gives rise to qualifying income under paragraph 
(c)(5)(ii) of this section. Therefore, the income Z receives from 
the sale of ethylene and propylene is not qualifying income for 
purposes of section 7704(d)(1)(E).
    Example 2. Petroleum streams chemically converted into refinery 
grade olefins byproducts. (i) Y, a publicly traded partnership, owns 
a petroleum refinery. Y classifies Y's assets used in the activity 
described in this paragraph under MACRS class 13.3 (Petroleum 
Refining). The refinery physically separates crude oil, obtaining 
heavy gas oil. The refinery then uses a catalytic cracking unit to 
chemically convert the heavy gas oil into a liquid stream suitable 
for gasoline blending and a gas stream containing ethane, ethylene, 
and other gases. The refinery also further physically separates the 
gas steam without additional chemical change, resulting in refinery 
grade ethylene. Y sells the ethylene to a third party.
    (ii) Y's activities are performed to physically separate crude 
oil into its component parts and to chemically convert the separated 
heavy gas oil into a liquid stream for recombining with other 
physically separated components of crude oil. Y has classified its 
assets used in that activity under an appropriate MACRS code 
pursuant to paragraph (c)(5)(i) of this section. Income Y receives 
from the liquid stream is qualifying income pursuant to paragraph 
(c)(5)(iii)(A)(2) of this section. Y's further physical separation 
of the gas stream produces ethane, ethylene, and other gases. 
Pursuant to paragraph (c)(5)(iii)(A)(3), income Y receives from the 
physically separated gases is qualifying income because the heavy 
gas oil was chemically converted as part of a processing activity 
pursuant to paragraph (c)(5)(iii)(A)(2) of this section.
    Example 3. Processing methane gas into synthetic fuels through 
chemical change. (i) Y, a publicly traded partnership, chemically 
converts methane into methanol and synthesis gas, and further 
chemically converts those products into gasoline and diesel fuel. Y 
receives income from sales of gasoline and diesel created during the 
conversion processes, as well as from sales of methanol.
    (ii) With respect to the production of gasoline or diesel, Y is 
engaged in the processing of natural gas as provided in paragraph 
(c)(5)(ii)(C) of this section. The production and sale of methanol, 
an intermediate product in the conversion process, is not a section 
7704(d)(1)(E) activity because methanol is not a liquid fuel 
otherwise produced from the processing of crude oil.
    Example 4. Delivery of refined products. (i) X, a publicly 
traded partnership, sells diesel and lubricating oils to a 
government entity at wholesale prices and delivers those goods in 
bulk.
    (ii) X's sale of refined products to the government entity is a 
section 7704(d)(1)(E) activity because it is a bulk transportation 
and sale as described in paragraphs (c)(6) and (7) of this section 
and is not a retail sale.
    Example 5. Delivery of water. (i) X, a publicly traded 
partnership, owns interstate and intrastate natural gas pipelines. X 
built a water delivery pipeline along the existing right of way for 
its natural gas pipeline to deliver water to A for use in A's 
fracturing activity. A uses the delivered water in fracturing to 
develop A's natural gas reserve in a cost-efficient manner. X earns 
income for transporting natural gas in the pipelines and for 
delivery of water.
    (ii) X's income from transporting natural gas in its interstate 
and intrastate pipelines is qualifying income for purposes of 
section 7704(c) because transportation of natural gas is a section 
7704(d)(1)(E) activity as provided in paragraph (c)(6) of this 
section.
    (iii) The income X obtains from its water delivery services is 
not a section 7704(d)(1)(E) activity as provided in paragraph (c) of 
this section. However, because X's water delivery supports A's

[[Page 25977]]

development of natural gas, a section 7704(d)(1)(E) activity, X's 
income from water delivery services may be qualifying income for 
purposes of section 7704(c) if the water delivery service is an 
intrinsic activity as provided in paragraph (d) of this section. An 
activity is an intrinsic activity if the activity is specialized to 
narrowly support the 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. Under paragraph (d)(2)(ii)(B) of this 
section, the provision of water used in a section 7704(d)(1)(E) 
activity is specialized to that activity only if the partnership 
also collects and cleans, recycles, or otherwise disposes of the 
water after use in accordance with federal, state, or local 
regulations concerning waste products from mining or production 
activities. Because X does not collect and clean, recycle, or 
otherwise dispose of the delivered water after use, X's water 
delivery activities are not specialized to narrowly support the 
section 7704(d)(1)(E) activity. Thus, X's water delivery is not an 
intrinsic activity. Accordingly, X's income from the delivery of 
water is not qualifying income for purposes of section 7704(c).
    Example 6. Delivery of water and recovery and recycling of 
flowback. (i) Assume the same facts as in Example 5, except that X 
also collects and treats flowback at the drilling site in accordance 
with state regulations as part of its water delivery services and 
transports the treated flowback away from the site. In connection 
with these services, X provides personnel to perform these services 
on an ongoing or frequent basis that is consistent with best 
industry practices. X has provided these personnel with specialized 
training regarding the recovery and recycling of flowback produced 
during the development of natural gas, and this training is of 
limited utility other than to perform or support the development of 
natural gas.
    (ii) The income X obtains from its water delivery services is 
not a section 7704(d)(1)(E) activity as provided in paragraph (d) of 
this section. However, because X's water delivery supports A's 
development of natural gas, a section 7704(d)(1)(E) activity, X's 
income from water delivery services may be qualifying income for 
purposes of section 7704(c) if the water delivery service is an 
intrinsic activity as provided in paragraph (d) of this section.
    (iii) An activity is an intrinsic activity if the activity is 
specialized to narrowly support the 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. Under paragraph 
(d)(2)(ii)(B) of this section, the provision of water used in a 
section 7704(d)(1)(E) activity is specialized to that activity only 
if the partnership also collects and cleans, recycles, or otherwise 
disposes of the water after use in accordance with federal, state, 
or local regulations concerning waste products from mining or 
production activities. X's provision of personnel is specialized 
because those personnel received training regarding the recovery and 
recycling of flowback produced during the development of natural 
gas, and this training is of limited utility other than to perform 
or support the development of natural gas. The provision of water is 
also specialized because water is an injectant used to perform a 
section 7704(d)(1)(E) activity, and X also collects and treats 
flowback in accordance with state regulations as part of its water 
delivery services. Therefore, X meets the specialized requirement. 
The delivery of water is essential to support A's development 
activity because the water is needed for use in fracturing to 
develop A's natural gas reserve in a cost-efficient manner. Finally, 
the water delivery and recovery and recycling activities require 
significant services to support the development activity because X's 
personnel provide services necessary for the partnership to perform 
the support activity at the development site on an ongoing or 
frequent basis that is consistent with best industry practices. 
Because X's delivery of water and X's collection, transport, and 
treatment of flowback is a specialized activity, is essential to the 
completion of a section 7704(d)(1)(E) activity, and requires 
significant services, the delivery of water and the transport and 
treatment of flowback is an intrinsic activity. X's income from the 
delivery of water and the collection, treatment, and transport of 
flowback is qualifying income for purposes of section 7704(c).

    (f) Proposed Effective/Applicability Date and Transition Rule--(i) 
Except as provided in paragraph (f)(ii) of this section, this section 
is proposed to apply to income earned by a partnership in a taxable 
year beginning on or after the date these regulations are published as 
final regulations in the Federal Register. Paragraph (f)(ii) of this 
section applies during the Transition Period, which ends on the last 
day of the partnership's taxable year that includes the date that is 
ten years after the date that these regulations are published as final 
regulations in the Federal Register.
    (ii) A partnership may treat income from an activity as qualifying 
income during the Transition Period if:
    (A) The partnership received a private letter ruling from the IRS 
holding that the income from that activity is qualifying income;
    (B) Prior to May 6, 2015, the partnership was publicly traded, 
engaged in the activity, and treated the activity as giving rise to 
qualifying income under section 7704(d)(1)(E), and that income was 
qualifying income under the statute as reasonably interpreted prior to 
the issuance of these proposed regulations; or
    (C) The partnership is publicly traded and engages in the activity 
after May 6, 2015 but before the date these regulations are published 
as final regulations in the Federal Register, and the income from that 
activity is qualifying income under these proposed regulations.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2015-10592 Filed 5-5-15; 8:45 am]
BILLING CODE 4830-01-P