Within the mix of securities that are traded on U.S. exchanges, there are units of publicly traded partnerships (PTPs), which are sometimes referred to as master limited partnerships. The shareholders – or unitholders – of PTPs enjoy the liquidity of corporate stocks and the tax advantages of a limited partnership, meaning that for tax purposes, the partnership is considered a pass-through entity. That is, no tax is paid at the partnership level, but rather the obligation passes through to each partner.
According to the National Association of Publicly Traded Partnerships there are more than 90 PTPs trading on the market today, most of them related to energy, natural resources, and real estate businesses. Indeed, one of key criteria to qualifying as a PTP is that the partnership must generate most of its cash flows from real estate, natural resources or commodities. Specifically, the tax code states that qualifying PTP activities relate to mineral or natural resource exploration, development, production, mining, refining, marketing and transportation. As a result, most PTPs are in energy, timber, or real estate (including mortgage securities) businesses, adds the trade group.
In November of last year, the Internal Revenue Service issued new guidance on PTPs, addressing the issue of whether companies that supply seismic data to oil and gas production companies could obtain PTP tax status. The guidance indicates that these data companies do qualify, and the government laid out its rationale in the private letter ruling.
In the IRS example, XCorp operates as a limited partnership. XCorp has been engaged throughout its existence of acquiring and licensing land and marine seismic data to oil and gas producers. Usually, XCorp grants the oil and gas client an exclusive license to the data for a brief period of time in exchange for the client funding a portion of the data acquisition costs. XCorp then markets and licenses its seismic data to other oil and gas producers to assist in their exploration and production of oil and gas resources.
According to XCorp, seismic data is “well-established” as an important component in the exploration for oil and natural gas resources. Moreover, an investment by oil and gas producers in seismic data can significantly decrease the risk of drilling a dry hole. Presently, more than 90 percent of the wells drilled in the United States are based on seismic data but, surprisingly, no oil and gas producer in the United States currently conducts its own seismic exploration.
XCorp claims that, aside from oil and gas exploration, there is no other commercial use for its seismic data. The company also says that the seismic data services it provides are “integral” to the exploration of oil and gas reserves because the exploration of oil and gas reserves would be “significantly curtailed” in the absence of such services.
XCorp also announced that it intends to form a “publicly traded partnership. As a result, it requested a ruling from the IRS regarding whether its income would constitute “qualifying income,” under the tax code. The IRS granted XCorp’s request by issuing guidance in the form of last year’s private letter ruling. (See LTR 200909006, November 21, 2008.)
The tax code, specifically Section 7704(a), says that a PTP shall be treated as a corporation. For this purpose, a PTP is any partnership with interests traded on an established securities market, or partnership interests that are readily tradable on a secondary market (or the substantial equivalent thereof).
However, the tax code goes on point out, in Section 7704(c), that a PTP can avoid being treated as a corporation if 90 percent of its gross income is comprised of qualifying income. As previously stated, many oil and gas exploration activities are considered qualifying activities. (See Section 7704(d)(1)(E).)
The IRS private letter ruling goes further, and concludes that the income derived from the business of acquiring and licensing seismic data to oil and gas producers for use in exploration constitutes qualifying income. Such income falls within the meaning of what the code refers to as income from the exploration of a mineral or natural resource, contends the IRS in its guidance letter.
Therefore, income derived from services that are clearly ancillary, yet integral, to the exploration for oil and gas resources will be classified as qualifying income for purposes of Section 7704. In other words, status as a partnership will not be denied to unincorporated entities with interests that are publicly traded if the following is true: That the entity performs services that are judged to be crucial to the efforts of oil and gas producers, while not being directly engaged in the exploration for, or development of, minerals or natural resources.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com