Qualifying Income From Activities of Publicly Traded Partnerships With Respect to Minerals or Natural Resources, 8318-8343 [2017-01208]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 82, Number 14 (Tuesday, January 24, 2017)]
[Rules and Regulations]
[Pages 8318-8343]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-01208]



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Vol. 82

Tuesday,

No. 14

January 24, 2017

Part III





Department of the Treasury





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Internal Revenue Service





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26 CFR Part 1





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

Federal Register / Vol. 82 , No. 14 / Tuesday, January 24, 2017 / 
Rules and Regulations

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9817]
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: Final regulations.

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SUMMARY: This document contains final regulations under section 
7704(d)(1)(E) of the Internal Revenue Code (Code) relating to the 
qualifying income exception for publicly traded partnerships to not be 
treated as corporations for Federal income tax purposes. Specifically, 
these regulations define the activities that generate qualifying income 
from exploration, development, mining or production, processing, 
refining, transportation, and marketing of minerals or natural 
resources. These regulations affect publicly traded partnerships and 
their partners.

DATES: Effective Date: These regulations are effective January 19, 
2017.
    Applicability Date: For dates of applicability, see Sec.  1.7704-
4(g).

FOR FURTHER INFORMATION CONTACT: Caroline E. Hay, (202) 317-5279 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 1 under section 
7704(d)(1)(E) of the Code relating to qualifying income from certain 
activities with respect to minerals or natural resources.
    Congress enacted section 7704 as part of the Omnibus Budget 
Reconciliation Act of 1987 (Section 10211(a), Public Law 100-203, 101 
Stat. 1330 (1987)). The following year, Congress clarified section 7704 
in the Technical and Miscellaneous Revenue Act of 1988 (Section 
2004(f), Public Law 100-647, 102 Stat. 3342 (1988)). Section 7704(a) 
provides that, as a general rule, publicly traded partnerships (PTPs) 
will be treated as corporations for Federal income tax purposes. In 
section 7704(c), Congress provided an exception to this rule if 90 
percent or more of a PTP'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.
    There has been no prior guidance that PTPs can rely on that defines 
the specific activities that generate qualifying income in the mineral 
and natural resource industries. In order to obtain certainty that 
income from their activities constitutes qualifying income under 
section 7704(d)(1)(E), PTPs have sought opinion letters from legal 
counsel or private letter rulings (PLRs) from the IRS. For the first 20 
years in which the legislation has been in force, demand for PLRs under 
section 7704(d)(1)(E) was minimal. The IRS issued only a few letters 
each year and often none. More recently, however, demand for PLRs has 
increased sharply, and in 2013, the IRS received more than 30 PLR 
requests under section 7704(d)(1)(E).
    The increase in PLR requests has been driven by a combination of 
factors. First, legal counsel have told the Department of the Treasury 
(Treasury Department) and the IRS that they are reluctant to issue 
opinion letters unless a certain activity was clearly contemplated by 
Congress, which has required PTPs to seek PLRs as their activities 
expand beyond more traditional qualifying activities, for example 
because of technological advances, deconsolidation, and specialization. 
Second, investor demand for higher yields has increased the incentive 
to push for an expanded definition of qualifying income through PLR 
requests concerning novel or non-traditional activities. See Todd 
Keator, ``Hydraulically Fracturing'' Section 7704(d)(1)(E)--Stimulating 
Novel Sources of ``Qualifying Income'' for MLPs, 29 Tax Mgmt. Real Est. 
J. 223, 227 (2013). Third, a PLR may not be used as precedent, 
requiring each PTP to obtain its own PLR for activities similar to 
those of a competitor. See section 6110(k)(3).
    Absent regulatory guidance prescribing a uniform framework for 
determining which activities generate qualifying income, the IRS has 
historically reviewed PLR requests one-by-one as they have arisen and 
without the benefit of codified or regulatory principles demarcating 
the outer boundary of activities that Congress intended to generate 
qualifying income. PLR requests often seek approval not only for 
activities that have been approved in a competitor's PLR, but also for 
additional activities similar to, but marginally different from, 
activities approved in earlier PLRs. The absence of regulatory guidance 
can make it difficult for the IRS to distinguish between such 
activities, creating the potential for treating similarly situated 
taxpayers differently or expanding the scope of qualifying income 
beyond what Congress intended. This risk of expansion persists and 
increases in the absence of regulatory guidance.
    Given the increased demand for PLRs, the responsibility to treat 
all taxpayers equally, and the desire to apply section 7704(d)(1)(E) 
consistent with congressional intent, the Treasury Department and the 
IRS determined there was a clear public need for guidance in this area. 
In March 2014, the IRS announced a pause in issuing PLRs under section 
7704(d)(1)(E), which it lifted on March 6, 2015. On May 6, 2015, the 
Treasury Department and the IRS published a notice of proposed 
rulemaking (REG-132634-14) in the Federal Register (80 FR 25970) 
providing guidance on whether income from activities with respect to 
minerals or natural resources is qualifying income under section 
7704(d)(1)(E). On June 18, 2015, the Treasury Department and the IRS 
published in the Federal Register (80 FR 34856) several non-substantive 
corrections to the proposed regulations.
    The Treasury Department and the IRS received numerous written and 
electronic comments in response to the proposed regulations. All 
comments are available at www.regulations.gov. The Treasury Department 
and the IRS held a public hearing on the proposed regulations on 
October 27, 2015. In addition, the Treasury Department and the IRS met 
with industry representatives and worked extensively with IRS engineers 
specializing in petroleum, mining, and forestry to understand the 
relevant industries. The many comments, hearing, and meetings were 
invaluable in understanding the technical aspects of exploration, 
development, mining and production, processing, refining, 
transportation, and marketing of minerals and natural resources, and 
how these final regulations can best provide needed guidance. After 
consideration of all of the comments received, including the comments 
made at the hearing, the proposed regulations are adopted as final 
regulations as revised by this Treasury decision. In general, these 
final regulations follow the approach of the proposed regulations with 
some modifications based on the recommendations made in public 
comments. This preamble describes the comments received by the Treasury

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Department and the IRS and the revisions made.
    These final regulations are divided into seven parts. The first 
part establishes the basic rule that qualifying income includes income 
and gains from qualifying activities with respect to minerals or 
natural resources. Qualifying activities are either ``section 
7704(d)(1)(E) activities'' or ``intrinsic activities.'' The second part 
defines ``mineral or natural resource'' consistent with the definition 
set forth in section 7704(d)(1) of the Code. The third part defines and 
identifies the specific component activities that are included in each 
of the section 7704(d)(1)(E) activities, that is, exploration, 
development, mining or production, processing, refining, 
transportation, and marketing. Where necessary, component activities 
are listed by type of mineral or natural resource. The fourth part 
provides rules for determining whether activities that are not section 
7704(d)(1)(E) activities are nonetheless intrinsic activities, which 
are those that are specialized, essential, and require significant 
services by the PTP with respect to a section 7704(d)(1)(E) activity. 
The fifth and sixth parts provide, respectively, a rule regarding 
interpretations of sections 611 and 613 of the Code (dealing with 
depletion of minerals and natural resources) in relation to Sec.  
1.7704-4 and examples illustrating the provisions in Sec.  1.7704-4. 
Finally, the last part provides that the final regulations apply to 
income received by a partnership in a taxable year beginning on or 
after January 19, 2017, but also contains a 10-year transition period 
for certain PTPs.

Summary of Comments and Explanation of Revisions

I. General Interpretation of Congressional Intent

    These final regulations prescribe a uniform framework for 
determining which mineral and natural resource activities generate 
qualifying income based on the statutory language and congressional 
intent as interpreted by the Treasury Department and the IRS. In 
relevant part, section 7704(d)(1)(E) provides merely that ``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)'' is qualifying income. The limited statutory text supplies 
only one relevant definition--for ``mineral or natural resource.'' See 
section 7704(d)(1). The legislative history regarding the specific text 
at issue is likewise brief and susceptible to different 
interpretations, as demonstrated by the comment letters received.
    Although the statute and the legislative history do not provide 
definitions or a clear demarcation of the eight active terms and 
industry experts disagree on the scope of these terms, certain guiding 
principles can be gleaned. First, the Treasury Department and the IRS 
regard as particularly significant the fact that Congress passed 
section 7704 in whole to restrict the growth of PTPs, which it viewed 
as eroding the corporate tax base. See H.R. Rep. No. 100-391, at 1065 
(1987) (``The recent proliferation of publicly traded partnerships has 
come to the committee's attention. The growth in such partnerships has 
caused concern about long-term erosion of the corporate tax base.'') 
Congress expressed alarm that the changes enacted in the Tax Reform of 
Act of 1986 that reflected their intent to preserve the corporate level 
of tax were ``being circumvented by the growth of publicly traded 
partnerships that are taking advantage of an unintended opportunity for 
disincorporation and elective integration of the corporate and 
shareholder levels of tax.'' Id. at 1066. Congress made an exception 
for passive-type income and ``certain types of natural resources'' 
because ``special considerations appl[ied].'' Id. at 1066, 1069. Well-
established statutory construction principles direct that, because 
section 7704(d)(1)(E) was an exception to the general rule, it should 
be read narrowly. See, for example, Comm'r v. Jacobson, 336 U.S. 28, 49 
(1949) (``The income taxed is described in sweeping terms and should be 
broadly construed in accordance with an obvious purpose to tax income 
comprehensively. The exemptions, on the other hand, are specifically 
stated and should be construed with restraint in the light of the same 
policy.'').
    Second, the eight listed active terms in section 7704(d)(1)(E) 
represent stages in the extraction of minerals or natural resources and 
the eventual offering of certain products for sale. A mineral or 
natural resource may be explored for and, if found, is developed, mined 
or produced, processed, refined, transported, and ultimately marketed. 
Manufacturing is not an activity referenced in the statute, although as 
some might argue, processing and refining are forms of manufacturing. 
The omission of manufacturing is significant especially in light of 
other directives from the legislative history. Most importantly, the 
Conference Committee Report provides, by example, an endpoint to 
activities the income from which would be qualifying, by indicating 
that ``[o]il, gas, or products thereof are not intended to encompass 
oil or gas products that are produced by additional processing beyond 
that of petroleum refineries or field facilities, such as plastics or 
similar petroleum derivatives.'' H.R. Rep. No. 100-495, at 947 (1987). 
The Treasury Department and the IRS have interpreted this language to 
mean that Congress did not intend to include extended processing or 
manufacturing activities beyond getting an extracted mineral or natural 
resource to market in a form in which those products are generally 
sold.
    This interpretation is reinforced by Congress's explanation in the 
legislative history that natural resources were granted an exception to 
the general rule of corporate taxation in section 7704 because the 
activities in those industries ``have commonly or typically been 
conducted in partnership form, and the committee considers that 
disruption of present practices in such activities is currently 
inadvisable due to general economic conditions in these industries.'' 
H.R. Rep. No. 100-391, at 1066 (1987). The committees responsible for 
drafting the legislation had previously held three days of hearings 
dedicated to reviewing the use and taxation of master limited 
partnerships (MLPs), another term for PTPs, and heard multiple 
witnesses discuss the use of partnerships and joint ventures to raise 
capital for oil and gas exploration, the difference between investing 
in wasting natural resource assets and investing in active businesses, 
the price of commodities, and the importance of natural resource 
development to the nation's security. See, for example, Master Limited 
Partnerships: Hearings Before the H. Subcomm. on Select Revenue 
Measures of the Comm. on Ways and Means, 100th Cong. 10 and 189 (1987) 
(statement of J. Roger Mentz, Asst. Sec. for Tax Policy, U.S. Dep't of 
the Treasury, expressing concern that the rise in MLPs was ``not 
limited to passive ownership or wasting assets such as oil and gas or 
natural resource properties,'' but instead were ``increasingly being 
used for active business enterprises,'' and statement of Christopher L. 
Davis, President, Investment Partnership Association, explaining that 
``[o]il and gas exploration and development are among the riskiest of 
business ventures,'' but that partnerships had been ``an economical way 
to share the risks''). See also Master Limited

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Partnerships: Hearing before the S. Subcomm. on Taxation and Debt 
Management of the Comm. on Finance, 100th Cong. 90 (1987) (statement of 
James R. Moffett, CEO, Freeport-McMoran, Inc., stating that the 
``commodities in this country have been decimated'' and that the mining 
and natural resources businesses must be completely rebuilt). There was 
no testimony about the need to protect manufacturing industries.
    These principles have informed the scope and approach of these 
final regulations and the responses to commenters in this Summary of 
Comments and Explanation of Revisions. The Treasury Department and the 
IRS have concluded that in using general terms without technical 
definitions, Congress did not intend a uniform definition of such terms 
across all minerals and natural resources. Rather, Congress meant to 
capture those activities customary to each industry that move a 
depletable asset to a point at which it is commonly sold, and did not 
mean to include those activities that create a new or different product 
through further, extended processing or manufacturing. Accordingly, 
these final regulations describe as qualifying income the income and 
gains from the activities performed to produce products typically found 
at field facilities and petroleum refineries or the equivalent for 
other natural resources, certain transportation and marketing 
activities with respect to those products, and intrinsic service 
activities that are specialized, essential, and require significant 
services with respect to exploration, development, mining and 
production, processing, refining, transportation, and marketing.

II. Definition of Mineral or Natural Resource

    In section 7704(d)(1), Congress defined the term ``mineral or 
natural resource'' as ``any product of a character with respect to 
which a deduction for depletion is allowable under section 611; except 
that such term shall not include any product described in subparagraph 
(A) or (B) of section 613(b)(7).'' Products described in section 
613(b)(7)(A) and (B) are soil, sod, dirt, turf, water, mosses, and 
minerals from sea water, the air, or other similar inexhaustible 
sources. The proposed regulations adopted, almost verbatim, this same 
definition, but also specifically included fertilizer, geothermal 
energy, and timber in the definition of mineral or natural resource, 
and explained that the regulations did not address 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).
    Many commenters recommended that the definition of mineral or 
natural resource be expanded to include not only products of a 
character with respect to which a deduction for depletion is allowable 
under section 611, but also ``products thereof.'' These commenters 
believed Congress intended the definition of mineral or natural 
resource to be read expansively, citing to the 1987 legislative 
history, which provides that: ``[N]atural resources include 
fertilizer[,] geothermal energy, and timber, as well as oil, gas or 
products thereof. . . . For this purpose, oil, gas, or products thereof 
means gasoline, kerosene, number 2 fuel oil, refined lubricating oils, 
diesel fuel, methane, butane, propane, and similar products which are 
recovered from petroleum refineries or field facilities.'' H.R. Rep. 
No. 100-495, at 946-947 (1987). The significance of these commenters' 
expansive definition is that, under this view, so long as a product was 
depletable at the time of its production or extraction, it remains a 
``product thereof'' throughout its processing, refining, 
transportation, and marketing. Under this theory, a depletable product 
does not lose its status as a mineral or natural resource by being 
processed or refined, and can therefore be further processed or refined 
without limitation.
    These final regulations do not adopt this recommendation. As 
originally passed in 1987, section 7704(d)(1)(E) did not define the 
term mineral or natural resource. Congress added the definition in 1988 
(one year after the 1987 legislative history cited by the commenters) 
as part of the Technical and Miscellaneous Revenue Act of 1988. It is 
that same statutory definition added by Congress that these final 
regulations adopt almost word for word. Moreover, in the statutory 
text, the phrase ``products thereof'' is used only in a parenthetical 
describing transportation. See section 7704(d)(1)(E) (``income and 
gains derived from the . . . transportation (including pipelines 
transporting gas, oil, or products thereof)''). The 1988 legislative 
history likewise used the phrase ``products thereof'' in a limited 
manner, that is only when describing transportation and marketing. See, 
for example, H.R. Rep. No. 100-1104(II), at 17 (1988) (``In the case of 
transportation activities with respect to oil and gas and products 
thereof'') and S. Rep. 100-445, at 424 (1988) (``With respect to the 
marketing of minerals and natural resources (e.g., oil and gas and 
products therefof [sic])''). Finally, defining mineral and natural 
resource without including products thereof is the most logical 
interpretation of the statute, taking into account the enumerated 
activities the statute contemplates to be undertaken with respect to 
those minerals or natural resources. One does not explore for gasoline, 
kerosene, or number 2 fuel oil, for example; rather, one explores for 
the depletable product, such as crude oil or natural gas. Once that 
crude oil or natural gas has been refined or processed, however, 
Congress intended to make clear that the ``products thereof'' (the 
gasoline, kerosene, number 2 fuel oil, etc.) could be transported and 
marketed and still give rise to qualifying income.
    Commenters cautioned, however, that the Treasury Department and the 
IRS should take into account the words ``of a character'' in the 
definition of mineral or natural resource and the additional 
legislative history from 1988. That legislative history explained: 
``The reference in the bill to products for which a depletion deduction 
is allowed is intended only to identify the minerals or natural 
resources and not to identify what income from them is treated as 
qualifying income. Consequently, whether income is taken into account 
in determining percentage depletion under section 613 does not 
necessarily determine whether such income is qualifying income under 
section 7704(d).'' S. Rep. No. 100-445, at 424 (1988). Commenters 
expressed the concern that the Treasury Department and the IRS would 
interpret the statutory definition to require those performing 
qualifying activities to have started with a depletable product 
themselves or otherwise be eligible to claim depletion deductions under 
section 611.
    The Treasury Department and the IRS agree with the commenters that 
the definition of mineral or natural resource under section 7704(d)(1) 
does not require continual ownership or control of the depletable asset 
from extraction through each of the eight listed active terms, but that 
qualifying activities can take place beginning at different points 
along that progression of activities described by the active terms by 
those who purchase, take control of, or merely perform section 
7704(d)(1)(E) activities with respect to partially processed or refined 
minerals or natural resources. Compare with Sec. Sec.  1.611-1(b) and 
(c) and 1.613-1(a) (providing that annual depletion deductions are 
allowed only to the owner of an economic interest in mineral deposits 
or standing timber). In adding the definition of minerals or

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natural resources to section 7704(d)(1), Congress meant to delineate 
the type of asset involved, and not to require any particular type of 
control or ownership of the property. See H.R. Rep. No. 100-1104(II), 
at 16 (1988) (``the Senate amendment includes as qualifying income of 
publicly traded partnerships the income from any depletable property 
(rather than from property eligible for percentage depletion . . .)''). 
The definitions of the eight listed active terms in these final 
regulations contemplate that qualifying income may arise from certain 
activities that may be performed on products altered by earlier 
qualifying activities.
    In addition to the income and gains derived from certain activities 
related to minerals or natural resources, Congress expanded section 
7704(d)(1)(E) in 2008 to include income and gains from certain 
activities related to industrial source carbon dioxide, fuels described 
in section 6426(b) through (e), alcohol fuel defined in section 
6426(b)(4)(A), or biodiesel fuel as defined in section 40A(d)(1) as 
qualifying income. Because the IRS has not received many PLR requests 
related to these products, the preamble to the proposed regulations 
asked whether guidance is needed with respect to those activities and, 
if so, the specific items the guidance should address. In response, 
commenters suggested that although liquefied natural gas (LNG) and 
liquefied petroleum gas (LPG) are included within those fuels described 
in section 6426(b), they should also be specifically identified as 
natural resources under section 7704(d)(1)(E). In the alternative, 
commenters requested that the final regulations treat the liquefaction 
and regasification of natural gas as part of transportation.
    These final regulations do not list LNG and LPG as natural 
resources since they are not a mineral or natural resource under the 
definition provided by Congress. Neither LNG nor LPG is found in mines, 
wells, or other natural deposits listed in section 611, but each is 
instead a result of processing or refining petroleum or natural gas, as 
well as of activities to prepare the processed or refined product for 
storage and transportation. The Treasury Department and the IRS thus 
agree with commenters that liquefaction and regasification of natural 
gas may be part of transportation as further discussed in section III.E 
of this Summary of Comments and Explanation of Revisions. Therefore, 
these final regulations include liquefying or regasifying natural gas 
on the list of qualifying transportation activities. Because the 
Treasury Department and the IRS received no other comments seeking 
guidance with respect to industrial source carbon dioxide, fuels 
described in section 6426(b) through (e), alcohol fuel defined in 
section 6426(b)(4)(A), or biodiesel fuel as defined in section 
40A(d)(1), these final regulations do not provide any further guidance 
with respect to those items.

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

A. Replacement of Exclusive List

    The proposed regulations provided that qualifying income included 
only income and gains from qualifying activities, which were defined to 
include section 7704(d)(1)(E) activities and intrinsic activities. The 
proposed regulations further provided an exclusive list of operations 
that comprised the section 7704(d)(1)(E) activities. Although the list 
could be expanded by the Commissioner through notice or other forms of 
published guidance, the proposed regulations specifically stated that 
``[n]o other activities qualify as section 7704(d)(1)(E) activities.''
    Numerous commenters objected to the use of an exclusive list of 
section 7704(d)(1)(E) activities. They argued that a static list would 
ignore technological advances in the dynamic mineral and natural 
resource industries and doubted the ability of the Treasury Department 
and the IRS to expeditiously issue guidance updating the list when 
needed. One commenter noted that an exclusive list is appropriate only 
when the universe of matters to be included or excluded is known, 
defined, considered, and categorized. The commenter questioned whether 
the Treasury Department and the IRS are aware of all of the current 
activities taking place in the mineral and natural resource industries. 
Illustrating these concerns, many commenters cited examples of 
activities they believed were omitted from the list (either through 
inadvertence or lack of knowledge). Rather than an exclusive list, some 
commenters recommended that the final regulations provide a general 
description of the eight listed active terms in section 7704(d)(1)(E) 
(that is, exploration, development, mining or production, processing, 
refining, transportation, and marketing), followed by a non-exclusive 
list of examples of qualifying activities and, where appropriate, non-
qualifying activities. They suggested that such a list would provide 
helpful guidance to PTPs, while allowing other activities to be treated 
as qualifying, including through the issuance of PLRs.
    Recognizing the practical difficulties of ensuring comprehensive 
coverage of the activities generating qualifying income, the Treasury 
Department and the IRS agree with commenters that the list of section 
7704(d)(1)(E) activities should not be exclusive. Therefore, these 
final regulations provide a general definition of each of the eight 
listed active terms in section 7704(d)(1)(E) followed by a non-
exclusive list of examples of each. The Treasury Department and the IRS 
anticipate that by setting forth the known activities that generate 
qualifying income, the guidance will be clearer and, as a result, the 
number of PLR requests the IRS receives will decrease. At the same 
time, the Treasury Department and the IRS do not intend that these 
final regulations be interpreted or applied in an expansive manner. 
Instead, they should be interpreted and applied in a manner that is 
consistent with their plain meaning and the overall intent of Congress 
to restrict this exception to treatment as a corporation under section 
7704(a) as described in section I of this Summary of Comments and 
Explanation of Revisions.

B. Exploration and Development

    The proposed regulations defined 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 by: (1) Drilling an 
exploratory or stratigraphic type test well; (2) conducting drill stem 
and production flow tests to verify commerciality of the deposit; (3) 
conducting geological or geophysical surveys; or (4) interpreting data 
obtained from geological or geophysical surveys. For minerals, 
exploration also included 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.
    Separately, the proposed regulations defined development as an 
activity performed to make minerals or natural resources accessible by: 
(1) Drilling wells to access deposits of minerals or natural resources; 
(2) 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); (3) 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

[[Page 8322]]

production can be removed from the premises; (4) 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 (5) 
constructing and installing gathering systems and custody transfer 
stations.
    One commenter noted that the proposed regulations provided a 
workable definition of exploration and development activities 
consistent with past standards of industry practice, but did not allow 
for changes in technologies developed in the future. Another commenter 
recommended expanding the list to include any activity the payment for 
which is: (1) A geological or geophysical cost under section 167(h); 
(2) an intangible drilling cost under section 263(c); or (3) a mine 
exploration or development cost under section 616(a) or 617(a). 
According to the commenter, the benefit of such a rule is that the 
relevant industries understand the costs covered by those Code 
provisions and the law in the area is well developed.
    The only change made to the definitions of exploration and 
development in these final regulations is the addition of the word 
``including'' to show that the list of activities is not exclusive, as 
discussed in section III.A of this Summary of Comments and Explanation 
of Revisions. These final regulations do not adopt the suggestion to 
include as a qualifying activity all services giving rise to costs 
under section 167(h), 263(c), 616(a), or 617(a). Some of the activities 
are already specifically included in the definitions of section 
7704(d)(1)(E) activities, but others would expand the list of 
qualifying activities beyond that intended by Congress and allow 
service-provider PTPs to circumvent the intrinsic test in Sec.  1.7704-
4(d). As discussed in section I of this Summary of Comments and 
Explanation of Revisions, Congress enacted section 7704 to restrict the 
growth of PTPs due to ``concern about long-term erosion of the 
corporate tax base.'' H.R. Rep. No. 100-391, at 1065 (1987). Congress 
made an exception for natural resource activities in part because it 
recognized the fragile economic conditions in those industries at the 
time. Id. at 1066. Although Congress intended to benefit oil and gas 
developers, it did not intend to exempt, for example, construction and 
debris removal companies, suppliers, or other non-specialized service 
providers to those industries. Intangible drilling costs, for example, 
include amounts paid for fuel, repairs, hauling, and supplies. See 
Sec. Sec.  1.263(c)-1 and 1.612-4(a). Although these costs may be 
necessarily incurred by oil and gas developers, that does not mean that 
a third-party service provider that receives payment for those services 
is performing activities giving rise to qualifying income.

C. Mining or Production

    The proposed regulations defined mining or production as an 
activity performed to extract minerals or other natural resources from 
the ground by: (1) Operating equipment to extract natural resources 
from mines and wells; or (2) 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).
    Generally, commenters sought to expand the definition of mining or 
production. They suggested that the regulations adopt the definition of 
mining from section 613, which includes not only the extraction of ores 
or minerals from the ground but also certain mining processes. See 
section 613(c)(2). Similarly, commenters suggested that the regulations 
define production to include not only the extraction of oil or natural 
gas from the well but also certain processing activities that occur 
post-production up to the ``depletion cut-off point'' established under 
sections 611 and 613. These commenters explained that the explicit 
reference in section 7704(d)(1) to the depletion rules in section 611 
should be interpreted as meaning that all the terms in 7704(d)(1)(E) 
should be defined the same as the terms in section 611. A consequence 
of expanding the definition of mining or production to include certain 
processing activities, commenters reasoned, is that the definition of 
processing for purposes of section 7704(d)(1)(E) would necessarily 
encompass something more, further expanding qualifying activities as 
discussed in section III.D.3 of this Summary of Comments and 
Explanation of Revisions (concerning processing and refining of ores 
and minerals other than crude oil and natural gas). Finally, one 
commenter noted that, in addition to mining from the ground, minerals 
and natural resources can be extracted from waste deposits or residue 
from prior mining, and that such extraction should also be treated as 
mining or production. See section 613(c)(3) and Sec.  1.613-4(i).
    These final regulations do not adopt the suggestion to expand the 
definition of mining or production to include mining processes or other 
processing activities before the depletion cut-off point. Instead, 
these final regulations clarify the proposed regulations' definition of 
mining or production activities to include only extraction activities. 
In addition, the final regulations move activities that convert raw 
mined products or raw well effluent into products that can be readily 
transported or stored to the definition of processing. As a result, 
qualifying processing activities are included under the definition of 
processing in these final regulations. In its entirety, section 
7704(d)(1)(E) covers a broader category of income than and contemplates 
a different end point of activities from those of sections 611 and 613, 
and therefore the definitions of mining and production are not 
interchangeable between the two regimes. Sections 611 and 613 describe 
what is gross income from the exhaustion of capital assets for purposes 
of applying the depletion rules. See section 611(a) and United States 
v. Cannelton Sewer Pipe Co., 364 U.S. 76, 81-85 (1960). For purposes of 
section 613, mining, an upstream activity, generally includes those 
treatments normally applied to prepare an extracted mineral or natural 
resource to the point at which it is first marketable (which may 
involve a limited amount of processing and transportation), but no 
further. See section 613(c)(2). In contrast, section 7704(d)(1)(E) 
separately lists certain upstream, midstream, and downstream 
activities, encompassing a progression of stages of activities 
performed upon a mineral or natural resource up to the point at which 
products are typically produced at field facilities and petroleum 
refineries or the equivalent for other natural resources, as well as 
transportation and marketing thereafter. It would therefore be 
duplicative to define mining to include both mining and mining 
processes as defined in section 613 for purposes of section 
7704(d)(1)(E). The reference in section 7704(d)(1) to section 611 
merely defines the scope of included minerals and natural resources as 
discussed in section II of this Summary of Comments and Explanation of 
Revisions. Nothing in the statute indicates that other concepts in 
section 611 and 613 are intended to be incorporated as well.
    These final regulations adopt the request that mining or production 
be defined to include the extraction of minerals or natural resources 
from the waste deposits or residue of prior

[[Page 8323]]

mining or production. The recycling of scrap or salvaged metals or 
minerals from previously manufactured products or manufacturing 
processes, however, is not considered to be the extraction of ores or 
minerals from waste or residue, and therefore does not give rise to 
qualifying income.

D. Processing and Refining

    The proposed regulations combined the activities of processing and 
refining together in one definition that included both a general 
definition followed by specific rules for different categories of 
natural resources (natural gas, petroleum, ores and minerals, and 
timber). The vast majority of the comments received on the proposed 
regulations concerned the definition of processing or refining, 
addressing issues related to both the general definition and specific 
rules. Section III.D.1 of this Summary of Comments and Explanation of 
Revisions addresses the comments related to the general definition. 
Sections III.D.2 through III.D.4 of this Summary of Comments and 
Explanation of Revisions address comments related to the specific 
rules.
1. General Definition
    The general definition of processing and refining in the proposed 
regulations stated that, except as otherwise provided, an activity was 
processing or refining if done to purify, separate, or eliminate 
impurities, but would not qualify if: (1) The PTP did not use a 
consistent Modified Accelerated Cost Recovery System (MACRS) class life 
for assets used in the activity (the MACRS consistency requirement); 
(2) the activity caused a substantial physical or chemical change in a 
mineral or natural resource (the physical and chemical change 
limitation); or (3) the activity transformed the extracted mineral or 
natural resource into a new or different mineral product or into a 
manufactured product (the manufacturing limitation).
a. Separate Definitions for Processing and Refining
    Multiple commenters argued that the proposed regulations' use of a 
joint definition for processing and refining wrongly read the term 
``processing'' out of the statute. These commenters reasoned that 
Congress used a comma between the terms to indicate that each term must 
be accorded significance and effect, in contrast to the ``or'' between 
mining (for ores and minerals) or production (for natural gas and crude 
oil), which described the same activity but with respect to different 
industries. Commenters noted that the version of the legislation that 
passed in the House did not include the term processing. Rather, it was 
added in conference and therefore must mean that the two terms are not 
synonymous. While some commenters admitted that it is not uncommon in 
the industry to use the words processing and refining interchangeably 
to refer to the same activities, they maintained that Congress intended 
to include a broader range of activities than either word alone would 
allow.
    Although the Treasury Department and the IRS have determined that 
the terms can overlap, these final regulations adopt the suggestion of 
defining processing and refining separately in order to better clarify 
what activities generate qualifying income under section 7704(d)(1)(E). 
These final regulations generally define processing for purposes of 
section 7704(d)(1)(E) as an activity performed to convert raw mined or 
harvested products or raw well effluent to substances that can be 
readily transported or stored as further described in the specific 
rules for the different categories of natural resources. This 
definition captures the processing that is generally performed at the 
wellhead, mine, field facilities, or other location where mining 
processes are generally applied, as described in Sec.  1.613-
4(f)(1)(iii), because the legislative history contemplates that 
qualifying activities do not include activities that create products 
through additional processing beyond that of petroleum refineries or 
field facilities.
    These final regulations do not provide a general definition of 
refining, but instead set forth the activities that qualify as refining 
activities under the specific rules for the different categories of 
natural resources. Consistent with the discussion in section III.D.1.e 
of this Summary of Comments and Explanation of Revisions, the Treasury 
Department and the IRS have concluded that refining does not have 
general application to all minerals and natural resources.
b. MACRS Consistency Requirement
    Commenters argued that the requirement in the proposed regulations 
that a PTP use a consistent MACRS class life for assets generating 
qualifying income as a result of being used for processing or refining 
has no statutory support and would create uncertainty for PTPs and 
their investors. They stressed that it would be inappropriate to deny 
qualifying income treatment to a PTP whose activities met the 
definition of processing or refining merely because it, or a processor 
or refiner further upstream, failed to use the appropriate MACRS class 
life. Commenters also challenged the idea that the asset class lives in 
Rev. Proc. 87-56 (1987-2 CB 674) are helpful in distinguishing between 
qualifying and non-qualifying activities. Commenters raised similar 
concerns regarding the discussion of the North American Industry 
Classification System (NAICS) codes in the preamble of the proposed 
regulations to give examples of qualifying activities.
    The proposed regulations included a MACRS requirement because the 
Treasury Department and the IRS believed MACRS provided a useful 
demarcation of those processing and refining activities typically 
performed by a field facility or a refinery, as compared to non-
qualifying processing activities performed further downstream from 
those activities, such as petrochemical manufacturing or the 
manufacturing of pulp and paper. Compare, for example, Rev. Proc. 87-
56, asset class 13.3 (Petroleum Refining) and asset class 28.0 
(Manufacture of Chemicals); also, asset class 24.1 (Cutting of Timber) 
and asset class 26.1 (Manufacture of Pulp and Paper). In addition, the 
IRS released Rev. Proc. 87-56 six months before the passage of section 
7704, making that demarcation contemporaneous with section 7704. After 
consideration of the comments received on this issue, however, the 
Treasury Department and the IRS are persuaded that the MACRS class 
lives are not comprehensive nor sufficiently detailed for every 
industry. Accordingly, these final regulations do not include a MACRS 
consistency requirement. Nor do these final regulations reference the 
NAICS codes. Notwithstanding the lack of a MACRS consistency 
requirement, MACRS or NAICS codes nevertheless may provide useful 
insight when determining whether an activity generates qualifying 
income as provided in these final regulations.
c. Physical and Chemical Change Limitation
    Many commenters contended that the physical and chemical change 
limitation in the proposed regulations ignored decades-old authorities 
that such transformative changes are an understood and realistic part 
of processing and refining. See Sec.  1.613A-7(s) (refining crude oil 
is ``any operation by which the physical or chemical characteristics of 
crude oil are changed''); IRM Sec.  4.41.1.6.1 (modern refining 
operations may involve the ``separation of components plus the breaking 
down, restructuring, and recombining of hydrocarbon molecules''); 
Processing, New Oxford

[[Page 8324]]

American Dictionary, 1307 (2001 ed.) (to perform a series of mechanical 
or chemical operations on, in order to change or preserve it). 
Commenters also criticized the reference to Sec.  1.613-4(g)(5) in the 
preamble of the proposed regulations, cited to show that the physical 
and chemical change limitation was consistent with definitions found 
elsewhere in the Code and regulations. They argued that the physical 
and chemical change prohibition in Sec.  1.613-4(g)(5) is helpful only 
in determining what is not included in calculating gross income from 
the exhaustion of capital assets for purposes of applying the depletion 
rules, but not in distinguishing when an activity qualifies as 
processing or refining under section 7704(d)(1)(E).
    The Treasury Department and the IRS agree with the commenters that 
processing and refining may cause a substantial physical or chemical 
change, depending on the mineral or natural resource at issue. Indeed, 
the specific rule in the proposed regulations for the processing or 
refining of petroleum recognized that refineries perform physical and 
chemical changes, for example when converting the physically separated 
components of crude oil into gasoline or other fuels. Accordingly, 
because the general definition is at odds with some of the specific 
rules for certain natural resources, these final regulations no longer 
include a general physical or chemical change limitation.
d. Manufacturing Limitation
    Commenters criticized the manufacturing limitation in the proposed 
regulations, arguing that the activities that qualify as processing and 
refining under section 7704(d)(1)(E) are types of manufacturing. Many 
commenters elaborated that the proposed regulations wrongly focus on 
the output of an activity. These commenters maintained that the entire 
analysis should instead rest on whether or not the input is a mineral 
or natural resource, or a product thereof. That is, so long as an item 
was once a mineral or natural resource, the income derived from any 
further processing or refining of the item up to and, some argued, 
including a plastic is qualifying. Similar to the comments regarding 
the definition of mineral or natural resource discussed in section II 
of this Summary of Comments and Explanation of Revisions, these 
comments reflect a belief that the Treasury Department and the IRS have 
misinterpreted the statement in the legislative history that ``[o]il, 
gas, or products thereof are not intended to encompass oil or gas 
products that are produced by additional processing beyond that of 
petroleum refineries or field facilities,'' H.R. Rep. No. 100-495, at 
947 (1987), as a limitation on processing and refining instead of a 
clarification of what is included as a natural resource that can be 
further processed and refined. As a corollary to the comments regarding 
output, some commenters argued that Congress knew how to, but did not, 
limit processing and refining to the creation of certain products, for 
example by specifying ``or any primary products thereof'' as it did 
when listing oil and gas as excluded property under the Foreign Sales 
Corporation provisions enacted in 1984. See section 927(a)(2)(C), now 
repealed.
    As discussed in section I of this Summary of Comments and 
Explanation of Revisions, the Treasury Department and the IRS interpret 
the terms processing and refining in section 7704(d)(1)(E) and the 
legislative history as capturing those activities that produce the 
products typically found at field facilities and petroleum refineries, 
or the equivalent for other natural resources. The Treasury Department 
and the IRS do not construe the lack of the word ``primary'' in the 
legislative history as an indication that products produced through 
additional processing beyond the refinery or field facility should be 
included. Instead, the similarity between the list of products in the 
regulations under former section 927 and in the legislative history for 
section 7704(d)(1)(E) indicate that Congress understood processing and 
refining oil and natural gas to result in the products identified as 
primary products in the regulations under former section 927. Compare 
Sec.  1.927(a)-1T(g)(2)(i) (defining ``primary product from oil'' as 
crude oil and all products derived from the destructive distillation of 
crude oil, including volatile products, light oils such as motor fuel 
and kerosene, distillates such as naphtha, lubricating oils, greases 
and waxes, and residues such as fuel oil) and Sec.  1.927(a)-
1T(g)(2)(ii) (defining ``primary product from gas'' as all gas and 
associated hydrocarbon components from gas or oil wells, whether 
recovered at the lease or upon further processing, including natural 
gas, condensates, liquefied petroleum gases such as ethane, propane, 
and butane, and liquid products such as natural gasoline) with the 
Conference Committee Report for section 7704(d)(1)(E), H.R. Rep. No. 
100-495, at 947 (1987) (``gasoline, kerosene, number 2 fuel oil, 
refined lubricating oils, diesel fuel, methane, butane, propane'').
    The Treasury Department and the IRS recognize, however, that the 
wording of the manufacturing limitation in the proposed regulations was 
vague and could cause confusion. Therefore, the general definitions of 
processing and refining in the final regulations no longer contain the 
specific language that made up the manufacturing limitation. Instead, 
the specific definitions for the processing and refining of natural gas 
and crude oil capture congressional intent by including only those 
activities that are generally performed at field facilities and 
petroleum refineries, or those that produce products typically found at 
field facilities and refineries. The definitions for processing and 
refining do not include additional processing or manufacturing 
activities, such as petrochemical manufacturing. The final regulations 
apply a similar end point for the processing and refining of ores, 
other minerals, and timber in a manner tailored to the type of resource 
at issue.
e. Specific Rules for Each Category of Natural Resource
    Some commenters dismissed the need for industry specific rules. 
These commenters maintained that Congress did not limit qualifying 
income based on the different processes used for the various types of 
minerals and natural resources, and therefore one overarching 
definition should apply consistently across all resources.
    The final regulations retain separate definitions for processing 
and refining of natural gas, crude oil, ores and other minerals, and 
timber. As a practical matter, the minerals and natural resources 
subject to depletion under section 611 are different, and there is no 
uniform way to address them. For example, geothermal energy is not 
processed or refined. The processing of timber necessarily differs from 
the processing of natural gas. The absence of specific rules for each 
type of natural resource would result in vague guidelines lacking clear 
distinctions between qualifying and non-qualifying activities. 
Furthermore, a more general approach would lead to an unwarranted 
expansion of the scope of qualifying income beyond that intended by 
Congress, since a general definition would need to encompass the 
activities of the resource with the broadest definition of processing 
and refining.
2. Natural Gas and Crude Oil
    The proposed regulations defined processing or refining of natural 
gas as an activity performed to: (1) Purify natural gas, including by 
removal of oil or condensate, water, or non-hydrocarbon gases 
(including carbon dioxide, hydrogen sulfide, nitrogen, and

[[Page 8325]]

helium); (2) 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 (3) convert methane in one integrated 
conversion into liquid fuels that are otherwise produced from 
petroleum. The proposed regulations defined processing or refining of 
petroleum as an activity, the end product of which is not a plastic or 
similar petroleum derivative, 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 in (1) and (2). The proposed 
regulations also provided a partial list of products that would not be 
treated as obtained through the qualified processing or refining of 
petroleum, including: (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 crude 
oil if it is not combined with other products separated from the crude 
oil. For example, the proposed regulations indicated that production of 
petroleum coke from heavy (refinery) residuum qualifies as processing 
or refining, but any upgrading of petroleum coke (such as to anode-
grade coke) does not qualify because it is further chemically changed.
    Numerous commenters argued that the proposed regulations 
inappropriately favored (1) crude oil over natural gas, and (2) fuel 
products over other products. For example, under the proposed 
regulations, qualifying processing or refining included chemically 
converting the component parts of crude oil into products that would be 
combined into a fuel and products that could be separated further, 
sometimes resulting in olefins such as ethylene and propylene. In 
contrast, the proposed regulations recognized as qualifying only the 
conversion of one component of natural gas (methane) into a fuel, and 
did not treat as qualifying the creation of olefins from natural gas. 
Commenters asserted that there is no basis for differentiating between 
hydrocarbon sources for fuels or olefins, and that such differentiation 
causes difficulties for pipeline operators and marketers, who cannot 
tell if the fungible fuels or olefins come from qualifying crude oil 
processing or non-qualifying natural gas conversions. Also regarding 
this same language in the proposed regulations, one commenter asked 
that the phrase ``in one integrated conversion'' be clarified so as to 
not exclude multistep conversion techniques which result in gasoline. 
Similarly, commenters contended that the refining of lubricants, waxes, 
solvents, and asphalts should also be included as qualifying activities 
since they, like fuel, are products of petroleum refineries.
    Two commenters stated that the proposed regulations were not 
consistent in favoring fuels since the sale of methanol was not treated 
as a qualifying activity. See proposed Sec.  1.7704-4(e), Example 3 
(concluding that ``the production and sale of methanol, an intermediate 
product in the conversion [from methane to diesel], is not a section 
7704(d)(1)(E) activity because methanol is not a liquid fuel otherwise 
produced from the processing of crude oil''). These commenters argued 
that the processing and sale of methanol should be a qualifying 
activity because it: (1) Is similar to methane or to natural gas 
liquids (NGLs), (2) is an intermediate product produced in the act of 
converting gas into gasoline, (3) is itself a fuel (albeit an alcohol 
fuel), and (4) can be produced from oil using typical refinery 
processes, catalysts, and equipment.
    Rather than the definitions in the proposed regulations, commenters 
offered two different possible regulatory standards for determining 
whether an activity qualifies as the processing or refining of crude 
oil or natural gas: (1) Whether the activity is performed in a crude 
oil refinery; or (2) whether the activity produces a product of a type 
that is produced in a crude oil refinery. For the second recommended 
standard, some commenters suggested that the final regulations adopt 
the list of products produced by a refinery as compiled by the U.S. 
Energy Information Administration (EIA). In support of this second 
standard, one commenter said that using the EIA list would give effect 
to the congressional intent that oil and gas products necessitating 
processing beyond the type of processing that takes place in petroleum 
refineries should not give rise to qualifying income. Another commenter 
added that using the second standard would make the regulations 
administrable by avoiding inquiry into the nature and extent of the 
production process. Other commenters recommended that the final 
regulations provide a list of ``bad products,'' that is products of 
processing or refining that do not give rise to qualifying income, such 
as a list of plastic resins maintained by trade industry associations 
for the plastic industry.
    In response to these comments, these final regulations make several 
changes. First, as discussed in section III.D.1.a of this Summary of 
Comments and Explanation of Revisions, these final regulations 
separately define processing and refining. Processing of natural gas 
and crude oil for purposes of section 7704(d)(1)(E) encompasses those 
activities that convert raw well effluent to substances that can be 
readily transported or stored, that is, what is generally performed at 
the wellhead or field facilities. For natural gas, processing is the 
purification of natural gas, including by removing oil or condensate, 
water, or non-hydrocarbon gases (such as carbon dioxide, hydrogen 
sulfide, nitrogen, and helium), and the separation of 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). For crude oil, 
processing is the separation of crude oil by passing it 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.
    Second, consistent with the legislative history's limitation to 
products of petroleum refineries or field facilities, the Treasury 
Department and the IRS adopt the suggestion to list the qualifying 
products of a refinery for the definition of refining of natural gas 
and crude oil for purposes of 7704(d)(1)(E) and, for this purpose, look 
to information compiled by the EIA. The Treasury Department and the IRS 
have determined that the EIA currently provides an authoritative list 
of products of a refinery. Following the oil market disruption in 1973, 
Congress established the EIA in 1977 to collect, analyze, and 
disseminate comprehensive, independent and impartial energy information 
in order to assess the adequacy of energy resources to meet economic 
and social demands.

[[Page 8326]]

See 42 U.S.C. 7135(a). As part of that mandate, the EIA is required to 
gather information from persons engaged in ownership, control, 
exploration, development, extraction, refining or otherwise processing, 
storage, transportation, or distribution of mineral fuel resources. See 
42 U.S.C. 7135(h)(4) and (6). These final regulations are informed by 
Form EIA-810, ``Monthly Refinery Report,'' and Form EIA-816, ``Monthly 
Natural Gas Liquids Report,'' which are the surveys that each refinery 
or natural gas processing plant must complete to report both finished 
and unfinished products of their operations.
    Specifically, these final regulations define the refining of 
natural gas and crude oil as the further physical or chemical 
conversion or separation processes of products resulting from 
processing and refining activities, and the blending of petroleum 
hydrocarbons, to the extent they give rise to products listed in the 
definition of processing or the following products: ethane, ethylene, 
propane, propylene, normal butane, butylene, isobutane, isobutene, 
isobutylene, pentanes plus, unfinished naphtha, unfinished kerosene and 
light gas oils, unfinished heavy gas oils, unfinished residuum, 
reformulated gasoline with fuel ethanol, reformulated other motor 
gasoline, conventional gasoline with fuel ethanol--Ed55 and lower 
gasoline, conventional gasoline with fuel ethanol--greater than Ed55 
gasoline, conventional gasoline with fuel ethanol--other conventional 
finished gasoline, reformulated blendstock for oxygenate (RBOB), 
conventional blendstock for oxygenate (CBOB), gasoline treated as 
blendstock (GTAB), other motor gasoline blending components defined as 
gasoline blendstocks as provided in Sec.  48.4081-1(c)(3), finished 
aviation gasoline and blending components, special naphthas (solvents), 
kerosene-type jet fuel, kerosene, distillate fuel oil (heating oils, 
diesel fuel, ultra-low sulfur diesel fuel), residual fuel oil, 
lubricants (lubricating base oils), asphalt and road oil (atmospheric 
or vacuum tower bottom), waxes, petroleum coke, still gas, and naphtha 
less than 401[emsp14][deg]F end-point, as well as any other products of 
a refinery that the Commissioner may identify through published 
guidance.
    The final regulations have modified or clarified several of the 
terms from the EIA lists to ensure that the listed products are only 
those of the type produced in a petroleum refinery or traditional gas 
field processing plant. Thus, for example, the listed product 
``lubricants'' includes the parenthetical ``lubricating base oils'' to 
clarify that refining does not include creating a lubricant not of the 
type produced in a petroleum refinery that has been mixed with non-
petroleum hydrocarbons. The EIA reports are required to be filed only 
by refiners and natural gas processors; consequently, the EIA need not 
circumscribe the products to include solely those generally produced by 
a petroleum refinery or processing plant. The Treasury Department and 
the IRS modified the EIA list to more specifically identify those 
products solely produced by refineries and field facilities. In 
addition, the list in the final regulations must be read consistently 
with that view to include only those types of listed products that are 
generally produced in a petroleum refinery or natural gas processing 
plant. For example, a lubricant that is not of a type that is generally 
produced by a refiner is not within the product list. Therefore, the 
definitions have been slightly adjusted to reflect lubricants of a 
petroleum refinery as opposed to those from a manufacturer or entity 
that is adding more than the minimal amount permitted under 
additization (discussed in section III.H.5 of this Summary of Comments 
and Explanation of Revisions) of different minerals, natural resources, 
or other products to the lubricant.
    Also, in adopting the approach of listing the products of a 
petroleum refinery or a natural gas processing plant, these final 
regulations no longer provide language regarding converting methane in 
one integrated conversion into liquid fuels or regarding the various 
acceptable chemical conversions with respect to crude oil. Activities 
are treated as refining to the extent they give rise to products listed 
in the regulation.
    Adopting the EIA's list of products of a refinery resolved several 
other issues raised by commenters. These final regulations no longer 
differentiate between the refining of natural gas and the refining of 
crude oil, particularly in regard to the creation of olefins and 
certain liquid fuels. Although traditional gas field processing plants 
do not produce olefins or certain fuels from natural gas, these 
products are created in petroleum refineries (albeit in small 
quantities in the case of olefins). The Treasury Department and the IRS 
recognize that changes in technology have expanded the ways to create 
liquid fuels, and thus continue to be guided by the stated goal in the 
legislative history of including as qualifying those activities that 
create products ``which are recovered from petroleum refineries or 
field facilities.'' H.R. Rep. No. 100-495, at 947 (1987). Similarly, 
the final regulations no longer omit the refining of non-fuel products 
of a refinery, such as lubricants, waxes, solvents, and asphalts of the 
type produced in petroleum refineries.
    Conversely, the EIA list does not include methanol as a product of 
a refinery or natural gas processing plant, and therefore these final 
regulations do not adopt commenters' suggestion to treat as qualifying 
the creation of methanol. Indeed, one commenter who recommended 
adopting the list of products produced by a refinery as compiled by the 
EIA acknowledged that the Treasury Department and the IRS would need to 
expand the EIA list to encompass methanol and synthesis gas since they 
are typically not produced at refineries. Given the EIA's expertise, 
the Treasury Department and the IRS decline to supplement the products 
of a refinery as identified by the EIA, and also note that alcohols 
(such as methanol) were specifically not included as a primary product 
of oil and gas in the regulations under the Foreign Sales Corporation 
provisions, whose list of oil and gas products is similar to that in 
the legislative history for section 7704(d)(1)(E). See Sec.  1.927(a)-
1T(g)(2)(iv) and discussion under section III.D.1.d of this Summary of 
Comments and Explanation of Revisions. Whether methanol is similar to 
NGLs, is a liquid fuel, or can be created using typical oil refining 
processes is immaterial to the determination of whether the manufacture 
of methanol is a qualifying activity. These final regulations, 
therefore, amend the reasoning in Example 3, now in Sec.  1.7704-4(f), 
to reflect that methanol is not included among the listed products.
    These final regulations also do not adopt the recommendation to 
treat as qualifying all activities performed in a refinery. Such a 
standard would allow PTPs to thwart Congress's limitation on qualifying 
activities by simply moving processes that are normally not conducted 
in a refinery within the refinery fence. For example, some refineries 
have added hydrogen production plants to their facilities, though 
Congress did not intend the generation of hydrogen for sale to be a 
qualifying activity. Indeed, these final regulations continue to 
provide that products of refining do not include products produced 
onsite for the use in the refinery, such as hydrogen, if excess amounts 
are sold. The Treasury Department and the IRS understand that some 
commenters suggested this broader definition of refining in order to 
include as qualifying the refining of non-fuel products (lubricants, 
waxes,

[[Page 8327]]

solvents, and asphalts). Their concern, however, is addressed to the 
extent those products are included in the list of products of a 
refinery, thus avoiding the need for a broad and potentially vague rule 
that would encompass all activities undertaken in a refinery.
    Finally, these final regulations retain language similar to that in 
the proposed regulations clarifying that certain other products are not 
products of refining, including heat, steam or electricity produced by 
refining processes, products obtained from third parties or produced 
onsite for use in the refinery if excess amounts are sold, any product 
that results from further chemical change of a product on the list of 
products of a refinery that does not result in the same or another 
product listed as a product of a refinery, and plastics or similar 
petroleum derivatives. For this last item, these final regulations do 
not adopt the suggestion of some commenters to provide a non-exclusive 
list of non-qualifying plastic resins, as the Treasury Department and 
the IRS do not agree that providing such a list aids taxpayers. A list 
of some of the non-qualifying products is not relevant because the 
final regulations list all of the qualifying products and might create 
confusion if a product were not included on either list.
3. Ores and Minerals
    The proposed regulations provided that an activity constituted 
processing or refining of ores and minerals if it met the definition of 
mining processes under Sec.  1.613-4(f)(1)(ii) or refining under Sec.  
1.613-4(g)(6)(iii). In addition, the proposed regulations repeated part 
of the definition of refining found in Sec.  1.613-4(g)(6)(iii) by 
stating that, 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.
    Commenters generally sought to expand the definition of processing 
and refining of ores and minerals. As discussed in greater detail in 
section III.C of this Summary of Comments and Explanation of Revisions, 
commenters maintained that section 7704(d)(1)(E) should use the 
definition of mining from section 613(c)(2). Because that definition 
already includes certain mining processes, commenters further argued 
that the definition of processing for section 7704(d)(1)(E) should 
include something more, specifically some or all of the ``nonmining 
processes'' listed in section 613(c)(5) and Sec.  1.613-4(g). Moreover, 
they reasoned that unless the nonmining processes are included in the 
definition of processing, there is a hole between processing and 
refining, as defined in the proposed regulations, which could not have 
been intended. For example, the proposed regulations identified the 
refining of blister copper as a qualifying activity, but did not allow 
as qualifying the activity that precedes that step (that is, the 
smelting of the copper ore concentrate to produce the blister copper), 
which occurs after the mining processes identified in Sec.  1.613-
4(f)(2)(i)(d). Additionally, commenters elaborated that some of the 
nonmining processes under section 613(c)(5) are themselves activities 
that ``purify, separate, or eliminate impurities,'' thus falling within 
the general definition of processing provided in the proposed 
regulations. Some commenters argued that the coking of coal, the making 
of activated carbon, and the fine pulverization of magnetite should all 
be considered qualifying activities.
    Based on the comments received, the Treasury Department and the IRS 
have determined that the definition of processing and refining of ores 
and minerals in the proposed regulations needed clarification. Like the 
final regulations on processing and refining of natural gas or crude 
oil, and as discussed in section III.D.1.a of this Summary of Comments 
and Explanation of Revisions, these final regulations separately define 
processing and refining of ores and minerals other than natural gas or 
crude oil.
    Processing of ores and minerals other than natural gas or crude oil 
is defined in these final regulations as those activities that meet the 
definition of mining processes under Sec.  1.613-4(f)(1)(ii), without 
regard to Sec.  1.613-4(f)(2)(iv) (related to who is performing the 
processing). Accordingly, processing includes the activities generally 
performed at or near the point of extraction of the ores or minerals 
from the ground (generally within a 50-mile radius or greater if the 
Commissioner determines that physical or other requirements cause the 
plants or mills to be at a greater distance) that are normally applied 
to obtain commercially marketable mineral products. Therefore, this 
definition captures the concept of ``field facilities'' in the 
legislative history to section 7704(d)(1)(E).
    Because the legislative history does not provide any examples of 
products produced from ores and minerals that may generate qualifying 
income, other than those relating to oil, gas, and fertilizer, the 
Treasury Department and the IRS have applied limitations to ores and 
minerals that are comparable to those specifically expressed by 
Congress regarding oil and gas. See H.R. Rep. No. 100-495, at 947 
(1987) (``[o]il, gas, or products thereof are not intended to encompass 
oil or gas products that are produced by additional processing beyond 
that of petroleum refineries or field facilities, such as plastics or 
similar petroleum derivatives''). In contrast, commenters' suggestion 
to include nonmining processes in the definition of processing is not 
consistent with the Treasury Department's and the IRS's view of 
congressional intent because the term ``nonmining processes'' in Sec.  
1.613-4(g) is a catch-all category that includes any process applied 
beyond mining processes, including refining, blending, manufacturing, 
transportation, and storage. See Sec.  1.613-4(g) (which lists various 
nonmining processes, and also provides that ``a process applied 
subsequent to a nonmining process (other than nonmining transportation) 
shall also be considered to be a nonmining process''). In addition to 
causing the definition of processing to be partly duplicative of other 
listed section 7704(d)(1)(E) activities, adopting this suggestion would 
mean that so long as a product started as a depletable product, any 
income derived from any manipulation of that product would be 
qualifying income. Such a result would be in direct conflict with the 
desire of Congress to restrict the scope of activities engaged in by 
PTPs. Therefore, these final regulations do not adopt that suggestion.
    Nevertheless, in response to comments, these final regulations 
include some nonmining processes in the definition of refining of ores 
and minerals other than natural gas or crude oil. Refining of ores and 
minerals other than natural gas or crude oil is defined in these final 
regulations as those various processes subsequent to mining processes 
performed to eliminate impurities or foreign matter and which are 
necessary steps in the goal of achieving a high degree of purity from 
specified metallic ores and minerals which are not customarily sold in 
the form of the crude mineral product. The specified metallic ores and 
minerals identified in these final regulations are: Lead, zinc, copper, 
gold, silver, and any other ores or minerals that the Commissioner may 
identify through published guidance. These are the same metallic ores 
and minerals treated as ``not customarily sold in the form of the crude 
mineral product'' under section 613(c)(4)(D), except that fluorspar 
ores and potash are not included in these

[[Page 8328]]

regulations because they will be addressed in regulations specifically 
addressing fertilizer and uranium is not included because it is not 
purified to a high concentrate. Uranium is not mined to isolate pure 
uranium at the high-purity levels as is done with other metals such as 
lead, zinc, copper, gold, or silver, but, overwhelmingly, is instead 
mined to attain a uranium oxide (UO2) material for the manufacture of 
nuclear fuel pellets. This process rejects approximately 95-99 percent 
of the originally-extracted uranium ore (a U238 + U235 mixture), in 
order to raise the concentration of the desired uranium isotope (U235), 
in what the Treasury Department and the IRS have concluded is a 
manufacturing process.
    Refining processes for these specified metallic ores and minerals 
include some non-mining processes (such as fine pulverization, 
electrowinning, electrolytic deposition, roasting, thermal or electric 
smelting, or substantially equivalent processes or combinations of 
processes) to the extent those processes are used to separate or 
extract the metal from the specified metallic ore for the primary 
purpose of producing a purer form of the metal, as for example the 
smelting of concentrates to produce Dor[eacute] bars or refining of 
blister copper. Income from the smelting of iron, for example, is not 
qualifying income under the final regulations because iron is an ore or 
mineral customarily sold in the form of the crude mineral product, and 
thus not a product listed in section 613(c)(4)(D). Compare Sec.  1.613-
4(f)(2)(i)(c) and (d). In addition, these final regulations 
specifically provide that refining does not include the introduction of 
additives that remain in the metal, for example, in the manufacture of 
alloys of gold. Also, the application of nonmining processes as defined 
in Sec.  1.613-4(g) to produce a specified metal that is considered a 
waste or by-product during the production of a non-specified metallic 
ore or mineral is not considered refining.
    These final regulations provide a more detailed definition of 
refining than the proposed regulations and better articulate a common 
understanding of what refining includes, that is in a metallurgical 
sense. To eliminate uncertainty, these final regulations define 
refining to include only activities with respect to those ores and 
minerals that are generally refined to a high degree of purity, which 
are also those ores and minerals that normally require more processing 
before they are sold, as identified in Sec.  613(c)(4) and Sec.  1.613-
4(f)(2)(i)(d). In addition, these final regulations also allow the 
necessary, preceding processes performed to eliminate impurities from 
the specified ores and minerals, thereby addressing commenters' 
concerns regarding a hole in processing activities in the proposed 
regulations. In providing this definition, the final regulations also 
effect congressional intent to limit qualifying income to certain 
activities that have ``commonly or typically been conducted in 
partnership form.'' H.R. Rep. No. 100-391, at 1066 (1987). Both in 1987 
and since, large manufacturing operations such as smelting aluminum and 
manufacturing steel have generally been conducted by corporations. 
Despite the existence of hundreds of different ores and minerals, only 
a handful of businesses that work with ores and minerals other than 
natural gas or crude oil have operated as PTPs, perhaps reflecting a 
general understanding that expanded processing activities were not 
considered by Congress to be activities that could generate qualifying 
income. The Treasury Department and the IRS have determined that it 
would be inappropriate to expand the definition of refining of ores and 
minerals beyond that intended by Congress.
    The final regulations do not recognize as qualifying activities the 
coking of coal or the making of activated carbon. The processing of 
coal, as contemplated by Sec.  1.613-4(f)(2)(i)(a), includes the 
cleaning, breaking, sizing, dust allaying, treating to prevent 
freezing, and loading for shipment. At that point, the coal is ready 
for sale. Because Congress intended products resulting from processing 
to include only those products produced in field facilities or 
refineries, coking of coal is not a processing activity. Furthermore, 
coal is not refined into coke or activated carbon in the metallurgical 
sense in which ores are refined. Coal is itself the mineral or natural 
resource for purposes of sections 611 and 613 that is extracted from 
the ground. Unlike ores where extraction occurs in order to obtain the 
mineral at issue--for which refining may be required to separate the 
mineral from the ore rock--coal is extracted to be used substantially 
as is. Refining ores to obtain a purer form of the minerals found in 
rock is not analogous to coking coal to obtain carbon. Cokemaking and 
creating activated carbon are manufacturing processes used to create a 
new product. Refining is not changing a mineral into a new or different 
mineral product or creating a product that is, altogether, not a 
mineral.
    Similarly, these final regulations do not include the fine 
pulverization of magnetite, as requested by a commenter. As discussed, 
Congress intended processing to include only those activities typically 
performed at the equivalent of field facilities for minerals and ores. 
Fine pulverization is generally not included as a mining process as it 
is not helpful in bringing the ores or minerals to shipping grade 
generally, although pulverization may qualify as a mining process if, 
with respect to the mineral or ore at issue, it is necessary to another 
process that is a mining process. See Sec.  1.613-4(f)(2)(iii). These 
final regulations do not alter this treatment.
4. Timber
    The proposed regulations provided that an activity constituted 
processing of timber if performed to modify the physical form of 
timber, including by the application of heat or pressure to timber, 
without adding any foreign substances. The proposed regulations 
specified that processing of timber did not include activities that 
added chemicals or other foreign substances to timber to manipulate its 
physical or chemical properties, such as using a digester to produce 
pulp. Products that resulted from timber processing included wood 
chips, sawdust, rough lumber, kiln-dried lumber, veneers, wood pellets, 
wood bark, and rough poles. Products that were not the result of timber 
processing included pulp, paper, paper products, treated lumber, 
oriented strand board/plywood, and treated poles.
    Commenters argued that the proposed regulations wrongly limited the 
products of timber processing and restricted additives. These 
commenters noted that the proposed regulations departed from PLRs 
issued in the past that permitted pulping and other engineered wood 
products made with resins and treated with chemicals. Specific to 
pulping, commenters applied the general definition in the proposed 
regulations that provided for separation and purification to reason 
that the pulping of cut timber is merely separation into the component 
parts of wood--water, cellulose fibers, lignin, and hemicelluloses--
through the addition of water and chemicals. Therefore, they argued, 
the specific rule for timber was more restrictive than the general rule 
for all natural resources. In contrast, one commenter acknowledged that 
the production of plywood and other engineered wood products should not 
generate qualifying income because a non-natural resource (that is, a 
synthetic adhesive) is a material input in the process that produces 
engineered wood products.
    The final regulations do not adopt commenters' requests to expand 
the

[[Page 8329]]

definition of the processing of timber, but adopt the rule in the 
proposed regulations without change. As discussed in section I of this 
Summary of Comments and Explanation of Revisions, the Treasury 
Department and the IRS interpret the legislative history of section 
7704(d)(1)(E) to mean that Congress did not intend to extend processing 
activities beyond those involved in getting a natural resource such as 
timber to market in a form generally sold. Potential products made from 
wood are numerous, and include: Pulp, paper and other paper products, 
certain chemicals (such as tar, tall oil, or turpentine), engineered 
wood products, lumber, sawdust, wood chips, and furniture. The point 
where processing turns into manufacturing is definable: The 
modification of the physical state of wood is a process, whereas the 
addition of chemicals in an attempt to manipulate the physical or 
chemical properties of wood is extended processing more akin to 
manufacturing, and thus beyond the scope of activities intended by 
Congress to generate qualifying income. The corollary of a field 
processing plant for timber is a sawmill or pellet mill. Sawmills 
produce lumber and lumber products (such as bark, sawdust, and wood 
chips) from felled logs. Pellet mills produce pellets from logs, 
chipped wood, lumber scraps, sawdust or pulpwood. These processes do 
not change the wood into a different product. The distinction between 
processing and manufacturing of timber is demonstrated in the MACRS 
class lives in Rev. Proc. 87-56, which separate the sawing of stock 
from logs (24.2 and 24.3) from the manufacture of furniture, pulp, and 
paper (24.4 and 26.1). Despite commenters' statements that pulping is 
like crude oil refining, timber is not commonly understood to be 
``refined'' to a higher level of purity. Timber is simply 
``processed''; therefore, these regulations do not include timber in 
the definition of refining.

E. Transportation

    The proposed regulations provided that transportation was the 
movement of minerals or natural resources and products of mining, 
production, processing, or refining, 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 did not include a person who acquired oil or gas for 
refining or processing, or a utility. The following activities 
qualified as transportation under the proposed regulations: (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 was run to connect a producer or refiner 
to a preexisting interstate or intrastate line owned by the PTP 
(interconnect agreements).
    Commenters requested both clarification and expansion of the 
definition of transportation in three main areas. First, commenters 
asked that the regulations explain who can generate qualifying income 
from transportation via pipeline and marine shipping. Specifically, 
different commenters sought assurances that those ``operating 
pipelines'' include operators who move the product, owners and lessors 
who receive income for use of their pipelines, and logistic service 
providers who schedule the movement of product on pipelines. Similarly, 
another commenter asked that the regulations specify that 
transportation under a time charter is a qualifying activity. Under 
such contractual arrangements, a PTP provides a crew and operates a 
marine vessel, though the customer (such as an oil and gas company) 
directs where the product is to be delivered. Essential to this request 
is the additional proposal that the term ``barges'' in the proposed 
regulations be read expansively to include marine transportation via 
other types of vessels, especially those that move under their own 
power rather than being pushed or towed.
    To transport is ``to carry or convey (a thing) from one place to 
another,'' and transportation is ``the movement of goods or persons 
from one place or another by a carrier.'' Black's Law Dictionary (8th 
ed. 2004). As a general matter, these final regulations do not require 
ownership or control of the assets used to perform a listed activity so 
long as the action being performed is within the definition of a 
qualifying activity. Following this approach, those performing the 
physical work to move the product along a pipeline (such as taking 
delivery of the product, metering quantities, monitoring 
specifications, and actually controlling the movement of the product) 
or to transport the product via marine vessel (including operating the 
vessel under a time charter) are performing a qualifying activity. 
Also, given the dedicated use of pipelines in the oil and gas industry, 
these final regulations specifically allow as qualifying income the 
income owners and lessors receive for the use of their pipelines to 
transport minerals or natural resources. In contrast, a logistics 
service provider involved in scheduling services alone neither carries 
nor conveys, and is therefore not a transporter. A logistics service 
provider may, however, have qualifying income if it meets the intrinsic 
test described in further detail in section IV of this Summary of 
Comments and Explanation of Revisions. Additionally, these final 
regulations replace the word ``barge'' with ``marine vessel'' so as not 
to limit marine transportation to one type of watercraft.
    The second area of concern raised by commenters dealt with the 
exception for transportation to retail customers. Commenters asked that 
the regulations clarify that certain transportation to retail customers 
is a qualifying activity. For example, citing to one sentence in the 
legislative history that ``[i]ncome from any transportation of oil or 
gas or products thereof by pipeline is treated as qualifying income,'' 
one commenter asserted that Congress intended to include as a 
qualifying activity the transportation of oil and gas by pipeline 
directly to homeowners. H.R. Conf. Rep. 100-1104(II), at 18 (1988) 
(emphasis added). Likewise, many other commenters asserted that 
Congress intended that the transportation and corresponding marketing 
of liquefied petroleum gas (primarily propane) to retail customers 
generate qualifying income. These commenters pointed to floor 
statements made by Senator Lloyd Bentsen and Representative Dan 
Rostenkowski after enactment of section 7704, which were specifically 
referenced in a footnote in the Conference Report to the Technical and 
Miscellaneous Revenue Act of 1988. See 133 Cong. Rec. S18651 (December 
22, 1987), 133 Cong. Rec. H11968 (December 21, 1987), and H.R. Conf. 
Rep. 100-1104(II), at 18 (1988).
    To provide more clarity, these final regulations explain when 
transportation to a place that sells to retail customers or 
transportation directly to retail customers is a qualifying activity. 
Specifically, these final regulations provide that transportation 
includes the movement of minerals or natural resources, and products 
produced under processing and refining, via pipeline to a place that 
sells to retail customers, but do not expand the list of qualifying 
activities to include the movement of such items via pipeline directly 
to retail customers. In addition, these final regulations provide that 
transportation includes the movement of liquefied petroleum gas via 
trucks, rail cars, or pipeline to a place that sells to retail 
customers as well as directly to retail customers.
    These provisions implement Congressional intent as expressed in the

[[Page 8330]]

legislative history accompanying the Technical and Miscellaneous 
Revenue Act of 1988 which provided: ``in general, income from 
transportation of oil and gas and products thereof to a bulk 
distribution center such as a terminal or a refinery (whether by 
pipeline, truck, barge or rail) be treated as qualifying income. Income 
from any transportation of oil or gas or products thereof by pipeline 
is treated as qualifying income. Except in the case of pipeline 
transport, however, transportation of oil or gas or products thereof to 
a place from which it is dispensed or sold to retail customers is 
generally not intended to be treated as qualifying income. Solely for 
this purpose, 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, nor does 
a retail customer include a utility providing power to customers. For 
example, income from transporting refined petroleum products by truck 
to retail customers is not qualifying income.'' H.R. Conf. Rep. 100-
1104(II), at 17-18 (1988). A footnote added that ``[i]ncome from 
transportation and marketing of liquefied petroleum gas in trucks and 
rail cars or by pipeline, however, may be treated as qualifying 
income,'' citing the floor statements identified by commenters. Id.
    Although the legislative history supports much of what commenters 
have asked to be clarified, it does not support the proposal that the 
transportation by pipeline of oil, gas, and products thereof (other 
than liquefied petroleum gas) directly to homeowners is qualifying 
income. Although Congress stated that ``any'' transportation by 
pipeline qualifies, when read in context with the remainder of the 
paragraph, it is clear that Congress was discussing bulk 
transportation. See also S. Rep. 100-445, at 424 (1988) (``[i]n the 
case of transportation activities with respect to oil and gas and 
products thereof, the Committee intends that, in general, income from 
bulk transportation of oil and gas and products thereof be treated as 
qualifying income''). This treatment also parallels Congressional 
intent regarding marketing, which is a qualifying activity ``at the 
level of exploration, development, processing or refining,'' but not 
``to end users at the retail level.'' Id.
    The third area of comments on transportation were requests to 
include specific, additional activities in the list of examples, in 
this case, compression services, liquefaction and regasification, and 
the sale of renewable identification numbers (RINs). Each of these 
activities relates directly to the conveyance of certain oil and 
natural gas products and therefore these final regulations adopt 
commenters' suggestions to add them as examples to the list of 
qualifying transportation activities. Natural gas compression is a 
mechanical process whereby a volume of natural gas is compressed to a 
required high pressure in order to transport the gas though pipelines. 
A compression service provider selects appropriate compression 
equipment (for example, the number of compressors and the compressor 
configuration), then installs, operates, services, repairs, and 
maintains that equipment, typically working on a continuous basis. More 
than the mere sale of equipment, a compression service company is 
engaged in transportation activities by making natural gas move from 
one point to another.
    Similarly, liquefaction and regasification are the process of 
transforming methane from a gas to a liquid (LNG) to facilitate its 
transportation and storage, and the process of reconverting the liquid 
to a gas, respectively. The regasified natural gas is fungible with 
natural gas that has not been liquefied and regasified. Moreover, in 
2008, Congress amended section 7704(d)(1)(E) to add that income and 
gains from the transportation or storage of any fuel described in 
section 6426(d), which includes compressed or liquefied natural gas, 
generates qualifying income. See Public Law 110-343, 122 Stat. 3765, 
Section 208(a), and section 6426(d)(2)(C). Since the transportation and 
storage of LNG clearly is a qualifying activity, the liquefaction and 
regasification must also generate qualifying income.
    Finally, RINs are part of a Congressionally-mandated program to 
ensure that transportation fuel sold in the U.S. contains a minimum 
percentage of renewable fuel. Generally, RINs are assigned to each 
gallon of renewable fuel, and are separated when the renewable fuel is 
combined with conventional fuel. Companies who blend such additives 
into conventional fuels are assigned annual quotas of RINs that they 
must acquire. Companies who acquire more RINs than needed in any year 
may sell the surplus to others who have not met their quota. Although 
it is not a direct, physical conveyance of a mineral or natural 
resource or product of processing and refining, the Treasury Department 
and the IRS agree that the sale of RINs gives rise to qualifying income 
as a part of transportation and marketing activities--that is, 
additization, as that activity is described in more detail in section 
III.H.5 of this Summary of Comments and Explanation of Revisions.
    In addition to the three areas of comments discussed regarding 
transportation in this section III.E of this Summary of Comments and 
Explanation of Revisions, commenters also suggested that the final 
regulations expand the types of interconnect agreements that are 
treated as giving rise to qualifying transportation activities. Because 
these final regulations address all construction activities related to 
performing section 7704(d)(1)(E) activities in a new section regarding 
cost reimbursements, construction of pipelines is moved from the 
section on transportation and those comments are discussed in more 
detail in section III.H.1 of this Summary of Comments and Explanation 
of Revisions.

F. Marketing

    The proposed regulations provided that an activity constituted 
marketing if it was performed to facilitate sale of minerals or natural 
resources and products of mining or production, processing, and 
refining, including by blending additives into fuels. The proposed 
regulations explained that marketing did not include activities and 
assets involved primarily in retail sales (sales made in small 
quantities directly to end users), which included, but were not limited 
to, operation of gasoline service stations, home heating oil delivery 
services, and local natural gas delivery services.
    In addition to the comments received concerning retail sales of 
liquid petroleum gas addressed in section III.E of this Summary of 
Comments and Explanation of Revisions, one commenter recommended 
revising the definition of marketing to better reflect the common 
meaning of the word by including the act of selling and other 
activities designed to encourage sales, including the packaging of 
products. This same commenter also suggested rewording the exclusion 
for retail sales so that the regulation is more direct and involves an 
intent test. The commenter proposed eliminating the concepts relating 
to ``assets'' and ``involved'' in retail sales because they create 
uncertainty and changing the definition from ``sales made in small 
quantities directly to end users'' to ``sales to ultimate consumers to 
meet personal needs, rather than for commercial or industrial uses of 
the articles sold.''
    Adopting some of these suggestions, these final regulations 
directly state that marketing is the bulk sale of minerals or natural 
resources, and products

[[Page 8331]]

produced through processing or refining, and includes activities that 
facilitate sales (such as packaging). These final regulations continue 
to provide that marketing generally does not include retail sales. 
These final regulations do not, however, change the definition of 
retail sales to create an intent-based test that looks to determine the 
purpose of the purchase. The final regulations are consistent with the 
legislative history, which clarified that, ``[w]ith respect to 
marketing of minerals and natural resources (e.g., oil and gas and 
products therefof [sic]), the Committee intends that qualifying income 
be income from marketing at the level of exploration, development, 
processing or refining the mineral or natural resource. By contrast, 
income from marketing minerals and natural resources to end users at 
the retail level is not intended to be qualifying income. For example, 
income from retail marketing with respect to refined petroleum products 
(e.g., gas station operations) is not intended to be treated as 
qualifying income.'' S. Rep. No. 100-445, at 424 (1988). This 
legislative history indicates that a small business owner who fills his 
delivery truck at the gas station before delivering his wares is still 
an end user at the retail level, even though the gasoline is used for 
commercial purposes.

G. Fertilizer

    The final regulations reserve a paragraph for fertilizer under 
section 7704(d)(1)(E) activities in anticipation of a new notice of 
proposed rulemaking that will define fertilizer as well as explain what 
activities involving fertilizer will generate qualifying income. The 
Treasury Department and the IRS will address the comment received on 
fertilizer in those proposed regulations.

H. Additional Activities

    The Treasury Department and the IRS received comments regarding 
certain other activities that are not exclusive to just one section 
7704(d)(1)(E) activity, including seeking reimbursement for the costs 
of performing section 7704(d)(1)(E) activities, receiving income from 
passive interests, blending, and additization. These final regulations 
include these activities as qualifying activities, and clarify the 
extent to which these activities generate qualifying income. This 
preamble also discusses comments received concerning hedging, and 
requests further comments.
1. Cost Reimbursements
    The list of section 7704(d)(1)(E) activities identified only the 
overarching pursuits undertaken by businesses engaged in the 
exploration, development, mining or production, processing, refining, 
transportation, or marketing of minerals or natural resources. The 
proposed regulations did not list as section 7704(d)(1)(E) activities 
the many other activities required to run a business, such as hiring 
employees, negotiating contracts, or acquiring assets used in the 
business. Normally those typical, administrative activities are 
considered to give rise to business costs, and are not understood to be 
the trade or business that generates income for those in the mineral 
and natural resource industries. Under the proposed regulations, 
however, a partnership could demonstrate that it performed intrinsic 
activities, meaning its activities were so closely tied to section 
7704(d)(1)(E) activities that income therefrom should be considered 
derived from those section 7704(d)(1)(E) activities, and thus be 
treated as qualifying income. Intrinsic activities included limited, 
active services that closely supported section 7704(d)(1)(E) activities 
by being specialized, essential, and significant. The proposed 
regulations also identified a number of service activities that would 
not meet the requirements to be considered an intrinsic activity, 
including legal, financial, consulting, accounting, insurance, and 
other similar services, or activities that principally involved the 
design, construction, manufacturing, repair, maintenance, lease, rent, 
or temporary provision of property. This did not mean that a business 
performing intrinsic activities was prohibited from engaging in the 
typical activities required to operate its own business, only that 
supplying those services to others would not generate qualifying income 
under section 7704(d)(1)(E) for those businesses.
    Commenters asked that the final regulations clarify two issues 
regarding these general services that are not specific to the mineral 
and natural resource industries. First, commenters recommended that the 
section 7704(d)(1)(E) activities be defined to include the functions 
(such as engineering, construction, operations, maintenance, security, 
billing, hiring, accounting, and tax financial reporting) that, taken 
in the aggregate, are necessary for the overall operation of the 
qualifying activity. Commenters thus recommended that the final 
regulations reflect more generally that income from performing the 
functions required for the operation of qualifying assets or qualifying 
businesses (including cost reimbursements) constitutes qualifying 
income, even if the operator does not own the underlying assets. As an 
illustration of this request, one commenter provided the example of a 
pipeline or processing facility operator that provides all of the 
services to run assets owned by a third party (such as contracting with 
customers for the use of the pipeline or processing facility, loading/
unloading the product, performing tasks necessary to transport or 
process the product, metering quantities, and monitoring 
specifications), but also manages the construction of any assets 
necessary for the completion of the activities and handles all of the 
back-office functions such as payroll and other administrative 
services. Although the costs of providing that work may be imbedded in 
the charge to its client for operating the pipeline or processing 
facility, sometimes an operating partnership may instead send its 
client a bill with a separate line item for construction or back office 
expenses.
    The Treasury Department and the IRS agree with commenters that 
operating income (including from construction and back-office 
functions) should constitute qualifying income so long as the 
activities to which the income is attributable are part of the 
partnership's business of performing the section 7704(d)(1)(E) 
activity. Whether the partnership adds the cost to a general overhead 
account or provides the client with a separate line item detailing that 
cost in its bill should not matter--that income is still derived from 
performing the section 7704(d)(1)(E) activity. A partnership performing 
a section 7704(d)(1)(E) activity that recoups its costs is markedly 
different from a business solely performing one of the services 
identified in the intrinsic activities section that are identified as 
not essential or not significant. Therefore, to clarify this issue, 
these final regulations provide that if the partnership is, itself, in 
the trade or business of performing a section 7704(d)(1)(E) activity, 
income received to reimburse the partnership for its costs incurred in 
performing that section 7704(d)(1)(E) activity, whether imbedded in the 
rate the partnership charges or separately itemized, is qualifying 
income. Reimbursable costs may include, but are not limited to, the 
cost of designing, constructing, installing, inspecting, maintaining, 
metering, monitoring, or relocating an asset used in that section 
7704(d)(1)(E) activity, or of providing office functions

[[Page 8332]]

necessary to the operation of that section 7704(d)(1)(E) activity (such 
as staffing, purchasing supplies, billing, accounting, and financial 
reporting). For example, a pipeline operator that charges a customer 
for its cost to build, repair, or schedule flow on the pipelines that 
it operates will have qualifying income from such activity whether or 
not the operator itemizes those costs when it bills the customer.
    Because these final regulations address reimbursement to a PTP for 
the construction of assets used by it to perform a section 
7704(d)(1)(E) activity more generally, these final regulations remove 
the narrow provision under the definition of transportation that listed 
construction of a pipeline as a qualified activity but only to the 
extent that the pipe was run to connect a producer or refiner to a 
preexisting interstate or intrastate line owned by the partnership. 
Many commenters protested that the provisions were too limited, 
explaining that the Federal Energy Regulatory Commission, which 
regulates pipelines, may require pipelines to connect with other 
pipelines to facilitate the efficient movement of product, and that 
many other new and existing operations (such as gathering systems, 
utilities, power generation facilities, refineries, local distribution 
companies, or other commercial or governmental clients) may also wish 
to connect to pipelines. Based on the hearings held before the passage 
of section 7704 and the legislative history, it is clear that Congress 
was concerned about certain mineral and natural resource partnerships 
being able to acquire necessary capital to build the assets to be used 
in their section 7704(d)(1)(E) activities. Building a new facility or 
pipeline is capital intensive and, to the extent that a partnership 
passes some of those costs on to the client, the income from the 
reimbursement of those costs, when received, is a part of the 
partnership's income from performing the section 7704(d)(1)(E) 
activity.
    The second issue raised by commenters is an extension of the first. 
Commenters suggested that management fees earned by a direct or 
indirect co-owner of a business performing a section 7704(d)(1)(E) 
activity should be treated as qualifying income. One commenter noted 
that the partner of the business may provide such legal, financial or 
accounting services for efficiency purposes or under agreement where 
one partner performs the section 7704(d)(1)(E) activities while another 
performs the administrative activities. These final regulations do not 
adopt this suggestion. To the extent a partner of a PTP is receiving a 
management fee (as distinguished from a distributive share of 
partnership income) for such administrative tasks as legal, financial 
or accounting services, it is no different than any other business 
providing a service to the PTP. Whether income from the services is 
qualifying will depend on whether the partner can demonstrate that it 
is performing an intrinsic activity as discussed in section IV of this 
Summary of Comments and Explanation of Revisions.
2. Hedging
    The proposed regulations did not address whether income from 
hedging transactions was qualifying income. Several commenters noted 
this and specifically requested guidance on this question. Commenters 
noted that commodity prices are volatile and PTPs must hedge their 
risks to ensure consistent cash flows, both from an operational and 
working capital perspective, and from an investor demand perspective. 
Commenters recommended that the final regulations provide that income 
derived from any hedging transactions that are entered into by a PTP in 
the normal course of its trade or business and that manage the PTP's 
risk with respect to price fluctuations of the minerals or natural 
resources should be included as qualifying income. Other commenters 
would include income from any hedging transactions entered into by a 
PTP in order to manage its prudent business concerns, including 
transactions hedging interest rate risks and foreign currency 
transactions related to its qualifying activities. One commenter 
further recommended that a hedge of an aggregate risk with respect to 
both a qualifying activity and a non-qualifying activity should be 
considered income from the qualifying activity if substantially all of 
the risk hedged relates to the qualifying activity.
    The Treasury Department and the IRS agree with commenters that 
hedging income, when it is derived from a section 7704(d)(1)(E) 
activity, should give rise to qualifying income under section 
7704(d)(1)(E). Engaging in hedging activities is a common part of the 
industry and represents prudent business practice. However, because 
hedging transactions are generally used to fix the price of property 
with respect to a section 7704(d)(1)(E) activity, the Treasury 
Department and the IRS believe that both the income and gains, as well 
as the deductions and losses, with respect to hedges should be taken 
into account in determining the income from a section 7704(d)(1)(E) 
activity. These final regulations reserve on the issue of hedging while 
the Treasury Department and the IRS consider what types of hedging 
transactions would result in qualifying income and whether to adjust 
gross income for such hedging transactions. To that end, the Treasury 
Department and the IRS request comments on methods to account for the 
income and gains, as well as the deductions and losses, with respect to 
hedges. For example, future regulations may generally provide that 
income, deduction, gain, or loss from a hedging transaction entered 
into by the partnership primarily to manage risk of price changes or 
currency fluctuations with respect to ordinary property (as defined in 
Sec.  1.1221-2(c)(2)) with respect to which qualifying income is 
derived from a section 7704(d)(1)(E) activity is treated as an 
adjustment to qualifying income, provided that the transaction is 
entered into in the ordinary course of the PTP's business and is 
clearly identified by the end of the day on which it is entered into. 
The principles of section 1221(b)(2)(B) and the regulations thereunder, 
regarding identification, recordkeeping, and the effect of 
identification and non-identification, would apply to hedging 
transactions entered into by the PTP.
    For example, a partnership might have gain or loss on a forward 
contract that it enters into to hedge the price risk related to its 
sale of a commodity with respect to which qualifying income is derived 
from a qualifying activity. If the partnership has gain that is 
recognized on the hedge under its method of accounting, then such gain 
would be treated, for purposes of section 7704(c)(2), as an additional 
amount realized with respect to the commodity and would be treated 
under these rules as increasing the amount of qualifying income derived 
from the qualifying activity. Conversely, if the taxpayer recognizes 
loss under its accounting method with respect to the hedge, then the 
loss would be treated, for purposes of section 7704(c)(2), as a 
decrease in the amount realized on the commodity thus decreasing the 
qualifying income derived from the qualifying activity.
    The Treasury Department and the IRS do not agree, however, that 
income from hedging with respect to an activity that is not a section 
7704(d)(1)(E) activity should give rise to qualifying income under 
section 7704(d)(1)(E). Other types of hedges, however, may be included 
under other provisions of section 7704. For example, as noted by some 
of the commenters, the existing regulations under Sec.  1.7704-3 
provide that qualifying income includes (1) income from notional 
principal contracts (NPC) if the property, income, or cash flow

[[Page 8333]]

that measures the amount to which the partnership is entitled under the 
NPC would give rise to qualifying income if held or received directly 
by the partnership and (2) other substantially similar income from 
ordinary and routine investments to the extent determined by the 
Commissioner. See Sec.  1.7704-3(a)(1).
3. Passive Interests
    Income from passive interests was not addressed in the proposed 
regulations. Commenters suggested that income from passive, non-
operating economic interests in minerals and natural resources (for 
example, royalty interests, net profits interests, rights to production 
payments, delay rental payments, and lease bonus payments) should be 
qualifying income. One commenter explained that passive economic 
interest owners have an economic interest in the minerals in place (for 
example, they are treated as the owner of the mineral or natural 
resource when it is in fact produced) and a right to share and 
participate in the proceeds derived from the production of the minerals 
and natural resources. Another commenter noted that surface damage 
payments may arise as a part of mining or production. For example, if 
surface ownership and mineral ownership are separate, a miner may pay 
royalties to both the surface owner and mineral owner. One commenter 
explained that several parties may derive income from exploration, 
development, mining, production, or marketing: (1) Owners of passive 
economic interests that themselves do not engage in the production 
operations associated with mineral or natural resource properties, but 
benefit from their respective shares of production revenue; (2) working 
interest owners (whether or not the ``operator'') that are responsible 
for the activities of exploring for, drilling for, and producing 
natural resources from the mineral properties, and (3) third-party 
service providers, who generally do not own an economic interest in the 
mineral properties, but charge the working interest owners fees or 
service charges. The commenter noted that the proposed regulations 
addressed income of working interest owners and third-party service 
providers, but not those with passive economic interests.
    Because income from passive economic interests can be generated at 
many different stages throughout the process of getting minerals and 
natural resources to a marketable form, these final regulations include 
income from passive economic interests in minerals and natural 
resources as qualifying income.
4. Blending
    Commenters raised several questions about the extent to which the 
blending of the same mineral or natural resource, or products thereof, 
was a qualifying activity. The proposed regulations referenced some 
blending activities by treating as a section 7704(d)(1)(E) activity the 
chemical conversion of the physically separated components of crude oil 
if one or more of the products of the conversion were recombined with 
other physically separated components of crude oil in a manner that was 
necessary to the cost-effective production of gasoline or other fuels. 
The proposed regulations also included ``blending additives into fuel'' 
as a marketing activity.
    Commenters noted that terminal operators also perform blending 
services as a part of their transportation activities, and requested 
that the regulations be clarified to list blending as a transportation 
activity. Commenters explained that terminals may blend different 
grades of crude oil together to achieve the desired grade or quality of 
crude oil, or they may blend a diluent (such as diesel fuel, or a 
lighter grade of crude oil) into heavier crude oil to achieve a level 
of viscosity appropriate for the subsequent mode of transportation. 
Another commenter stated that refineries also perform some blending 
activities, and asked that income from such blending be treated as 
qualifying income. Commenters also raised concerns that the restriction 
in the proposed regulations to the blending of just fuels does not 
account for the other products of a refinery that may be produced 
through blending activities. In addition, one commenter noted that 
terminals for other natural resources perform blending activities. For 
example, the commenter explained that coal terminals may mix or 
homogenize grades of coal from different mines or mining regions with 
dissimilar characteristics (for example, higher sulfur coal and lower 
sulfur coal) to achieve coal that meets product specifications.
    Expanding on this idea, some commenters asked for clarification 
that the combination of different minerals and natural resources, or 
products thereof, should also be a qualifying activity where all 
products combined are natural resources or products thereof. For 
example, one commenter suggested that the physical mixing of asphalt 
with aggregates to produce road paving material should be treated as 
processing provided that the primary purpose of the mixing is to 
enhance the inherent use of each of the products mixed. That commenter 
thought that a product would no longer be considered a natural resource 
if the product does not retain a majority of the physical and chemical 
characteristics of the mineral or natural resource from which it was 
produced.
    These final regulations adopt the recommendation that qualifying 
income should include income from the blending of the same mineral or 
natural resource, or products thereof. Income from blending is thus 
added as a type of additional qualifying income because blending may be 
part of processing, refining, transportation, or marketing. In response 
to comments, these final regulations also provide that, for purposes of 
the blending rules in these regulations, products of crude oil and 
natural gas will be considered as from the same natural resource. These 
final regulations do not, however, expand the definition of processing 
or refining to include the combination of different minerals or natural 
resources, except as permitted under the rules related to additization, 
which are discussed in section III.H.5 of this Summary of Comments and 
Explanation of Revisions. Allowing the combination of different natural 
resources would greatly expand the scope of qualifying activities 
beyond that intended by Congress, and is akin to additional processing 
to the point of manufacturing a new product. For example, once asphalt 
is mixed with rock aggregate, it is no longer a product of a refinery 
or a product of mineral processing, but has become a new road paving 
product.
5. Additization
    As they did for blending, commenters raised several questions about 
the extent to which the addition of a minimal amount of different 
minerals or natural resources or other materials to minerals or natural 
resources is a qualifying activity. The proposed regulations recognized 
that some additization was a qualifying activity, but only to the 
extent it was a marketing activity and only with respect to fuels.
    The proposed regulations left undefined what additization included. 
One commenter recommended that the addition of additives to enhance, 
preserve, or complement the mineral or natural resource product, such 
as the chemical treatment of sand, should qualify. Another commenter 
recommended that additization activities that do not change a natural 
resource into a new product should give rise to qualifying income 
whether done as part of processing, refining, transportation, or 
marketing and no matter the type of product (allowing, for

[[Page 8334]]

example, additization with respect to lubricants or asphalt).
    The Treasury Department and the IRS agree that it is appropriate to 
treat some additization services as qualifying activities. For example, 
certain additization may occur in order to safely transport a product 
(sand terminals, for example, may treat sand with a detergent to 
prevent dust as the sand travels by rail or truck to its final 
destination) or to comply with Federal, state, or local regulations 
concerning product specifications (as, for example, in the case of the 
addition of dyes to gasoline). However, the Treasury Department and the 
IRS remain concerned about distinguishing between products of 
refineries and field facilities, and products of additional processing. 
Accordingly, and consistent with some of the comments received, these 
final regulations distinguish between additives that are merely a small 
addition to a product of a refinery, field facility, or mill, and 
additives that may change the product into a new or different product. 
These final regulations thus provide rules regarding additization 
tailored to crude oil, natural gas, other ores and minerals, and 
timber.
    With respect to crude oil, natural gas, and products thereof, 
commenters explained that the additives, which are typically not 
natural resources for the purposes of section 7704, are often required 
by applicable regulations or otherwise enhance motor fuel blend stock. 
These additives are added at the terminal because it allows products 
owned by different customers to be commingled for storage, but then 
customized for each customer as loaded into carriers for shipment. 
Typical additives include detergents, dyes, cetane improvers, cold flow 
improvers, fuel oil stabilizers, isotopic markers, lubricity/
conductivity improvers, anti-icing agents, and proprietary gasoline 
additives. Ethanol is also typically blended into gasoline to satisfy 
EPA guidelines, and biodiesel is often blended into diesel fuel. 
Commenters noted that ethanol typically constitutes 10 percent of the 
blend but can be higher, while biodiesel typically constitutes 20 
percent of the blend but can be lower or higher. Other additives 
typically make up a very small portion of the blended stock (typically 
less than 1 percent).
    Commenters also argued that, just as additives were permitted in 
the proposed regulations with respect to fuels, additization should 
also be allowed for other products of oil and natural gas processing 
and refining. These commenters noted that there is no practical 
difference between adding ethanol, biodiesel, or other additives into 
fuels, and adding additives into lubricating oils and waxes. For 
example, commenters explained that lubricating oils, waxes, and other 
refined products may be blended together and with additives to provide 
increased anti-wear protection, reduce friction, extend oil life, 
improve corrosion protection, give the ability to separate from water, 
and reduce energy usage. Lubricants may also be mixed with a detergent 
and a thickener to produce greases in multiple grades and for many 
uses. These commenters also recommended that additization should not be 
limited to just a marketing activity as, for example, terminals and 
refineries both may perform additization activities.
    The Treasury Department and the IRS agree that, since additization 
activities are commonly performed by refineries and by terminals with 
respect to all products of a refinery, additization should be treated 
as a qualifying activity that generates qualifying income. These final 
regulations adopt this change and provide that, to the extent the 
additives generally constitute less than 5 percent of the total volume 
for products of natural gas and crude oil and are added into the 
product by the terminal operator or upstream of the terminal operator, 
the additization activity generates qualifying income. As previously 
explained, added ethanol and biodiesel may constitute up to 20 percent 
of the total volume for products of natural gas and crude oil; 
therefore, the final regulations provide for a 20 percent threshold for 
ethanol and biodiesel. Although the Treasury Department and the IRS 
remain concerned that qualifying income not include the manufacture of 
new products beyond those generally produced in field facilities or 
refineries, the Treasury Department and the IRS have concluded that the 
small amount of additives discussed in some of the comments do not pose 
a risk if they are consistent with the limitations set forth in the 
final regulations.
    In the case of minerals other than oil and gas, the final 
regulations provide that the addition of incidental amounts of material 
such as paper dots to identify shipments, anti-freeze to aid in 
shipping, or compounds to allay dust as required by law or reduce 
losses during shipping is permissible.
    Regarding timber, one commenter noted that the treatment of lumber 
and poles with an immaterial amount of additives that protect or 
enhance the natural resource or that are necessary to meet 
environmental or regulatory standards should also constitute timber 
processing. This commenter noted that the proposed regulations included 
an intent-based test that looks to whether chemicals are added to 
``manipulate'' physical or chemical properties of the timber. The 
commenter argued that there is no manipulation of physical or chemical 
properties of the timber in the case of relatively small amounts of 
additives, such as those that constitute five percent or less of the 
product. This commenter provided no examples of what types of treatment 
processes would be required under environmental or regulatory standards 
for lumber and poles, but did argue that, although wood pellets are 
commonly made without the addition of any non-timber additives, it is 
possible that customers or regulators may require the addition of an 
additive to reduce the emissions profile of wood pellets.
    As previously discussed, these final regulations generally allow 
for small amounts of additives where required in order to comply with 
Federal, state, or local law when such additives do not rise to the 
level of a manufacturing activity. As such, the final regulations 
provide that, for timber, additization of incidental amounts of 
material as required by law is permissible, to the extent such 
additions do not create a new product. These final regulations clarify, 
however, that the application of chemicals and pressure to produce 
pressure treated wood does not give rise to qualifying income. This is 
a process generally completed at a separate site from the mill, and 
creates a new and different manufactured product.

IV. Intrinsic Activities

    The proposed regulations provided that 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. 
Qualifying activities were defined to include section 7704(d)(1)(E) 
activities and intrinsic activities. The preamble to the proposed 
regulations explained that the Treasury Department and the IRS believed 
that certain limited support activities intrinsic to section 
7704(d)(1)(E) activities also gave 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 a section 7704(d)(1)(E) activity: The 
activity must be specialized to support the section 7704(d)(1)(E) 
activity, essential to the completion of the section 7704(d)(1)(E) 
activity, and require the provision of significant services to support 
the section 7704(d)(1)(E) activity. The

[[Page 8335]]

preamble further explained that the Treasury Department and the IRS 
intended that intrinsic activities constitute active support of section 
7704(d)(1)(E) activities, and not merely the supply of goods.

A. General Issues

    The intrinsic activities provision provided a way for businesses 
whose activities were not listed as section 7704(d)(1)(E) activities to 
demonstrate that they were so closely tied to section 7704(d)(1)(E) 
activities that they should be considered a part of the mineral or 
natural resource industries, and that their activities therefore 
generated qualifying income. Because these intrinsic activities were 
discussed as support or service activities, some commenters mistakenly 
believed that all service providers that did not own or possess control 
of the underlying mineral or natural resource (such as a subcontractor) 
must test whether their activities generated qualifying income solely 
under the intrinsic activities test, even if the activity being 
performed was listed as a section 7704(d)(1)(E) activity. For example, 
one commenter recommended an alternative intrinsic activity standard 
whereby activities of a service provider would qualify as intrinsic to 
a section 7704(d)(1)(E) activity if they would have qualified as a 
section 7704(d)(1)(E) activity, or an indispensable part thereof, if 
performed directly by the service recipient.
    Conversely, one commenter argued that the simplest and most direct 
way to define what activities are qualifying for purposes of section 
7704(d)(1)(E) is to require possession of the mineral or natural 
resource. This commenter argued that the Treasury Department and the 
IRS expanded the scope of qualifying income beyond that intended by 
Congress by accommodating additional support activities such as water 
delivery and disposal.
    Like the proposed regulations, these final regulations do not 
contain any requirement that a PTP engaged in a section 7704(d)(1)(E) 
activity must own or possess control of the underlying mineral or 
natural resource. Such a requirement conflicts with some of the listed 
7704(d)(1)(E) activities. For example, a PTP pipeline company may not 
own the products being transported. Many of the examples of activities 
defining each of the listed 7704(d)(1)(E) activities can be performed 
without having ownership or possession of the mineral or natural 
resource. Furthermore, the legislative history clarified that ``[t]he 
reference provided in the bill to depletable products is intended only 
to identify the minerals or natural resources and not to identify what 
income from them is treated as qualifying income. Consequently, whether 
income is taken into account in determining percentage depletion under 
section 613 is not necessarily relevant in determining whether such 
income is qualifying income under section 7704(d).'' H.R. Rep. No. 100-
795, at 400 (1988). Because the activities listed in section 
7704(d)(1)(E) may commonly be performed by persons without ownership of 
the underlying resource, the ownership requirements in sections 611 and 
613 are not relevant in determining whether income is qualifying for 
purposes of section 7704(d)(1)(E). Finally, section 7704(d)(1)(E) 
provides that qualifying income is income ``derived from'' exploration, 
development, mining or production, processing, refining, 
transportation, and marketing. The intrinsic activities test applies to 
those PTPs who engage in activities other than those listed as a 
section 7704(d)(1)(E) activity but that may receive income ``derived 
from'' a section 7704(d)(1)(E) activity. Although the existence of the 
intrinsic activities test was especially important in the proposed 
regulations since the list of section 7704(d)(1)(E) activities was 
exclusive, the test retains purpose in the final regulations because it 
potentially allows as qualifying some activities that closely support, 
but do not specifically constitute, an enumerated section 7704(d)(1)(E) 
activity.
    To the extent the commenter who suggested the alternative intrinsic 
activities standard was also asking that an activity be considered a 
qualifying activity when a subcontractor performs only a subset of the 
tasks of a larger qualifying activity, that suggestion ignores the main 
thrust of section 7704(d)(1)(E), which looks to the activity that is 
being performed that generates the income received. For example, this 
commenter argued that, because a refiner may use an air separation unit 
to separate air into its primary components for use in refining, a 
taxpayer that is solely engaged in providing air separation unit 
services to that refiner should have qualifying income. However, the 
use of air to produce nitrogen and oxygen is clearly not a section 
7704(d)(1)(E) activity. Air is not a mineral or natural resource. See 
sections 7704(d)(1) and 613(b)(7)(B). A refinery may use such gases in 
its activities, but that does not mean the provision of the air 
separation unit to create the gases somehow should give rise to 
qualifying income solely because the nitrogen and oxygen are provided 
to a refinery. The provision and operation of an air separation unit 
would only qualify to the extent such activity meets the intrinsic 
test.
    Aside from general criticism that the intrinsic activities 
provision was too subjective overall and challenging to apply in 
situations that require a high level of certainty, the remainder of the 
comments on the intrinsic activities provision requested changes to the 
requirements of two specific prongs of the test dealing with 
specialization and significant services, as discussed in sections IV.B 
and IV.C, respectively, of this Summary of Comments and Explanation of 
Revisions. The Treasury Department and the IRS received no comments 
recommending changes to the essential prong of the intrinsic activities 
test in the proposed regulations, which required that the activity be 
necessary to (a) physically complete the 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. These final regulations 
thus adopt the essential prong of the intrinsic activities test with no 
changes.

B. Specialization

    The proposed regulations provided that an activity was specialized 
if the partnership provided personnel to perform or support a section 
7704(d)(1)(E) activity and those personnel received training unique to 
the mineral or natural resource industry that was of limited utility 
other than to perform or support a section 7704(d)(1)(E) activity 
(hereinafter ``specialized personnel requirement''). In addition, to 
the extent that the activity included the sale, provision, or use of 
property, the proposed regulations required that either: (1) The 
property was primarily tangible property that was dedicated to, and had 
limited utility outside of, section 7704(d)(1)(E) activities and was 
not easily converted to another use (hereinafter ``specialized property 
requirement''); or (2) the property was used as an injectant to perform 
a section 7704(d)(1)(E) activity that was 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 collected and 
cleaned, recycled, or otherwise disposed of the injectant after use in 
accordance with Federal, state, or local regulations concerning waste 
products from mining or production activities (hereinafter ``injectants 
exception'').

[[Page 8336]]

    Commenters identified concerns with all three parts of the 
specialization prong. Regarding the specialized personnel requirement, 
one commenter said it was unclear how much training was necessary for a 
skill to be considered specialized. Regarding the specialized property 
requirement, the same commenter criticized as vague the language about 
property having limited utility outside section 7704(d)(1)(E). Other 
commenters argued that the specialized property requirement should be 
removed entirely or that the use of specialized property should be 
treated as an indication that a certain activity was specialized rather 
than being required. They explained that service companies use a lot of 
equipment, some of which would not be specialized (for example, 
telephones, hammers, or bulldozers) in performing their duties. 
Finally, one commenter recommended that the specialization prong be 
amended to recognize that activities may be specialized if they support 
a section 7704(d)(1)(E) activity in a remote or difficult environment 
(for example, marine locations). This commenter described as an example 
of such activities allowing access to and use of its marine docks and 
terminals, as a support base for unrelated third-party oilfield service 
companies selling products and providing services in the Gulf of Mexico 
in support of production of oil and gas.
    Overall, the Treasury Department and the IRS remain concerned that 
the final regulations provide a means to differentiate between the mere 
provision of general services, goods, or equipment to others and the 
active support of a section 7704(d)(1)(E) activity. The final 
regulations thus do not adopt the recommendation that the test be 
amended to include any support provided for section 7704(d)(1)(E) 
activities performed in remote or difficult environments. Support is a 
vague term that could include the provision of food or everyday 
supplies to workers on a marine platform. In addition, merely making 
docks available for use by third parties does not give rise to 
qualifying income under section 7704(d)(1)(E). The Treasury Department 
and the IRS continue to consider the specialized personnel and 
specialized property requirements important in insuring that the 
services or goods provided have a clear nexus to section 7704(d)(1)(E) 
activities.
    The final regulations also do not adopt the suggestion to provide 
requirements for how much training is necessary to meet the specialized 
personnel requirement. Instead, these regulations retain the provision 
that personnel must have received training unique to the mineral or 
natural resource industry. The particular industry at issue would 
determine the type and amount of training necessary to perform the 
support activity. However, the Treasury Department and the IRS agree 
with commenters that the specialized property requirement in the 
proposed regulations was overly broad. These final regulations 
specifically provide that the use of non-specialized property typically 
used incidentally in operating a business will not cause a PTP to fail 
the specialized property requirement. However, these final regulations 
retain the restrictions in the specialized personnel requirement and 
the specialized property requirement that training provided for and 
property (other than property typically used incidentally in operating 
a business) involved in the activity must not have applications outside 
of section 7704(d)(1)(E) activities.
    Commenters provided many suggestions for changes regarding the 
injectants exception. Multiple commenters recommended that sand should 
be removed from the examples of injectants because it is a natural 
resource, and therefore the bulk sale or wholesale of sand would, in 
itself, qualify as a section 7704(d)(1)(E) activity--marketing. These 
final regulations adopt this recommendation and remove sand as an 
example of an injectant in the injectants exception.
    Another commenter recommended expanding the injectants exception to 
encompass the supply, cleaning, or recycling of all products required 
for any section 7704(d)(1)(E) activity, not just injectants. This 
commenter provided as an example the supply and recycling of sulfuric 
acid, used as a catalyst for purposes of alkylation (a process used to 
produce alkylates). These final regulations do not adopt this 
suggestion. A general rule that allows for supply, cleaning, and 
recycling of any good provided to others engaged in section 
7704(d)(1)(E) activities is too broad and contrary to the stated goal 
of the intrinsic test in differentiating section 7704(d)(1)(E) support 
activities from the mere provision of a good. The Treasury Department 
and the IRS continue to consider it appropriate to limit the exception 
to just injectants because Federal, state, and local law require that 
producers recycle or otherwise properly dispose of injectants, such as 
water, after use in mining and production activities. Oilfield service 
companies providing that service are thus a required part of the mining 
and production process--their income is thus ``derived from'' the 
production activity. Expanding the injectants exception as requested 
would lead to many industrial waste recycling activities potentially 
being included in what is intended to be a limited exception for a 
legally required step in section 7704(d)(1)(E) activities. Thus, these 
regulations do not adopt this suggestion.
    Commenters also had a number of comments specifically concerning 
water under the injectants exception. Multiple commenters noted that, 
although they generally supported the proposed regulations in their 
effort to provide a framework for the types of oilfield service 
activities that would generate qualifying income, as a practical 
matter, they believed that a requirement that a PTP perform both the 
water delivery and disposal activities at each well or development site 
in order for that water delivery service to qualify would be satisfied 
infrequently. These commenters also argued that, so long as they also 
are engaged in performing disposal services, their business model is 
not merely supplying a good, that is, water. Multiple commenters 
recommended that the injectants exception should not require that the 
product (in particular, water) that is delivered must be the product 
that is picked up and recycled--what these commenters described as a 
``well by well'' approach. These commenters explained that it is common 
in the industry for a well operator to source its water supply and 
disposal service requirements with multiple providers and that it may 
be difficult or impossible for a PTP to satisfy the necessary ``well by 
well'' factual determination. Accordingly, commenters suggested several 
alternatives to the ``well by well'' approach.
    One commenter recommended that water delivery services should 
qualify as intrinsic activities only if exclusively provided by a PTP 
to those engaged in one or more section 7704(d)(1)(E) activities in 
cases where the PTP's operations also include conducting necessary 
water disposal services on an ongoing or frequent basis, though not 
necessarily in the same location. Another commenter recommended that 
the injectants exception be met if the partnership providing the 
injectant also provides other specialized services with respect to such 
injectant at the wellsite, such as transporting the water to smaller 
temporary storage facilities at the wellsite, treating the water prior 
to it going downhole, and monitoring and testing the utilization of 
water throughout the transfer and pressure pumping process. This 
commenter

[[Page 8337]]

alternatively recommended that the regulations only require that there 
be delivery and clean up in the same geographic area (a ``basin by 
basin'' approach). Others suggested that mere water delivery should 
qualify so long as the water is delivered to those engaged in one or 
more section 7704(d)(1)(E) activities, or the water enhances the 
producers' ability to produce oil or gas (as opposed to being provided 
for other purposes). Finally, one commenter argued that the regulations 
should not require disposal in compliance with Federal, state, or local 
regulations since making a tax determination contingent on such 
compliance introduces a standard that would be difficult to administer.
    The Treasury Department and the IRS do not find support for the 
argument that the mere delivery of water qualifies. Section 7704(d)(1) 
is clear that a mineral or natural resource does not include water; 
thus, income from the simple marketing and transportation of water is 
not qualifying income. As explained previously, the Treasury Department 
and the IRS have concluded that companies that provide water with 
legally required disposal services have a strong nexus to a section 
7704(d)(1)(E) activity (in particular, mining and production). Some 
commenters share that belief and support the efforts of the Treasury 
Department and the IRS, agreeing that there is a difference between 
companies that simply provide water (the mere provision of a good) and 
those that provide both water and specialized services. Nor do the 
final regulations adopt the suggestion to remove the language that the 
injectants are disposed after use in accordance with Federal, state, or 
local regulations concerning waste products from mining or production 
activities. Although, for tax compliance purposes, the IRS will 
generally not confirm that the PTP actually disposed of the injectants 
as required under Federal, state, or local law, the injectants 
exception is based on the PTP providing disposal services where 
required by Federal, state, or local law.
    The Treasury Department and the IRS agree with commenters that the 
injections exception should be revised to account for industry practice 
in which a miner or producer may not hire the same company to provide 
both water delivery and disposal services. Accordingly, these final 
regulations instead adopt the ``basin by basin'' approach recommended 
in comments--so long as the PTP provides the water exclusively to those 
engaged in section 7704(d)(1)(E) activities and both delivers and 
recycles within the same geographic area, the PTP's income from such 
activities is qualifying. The Treasury Department and the IRS have 
concluded that this requirement would provide a clear, administrable 
rule concerning when water delivery is not merely the delivery of a 
good, but part of the provision of specialized disposal services.

C. Significant Services

    The proposed regulations provided that 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 could 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. Partnership personnel performed significant services only if 
those services were 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. Finally, an activity did 
not constitute significant services with respect to a section 
7704(d)(1)(E) activity if the activity principally involved the design, 
construction, manufacturing, repair, maintenance, lease, rent, or 
temporary provision of property.
    One commenter argued that a facts and circumstances test to 
determine whether services are conducted on an ongoing basis is vague 
and would be subject to various interpretations. Another commenter 
recommended the removal of the significant services prong completely, 
arguing that the frequency with which an activity is performed is not 
relevant to determining whether an activity should qualify. Instead, 
the test should focus on the needs and activities of the operator, 
rather than the activities of the service provider. One commenter 
suggested that the proposed regulations wrongly listed repair and 
maintenance as activities that do not constitute significant services 
with respect to a section 7704(d)(1)(E) activity, arguing that the 
repair and maintenance of equipment and facilities are often required 
by the operator on a near-continuous basis under typical services 
agreements.
    The Treasury Department and the IRS do not find support for the 
contention that the test should solely focus on the needs of the 
operator. Section 7704(d)(1) applies to determine whether a PTP's 
income is qualifying income; therefore, the focus of these regulations 
is on the activities performed by the PTP giving rise to the income at 
issue. The significant services prong is an important part of 
determining whether the activity performed by a support services PTP 
has the required nexus with a section 7704(d)(1)(E) activity. As such, 
these final regulations do not adopt these changes and retain the 
``significant services'' prong of the intrinsic services test as well 
as the statement that significant services do not include an activity 
principally involving repair or maintenance of property.
    One commenter recommended that the restriction that services 
conducted offsite must be offered exclusively to those engaged in 
performing section 7704(d)(1)(E) activities should be removed, since 
activities such as clean-up and disposal happen offsite and may be 
performed for service recipients other than those engaged in section 
7704(d)(1)(E) activities. These final regulations modify this provision 
to provide that services may be conducted offsite if the services are 
offered to those engaged in one or more section 7704(d)(1)(E) 
activities. If the services are monitoring services, those services 
must be offered exclusively to those engaged in one or more section 
7704(d)(1)(E) activities.
    Finally, commenters also expressed concerns that it was not clear 
whether services are counted for purposes of the personnel requirement 
if they are provided by an affiliate, subcontractor, or independent 
contractor. These commenters noted that it is common for PTPs to work 
through related companies and subcontractors. One commenter recommended 
that the definition of ``qualifying activities'' in the regulations 
make clear that an activity is no less a qualifying activity because it 
is performed by a subcontractor or consists of a subset of the tasks of 
a larger qualifying activity.
    The Treasury Department and the IRS agree that a PTP should be able 
to meet the personnel requirement through affiliates or subcontractors 
in addition to the PTP's own employees. This is true for purposes of 
satisfying the specialization prong (including determining whether the 
personnel have received specialized training) or the significant 
services prong. Accordingly, the final regulations adopt this change 
and clarify that these prongs can be met through employees of 
affiliates or

[[Page 8338]]

subcontractors, so long as they are being compensated by the PTP.

V. Effective Date

    The proposed regulations provided that, except as otherwise 
provided, the regulations would apply to income earned by a partnership 
in a taxable year beginning on or after the date the final regulations 
are published in the Federal Register. An exception was made for 
certain income earned during a transition period, which would end on 
the last day of the partnership's taxable year that included the date 
that is ten years after the date the final regulations are published in 
the Federal Register (the Transition Period). That exception provided 
that a partnership could 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 the publication of the 
final regulations, 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 
the proposed regulations; or (c) the partnership is publicly traded and 
engages in the activity after the issuance of the proposed regulations 
but before the date the final regulations are published in the Federal 
Register and the income from that activity is qualifying income under 
the proposed regulations.
    Commenters objected that the Transition Period is not sufficient 
and that the IRS should allow PTPs that have received favorable PLRs 
that are contrary to these final regulations to continue to rely on 
them permanently. They argued that revoking a PLR sets a bad precedent 
that will cause taxpayers and investors not to rely on PLRs. They also 
argued that the revocation of a PLR would hurt them economically and 
would harm investors. Finally, some commenters requested that the final 
regulations clarify that a technical termination of a partnership under 
section 708(b)(1)(B) does not end the Transition Period.
    The Transition Period is a reasonable amount of time for PTPs to 
rearrange their affairs as necessary and is consistent with comments 
made in Congress concerning the ten-year transition relief granted when 
section 7704(d)(1)(E) was added in 1987. The IRS may revoke a PLR when 
the letter is found to be in error or not in accord with the current 
views of the Service, or there is a material change in fact. If the 
revocation is as a result of an error or a change in view, this 
revocation may occur through the issuance of final regulations. See 
Section 11.04 of Rev. Proc. 2016-1, 2016-1 I.R.B. 1. Therefore, the 
final regulations do not adopt the suggestion that the IRS permanently 
allow PTPs with favorable PLRs that are contrary to these final 
regulations to continue to rely on them. The final regulations do, 
however, adopt the request for clarification that a technical 
termination does not end the Transition Period. This addition is 
consistent with statements made concerning the original 10-year 
transition period provided by Congress when section 7704(d)(1)(E) was 
added. See Joint Comm. on Taxation, 100th Cong., Description of the 
Technical Corrections Act of 1988 (H.R. 4333 and S. 2238), JCS-10-88, 
at 412 (1988) (``[i]t is intended that a publicly traded partnership 
not be treated as ceasing to be an existing partnership solely by 
reason of a termination of the partnership (within the meaning of 
section 708) caused by the sale or exchange through trading of 50 
percent or more of the partnership interests.'')

Special Analyses

    Certain IRS regulations, including these, are exempt from the 
requirements of Executive Order 12866, as supplemented and reaffirmed 
by Executive Order 13563. Therefore, a regulatory impact assessment is 
not required. Because these 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, the 
notice of proposed rulemaking that preceded these final regulations was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business, and no 
comments were received.

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income Taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is 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 is income and gains from qualifying activities with respect to 
minerals or natural resources as defined in paragraph (b) of this 
section. Qualifying activities are 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, or 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. Solely for purposes of section 
7704(d), such terms are defined as provided in this paragraph (c).
    (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 including 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

[[Page 8339]]

similar types of activities described in Rev. Rul. 70-287 (1970-1 CB 
146), (see 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, including 
by--
    (i) Drilling wells to access deposits of minerals 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 other 
than oil and natural gas, stripping, benching and terracing, dredging 
by dragline, stoping, and caving or room-and-pillar excavation, and for 
oil and natural gas, fracturing; or
    (v) 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 natural resources 
from the ground including by operating equipment to extract minerals or 
natural resources from mines and wells, or to extract minerals or 
natural resources from the waste or residue of prior mining or 
production allowable under this section. The recycling of scrap or 
salvaged metals or minerals from previously manufactured products or 
manufacturing processes is not considered to be the extraction of ores 
or minerals from waste or residue.
    (5) Processing. An activity constitutes processing if it is 
performed to convert raw mined or harvested products or raw well 
effluent to substances that can be readily transported or stored, as 
described in this paragraph (c)(5).
    (i) 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 (such as carbon dioxide, hydrogen 
sulfide, nitrogen, and helium); and
    (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 
heavier streams).
    (ii) Crude oil. An activity constitutes processing of crude oil if 
it is performed to separate produced fluids 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.
    (iii) Ores and minerals other than natural gas or crude oil. An 
activity constitutes processing of ores and minerals other than natural 
gas or crude oil if it meets the definition of mining processes under 
Sec.  1.613-4(f)(1)(ii), without regard to Sec.  1.613-4(f)(2)(iv).
    (iv) 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.
    (6) Refining. An activity constitutes refining if the activity is 
set forth in this paragraph (c)(6).
    (i) Natural gas and crude oil. (A) The refining of natural gas and 
crude oil includes the further physical or chemical conversion or 
separation processes of products resulting from activities listed in 
paragraph (c)(5)(i) and (ii) of this section, and the blending of 
petroleum hydrocarbons, to the extent they give rise to a product 
listed in paragraph (c)(5)(i) or (ii) of this section or to the 
products of a type produced in a petroleum refinery or natural gas 
processing plant listed in this paragraph (c)(6)(i)(A). Refining of 
natural gas and crude oil also includes the further physical or 
chemical conversion or separation processes and blending of the 
products listed in this paragraph (c)(6)(i)(A), to the extent that the 
resulting product is also listed in this paragraph (c)(6)(i)(A). The 
following products are of a type produced in a petroleum refinery or 
natural gas processing plant:
    (1) Ethane.
    (2) Ethylene.
    (3) Propane.
    (4) Propylene.
    (5) Normal butane.
    (6) Butylene.
    (7) Isobutane.
    (8) Isobutene.
    (9) Isobutylene.
    (10) Pentanes plus.
    (11) Unfinished naphtha.
    (12) Unfinished kerosene and light gas oils.
    (13) Unfinished heavy gas oils.
    (14) Unfinished residuum.
    (15) Reformulated gasoline with fuel ethanol.
    (16) Reformulated other motor gasoline.
    (17) Conventional gasoline with fuel ethanol--Ed55 and lower 
gasoline.
    (18) Conventional gasoline with fuel ethanol--greater than Ed55 
gasoline.
    (19) Conventional gasoline with fuel ethanol--other conventional 
finished gasoline.
    (20) Reformulated blendstock for oxygenate (RBOB).
    (21) Conventional blendstock for oxygenate (CBOB).
    (22) Gasoline treated as blendstock (GTAB).
    (23) Other motor gasoline blending components defined as gasoline 
blendstocks as provided in Sec.  48.4081-1(c)(3) of this chapter.
    (24) Finished aviation gasoline and blending components.
    (25) Special naphthas (solvents).
    (26) Kerosene-type jet fuel.
    (27) Kerosene.
    (28) Distillate fuel oil (heating oils, diesel fuel, and ultra-low 
sulfur diesel fuel).
    (29) Residual fuel oil.
    (30) Lubricants (lubricating base oils).
    (31) Asphalt and road oil (atmospheric or vacuum tower bottom).
    (32) Waxes.
    (33) Petroleum coke.
    (34) Still gas.
    (35) Naphtha less than 401 [deg]F end-point.
    (36) Other products of a refinery that the Commissioner may 
identify through published guidance.
    (B) For purposes of this section, the products listed in this 
paragraph (c)(6)(i)(B) are not products of refining:
    (1) Heat, steam, or electricity produced by processing or refining.
    (2) Products that are obtained from third parties or produced 
onsite for use in the refinery, such as hydrogen, if excess amounts are 
sold.
    (3) Any product that results from further chemical change of a 
product listed in paragraph (c)(6)(i)(A) of this section that does not 
result in the same or another product listed in paragraph (c)(6)(i)(A) 
of this section (for example, production of petroleum coke from

[[Page 8340]]

heavy (refinery) residuum qualifies, but any upgrading of petroleum 
coke (such as to calcined coke) does not qualify because it is further 
chemically changed and does not result in the same or another product 
listed in paragraph (c)(6)(i)(A) of this section).
    (4) Plastics or similar petroleum derivatives.
    (ii) Ores and minerals other than natural gas or crude oil. (A) An 
activity constitutes refining of ores and minerals other than natural 
gas or crude oil if it is one of the various processes performed 
subsequent to mining processes (as defined in paragraph (c)(5)(iii) of 
this section) to eliminate impurities or foreign matter and which are 
necessary steps in achieving a high degree of purity from metallic ores 
and minerals which are not customarily sold in the form of the crude 
mineral product, as specified in paragraph (c)(6)(ii)(B) of this 
section. Refining processes include: fine pulverization, 
electrowinning, electrolytic deposition, roasting, thermal or electric 
smelting, or substantially equivalent processes or combinations of 
processes used to separate or extract the specified metals listed in 
paragraph (c)(6)(ii)(B) of this section from the ore for the primary 
purpose of producing a purer form of the metal, as for example the 
smelting of concentrates to produce Dor[eacute] bars or refining of 
blister copper.
    (B) For purposes of this section, the specified metallic ores or 
minerals which are not customarily sold in the form of the crude 
mineral product are--
    (1) Lead;
    (2) Zinc;
    (3) Copper;
    (4) Gold;
    (5) Silver; and
    (6) Any other ores or minerals that the Commissioner may identify 
through published guidance.
    (C) Refining does not include the introduction of additives that 
remain in the metal, for example, in the manufacture of alloys of gold. 
Also, the application of nonmining processes as defined in Sec.  1.613-
4(g) in order to produce a specified metal that is considered a waste 
or by-product of production from a non-specified mineral deposit is not 
considered refining for purposes of this section.
    (7) Transportation--(i) General rule. An activity constitutes 
transportation if it is performed to move minerals or natural 
resources, and products under paragraph (c)(4), (5), or (6) of this 
section, including by pipeline, marine vessel, rail, or truck. Except 
as provided in paragraph (c)(7)(ii) of this section, transportation 
does not include the movement of minerals or natural resources, and 
products produced under paragraph (c)(4), (5), or (6) of this section, 
directly to retail customers or 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. Transportation 
includes the following activities:
    (A) Providing storage services.
    (B) Providing terminalling services, including the following: 
Receiving products from pipelines, marine vessels, railcars, or trucks; 
storing products; loading products to pipelines, marine vessels, 
railcars, or trucks for distribution; testing and treating, as well as 
blending and additization, if income from such activities would be 
qualifying income pursuant to paragraph (c)(10)(iv) and (v) of this 
section; and separating and selling excess renewable identification 
numbers acquired as part of additization services to comply with 
environmental regulations.
    (C) Moving or carrying (whether by owner or operator) products via 
pipelines, gathering systems, and custody transfer stations.
    (D) Operating marine vessels (including time charters), railcars, 
or trucks.
    (E) Providing compression services to a pipeline.
    (F) Liquefying or regasifying natural gas.
    (ii) Transportation to retail customers or to a place that sells to 
retail customers. Transportation includes the movement of minerals or 
natural resources, and products under paragraph (c)(4), (5), or (6) of 
this section, via pipeline to a place that sells to retail customers. 
Transportation also includes the movement of liquefied petroleum gas 
via trucks, rail cars, or pipeline to a place that sells to retail 
customers or directly to retail customers.
    (8) Marketing--(i) General rule. An activity constitutes marketing 
if it is the bulk sale of minerals or natural resources, and products 
under paragraph (c)(4), (5), or (6) of this section. Except as provided 
in paragraph (c)(8)(ii) of this section, marketing does not include 
retail sales (sales made in small quantities directly to end users), 
which includes the operation of gasoline service stations, home heating 
oil delivery services, and local natural gas delivery services.
    (ii) Retail sales of liquefied petroleum gas. Retail sales of 
liquefied petroleum gas are included in marketing.
    (iii) Certain activities that facilitate sale. Marketing also 
includes certain activities that facilitate sales that constitute 
marketing under paragraphs (c)(8)(i) and (ii) of this section, 
including packaging, as well as blending and additization, if income 
from blending and additization would be qualifying income pursuant to 
paragraph (c)(10)(iv) and (v) of this section.
    (9) Fertilizer. [Reserved]
    (10) Additional activities. The following types of income as 
described in paragraph (c)(10)(i) through (v) of this section will be 
considered derived from a section 7704(d)(1)(E) activity.
    (i) Cost reimbursements. If the partnership is in the trade or 
business of performing a section 7704(d)(1)(E) activity, qualifying 
income includes income received to reimburse the partnership for its 
costs in performing that section 7704(d)(1)(E) activity, whether 
imbedded in the rate the partnership charges or separately itemized. 
Reimbursable costs may include the cost of designing, constructing, 
installing, inspecting, maintaining, metering, monitoring, or 
relocating an asset used in that section 7704(d)(1)(E) activity, or 
providing office functions necessary to the operation of that section 
7704(d)(1)(E) activity (such as staffing, purchasing supplies, billing, 
accounting, and financial reporting). For example, a pipeline operator 
that charges a customer for its cost to build, repair, or schedule flow 
on the pipelines that it operates will have qualifying income from such 
activity whether or not it itemizes those costs when it bills the 
customer.
    (ii) Hedging. [Reserved]
    (iii) Passive Interests. Qualifying income includes income and 
gains from a passive interest or non-operating interest, including 
production royalties, minimum annual royalties, net profits interests, 
delay rentals, and lease-bonus payments, if the interest is in a 
mineral or natural resource as defined in paragraph (b) of this 
section. Payments received on a production payment will not be 
qualifying income if they are properly treated as loan payments under 
section 636.
    (iv) Blending. Qualifying income includes income and gains from 
performing blending activities or services with respect to products 
under paragraph (c)(4), (5), or (6) of this section, so long as the 
products being blended are component parts of the same mineral or 
natural resource. For purposes of this paragraph (c)(10)(iv), products 
of oil and natural gas will be considered as from the same natural 
resource. Blending does not include combining different minerals or 
natural resources or products thereof together. However, see paragraph 
(c)(10)(v) of this

[[Page 8341]]

section for rules concerning additization.
    (v) Additization. Qualifying income includes income and gains from 
providing additization services with respect to products under 
paragraph (c)(4), (5), or (6) of this section to the extent 
specifically permitted in this paragraph (c)(10)(v). The addition of 
additives described in paragraph (c)(10)(v)(A) through (C) of this 
section is permissible if the additives aid in the transportation of a 
product, enhance or protect the intrinsic properties of a product, or 
are necessary as required by federal, state, or local law (for example, 
to meet environmental standards), but only if such additives do not 
create a new product.
    (A) The addition of additives to products of natural gas and crude 
oil is permissible, provided that such additives constitute less than 5 
percent (except that ethanol or biodiesel may be up to 20 percent) of 
the total volume for products of natural gas and crude oil and are 
added into the product by the terminal operator or upstream of the 
terminal operator.
    (B) In the case of ores and minerals other than natural gas or 
crude oil, the addition of incidental amounts of material such as paper 
dots to identify shipments, anti-freeze to aid in shipping, or 
compounds to allay dust as required by law or reduce losses during 
shipping is permissible.
    (C) In the case of timber, additization of incidental amounts to 
comply with government regulations is permissible, to the extent such 
additization does not create a new product. For example, the pressure 
treatment of wood is impermissible because it creates a new product.
    (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 (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; and
    (ii) To the extent that the activity involves the sale, provision, 
or use of specific 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 (as determined 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 (except that the use of non-specialized 
property typically used incidentally in operating a business will not 
cause a partnership to fail this paragraph (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.
    (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 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.
    (ii) 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.
    (iii) 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.
    (e) Interpretations of section 611 and section 613. This section 
and interpretations of this section have no effect on interpretations 
of sections 611 and 613, or other sections of the Code, or the 
regulations thereunder; however, this section incorporates some of the 
interpretations under section 611 and 613 and the regulations 
thereunder as provided in this section.
    (f) 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 and propylene through use of a steam 
cracker. Z sells the ethylene and propylene in bulk to a third 
party.
    (ii) Ethylene and propylene are products of refining as provided 
in paragraph (c)(6)(i) of this section; therefore, Z is engaged in a 
section 7704(d)(1)(E) activity. The income Z receives from the sale 
of ethylene and propylene is 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. 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 stream, resulting in refinery-grade ethylene. Y 
sells the ethylene in bulk to a third party.
    (ii) Y's activities give rise to products of refining as 
provided in paragraph (c)(6)(i) of this section; therefore, Y is 
engaged in a section 7704(d)(1)(E) activity. The income Y receives 
from the sales of ethylene is qualifying income for purposes of 
section 7704(d)(1)(E).
    Example 3.  Converting methane gas into synthetic fuels through 
chemical change. (i)

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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 bulk 
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 from 
methane, gasoline and diesel are products of refining as provided in 
paragraph (c)(6)(i) of this section; therefore, Y is engaged in a 
section 7704(d)(1)(E) activity. Y's income from the sale of gasoline 
and diesel is qualifying income for purposes of section 
7704(d)(1)(E).
    (iii) The income from the sale of methanol, an intermediate 
product in the conversion process, is not qualifying income for 
purposes of section 7704(d)(1)(E) because methanol is not a product 
of processing or refining as defined in paragraph (c)(5) and (6) of 
this section.
    Example 4.  Converting methanol into gasoline and diesel. (i) 
Assume the same facts as in Example 3 of this paragraph (f), except 
Y purchases methanol and synthesis gas and chemically converts the 
methanol and synthesis gas into gasoline and diesel.
    (ii) The chemical conversion of methanol and synthesis gas into 
gasoline and diesel is not refining as provided in paragraph 
(c)(6)(i) of this section because it is not the physical or chemical 
conversion or the separation or blending of products listed in 
paragraph (c)(6)(i)(A) of this section. Accordingly, the income from 
the sales of the gasoline and diesel is not qualifying income for 
purposes of section 7704(d)(1)(E).
    Example 5.  Delivery of refined products. (i) X, a publicly 
traded partnership, sells diesel to a government entity at wholesale 
prices and delivers those goods in bulk.
    (ii) X's sale of a refined product to the government entity is a 
section 7704(d)(1)(E) activity because it is a bulk transportation 
and sale as described in paragraph (c)(7) and (8) of this section 
and is not a retail sale.
    Example 6.  Constructing a pipeline. (i) X, a publicly traded 
partnership, operates interstate and intrastate natural gas 
pipelines. Y, a corporation, is a construction firm. X pays Y to 
build a pipeline. X later seeks reimbursement for its cost to build 
the pipeline from A, a refiner who contracts with X to transport 
gasoline.
    (ii) X, as an operator of pipelines, is engaged in 
transportation pursuant to paragraph (c)(7)(i)(C) of this section. 
The reimbursement X receives from A for X's cost to build the 
pipeline is qualifying income pursuant to paragraph (c)(10)(i) of 
this section because X receives the income to reimburse X for its 
costs in performing X's transportation activity and reimbursable 
costs may include construction costs. In contrast, Y is not in the 
trade or business of performing a 7704(d)(1)(E) activity, thus 
income Y received from X for building the pipeline is not qualifying 
income to Y.
    Example 7.  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)(7)(i)(C) 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 
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 
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 for use as an injectant in a section 
7704(d)(1)(E) activity is specialized to that activity only if the 
partnership (1) provides the water exclusively to those engaged in 
section 7704(d)(1)(E) activities, (2) is also in the trade or 
business of cleaning, recycling, or otherwise disposing of water 
after use in accordance with Federal, state, or local regulations 
concerning waste products from mining or production activities, and 
(3) operates these disposal services within the same geographic area 
as that in which it delivers water. Because X does not perform such 
disposal services, X's water delivery activities are not specialized 
to 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 8.  Delivery of water and recovery and recycling of 
flowback. (i) Assume the same facts as in Example 7 of this 
paragraph (f), 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 (c) 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 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 for use as an injectant in a 
section 7704(d)(1)(E) activity is specialized to that activity only 
if the partnership (1) provides the water exclusively to those 
engaged in section 7704(d)(1)(E) activities, (2) is also in the 
trade or business of cleaning, recycling, or otherwise disposing of 
water after use in accordance with Federal, state, or local 
regulations concerning waste products from mining or production 
activities, and (3) operates these disposal services within the same 
geographical area as where it delivers water. 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 
specialization 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).

    (g) Effective/applicability date and transition rule. (1) In 
general. Except as provided in paragraph (g)(2) of this section, this 
section applies to income earned by a partnership in a taxable year 
beginning on or after January 19, 2017. Paragraph (g)(2) of this 
section applies during the period that ends on the last day of the 
partnership's taxable year that includes January 19, 2027 (Transition 
Period).
    (2) Income during Transition Period. A partnership may treat income 
from an activity as qualifying income during the Transition Period if--

[[Page 8343]]

    (i) The partnership received a private letter ruling from the IRS 
holding that the income from that activity is qualifying income;
    (ii) 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 
May 6, 2015;
    (iii) Prior to May 6, 2015, the partnership was publicly traded and 
had entered into a binding agreement for construction of assets to be 
used in such activity that would give rise to income that was 
qualifying income under the statute as reasonably interpreted prior to 
May 6, 2015; or
    (iv) The partnership is publicly traded and engages in the activity 
after May 6, 2015 but before January 19, 2017, and the income from that 
activity is qualifying income under the proposed regulations (REG-
132634-14) contained in the Internal Revenue Bulletin (IRB) 2015-21 
(see https://www.irs.gov/pub/irs-irbs/irb15-21.pdf).
    (3) Relief from technical termination. In the event of a technical 
termination under section 708(b)(1)(B) of a partnership that satisfies 
the requirements of paragraph (g)(2) of this section without regard to 
the technical termination, the resulting partnership will be treated as 
the partnership that satisfies the requirements of paragraph (g)(2) of 
this section for purposes of applying the Transition Period.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: January 12, 2017.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2017-01208 Filed 1-19-17; 4:15 pm]
 BILLING CODE 4830-01-P