Current Trends in Master Limited
Partnerships (MLPs)
March 14, 2013
Todd D. Keator
Thompson & Knight LLP
214-969-1797
[email protected]
©2013 Todd D. Keator
Agenda
• Introduction
• Formation Issues
• Legal Structure
• Trends in “Qualifying Income”
• Market Opportunity
MLPs – In General
• A “publicly traded partnership”.
• No entity level tax – investors pay tax at the individual owner
level and receive K-1s (not 1099s).
• Sponsor retains control via ownership of General Partner.
• Produces more value that comparable corporation because of
ability to distribute earnings pre-tax; cheaper cost of capital.
• Typically a Limited Partnership under state law (Delaware is most
common).
• Can be organized as LLCs as well.
• Assets can be monetized in tax-efficient manner.
• Traded on NYSE or NASDAQ.
• Investors own “units” and are “unitholders”.
• Returns averaged 17% over past decade.
• “Sticky” investor base due to recapture concerns.
Legal Structure
• MLP called “master” because owns no assets directly.
• OLP is the “operating” partnership and a disregarded entity.
• Allows for property level debt and structurally subordinated debt. • Minimizes state tax filings by public
holders because the MLP is qualified in only one state.
• Allows assets and liabilities of
different divisions to be segregated in multiple OLPs.
• Debt at OLP level does not impair ability of MLP to make cash
Distributions
• “Cash is King” – Contractual obligation to distribute all “available cash” quarterly.
• MLPs prefer assets with steady, predictable cash flow, such as pipelines with long-term contracts to credit-worthy parties.
• Some upstream MLPs as well for long-lived assets or coupled with hedging.
• Some refinery MLPs also hitting the market. • Distribution pattern typically flat or increasing. • Public owns “common” units.
• Sponsor owns “subordinated” units.
• Common units have first call on quarterly cash distributions to the extent of a minimum amount (the “minimum quarterly distribution” or “MQD”).
– No guarantee MQD will be paid.
• Common units also accrue arrearages.
• After common receives all MQDs (current and accumulated), subordinated units receive equal distributions up to MQD.
• Distributions after MQD (on common and subordinated) go pro rata.
• Presence of subordinated units enhances stability of cash distributions to the public.
• Subordination typically ends after defined period or financial test is met.
– E.g., after 5 years or after MQD earned and distributed for 12 straight quarters.
Incentive Distribution Rights (IDRs)
• Typically owed to the MLP GP (in addition to GP’s 2% interest).
• Encourages GP to operate the MLP in a way to maximize its value.
• Provides the sponsor with a
disproportionate share of upside. Thus, the GP is distributed increasing %
shares of incremental cash as cash hurdles are met.
• Ordinary income – no capital gain game. • Example: Sponsor MLP Public General Partner OLP General Partner 100% 2% + IDRs X% Y% 100% 0.01% 99.99%
Cash Yield GP % Share
0 – 10% 2% 10 – 12.5% 15% 12.5 – 15% 25% Over 15% 50%
Formation Issues
• Most MLP assets formerly owned by corporations.
• Corporate sponsor typically contributes assets to MLP in
exchange for subordinated units.
• Asset contribution raises legal issues:
– Contractual prohibitions on asset transfers. – Consent requirements.
– Rights of first refusal.
– Licenses and permits (FERC “certificate of public convenience” is a key issue).
– Debt that is not pre-payable. – Transfer taxes.
• Transfer via merger may solve some legal issues.
• Conversions also possible (treated as taxable liquidation).
• MLP then undergoes IPO and issues common units to the
public for cash.
Tax Consequences of Formation
• Typically structured as primary IPOs where sponsor contributes
appreciated assets and public contributes cash for new units; cash then distributed to sponsor.
• Assets typically contributed “tax-free” by sponsor to MLP under IRC Sec. 721.
• “Disguised sale” issues arise depending upon use of IPO cash or MLP debt. • Key exceptions to disguised sale:
– Reimbursement of pre-formation Capex. – Debt-financed distributions.
– See Treas. Reg. Secs. 1.707-4 and -5.
• Gain deferred by sponsor typically is allocated only to the sponsor over the useful life of the contributed assets using “remedial allocations.”
• Maintains uniformity of units via IRC Sec. 754 elections and remedial
allocations. Thus, each purchaser receives uniform tax benefits based on the price paid for the units.
Formation – the “Shield”
• Shield affects market value of the MLP units.
• Shield is the ratio of (i) cash distributions
effectively treated as a non-taxable return of tax
basis, over (ii) total cash distributions.
• Shield is the result of depreciation and depletion
deductions allocable to unitholders.
• Typical shield is 70-80% over first 3-5 years of the
MLP.
• Result: For every $1 cash distributed, taxable
income allocation is only $0.20 - $0.30.
• Shield clearly affects after-tax yield of the MLP.
• Downside: Shield results in recapture on sale.
Investor Base
• Dominated by U.S., individual investors (“retail” investors). • Creates “UBTI” (bad) for tax-exempt investors.
– Taxable income.
• Creates “ECI” (bad) for foreign investors.
– Return filing requirement. – Withholding tax.
• PWC statistics show following MLP owners by total accounts:
– Individual investors: 40%. – IRAs: 35%.
– Trusts: 16%. (for individuals?)
• Although MLP income is UBTI for IRA investors, IRAs receive (i) benefit of tax shield, plus (ii) annual $1,000 deduction against UBTI, and so can absorb some MLP investment.
• “Blocker” structures recently employed to attract tax-exempt and foreign investment. Blocker converts UBTI and ECI into dividends.
– Use of blockers in acquisitions? See recent Linn Energy acquisition of Berry Petroleum Co.
Partnership Qualification
• Generally, a “publicly traded partnership”
(including an MLP) is taxed as a corporation
for federal tax purposes. IRC Sec. 7704(a).
• Key Exception: A publicly traded partnership
is not treated as a corporation if 90% or more
of its income is “qualifying income.” IRC Sec.
7704(c).
• Contrary to REITs, there is no annual cash
distribution requirement (instead, it is purely
contractual).
Qualifying Income
• Interest.
• Dividends.
• Real property rents (cross references the REIT
definition of “rents from real property”).
– Real property can be in either an MLP or a REIT.
– Historically REITs are preferred over MLPs for real
property and have traded at a higher multiple.
• Gain from the sale of real property (even by
“dealers”).
• Natural resource exception!
Natural Resource Exception
• “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),
[or] industrial source carbon dioxide, or the
transportation or storage of any fuel described in
subsection (b), (c), (d), or (e) of section 6426, or any
alcohol fuel defined in section 6426(b)(4)(A) or any
biodiesel fuel as defined in section 40A(d)(1)”.
– Must have “qualified” activity.
– Must be directed at “mineral or natural resource.”
Mineral or Natural Resource
• Special carveout for fertilizer, geothermal energy and timber.
• Clear that “gas, oil or products thereof” also count. 1987 Conference Report defines the “products thereof” to include:
– “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.” These all come directly from oil and gas.
• Butane and Propane are liquids (NGLs) that come out of natural gas.
– Also states that “products” means only those products derived from petroleum refineries or field facilities and not products that are produced by “additional
processing beyond that of petroleum refineries or field facilities.” (i.e., no plastics). – Clear intent is to allow products produced at refineries and gas processing facilities,
but nothing further downstream (e.g., no plastics).
• Flush language added in 1988 states that “mineral or natural resource” means “any product of a character with respect to which a deduction for depletion is allowable under section 611”.
– Section 611 allows depletion with respect to mines, oil and gas wells, other natural deposits and timber. Allows minerals and ores – e.g., coal MLPs.
• Key exclusions: (i) soil, sod, turf, water, mosses, and minerals from seawater, the air or similar inexhaustible sources (in 1988 statute); and (ii) income from fishing, farming, or from hydroelectric, solar, wind or nuclear power generation (in 1988 legislative history). No renewable energy.
Qualified Activities
• The “activities” in IRC Sec. 7704(d)(1)(E) are not
defined. They include:
– Exploration.
– Development.
– Mining or Production.
– Processing.
– Refining.
– Transportation.
– Marketing.
• But see legislative history forbidding “marketing minerals and natural resources to end users at the retail level” (e.g., gas station operations are specifically excluded).
Private Letter Rulings
• Required by most public companies for any type
of revenue that is not specifically listed by
statute.
• Typically takes 4-6 months to receive.
• Can only be relied on by the taxpayer it is issued
to.
• Trend has been to broaden the definition of
“qualifying income” – watch for services that are
“integral to” activity that produces qualifying
income.
Three Basic Types of Private Letter Rulings
• First, those that determine an activity is covered in the
statute.
– E.g., “terminaling” as a form of “transportation” or separation of
wet gas into NGLs and dry gas as “processing.”
• Second, those that allow an MLP whose core business
produces qualifying income to add an addition, novel
revenue stream.
– E.g., gas gathering MLP that adds a water distribution system to
its existing right-of-way.
• Third, those that allow a new entity to become an MLP based
solely on a single, novel source of income from customers
that engage in businesses that produce qualifying income.
– E.g., new MLP whose only source of revenue is from licensing
geological data to E&P companies or from providing fracing
services to natural gas producers.
Trends in Private Letter Rulings
• Early PLRs allowed income streams that fit easily
with the scope of the statute. Examples:
– 199338028: Income from sales of plywood and
fiberboard produced from timber. Treated as
income from “processing” of timber.
– 199339014: Sale of nitric acid and carbon dioxide
produced as a bi-product of fertilizer production.
– 199452013: Income from storage of natural gas.
– 199639011: Income from “processing” wet natural
gas into NGLs and dry gas.
Early “Integral to” Rulings
• 199340031: Taxpayer conducted “terminaling”
operations for petroleum products and represented
that terminaling activities were an “integral part of the
transportation of oil and gas and products thereof.” IRS
ruled that the terminaling activities were “integral to
the transportation of petroleum and related products.”
Therefore, the fees were qualifying income.
• 199619011: If owners of oil and gas purchase
derivative products to hedge price changes, income
from such products is “integral to” a qualifying activity
and gives rise to qualifying income.
Current “Integral to” Rulings
• 200845035: X’s core business was transportation, gathering and storage of natural gas. Also entered into “interconnect agreements” whereby new customers agreed to reimburse X for cost of constructing pipeline extensions to customer’s fields. X represented that (i) the interconnect agreements were “an integral party of the tranportation of oil, gas,
and/or products thereof” and (ii) that the “sole purpose of the interconnect agreement is to facilitate the transportation and/or gathering agreement.”
• IRS ruled that “the interconnect agreements are integral to the transportation and/or gathering of gas, oil, or products thereof. Therefore, the amounts X receives from pipeline transportation
customers as reimbursement for construction of pipeline extensions . . . for the transportation of gas, oil, or products thereof constitute qualifying income within the meaning of § 7704(d)(1)(E).”
• However, the ruling did not extend to any amount of the reimbursement payments that exceeded the pipeline extension construction costs.
• Note that X’s core business was transportation and gathering, which clearly produce qualifying income.
Current “Integral to” Rulings
• 200909006. X was in the business of “acquiring and licensing
land and marine seismic data to oil and gas producers.” X
maintained a library of seismic data for license to oil and gas
producers.
• X represented that (i) aside from oil and gas exploration, there is
no other commercial use for X’s seismic data, and (ii) “the
seismic data services provided by X are integral to the
exploration of oil and gas resources, because the exploration . . .
of oil and gas resources would be significantly curtailed in the
absence of such services.”
• X sought the ruling in conjunction with an IPO of a new MLP.
• IRS ruled that X’s incomd from acquiring and licensing seismic
data to oil and gas producers for use in their exploration activity
produced qualifying income.
Current “Integral to” Rulings
• 201025037. X conducted a marine terminaling business. The
terminal included marine docks for LNG tankers to offload
imported LNG. X’s terminals then converted the LNG back to gas
in a process called regasification. Through a disregarded entity, X
also provided marine services to customers using the marine
terminals. Services included: escorting LNG vessels; assisting in
berthing and unberthing the vessels; “standing-by” the vessels at
all times while docked; performing fire-fighting, life saving and
emergency response services; conducting salvage or marine
wreckage services; and providing picket boat services. X used
specially-designed tug boats to provide these services. X
represented that the marine services were “an integral and
necessary part of the terminal’s operations of transporting and
processing the LNG delivered to the terminal.”
• IRS ruled that the income from marine services was qualifying
income.
Current “Integral to” Rulings
• 201226018: X was in the “extractive logistics” business. X derived income from delivery and sale of refined petroleum products (diesel fuel and
lubricating oil), antifreeze, methanol, and other chemicals to E&P customers at the drilling sites. Services also included online reporting of fuel
deliveries; on-site refueling of customer’s oil and gas drilling equipment; removal, recycling and disposal of used oil, lubricants, and non-hazardous waste from drilling; maintenance of drilling rig equipment; equipment
inspections; provision of storage tanks; and supply and/or transportation of fracturing fluid to well sites, supply of “frac tanks,” removal of production fluid and flowback generated in the fracturing process, and the disposal or treatment of the production fluid or flowback. X represented that the
extractive logistics services were “integral to the exploration, production and development of oil, gas and coal resources” because such activity “would be significantly curtailed in the absence of such services.”
• IRS ruled that “X’s gross income from the extractive logistics business
(excluding any portion of such income derived from the delivery or sale of products to customers who are not engaged in drilling, exploration and production, or mining activities) . . . is qualifying income. “
• Note that X otherwise did not have a core “qualifying income” stream.
Current “Integral to” Rulings
• 201227001: X is principally derives income from the
exploration, development, mining or production, transportation,
and marketing of a mineral or natural resource. X also expects
to derive income from the transportation of refined petroleum
products and other products to customers engaged in E&P
operations at the drilling sites. X represented that (i) the
vehicles used to provide these services are specially designed
and custom built to deliver products to above-ground tanks in
remote locations and (ii) the services provided “are integral to
the exploration, production and development of oil, gas and
coal resources” because such activities “would be significantly
curtailed in the absence of such services.”
• IRS ruled that X’s gross income from the transportation of
refined petroleum products and other products to customers
engaged in E&P activity at the site of such activity is qualifying
income.
Current “Integral to” Rulings
• 201234005: X engaged in the transportation and processing of natural gas (via gathering lines, pipelines and processing facilities). X’s customers are natural gas producers that use hydraulic fracturing (“fracing”) to
extract natural gas. Fracing requires large volumes of water. To meet the water needs of its customers, X (through a subsidiary) constructed and operated a water delivery pipeline for the purpose of supplying water to X’s customers and other natural gas producers for use in the production of natural gas through fracing. Under the water agreements, customers will pay X for the pipeline supply and transportation of fresh water. X represented that the supply and transportation of water to natural gas producers for use in fracing was “integral to the exploration and
production of natural gas from shale formations and the preservation and growth of X’s existing activity of natural gas transportation.”
• IRS ruled that X's gross income derived from the supply and transportation of water to oil and gas producers for use in the exploration, development, and production of oil or natural gas is qualifying income
Other Recent, Similar Rulings (without
“Integral to” Language)
• 201137005: Income from the supply, transportation and
storage of fractionation fluid and other fluids for oil and
natural gas wells, including any associated fractionation
fluid heating services, and from the removal, treatment and
disposal of fracturing flowback and produced water,
including the provision of frac tanks and transportation
services, is qualifying income.
• 201222029: Income from transportation, storage, and
disposal of petroleum-water mix derived from oil and
natural gas wells is qualifying income.
• 201227002: Income from the removal, treatment,
recycling, and disposal of fracturing flowback, produced
water, and other residual waste products generated by oil
and gas wells during the fracturing process is qualifying
Other Recent, Similar Rulings (without
“Integral to” Language)
• 200821021: production of electricity from natural resources does not produce qualifying income.
• 200827022: Income from providing drilling and related services to third parties that owned the underlying oil & gas property was qualifying
income. Services included well servicing and maintenance, workover service, completion service, and other specialized service.
• 201241004: Income derived from (i) processing natural gas liquids into olefins (used as feedstocks in the production of chemical derivatives) through a “cracking process” and (ii) olefin storage and transportation services, is qualifying income. This is the first ruling to treat olefins as a natural resource for an MLP.
• 201301010: Refining, blending, processing, packaging, marketing, and distributing crude oil and other natural resource based products
generates qualifying income. Some refined products were sole in bulk to governmental, commercial, and industrial users in wholesale
transactions. This is the first ruling to treat bulk sales of refined products to end users as qualifying income (for a contrary result, see PLR
Market Opportunity
• The “integral to” rulings imply that income from services that are
“integral to” petroleum transportation or E&P activity
themselves produce qualifying income.
– Examples of novel activities that generate qualifying income include: sales of geologic data to E&P companies, marine terminaling services for LNG transportation, extractive logistics business to E&P
companies, transportation of refined petroleum products to E&P producers, supply and transportation of water to natural gas
producers, and supply and disposal of fracing fluids and produced water for E&P companies.
– What else may qualify?
• It is clear that the activity must be marketed solely toward customers who are engaged in activity giving rise to qualifying income.
• Must the activity also have no application except to a customer engaged in activity giving rise to qualifying income?
