Oilfield fluid management and disposal produce qualifying income

Plain-English summary

A limited liability company planned to take a subsidiary public as a publicly traded partnership providing fluid management and disposal services to oil and gas producers. The services included freshwater and brine handling, chemical support, flowback and produced-water transportation, disposal-well operations, and recovery of filtered hydrocarbons. The IRS ruled that income from the described fluid management and disposal services qualified under section 7704(d)(1)(E). Income from selling recovered hydrocarbons also qualified if sales were not retail sales to end users. Stand-alone delivery of freshwater or chemicals did not qualify when the partnership did not also collect and clean, recycle, or dispose of those materials after use.

Ruling snapshot

• Question: Does income from the subsidiary's oil-and-gas fluid management and disposal business qualify under section 7704(d)(1)(E)?
• Outcome: Yes, subject to limits on retail hydrocarbon sales and stand-alone freshwater or chemical delivery.
• Key authorities: IRC §§ 611, 613, and 7704; Rev. Rul. 73-540

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201608011                                              Third Party Communication: None
Release Date: 2/19/2016                                        Date of Communication: Not Applicable
Index Number: 7704.03-00
                                                               Person To Contact:
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                                                               Refer Reply To:
                                                               CC:PSI:B3
                                                               PLR-138270-13
                                                               Date:



LEGEND

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

Y        =         ------------------------------------------------
------------------------------------------

State1 =          ---------

State2 =          -------------

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

       This responds to a letter dated August 29, 2013, and subsequent
correspondence, submitted on behalf of X by X’s authorized representative, requesting
a ruling under § 7704(d)(1)(E) of the Internal Revenue Code.

                                                     FACTS

       X is a limited liability company organized under the laws of State1. X formed Y
under the laws of State2 and intends to cause Y to become a publicly traded
partnership within the meaning of § 7704(b) by effecting an initial public offering of units.
X represents that Y will earn income by providing fluid management and disposal
services to customers engaged in the exploration for, and the development and
production of, oil and natural gas.

       Y’s fluid management services business will consist of fluids hauling, storage,
and disposal services (both freshwater and brine), and specialized chemical services.
With respect to its freshwater services, Y will remove freshwater from its sources using
submersible pumps, transferring the water to storage containers before later trucking
the water to a producer’s site. Also as part of its fluid services, Y will provide storage


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tanks and mixers for well-site use and will transport chemicals to a producer’s site and
monitor the flow rate of the chemicals into the storage tanks and mixers.

        In order to supply brine to its customers, Y will design, construct, operate, and
maintain a number of brine stations, which will be comprised of a salt cavern, a fresh
water source, storage tanks, and pumps. As part of this process, Y will mine sodium
chloride (salt) by drilling a cavern in a natural salt formation, and then pumping
freshwater into the salt cavern to dissolve and absorb the salt, thereby producing brine.
After the brine is extracted from the cavern, Y may sell the brine at the site of the cavern
or transport the brine to an oil and natural gas producer’s site.

        Y will also transport flowback fluids generated by fracturing operations and
produced water to disposal wells. Y’s disposal services will include the design,
construction, operation, and maintenance of saltwater disposal wells, and the transfer of
waste from drilling operations to those wells by truck and pipeline for proper disposal. Y
will earn income from agreements with exploration and production companies that
obligate Y to transfer fixed quantities of associated waste from a drilling operation to a
salt water disposal well for proper disposal, and may also provide disposal services to
other oil and gas producers when Y has excess well capacity. Y may also earn income
from selling the filtered hydrocarbons that are collected as part of the disposal process.

       X makes the following representations:

       1. Y will provide personnel for its fluid management and disposal services. Y’s
          personnel will have specialized training, tools, and equipment for the
          performance of these operations.
       2. The equipment used in and the personnel training associated with the fluid
          management and disposal services have no utility outside of oil and gas
          exploration. Under legal and environmental restrictions, the saltwater
          disposal wells are restricted to storing and disposing of waste associated with
          exploration and production activities, and are thus not easily converted to
          other use.
       3. The production of oil and gas using the hydraulic fracturing process would not
          be commercially viable without fluid management services.
       4. Processing and treatment of flowback fluids and produced water is required
          prior to injection into a disposal well in order to comply with governmental
          regulations and industry standards.
       5. Y’s personnel will design, permit, install, and operate Y’s business and
          oversee day-to-day operations. Those individuals who will oversee the
          saltwater disposal wells will be present daily. Y will also remotely monitor
          operating conditions of its disposal wells.


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                                  LAW AND ANALYSIS

      Section 7704(a) provides that, except as provided in § 7704(c), a publicly traded
partnership will be treated as a corporation.

       Section 7704(b) provides that the term “publicly traded partnership” means any
partnership if (1) interests in that partnership are traded on an established securities
market, or (2) interests in that partnership are readily tradable on a secondary market
(or the substantial equivalent thereof).

       Section 7704(c)(1) provides that § 7704(a) does not apply to a publicly traded
partnership for any taxable year if such partnership meets the gross income
requirements of § 7704(c)(2) for the taxable year and each preceding taxable year
beginning after December 31, 1987, during which the partnership (or any predecessor)
was in existence.

       Section 7704(c)(2) provides, in relevant part, that a partnership meets the gross
income requirements of § 7704(c)(2) for any taxable year if 90 percent or more of the
gross income of the partnership for the taxable year consists of qualifying income.

       Section 7704(d)(1)(E) provides that the term “qualifying income” includes income
and gains derived from the exploration, development, mining or production, processing,
refining, transportation (including pipelines transporting gas, oil, or products thereof), or
the marketing of any mineral or natural resource (including fertilizer, geothermal energy,
and timber).

      Section 7704(d)(1) provides that, for purposes of § 7704(d)(1)(E), the term
“mineral or natural resource” means any product of a character with respect to which a
deduction for depletion is allowable under § 611; except that such term shall not include
any product described in § 613(b)(7)(A) or (B).

       Section 611 provides, in part, that in the case of mines, oil and gas wells, other
natural deposits, and timber, there shall be allowed as a deduction in computing taxable
income a reasonable allowance for depletion. Section 613(b) lists certain of the mines,
wells, and other natural deposits subject to depletion. Section 613(b)(4) identifies
sodium chloride.

       Section 613(c) provides that mining includes the extraction of ores or minerals
from the ground.

       Revenue Ruling 73-540, 1973-2 C.B. 203, provides that extracting sodium
chloride by the use of water in the solution mining method from underground rock salt
beds are extraction processes and are considered allowable mining processes within
the meaning of § 613(c).


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                                      CONCLUSION

       Based solely on the facts submitted and representations made, we conclude that
the gross income to be derived by Y from its fluid management and disposal services
constitutes qualifying income within the meaning of § 7704(d)(1)(E). In addition, income
derived by Y from selling the filtered hydrocarbons that are collected as part of the
disposal process constitutes qualifying income within the meaning of § 7704(d)(1)(E) so
long as the sales are not to end users at the retail level. This ruling is not applicable to
any income derived by Y from the delivery of freshwater or chemicals where Y does not
also collect and clean, recycle, or otherwise dispose of the delivered water or other
chemicals after use.

       Except has expressly provided herein, no opinion is expressed or implied
concerning the federal tax consequences of any aspect of any transaction or item
discussed or referenced in this letter. In particular, no opinion is expressed as to
whether Y will meet the 90 percent gross income requirement of § 7704(c)(1) in any
taxable year for which this ruling may apply.

       The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

        This ruling is directed only to the taxpayer requesting it. However, in the event of
a technical termination of Y under § 708(b)(1)(B), the resulting partnership may continue
to rely on this ruling in determining its qualifying income under § 7704(d)(1)(E). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.


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         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representative.


                                       Sincerely,


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

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

cc: