A significantly redacted Legal Advice Memorandum (GLAM 20161101F) from an Associate Area Counsel (LB&I) to IRS Examination, Counsel reviewed the facts and circumstances surrounding the investment provisions of a Section 45 refined coal tax credit partnership and determined that Taxpayer is not a bona fide partner in the partnership because the investment does not provide it with either a "significant downside risk" or a "significant upside potential." On that basis, Counsel concluded that Taxpayer is not entitled to an allocation of the partnership's Section 45 refined coal tax credits.

Facts

Taxpayer is being examined under the Compliance Assurance Process (CAP) program and is the sole owner of a limited liability company (SMLLC) that elected to be treated as a corporation. At issue is the nature of LLC's investment in X, a wholly owned LLC subsidiary of Y. Y formed X to own and operate a facility producing refined coal, as defined in Section 45(c)(7), located at a power plant owned by Utility.

Y's promotional material advertised ownership interests in X for sale and stated that the tax credits earned by X would be allocated to its owners on a pro rata basis. The promotional material explained the commercial and tax risks against which a potential investor would be protected and provided an Investor Benefits Schedule, showing projected capital contributions and tax benefits. Ownership interests could be purchased for a certain amount of cash down, plus future, nonrecourse payments that would vary in size, depending on how much refined coal the facility produced. The Sale and Purchase Agreement and X's Amended LLC Agreement indemnified investors from losses resulting from or arising out of certain events, including certain "tax events" related to the tax credits or tax deductions.

The question at issue was whether SMLLC was a bona fide partner in X and thus able to be allocated refined coal tax credits.

Law and analysis

A tax credit is available under Section 45 for electricity produced from certain renewable resources and for the production of refined coal. Refined goal generally is fuel: (1) produced from coal, (2) sold with a reasonable expectation that it will be used to produce steam, and (3) certified as reducing emissions by at least 20%, compared with burning regular coal. (Section 45(c)(7)(B).)

The refined coal tax credit is a specified per-ton amount times the number of tons of qualified refined coal the taxpayer produces and sells. To claim the credit, a taxpayer must produce refined coal at a refined coal production facility (defined in Section 45(d)(8)) during the first 10 years the facility is in operation, and sell refined coal to an unrelated party during that 10-year period.

To determine whether investment in a production facility constitutes a bona fide partnership interest that would entitle the taxpayer to claim the refined coal credit, the memorandum discusses several court decisions. In Commissioner v. Culbertson, 337 U.S. 733 (1949), the Supreme Court established a facts-and-circumstances test for determining whether an interest in an entity rises to the level of a partnership interest. A partner must contribute capital or services, or both, to a partnership. Factors identified in Culbertson for determining whether a partnership exists include: the parties' agreement; their conduct in executing the terms of their agreement, their contributions to the partnership; each party's control over income and capital and rights of withdrawal; whether each party was a principal or co-proprietor; whether the parties are obligated to share losses; whether one party was the agent or employee of the other; whether business was conducted in the joint names of the parties; whether federal partnership returns were filed or the parties otherwise held themselves out as a joint venture; whether separate books of account were maintained for the venture; and whether the parties exercised mutual control over and assumed mutual responsibility for the venture.

The memorandum cites four circuit court cases as "informative on whether an interest constitutes a partnership interest" — TIFD lll-E, Inc. v. United States (referred to as Castle Harbour), 459 F.3d 220, 232 (2d Cir. 2006) (see Tax Alerts 2006-626 {}, 2009-1570 {}, and 2012-195 {}); Virginia Historic Tax Credit Fund 2001 LP, et al. v. Commissioner, 639 F.3d 129 (4th Cir. 2011) (see Tax Alert 2011-632 {}); Historic Boardwalk Hall LLC v. Commissioner, 694 F.3d 425, 449 (3d Cir. 2012) (see Tax Alert 2012-1539 {}); and Chemtech Royalty Assocs. v. Commissioner, 766 F.3d 453 (5th Cir. 2014).

In Castle Harbour, the Second Circuit reversed a federal district court to hold that two tax-neutral Dutch banks did not qualify as partners under Section 704(e)(1) because their interest was not a capital interest, and that the IRS was entitled to impose substantial understatement penalties under Section 6662.

In Virginia Historic Tax Credit, the Fourth Circuit reversed the Tax Court to hold that certain transactions between a partnership and its partners in which the partners contributed cash to the partnership and received an allocation of state tax credits were properly recharacterized for US federal income tax purposes as the disguised sales of property under Section 707.

In Historic Boardwalk, which the LB&I legal memorandum characterizes as "the most applicable case" to the instant facts, the Third Circuit agreed with the IRS that an investor was not a bona fide partner because it had no meaningful stake in either the success or failure of the partnership. According to the court, the investor would receive a sponsor-funded guaranteed allocation of Section 47 rehabilitation credits (or their cash equivalent) and a preferred return, with no share of losses and only a remote opportunity for an additional share of partnership profits.

At issue in Historic Boardwalk was whether a purported partner in an LLC (partnership) qualified as a bona fide partner for tax purposes. Because Section 47 historic rehabilitation tax credits are only available to property owners, the credits may not be sold. The state agency tasked with restoring an historic landmark on the New Jersey Boardwalk formed a partnership and sold membership interests, intending to allocate tax credits generated by the rehabilitation project to the members. The partnership was structured in such a way that a member's sole benefit from its investment would be tax credits and deductions. Relying on Castle Harbour and Virginia Historic, the court emphasized that risk is an essential element in a partnership, noting that "'whether a purported partner had a meaningful stake in the success or failure of the partnership … goes to the core of the ultimate determination of whether the parties intend to join together in the present conduct of the enterprise.'" Finding neither entrepreneurial risk nor an "upside potential" to purchasing a membership interest, the court looked past the form of the transaction to its substance and concluded that no partnership actually existed.

In Chemtech Royalty, the Fifth Circuit affirmed a district court's finding that a tax shelter transaction, in which a taxpayer participated through a special limited investment partnership, lacked economic substance. To form a valid partnership, the Fifth Circuit noted, parties must intend to act in good faith for a genuine business purpose and intend to share in the profits and losses generated by that business. The facts indicated that the transactions were structured to ensure that purported partners: (1) would receive a fixed return on their investment, independent of the success of the venture, (2) did not bear significant risks, and (3) did not meaningfully share in any upside to the venture.

LB&I Area Counsel's conclusion

Taking into consideration the four circuit court opinions, along with the facts-and-circumstances Culbertson test, Counsel focused on whether the facts at issue indicate "entrepreneurial risk and upside potential separate from [the] allocated tax credits or whether investment in [the partnership] is in substance the prohibited sale of tax benefits." Counsel acknowledged that the agreements support treating Taxpayer as a bona fide partner, but argued that it must look to the "true facts and circumstances" of the transaction and not its "labels" when determining whether Taxpayer was a partner.

On that basis, Counsel provided the following analysis of the transaction:

A. Contributions of the parties

(1) Future payment obligation — Taxpayer was only obligated to make future payments contingent on the numbers of tons of refined coal produced, taking into consideration the fixed payments and capital contributions. Because the "purported capital contributions are largely to be made in the future and only in relation to the amount of refined coal, and by extension tax credits generated, we believe that the payments are in exchange for tax benefits and do not constitute capital contributions in substance."

(2) Indemnification Agreement and Amended LLC Agreement — The indemnification agreement in the Purchase and Sale Agreement and the LLC Amended Agreement may protect LLC's contributions in the event that tax credits and deductions are disallowed. Y was obligated to indemnify Taxpayer for tax credits or deductions attributable to a month in which SMLLC met its obligations to make payments and capital contributions. The Amended LLC Agreement indemnified X for disallowed tax credits and deductions. "We believe that these provisions, the indemnification agreement and the language from the Amended LLC Agreement, operate to protect [Taxpayer's] contributions in the event that tax credits are deductions are disallowed and support a finding that [SMLLC] is not a bona fide partner in X."

B. Statement of the parties

The promotional material indicated that the parties were interested in the generation and allocation of tax credits, not in undertaking a joint venture to operate a profitable refined coal facility.

C. Relationship of the parties

The relationship of the parties was akin to that of buyer and seller of refined coal tax credits. Utility is the operator of the facility and SMLLC is not involved in the management and decision-making regarding the production facility.

D. Absence of sufficient downside risk

(1) Indemnification agreement — The transaction agreement indemnified under certain circumstances the tax credits and deductions.

(2) Payment structure — SMLLC did not make its variable payments unless it had assurances that enough refined coal was produced. Those payments were wholly contingent on the production of refined coal. In addition, the fixed payments were nonrecourse to Taxpayer and only recoverable against SMLLC's assets, its interest in LLC.

(3) Tax event — In addition to limiting payments if tax credits were not generated, SMLLC was also excused from making payments should a "Tax Event" occur. This provided significant protection against risk of loss.

E. Lacks any pre-tax upside potential

No pre-tax operational profits were projected or, in fact, possible, without a premium in the refined coal selling price over the feedstock purchase price. Therefore, there was no reasonable expectation of a pre-tax profit and no possible return on investment aside from tax credits.

Implications

Because this IRS legal memorandum is heavily redacted, the relevant terms of the agreements can only be tentatively reconstructed from the legal discussion. Therefore, it is unclear to what extent the terms under review reflect terms currently used in refined coal transactions. It should be noted that this memorandum is not a precedential, formal decision of the IRS, but represents the views of the local Associate Chief Counsel (LB&I). The views of IRS Chief Counsel must await a future PLR or TAM (which itself also would not be precedential).

Since the Historic Boardwalk decision, tax credit transactions have been revised to provide the tax equity investor (TEI) with an increased share of the upside and the downside of partnership operations. In this regard, a significant down payment by the TEI does expose it to the downside of facility operations (especially with utilities increasingly converting to gas-fired plants). The IRS itself has provided a structured payment safe harbor for wind and historic credit transactions consisting of a significant down-payment, fixed notes, and future contingent payments. See Revenue Procedure 2007-65 (wind safe harbor where at least 75% of the investor's fixed capital contributions, plus reasonable anticipated contingent capital contributions, must be fixed and determinable) (see Tax Alert 2007-863{}), and Revenue Procedure 2014-12 (historic rehab safe harbor under which the investor must contribute a minimum unconditional amount of 20% of its total expected capital contributions and at least 75% of the investor's total expected contributions must be fixed in amount)( see Tax Alert 2014-135{}). Under both safe harbors, the tax credits may not be directly or indirectly guaranteed, especially should the IRS challenge all or a portion of the transactional structure of the partnership.

While neither safe harbor addresses the refined coal tax credit, the minimum investment provisions are general provisions that do not reflect the particulars of either credit so it would be expected (and TEIs do expect) that a similar investment analysis would apply to other tax credit arrangements. Thus, it is noteworthy that the Memorandum attacks the generic use of fixed payments related to coal production but does not address either safe harbor or the implication of the minimum investment provisions in those safe harbors. While it is difficult to reconstruct the elements of the investor's payment obligations, it should be recognized that an indemnification of tax credits would violate both safe harbors. (To that extent, the agreements under review may predate the Historic Boardwalk decision.)

Finally, we need to address the conclusion that there is no upside since tax credits alone do not represent an economic return, that only an operational pre-tax return may be considered when considering the upside of a tax credit investment. Should this argument succeed, it would undermine the economic analysis of not only the TEI investing in a refined coal partnership, but also the economic analysis of the stand-alone owner of a facility producing refined coal at a pre-tax loss.

The IRS lost a similar argument many years ago in Sacks v. Commissioner, 69 F. 3d 982, 991-2 (9th Cir. 1995), on investment tax credits for solar water heaters. The IRS argued that the sale-leaseback transaction under review was a sham with no economic substance because there was no pre-tax profitability. As the court noted:

Absence of pre-tax profitability does not show "whether the transaction had economic substance beyond the creation of tax benefits." Casebeer, 90 F.2d at 1365, where Congress has purposely used tax incentives to change investors' conduct … If the government treats tax-advantaged transactions as shams unless they make economic sense on a pre-tax basis, then it takes away with the executive hand what it gives with the legislature. A tax advantage such as Congress awarded for alternative energy investments is intended to induce investment which otherwise would not have been made.

At no point in its analysis did the memorandum argue that the coal produced was not refined coal or that the tax credits were not earned by the joint venture under review.

———————————————