In TAM 201729020, the IRS concluded that investors in a partnership that operated refined coal production facilities are not entitled to deduct Section 45 refined coal tax credits because the investment transaction was solely to facilitate the purchase of the credits.

Facts

Taxpayer is a partnership that owns and operates two refined coal facilities. Taxpayer is owned by Operator, Investor 2, and Investor 1, which is owned by Operator and X, an LLC classified as an association. Under a 10-year site lease with Electric Company, Operator, through Taxpayer, designed, engineered, developed, and constructed two refined coal facilities that use a proprietary coal-refining process (the Technology). Operator licensed the Technology from Licensor, making royalty payments to Licensor at a set rate per ton during the first three years of production. After the third year, the royalty payments increased to the greater of [redacted] cents per ton or [redacted] of the available Section 45 tax credits per ton. The license expired upon termination of the availability of Section 45 credits.

Taxpayer entered into a 10-year agreement to sell refined coal back to Electric Company at a rate equal to [redacted] cents per ton less than the rate at which Taxpayer purchased the unrefined (feedstock) coal under a separate Feedstock Coal Supply Agreement with Electric Company.

X and Investor 2 purchased from Operator membership interests in Investor 1 and Taxpayer that were, in large part, reimbursements of their proportionate share of Operator's costs for constructing and installing the refined coal production facility. Taxpayer's Operating Agreement required each member to contribute its pro rata share of Taxpayer's ongoing operating expenses, regardless of whether Taxpayer's facility was in operation and producing refined coal. Members have no right to a return of their capital contributions, although a liquidated damages provision would compensate X for a portion of its initial capital contribution to Investor 1, but not for any ongoing contributions to cover Taxpayer's operating costs. Taxpayer allocated all items of income, gain, loss, deduction, and credit (including the Section 45 credit) pro rata among its members.

Taxpayer's operations did not achieve its production expectations as the facilities were idle for significant periods of time until Taxpayer halted operations permanently in the fifth year of operations. Nonetheless, the investors received tax benefits (tax credits, losses, depreciation) that exceeded their capital contributions during those years. Additionally, Operator received amounts from Taxpayer under a sub-licensing agreement for the use of the Technology that exceeded the amount Operator paid Licensor. Both X and Investor 2 redeemed their interests in Taxpayer back to Operator, either through sale or the receipt of liquidating damages, in the fifth year.

Law and conclusion

Section 45 allows for a tax credit for qualified refined coal produced at a qualifying refined coal production facility and sold to an unrelated person during the 10-year period after the facility is placed in service. This legislation was intended to incentivize taxpayers to produce refined coal that significantly reduces harmful emissions during the production of steam to generate electricity by coal burning utilities. While the monetization of tax benefits is not prohibited, taxpayers may not sell federal tax benefits. In Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012), cert. denied, 133 S.Ct. 2734 (May 28, 2013), the court disallowed the tax credits to an investor who had no meaningful potential in the return from the partnership activity itself, only from the purported tax benefits from the activity.

In the present case, the IRS determined that the facts of the transactions demonstrate a plan to sell refined coal tax credits and other tax benefits, rather than a plan for X and Investor 2 to become producers of refined coal through an investment in Taxpayer. The IRS noted that the agreements guaranteed that Taxpayer would always incur additional financial losses even when the activity was producing refined coal and, thus, the investors' only possible incentive to make additional capital contributions was the prospect of claiming additional tax benefits.

As evidence for its conclusion, the IRS pointed to significant pre-tax profits to both Operator (through the substantial markup on its sub-License of the Technology to Taxpayer) and Electric Company (through site lease fees and a guaranteed profit on its sale of the feedstock coal for a higher price than its repurchase of the refined coal). However, the arrangement made it highly unlikely that X and Investor 2 would derive any financial benefit other than from the tax credits received. Further, the arrangement caused X and Investor 2 to suffer small losses of their initial capital contributions restricted to amounts dependent on the amount of tax credits produced, not to amounts attributable to the production of refined coal. Any additional contributions were limited to the amount necessary to keep Taxpayer operating and to continue producing tax credits. The IRS concluded that the contributions from X and Investor 2 are more accurately classified as fees paid to purchase tax credits. Accordingly, X and Investor 2 may not claim the refined coal tax credits.

Implications

Even before this TAM, many investors were concerned about the lack of specific guidance as to which financial structures monetizing these type of projects would be respected by the IRS. Wind Production Tax Credits and Historic Rehabilitation Tax Credits have their own safe harbors (see Notice 2006-88 and Revenue Procedure 2014-12, respectively). The refined coal production tax credits have been monetized for years using similar structures and, generally, investors have assumed that they would be respected by the IRS.

Congress enacted the refined coal tax credit legislation to incentivize taxpayers to develop and produce technology that does in fact reduce harmful emissions when used to generate electricity. The TAM does not dispute the fact that refined coal was properly produced and that tax credits were being generated. However, the TAM concludes that the substance of the transaction and the totality of the facts and circumstances support a finding that the Investor and Operator entered into the transaction with the Taxpayer to purchase refined coal tax credits and not to participate in the business. This follows a number of similar challenges in the tax credit industry, most notably, Historic Boardwalk Hall (see Tax Alert 2012-1539).

The TAM provides little guidance on what type of investment structure will be respected and until additional guidance is forthcoming from the IRS or the courts on these investment structures, taxpayers with existing investments should review their fact pattern in light of the TAM to evaluate potential audit risk/exposure.

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