In AM 2018-002, the IRS outlines several factors to assist in determining if investors in a partnership that operated refined coal production facilities may deduct Section 45 refined coal tax credits. As the credits may not be sold, investors must intend to become producers of refined coal through an investment in the partnership venture. The factors outlined can be used to determine the economic substance of a partnership agreement and the investor's entrepreneurial risk, but are not absolute.

Background

Section 45 allows a tax credit for qualified refined coal produced at a qualifying refined coal production facility and sold to an unrelated person during the 10 years after the facility is placed in service, provided that facility was initially placed in service before January 1, 2012. 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. Investment structures used to provide funding for such projects are not per se prohibited, but the court in Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012), cert. denied, 133 S.Ct. 2734 (May 28, 2013), disallowed tax credits to an investor that had no meaningful potential for return from the partnership activity itself, only from the purported tax benefits from the activity.

In TAM 201729020, the IRS concluded that investors in a partnership (Taxpayer) that operated refined coal production facilities were not entitled to deduct Section 45 refined coal tax credits because the investment transaction was solely to facilitate the purchase of the credits and other tax benefits, rather than a plan for the investors to become producers of refined coal through an investment in Taxpayer. The IRS, in determining that the investors did not qualify for the tax credits, 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.

AM 2018-002

The AM is intended to provide guidance to developers and investors in refined coal tax credit projects regarding the financing of such projects. It includes factors that will be considered and identifies what monetization structures will be generally respected. The AM also includes a lengthy discussion of the economic substance doctrine, settling on three common analytic principles: an investor has a meaningful stake in the success or failure of the partnership (Bona Fide Partner); an investor's economic return has the potential for variability (Sale of Tax Credits); or an investor's economic position can change in a meaningful way (Economic Substance).

When a bona fide partnership exists (i.e., the developer is engaging in the activity the credit was intended to encourage and is subject to the risks and rewards of the refined coal production activity), then the economic substance doctrine will not disallow the credit.

When credits are sold (i.e., when an investor in form is engaging in the production of refined coal, but the facts and circumstances indicate that the investor is insulated from the upside potential and downside risks of the activity), the economic substance doctrine may be used to disallow the credits.

In connection with the third scenario (i.e., does the investor's economic position change in a meaningful way, in order to claim the credits), an analysis of the governing agreements between the investor and developer (and any related parties), including any side agreements and understandings, must show that the investor will meaningfully share in the economic returns of the activity and is not insulated against economic risks, whether anticipated or unanticipated, at the time the agreements are entered.

AM 2018-002 includes three factors supporting a conclusion that the transaction has economic substance. First, an investor makes a significant upfront investment (for example 20% of its total investment) that is fixed, nonrefundable, non-contingent and fully at risk. An investment will be considered refundable if the parties have a side agreement or understanding (even if not legally enforceable) that the investor can exit the transaction and receive a full or significant refund of its investment. The IRS noted that contributions or payments to fund operating expenses of the coal-refining activity do not count as an upfront investment. Second, changes in circumstances, for example changes in the price of coal, will alter the fortunes of the partnership and the investor as a result. Third, the partnership takes steps that are reasonably available to minimize the economic losses of the activity, and to the investor as a result.

Conversely, AM 2018-002 includes four factors used to show that an investor does not face meaningful entrepreneurial risk or reward. First, the investor does not make a significant upfront investment in the coal-refining activity. Second, the agreements restrict the potential for the partnership and investor to be affected by changes in circumstances. Third, the investor's tax benefits are guaranteed in any way. Fourth, the venture does not take steps that are reasonably available to minimize the economic losses of the activity.

AM 2018-002 does not give weight to any factor, noting that each case depends upon its specific facts and circumstances. The AM also includes an example transaction and analysis wherein the taxpayer qualifies for the tax credits.

Implications

The guidance follows the broad outline of the safe harbor for wind partnerships (Revenue Procedure 2007-65) and Historic tax credit partnerships (Revenue Procedure 2014-14), and may be helpful to industry participants needing more certainty when structuring transactions relating to Section 45 refined coal projects. While a number of historic deals may not fit within the four corners of the guidance, there still may be opportunities for investors to benefit from facilities already placed in service and still producing refined coal. We would encourage taxpayers that have previously entered into these transactions to evaluate their potential exposure by comparing the facts of their transactions to the AM guidance. This may also be instructive for taxpayers participating in tax credit monetization transactions that are not covered by a safe harbor as it provides further insight to IRS thinking on the proper way to structure such a transaction. Finally, the validity of the IRS's position on what is needed for a valid monetization structure for a Section 45 tax credit project is currently being litigated in the U.S. Tax Court, Cross Refined Coal, LLC vs Commissioner, Docket No. 19502-17. That case is not yet scheduled for trial and therefore it is uncertain when an opinion will be issued.

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