Vacating and remanding a decision by the Court of Federal Claims (the Claims Court), the Court of Appeals for the Federal Circuit (the Court of Appeals) has held in Alta Wind I Owner Lessor C, et al. v. United States that the lower court erred in: (1) refusing to utilize the residual method of basis calculation in determining the amount of a cash grant available to entities that launch certain renewable energy facilities; and (2) excluding the testimony of the government's expert witness as to the appropriate basis calculation. (For a summary of the Claims Court's decision, see Tax Alert 2016-1927.)

Background

Section 1603 of the American Recovery and Reinvestment Act of 2009 (ARRA Section 1603) is a provision outside the Internal Revenue Code (the Code) under which the Department of the Treasury pays cash grants to entities that place in service certain renewable energy facilities. The size of the grant generally is determined using the basis of the facility's tangible personal property.

Under ARRA Section 1603, Treasury will pay a cash grant to the owner of qualified renewable energy property who elects the grant as an alternative to the investment tax credit under Code Section 48 or the production tax credit under Code Section 45. Qualifying renewable energy property includes qualified property (within the meaning of Section 48(a)(5)(D)) that is part of a qualified facility (within the meaning of Section 45).

Section 45 specifies that "qualified facilities" include a facility using wind to produce electricity. Section 48(a)(5)(D) further states that "qualified property" includes: (i) tangible personal property, or (ii) other tangible property (not including a building or its structural components) used as an integral part of the qualified facility.

ARRA Section 1603 states that the amount of the grant payment is equal to the applicable percentage of basis of the qualified property (30% of basis in the case of qualified property that is part of a wind facility). For this purpose, basis has the same meaning as when used in Section 48. Thus, the basis for purposes of ARRA Section 1603 is the same as the basis for purposes of the Federal income tax. Under Code Section 1012(a), "[t]he basis of property shall be the cost of such property."

Facts

The owners (Alta Wind Owners or Owners) acquired six wind farms in Southern California either by outright sale (one wind farm) or in sale-leaseback transactions (five wind farms). The wind farms were acquired between 2010 and 2012 and were placed in service over the same period. Owners applied to Treasury for an energy grant under ARRA Section 1603 in an amount equal to 30% of the amount paid for eligible property (i.e., the total purchase price paid for the wind farms reduced by amounts allocable to ineligible property such as land and transmission assets). Treasury paid Owners a reduced amount equal to 30% of the construction and development costs incurred by the developer of the wind farms. The aggregate difference between the amount claimed by Owners and the amount paid by Treasury was approximately $207 million.

The Claims Court awarded Owners the full amount of their claim, finding they had properly claimed a grant based on the amount paid to purchase the wind farm (with minor reductions for ineligible property) and that the government's use of a different valuation approach to reduce the basis of the property was not supported by ARRA Section 1603 or the Code. In reaching its decision, the Claims Court excluded the testimony of the government's sole expert witness, concluding that he was unreliable because he had failed to disclose his complete publication record. (He had excluded from his curriculum vitae (CV) articles written in the 1980s in which he allegedly advocated socialism over capitalism.)

Court of Appeals decision

On appeal, the parties continued to dispute how to calculate Owners' basis in eligible property for purposes of the ARRA Section 1603 grants. They agreed that the portion of the purchase price attributable to tangible property that was not eligible for the grant (e.g., real estate, transmission equipment, buildings) must be deducted, but they disagreed over how the remainder of the purchase price should be allocated.

The Owners contended that nothing should be allocated to intangibles and the entire remainder of the purchase price should be allocated to grant-eligible personal property (referred to as the "unallocated method").

The government argued that the residual method under Code Section 1060 should be applied and "the overall purchase price must be allocated on a waterfall basis among several categories of assets, some grant-eligible and some not, resulting in a lower basis in eligible property" (referred to as the "residual method").

Section 1060 and its corresponding regulations require the residual method to be used to calculate basis in an "applicable asset acquisition." Applicable asset acquisitions generally are defined as transfers of any group of assets that constitute a trade or business. A group of assets constitutes a trade or business if goodwill or going concern value could under any circumstances attach to the assets (Treas. Reg. Section 1.1060-1(b)(2)(i)).¹

The Claims Court rejected the government's argument. The Claims Court concluded, largely because the wind farms were not operational at the time of the sale, that neither goodwill nor going concern value could attach to the assets and, therefore, Section 1060 did not apply.

The Court of Appeals disagreed, stating that the test was not whether there was "actual accrued goodwill or going concern value at the time of the transaction," but rather, whether "goodwill or going concern value could under any circumstances attach." The Court noted that Treasury regulations provide that this is a facts-and-circumstances determination and set out factors indicating that goodwill or going concern value could attach, including: (1) the presence of any intangible assets, (2) excess of total consideration over book value, and (3) related transactions between the purchaser and seller.

The Court of Appeals concluded that there was no dispute regarding the presence of the second and third factors. It then provided extensive analysis to rebut Owners' contention and the Claims Court conclusion that no intangible assets were present. In particular, the Court of Appeals focused on the power purchase agreements (PPAs) that had been entered into prior to the acquisition by Owners.

The Claims Court held that the PPAs should not be treated as separate intangibles because they "relate only to their specific wind farm facilities and are not transferable or assignable." The Appeals Court concluded, however, that "the customer relationships, like goodwill itself, can exist as separate intangibles even if they are associated with a particular facility." The Appeals Court concluded that "the PPAs, or at least some portion thereof, may be characterized as customer-based intangible assets under [Code Section] 197." The Appeals Court also noted that it "appears that [Owners] acquired other intangibles, such as transmission rights, which ensured that the windfarms would be able to connect to the larger electrical grid."

The Court of Appeals also addressed the argument that goodwill cannot exist before a business has begun operations, finding that goodwill could arise from the PPAs. Although conceding that technically there may have been no goodwill at the time of the transaction, the Appeals Court noted that operation of the wind farms was to begin immediately after the sale. The Appeals Court found it "readily apparent that goodwill could attach once the wind farms began operation," meaning that "this expectation of goodwill was baked into each purchase price." Therefore, Section 1060 "is clearly applicable in circumstances of this case, where goodwill could attach to the transferred assets immediately after the transaction in question."

Having considered all of the facts and circumstances around the transactions at issue, the Court of Appeals concluded that goodwill and going concern value could have attached to the group of transferred assets immediately after the transaction and that the assets constitute a trade or business. As a result, the sales transactions constitute applicable asset acquisitions for Section 1060 purposes "and their purchase prices must be allocated using the residual method."

The Court of Appeals held that on remand, the Claims Court: (1) must determine the proper allocation of the purchase price; (2) may not reject the testimony of the government's expert witness solely because he omitted certain political writings from his CV; and (3) must assign the case to a different judge than the one who decided the underlying case.

Implications

Strictly speaking, the Court held only that some intangible assets were acquired by the Owners and that Section 1060 is applicable to the transaction. Under Section 1060, the acquisition cost is allocated first to the tangible property acquired, to the extent of its fair market value, and only the remainder is allocated to intangible assets and goodwill and going concern value. The Court did not describe how the tangible property should be valued. It did, however, identify intangible assets that may contribute value to the wind farm in excess of the value of its tangible property.

The most significant of these assets are the PPAs. The Court held that the PPAs are separable from the tangible property of the wind farm and part or all of the PPAs may be characterized as Section 197 assets. The second of these elements, specifically the "part or all" and "may be characterized" language, seems oddly tentative. In addition, while concluding that "it may be that there was technically no goodwill at the time of the transaction," the Court also suggested that there was an expectancy of future goodwill that "could well be reflected in the purchase price, and itself constitute[s] an intangible asset."

The identification of intangible assets to which costs can potentially be allocated under Section 1060 seems intended to impose limits on the extent to which costs can be allocated to tangible property. This would be particularly significant in cases in which above-market PPAs or other favorable contracts are involved.

In many cases, acquisition costs will include, in addition to costs actually incurred by the developer, a developer's markup. The Court of Appeals did not prohibit such markups, recognizing that the cost of the acquired tangible property may be greater than the construction costs incurred by the developer. Specifically, the Court noted that turn-key value may be a component of cost of the tangible assets, however in reversing the decision, it introduced risk to those deals where there is a significant mark-up included in the investment tax credit basis.

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ENDNOTES

¹ Assets that would constitute an active trade or business under Section 355 also qualify as a trade or business, but Section 355 includes a requirement, not satisfied in this case, that the business have been conducted for five years.