In two consolidated cases, the US Court of Federal Claims has held that taxpayers that elected to receive grants for specified energy property under Section 1603 of the American Recovery and Reinvestment Tax Act of 2009 (ARRA Section 1603), in lieu of tax credits, are not entitled to the grants for the portions attributable to unsubstantiated development fees paid to a related party (Bishop Hill Energy, LLC v. US, No. 14-251 C (Fed. Cl. June 20, 2019), California Ridge Wind Energy, LLC v. US, No. 14-250 C (Fed. Cl. June 20, 2019)).

Background — ARRA Section 1603

ARRA Section 1603 is a provision outside the Internal Revenue Code (IRC) under which the Department of the Treasury paid cash grants to entities that placed certain renewable energy facilities in service. Owners of qualified renewable energy property were able to elect the ARRA Section 1603 cash grant as an alternative to the investment tax credit under IRC Section 48 (ITC) or the production tax credit under IRC Section 45 (PTC). Qualifying renewable energy property includes qualified property (within the meaning of IRC Section 48(a)(5)(D)) that is part of a qualified investment credit facility (within the meaning of IRC Section 48(a)(5)(C)). For purposes of ARRA Section 1603, qualified investment credit facilities include wind energy facilities that are described in IRC Section 45 and satisfy certain other requirements, including a requirement that construction begin before 2012.

Treasury awarded ARRA Section 1603 grants to applicants for eligible costs that applicants supported with relevant facts and figures. Treasury's review has generally been limited to documents submitted by the applicant.

Facts

In each of the consolidated cases, the developer built a wind energy production facility with the expectation of receiving a Section 1603 grant equal to 30% of the amount that the developer claimed as the wind facility's cost basis. While Treasury awarded the grants in general, it also challenged a portion of the cost bases attributed to a "development fee" paid to a related party (parent company).

To support the development fees, the developers had submitted to Treasury a three-page development agreement and a document intended to show proof of payment. The government, however, found the support insufficient and contended that the development fee was a "sham transaction" (the sham transaction doctrine is a judicial doctrine, explained in the following discussion of the court's opinion).

Opinion

The court concluded that ARRA Section 1603 permits an applicant to include a development fee as part of a wind energy project's cost basis and that such development fees may increase the cash grant awarded by Treasury. It determined, however, that the developers in the current cases failed to demonstrate the business purpose or the economic substance of those development fees.

The court explained that the "sham transaction doctrine" applies if a transaction lacks objective economic substance or if it is subjectively shaped solely by tax avoidance motivations. The court noted that the chief development officer of the parent company testified generally about development fees but gave no testimony specific to the development services involved in the current cases. Moreover, an employee of the companies' tax services provider testified that the development agreement contained no quantifiable services and that the tax provider relied on information provided by the company to certify the eligible cost bases.

Regarding the payment of the Development Fee, the court noted that bank records showed that the relevant money passed through several bank accounts and then back within the same day. The developers contended that the wire transfers were intended to memorialize the value of the development agreement, but the court regarded the circular flow of funds with suspicion.

With limited evidence of development services provided and a circular flow of funds, the court concluded that the evidence presented by the developers fell short of the burden under the sham transaction doctrine to establish economic substance. Accordingly, the court held that the developers were not entitled to additional cash grants with respect to the unsubstantiated development fees.

Implications

One of the items that made this case particularly interesting was that the original development fee was only 12%, which is lower than what is seen in many deals in the market (where 15% to 20% is not uncommon). While we will have to see if the results of this case will cause an increase in ITC bases audit activity, it is prudent for renewable energy developers to take a fresh look at their policies and procedures around development fees. We would recommend renewable energy developers to consider the following:

• Would the sale of a system from the developer to a project partnership result in less risk? Such an approach might shift the risk from the development fee to the allocation of the purchase price across assets.
• If a development fee is being applied, are the development services being clearly and contemporaneously documented and what support is being maintained as to the reasonableness of the fees associated with the services? This is an area where we encounter a diversity of practice across developers as to the thoroughness of the documentation and the detail that is retained.

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