In California Ridge Wind Energy LLC v. United States,¹ the Court of Appeals for the Federal Circuit found that two renewable energy companies could not prove that development fees should be included in their cost bases on which federal energy grants were based. As a result, the companies were not entitled to claim the portion of the grant denied by the Treasury Department.

In so finding, the Federal Circuit affirmed two earlier decisions by the Court of Federal Claims, finding that the development fees were sham transactions and therefore not includible in the cost bases.

Facts

Two companies, California Ridge Wind Energy LLC and Bishop Hill Energy LLC, belong to Invenergy, a family of related entities in the business of creating wind farms. Several years after starting a project, Bishop Hill entered into a development agreement with the Invenergy subsidiary Invenergy Wind North America LLC (IWNA), under which Bishop Hill was obligated to pay IWNA $60 million. California Ridge entered into a development agreement with the Invenergy subsidiary Invenergy Wind Development North America LLC (IWDNA), under which California Ridge was obligated to pay $50 million. The development agreements were similar, stating that IWNA and IWDNA were assisting the companies by negotiating construction financing terms, negotiating the project and operational documents necessary or appropriate for the projects, obtaining permits and performing other services relating to the projects.

On the day of payment from Bishop Hill to IWNA, IWDNA transferred $60 million to Bishop Hill, which then wired $60 million to IWNA. The same day, IWNA wired $60 million to IWDNA. On the day of the payment from California Ridge to IWDNA, IWDNA transferred $50 million to California Ridge, which then wired $50 million back to IWDNA. According to the appeals court, payments from the companies to the subsidiaries involved "a round trip of funds starting and ending with IWDNA."

California Ridge and Bishop Hill subsequently applied to the Treasury Department for Section 1603 grants. Section 1603 of the American Recovery and Reinvestment Tax Act of 2009 requires Treasury to make payments in lieu of investment tax credits to reimburse taxpayers for a portion of their expenses in placing certain renewable energy property into service. For California Ridge and Bishop Hill, the applicable percentage for the grant equaled 30% of the property's qualifying basis.

Treasury reduced the grants to California Ridge and Bishop Hill by approximately $9 million and $13 million, respectively (from grant applications of roughly $137 million and $130 million) on the grounds that the developer fees were a "sham transaction" and should not be added to the cost bases on which the grants were based. The two companies filed lawsuits in the Federal Claims Court, alleging Treasury had unlawfully withheld payments under Section 1603. The government counterclaimed on the grounds the development fees were "sham" transactions and therefore not includable as eligible costs. The Federal Claims court ruled for the government, finding that the companies failed to show that the development agreements had "economic substance" and concluding that the agreements were sham transactions.

In consolidating the cases on appeal, the court referred to both companies as California Ridge.

Appeals court's analysis

In its analysis, the appeals court said, "California Ridge, to support its claim, was required to prove that the dollar amounts of the development fees claimed — stated in the development agreements and paid to IWNA and IWDNA out of IWDNA's own funds — reliably measured the actual development costs for the windfarms."

The appeals court found that the trial court did not err in finding that the amounts stated in the development agreements did not reliably indicate the development costs. According to the appeals court, the trial court's finding was supported by three factors.

First, the finding was supported by the round-trip nature of the payments. The appeals court said, "[N]ot only was the amount of the development fee negotiated between related entities, the fee was paid in a round-trip transaction such that neither the payor nor the payee was materially affected by the transaction."

Second the finding was supported by the absence in the agreements of any meaningful description of the development services to be provided. "There is no concrete specification of services that, if examined, might lend support to the amount set in the agreement for a premium on those services," the appeal court said.

Finally, the finding was supported by the fact that all, or nearly all, of the development services had been completed by the time the agreements were executed. "[B]ecause the services were already rendered, in full or in large part, the appeals court said, "the negotiated price for a premium as part of those services was not part of a pre-acquisition market transaction that would lend the price reliability as an indicator of market value."

Implications

The opinion of the appeals court highlights the criticality of timely and substantive documentation supporting any development service fees, particularly in related-party arrangements.

Development fee agreements should be entered before services are performed. In addition, they need to clearly outline the services to be provided and contain a reasonable market-based fee. Parties should contemporaneously document completion of the related services and the value delivered before making the related payments. This evidence should include third-party support wherever practical, including a fair market value appraisal of the energy project from a qualified firm.

Although the context of this case was the IRC Section 1603 Treasury Grant program, solar developers and investors are keenly aware that these decisions provide a lens into how development service fees will be evaluated in the context of other cost-based tax credits, including the IRC Section 48 investment tax credit.

We anticipate that this will accelerate the movement away from development fees to sale-based transactions — changing the question from whether the development fee was reasonable for the services provided to whether the purchase price was for fair market value and how the purchase price was allocated among the assets purchased.

———————————————

———————————————
ENDNOTE

¹ Nos. 2019-1463, 2019-1465 (Fed. Cir. May 21, 2020).