Synfuel and landfill gas producers are fretting about whether high oil prices will cause federal tax credits for their projects to phase out.

In the meantime, two synfuel plant owners received good news in their audits with the IRS.

The US government allows anyone producing synthetic fuel from coal or landfill gas to claim tax credits of $1.13 an mmBtu on the output. This is the credit amount for output during 2004. The synfuel plant or gas collection system must have been put into service by June 30, 1998 to qualify for credits. The credits run through 2007. However, they phase out if oil prices return to levels reached during the Arab oil embargo in the mid-1970’s. Credits would have phased out during 2004 as oil prices moved across a range of $51.35 to $64.46 a barrel. Both the tax credit and the phaseout range are adjusted each year for inflation. The 2005 figures will be announced by the IRS around April 1. The relevant oil price is the average wellhead price for domestic crude oil for the entire year, which has historically been 85% to 89% of the price for oil contracts traded on NYMEX.

The IRS has disallowed tax credits at a number of synfuel plants on various grounds. Some of the audits are still moving through appeals. In two of the audits where the sole issue was whether the plants were put into service in time, the IRS field teams handling the audits agreed to submit the issue to the IRS national office for a ruling. The national office ruled for the taxpayer in one of the audits — involving three synfuel plants — last June. The IRS has now also ruled for the taxpayer in the second of the two audits, according to the taxpayer involved, Progress Energy. The result is good news for synfuel plant owners. The first case decided last June involved synfuel plants that had some of the strongest facts of any synfuel plants. The latest batch of four plants that were the focus of the second audit had weaker facts.

Duquesne Power & Light said within days after the Progress announcement that the IRS field team had decided to give up on its audit, apparently after learning of the result in the Progress audit.

Other cases are still pending, but are working their way through appeals rather than the IRS national office. The IRS field teams handling those audits have refused to let the cases be heard in Washington. In some of the audits, IRS agents have raised additional grounds beyond whether the plants were put into service in time.

Meanwhile, synfuel and landfill gas producers are waiting to see whether a tax reconciliation bill that is in the final stages of moving through Congress will include language the Senate added to the bill last November that would change how the oil price phaseout works. The current phaseout is linked to oil prices during the current year. The Senate voted to link it to oil prices the year before. Thus, whether credits phase out during 2006 would be linked to oil prices during 2005. The Senate “paid” for the provision by dropping the inflation adjustment for the credit itself. Thus, the credit amount would remain fixed at the 2004 level of $1.13 an mmBtu. However, the oil price phaseout range would continue to be adjusted for inflation.

The industry benefited from a good lobbying strategy and fortunate timing. The Joint Tax Committee staff, which scores tax proposals for their revenue effects, said last November that the Senate provision would raise money for the government. The forecast of oil prices that it was using at the time suggested prices would not reach the phase- out range during 2006 or 2007. Therefore, it concluded that the government would collect an extra $151 million in revenue over five years as a consequence of freezing tax credits at the 2004 amount.

The debate has now shifted to a House- Senate conference committee. The House did not have a similar oil price provision in its version of the tax reconciliation bill. House negotiators are expected to resist including the provision in the final bill. A hostile news article in Time magazine in late February appears to have been planted by opponents of the Senate provision either at Treasury or in the House. Two coalitions of synfuel plant owners are lobbying hard to keep it.

In another development, the owners of five synfuel plants failed in an effort to have a federal district court in Pennsylvania declare that their plants were put in service in time to qualify for tax credits.

The IRS does not usually rule outside of a tax audit about when plants were put into service because it considers the issue too factual. A prior owner of the five plants went into bankruptcy. The bankruptcy court involved at the time recited in the fact portion of an opinion on unrelated bankruptcy issues that the plants qualify for tax credits. The current owners of the plants tried to force the IRS to acknowledge in new court proceedings that the plants were in service in time by forcing the agency to acknowledge that the owners of the plants during 1998 were entitled to depreciate them that year. This would have established that the plants were in service.

The IRS refused to be drawn into the case, and the federal district court declined to issue an order finding that the IRS was bound by its failure to challenge the earlier depreciation deductions. The case is Dycoal v. Internal Revenue Service. The court released its decision on February 15.

Keith Martin