A refined coal transaction got raked over on audit.
The IRS released a heavily redacted internal memo in March indicating that it is moving to disallow production tax credits claimed in a refined coal transaction on grounds that the tax equity investor is not a real partner in a partnership that owns the refined coal facility.
The memo is a “field service advice” by an associate area counsel in the IRS field to an IRS agent who asked how to handle a deal that the agent is reviewing on audit. The memo is Field Service Advice 20161101f.
The audit is under the CAP program, meaning the tax equity investor is a large taxpayer whose transactions are audited in real time by the IRS.
The transaction structure is fairly typical for refined coal deals.
The US government allows a tax credit of $6.71 a ton for producing refined coal. Refined coal is coal that has been treated to make it less polluting. It must produce at least 20% lower nitrogen oxide emissions and at least 40% lower mercury or sulfur dioxide emissions when burned compared to the raw coal used to make it. The tax credit is claimed by the producer of the refined coal and can be claimed for 10 years after the refined coal facility is first put in service. All such facilities had to be in service by the end of 2011 to qualify for tax credits. The tax credit amount is adjusted each year for inflation. The figure $6.71 a ton is the 2015 tax credit.
Three structures are being used to transfer tax credits to tax equity investors.
The deal under audit used a partnership structure.
The tax equity investor under audit paid a sponsor for an interest in a partnership that owns the refined coal facility. There is more than one tax equity investor in the deal.
Each investor made an initial payment to the sponsor that is amortized over an initial period. It then makes fixed and variable quarterly payments. There is a cap on the total payments that are required each quarter. The variable payments are an amount per ton of refined coal produced, minus the fixed payments and ongoing capital contributions to cover operating costs. There is an “annual adjustment amount” to keep the total payments linked to actual output.
After a “tax event,” like an IRS challenge to the tax credits, the investors can notify the sponsor to suspend production and then, with a time lag during which the sponsor is supposed to negotiate with the utility that is taking the refined coal, the investors can direct that the contracts with the utility be terminated.
The partnership buys raw coal from the utility and sells back refined coal at the same price.
The partnership pays for the raw coal with some cash and the balance with a promissory note. The amount owed for raw coal is probably netted against the amount the utility owes for the refined coal.
The sponsor has an option to buy the investor interests in the partnership for fair market value after the refined coal credits expire.
The IRS is not challenging whether the facility is producing refined coal.
Rather, the memo suggests the agency take the position that the tax equity investor under audit is not a real partner in the partnership that owns the refined coal facility. Only a partner can share in tax credits.
The memo points to the following to support the view that the investor is not a real partner.
The investor payments have been set up so that the investor takes little risk that it will have to pay more than is justified by actual tax credits, and the rights to suspend and terminate the utility contracts are additional protection. The “fixed” quarterly payments by the investor are not really fixed because the only recourse the sponsor has to collect them is to take back the investor’s interest in the partnership. The memo acknowledges that the investor is exposed to potential loss of its initial payment, but information on how long it takes to recover the initial payment is redacted.
The promotional information given to investors was focused on tax benefits. It “indicates the parties were interested in the generation and allocation of tax benefits, not in undertaking a joint endeavor to operate a profitable refined coal facility. The main focus . . . is the tax credits.” Almost all the risks highlighted in the risks section of the promotional material were things that affect the tax credits.
The quarterly operations reports to the partners are focused on information relating to tax credits.
The investors are indemnified against loss of tax credits if the sponsor misrepresented anything or breaches its duties to the investors.
The investors are not involved in decision making about the refined coal facility. The utility that takes the refined coal is effectively making all the decisions about operation.
The investors have no real downside risk, apart from the initial payment that is recovered quickly, and no upside potential apart from tax credits. The refined coal operations lose money because the partnership is paying the utility to take the refined coal through payments for use of the site and for use of equipment on site to move the coal.
In most refined coal deals, the utility can cancel the contract to buy refined coal after only a short notice period. The memo does not mention this risk to the investor.