Some refined coal transactions will remain audit targets after a new IRS field directive was made public in mid-March.
The US government offers tax credits of $6.909 a ton as an inducement to companies to turn raw coal into “refined coal” that is less polluting. Nitrogen oxide emissions must be at least 20% lower, and mercury or sulfur dioxide emissions must be at least 40% lower, than emissions from burning raw coal.
The equipment for making refined coal had to be in service by December 2011. Tax credits can be claimed for 10 years on the output from such equipment. Only refined coal sold to third parties qualifies for tax credits.
Several developers put refined coal equipment in service before the deadline with the aim of deploying the equipment at coal-fired utility power plants. Utilities must usually be paid to take the product. Thus, the refined coal operations lose money and would be uneconomic without the tax credits. The developers have too little tax capacity to use the tax credits. They enter into various forms of transactions to get value for them.
The transactions take several forms. The most common is for the developer to bring in the tax equity investor as a partner to own a refined coal facility through a partnership. In other tax equity deals, the refined coal facility is leased or sold outright to the tax equity investor. In all three cases, the developer remains the contract operator of the facility. It is also the managing partner in transactions structured as partnerships.
In March 2016, the IRS released a heavily redacted internal memo suggesting that it was moving to disallow tax credits in a partnership transaction on grounds that the tax equity investor retained too little risk of the refined coal business to be considered a real partner. (For more details, see “Refined Coal” in the April 2016 NewsWire.)
A different partnership transaction ended up in front of the IRS chief counsel in Washington for a good part of 2016. Tax credits in that deal were ultimately disallowed in a “technical advice memorandum,” or memo issued by the IRS national office to settle a dispute between a taxpayer and an IRS agent in the field. The technical advice memorandum was sent to the taxpayer in early February 2017.
The transaction addressed in the technical advice memorandum was aggressively structured. There were two tax equity investors in a single partnership with the developer. Each paid a small amount to the developer up front for an interest in the facility, but most of the investment was supposed to be in the form of ongoing capital contributions over time to the partnership so that it could pay royalties to the developer for use of the chemical formula for treating the raw coal. The royalties were tied to the amount of tax credits the investors were allocated. The IRS said the investors “invested only in tax benefits, and had no meaningful expectation of risks or rewards” from the underlying business. (For more details, see “Refined Coal Transaction Nixed” in the April 2017 NewsWire.)
The tax equity market for refined coal transactions largely froze while awaiting a decision in the audit case by the IRS chief counsel.
After the technical advice memorandum was released, concern spread among developers with existing deals that were structured largely as “pay-go” transactions where the amount invested was contingent on tax credits. A group representing such developers submitted a list of principles for evaluating refined coal transactions that it urged the chief counsel to issue as a “field directive” to IRS agents handling refined coal audits.
The IRS associate chief counsel who oversees refined coal credits finally sent a memo to the field on February 28. A copy was released to the public in mid-March as AM2018-002.
It did not do what the group hoped.
The memo describes an ideal “base case” that it says works where a developer and investor enter into a joint venture to own the “technology” and multiple refined coal facilities.
It then analyzes a “common case” that it says has developed in the refined coal market where a partnership of a developer and an investor own a single facility and contract with a utility effectively to pay it to take refined coal at a loss to the partnership, with all the arrangements running just for the tax-credit period.
The memo encourages the IRS field to look closely at such deals.
It says the tax equity investor may not be a real partner, it may be a bare purchaser of tax credits, or the transaction may lack substance beyond a pure tax play.
The common thread in all three lines of attack, the IRS said, is the tax equity investor is too insulated from the risks of the underlying business and has no “substantial exposure to variability of economic returns.”
The memo lists factors that it says suggest the investor faces an acceptable level of entrepreneurial risk and reward.
First, the investor must make a upfront investment of at least 20% of its “total capital investment” and more than 50% of its total investment should be fixed in amount and non-refundable. Its total investment for this purpose does not include ongoing capital contributions to cover operating costs, but does include royalty payments that are tied to the refined coal produced.
Second, the investor should be exposed under the various contracts to changes in circumstances. For example, the investor’s return to should change in response to changes in operating costs. If the technology improves, the investor should be able to benefit from the changes. It helps if the utility contracts let the investor revisit the refined coal price if there is a change, for example in environmental regulations, that makes the product more valuable.
Third, the investor should take steps to try to minimize operating costs.
The memo also lists bad factors.
One is that the tax benefits are guaranteed to the investor. The tax equity investor should not be able to get its investment back if the tax credits are disallowed.
The memo ends with an example of a partnership transaction that it concludes works.
In the example, the investor contributes 50% of its total investment up front and another 25% as a fixed amount within two years. The remaining 25% is contingent on meeting production and sales targets. The utility is paid to take the product. The contracts run for the tax credit period, which, in the example, is the full 10 years. In theory, the price can be reset if the parties agree to extend the deal. However, the partnership will liquidate after the tax credits run, and the assets will be distributed according to capital account balances. The technology is licensed from a third party rather than from the developer. Royalties are paid under the technology license that are a per-ton amount of refined coal produced.
There appear to be conflicting views within the IRS national office about these deals. Much of the memo has a tough tone. However, someone wanted to end on a positive note. The large upfront investment and payment of another 25% within two years (in a 10-year deal) appear to have been enough to swing to a positive conclusion.