Tax contest rights

Tax contest rights

February 10, 2020 | By Keith Martin in Washington, DC

Tax contest rights could be eviscerated if the US government wins a motion it filed in late January in the Alta Wind case.

The motion calls into question whether tax equity investors in sale-leaseback and inverted lease transactions can go to court to challenge any loss of tax benefits for which the investors are indemnified by the sponsor or protected by tax insurance.

Partnership flip transactions would also be affected where tax indemnities or insurance run to the partnership rather than to the tax equity investor directly.

Tax contest rights in some M&A transactions could also be affected.

Many renewable energy developers raise tax equity to finance projects. Tax equity is a form of capital that is returned to the investor partly in cash and partly in tax benefits. The sponsor must sometimes indemnify the tax equity investor if the tax benefits are less than expected.

The Alta Wind case involves six wind farms in California. Five of the wind farms were financed in sale-leasebacks. The sale-leasebacks occurred in 2010 and 2011. One project was sold to another wind developer in 2012. All of the projects had long-term contracts to sell their electricity to Southern California Edison.

The owners of the projects — mostly tax equity investors — applied for Treasury cash grants based on what they paid for the projects rather than what the developer, Terra-Gen, spent to build them.

At the time, the US Treasury was paying owners of new renewable energy projects 30% of their tax bases in the generating equipment under a so-called section 1603 program that was part of a group of economic stimulus measures that the US government put in place in 2009 to help pull the economy out of a tailspin. Anyone receiving a Treasury cash grant had to forego tax credits, but could still depreciate the project.

The tax equity investor in a sale-leaseback buys the project for its fair market value after construction and claims tax benefits on the project, but must first allocate the purchase price among the various assets that make up the project. Treasury cash grants were paid only on the share of purchase price allocated to the generating equipment as opposed to transmission assets, real estate, contracts and other intangibles.

The Alta investors assigned 93.1% to 96.9% of what they paid for the projects to the generating equipment. The government did not challenge the overall prices, but said that roughly 29% of what was paid should have been treated as purchase price for intangibles.

The taxpayers won in the trial court in 2016.

However, a US appeals court set the decision aside in 2018 and ordered a retrial. It instructed the trial court to appoint a different judge and to use a so-called section 1060 method for allocating the purchase price among the various assets. Under a section 1060 method, the purchase price is allocated first to the hard assets up to their market values and what remains is considered purchase price for intangibles like the power contract, customer goodwill or going concern value. (For earlier coverage, see “Tax Basis Issues: Alta Wind” in the August 2018 NewsWire and “Treasury Loses Key Case” in the December 2016 NewsWire.)

The government asked the trial court in late January to dismiss the retrial on grounds that the court lacks “subject matter” jurisdiction to hear the case.

It argues that the tax equity investors have no standing to use the court’s time since they are indemnified for any loss by the sponsor.

The sponsor responded in part that it is too late for the government to object on such grounds since the government has known of the indemnity for eight years through a full trial and appeal. The sponsor is expected to make other, substantive arguments in a brief in February.

Treasury cash grants were paid to the legal entity that owns the project with one exception. The owner in an inverted lease structure could choose to pass through the grant to the lessee. Sponsors often indemnified tax equity investors if the actual grant paid was less than expected.

There are three main tax equity structures in use today in the renewable energy market. In sale-leasebacks and inverted leases, the sponsor makes representations about the tax benefits. If any of these representations is untrue, then an indemnity must be paid. Representations are most common about whether the project was under construction in time to qualify for tax credits and about the tax basis used to calculate tax benefits. Tax insurance is sometimes purchased.

Representations may also be made in partnership flip structures, although the representations and indemnity obligation may run to the tax equity investor directly or from the sponsor to the tax equity partnership with the partnership then distributing the indemnity to the tax equity partner.

The sponsor has contest rights before it is required to pay an indemnity. In sale-leasebacks and inverted leases, it can require the tax equity investor to challenge any IRS disallowance. In partnership flip deals, any IRS audit should be at the partnership level. The sponsor is usually the partnership representative for dealing with tax audits and can cause the partnership to contest directly.

If the US Court of Federal Claims dismisses the Alta retrial, it could place a cloud over the ability to challenge IRS disallowances of tax benefits in tax equity deals in court.

Many M&A transactions could also be affected where the seller makes tax representations and can require the buyer to contest any IRS disallowance before the seller must pay an indemnity.

The issue will be how much weight to put in a ruling by a single court.