Section 1060 and Purchase Price Allocations
Tax basis allocation issues are getting more attention in court.
The latest skirmish, in a Treasury cash grant case, suggests that the US government may regret insisting that the purchase price in M&A and tax equity transactions must be allocated among the assets purchased using the “section 1060 method.”
It usually makes a difference in transactions that are treated as asset sales or sales of partnership interests for tax purposes how the purchase price is allocated among the various assets. For example, an investment tax credit cannot be claimed on the part of the purchase price allocated to a power purchase agreement. If the seller is an individual selling partnership interests and trying to treat any gain as long-term capital gain, it is better to allocate purchase price to goodwill and going concern value.
The section 1060 method must be used to allocate purchase price when someone is buying a business as opposed to a piece of equipment.
IRS regulations also require use of the section 1060 method in any sale involving assets with goodwill or going concern value.
The section 1060 method requires separating the assets that come with the business into seven asset classes from easiest to hardest to value. Classes I through IV are, in order, cash, things like commodities that are actively traded so that quotes are readily available, accounts receivable and inventory held out for sale. All other tangible assets go into class V. Class VI is intangible assets like power contracts, site leases and licenses. Any remaining purchase price goes into class VII and is considered a payment for customer goodwill or going concern value.
The government persuaded a US appeals court in 2018 that the section 1060 method should be used to allocate purchase price in sale-leasebacks of wind farms. A lower court said that the method is required only in sales of the kind of business that has customer goodwill. There is no customer goodwill in a project that is not yet operating and has only a single utility as a customer under a long-term power purchase agreement, the lower court said.
The appeals court said that there can be customer goodwill by virtue of merely signing a contract with a customer — presumably even before the project is built — and directed the lower court to retry the case using the section 1060 method to allocate purchase price. (For more detail, see “Tax Basis Issues: Alta Wind” in the August 2018 NewsWire.)
The retrial is unlikely before 2023.
In the meantime, the government is showing signs of regretting the outcome in that case.
The government lost a series of motions in a separate case, called Desert Sunlight v. United States, involving two large solar power plants in a decision that was unsealed in early November. Under the section 1060 method, the parties assign purchase price to the equipment first and treat any remaining purchase price as basis in contracts and other intangibles like customer goodwill or going concern value.
If the entire purchase price is used up allocating to the hard assets, then there is nothing left to allocate to a power contract or goodwill.
The government argued that the power contract and interconnection agreement should be lumped in with the hard assets so that at least some of the purchase price would be allocated to them. The US Court of Federal Claims said no.
First Solar developed two large power plants — one with a capacity of 250 megawatts and the other 300 megawatts — in the California desert. It sold the development rights to NextEra and GE Energy Financial Services in 2011 before construction started on either project. At the time, the development rights included long-term power contracts to sell the electricity from one power plant to Southern California Edison and from the other to Pacific Gas & Electric that had been signed in 2009 and 2010 as well as interconnection agreements to connect both projects to the California grid.
The parties signed five sets of contracts in 2011 when the project companies with the development rights were sold: an agreement to sell the project companies holding the development rights, three construction contracts for First Solar to build the projects and shared facilities, O&M contracts for it to operate them, a US Department of Energy loan guarantee and other financing agreements.
After completing the power plants, the owners applied for section 1603 payments from the US Treasury in lieu of investment tax credits.
First Solar had originally asked for a fixed price of $2.36 billion to do all of the construction work, but the price was negotiated down to $1.95 billion. The final figure included $104 million in sales taxes.
NextEra and GE paid First Solar $14.45 million in 2011 to buy the two project companies that owned the development rights. Immediately upon sale, the project companies borrowed $1.46 billion that First Solar had arranged with several banks. DOE provided a loan guarantee for $1.68 billion. NextEra and GE put in $600 million in equity.
The two power plants were built in 20 blocks.
The owners submitted 15 separate applications to the US Treasury for section 1603 payments as blocks were placed in service. The power plants were completed in 2014.
The owners ended up spending $2.13 billion to put the power plants in service, including $87 million in construction-period interest and $72 million for an early-completion bonus for First Solar.
They claimed $2.05 billion, or 96.2%, as tax basis in assets qualifying for an investment tax credit. They applied for a Treasury cash grant of $616.8 million, or 30% of the eligible basis. The Treasury paid $59.3 million less than this amount. The owners sued for the shortfall.
The case is still in the early rounds, but the mental gymnastics by the government lawyers so far have earned them a poor score.
The government asked the court to award it summary judgment based on legal briefs without going to trial on grounds that the owners failed to file an IRS Form 8594. Both the seller and the buyer must file a Form 8594 with their tax returns for the year of sale showing how they allocated the purchase price in sales transactions to which section 1060 applies.
The court said no. The penalty for failure to file is $250, not forfeiture of a claim. If the government truly thought the application for section 1603 payments was fatally deficient for failure to file a form with a later tax return, the court said, it is unfathomable that the government would have paid more than $555 million in Treasury cash grants.
The government next found fault with a number of cost items that the project owners treated — or failed to treat — as basis in ITC assets.
The government said that the bank loans were non-ITC assets to which part of the purchase price should have been allocated in class III or V of the section 1060 waterfall. The court said no. Even if the loans are “assets,” the court said, purchase price must be allocated only to assets acquired in the acquisition. The bank loans were borrowed later. Moreover, even if they are assets, the court said, they are intangibles belonging in class VI.
Next the government argued that the court should ignore the price that two hard bargainers negotiated for the construction job — First Solar on the one side and GE and NextEra on the other — because investment tax credits and, by extension, cash grants must be calculated on a price established in a hypothetical negotiation.
The government argued next that NextEra and GE paid too little for the development rights, since First Solar had spent $35 million on the projects by the time they were sold in 2011. The court said this is a question of fact that requires a trial to settle.
Meanwhile, the court confirmed, at the request of NextEra and GE, that the power contracts and interconnection agreements are class VI rather than class V assets, the DOE loan guarantee is not a separate asset capable of soaking up purchase price, and if the entire value is used up by class V, then there is no need to continue down the waterfall to allocate anything to class VI or VII.
The case is headed for a trial in June 2022 — if the parties do not settle before then.