A tax equity partnership does not have to expect a profit apart from tax credits, a US appeals court said in early August.

The decision will help tax equity investors looking to invest in carbon capture transactions.

In such transactions, the owner of a factory may form a partnership with a tax equity investor to install and own capture equipment to trap carbon dioxide emissions from the factory and either bury the CO2 permanently underground or put it to one of two other permitted uses.

In most such transactions, there is no cash coming into the partnership.

The partnership spends money to install and operate the capture equipment, including paying a sequestration company to dispose of the CO2 permanently underground. The only source of “revenue” is section 45Q tax credits of $35 to $50 a metric ton on the CO2 captured.

The Inflation Reduction Act increases the tax credits to $60 to $85 a ton for capture equipment put in service after 2022. (For more information about carbon capture transactions, see “Tax Credits for Carbon Capture” in the February 2021 NewsWire, “Stalled Carbon Capture Projects” in the August 2021 NewsWire and “Carbon Capture Terms” in the June 2022 NewsWire.)

The August court decision involved a refined coal transaction.

Refined coal is coal that has been treated to make it less polluting. The federal government used to offer tax credits as an inducement to make refined coal. The equipment to make the refined coal had to be in service by December 2011 to qualify.

AJG Coal, Inc., an Arthur J. Gallagher affiliate, formed a partnership with the Fidelity Investments management company and Schneider Electric to make refined coal on site at the Cross coal-fired power plant owned by Santee Cooper, an electric utility, in South Carolina.

AJG projected that the partnership would have an after-tax profit of $140 million over the 10 years that tax credits could be claimed for making refined coal. Fidelity paid AJG $4 million and invested another $1.1 million to cover the first two months of expenses for a 51% interest in the partnership. Schneider Electric paid $1.8 million and invested another $654,000 for a 25% interest.

The partnership signed two contracts with Santee Cooper to lease space on the power plant site to put the refined coal facility and to buy untreated coal and sell back treated coal for 75¢ less a ton than the partnership paid for the untreated coal. The tax credits could only be claimed on refined coal “sold” to an unrelated person. (For more discussion about whether it is a “sale” to pay someone to take a product, see “Production Tax Credits and ‘Sales’” in the October 2019 NewsWire.)

The Internal Revenue Service disallowed the tax credits claimed by Fidelity and Schneider Electric on audit after concluding that no real partnership was formed since there was no business from which the parties intended to share profits. The operation was a consistent money loser.

The IRS lost in the US Tax Court. (For a more detailed look at the facts and the Tax Court decision, see “Refined Coal” in the October 2019 NewsWire.)

The IRS lost again before a US appeals court in early August.

The case is Cross Refined Coal, LLC v. Commissioner.

The appeals court said two things are required to have a real partnership. First, the parties must intend to carry on business as a partnership, meaning the enterprise must be “undertaken for profit or some other legitimate nontax business purpose.” A partnership that “has no practical economic effect other than creation of tax losses” is a sham. Second, the parties must intend to share in the profits or losses or both.

The court said a partnership does not have to expect a pre-tax profit. It is enough that it expects to profit after taking into account tax credits that are an inducement to engage in an activity that is uneconomic without them.

This is the second time a federal appeals court has said it makes no sense to require a company to show it does not need tax credits — because the business is profitable without them — in order to claim the tax credits. Another US appeals court said the same thing in a 1995 case called Sacks v. Commissioner.

There are two other federal court decisions in cases with messy facts that reached the opposite conclusion.

The IRS has generally shied away from acknowledging this principle. However, numerous private letters rulings were issued to owners of synfuel plants and gas wells that qualified for section 29 tax credits for making synthetic fuel from coal or trapping landfill gas or coal-bed methane acknowledging that no profit was expected in such transactions apart from tax benefits. The IRS also acknowledged in a private letter ruling issued to investors in three early wind partnership flip transactions that the investors did not expect to earn pre-tax profits unless production tax credits were taken into account.

“[A] partnership’s pursuit of after-tax profit can be a legitimate business activity for partners to carry on together,” the Cross appeals court said. “This is especially true in the context of tax incentives, which exist precisely to encourage activity that would not otherwise be profitable.”

The appeals court also analyzed whether Fidelity and Schneider Electric were essentially lenders who were assured of getting their money back plus a return by a fixed maturity date. It said they were not.

The two companies went into the transaction expecting to receive $105 million in tax credits over 10 years. They ended up earning only $14.25 million over four years due to two lengthy shutdowns of the refined coal facility. The two lost $2.9 million and $700,000 respectively after investing with AJG in a refined coal facility at another Santee Cooper power plant.