No sale occurs if the seller must pay the buyer to take a product, a US appeals court said.

The decision is important because some federal tax credits require a sale to a third party before the tax credit can be claimed. Examples are production tax credits for generating electricity from renewable energy or for making refined coal and some tax credits for producing alternative fuels.

Alternative Carbon Resources claimed $19.8 million in federal tax credits in 2011 for making an “alternative fuel mixture.” It collected liquid residue from ethanol makers and paid a trucking company to transport it to owners of anaerobic digesters and to splash in a little diesel fuel before delivery. The court said it is not a “sale” to pay someone to take a product. At least two of the anaerobic digester owners paid a flat annual fee of $950 for the product that was offset by a $950 “administrative fee” paid back. The court said this arrangement lacked substance.

The US government rewarded anyone producing an “alternative fuel mixture” at the time with a refundable tax credit of 50¢ a gallon. An “alternative fuel mixture” is a mix of one of seven alternative fuels with a more traditional fuel, like diesel fuel. The IRS said in Notice 2006-92 that the traditional fuel can make up as little as 0.1% of the mixture by volume. One of the permitted alternative fuels is liquid derived from biomass. Ethanol is made from corn, which is a type of biomass.

The mixture then had to be sold by the taxpayer producing it to a third party for use as fuel or used by the taxpayer itself as fuel. The tax credit is in section 6426(e) of the US tax code. It expired at the end of 2017, but could be extended by Congress later this year as part of a tax extenders bill.

The process of distilling ethanol leaves water and a form of corn mash called “stillage” as byproducts. The stillage is run through a centrifuge, like the spin cycle in a washing machine, to wring out the liquid. Alternative Carbon paid ethanol producers for the liquid and paid a trucking company to transport it and splash in a small amount of diesel fuel.

The trucking company delivered the mixture to digester operators who were paid a “disposal fee” to take it with the disposal fee amount tied to how much they accepted. For example, the Des Moines Wastewater Reclamation Authority (WRA) was paid 2.634¢ a gallon. Amana Farms, another digester operator, was paid $25 a ton. Both WRA and Amana Farms paid an annual fee to Alternative Carbon. In 2011, Alternative Carbon received $8,950 in total fees compared to almost $1.7 million that it paid the digester operators in disposal fees. It earned approximately $19.8 million that year in tax credits.

Alternative Carbon had limited advice from an outside tax lawyer. It sent him the proposed agreement with the WRA by email the same day it signed the agreement and asked him whether the proposed arrangement would qualify as a “sale.” He replied that Alternative Carbon would have “a better case if you charge the user of the mixture for the fuel value, and they charge you a disposal fee.”

The IRS began asking questions soon after. It sent Alternative Carbon a request for information. The company asked the outside tax counsel for help with its response. He asked which tax credit the company was trying to claim.

An internal IRS memo in July 2011 indicated the IRS was troubled by some claims for alternative fuel mixture credits involving taxpayers who sprayed small amounts of atomized diesel fuel into methane produced by anaerobic digestion of cow and hog manure when feeding the methane into generators to make electricity. The government said a fuel mixture rewarded by the tax credit required producing a single fuel and what Congress had in mind when it allowed tax credits to be claimed on alternative fuel mixtures built around “liquid derived from biomass” is that the liquid would be converted into something equivalent to compressed natural gas. The IRS memo is Chief Counsel Advice 201133010.

The IRS began a formal audit of Alternative Carbon in March 2012 and disallowed the tax credits the company claimed on multiple grounds.

It said the mixture was not sold to a third party, and the mixture was not used by the third party “as a fuel” since it was just dumped into anaerobic digesters along with other waste material.

The US claims court agreed and imposed a penalty. Alternative Carbon appealed.

The appeals court said Alternative Carbon was paying the digester owners to dispose of the mixture and not selling it to them. It said the fixed annual payments the digester owners made to Alternative Carbon lacked substance since they were not tied to the quantity or value of the mixture and were returned as an “administrative fee.”

The appeals court went further and said the entire arrangement lacked “economic substance” because “Alternative Carbon offered no evidence it ever ‘reasonably expected’ to generate any profit apart from tax credits.” It distinguished a well-known decision by another US appeals court in a case called Sacks v. Commissioner in 1995 that taxpayers do not have to show their activities are profitable without the tax credit in order to claim it in cases where tax credits are intended to induce companies to undertake activities that are otherwise economic. The court said that the taxpayer in the Sacks case at least showed that it would be able to make money in the longer term from the business.

The court said there were no grounds to waive the penalty imposed on Alternative Carbon. Alternative Carbon would have had to show that its reliance on outside tax advice was reasonable. The court said Alternative Carbon failed to follow its lawyer’s advice and the lawyer had an incomplete understanding of what Alternative Carbon was doing.

Summing up, the court said, “Alternative Carbon’s partners should have recognized that receiving millions of dollars in tax credits for transferring feedstock from one entity to another — while mixing in a meaningless amount of diesel along the way — was too good to be true.”

The court did not reach the question whether the mixture was being used as fuel.

Advice between a company and its outside counsel is normally privileged from disclosure to the government. This case shows the limits of that privilege in cases where the taxpayer must prove it relied on the advice to avoid a penalty.

The case also shows the danger of loose descriptions by others about what is happening.

The WRA person who signed the contract between Alternative Carbon and the WRA said the fixed annual fee that WRA paid to buy the mixture was “[a] once a year charge” that was “for [Alternative Carbon’s] tax stuff . . . . We turn around and charge them $950 for admin fees, so it is a wash.” Alternative Carbon’s own expert testified that the mixture “has a splash of diesel fuel in it . . . so that we can generate tax credits.”

The case also shows the danger of relying on private letter rulings issued to others that an arrangement works.

Alternative Carbon pointed to two PLRs involving a similar tax credit for producing alcohol-based fuels where the IRS said the fuel mixtures were sold, even though nothing was paid for them, because each producer was “relieved from the duty associated with having to dispose of the [mixture].” The rulings are PLR 9631012 and PLR 9229038. Private letter rulings are not binding on the government except for the taxpayers who received them.

The case is Alternative Carbon Resources, LLC v. United States. It was heard in the US appeals court for the federal circuit. The court released its decision in late September.