A refined coal transaction landed in court.

The taxpayers won.

Refined coal is raw coal that has been treated to make it less polluting when burned in a power plant or factory to make steam. There must be at least a 20% reduction in nitrogen oxide emissions and at least a 40% reduction in either sulfur dioxide or mercury emissions compared to burning raw coal.

The government offers a tax credit of $7.173 a ton in 2019 to anyone producing refined coal and selling it to a third party. The equipment that makes the refined coal had to be in service by December 2011 to qualify for tax credits. The tax credits run for 10 years after the refined coal facility was originally placed in service.

Most refined coal facilities spray or drop chemicals on raw coal as it passes overhead on a conveyor belt that moves the coal into a boiler at a power plant.

An Arthur J. Gallagher subsidiary called AJG Coal, the Fidelity Investments management company and Schneider Electric owned refined coal facilities that were placed at several coal-fired power plants owned by Santee Cooper, a utility in South Carolina.

Santee Cooper earned 75¢ a ton from taking the product. It sold the raw coal at cost and then bought back the refined coal for 75¢ less a ton.

After a long audit, the IRS sent a final notice in June 2017 disallowing tax credits that the partners claimed on the refined coal in 2011 and 2012. The refined coal facilities were put in service as early as 2009.

The IRS said no real partnership was formed since there was no real business from which the parties intended to share profits. The operation was a consistent money loser. The IRS said Fidelity and Schneider Electric were not real partners. They were just in the transaction to “monetize” tax credits.

The US Tax Court held a nine-day trial in August 2019.

Between the trial and the audit, there were meetings between multiple refined coal producers and the IRS national office in an attempt to get the national office to draw clearer lines for IRS agents in the field. (For earlier coverage, see “Refined Coal” in the April 2018 NewsWire and “Refined Coal” in the April 2016 NewsWire.)

The Tax Court rejected the IRS view of the transaction.

It said both parties took significant risks by entering into the transaction.

Santee Cooper risked using a product that might damage its boilers, affect the burn temperature for the coal and affect processes in place at its power plants to control harmful emissions.

The partners risked being left empty handed after spending money to put the refined coal facilities in place since Santee Cooper could direct the partnership at any time to turn off the chemicals and let the raw coal move untreated along the conveyors. In fact, it did this multiple times. Santee Cooper shut down refined coal production “with a frequency that frustrated” the partners, including one shutdown at the Cross power plant that lasted nine months, the court said.

Arthur J. Gallagher showed Fidelity and Schneider Electric projections at the outset that suggested an investment of $7 million in one of the refined coal facilities at the Cross power plant would be returned before the end of the first year and generate $140 million in tax savings over 10 years for a 197% internal rate of return.

The actual returns were significantly less. Fidelity exercised puts to resell its interests in the refined coal facilities to Gallagher in 2013 and 2014. Schneider Electric had no put, but was bought out by Gallagher in 2013.

The Tax Court said the arrangements had “economic substance.” It cited a case called Sacks v. Commissioner, a 1995 decision by a US appeals court that concluded it makes no sense to require a pre-tax profit in cases where Congress has offered a tax incentive to do something that would otherwise be uneconomic without the tax subsidy.

The judge was impressed by the amount of time that each investor spent doing diligence and the degree to which they had remained involved during operations, receiving updates and asking questions.

The witnesses at trial disagreed with the seriousness of the risks that Fidelity and Schneider Electric faced, but the court said it did not have to quantify the risks beyond finding that the risks were not “de minimis or remote but instead were serious risks.” It concluded, “An investor might not run shrieking from these risks, but he would consider that he was bearing these risks as he made his investment.”

The investors were real partners and not bare purchasers of tax credits, the court said. “In this case, we do not have mere paper transactions or distant, passive investors,” but “obviously real transactions with participants substantially involved in the activity.”

The investors were not lenders. There was no “written unconditional promise to pay on demand or by a date certain a sum certain.”

Each investor had to make ongoing capital contributions to cover its share of operating costs in addition to paying to buy an interest in the refined coal facilities.

Schneider also had to pay Gallagher a “finder’s fee” of 5¢ per dollar of tax credits allocated to Schneider. The partnership had to pay Gallagher ongoing royalties for use of the refined coal technology of 85¢ per dollar of tax credits (expressed in terms of the tons of refined coal that had to be sold to get to this level).

Gallagher largely bore the operating costs through adjustments to the royalties. The “actual capital and operating expenses” were subtracted from the royalties the partnership had to pay Gallagher.

If operating costs increased to more than 30¢ cents “per unit,” then the royalty amount decreased. However, the royalty could not fall below 55¢.

Fidelity had a right to exit upon various triggers. Schneider Electric did not. Gallagher ran the business, but the investors had a say in 26 “major decisions.”

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

The US Tax Court issued a “bench opinion” in late August that technically cannot be relied on as precedent in any other case.