A tax equity transaction was set aside on audit.

The Internal Revenue Service said two tax equity investors “invested only in tax benefits, and had no meaningful expectation of risks or rewards” from the underlying business. The business was producing refined coal.

The IRS made the statement in a technical advice memorandum that it sent to the tax equity investors on February 10. The memorandum is TAM 201729020.

The case had been pending in the IRS national office during much of 2016 and went all the way up to the IRS chief counsel for resolution.

Refined coal is coal that someone has altered to make less polluting. Nitrogen oxide emissions must be reduced by at least 20% and mercury or sulfur dioxide emissions must be reduced by at least 40% compared to the emissions from burning raw coal. The US government allows a tax credit of $6.71 a ton for producing refined coal. The facility at which the refined coal is produced must have been in service by December 2011. Tax credits can be claimed for 10 years on the output sold to third parties.

The case under audit involved two refined coal facilities that a developer installed on a site belonging to a utility. The developer arranged to buy raw coal from the utility and then sell the utility the refined coal at a discount to the raw coal. The developer also paid the utility for use of the site.

The developer brought in two tax equity investors as partners to own the refined coal facilities. Each partner paid the developer its ownership share times the cost to install the two facilities. One of the investors also paid the developer an ongoing “finder’s fee” that was a fixed number of cents per dollar of refined coal tax credits allocated to the investor.

However, most of what the tax equity investors paid to buy into the deal were ongoing royalty payments tied to the amount of tax credits they were allocated. The partnership paid these royalty payments to an entity the developer formed with some other investors. The royalties were for use of the chemical formulas for treating the raw coal to turn it into refined coal. The IRS said the royalties were the bulk of the payments to the developer. The tax equity investors made capital contributions to the partnership to fund them.

The entity receiving the royalty payments did not own the chemical formulas. Rather it had a license to use them from someone else. It entered into a sublicense with the partnership allowing the partnership to use them. The IRS said the royalties the refined coal partnership paid under the sublicense greatly exceeded the royalties that had to be paid under the main license.

The developer operated the projects for the partnership.

All of the contracts had terms that expired when the federal tax credits expired.

One of the investors had a “put” to sell its partnership interest back to the developer if a period of months passed without tax credits.

The facilities failed to produce as much refined coal as expected. They were idle for roughly two years out of the first five years. Both investors exited in year 5. One exercised the put and the other negotiated an exit.

The IRS said “monetization of tax benefits is not necessarily prohibited,” but this was nothing more than a sale of tax benefits. It did not reach the question whether the investors were real partners or invoke something called the “economic substance doctrine” to say the transaction lacked real substance. Instead, it said while there was a real activity of producing refined coal, the investors were not really engaged in making refined coal. They would have received no benefit if the price of refined coal had gone up. There was no meaningful variation in the financial return from the underlying business. The investors were “merely observers in an activity engaged in by others.”

The IRS said it was reserving on the issue whether there was a “sale” of refined coal to the utility since the utility was being paid, in effect, to take the product. Refined coal tax credits can only be claimed on refined coal that the producer of the refined coal sells to a third party.

The refined coal market was largely frozen while the technical advice memorandum or TAM was being worked on by the IRS.

The TAM suggested the same developer has 12 other facilities that may be audited next.

It is not the IRS position that no transactions work in this area. The amount the investors invested seemed to be largely a function of the tax credits they received and to be paid on a pay-go basis. In some other areas, like tax equity transactions in the wind market, the IRS has guidelines requiring at least 75% of the tax equity investment to be fixed in amount. The IRS had an informal policy in synfuel transactions — which qualified for a forerunner of the refined coal credit — that at least 50% of the investment amount had to be fixed.