The renewable energy industry has been waiting since January for the opinions of the US Court of Federal Claims in Bishop Hill Energy, LLC and California Ridge Wind Energy, LLC. Those opinions were released yesterday.
The judge in the cases in January entered multi-million dollar judgments in favor of the United States government, but the opinions were not released due to a dispute between Invenergy and the Department of Justice over whether certain language in the opinions was proprietary. More than five months later, the court has made the opinions public.
The opinions are identical but for entity names, dates and dollar amounts. The court's holding in each opinion is identical:
In sum, [the project owner which is an affiliate of Invenergy Wind, LLC] proffered: an independent certification of the Development Fee that is based on information from Invenergy management; a development agreement without quantifiable services; and a round-trip wire transfer that began and ended in the same bank account, on the same day, none of which were corroborated by independent testimony. This falls well short of the burden under the sham transaction doctrine.
Below is background and analysis of the cases, which is followed by a discussion of market implications.
In 2012, affiliates of Invenergy placed two wind projects into service and applied for a cash grant from the US Treasury under section 1603 of the American Recovery and Reinvestment Tax Act. The grant was 30 percent of the eligible basis of the wind projects. The rules for the grant were supposed to "mimic" the rules of the investment tax credit under section 48 of the Internal Revenue Code. Accordingly, although the cash grant program is long over, these cases have implications for today's investment tax credit transactions.
Each of two projects was owned by a separate limited liability company. The limited liability companies each entered into a three-page development services agreement with its respective parent, Invenergy Wind, LLC. The California Ridge project's development services agreement provided for a US$50 million fee, which was approximately 12 percent of the cost of the project before the development fee; the Bishop Hill project's development services agreement called for a US$60 million fee, which was approximately 16 percent of the cost of the project.
The development fees were paid by the project companies after a tax equity investor made an investment in the limited liability companies, which for tax purposes caused the limited liability companies to become partnerships.
The US Treasury, which administered the cash grant program, agreed to pay a cash grant based on approximately a five percent development fee for each project. The Treasury's stated rationale for that being an appropriate fee level was:
The cost basis has been adjusted to allow for base costs plus an appropriate markup (to include reasonable overhead, profit, and if appropriate development fees) resulting in a total that more closely reflects the amount that would have been paid in an arm's length transaction between parties with adverse interests.
Invenergy was not satisfied with that and sued for the difference. Invenergy likely believed that it had a strong case because Treasury had published a memorandum on June 30, 2011 on its website that advised that a 10 to 20 percent development was generally reasonable. That memorandum was specific to solar projects, but it is difficult to see a reason to distinguish solar from wind.
Invenergy sued to recover over US$9 million in cash grant shortfall for California Ridge and over US$12 million for Bishop Hill. When the case got to trial, the Department of Justice asserted that no development fee should have been allowed by Treasury at all and sought to recover the cash grant amount attributable to the allowed development fee: over US$5 million for California Ridge and over US$4 million for Bishop Hill.
The court ruled against Invenergy's claim and awarded the government a judgment equal to the cash grant on the development fee approved by the Treasury.
Development fees are valid in concept
The court reached the following conclusions demonstrating its acceptance of the concept of a development fee. First, section 1603 "permits an applicant to include a 'Development Fees' as part of a…project's cost basis." Second, "Development Fees may increase the cash grant awarded by Treasury."
These conclusions on a high level are favorable for the renewable energy industry in that the court accepts the common practice of "developer service agreements" and the associated "development fees" as a means to increase the cash grant and accordingly the investment tax credit eligible basis of a project.
Objections to Invenergy's development fees
Next, came the question of evidence to support the legitimacy of the development fees paid. Unfortunately, the court did not like the facts that were unearthed during the discovery process: "Discovery … revealed information …,which Treasury did not have when it awarded the cash grant. [The Department of Justice] contends that the transaction is a sham."
The court agreed with DOJ that the transaction was a sham. The court's rationale was based on four findings. First, that the "development agreement contained no quantifiable services." That seems to mean that the development services agreement did not assign a value to each service provided under the agreement. However, the court fails to explain why the omission of that granularity from the development services agreement means the whole development fee is invalid. Instead, it would seem that such an omission would mean that the court would find facts to determine how much of the fee was valid.
Second, Invenergy offered Deloitte as "independent certification of the Development Fee." As auditors typically do, Deloitte relied upon information provided by Invenergy's management to give its certification. Deloitte even "tested that categorization by sampling certain costs." Nonetheless, the court found Deloitte to be "unpersuasive" as it "didn't verify all costs." The court failed to explain why "sampling," which is a widely accepted audit technique was not sufficient. Further, the court failed to explain why at least the sampled costs were not eligible.
Third, with respect to the payment of the development fee "money passed through bank accounts of several entities related to [Invenergy] by wire transfer and then back into the account from which it originated. These transactions raised suspicion at the Department of Justice, and in the court's mind as well."
When dealing with related-party transactions, cash ending up where it started is a common occurrence. It is common because there are often interest rate advantages for a business operation to hold its cash in a single entity's bank account. Further, it is cumbersome to track cash scattered about the bank accounts of numerous entities. For these reasons, some businesses even have a "cash sweep" arrangement whereby, at the end of each day, its bank collects all of its cash in a single account.
But the court does not explain why what it labeled a "round trip" of the funds was problematic. If agreements between related parties are permissible under the tax law, which tax rules about transfer pricing, consolidated corporate groups and transactions between partners and partnerships imply they must be, then what is wrong with the round tripping of funds so long as each leg is appropriately treated as a contribution, distribution or loan.
Fourth, an Invenergy accountant testified about Invenergy's accounting practices. However, he "did not show the journal entries and, therefore, the court must rely on [his] self-serving testimony alone." From what it is included in the court's opinions, it is difficult to explain why Invenergy did not introduce the accounting entries into evidence.
The court could have merely held that Invenergy failed to carry its burden of proof that the development fee was for grant eligible costs. However, the court went a step further and held that the development services agreement was a "sham transaction on which the … Development Fee is based lack[s] a business purpose or economic substance."
It is difficult to square the court's sham transaction conclusion with the its conclusion that "Development Fees may increase the cash grant awarded by Treasury."
In terms of "economic substance," that is tested at the taxpayer level. "Economic substance" requires changing in a meaningful way the taxpayer's economic positon. In this instance, the taxpayer is the tax equity partnership, and at times the tax law views a partnership as an "aggregation" of its partners.
One way to view such a meaningful change is that that an Invenergy entity contributed cash to the tax equity partnership, and then the tax equity partnership used that cash to pay the development fee to Invenergy Wind, LLC. Partnership agreements in tax equity transactions typically require the partners in a liquidation to share the proceeds from the sale of the partnership's assets in accordance with their respective capital account balances. These two facts in combination mean that if the tax equity partnership had liquidated, the Invenergy partner would have been entitled to a much larger portion of the liquidation proceeds than if it had not made the capital contribution to fund the development fee. Therefore, assuming the liquidation provision was drafted in the typical manner for a tax equity transaction, there was a meaningful economic change with respect to what each of the taxpayer's partners was entitled to in a liquidation.
This case will likely lead to growth in the trend in the tax equity market of stepping up the project's tax basis from "cost" to fair market value by selling the project company to the tax equity partnership, rather than through the payment of a development fee to an affiliate of the sponsor.
In theory, the tax result should be the same whether a FMV sale structure or development fee structure is used; however, these two cases demonstrate that development fee structures entail baggage that FMV sales may not.
Generally, tax equity investors already require sponsor indemnification for the risk of how much investment tax credit will be available. Accordingly, the case is unlikely to cause material changes in the behavior of tax equity investors. In contrast, sponsors may want to reconsider the use of related- party development services agreements and the nature of the information that they provide which appraisers rely upon.