Refined-coal investors bought tax benefits rather than a production stake

Plain-English summary

A partnership owned refined-coal facilities and allocated IRC § 45 credits to two outside investors. The governing contracts tied the investors' contributions to credit generation, guaranteed operating losses from selling refined coal below cost, limited exposure when credits were unavailable, and left meaningful pre-tax returns with the operator and electric company. One investor also had a liquidated-damages right that could refund part of its initial investment if expected credits did not materialize. The IRS concluded that the investors had no meaningful opportunity for returns from, or exposure to risks of, the coal-production activity apart from tax benefits. Their payments were therefore fees for a prohibited purchase of tax credits, so neither investor could claim the refined-coal credits. The memorandum did not decide whether the investors were bona fide partners or whether the transaction lacked economic substance.

Ruling snapshot

• Question: Could two investors claim IRC § 45 refined-coal credits allocated through the facility partnership?
• Outcome: advice given, the credits were disallowed
• Key authorities: IRC § 45(c)(7), (e)(8); Historic Boardwalk Hall, LLC v. Commissioner; Rice's Toyota World, Inc. v. Commissioner

Full text (IRS public release)

                   INTERNAL REVENUE SERVICE
         NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                   March 23, 2017

Number: 201729020
Release Date: 7/21/2017

                                         Third Party Communication: Unrelated
                                         Taxpayer
                                         Date of Communication: June 20, 2016

Index (UIL) No.: 704.00-00
CASE-MIS No.: TAM-108848-17

Director
RFTH-West

  Taxpayer's Name:                       ---------------------------------
  Taxpayer's Address:                    -----------------------------
                                         -----------------------------

                                         ------------------------
                                         -------------------
                                         -------------------
                                         --------------------------
  Taxpayer's Identification No           ---------------
  Year(s) Involved:                      --------------
  Dates of Conferences:                  ------------------------------------------------------

LEGEND:

Taxpayer = ---------------------------------

Operator = -------------------

Investor 1 = -------------------------------

Investor 2 = --------------------------------------------------
TAM-108848-17 2

X = -------------

Electric Company = -----------------------------------------------------

Licensor = ----------------------

Date1 = ----------------

Date2 = ----------------

Date3 = ----------------

Date4 = ------------------

Date5 = ------------------

Month1 = -------------

Month2 = ----------

Month3 = -----

Month4 = -----

Year1 = ------

Year2 = ------

Year3 = ------

Year4 = ------

Year5 = ------

Year6 = ------

a = ---

b = -

c = ---

d = ---
TAM-108848-17 3

e = ---

f = ----

g = ---

h = ---

i = ---

j = ----

k = ---

l = ---

m = ---

n = ---

o = -------

p = -----

q = -------

r = -------------

s = -----

t = -------------

u = -----

v = -

w = ---

x = ---

y = -

z = ----
TAM-108848-17 4

aa = ----

bb = ----

cc = ---------------

dd = -----------

ee = --------------

ff = --------------

gg = -------------

hh = -------------

ii = -------------

jj = ---------------

kk = --------------

ll = ----------

mm = -------------

nn = -----

oo = -----

pp = -----

qq = -----

rr = ----------------

ss = ----------------

tt = -

uu = -

vv = ----
TAM-108848-17 5

ww = -------

xx = -------

ISSUE(S):

  Whether X and Investor 2 may claim “refined coal” tax credits under § 45(e)(8)

based on the transaction at issue?

CONCLUSION(S):

    Neither X nor Investor 2 may claim refined coal tax credits from this transaction

which was structured, insofar as the participation of X and Investor 2 were concerned,
solely to facilitate the prohibited purchase of refined coal tax credits.1

FACTS:

   Taxpayer is a limited liability company classified as a partnership for Federal tax

purposes. Taxpayer owns and operates two refined coal facilities. As depicted in the
diagram below, the Taxpayer had three owners during the years at issue: Operator,
Investor 1, and Investor 2 (we refer to Investor 1 and Investor 2 collectively herein as
“Investors”). Operator is a Subchapter C corporation that owns a% of Taxpayer.
Operator also owns b% of Investor 1, which is a limited liability company classified as a
partnership for federal tax purposes; X is a limited liability company classified as an
association for federal tax purposes that owns the remaining c% of Investor 1 through a
disregarded entity. Investor 1 owns d% of Taxpayer, and Investor 2, a Subchapter C
corporation, owns the remaining e%.

 1
   Because we conclude that the Investors engaged in the prohibited purchase of tax benefits, we do
 not reach the issue posed to us of whether the Investors are bona fide partners in Taxpayer, or
 whether Taxpayer is a bona fide partnership. Consequently, our later references in this
 memorandum to “partner” or “partnership” are for convenience only and we do not intend our use of
 the terms to create any inference regarding their accuracy for federal income tax purposes. We also
 do not reach the issue posed to us concerning whether the transaction(s) entered into by the taxpayer
 lack economic substance pursuant to § 7701(o) or the common law economic substance doctrine.

TAM-108848-17 6

  A. Formation of Taxpayer and Construction of the Facilities

     In Month1 of Year1, prior to the entrance of X and Investor 2 into the transaction,

Operator formed Taxpayer as a limited liability company and remained its sole owner
(both directly and indirectly) during the construction of the facilities and execution of the
operative contracts detailed below. Also on or about Month1 of Year1, Operator,
through Taxpayer, entered into a ten-year site lease at a de minimis rental rate of $f per
month with Electric Company that was coterminous with the availability of the § 45
refined coal tax credit. Operator then designed, engineered, developed, and
constructed two refined coal facilities for Taxpayer on its leased site (-------------------------

-----------------------------------------------------------------------------------------------------). Operator
designed the facilities to use a proprietary coal-refining process (the “Technology”),
which it licensed from Licensor, a partnership in which Operator owned a g% interest
and of which Operator was the managing member. Under the terms of Operator’s
license, it was obligated to make royalty payments to Licensor of h cents per ton of
refined coal it produced during the first three years of production; thereafter, the royalty
payment increased to the greater of i cents per ton or j% of the available § 45 tax credits
per ton. The license expired upon termination of the availability of § 45 credits.

    After constructing the facilities, Operator contributed them to Taxpayer, k%

directly in exchange for a direct k% interest in Taxpayer, and d% through Investor 1--at
that time its wholly-owned and disregarded entity--by assigning d% of the facilities to
Investor 1 and then causing Investor 1 to contribute the fractional share of the facilities
to Taxpayer in exchange for a d% interest in Taxpayer. Operator then caused Taxpayer
to enter into the following agreements, all of which terminated when the availability of
the § 45 credit ceased:
TAM-108848-17 7

1. Technology Sub-License. Operator sublicensed its rights to use the Technology
   to Taxpayer for the duration of the § 45 credit’s availability (the “Sub-License”).
   The terms of the Sub-License call for Taxpayer to make royalty payments to
   Operator as it uses the Technology to refine coal. The payment amounts vary
   depending primarily not on the value of the coal refined using the technology but
   on the value of the credit to Taxpayer; the payment formula in the agreement
   specifies that the royalty is equal to the excess of l cents per dollar of § 45 credit
   over all other capital and operating costs that Taxpayer incurred, not to exceed a
   total price of m cents per dollar of § 45 credit and not to be less than the
   minimum royalty that Operator owed to Licensor under its license agreement
   (i.e., h cents per ton, i cents per ton, or j% of the available § 45 credits per ton,
   depending on surrounding circumstances).

2. ------------- (Unrefined) Coal Supply Agreement. Taxpayer entered into a 10-year
   agreement with Electric Company to purchase feedstock coal from Electric
   Company at terms approximating Electric Company’s average cost of acquiring
   the coal from third-party vendors.

3. Refined Coal Sale Agreement. Taxpayer entered into a separate 10-year
   agreement with Electric Company to sell refined coal back to Electric Company
   at a rate equal to n cents per ton less than the rate at which Taxpayer purchased
   the coal under the Feedstock Coal Supply Agreement. Electric Company had
   the right, however, to discontinue further purchases of refined coal in the event it
   had operational concerns with burning refined coal. According to Taxpayer’s
   representation, it was these operational concerns that required Taxpayer to
   discount the refined coal below cost in order to compensate the Electric
   Company for the increased risk to its boilers resulting from its use of the refined
   coal (but see footnote 4 below).

   B. Acquisition of Interests by X and Investor 2

   1. Taxpayer’s Operating Agreement and Member Interest Purchase
      Agreements

   As stated above, Operator formed Taxpayer in late Month1 of Year1 and was its
   sole owner (k% held directly by Operator and d% held indirectly through Operator’s f%
   interest in Investor 1) until X’s and Investor 2’s purchases of interests in Investor 1 and
   Taxpayer, respectively. In Month2 of Year2, X acquired an indirect interest in Taxpayer
   by purchasing c% of Operator’s interest in Investor 1 which, in turn, owned d% of
   Taxpayer. Operator retained the remaining b% interest in Investor 1. See Section B.2
   below for more detail on X’s acquisition of its interest. Investor 2 acquired a e% direct
   interest in Taxpayer by purchasing it out of the k% interest in Taxpayer that Operator
   owned directly, leaving Operator with a a% direct interest in Taxpayer. Thus, at that
   point, Operator owned a o% interest in Taxpayer (a% directly and p% indirectly through
   TAM-108848-17 8

its b% ownership of Investor 1), X indirectly owned q% of Taxpayer through its c%
ownership of Investor 1, and Investor 2 directly owned the remaining e% interest in
Taxpayer.

     The separate membership interest purchase agreements that X and Investor 2

entered into with Operator set their purchase prices approximately equal to a
proportionate share of Operator’s total capital costs of constructing and installing the
refined coal production facilities, though the information submitted to us does not
specify what portion of the costs relates to construction versus installation of the
facilities. X’s purchase price for a c% interest in Investor 1 was $r, which represented
s% of Operator’s costs. Investor 2’s purchase price for a e% interest in Taxpayer was
$t, which represented u% of Operator’s construction and installation costs, plus an
ongoing “finder’s fee” to Operator equal to v cents per each dollar of credit allocated to
Investor 2. Consequently, X’s and Investor 2’s membership interest purchase prices
(paid to Operator for interests in Investor 1 and Taxpayer, respectively) were, in large
part, reimbursements of their proportionate share of Operator’s costs for constructing
and installing the refined coal production facility.

   Under the terms of Taxpayer’s Operating Agreement, each of its members was

obligated to contribute its pro rata share of Taxpayer’s ongoing operating expenses as
Taxpayer incurred them, regardless of whether Taxpayer’s facility was in operation and
producing refined coal. Taxpayer allocated all items of income, gain, loss, deduction,
and credit (including the § 45 credit) pro rata among its members. The Operating
Agreement specifies that Taxpayer’s members’ intention is for their capital contributions
not to exceed l cents per dollar of § 45 refined coal credit. The Operating Agreement
also specifies that the members have no right to a return of their capital contributions
(but see below for X’s right to liquidated damages). The members share rights to
decision-making for Taxpayer, including the handling of tax audits and financial matters.

   2. Investor 1’s Operating Agreement and Member Interest Purchase
      Agreement

   Operator formed Investor 1, a limited liability company, on Date1. On Date2,

Operator entered into a membership interest purchase agreement to sell X a c%
interest in Investor 1. On the same date, Investor 1 executed an agreement with X and
Operator. The agreement specified similar contribution obligations and item allocations
as Taxpayer’s Operating Agreement described above. However, the agreement
contained an additional provision that, in the event of a federal tax audit, Operator would
place the royalty payments otherwise payable to it under the Sub-License into an
escrow account to defray the costs of the audit.

    X’s membership interest purchase agreement in Investor 1 set a purchase price

equal to a proportionate share of Operator’s total capital costs of constructing and
installing the refined coal production facilities. The membership interest purchase
TAM-108848-17 9

agreement also included a liquidated damages provision under which Operator was
obligated to purchase X’s interest in Investor 1 at a price equal to the initial purchase
price times the number of months remaining in the 10-year term divided by 120 (i.e. the
total number of months in the term). The liquidated damages provision was triggered by
any one of fifteen specified conditions, including conditions leading to unavailability of
the § 45 credit or a period of uu months in which the actual or projected net cash
expenses of Taxpayer would exceed l% of the credits generated by the respective entity
during that period. X had the option to exercise its rights under the terms of the
liquidated damages provision with respect to any refined coal facility owned by
Taxpayer that met one of the fifteen enumerated conditions. If X exercised its right with
respect to any individual facility, Operator would pay X damages equal to X’s prorated
purchase price described above that was attributable to that particular facility, and X
would assign all of its indirect economic interest in that facility to Operator. If X
exercised its right with respect to both refined coal facilities owned by Taxpayer, X
would no longer hold an indirect economic interest in Taxpayer, leaving Investor 1 with
one indirect owner in Taxpayer. In that event Investor 1 would presumably be treated
as a single-member entity with respect to its ownership interest in Taxpayer and
disregarded, leaving Taxpayer with two owners – Operator (both directly and indirectly
through Investor 1) and Investor 2.

     Although the liquidated damages provision would compensate X for a portion of

its initial capital contribution to Investor 1, which in turn was used for Investor 1’s initial
capital contribution to Taxpayer, it would not compensate X for any ongoing
contributions to cover Taxpayer’s operating costs. Therefore, if conditions arose to
trigger availability of the liquidated damages provision, X could cover some—but not
all—of its economic losses by invoking its rights under the provision, or it could choose
to remain in the partnership and bear the risk that its relatively small ongoing
contributions would not be offset by anticipated tax benefits. Even this small risk was
limited by the pay-as-you-go structure of Taxpayer’s operations, which reduced its
partners’ contribution obligations substantially whenever Taxpayer was not producing
refined coal and receiving the corresponding § 45 tax credit. We note that because the
arrangements contractually guaranteed that Taxpayer would always incur additional
financial losses even when the activity was producing refined coal, the only possible
incentive for the Investors to make such additional capital contributions was the
prospect of claiming additional tax benefits.

 C. Operation of Taxpayer

    Taxpayer’s operations did not achieve its expectations. The facilities were idled

from Month1 of Year2 to Month3 of Year3, and again from Month4 of Year4 until Year5,
when the Taxpayer halted operations permanently. Over the w months of Taxpayer’s
existence, the facility was in operation for a total of x months. Despite projecting an
estimated production of y million tons of refined coal per year, Taxpayer produced only
z million tons in Year2, aa million tons in Year3, and bb million tons in Year4.
TAM-108848-17 10

   Nonetheless, the Investors enjoyed very substantial tax benefits (tax credits,

losses, depreciation) well in excess of their capital contributions during those years. In
Year3 alone, for example, Taxpayer reported $cc in tax deductions-- including a net loss
of $dd on its sales of refined coal (revenue from refined coal sales of $ee less feedstock
costs of $ff), royalty expenses under its sublicensing agreement of $gg, and other
expenses of $hh (including $ii depreciation)—plus refined coal tax credits of $jj, the
combination of which exceeded its partners’ $kk in capital contributions.

    Also noteworthy is the wide gap between the licensing and sub-licensing royalty

payment amounts the parties made with respect to the Technology. In Year3, the terms
of Taxpayer’s Sub-License resulted in a $gg million royalty payment to Operator. Under
the terms of Operator’s license agreement with Licensor, however, Operator paid only
$ll to Licensor, retaining the balance ($mm) for itself; stated differently, Operator paid
Licensor h cents per ton of coal to use the Technology, but it received royalty payments
of $nn per ton of coal under the Sub-License.

  We also note that Taxpayer achieved some cost savings in Year6, after both X

and Investor 2 were no longer participants in Taxpayer. In response to environmental
concerns caused by the chemical used in Taxpayer’s refining process, Electric
Company obtained a permit to use a different chemical, which was less expensive than
the one it had been using. The result of this change was a cost savings with respect to
the chemical of a dollar per ton of coal (from $oo/ton to $pp/ton).

 D. X and Investor 2 Exit the Transaction

   Both X and Investor 2 exited Taxpayer in Year5. Investor 2 sold its interest back

to Operator on Date3, pursuant to a negotiated agreement that included cancellation of
one or more limited-recourse notes owed by Investor 2 to Operator for its purchase of
an interest in another coal refining facility. X exercised its rights under the liquidated
damages provision (under the condition regarding three consecutive months of
excessive expenses) on Date4. On Date5, X sold its c% interest in Investor 1 to
Operator.

LAW:

   Section 45(e)(8) of the Internal Revenue Code provides that a producer of

refined coal is eligible for a tax credit for qualified refined coal that the taxpayer (i)
produces at a refined coal production facility during a ten-year period beginning on the
date the facility is placed in service, and (ii) sells to an unrelated person during that ten-
year period.

   Section 45(c)(7) defines “refined coal” as a fuel which meets certain formal and

functional requirements. In order to constitute refined coal, the burning of the refined
TAM-108848-17 11

coal must result in the reduction of at least 20% of the emissions of nitrogen oxide and
at least 40% of the emissions of either sulfur dioxide or mercury released as compared
to burning the feedstock coal.

   Barring express statutory authorization, taxpayers may not sell federal tax

benefits. For example, in Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425
(3d Cir. 2012), cert. denied, 133 S.Ct. 2734 (May 28, 2013), the Third Circuit considered
whether an investor’s interest in the success or failure of a partnership that incurred
qualifying rehabilitation expenditures under § 47 was sufficiently meaningful for the
investor to qualify as a partner in that partnership. The agreements governing the
Historic Boardwalk Hall transaction ensured that the investor would receive the § 47
rehabilitation credits (or their cash equivalent) and a preferred return, with no potential
for meaningful variability in the return from the partnership activity itself. As a result, the
investor could look only to the purported tax benefits from the activity for a return of its
investment.

    In reaching its conclusion disallowing the tax credits to the investor, the Third

Circuit stated,

   [i]t is the prohibited sale of tax credits, not the tax credit provision itself, that the
   IRS has challenged. Where the line lies between a defensible distribution of risk
   and reward in a partnership on the one hand and a form-over-substance violation
   of the tax laws on the other is not for us to say in the abstract. But, “[w]here, as
   here, we confront taxpayers who have taken a circuitous route to reach an end
   more easily accessible by a straightforward path, we look to the substance over
   form.” Southgate Master Fund, 659 F.3d [466, 491 (5th Cir. 2011)]. (Emphasis
   added).

    The lack of a potential for a meaningful return that could vary depending on

whatever success the underlying activity might achieve meant that at the end of the
straightforward path in Historic Boardwalk was an arrangement that, in substance, was
merely a sale of tax benefits, and tax benefits alone. And, as the court noted, the sale
of tax credits is prohibited. See also Rice’s Toyota World, Inc. v. Commissioner, 81
T.C. 184, 207 (1983), aff’d., 752 F.2d 89 (4th Cir. 1985) (“Since petitioner was not
making an actual investment in an asset, the transaction presents no opportunity other
than for tax reduction. Because the cash down payment was not used to acquire an
asset but was more akin to a fee to purchase tax savings, it too is excluded from
basis”).

ANALYSIS:
TAM-108848-17 12

    We begin by noting that monetization of tax credits is not an unprecedented

practice in the refined coal industry.2 It is also important to note that monetization of tax
benefits is not necessarily prohibited in the context of a transaction that involves more
than a sale of tax benefits. The facts in Taxpayer’s case, however, demonstrate a plan
to sell refined coal tax credits and other tax benefits, rather than a plan on the part of X
and Investor 2 to become producers of refined coal through an investment in Taxpayer.
Specifically, the transaction in this case provided significant pre-tax profits to both
Operator (through the substantial markup on its Sub-License of the Technology to
Taxpayer) and Electric Company (through site lease fees and a guaranteed profit on its
sale of the feedstock coal for a higher price than its repurchase of the refined coal). In
contrast, the arrangement made it highly unlikely that X and Investor 2 would derive any
financial benefit, meaningful or otherwise, from the production of refined coal; to the
extent any financial benefit did materialize, we see no evidence that the parties pursued
the benefit intentionally, or that the remote possibility of a benefit played any role in the
investors’ decision to participate in the transaction. While that arrangement also
guaranteed that X and Investor 2 would suffer small and carefully circumscribed losses
of their capital contributions, we do not think those losses can be fairly characterized as
losses attributable to the production of refined coal, because those losses were
primarily dependent on the amount of tax credits produced rather than the economic
consequences of an investment in a refined coal production activity. Consequently, we
conclude that those contributions are more accurately described as fees paid to
purchase tax credits for a relatively small upfront payment followed by additional
payments only to the extent necessary to generate additional tax benefits. Rice’s
Toyota World, Inc. v. Commissioner, supra.

 A. X and Investor 2’s Only Meaningful Return is from Tax Benefits

      1. X and Investor 2’s Return From Their Investment in Taxpayer Could Not Vary
      Regardless of the Success or Failure of the Refined Coal Production Activity

    The parties in this case structured the governing contracts to produce little more

than tax benefits commensurate with X and Investor 2’s regular and ongoing
contributions—significantly curtailing any potential for them to benefit from the success
of the refined coal production activity, while simultaneously limiting the risks of the
failure of that activity. 3 The feedstock coal supply and refined coal sale agreements
2

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3
It is important to note that we do not take the position that investors must have the potential for a pre-tax
profit from the refining activity in order to claim the credit. Cf. Sacks v. Commissioner, 69 F.3d 982 (9th
TAM-108848-17 13

locked in a fixed and guaranteed loss to Taxpayer (and indirectly to X and Investor 2) of
n cents per ton of refined coal sold to Electric Company for the entire duration of the
availability of the § 45 credit. As a result, a favorable change in the market value of
refined coal could never benefit X and Investor 2 in any way. Taxpayer argues that
Electric Company’s concern about the safety of using refined coal in its boilers meant
that Taxpayer had no choice but to sell the refined coal at a loss.4 Taxpayer explained
that Electric Company was under no obligation to use refined coal to generate
electricity, and that their goal in doing so was to reduce fuel costs and provide certainty
with respect to those costs going forward. Coupled with the safety concerns, Taxpayer
argues that these factors provided Electric Company with sufficient leverage at the time
the contracts were entered into to lock in the discount over their full 10-year term,
thereby guaranteeing a fixed loss per ton of coal to Taxpayer without regard to the value
of that coal. While operational concerns may explain the initial discounted sale price for
refined coal, we question whether Taxpayer would have been able to, or whether they
even attempted to, negotiate for a price adjustment at some point during the term of the

Cir. 1995) (the taxpayer’s activity was not expected to generate a pre-tax profit but the taxpayer’s
economic fortunes, wholly apart from the tax benefits, would rise and fall with the success of the
business, and therefore his enterprise had economic substance). Congress enacted § 45(e)(8) to
incentivize an activity that might not otherwise be profitable without the tax credits. Therefore, a pre-tax
profit cannot be a condition of claiming that benefit. That does not mean, however, that a genuine
producer within the meaning of § 45(e)(8) does not need to have a meaningful financial interest in the
underlying production activity. For example, a taxpayer might reasonably anticipate incurring a financial
loss in a tax-subsidized activity when tax incentives are not taken into account. Nevertheless, a taxpayer
that has a genuine interest in the activity will strive to maximize its opportunity for whatever financial
return is possible from the activity and to minimize its financial loss in order to increase its overall gain
when tax incentives are taken into account. In other words, it has a meaningful financial stake in the
success or failure of the activity apart from the tax benefits. Contrast that with X and Investor 2 in this
case who are indifferent to the financial prospects of the production activity (aside from the tax benefits)
because their investment in Taxpayer provided such limited likelihood of any meaningful variation in
financial return from the underlying coal refining activity that we find it implausible that the outside chance
of variability was played any role in their decision to invest. As a consequence, it is more accurate to
characterize X and Investor 2 as merely observers of an activity engaged in by others.
4
While we base our response on the agreed facts as submitted by the Taxpayer and the IRS, we note
that those initial facts appear to have changed shortly after Taxpayer began operations. ----------------------

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TAM-108848-17 14

contract if the operational concerns giving rise to the discount might have been
substantially reduced or eliminated early on in the transaction. Presumably, after the
Electric Company had burned refined coal for a reasonable period of time (assuming
the initial use was successful), its operational concerns would have been reduced
significantly. In addition, as noted above, Electric Company already had the right
throughout the duration of the Refined Coal Purchase Agreement to stop purchasing
refined coal at any time it had operational concerns. It seems reasonable to us that the
ability to save n cents per ton of refined coal during an initial period of the contract,
coupled with a smaller discount that still provided them with a below-market fuel source,
may have been sufficient inducement for Electric Company to agree to a price
adjustment at some point during the term of the contract after their operational concerns
had been addressed.

     We do note that the number of electric utilities available to purchase refined coal

was limited, ----------------------------------------------------------------------------------------------------
----------------------. Therefore, an offer by Taxpayer to share a portion of the value of the
tax benefits with Electric Company (which could not otherwise earn those benefits itself
due to the unrelated purchaser restriction in § 45(e)(8)(A)(ii)(I)) through a re-purchase
price advantage, fees, or other similar arrangements was no doubt helpful in
encouraging Electric Company to participate in the transaction.5 However, we also note
that the only parties to the transaction that did not receive an anticipated financial
benefit6 from the activity were X and Investor 2. Operator, which negotiated the terms
of the transaction with Electric Company and with what was at the time its wholly owned
disregarded entity, Taxpayer, received a markup on its Sub-License to Taxpayer of $qq
per ton of coal refined and sold to Electric Company, and Electric Company received
site lease payments and a profit of n cents per ton of coal sold and repurchased under
the terms of the coal supply and repurchase agreements.

5

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6
We note that Taxpayer did recognize some cost savings from changing chemicals used in the coal
refining process to comply with environmental requirements, but, as we state below, this change was
neither anticipated nor voluntary, and therefore not likely to have been part of the expected return for the
investors prior to the transaction.
TAM-108848-17 15

    Taxpayer argues that Operator, X, and Investor 2 all had unlimited upside

potential at the time the partnership was formed. First, Taxpayer argues that to the
extent Taxpayer was able to manage operating costs (by improving the production
process to reduce the amount of additives needed, negotiating for reduced labor costs,
etc.), Operator, X, and Investor 2 would each enhance their pre-tax return. In addition,
Taxpayer asserts that upon the expiration of the contracts with Electric Company,
Taxpayer could negotiate a new contract with Electric Company on more favorable
terms; after ten years of experience, the refined coal product would be a known
commodity and the risks of using it as a feedstock may disappear7, or Electric Company
could have a greater need for refined coal due to heightened environmental regulatory
standards. Alternatively, at the end of ten years, Taxpayer could relocate the facility to
a new utility and enter into a contract with that utility on more favorable terms. Finally,
Taxpayer points out that Taxpayer could sell the facility, in which case Operator, X, and
Investor 2 would share the proceeds of the sale pro rata. As we explain below, these
arguments do not withstand scrutiny.

    First, Taxpayer vastly overstates its potential for cost reduction. Under any

scenario, Taxpayer was always obligated to sell its product at a predetermined loss to
Electric Company, and was always obligated to pay Operator a mark-up on its use of
the Technology. Taxpayer’s royalty payments and discounts on the sale of refined coal
over the life of the partnership totaled $rr, at rates that were not subject to variation. By
contrast, Taxpayer’s total cash expenses, exclusive of these contractually-guaranteed
expenses, totaled $ss during that same period, and it appears very unlikely that
Taxpayer had a realistic possibility of reducing many of those costs. It seems
improbable that insurance premiums or utility costs, for example, would decrease by
any significant amount (rather than increase) over time. We acknowledge that
Taxpayer could fine-tune its production process to reduce the amount of chemical
additives needed, thereby reducing its costs, and that Taxpayer did in fact succeed in
changing its chemical use and reducing its costs in a year subsequent to the
participation of Investor 1 and Investor 2. However, the necessity of obtaining a new
permit to implement any change and the attendant risks of the permitting process make
it unlikely the parties would have changed chemicals absent the circumstances that
actually unfolded in Taxpayer’s case—that is, a requirement imposed by a regulator to
address environmental concerns. Furthermore, under the payment formula in the Sub-
License royalty agreement between Taxpayer and Operator, those cost savings would
simply result in increasing the royalty payments to Operator until they reached the m
cents per dollar of credit cap, lessening considerably the likelihood that the Investors
would benefit from any reasonably foreseeable cost savings. Although Taxpayer
argues that the royalty payment cap would allow it to share in cost savings, under the

7
We note that despite Taxpayer’s professed optimism about the potential for an increase in the value of
refined coal, Taxpayer did not insist on a price adjustment clause in the Refined Coal Sale Agreement
that would have allowed Taxpayer to share in any such increase in value during the term of the
transaction.
TAM-108848-17 16

formula in the Sub-License, based on Taxpayer’s projections, non-royalty operating
costs would have had to decrease by a substantial percentage in order for the cost
savings to begin to inure to the benefit of the Investors rather than merely increase the
royalty payable to Operator.8 Taxpayer’s own cost projections show that cost savings of
this magnitude were not anticipated. More generally, the royalty formula made it
unlikely that that reasonably foreseeable decreases or increases in operating costs
(excluding the royalty) would affect the amount of losses flowing through to the
Investors.9

Moreover, per Taxpayer’s pre-transaction financial models, the parties were projecting
that the cost of chemical additives used in the production process would increase by tt
percent per year over the ten-year life of the contracts. Although the benefit of hindsight
shows chemical costs could in fact decrease, Taxpayer has put forward no evidence
that the parties gave any consideration to the possibility, let alone likelihood, of a
decrease at the time they entered into the transaction. We are also unpersuaded that
Taxpayer’s ability to renegotiate labor costs after a uu-year period (with vv days’ notice)
was viewed by Taxpayer or its investors as a meaningful source of potential cost
reduction; although Taxpayer has shown that at least one competitor with lower contract
labor costs entered the market, Taxpayer presented no evidence that it ever
contemplated or expected a reduction in labor costs when creating its financial
projections. Furthermore, Taxpayer never actually renegotiated labor costs, even once
it ostensibly had the ability to do so, suggesting that any potential for labor cost savings
was illusory. The reality is that all of the parties (Investors, Electric Company, and
Licensor) had a profitable agreement (including tax credits) that fixed the costs and
profit over ten years using the agreements to each claim a portion of the refined coal tax
credit while providing an acceptable return for each party, and there was little incentive
given the profitability of the transaction to re-open contractual negotiations among the
parties or seek adjustments that would require the review and consent of all of the
parties to the transaction.

8
For example, based on the projections included in -----------------------------------------------------------------------
--of Investor 1, which was included as Exhibit D of the submission for this memorandum, entitled
“Estimated Year2 Operating Results for Investor 1,” non-operating expenses would have had to decrease
by more than h% before the royalty cap was reached.
9
As a result of the royalty formula, non-royalty costs would have had to increase by a substantial
percentage in order for the minimum royalty to apply. Cost increases up to that level would simply result
in an offsetting reduction in royalty payments. For example, based on the projections included in -----------
--------------------------------------------------------------- of Investor 1, which was included as Exhibit D of the
submission, entitled “Estimated Year2 Operating Results for Investor 1”, as well as the projections
provided to Investor 2 before its investment that were included in Exhibit J of the submission, entitled
“Licensor Section 45 Project Financial Model for Implementation at Taxpayer Plant,” concerning projected
increases in non-royalty operating costs, non-royalty costs would have had to increase between n% and
l% in order for the minimum royalty to apply.
TAM-108848-17 17

     Second, we find implausible Taxpayer’s claim that it could have entered into a

new and more favorable contract, either with Electric Company or a new utility, after the
Sub-License, the land lease and the § 45 credit period expire. At that point, Taxpayer
would own nothing more than a 10-year-old facility with no rights to use the Technology
to refine coal and no right to keep the facility on Electric Company’s property. Also at
that point, because there is no longer any need to sell refined coal to an unrelated party
to satisfy the requirements of § 45(e)(8), Operator and Operator’s parent company
(which manages and owns g% of Licensor) would appear to have little incentive to
negotiate favorable terms with Taxpayer (and indirectly with X and Investor 2).
Assuming that refined coal by that point would have sufficient value to justify an
investment without the § 45 tax credit subsidy, Operator could obtain its own license
from Licensor and refine and sell coal directly to a utility, whether Electric Company or a
different utility, or the utility could license the Technology and refine coal itself. Operator
would have no economic incentive to include X or Investor 2 in this new contractual
arrangement. Operator is the managing member of Licensor, which owns the
Technology, and would have no incentive to share the potential for a genuine pre-tax
profit it may receive from royalty payments on a new Technology sub-license. Taxpayer
argued that an already-built (and therefore permitted) facility is a genuine asset, the
possession of which confers at least some bargaining power on Taxpayer to enter into a
new contract with the utility. The permitting process for building a coal refining facility is
fraught with uncertainty and can involve costly hurdles, as regulators may use that
process to impose other regulatory requirements on the permit applicant wholly
unrelated to the refining of coal. Some utilities may be willing to continue to operate the
existing refined coal facility after the 10-year credit period and contracts expire rather
than reopen their permits. We note, however, that Taxpayer’s bargaining power due to
owning a permitted facility remains limited; the facility is located on the utility’s land, the
viability of refined coal as a profitable product remains speculative without the tax credit
or more stringent environmental emission control regulations, and Taxpayer would bear
the costs of dismantling the facility if it cannot sell it.

    Finally, although Taxpayer is correct that upon the sale of the facility the

proceeds would be shared pro rata among Operator, X, and Investor 2, the proceeds
are unlikely to amount to a sum that is significant relative to the parties’ investment.
Coal refining facilities generally consist of relatively inexpensive and readily replaceable
equipment, such as conveyer belts for raw feedstock coal, mixers where chemicals are
added, return conveyer belts for the refined coal, etc. At the end of the contracts with
Electric Company, the facility would have had ten years of wear and tear and a
corresponding decline in value and it would be sitting on land for which the lease had
expired. Therefore, it strains credulity to suggest that Electric Company, Operator, or
any other purchaser would be willing to pay more for the used facility than its original
cost to Operator. Plus, if Taxpayer sought to sell the facility to any purchaser other than
Electric Company, it would face the added cost of dismantling the facility and re-
installation at another site. Thus, assuming a purchaser could be found, any amount of
TAM-108848-17 18

possible profit on this transaction would not be meaningful compared to the substantial
purported tax benefits that X and Investor 2 seek to obtain through this arrangement.

    In short, this is not a case in which the potential for a return on X and Investor 2’s

contributions could vary meaningfully based on the degree of success or failure in
producing refined coal. Instead, from the perspective of X and Investor 2, this
transaction was structured solely to generate tax benefits. Ironically, in fact, under this
arrangement increased sales of refined coal had the perverse effect of decreasing X’s
and Investor 2’s overall financial return. Of course, neither X nor Investor 2 objected to
this arrangement because increased sales of refined coal produced the one thing that
the X and Investor 2 wanted, and the only thing they could receive from the
transaction—tax benefits.

2. Limitations on Risks from Production of Refined Coal

    The parties structured the governing contracts to strictly circumscribe the
   

   Investors’ exposure to unanticipated losses, another strong indication that their intent
   was to purchase tax benefits, not to participate in a refined coal production venture.
   The terms of the Operating Agreement, the site lease, and the Technology Sub-License
   all limited Taxpayer’s operating costs significantly at any time the tax credit was not
   available to offset the partners’ contributions; despite the facility being idled ww% of the
   time, the expenses attributable to those time periods during which the facility was idle
   totaled only xx% of the total operating expenses over the life of Taxpayer. In addition,
   like the coal supply and sale agreements, these agreements were all coterminous with
   the duration of the credit’s availability, guaranteeing that the Investors would not be
   obligated to fund the expense of refining coal unless they were assured of the
   availability of an offsetting credit. Although X and Investor 2 continued to make
   contributions during a period when the facility was idled, they did not do so in an effort
   to earn additional revenue—again, they had no non-tax financial stake in whether
   refined coal was actually produced—they made additional contributions only in the hope
   of additional tax benefits if the facility began production again. Thus, those payments
   were simply additional fees paid for future tax benefits. Moreover, X’s liquidated
   damages provision provided an effective refund right to X on a prorated portion of its
   initial investment should the anticipated credits not materialize, and Investor 2’s
   payment of the bulk of its initial investment with limited recourse debt rather than cash
   also mitigated its exposure to genuine financial risk. Thus, neither X nor Investor 2
   committed capital to the business of producing refined coal. They invested instead only
   in tax benefits, and had no meaningful expectation of risks or rewards from the
   production activity.

B. Substance of the Transaction

   We recognize that our conclusion in this case may seem at odds with the fact

that the activity that Congress intended to incentivize did take place, as refined coal was
TAM-108848-17 19

produced. However, if we assume—without concluding—that the transaction between
Electric Company and Taxpayer amounted to a genuine sale of refined coal to an
unrelated party, we find that X and Investor 2 did not participate directly or indirectly in
the production and sale of refined coal. The totality of facts and circumstances point to
the conclusion that X and Investor 2 entered into the transaction with Taxpayer to
purchase refined coal tax credits and other tax benefits, not to participate in a business
in which Taxpayer would act as a producer of refined coal. All of Taxpayer’s contract
negotiations took place when Operator was its sole owner, and Operator negotiated
these contracts to correlate contribution obligations to tax credit generation, as well as
to eliminate any opportunity for Taxpayer to realize any meaningful risks or rewards
from the sale of refined coal. As the Third Circuit made clear in Historic Boardwalk,
when a partnership’s contracts governing a tax credit-generating activity lie on the
wrong side of “a defensible distribution of risk and reward,” the substance of the
transaction points to a “prohibited sale of tax credits.” In this case, Taxpayer’s various
contracts carefully circumscribed the risk of unanticipated expenditures by X and
Investor 2 while just as assuredly preventing them from enjoying any financial rewards
from the coal refining activity. Therefore, the substance of this transaction, insofar as it
concerns X and Investor 2, was nothing more or less than the purchase and sale of
refined coal tax credits.10

   In sum, we conclude that the parties structured a financial transaction in which

Taxpayer facilitated the improper sale of § 45 tax credits to X and Investor 2. Further,
we reserve for further consideration the possibility that the transaction between Electric
Company and Taxpayer did not amount to a genuine sale of refined coal to an unrelated
party. Accordingly, neither X nor Investor 2 is entitled to claim the tax credits arising
from Taxpayer’s activity.

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the Taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent. An
earlier version of this Technical Advice Memorandum, dated February 10, 2017 (TAM-
136522-15), was revoked prior to its publication.

10
Operator’s parent company, in fact, describes the Investors’ capital contributions as --------------------------

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