Tax Court Opinion Brings Relief to Tax Incentive Practitioners

Published by Brad Stanhope on Tuesday, November 5, 2019
Journal cover thumb November 2019

When the U.S. Tax Court finally released a bench opinion Sept. 4 in the closely watched Fidelity Investments tax credit case, the tax incentive community was relieved.

It was good news.

More importantly, it wasn’t terrible news.

The case, formally called Cross Refined Coal LLC, USA Refined Coal LLC Tax Matters Partner vs. Commissioner of Internal Revenue, involved an appeal of an Internal Revenue Service (IRS) decision to deny Fidelity Investments millions of dollars in production tax credits (PTCs) in 2011 and 2012. The IRS based its decision on the belief that the investor partnership was created to “facilitate the prohibited transaction of monetizing refined coal tax credits” and lacked both upside potential and significant downside potential.

The U.S. Tax Court disagreed and granted the credits, bringing a sigh of relief from the tax incentive world.

“Based on the facts as presented by the decision, it’s not a surprising outcome,” said Scott Lindquist, a partner at Dentons in Chicago. “Perhaps it’s surprising that the IRS went after this investment as aggressively as it did, given the facts. Had the IRS prevailed, it would have called a lot of what we accept as settled law into question.”

Lindquist wasn’t alone. Jerry Breed a principal at Miles & Stockbridge in Washington, D.C., echoed his sentiments.

“If the court had come out the other way, it would have been disastrous,” Breed said. “Now, we can continue to rely on the result reached by the 1995 Ninth Circuit decision in Sacks v. Commissioner. [An alternate decision] would have been catastrophic.”

The implications of the decision, though, are limited because of the form by which it was issued.

The Case

Fidelity Investments invested in a company that engaged in the production of refined coal at three power plants in South Carolina, which treated coal with chemicals to cut mercury and smog pollution. The PTCs were an important part of the transaction, since Congress created the PTCs to offset the expense of removing the pollutants and later amended the statute to remove a requirement that the refining enrich the value of the refined coal.

“The economics of the Fidelity Investments transaction were that the coal refiner purchased coal for $1 and sold it back to the utility for 75 cents,” Breed said. “Mathematically, it’s impossible to make an economic profit without the tax credit. The more coal you refine, the more money you lose. Outside a small handful of tax-incentivized transactions, a taxpayer must have an intent to make a profit to claim tax benefits, but with refined coal, it’s solely the tax credit that gives you profit.”

Still, the IRS disallowed millions of dollars in tax credits and losses claimed by the partnership, ruling that there was no upside benefit nor any material downside risk, and that the partnership was created simply to facilitate monetizing the credits. Among other things, contrary to the Sacks opinion, the IRS argued that tax credits could not be included as part of the potential upside to the investors.

“The IRS took a pretty aggressive position,” Lindquist said. “The facts were different from the [landmark] Historic Boardwalk Hall case, where the IRS went after a situation where the investor put money in, got out a fixed amount [primarily the tax credits] and there was no financial upside or downside.”

In the Fidelity Investments case, the U.S. Tax Court agreed with that assessment.

The Ruling

After hearing arguments at the appeal hearing in Boston, Judge David Gustafson ruled that the investors were bona fide partners, that there was both an upside potential and a downside risk, and then highlighted the fact that credits were PTCs rather than investment tax credits. He sided with the investors.

Much of the decision’s rationale was based on the Sacks ruling that established that, “[W]hen Congress creates a tax credit for participating in a particular activity that would otherwise be uneconomical without the credit, the economic substance of the activity should be evaluated to include the credit.” In other words, the evaluation of the profits of the enterprise should include the credit.

In addition, the court ruled against the IRS concerning the presence of downside risk, based in part on the fact that the investors put in large amounts of money to cover operating losses and other costs that were never recovered, and in part on the potential loss of PTCs, which depended on the amount of coal produced (which turned out to be much less than anticipated).

Importantly, the court recognized that the Congressional intent was to provide an incentive to an otherwise unprofitable venture, that the tax credits were part of the return to the investors and that the risk of loss or reduction of the credits was an element of downside risk to the investors.

The decision was no surprise to Breed and Lindquist, starting with the production credit reasoning.

“[The decision] recognized that the refined coal credit is a production credit, not an investment credit,” Breed said. “In this case, the taxpayer earns more credit the more coal that is refined.”

Lindquist said that by their nature, PTCs generally involve a downside risk, because production can be lower than anticipated. When the court determined that the credits should be considered a part of the investor’s return, it gutted one of the IRS’s arguments.

“One other positive of this case is that it provides a guide list of good facts that help support a favorable ruling,” Lindquist said. “The court laid out a variety of factors that represented elements of risk to the investors, which practitioners may find helpful in future cases where the IRS might challenge an investor’s claim to tax credits.”

The Reaction

While Breed and Lindquist heralded the decision, both emphasized that its form diminished its precedential value.

“The joy with which it was received may be overstated,” Breed said. “First, a bench opinion, given verbally, is a relatively unusual way of announcing a decision. The tax credit court has two typical ways to make decisions. First, an opinion of the tax court, which is a precedent and carries more significance. Second is a tax court memorandum, which is the application of law to a factual situation. It is less important, with less precedential value. This was an oral opinion, not even a memorandum decision.”

Lindquist agreed–and went a bit further:

“One of the things important to note is that the case has no actual precedential value,” Lindquist said. “It’s like an IRS private letter ruling (PLR). In fact, in some ways it’s less useful than a PLR, because a PLR comes from the IRS and you can see what the IRS’ position is and what you’re allowed to do. This case is the opposite–the IRS took an aggressive position and lost, so you don’t really know how this will affect their position in future situations.”

The Bottom Line

Despite the lack of setting a precedent, both Breed and Lindquist said the Fidelity case was important, mostly because of what it didn’t do.

“Congress repealed the need for the profit motive for the refined coal credit and the court held that Congress’s intent should be followed,” Breed said. “I’m happy the court reached the result it did. ... It decided that Congress shouldn’t take away with one hand what it gave with the other. An adverse decision would have gone against the Tax Court’s history of upholding the Sacks rationale.”

Lindquist agreed.

“I think there are several things to take away as positives,” Lindquist said. “One is that it’s an expressed recognition that in a tax case involving a credit that is designed to take the place of an economic benefit, you can’t ignore tax credits. Had the court ruled for the IRS, it would have been a rejection of the rationale in Sacks, which is an important underpinning for most tax credit programs–that the credits should be included in the evaluation of the upside potential of an investment. The fact that the IRS argued that the investments here were a sham and that only pretax benefits can be considered, when the credits were specifically designed to make up for a gap in economic returns, is surprising.”

Next Steps

With a strong ruling, it seems unlikely the IRS will appeal the case.

“I would hope not,” Breed said. “It was a convincing opinion.”

Lindquist, however, looked at the decision not so much for what the court said, but for what the IRS claimed. And that’s not all good.

“It’s not a precedent because of the nature of the opinion,” Lindquist said, “but you can look at it as part of a trend of the IRS getting really aggressive on credits, and that could be a source of concern for the tax credit industry.”