United States: FERC And IRS Diverge On Approaches To Tax Equity Investors

Meredith Hiller is an Associate in the Boston office

The Internal Revenue Service (IRS) and the Federal Energy Regulatory Commission (FERC) have recently taken different approaches to issues raised by tax equity investors that have invested specifically in renewable energy projects or in companies engaged in electric energy generation from renewable resources.

FERC said on Wednesday that tax equity investors in public utilities needn't seek authorization from FERC under Section 203 of the Federal Power Act (FPA) to make their investments, something many investors had sought out of an abundance of caution. A group of renewable energy investors had filed a petition in December, 2016, seeking a declaratory order that their tax equity interests did not constitute voting securities under the FPA, and therefore they did not need advance FERC authorization, and that a holding company has blanket authorization under FERC regulations to acquire such interests.

FERC relied on the fact that the petitioners' equity investments are passive investments that do not assert day-to-day control of the utility, and on its 2009 order in AES Creative Resources LP et al., where it found tax equity investments in utilities do not assert day-to-day control over the utilities for purposes of Section 205 of the FPA, governing electricity rate-making and sales. Although that finding was under Section 205 of the FPA, FERC focused on the fact that both Sections 203 and 205 address whether the interests give the holders control over the company's activities, or whether they are passive, and saw no reason not to apply the findings under Section 205 to the similar factual situation that arose under Section 203.

However, FERC was careful to limit the tax equity investors' activities to the general definition of a "passive investor" as set out in earlier FERC orders – the investors can only have rights that do not hand them day-to-day control of the company. Clarity on the issue of Section 203 approval from FERC should help tax equity investors, who are generally very cautious, continue to invest in renewable energy projects, and benefit from the federal investment tax credit and production tax credit. Since Section 203 approval could take a few months, it delayed project development, and should allow projects to move ahead at a faster pace.

In contrast to the FERC order, which should stimulate renewable energy project growth, the IRS issued a Technical Advice Memorandum in late July denying claims of two tax equity investors for energy tax credits, suggesting that the IRS is reviewing renewable energy investments with a higher level of scrutiny than before. This may have the opposite effect of chilling renewable energy investment, if the IRS memorandum sufficiently unnerves tax equity investors.

The tax equity investors had claimed credits under Section 45(e)(8) of the Internal Revenue Code on the basis of their interests in a joint venture that owned two production facilities making refined coal. The credits are usually available to valid partners for U.S. federal tax purposes, provided the arrangement furthers the purpose for which the credit was enacted, in this case the production of refined coal.

In this case, an operator designed and constructed two refined coal facilities, and then contributed them to a wholly-owned limited liability company that the investors bought interests in, and which then constituted a partnership for U.S. federal tax purposes. The LLC operating agreement allocated partnership tax items among the owners (the operator and the investors) on a pro rata basis, and the joint venture made royalty payments to the operator under a sub-license agreement based on the value of the tax credits produced by the facilities. The joint venture also entered into a supply agreement to purchase feedstock coal from an electric company at cost, and the electric company agreed to purchase the refined coal at a price discounted from the feedstock coal price.

The facilities were less than successful, however, sometimes not producing for months at a time, and ending production permanently in the fifth year of operation. Despite this performance, the investors received tax benefits well in excess of their capital contributions, including tax losses, depreciation and credits.

The IRS found that the parties facilitated the improper sale of Section 45 tax credits – a finding usually based on an IRS decision that a taxpayer is not a partner. However, the IRS specifically denied finding the investors were not partners, the entity was not a partnership, or that pre-tax profit potential was required, even though it reviewed the transaction based on factors that would usually align with such findings.

Strangely, the IRS began its analysis with the assumption that taxpayers may not sell federal tax benefits, citing Historic Boardwalk Hall LLC v. Commissioner, but the prohibition on such a sale is not the basis of the holding in Historic Boardwalk.  In that case, the Third Circuit ruled an investor was not a bona fide partner for U.S. federal tax purposes because the agreements governing the transaction ensured the investor would receive Internal Revenue Code Section 47 rehabilitation tax credits and a preferred return without any meaningful downside risk or upside potential with respect to the underlying economic venture.

The IRS did compare the refined coal arrangements to the transaction in Historic Boardwalk, finding that the parties created a similar situation – one where the investors faced gain, but very little risk of loss. The agreements with the electric company appear to be key to the IRS finding, however, since they allowed joint venture to incur small, limited losses from the discounted sales of the refined coal, but no benefit if the market for coal changed.

The approach to reviewing this renewable energy transaction raises the specter of increased IRS scrutiny of transactions with a renewable tax credit component, possibly leading tax equity investors to be more cautious when structuring such arrangements, even while some tax equity investors now have comfort that FERC need not approve their investments under Section 203 of the FPA.

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