In a highly-anticipated Technical Advice Memorandum (TAM) dated March 23, 2017 and released on July 21, 2017, the Internal Revenue Service (IRS) ruled that two taxpayers who had invested in a Limited Liability Company that owned and operated a refined coal facility (the LLC) were not entitled to refined coal production credits they had claimed because their investment in the LLC was structured “solely to facilitate the prohibited purchase of refined coal tax credits.” This analysis marks a departure from the position staked out by the IRS in a number of recent refined coal credit cases, which focused on whether taxpayers claiming refined coal credits were partners in a partnership that owned and operated a refined coal facility.

Congress enacted the refined coal production tax credit under Internal Revenue Code (IRC) section 45(c)(7) and (e)(8) to encourage investment in the development of refined coal facilities and the use of refined coal, which would otherwise be unprofitable. In the current technological and regulatory environment, it is generally not possible to produce and sell refined coal at an economic (i.e., pre-tax) profit. Having determined that the burning of refined coal by coal-fired utilities would be beneficial, and recognizing these economic facts, Congress enacted the refined coal production credit. To advance Congress’s intent, the Obama Administration promoted investment by non-traditional energy investors using “tax equity structures.” Indeed, the Department of Energy endorsed the use of tax equity structures to raise capital from investors for clean energy projects. See, e.g., White House Tax Equity Seminar: Maximizing Incentives from Renewable Generation: Best Practices and Financial Opportunities from Renewable Energy Tax Credits (Mar. 13, 2012). Through these actions, the government has attempted to create a refined coal industry, using the tax credit to incentivize investments in clean energy that otherwise would never have been made.

Under IRC section 45, a taxpayer must satisfy four requirements to qualify for the refined coal production tax credit: (1) refined coal must be produced by the taxpayer from feedstock coal; (2) the refined coal must be sold to an unrelated person with the reasonable expectation that it will be burned to produce steam; (3) refined coal must produce a 20 percent reduction of NOx and a 40 percent reduction of mercury or sulfur dioxide; and (4) the refined coal facility must have been placed in service before January 1, 2012. In general, the IRS has not challenged taxpayers’ compliance with these conditions. Instead, typically the IRS has challenged claimed refined coal credits on substance-based arguments relating to the structures by which investors invest in refined coal facilities.

In previous cases involving the refined coal credit, the IRS based its analysis on the Supreme Court’s opinion in Commissioner v. Culbertson, 337 U.S. 733 (1949), and three “informative” circuit court opinions: TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (“Castle Harbour”), Virginia Historic Tax Credit Fund 2001 L.P. v. Commissioner, 639 F.3d 129 (4th Cir. 2011), and Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012). Applying its interpretation of those opinions, the IRS typically concluded that taxpayers claiming the refined coal credit by reason of investment in an entity that owned and operated a refined coal facility were not “partners” in a “partnership” and, as such, were not entitled to the credit.

In the TAM, the IRS approached the issue from the perspective of the Third Circuit’s opinion in Historic Boardwalk. In that case, according to the IRS, claimed IRC section 47 rehabilitation credits were denied on the ground that the investments of the taxpayers claiming the credits were structured in such a way that they had no “meaningful financial stake in the success or failure of the activity apart from the tax benefits.” Analyzing the various agreements governing the LLC’s operation of the refined coal facility in question and the taxpayers’ investments in the LLC, the IRS found that there was only a “limited likelihood of any meaningful variation in financial return from the underlying coal refining activity.” This, according to the IRS, was fatal to any claim by the taxpayers to refined coal credits related to the LLC’s production of refined coal.

The IRS acknowledged 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 produced.” However, noting the “totality of facts and circumstances,” the IRS found that the taxpayers in question “did not participate directly or indirectly in the production and sale of refined coal,” which led to the conclusion that the taxpayers “entered into the transaction with [the LLC] to purchase refined coal tax credits and other tax benefits, not to participate in a business in which [the LLC] would act as a producer of refined coal.”

While the approach taken by the IRS in the TAM focuses on whether taxpayers engaged in a prohibited purchase of tax benefits, as opposed to being participants in the LLC’s refined coal business, it may be premature to conclude that the IRS has moved away from its partnership-based analysis entirely. In the opening footnote to the TAM, the IRS notes that “[b]ecause we conclude that the [taxpayers] engaged in the prohibited purchase of tax benefits, we do not reach the issue posed to us of whether the [taxpayers] are bona fide partners in [the LLC], or whether [the LLC] is a bona fide partnership.” Moreover, much of the IRS’s discussion of the factors that led it to conclude that the taxpayers had purchased tax benefits rather than participated in a refined coal business is based on the same factors that it has relied on in its prior partnership-based analyses.

It does seem, though, that the IRS is moving toward an analysis in which direct or indirect participation in the coal refining business is a significant factor in determining eligibility for the credit. This is at least suggested by the IRS’s observation that “[i]t 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.” An investor’s potential for pre-tax profit was a prominent feature of many of the IRS’s partnership-based analyses. Instead, the IRS seems to be saying, the key factor is “a meaningful stake in the success or failure of the activity apart from the tax benefits.” In the TAM, this approach led the IRS to conclude that the taxpayers had only a “limited likelihood of any meaningful variation in financial return from the underlying coal refining activity,” and “[a]s a consequence, it is more accurate to characterize [the taxpayers] as merely observers of an activity engaged in by others.” Accordingly, the IRS determined that the taxpayers are not entitled to the claimed refined coal credits.

Practice Point: The IRS has been struggling with the tax ramifications of refined coal transactions. As in other areas of tax law, the IRS’s position on individual cases seems to fly in the face of congressional intent: to encourage the development and use of emissions-reducing coal technologies by creating incentives for investment in such technologies. Here, the IRS ruled that the two taxpayers were not entitled to the claimed credits because it concluded that they had no real economic interest in the transaction, but it appears possible to structure such transactions to provide participants with a level of economic interest that would satisfy the IRS.