Attached are two decisions from the United States Court of Federal Claims, California Ridge Wind Energy LLC, v. United States of America, No. 14-250 C (reissued June 20, 2018) and Bishop Hill Energy LLC, et al. v. United States of America, No. 14-251 C (reissued June 20, 2018), involving grants pursuant to Section 1603 of Division B of the American Recovery and Reinvestment Act. In substantially similar opinions, the court denied the plaintiff’s request for an additional Section 1603 grant and granted the government’s counterclaim to recover an overpayment of the Section 1603 grant. Although the results in the cases have been known for some time, the publication of the opinions was delayed for several months.
In the cases, the plaintiff constructed a wind facility and applied for a Section 1603 grant payment from the Treasury in an amount equal to 30 percent of the wind facility’s eligible cost basis. The Treasury awarded the plaintiff a reduced amount, after which the plaintiff filed a complaint that demanded damages in the amount of the alleged underpayment. The defendant filed a counterclaim seeking recovery of an alleged overpayment of the Section 1603 grant. At issue was the use of a fee for development services (defined as a “Development Fee” in the opinions).
Before describing the holdings in detail, some background on two aspects of tax equity structuring will be helpful. First, as a general matter, the fair market value of a renewable energy project will exceed the sponsor’s out-of-pocket cost to construct the project. That excess is sometimes called the “developer profit” or “developer premium”, which represents the profit the sponsor would realize if it sold the project outright. Most partnership flip transactions involve a transaction pursuant to which (i) the sponsor or a related party realizes that the developer profit in a fully taxable transaction and (ii) the partnership obtains a fair market value basis in the project (i.e., a basis “stepped up” to fair market value). One common way to structure the basis step-up is by means of a development fee. Another common structure involves a sale of the project to the tax equity partnership. Other variations exist.
Second, in many tax equity structures, the basis step-up transaction may result in a feature referred to as “circular cash flows” or “round-tripping of cash”. This happens because the sponsor (or a related entity) will make a capital contribution to the partnership, and the partnership will in turn pay consideration to the sponsor (e.g., a development fee or project purchase price). Accordingly, it is possible to view a portion of the cash as moving from the sponsor to the partnership and back again from the partnership to the sponsor. Although some uses of the terms “circular cash flows” and “round-tripping of cash” may have pejorative connotations, the phenomenon is common in a variety of commercial contexts, including in transactions between affiliated entities.
The Court of Federal Claims concluded that Section 1603 permits an applicant to include a Development Fee as a part of a wind project’s cost basis and that Development Fees could increase the Section 1603 grant awarded by the Treasury. However, the court also concluded that the plaintiff did not substantiate the Development Fee, the plaintiff was not entitled to the alleged underpayment of the grant attributable to the Development Fee, and the defendant was entitled to the alleged overpayment of the grant attributable to the Development Fee.
The court’s analysis is cursory and opaque. Notwithstanding that Section 1603 generally incorporates concepts and definitions applicable to the investment tax credit (“ITC”) under section 48 of the Internal Revenue Code of 1986 (the “Code”), the court cited no sections of the Code in its analysis. (The only two cites to the Code were general in nature.) This failure is hard to explain. Furthermore, the opinions do not clearly specify the tax classifications of the relevant parties (including whether any of the entities are disregarded), which are facts that are essential to the analysis. Instead, the court simply held that each Development Fee transaction was a sham transaction that lacked a business purpose and economic substance, stating:
In sum, plaintiff 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.
It appears that the holdings depended crucially on the related party nature of the transactions—specifically, the fact that the recipient of the Development Fees was related to the tax partnerships that paid the Development Fees. It also appears that the court felt that the plaintiff failed to adequately substantiate the value of the development services provided, but it did not indicate what would have constituted adequate substantiation. Furthermore, although the court noted that cash was round-tripped in the relevant transactions, the opinions did not explain the significance of that fact to the analysis. Accordingly, the precise basis for the holdings, and therefore the potential application of the holdings to other transactions, is not entirely clear. In particular, it is unclear to what extent the round-tripping of cash (a relatively common feature in tax equity financings, not to mention in many routine intercompany transactions) would be relevant in the court’s evaluation of other transactions.
Although sponsors typically make a representation as to the amount of the ITC-eligible basis in a project, investors also have an interest in ensuring that the claimed amount of the ITC-eligible basis will be respected by the IRS. Accordingly, in any structure that does use a development fee, the participants should ask the appraiser for a detailed analysis as to whether the amount of any development fee is appropriate in relation to the development services provided. Although the Court of Federal Claims did conclude that development fees could be included in basis in the right circumstances, sponsors and investors may wish to consider whether to opt for basis step-up structures that do not use developer fees (e.g., structures that use project sales). Finally, where possible, sponsors should consider putting in place organizational structures that may make it harder for the IRS to assert that cash is being round-tripped.