Coal-Seam Tax Credits Now More Readily Salable

Keith Martin

he Internal Revenue Service supplied an- T swers in a number of rulings this year to many hard questions that developers ask when trying to structure projects to take advantage of Section 27 tax credits.

- - . Internal Revenue Service supplied answers in a

series of rulings this year to many hard questions I . .

Credit Has Changed through Time The Section 27 tax credit is a credit that

Congress enacted in 1980, after the Arab oil embargo, as an inducement for Americans to look for fuel in unusual places. The credit was originally three dollars for the equivalent of each barrel of oil a person produced in alterna- tive fuels. The amount is adjusted each year for inflation. By 1795, it worked out to $1.005 per million BTUs of gas produced. The inflation adjustment is announced each April for the year before. Thus, the 1996 figure will not be known until April 1777.

The credit used to apply to a larger number of fuels than it does today. Gas from coal seams, tight-sand formations, Devonian shale, geopres- sured brine or biomass, as well as synthetic fuels from coal, still qualify for credits through De- cember 2002. However, they must come from a well or facility put into service between 1780 and 1772. The producer must sell the fuel to an unrelated party.

Newer projects qualify for credits on the fuel they produce through 2007. “New” means put in service since 1773. However, only two kinds of new projects qualify for credits: projects that produce gas from biomass or synthetic fuels from coal. Nevertheless, this has not stopped an

active market from developing tax credits on fuels from older projects. The owners of the gas rights of these projects frequently try to figure out ways to “sell” tax credits that they are unable for various reasons to use.

Coal-Seam Gas Plays Large Role in Credits

The last year for new coal-seam gas projects was 1992. However, credits from these projects remain in demand. The reason coal-seam gas was cut out was opposition from the “tnie” natural gas producers, who did not want addi- tional gas coming into the market at a time when prices were depressed. In spite of today’s gen- erally higher prices, there is no movement to restore the tax credit for coal-seam gas.

In spite of today’s enerally higher prices, there is no movement

to restore the tax credit for coal-seam gas.

Probably half the gas-tax credits that are being sold on the market are from coal-seam projects. Second, there were seven rulings this year confirming that essentially people can sell tax credits to others who need them, and most of those rulings dealt with coal-seam projects. This is not because most of the credits on the market are coal-seam projects, but because the larger projects, in terms of dollar volume, are coal-seam projects. Landfill gas projects may be more numerous, but they are smaller. One must

Keith Martin is a partner in the Washington, DC, office of the law firm of Chadbourne & Parke LLP.

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package a number of them together to have anything useful to sell in the market.

The seven rulings are likely to cause more producers to decide to sell their credits, because there does not have to be much change in the project in order to strip out the credits. In the past, people worried that the producer had to sell eveytbing-he had to sell the gas rights, and he had to sell the equipment. There were constraints on the role the producer would play going forward. However, these most recent rulings show that very little needs to change. One can almost strip the tax credits and sell them.

There is more good news about the credit: Congress extended old landfiill gas and other deadlines for the credit in a rider to a minimum wage bill in early August. President Clinton signed the bill on August 20. The new deadlines are December 31, 1996, for signing binding contracts for any remaining projects, and June 30, 1998, for placing all remaining projects in service.

Gasification Rules Remain Tight There was talk at one point of relaxing the

rule that the fuel producer must sell the fuel to an unrelated party to qualify for tax credits. The proposal was to let the same company that produces the fuel use it to generate electricity, provided the electricity is sold to an unrelated party. However, this proposal was dropped after stiff opposition from the Treasury Depart- ment.

The IRS intends to attack transactions where a company is already using fuel in one form- for example, wood waste or coke-but realizes it could qualify for large tax subsidies by first gasifying the fuel and then burning the gas rather than the fuel directly. It brings in an unrelated party in an artificial capacity to ensure there is an unrelated-party sale. Treasury offi- cials consider such transactions abusive. This is because they result in loss of government rev- enue with no real increase in the supply of

alternative fuels. The government insisted it needed the unrelated-party sale rule in order to attack such transactions.

Contract Requirements Eased Project developers face an immediate dead-

line this December to sign binding written contracts for all remaining projects they want to qualify for tax credits.

“Binding written contract” is a term of art. There is a body of court cases and IRS rulings going back at least 30 years about what a contract must say in order to be considered “binding” for tax purposes. For example, the contract cannot limit the damages the parties must pay if the contract is later canceled, or if it does, the limit cannot be less than 5 percent of the total contract price. All key terms of the business deal must be clear from the contract; key terms-like price, equipment specifica- tions, and performance dates-cannot be left to be determined later. There cannot be conditions to performance, unless they are outside the control of the parties. A contract that binds the buyer to install ten wells and gives him the option of purchasing another five is only bind- ing for the first ten wells.

Many developers ask what kind of contract must be signed by December-a contract to do what? The IRS made its view clear this year in several private letter rulings. It wants to see a contract between the fuel producer and a third party to install the landfill gas collection system or other facility that will produce the fuel. A contract with a municipality where a developer acquires the gas rights in exchange for a prom- ise to control landfill gas is insufficient.

The IRS said in two private rulings that it will not treat a contract as binding if it is between related parties. It is too easy for the parties simply to ignore the contract later.

Must Be “Economic Interest” Probably the biggest development this year-

after the news that Congress extended the tax credit-is that the IRS said in a series of rulings

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that it is willing to allow fuel producers who cannot use tax credits essentially to sell them to others who can use them. The IRS issued at least seven private rulings in which the agency blessed a structure for stripping tax credits that many developers would have regarded as aggressive as recently as a year ago.

The rulings all involve variations on the same theme. In each case, a fuel producer sold the “working interest”-or rights to remove gas-to a taxpayer who wanted the tax credits in exchange for a small, cash down payment and recourse note for the balance. The note was not for a specific dollar amount, but rather the buyer promised to pay the producer as much as 100 percent of operating profits from the project plus a fixed percentage o f the Section 29 tax credits the buyer receives for a set number of years. (In some cases, only the note to share value from Section 29 tax credits is recourse.)

The payments stop after a year-for ex- ample, 2006-when production is expected to have used up 80 percent of the reserves that were estimated to have been in the ground at inception. In each case, the taxpayer also repre- sented that the gas still remaining in the ground after the payments stop is expected to be worth at least 5 percent of the total value of the reserves on a net present value basis.

This structure appeals to gas producers lxcause there is little change in practice in their status-all that occurs is a sale of Section 29 tax credits for a cash down payment plus part of the value over time of the tax credits. The buyer hires the producer to continue operating the gas wells. The gas producer often has an option to buy hack the working interest after payments on the note stop. The option price is fair market value at time of exercise o f the reserves that still remain out of the original estimate. The IRS said it would let the producer hold back from the transaction any gas above the original estiinate of what is in the reserve. This gas remains property o f the producer.

By law, anyone with an “economic interest”

in gas must share in the tax credits. A person has an “economic interest” in gas if he must look solely to the gas to recover his investment. In this case, the producer retains no economic interest because the producer can theoretically receive more than the gross revenues from gas sales. This is true for three reasons. First, each note is set up so that the buyer is required to pay a fixed amount per million BTUs of gas pro- duced. However, the rate at which the amount is paid is a percentage of operating profits. Second, the note also represents a sharing of benefits from the Section 29 tax credit-this is on top of payments of operating profits. Third, the note is at least partly recourse.

Profit May Be Required A question that continues to nag many

developers is whether their projects must show a profit, apart from tax benefits, in order to qualify for Section 29 tax credits.

In one private ruling this year, the IRS made the taxpayer represent that a landfill gas project “is expected to produce an economic profit for [the taxpayer] in excess of any tax benefits associated with the Section 29 tax credit.” The ruling involved a case where a factory had acquired the gas rights and installed a collection system at a nearby municipal landfill. It was using the gas itself. A buyer approached the factory about taking over the gas rights and the collection system and selling the gas to the factory, presumably at a price that took into account Section 29 tax credits that had previ- ously gone unused. The Factory owner did not qualify for credits because gas was not being sold to an unrelated party.

in a s e r i e s at it is willing

Ily to set! - . .

The IRS said it would let the buyer take tax credits, but only on condition that the transac- tion serve some business purpose other than stripping tax benefits. This approach is consis- tent with what IRS officials say privately is their position on whether a profit is required. As a rule, a profit apart from tax benefits is not

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required. The credit is supposed to induce people to do what they would not do if left to market forces. Presumably, there is no profit in producing these fuels without the subsidy. How- ever, the IRS will not say this publicly because it wants to reserve the fullest possible arsenal to attack transactions that simply create tax ben- efits, where there were none previously, with- out increasing the supply of fuel.

The private ruling where the taxpayer had to represent that he expected a business profit was a transaction where the parties were arguably restructuring merely to create tax credits. How- ever, it helped show a real business purpose that the buyer planned to take over operation of the collection system from the factory using the buyer’s own employees. It also helped that the buyer was already in the landfill gas business.

Expansion Wells The IRS threw cold water this year on the

idea that producers can claim tax credits on gas from expansion wells that are put in service after June 30, 1998.

Developers often ask: What happens where a landfill gas facility is put in service by the deadline, but more wells are added to the collection system later-does gas from these expansion wells qualify?

The IRS position is that gas from “replace- ment wells” qualifies. A replacement well is a new well to replace a well that became clogged or damaged; it draws gas from the same area as the well it replaces. However, this year the IRS

national office refused to rule concerning whether gas from additional wells-added after June 1998 to a landfill gas collection system that went into service earlier-will qualify for tax credits. The IRS seemed at first to feel that gas from such wells that were part of the original “footprint” for the landfill would qualify. However, it later backed off.

The IRS also refused to rule whether gas from wells added since 1993 to a collection system that went into service earlier-in other words, added to an older project that qualifies for tax credits only through 2002--qualifies for tax credits through 2007. There was a split in the national office among three positions. One view was that the gas should qualify for tax credits through 2007. Another was that it should qualify only through 2002. Another was that there are no credits allowed on this gas because it is from wells that are part of an older system but installed after the deadline for placing the project in service.

However, in August the IRS released a ruling showing how to make all gas from an older project qualify for credits through 2007. The taxpayer bought an old collection system and upgraded it. The amount he paid for the existing equipment was “approximately” 10 percent of the total cost of the used equipment and the upgrades combined. (The IRS was also im- pressed that the upgrade was expected to increase gas production more than 25-fold.) The IRS viewed the collection system, after the upgrades, as an entirely new facility.

14 NATURAL G A S OCTOBER 1996 0 1996 John Wiley & Sons, Inc.