Tuesday, April 3, 2018
The Congress, through numerous tax and other legislative bills that have been enacted since the 1970s, has provided numerous subsidies designed to stimulate the production, sale and use of alternative fuels. In addition to the production-related subsidies, alternative fuel infrastructure subsidies also exist. In addition to the tax subsidies, Title IX of the 2014 Farm Bill included $694 million of mandatory funding and $765 million of discretionary funding for biofuels. In addition to tax subsidies and other funding mechanisms, the Renewable Fuel Standard provides preferential treatment for corn and soybean production. Many farmers, particularly in the Midwest, view the credits as important to their businesses (by removing supply and creating demand) and as an investment opportunity (“fueled” as it is, by government mandates).
The Internal Revenue Code (Code) provisions concerning the tax credits for alternative fuels are complex and must be precisely followed. The fact that many of these credits are refundable (can reduce the tax liability below zero and allow a tax refund to be obtained) increases the likelihood of fraud with respect to their usage. As a consequence, the IRS can levy huge penalties for the misuse of the credits. A recent federal case from Iowa illustrates how the alternative fuel credit can be misused, and the penalties that can apply for such misuse.
The alternative fuel credit – that’s the topic of today’s post.
The Alternative Fuel Credit
Section 6426 of the Code provides for several alternative fuel credits. Subsection (d) specifies the details for the alternative fuel credit. The initial version of the credit was enacted in 2004 as part of the American Jobs Creation Act of 2004. That initial version provided credits for alcohol and biodiesel fuel mixtures. In 2005, the Congress added credits to the Code for alternative fuels and alternative fuel mixtures. The credits proved popular with taxpayers. During the first six months of 2009, more than $2.5 million in cash payments were claimed for “liquid fuel derived from biomass.” That’s just one of the credits that were available, and the bulk of the $2.5 million went to paper mills for the production of “black liquor” as a fuel source for their operations (which they had already been using for decades without a taxpayer subsidy). The IRS later decided that “black liquor” production was indeed entitled to the credit because the process resulted in a net production of energy. C.C.M. AM2010-001 (Mar. 12, 2010). However, later that year new tax legislation retooled the statute and removed the production of “black liquor” from eligibility for the credit.
As modified, I.R.C. §6426(d) (as of 2011) allowed for a $.50 credit for each gallon of alternative fuel that a taxpayer sold for use as a fuel in a motor vehicle or motorboat or sold by the taxpayer for use in aviation, or for use in vehicles, motorboats or airplanes that the taxpayer used. In addition, an alternative fuel mixture credit of $.50 per gallon is also allowed for alternative fuel that the taxpayer used in producing any alternative fuel mixture for sale or use in the taxpayer’s trade or business.
For purposes of I.R.C. §6426, “alternative fuel” is defined as “liquid fuel derived from biomass” as that phrase is defined in I.R.C. 45K(c)(3). I.R.C. §6426(d)(2)(G). “Liquid fuel” is not defined, but the U.S. Energy Information Administration defines the term as “combustible or energy-generating molecules that can be harnessed to create mechanical energy, usually producing kinetic energy [, and that] must take the shape of their container.” An “alternative fuel mixture” requires at least 0.1 percent (by volume) (i.e., one part per thousand) of taxable fuel to be mixed with an alternative fuel. See Notice 2006-92, 2006-2, C.B. 774, 2006-43 I.R.B. §2(b). An alternative fuel mixture is “sold for use as a fuel” when the seller “has reason to believe that the mixture [would] be used as a fuel either by the buyer or by any later buyer. Id. In other words, a taxpayer could qualify for the alternative mixture fuel credit by blending liquid fuel derived from biomass and at least 0.1 percent diesel fuel into a mixture that was used or sold for use as a fuel, once the taxpayer properly registered with the IRS. I.R.C. 6426(a)(2).
In Alternative Carbon Resources, LLC v. United States, No. 1:15-cv-00155-MMS, 2018 U.S. Claims LEXIS 189 (Fed. Cl. Mar. 22, 2018), the plaintiff was a Pella, IA firm that produced alternative fuel mixtures consisting of liquid fuel derived from biomass and diesel fuel. The plaintiff registered with the IRS via Form 637 and was designated as an alternative fueler that produces an alternative fuel mixture that is sold in the plaintiff’s trade or business. Clearly, the plaintiff’s business model was structured around qualifying for and taking advantage of the taxpayer subsidy provided by the I.R.C. §6426 refundable credit for alternative fuel production.
To produce alternative fuel mixtures, the plaintiff bought feedstock from a supplier, with a trucking company picking up the feedstock and adding the required amount of diesel fuel to create the alternative fuel mixture. The mixture would then be delivered to a contracting party that would use the fuel in its business. The plaintiff entered into contracts with various parties that could use the alternative fuel mixture in their anaerobic digester systems to make biogas. One contract in particular, with the Des Moines Wastewater Reclamation Authority (WRA), provided that the plaintiff would pay WRA to take the alternative fuel mixtures from the plaintiff. The plaintiff’s consulting attorney (a supposed expert on energy tax credits from Atlanta, GA) advised the plaintiff that it would “look better” if the plaintiff charged “anything” for the fuel mixtures. Accordingly, the plaintiff charged the WRA $950 for the year for all deliveries. In return, the plaintiff was charged a $950 administrative fee for the same year. The WRA also charged the plaintiff a disposal fee for accepting the alternative fuel mixtures in the amount of $.02634/gal. for up to 50,000 gallons per day.
The plaintiff treated the transfers of its alternative fuel mixtures as sales for “use as a fuel.” That was in spite of the fact that the plaintiff paid the fee for the transaction. The plaintiff never requested a formal tax opinion from its Atlanta “expert,” however, the “expert” advised the plaintiff that the transaction qualified as a sale, based upon an IRS private letter ruling to a different taxpayer involving a different set of facts and construing a different section of the Code. The expert did advise the plaintiff that an IRS inquiry could be expected, but that the transaction with the WRA amounted to a sale “regardless of who [paid] whom.” A few months later, the IRS issued a Chief Counsel Advice indicating that if the alternative fuel was not consumed in the production of energy or did not produce energy, it would not qualify for the alternative fuel credit. C.C.A. 201133010 (Jul. 12, 2011). The “expert” contacted the IRS after the CCA was issued and then informed the plaintiff that the IRS might challenge any claiming of the credit, but continued to maintain that the “plaintiff’s qualification for tax credits…was straightforward.”
The plaintiff claimed a refundable alternative fuel mixture credit in accordance with I.R.C. §6426(e) of $19,773,393 via Form 8849. The IRS initially allowed the credit amount of $19,773,393 for 2011, but upon audit the following year disallowed the credit and assessed a tax of $19,773,393 in 2014. The IRS also assessed an excessive claim penalty of $39,546,786 for claiming excessive fuel credits without reasonable cause (I.R.C. §6675); civil fraud penalty (I.R.C. §6663) and failure-to-file and failure-to-pay penalties (I.R.C. 6651).
The court agreed with the IRS. While the court noted that the plaintiff was registered with the IRS and produced a qualified fuel mixture, the court determined that the plaintiff did not sell an alternative fuel mixture for use as a fuel. While the court noted that the term “use as a fuel” is undefined by the Code, the court rejected the IRS claim that the alternative fuel mixtures were not used as a fuel because the mixtures did not directly produce energy. Instead, they produced biogas that then produced energy, and the court noted that the IRS had previously issued Notice 2006-92 stating that an alternative fuel mixture is “used as a fuel” when it is consumed in the energy production process. However, the “production of energy” requirement contained in the “use of a fuel” definition meant, the court reasoned, that the alternative fuel mixture that is sold must result in a net production of energy. As applied to the facts of the case, the WRA could not provide any data that showed which of the feedstock sources from its numerous suppliers was producing energy, and which was simply burned off and disposed of. As such, the plaintiff could not prove that its fuel mixtures resulted in any net energy production, and the “use as a fuel” requirement was not satisfied.
In addition, even if the “use as a fuel” requirement was deemed satisfied, the court held that the plaintiff did not “sell” the alternative fuel mixture to customers. The nominal flat fee lacked economic substance. The fee, the court noted was “charged” only for the purpose of receiving the associated tax credit. In addition, no sales taxes were charged on the “sales.” Thus, the plaintiff was not entitled to any alternative mixture fuel credits.
The court upheld the 200 percent penalty insomuch as the professional advice the plaintiff received was not reasonably relied upon. The court noted that the plaintiff’s “expert” told the plaintiff that he was not fully informed of the plaintiff’s production process and informed the plaintiff that he did not understand the anaerobic digestion process. In addition, while the plaintiff was informed that there had to be a net production of energy from its production process to be able to claim the credit, the plaintiff ignored that advice. In addition, the court noted that the IRS private letter ruling the “expert” based his opinion on involved a different statute, a distinguishable set of facts, and did not support the plaintiff’s position and, in any event, was ultimately not relied upon. Likewise, a newly admitted local CPA that was hired to track feedstock received from suppliers and alternative fuel mixtures deliveries for the plaintiff provided no substantive tax advice that the plaintiff could have relied upon.
The end result was that that plaintiff had to repay the $19,773,393 of the claimed credits and pay an additional penalty of $39,546,786. A large part of the other penalties had already been abated. The court noted that any portion of those penalties that had not been abated may remain a liability of the plaintiff.
Initially, the refundable credits were presented to Congress as incubators. As the business and demand grew, there would be less need for the subsidy. The initial tax subsidies are critical for these business models to succeed. Unknown is whether any of the business models wean themselves off of the credit to be successful without taxpayer subsidy.
Each year, the IRS releases a list of the “Dirty Dozen” tax scams. On the current list are “excessive claims for business credits.” That includes alternative fuel tax credits. The fact that the alternative fuel credit is refundable makes it even more enticing to those that are seeking to scam the system. While alternative fuel credits may have their place, extreme care must be taken to ensure that appropriate business models and transactions are utilized to properly claim them. In the recent case, a local municipality (the WRA) was brought in to help make the scam look legitimate.