Low-Risk Tax Credit Partnership Investor Isn't Bona Fide Partner

UILC: 761.01-00; 45.07-00

* * * was formed on * * * as a * * * limited liability company. * * *, at * * * (Amended LLC Agreement). Upon its formation on * * *, * * * was wholly owned by * * * (* * *). Id. * * * is a wholly owned subsidiary of * * * (* * *). * * * was formed to own and operate a facility for the production of refined coal as defined by I.R.C. § 45(c)(7) that would be located at the * * * power plant owned by * * * (Utility). Amended LLC Agreement, at * * *. By the terms of the Amended LLC Agreement, it will continue until * * *, unless earlier terminated under applicable provisions. Id. at * * *.

Prior to * * * investment in * * *, * * * provided a document to * * *. The document is titled * * * (Promotional Material). * * * is the 100% owner of * * *, as mentioned above. The Promotional Material stated that "up to [a] * * *% ownership interest is available for sale in * * *", "* * *, as the producer and seller of the refined coal, should be entitled to receive production tax credits" and * * * will "allocate [the tax credits] to the owners of the company on a pro rata basis." Promotional Material, at * * *.

The following statements from the Investor Highlights and Risk Mitigation portions of the Promotional Material speak to commercial and tax risks that a potential investor would be protected against:

The quarterly fixed payment dates began with the first payment due on * * *, and are scheduled to continue with the last payment due on * * * Id. at Schedule * * *. The fixed payments total $* * * and bear an interest rate of * * *% per annum. Id. at * * *. Schedule * * * of the Purchase Agreement details the dates and amounts of each monthly fixed payment. The Purchase Agreement states:

* * * is also expected to make quarterly variable payments, the amounts of which are determined by the number of tons of refined coal produced, taking into consideration the fixed payments and capital contribution.⁵ Purchase Agreement, at * * *. According to a spreadsheet calculating the projected losses and tax benefits provided from * * * to the Revenue Agent, it is expected that * * * will make variable payments totaling $* * * between * * * and * * *.

In addition to the initial payment, quarterly fixed payments, and quarterly variable payments, * * * is required to make quarterly capital contributions. Purchase Agreement, at * * *; Amended LLC Agreement, at * * *. * * * initial capital contribution totaled $* * *. Amended LLC Agreement, at Exhibit * * *.

* * * must direct * * *, as manager, to prepare and deliver an "Operations Report" on or before the * * * day after the end of each quarter. Purchase Agreement, at * * *. The Operations Report sets forth the following information:

The Operations Report is final and binding on * * * and * * * and serves as the basis for determining * * * variable payment for the applicable quarter. Id. If * * *, in good faith, asserts that the Operations Report does not accurately reflect the information and calculations, or that the information in the Report is untrue, incomplete or misleading, and such dispute is not resolved by the time the payment is due, * * * must pay the undisputed portion. Id. at * * *. The parties must then hire an accounting firm to resolve the dispute. Id.

As alluded to above, * * * is also responsible for calculating and delivering to * * * a statement showing the sum of the aggregate "tonnage amount" for the preceding fiscal year using information on actual sales by * * * to unrelated persons of refined coal. * * * calculates the "annual adjustment amount" which is the actual tonnage amount for each quarter (computed as set forth in footnote 4), reduced by the sum of:

If the annual adjustment amount is a positive amount, such amount is added to * * * variable payment. If the annual adjustment is a negative amount, such amount is set off and applied against the variable payment, and any excess will be credited to future variable payments. Id.

While the schedule itself was not provided, the Purchase Agreement includes Initial Payment Amortization as a defined term. Id. at 4. Further, the purchase price section reflects the manner in which the Initial Payment Amortization bears on the computation of the variable payment. From the definition, the initial payment is amortized over the first * * * of production.

A "tax event" is defined as:

Additionally, the Amended LLC Agreement provides "* * *" Id. at * * *. The member is then obligated to provide * * * with * * * and "* * *" Amended LLC Agreement, at * * *.

Under the Supply Agreement, generally, Utility is to purchase from * * * all of Utility's refined coal fuel requirements for its * * * power plant. * * * is permitted to sell any refined coal it produces that is not purchased by Utility to third parties. To the extent Utility's requirements for coal-based fuel at its * * * power plant are not fully satisfied by product produced by * * *, * * * will sell unrefined coal to Utility that * * * has available to it.

Under the Coal Purchase Agreement and the Supply Agreement, the sales price of refined coal sold to Utility is equal to the purchase price of the feedstock coal purchases from Utility.

Among the provisions triggering indemnification under the Purchase Agreement are the operator's breach of section * * * (Redetermination Testing and Procedures) or * * * (Refined Coal Specifications) of the Operating and Maintenance Agreement or the operator's breach "* * *" Purchase Agreement, at * * *.

At issue in this case is whether * * * investment in * * * constitutes a bona fide partnership interest under Federal tax law. If * * * is not a bona fide partner in * * *, * * * cannot allocate the refined-coal tax credit, or any other tax benefits, to * * *, as * * * investment does not constitute the purchase of a membership interest, but rather a purchase of the tax credit.

The amount of the refined coal tax credit is determined by the number of tons of qualified refined coal produced by the taxpayer. See section 45(e)(8)(A). To qualify for the credit, refined coal must be produced by the taxpayer at a refined coal production facility as defined by section 45(d)(8) during the 10-year period⁷ beginning on the date the facility was originally placed in service. Section 45(e)(8)(A). Refined coal must be sold by the taxpayer to an unrelated person during the 10-year credit period and the taxable year in which the credit is claimed. Id.

In Commissioner v. Culbertson, the Supreme Court set forth the test for determining whether an interest in an entity constitutes a partnership interest. 337 U.S. 733 (1949). "A partnership is . . . an organization for the production of income to which each partner contributes one or both of the ingredients of income -- capital or services." 337 U.S. at 740 (citation omitted); see also Staff of Joint Comm. on Taxation, 98th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 226 (1985) (explaining that partners "pool their assets and labor for the joint production of profit," and that "[t]o the extent that a partner's profit from a transaction is assured without regard to the success or failure of the joint undertaking, there is not the requisite joint profit motive"). The question of whether a partnership exists for income tax purposes turns on:

The Culbertson> test "turns on the fair, objective characterization of the interest in question upon consideration of all the circumstances." TIFD III-E, Inc. v. United States, 459 F.3d 220, 232 (2d Cir. 2006) (hereinafter "Castle Harbour"). The following factors, none of which is conclusive, may be considered by the courts:

In applying the Culbertson test, courts "are compelled to look not so much at the labels used by the partnership but at true facts and circumstances." Id. at 241. "In essence, to be a bona fide partner for tax purposes, a party must have a 'meaningful stake in the success or failure' of the enterprise." Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425, 449 (3d Cir. 2012) (quoting Castle Harbour, 459 F.3d at 231)).

Four cases are informative on whether an interest constitutes a partnership interest. The first case is the Castle Harbour case. In Castle Harbour, the United States Court of Appeals for the Second Circuit was called upon to determine whether foreign banks were partners in a partnership. 459 F.3d at 223. In that case, two Dutch banks invested in Castle Harbour, the partnership. Castle Harbour, 459 F.3d at 223. The other partner was TIFD lll-E, Inc., a General Electric Capital Corporation subsidiary. Id. The banks were not liable for taxes in the United States and, under the partnership's Operating Agreement, were allocated "98% of the 'Operating Income,' which comprises the great majority of the partnership's income." Id. However, the operating income vastly exceeded the amount actually received by the banks because the amount was "drastically reduced by huge depreciation deductions which the IRS would not recognize, as the assets in question had already been fully depreciated." Id. The effect of the partnership allocations to the banks "was to shelter most of the partnership's income from taxation and redirect that income tax-free to [TIFD lll-E, Inc.]." Id. The payments the banks were actually to receive was the reimbursement of their initial investment with an annual rate of return.

In Castle Harbour, the Service issued notices of Final Partnership Administrative Adjustments providing for reallocation of Castle Harbour's income from the banks to TIFD lll-E, Inc. Id. at 223-24. The Service's reallocation was a result of rejecting the partnership's treatment of the banks as partners and finding that the banks' investment was in substance a secured loan. Id. The Service advanced two arguments. First, the Service argued that the transaction was a sham. Id. at 224. Second, the Service argued that the interest of the banks was not "a bona fide equity partnership participation because the banks had no meaningful stake in the success or failure of the partnership." Id.

In addressing the Service's contention that the banks were not bona fide equity partners, the court applied the Culbertson test. In doing so, the court focused on whether the banks' interests had the prevailing character of debt or equity. Id. at 232. If the interests were debt, the banks would not be placed at the risk of the business and would not be considered partners. In its analysis, the court looked at: the banks' share in the upside potential of the partnership; whether the banks were the recipients of a promise by Castle Harbour to pay a sum certain; whether the banks' interest were subordinated to general creditors of the partnership; the banks' rights to enforce payment of principal and interest; management rights; labels used by the parties; the banks' right to a fixed percentage in interest payable regardless of the partnership's income or lack thereof; the reasonableness of expectation of payment; and the use to which the invested funds were put by the partnership and whether payment to the banks can only be paid out of future profits. Id. at 233-40. Based on its application of these factors, the court held that the banks' interests were in the nature of a secured loan and, for tax purposes, were not bona fide equity participation. Id. at 241.

The second case is Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011). In that case, the United States Court of Appeals for the Fourth Circuit overturned the Tax Court by ruling that a purported partnership's allocations of Virginia state tax credits to certain purported partners constituted sales of the state tax credits pursuant to I.R.C. § 707. Id. at 137. The court made its ruling "[a]ssuming, without deciding that a 'bona fide' partnership existed." Id. Although the court did not conduct a Culbertson analysis, it looked to similar factors. Specifically, the court, in addressing the Tax Court's holding, considered whether the purported partners had entrepreneurial risk. Id. at 144-46.

In Virginia Historic Tax Credit, the court considered the risks identified by the Tax Court: the developers would not complete their projects on time; the Virginia administrative agency would not be satisfied with the rehabilitation and the developers would not receive the credits; the Virginia administrative agency would revoke the credits and recapture them in later years; at the partnership level there could be liability for improper construction, mismanagement, or fraud; there could be fraud by another investor; retroactive changes in the law could happen; and there could be litigation in general. Id. at 145. The court stated that "[s]everal facts point to the conclusion that there was no true entrepreneurial risk faced by [purported partners]." Id.

The court noted that: purported partners were promised a fixed rate on return rather than a share in partnership profits; the partnerships assigned each purported partner a very small partnership interest and told purported partners to expect no material allocations of income, gain, loss, or deduction; purported partners were secured against losing their contributions by the promise of a refund if the promised tax credits did not materialize; and the partnerships hedged against the possibility of insolvency by only contributing to completed projects. Based on the above, the court found "persuasive the Commissioner's contention that the only risk here was that faced by any advance purchaser who pays for an item with a promise of later delivery" and ruled that the transaction constituted the sale of the state tax credit. Id. at 145-46.

The third and most applicable case is Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012). In Historic Boardwalk, the United States Court of Appeals for the Third Circuit was called upon to determine whether a purported partner in Historic Boardwalk Hall, LLC (HBH), the partnership, was a bona fide partner for tax purposes. Id. at 429. At issue in Historic Boardwalk was whether Pitney Bowes, Inc. (PB) was a bona fide partner in HBH such that PB can be allocated section 47 historic rehabilitation tax credits.

In Historic Boardwalk, the New Jersey Sports and Exposition Authority (NJSEA), a state agency, was tasked with restoring the East Hall, an historic landmark. Id. at 428-29. In the case of the section 47 historic rehabilitation tax credit, the credit is only available to the owners of property and therefore the Code does not permit the credits to be sold. Id. at 430. Because NJSEA was a tax-exempt entity, it could not benefit from the credit unless it was able to monetize it through the involvement of a tax-equity investor. Id. at 433.

After learning about the tax-equity-investor market, NJSEA formed the partnership and sold a membership interest to PB. Id. at 429. The partnership was designed so that PB could be allocated the tax credits generated from the rehabilitation of East Hall. Id. Upon investing in the partnership, PB was to receive 99.9 percent of all partnership items and a guarantee of tax benefits, including depreciation deductions and tax credits, and a 3-percent return on its investment. Id. at 436. Although PB was to receive 99.9-percent of the partnership's income, the partnership was structured such that PB would never benefit from its investment in excess of the tax credits and deductions and the 3-percent return. Id. at 459-60. In addition, the structure guaranteed that PB would benefit in the amount of projected tax credits and deductions and would receive the 3 percent return. Id. at 455-59.

In evaluating whether PB had a bona fide partnership interest in HBH, the court applied the Culbertson test noting that "to be a bona fide partner for tax purposes, a party must have a 'meaningful stake in the success or failure' of the enterprise." Historic Boardwalk, 694 F.3d at 449 (quoting Castle Harbour, 459 F.3d at 231). The court then used Castle Harbour and Virginia Historic to guide its analysis.

The court, citing Castle Harbour, stated that "whether a purported partner had a meaningful stake in the success or failure of the partnership . . . goes to the core of the ultimate determination of whether the parties intend to join together in the present conduct of the enterprise." Historic Boardwalk, 694 F.3d at 454 (internal quotations and citations omitted). The court found Castle Harbour's analysis that the banks' indicia of equity participation was illusory or insignificant and Virginia Historic's conclusion that the purported investors did not face entrepreneurial risks of partnership operations to be highly relevant to the question of whether HBH was a partnership in which PB had a true interest in profit and loss. Id. at 454. In its analysis, the court focused on an assessment of risk from PB's participation. Id. at 455. Specifically, the court focused on PB's downside risk and upside potential and the form and substance of PB's investment. Id. at 455-63.

The court found that PB had no meaningful downside risk. In so finding, the court focused on three facts. First, any risk that PB would not receive credits in an amount at least equivalent to installments it had made was non-existent because under its agreements PB was not required to make installment contributions to the partnership until NJSEA had verified that it had achieved a level of progress on the renovation that would generate enough credits to at least equal the sum of the installment plus all prior capital contributions made by PB. Id. at 455. While PB did not have the contractual right to "compel [the partnership] to repay all or any part of its capital contribution [in the event that the anticipated credits were not generated,] PB had an even more secure deal. Even before PB made an installment contribution, it knew it would receive at least that amount in return." Id. at 456 (internal quotations and citations omitted).

Second, PB had a Tax Benefits Guaranty that eliminated risk of the Service disallowing the credits. Under the Guaranty, NJSEA agreed to pay PB the amount of tax credits disallowed, penalties and interest, and up to $75,000 in legal and administrative expenses incurred in connection with a Service challenge. Id.

Third, the court noted that PB did not have any risk that it would not receive all of its bargained-for tax credits due to the risk that the renovations would not be completed because the project was fully funded before PB entered into any agreement to contribute to the partnership. Id. at 456-57. Thus, the court determined that "PB was not subject to any legally significant risk that the renovations would falter. Historic Boardwalk, 694 F.3d at 457. Based on its analysis of these three risk items, the court determined that "PB bore no meaningful risk in joining [the partnership], as it would have had it acquired a bona fide partnership interest . . . [because] the parties agreed to shield PB's 'investment' from any meaningful risk." Id. at 457, 459.

The court continued its analysis by finding that PB also had no meaningful upside potential. The court noted that "'[w]hether [a putative partner] is free to, and does, enjoy the fruits of the partnership is strongly indicative of the reality of his participation in the enterprise.'" Historic Boardwalk, 694 F.3d at 459 (quoting Culbertson, 337 U.S. at 747). The court noted that, although PB's 99.9-percent interest created the impression that it had a chance to share in potential profits of the partnership, in reality, PB would only benefit after numerous payments are made from the partnership to NJSEA. Id. Even the partnership's own "fantastically inaccurate" financial projections "forecasted no residual cash flow available for distribution" to PB through 2042. Id. at 459-60. Furthermore, even if there were an upside, NJSEA and PB had put and call options under which NJSEA could exercise its option and cut PB out by paying a purchase price unrelated to the fair market value of PB's membership interest. Id. at 460. This ensured that PB would never receive any economic benefits from the partnership and constituted compelling evidence that PB was not a bona fide partner in HBH. Id. After considering PB's lack of upside potential, the court addressed the form and substance of the transaction.

In discussing the form and substance of PB's investment, the court stated that "'the sharp eyes of the law' require more from parties than just putting the 'habiliments of a partnership whenever it advantages them to be treated as partners underneath.'" Historic Boardwalk, 694 F.3d at 461 (quoting Culbertson, 337 U.S. at 754 (Frankfurter, J., concurring)). After looking past the outward appearance of a partnership, the court, for the same reasons that it determined that PB lacked both entrepreneurial risk and upside potential, determined that PB is not a bona fide partner in HBH. In looking at the substance of the transaction, rather than the form, the court stated that "[r]ecruiting teams of lawyers, accountants, and tax consultants does not mean that a partnership, with all its tax credit gold, can be conjured from a zero-risk investment." Id. at 462.

Although the court rejected PB's claim that it is a partner in HBH, the court "reached its conclusion mindful of Congress's goal of encouraging rehabilitation of historic buildings." Id. The court noted that the tax credits were not under attack; rather, the prohibited sale of tax credits was what was at issue. Id. at 462-63.

The fourth and most recent case is Chemtech Royalty Assocs. v. Commissioner, 766 F.3d 453 (5th Cir. 2014). In 1992, Dow Chemical Company ("Dow") decided to pursue a tax shelter promoted by Goldman Sachs called Special Limited Investment Partnerships ("SLIPs"). Id. at 455-56. Dow selected 73 patents to contribute to this partnership. Id. at 456. The patents were valued at approximately $867 million, and 71 out of 73 of the patents had a zero tax basis. Id. Through its subsidiaries, Dow formed Chemtech as a Delaware limited partnership and contributed the 73 patents, $110 million and all the stock of a pre-existing shell corporation owned by Dow. Id.

Five foreign banks invested a total of $100 million as limited partners in Chemtech. Id. In October 1993, Dow's domestic subsidiary owned 81% of Chemtech, its foreign subsidiary owned 1% as general partner, and the foreign banks owned 18%. Id. Chemtech operated from April 1993 through June 1998. Id. at 457. Its primary source of income was the royalty payments from Dow. Id. Dow and the foreign banks entered into a variety of agreements governing the transaction, under which Dow continued to use the patents it had contributed to Chemtech, continued to bear responsibility for all costs related to the patents, and indemnified the foreign banks against any liabilities arising from the patents. Chemtech allocated substantially all of its income to the tax-indifferent foreign banks in the form of a priority return, but only a fraction to Dow. Id. at 457-58. At the same time, Dow took deductions for the royalty payments it made to Chemtech. Upon Chemtech's liquidation, the banks received a return of their capital plus a premium provided for in the partnership agreement.

After terminating Chemtech, Dow embarked on a similar transaction, this time involving the depreciable property of one of its Louisiana chemical plants ("Chemtech II"). Id. As in the first transaction, Dow utilized a subsidiary -- the Dow Chemical Delaware Corporation ("DCDC"). Id. In June 1998, DCDC contributed the Louisiana plant and the stock of a shell subsidiary to Chemtech II. Id. Dow entered into a lease with Chemtech II for use of the Louisiana plant; under the lease, Dow retained responsibility for all expenses of the plant and was required to pay rent regardless of its use of the plant. Id. RBDC, Inc., a U.S. affiliate of Rabo Merchant Bank N.V., purchased a limited interest in Chemtech II for $200 million. Id. At this point, Chemtech II was owned 20.45% by RBDC, 73.18% by DCDC, and 6.37% by the general partner. Chemtech II allocated a portion of Dow's lease payments to RBDC as a priority return, but allocated all of the depreciation deductions associated with the plant to Dow. Once the plant assets were fully depreciated, RBDC withdrew from the partnership and the partnership liquidated shortly thereafter.

Citing Culbertson, Commissioner v. Tower, 327 U.S. 280 (1946), and Southqate Master Fund. LLC ex rel. Montgomery Capital Advisors. LLC, v. United States, 659 F.3d 466 (5th Cir. 2011), the Fifth Circuit pointed out that "parties, to form a valid partnership, must have two separate intents: (1) the intent to act in good faith for some genuine business purpose and (2) the intent to be partners, demonstrated by an intent to share 'the profits and losses.'" Id. at 461. The court focused on "whether Dow had the intent to share in the profits and losses with the foreign banks." In doing so, the court found: (1) "the transactions were structured to ensure that Dow paid the foreign banks a fixed annual return on their investment" regardless of the venture's success or lack thereof; (2) Dow agreed to bear "all non-insignificant risks" and the agreements ensured that Dow would not lose the banks' initial investment; (3) the foreign banks did not meaningfully share in any upside -- the record suggested that Dow and other parties did not consider the patents to be profitable, and even if they did, the agreements "allocated only 1% of the increased value of a [patent] to all of the foreign banks collectively." Id. at 463-64 (emphasis in original). Finding that Dow lacked the intent to share the profits and losses of the Chemtech transactions, the court held the partnerships were not bona fide. Id. at 464-65.

In light of the four cases discussed above and in our application of the Culbertson test, we must focus on whether * * * is a bona fide partner in * * * Specifically, we must focus on whether * * * has entrepreneurial risk and upside potential separate from its allocated tax credits or whether * * * investment in * * * is in substance the prohibited sale of tax benefits. Pertinent factors are discussed below.

Although * * * is obligated to make the future payments, the obligation is contingent on the numbers of tons of refined coal produced, taking into consideration the fixed payments and capital contribution. The variable payments and quarterly capital contributions are only required if * * * generates enough tons of refined coal. Furthermore, * * * fixed payment obligations are non-recourse against * * * and * * * and their affiliates, so that breach of the obligation can only be satisfied out of * * * interest in * * *.

Because * * * purported capital contributions are largely to be made in the future and only in relation to the amount of refined coal, and by extension tax credits generated, we believe that the payments are in exchange for tax benefits and do not constitute capital contributions in substance. Since * * * contributions are largely protected by the payment terms, this factor supports finding that * * * is not a bona fide partner in * * *. Historic Boardwalk, 694 F.3d at 455-56.

The indemnification provision goes on to state that if an indemnified loss is with respect to tax credits or tax deductions allocated to * * *, * * * is obligated to indemnify * * * with respect to tax credits or deductions that are attributable to a month for which * * * met its obligations to make payments and capital contributions. Read alone, * * * could argue that the indemnification provision may limit indemnification of lost tax credits and deductions to losses related to operational issues. However, the Amended LLC agreement further indicates that * * * is to be indemnified for disallowed tax credits and deductions.

The Amended LLC Agreement states that any member, including * * *, is obligated to inform * * * in the event that the IRS commences any audit or proceeding with respect to, inter alia, tax credits. The Agreement further states that, if a "tax event" -- which is defined in the Agreement as * * * -- occurs, the members with at least a * * *% interest may deliver notice that they wish to suspend production of refined coal. Notably, * * * is the only member with at least a * * *% interest and, as a result, the sole member that is able to suspend production by itself.⁸ Other members would have to combine their membership interests to meet the * * *% threshold. We believe that these two provisions, the indemnification agreement and the language from the Amended LLC Agreement, operate to protect * * * contributions in the event that tax credits or deductions are disallowed and support a finding that * * * is not a bona fide partner in * * *. What is not clear, however, is the means by which * * * could recover its initial $* * * investment in case of a cessation of production prior to the end of the Initial Payment Amortization * * * period for a reason other than one meeting the definition of a tax event.

The Promotional Material's discussion of the Investor Highlights, Risk Mitigation and the included Investor Benefits Schedule also show that the parties were interested in the generation and allocation of tax benefits. The Investor Highlights include almost guaranteed financial benefits, e.g., "* * *" and the investors are not expected to be "out-of-pocket" after * * *. The Investor Benefits Schedule was not based on an expectation of profit from the production and sale of refined coal. Instead, the Schedule focused on "* * *" Promotional Material, at * * * (emphasis added). Per the Schedule, the tax benefits equal $* * *; thus, $* * * less * * * taxable loss of $* * * = $* * * total net after-tax cash flow.

Additionally, a "tax event" includes "* * *" Amended LLC Agreement, at * * *. Because the tax credit would be eliminated by a finding that * * * investment in * * * is not a partnership interest, it appears that such a finding would constitute a tax event as defined by the Amended LLC Agreement.

The parties' statements in the Promotional Material and the Amended LLC Agreement strongly indicate that * * * was paying for tax benefits, and was not undertaking a joint endeavor to operate a profitable refined coal facility.

As mentioned, the Promotional Material actually quantifies the amount that a potential investor would pay for tax credits. In the Investor Benefits Schedule, currently projected section 45 tax credits equal $* * *. Absent the tax benefits of the investment, the investor could have expected a loss.

The operation of the refined coal facility further shows that the relationship of the parties is not one of parties undertaking a joint endeavor to operate a profitable refined coal facility. Under the agreements between the parties, e.g., * * * (Sale Agreement), Utility is the operator of the facility running it on a day-to-day basis. In fact, neither * * * nor * * * is even mentioned in the Sale Agreement or the Operating and Maintenance Agreement. Although * * * is sent quarterly * * * (Reports), primarily for purposes of calculating the quarterly variable payments and quarterly capital contributions, * * * is not involved in the management and decision-making regarding the production facility. Based on the above, we believe that the relationship of the parties supports finding that * * * is not a bona fide partner in * * *.

Similarly, * * * will not make variable payments unless it has assurances that enough refined coal was produced. With respect to the quarterly variable payments, the amount of each payment is equal to * * *¹⁰ * * *. Purchase Agreement, at * * *. In other words, the variable payments are determined by the number of tons of refined coal produced, taking into consideration the fixed payments and capital contribution. The variable payments are determined by the number of tons of refined coal produced, taking into consideration the fixed payments and capital contribution.

Further, * * * Report, final and binding on all parties, serves as the basis for determining * * * variable payment for the applicable quarter. This Report, like the variable payments themselves, contains substantial information related to * * * refined coal production. Likewise, * * * statement showing the "annual adjustment amount", also used to compute * * * quarterly variable payment, is based on the "tonnage amount", i.e. * * *. Purchase Agreement, at * * *.¹¹

In other words, if * * * does not produce enough refined coal to generate the requisite amount of credit, * * * does not have an obligation to make variable payments. * * * variable payments are wholly contingent on * * * production of refined coal.

Additionally, the fixed payments are nonrecourse to * * *, and are only recoverable against * * * assets. Thus, the fixed payment obligation is only enforceable against * * * interest in * * *, without other recourse to * * *. Moreover, since * * * has the ability to exit the transaction if it does not make the "fixed payment," that obligation is not truly fixed.

The agreements in this case provide * * * significant protections against risk of loss. Based on the above, we believe that * * * is largely protected from downside risk, which weighs in favor of finding that * * * is not a bona fide partner in * * *.

Additionally, under the Coal Purchase Agreement and the Supply Agreement, the sales price of refined coal sold to Utility is equal to the purchase price of the feedstock coal * * * purchases from Utility. Because there is no mark-up on the refined coal sold by * * * to Utility, there is no possible return on investment aside from tax credits.

* * * and * * * and * * * can be analogized to NJSEA in Historic Boardwalk. NJSEA entered into various rehabilitation contracts before even attempting to find a partner, and had assurances that the project was fully funded before PB purportedly invested in the partnership. Historic Boardwalk, 694 F.3d at 433-34. NJSEA's request for proposal provided that the tax credits would be marketed to potential investors. Id. at 434. In essence, NJSEA fashioned a transaction in which an investor would have no risk.

Likewise, * * * created a transaction in which passive investors would have little to no risk. Like the confidential offering memorandum in Historic Boardwalk, * * * Promotional Material highlights the lack of risk to potential investors. The Promotional Material boasts that "* * *" and "* * *" Like PB in Historic Boardwalk, * * * knew that it would bear no meaningful risk "as it would have had it acquired a bona fide partnership interest." Id. at 457.

Additionally, "in form PB had the potential to receive the fair market value of its interest if either NJSEA exercised its [c]all [o]ption or PB exercised its [p]ut [o]ption, [but] in reality, PB could never expect to share in any upside." Id. at 460. Thus, the court determined that PB would never receive economic benefits from this transaction as NJSEA had actual control over the income and the purposes it was used. Id. (internal quotations and citations omitted).

Similarly, * * * maintains significant control regarding the reacquisition of * * * assets at the end of the term. If members holding at least * * *% of the outstanding membership interests cannot agree on who to appoint as liquidators, * * * acts as liquidator. * * * is permitted to purchase the facility from * * * if it so chooses. Further, * * * assets are to be distributed pro rata to the members, but, if * * * assets, after the payment or discharge of the debts and liabilities, are insufficient to return the capital contributions of each member, such member has no recourse against * * * or any other member. As a result, * * * and the other members lack upside potential at the dissolution stage, as it cannot even recover its capital contribution -- and has no recourse to do so -- if * * * lacks sufficient assets at the end of the term. Thus, it appears * * * has upside potential whereas the other investors, including * * *, do not.

This writing may contain privileged information. Any unauthorized disclosure of this writing may undermine our ability to protect the privileged information. If disclosure is determined to be necessary, please contact this office for our views. Please call * * * at * * * if you have any further questions.

      Tax credits              $* * *

³ * * * is included as a party to the agreement solely for the purposes of * * *.

⁴ The "tonnage amount", with respect to any quarter, is the product of * * * Purchase Agreement, at * * *.

⁵ Each variable payment is the amount equal to * * *. Purchase Agreement, at * * *.

⁶ In short, the * * * Agreement is among * * *, Utility and * * *, and provides the terms and obligations for the parties for the sale of the refined coal eligible for tax credits.

⁷ * * *

⁸ A chart entitled "Comparison of Members' Risk of Loss and Potential for Profit", contrasting those circumstances under which * * * and the other members of * * * held the same potential for profit and risk of loss from those where * * * risk was less than that of other members is included as an attachment hereto.

⁹ Even if * * * retained an interest in * * * it would be unable to use the tax benefits because section 45(e)(8)(A)(ii)(I) requires that the refined coal be sold to an unrelated person, and since * * * wholly owns * * *, they are related parties.

¹⁰ * * *

¹¹ Tonnage amount = * * *.

¹² Several agreements, based on their terms or the Schedules attached thereto, self-terminate after * * * years.