Skadden Arps Seeks Guidance on Alternative Fuels Credits

Attached for your consideration is a paper that identifies issues under the new alternative fuels credits enacted in 2005 for which published guidance is urgently needed. Guidance is particularly time sensitive for these credits because they either already are or soon will be effective and are only available for a brief period. As you no doubt are aware, taxpayers need guidance on how the credits will be applied so that they can implement any necessary changes to their business operations to ensure the incentives for alternative fuels operate as Congress intended.

We very much appreciate your consideration of these comments and would be pleased to discuss them with you at your convenience. You may reach Pam at the number above or Cary at (202) 371-7178.

BACKGROUND

The Energy Tax Incentives Act of 2005 and the Safe, Accountable, Flexible, Efficient Transportation Equity Act of 2005 modified the amount of the retail excise tax that applies to alternative fuels under section 4041, and added three new credits pertaining to the use of alternative fuel: (1) an excise tax credit for alternative fuels in sections 6426(d) and 6427(e); (2) an income tax credit for alternative fuel vehicles in section 30B(e); and (3) an income tax credit for alternative fuel vehicle refueling property in section 30C.¹

The excise tax credit is built on the credit for alcohol and biodiesel fuels which was enacted in 2004 (see Notice 2005-4, 2005-2 I.R.B. 289, as modified by Notice 2005-24, 2005-12 I.R.B. 757, Notice 2005-62, 2005-35 I.R.B. 443, and 2005-80, 2005-46 I.R.B. 953 ("Notice 2005-4")). The alternative fuel vehicle credit and the refueling station credit expand upon and replace deductions under section 179A for clean fuel vehicle property and clean fuel vehicle refueling property. Notice 2006-54, 2006-26 I.R.B. ("Notice 2006- 54"), provides preliminary guidance regarding certification of alternative fuel vehicles.

DISCUSSION

I. Alternative Fuel Excise Tax

We believe the statutory framework indicates the broad definition of motor vehicle in the existing regulations is consistent with congressional intent and should be retained as the general rule. The statute uses the term "motor vehicle" and then narrows the application of the tax with the exemption for "off-highway business use" in section 6421(e)(2). Off-highway business use is use:

It is our understanding that there are very few retail LNG fueling stations yet in existence; thus almost all LNG sales are bulk sales. In an LNG sale, the alternative fuel seller either will produce LNG or will purchase LNG from a production plant and then deliver the LNG by truck to a storage tank at a customer's location (a refueling station primarily owned by customers). The customer then fuels its vehicles from the storage tank (refueling station). The LNG sale described above is a straightforward bulk sale that already should be covered under the existing regulations.

Although current regulations also apply the bulk sales rules to CNG, described below are the three scenarios for CNG sales with which we are familiar, none of which involves a bulk sale.

In the first scenario, the alternative fuel seller purchases pipeline gas from a natural gas utility, compresses it, and then distributes the fuel to the customers at retail refueling stations owned by the alternative fuel seller (the natural gas may be delivered directly from the compressors to fuel dispensers or may be delivered to storage vessels and then from the storage vessels to fuel dispensers). This is a straightforward retail sale of fuel to customers and does not present unusual issues requiring guidance.

In the second scenario, the alternative fuel seller purchases the gas from the pipeline and uses the customer's compressor equipment and dispenser, which it is responsible for operating and maintaining, to provide fuel to the customer. The alternative fuel seller is paid for the fuel after the fuel is dispensed into the customer's vehicle, typically on a per-gallon basis. This arrangement should be treated as a retail sale because title to the fuel transfers to the customer when the fuel is dispensed into the customer's vehicles and the customer pays for the fuel. The fact that the customer owns the compressor equipment and dispenser should not affect the analysis because the alternative fuel seller operates and maintains the equipment to compress and dispense the natural gas that it owns (in exchange for a reduced price for the CNG, which price does not have a capital recovery component for the compressor equipment and dispenser).

In the third scenario, the customer purchases the gas directly from the pipeline and owns the compressor equipment and dispenser, and the alternative fuel seller operates and maintains the compressor equipment and dispenser. The alternative fuel seller tracks the amount of compressed natural gas dispensed into vehicles and charges a fee per gallon dispensed. In this scenario, the statute appears to impose responsibility on the customer for the tax as the fuel is used. The sale of natural gas by the pipeline would not qualify because the fuel is not yet compressed when it is sold to the customer. In addition, the alternative fuel "seller" in this case never takes title to the fuel, but only operates and maintains the compressor equipment. As noted above, guidance should make clear who in this scenario is responsible for the excise tax to ensure that responsibility for the tax (and entitlement to the credit as discussed below) are properly allocated in the contract for the fuel.

The registration regime originally was intended to curb excise tax evasion in the bulk transfer of fuels. Current regulations applicable to diesel fuel, kerosene, and gasoline require blenders, enterers (i.e. fuel importers of record), pipeline operators, position holders, refiners, terminal operators and vessel operators to register. In addition, the regulations require bus and train operators who are taxed at a reduced rate on diesel fuel or kerosene to register. The regulations permit, but do not require, feedstock users, gasohol blenders, industrial users, through putters which are not position holders, ultimate vendors and ultimate vendors (blocked pump) to register. (The regulations do not explain these terms.)

Notice 2005-4 provided that the IRS would register an applicant as an alcohol producer or biodiesel producer only if the IRS determined that (1) the applicant was so engaged as a producer or importer or was likely to become so engaged within a reasonable period after being registered and (2) the filing, deposit, payment, reporting and claim history for all federal taxes for the applicant and all related persons is satisfactory. We believe that similar requirements are appropriate for alternative fuel sellers. In addition, because the credit may be claimed by users of the fuel, the IRS should provide for registration by alternative fuel users. To assure no bias in the marketplace, we believe the registration requirements for alternative fuel users should be the same as the requirements imposed on alternative fuel sellers (other than the requirement that they be engaged in the business of selling alternative fuel).

II. Alternative Fuel Excise Tax Credit

In addition, guidance should clarify the overlap between section 6427(e)(2) and 6427(a) and (b). If the seller claims the credit under section 6427(e)(2), then a tax exempt entity should not be eligible to claim the credit under section 6427(e)(2) as well. However, if the excise tax had been imposed under 4041 on the sale of fuel, the tax exempt purchaser should still be entitled to a refund of that tax under section 6427(a) or (b).

Finally, guidance should address those situations in which the seller is not able to claim the credit (for example, in the case of CNG when a tax exempt entity purchases the natural gas before it is compressed), and should coordinate the registration requirement in section 6427(e)(4) so that the credit can be claimed on all eligible sales of fuel.

We note that when Congress added the credit in 2005, it did not update section 6427(i) to permit quarterly refunds. It is our understanding that this was an oversight and a technical correction would be appropriate.⁶ The legislative history to the provision states: "The provision also allows persons to file a claim for payment equal to the amount of the alternative fuel credit and alternative fuel mixtures credits." See H.R. Rep. No. 109-203, 109^th Cong., 1^st Sess. 1121 (2005). We also believe that the IRS should have regulatory latitude to permit quarterly refunds under section 6427(n) as quarterly refunds are necessary to carry out the intent of Congress and ensure that the excise tax credit works properly.

As noted above with respect to the excise tax, it is especially important that guidance make clear who is responsible for the tax and who is eligible for the credit in each of the scenarios so that the parties can factor the tax and the credit into their contractual arrangements. Because taxpayers are entering into contracts for sales of LNG and CNG now, we believe guidance on eligibility for the credit, bulk sales and the content of any required statements is especially time sensitive.

III. Alternative Fuel Vehicle Credit

The amount of the alternative fuel motor vehicle credit is 50% of the incremental cost of the vehicle. For purposes of the credit calculation, the incremental cost is capped based on the weight of the vehicle -- for example, the incremental cost of vehicles weighing less than 8,500 pounds is capped at $5,000. A vehicle is eligible for a credit of 80% of the incremental cost if the vehicle meets or exceeds the "most stringent standard available for certification" under the Clean Air Act or California state laws for that make and model year vehicle (other than a zero emission vehicle) and receives a certificate of conformity under the Clean Air Act, or an order certifying that it meets the California standards, as applicable.

When a purchaser claims the credit, the purchaser's basis in the vehicle is reduced by the amount of the credit. If the credit is recaptured, the amount recaptured is added back to basis.

A vehicle qualifies for the credit if it is only capable of operating on an alternative fuel (i.e., it cannot be modified to operate on diesel or gasoline) or mixed fuel. Section 30B(e)(4)(A)(i), 30B(e)(5). Notice 2006-54 provides a certification process for alternative fuel vehicles. Under this process, the vehicle's manufacturer or its domestic distributor must certify to the IRS, under penalties of perjury, that the vehicle can only operate on alternative fuel or mixed fuel, specify the type of credit for which the vehicle qualifies (the alternative fuel or mixed fuel credit), the amount of the credit for the vehicle (showing computations), the vehicle weight, the manufacturer's suggested retail price for the vehicle and the manufacturer's suggested retail price for a gasoline or diesel vehicle, the alternative fuel used by the vehicle, and a statement that the vehicle complies with emissions and safety standards. The IRS will acknowledge the certification within 30 days of receipt. The acknowledgement will state whether purchasers can rely on the certification. A purchaser will be permitted to rely on a certification received after the purchase of the vehicle.

We note however that in the case of converted vehicles, the "manufacturer" under Notice 2006-54 may not know the manufacturer's suggested retail price for the gasoline or diesel model and there may be no manufacturer's suggested retail price for the alternative fuel model. For example, in a typical sale of a light duty vehicle by a dealer to a customer, the customer will approach the dealer expressing interest in an alternative fuel vehicle. The dealer then will order the gasoline version of that make and model vehicle from a manufacturer. The dealer then will contract with an "upfitter" to convert the vehicle to run only on natural gas. Under Notice 2006-54, the upfitter is treated as the "manufacturer" for purposes of certification because it is required to obtain a certificate of conformity under the Clean Air Act. See Notice 2006-54, Section 6.02. After the conversion, the upfitter will deliver the vehicle to the dealer and the dealer will deliver the converted vehicle to the customer. In this transaction, the dealer, not the upfitter, is in the best position to know the manufacturer's suggested retail price. However, under Notice 2006-54, the upfitter, as manufacturer, would be required to provide the manufacturer's suggested retail price for both the gasoline and the alternative fuel versions of the engine even though the upfitter may not know what the manufacturer charges for the gasoline version or what the dealer charges for the alternative fuel version. Guidance should permit the upfitter to certify as to the costs that it charges to the dealer for the conversion as this is truly the incremental cost of the alternative fuel vehicle.

The statute also does not explain how to determine incremental cost when there is no "manufacturer's suggested retail price," for example, in the case of heavy duty vehicles, which may be custom built with parts supplied by multiple manufacturers. In certain cases, such as the manufacture of large trucks, a vehicle may be assembled with component parts from different manufacturers (e.g., a purchaser may acquire a chassis and trailer from one manufacturer and the engine from another manufacturer).

For purposes of the deduction for clean fuel vehicles under section 179A, the IRS allowed the original equipment manufacturer to certify to the IRS the per-vehicle incremental cost of allowing hybrid vehicles weighing less than 10,000 pounds to run on clean fuel (electricity). Likewise, the new hybrid vehicle credit provides that the manufacturer will certify the incremental hybrid cost for vehicles with a gross vehicle weight rating greater than 8,500. There is no similar statutory requirement for alternative fuel vehicles. Because of the way alternative vehicles are manufactured (specifically, the same manufacturer may not manufacture both a diesel engine and an alternative fuel engine), requiring manufacturers to certify the manufacturer's suggested retail price for an alternative fuel vehicle and a gasoline or diesel fuel vehicle of the same model may not always be practical. That being the case, guidance should give taxpayers the option of demonstrating incremental cost by establishing the cost of a comparable vehicle equipped with a gasoline or diesel engine, or, by relying on a manufacturer's certification if one is available. In addition, a certification should be permitted as to the conversion cost of a vehicle rather than the manufacturer's suggested retail price.

In addition, based on the parenthetical in section 30B(h)(8) ("(including recapture in the case of a lease period of less than the economic life of a vehicle)"), similar recapture rules should be applied to lessors, substituting "lessor" for "original purchaser".

In addition, it is our understanding that many light duty vehicles are not manufactured originally as alternative fuel vehicles. Rather, in most cases, a new alternative fuel vehicle is a gasoline or diesel fuel vehicle that has been modified by a third party (an "upfitter" or "Small Volume Manufacturer") so that it can run only on alternative fuel. A new vehicle is delivered from the original equipment manufacturer to the upfitter for modification and then to a dealer for sale to customers. In addition, previously used vehicles may be retrofitted or repowered to run only on alternative fuel. It is our understanding that these vehicles would qualify as converted vehicles under the credit so long as the upfitter or entity that retrofits or repowers the vehicle obtains a certificate of conformity under the Clean Air Act.

IV. Alternative Fuel Refueling Property Credit

The statute defines refueling property as depreciable property that is for the storage or dispensing of a clean burning fuel such as LNG and CNG into the fuel tank of a motor vehicle propelled by that fuel. In addition, the refueling property must be physically located where the fuel is delivered into the fuel tank of the vehicle.

² Mobile machinery is defined in section 6421(e)(2)(C) as a vehicle (1) with a chassis on which there has been permanently mounted machinery or equipment that performs a specific construction, manufacturing, processing, farming, mining, drilling, timbering or similar operation unrelated to transportation on or off the public highways, (2) that has been designed to serve as a mobile carriage and mount for the machinery, and (3) that could not without substantial modification be used as a component of a vehicle designed to transport any load other than the machinery or equipment it was designed to carry. A vehicle qualifies as mobile machinery only if it is used on public highways less than 7,500 miles per year.

³ As defined in section 7701(a)(48), a vehicle is not a "highway vehicle" if it is limited or impaired in its ability to transport a load over the public highways, e.g., not able to travel at highway speeds, or because of size (overweight, overheight or overwidth).

⁴ The statement must indicate that the entire quantity of fuel covered by the sale is for a taxable use in a motor vehicle, motor boat or aircraft. If there are regular or frequent sales, the purchaser may provide a written statement covering a specified period (not to exceed 12 calendar quarters -- that is 3 years). Treas. Reg. § 48.4041-5(a)(2)(ii). In the case of CNG, the seller must give the buyer written acknowledgement of receipt of the statement. Treas. Reg. § 48.4041-21(b)(2). In addition, the regulations pertaining to CNG do not mention a three year certificate.

⁵ The 2005 legislation also added a credit for alternative fuel mixtures used as fuel in the amount of 50 cents per gallon of alternative fuel used in the mixture.

⁶ That this was an oversight is apparent from the fact that the legislation failed to update the heading in section 6427(i)(3) which provides a special payment rule for "alcohol fuel and biodiesel mixture credit" to indicate that the provision cited (section 6427(e)(1)) now includes alternative fuel mixtures.

⁷ Treas. Reg. § 1.30-1(b) includes as a recapture event the use of the vehicle in a manner described in section 50(b) which in turn includes use by a tax exempt entity (other than an unrelated trade or business) or by a governmental entity.

⁸ Treas. Reg. § 1.179A-1(b)(2)(C) includes as a recapture event the use of the refueling property in a manner described in section 50(b) which in turn includes use by a tax exempt entity (other than an unrelated trade or business) or by a governmental entity.