PLR 200031026: Synthetic fuel credit treatment for a partnership's coal facilities

Plain-English summary

A partnership operating coal-based synthetic fuel facilities asked about the section 29 credit after new members acquired the original members' interests. Based on the submitted process information, the IRS concluded that its fuel would be qualified solid synthetic fuel and that credit for qualifying sales to unrelated buyers could pass through to partners according to their interests when the credit arose. A technical partnership termination from transfers of interests would not itself prevent the credit. Moving a facility after June 30, 1998, would not reset an earlier placed-in-service date if the facility met the stated used-property value test. The IRS did not decide when the facilities actually were placed in service or how the partners' interests should be determined. Those factual questions remained central to whether the credit was available and how it was allocated.

Ruling snapshot

• Question: Do the fuel, partnership transfers, and facility relocations permit the section 29 credit and its allocation among partners?
• Outcome: Approved for the five specified rulings, subject to the unresolved placed-in-service and partner-interest facts.
• Key authorities: IRC §§ 29, 702(a)(7), 704, and 708(b)(1)(B).

Full text (IRS public release)

Internal Revenue Service                      Department of the Treasury

Index Number:       29.00-00; 702.01-09       Washington, DC 20224



Number: 200031026                             Person to Contact:
Release Date: 8/4/2000                        Telephone Number:

                                              Refer Reply To:
                                              CC:DOM:P&SI:6--PLR-111202-99
                                              Date:
                                              April 28, 2000




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Date 1       =
Date 2       =
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Dear

       This letter responds to a letter dated June 22, 1999, and subsequent
correspondence, submitted on behalf of P by its authorized representative, requesting
rulings under sections 29 and 702 of the Internal Revenue Code.
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                                          FACTS

       The facts as represented by P and P’s authorized representative are as follows:

       P is a Delaware limited liability company formed in 1998 for the purpose of
constructing and operating facilities for the production of a solid synthetic fuel from coal.
P is (and will continue to be) classified as a partnership for federal income tax
purposes. The initial members of P were A and B (collectively, the “Sellers”).

       Currently, the members of P are C and D (collectively, the “New Members”). C is
a single member limited liability company that is wholly owned by E; as such, C will be
disregarded for federal income tax purposes. D is a single member limited liability
company that is wholly owned by F; as such, D will be disregarded for federal income
tax purposes. Both E and F join in the consolidated federal income tax return filed by
G.

       G is the common parent of an affiliated group of numerous subsidiaries engaged
in a variety of businesses. G will guarantee certain of the financial obligations of the
New Members.

       The Sellers capitalized P with a certain amount of capital contributions and
provided additional funds through loans for the construction of the facility and its
operations. (The loans are evidenced by promissory notes from P to the Sellers.)

       The New Members acquired the Sellers’ membership interests in P pursuant to
the Purchase and Sale Agreement dated Date 1. This agreement requires the New
Members to make payments to the Sellers directly and to make capital contributions to
P that should permit P to repay the loans made by the Sellers. On Date 1, the New
Members made payments to the Sellers as well as capital contributions to P. The New
Members also made available to P new financing from an affiliate of G.

        The New Members have agreed to contribute to P an amount sufficient to allow
P to repay in full the notes payable to the Sellers (including accrued interest through the
date of the payment). This contribution is due within 15 days following the later of (i)
the date on which P has achieved a monthly average production of a certain quantity of
MMBtu of qualified fuel within certain specified periods, and (ii) the earlier of Date 2 or
the date on which all of the following requirements are satisfied: (A) receipt of a
favorable private letter ruling, (B) receipt of a pre-filing determination from the relevant
District Office that the facility was placed in service for purposes of section 29 on or
before June 30, 1998, or the satisfactory completion of an audit of P’s 1998 federal
income tax return, and (C) (unless waived by the New Members) J or its parent
corporation has contracted for, used, and approved for use in their electrical generating
plants in State X solid synthetic fuel made with petroleum-based binders and has not
issued requirements that make P’s production ineligible for sale to their plants. (J and
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its affiliates generate more than 90 percent of the electricity generated within the
immediate vicinity of P’s facility, and thus represent unusually important customers to
P.) It is currently expected that these payments and contributions by the New Members
(collectively the “Down Payment”) will exceed the amounts paid to construct the facility.

       In addition to the Down Payment, the New Members are required to make
additional quarterly payments to the Sellers (the “Installment Payments”). The
Installment Payments are payable quarterly in arrears based on the energy content of
synthetic fuel produced and sold to unrelated parties during the preceding calendar
quarter, adjusted to remove the energy content of the binder material. The amount thus
payable will be based on a schedule of rates, subject to a maximum weighted average
price per MMBtu, depending on the total energy content of synthetic fuel produced and
sold during the quarter. These rates were based on the 1997 credit rates as
announced in Notice 98-28 and will be adjusted for inflation. The Installment Payments
are reduced by amounts designed to permit funding of operating and reclamation
reserves for P; by pre-closing obligations of P; by any payments to R for use of its
technology; by payments on the assignments of the construction contracts; and by
certain specified yearly amounts (not adjusted for inflation) per ton of synthetic fuel
produced.

       The Installment Payments are subordinated to the extent there is any cash
operating deficit or required addition to reserves with respect to the synthetic fuel facility
in excess of the per ton amounts specified in the last sentence. Any Installment
Payment thus subordinated would be payable out of operating cash flow of P in later
periods. (Thus, each Installment Payment will become fixed in amount in the quarter
that synthetic fuel is produced and sold, but may be paid over time.) Amounts
subordinated will be represented by a promissory note and are unconditionally payable
in Date 3, regardless of cash availability.

       According to P’s authorized representative, when measured on a present value
basis using an a percent discount rate, the Down Payment amounts to approximately b
percent of the purchase price, and the Installment Payments amount to approximately c
percent of the purchase price.

        The Sellers have an option to reacquire their interests in P at a fair market value
price in certain limited circumstances.

         P has entered into a number of auxiliary agreements. P has entered into a site
lease agreement with I for the site of the facility and land used for coal storage for an
initial term equal to five years and five days. P has the right to extend the term of this
lease for two consecutive five year periods. The lease also includes various licenses
and rights of access necessary for P to carry on its business.

       P also has entered into an agreement with E for the marketing of its production.
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As compensation for its marketing efforts, E will receive a commission on all sales
based on a percentage of net sales proceeds (subject to a minimum based on the
tonnage of synthetic fuel sold), plus a bonus based on a percentage of the amount by
which the sales price exceeds an index adjusted based on changes in coal prices at
three local power plants. In its capacity as the exclusive sales representative for P’s
output, E may also arrange for transportation of the output. E also has a right of first
refusal for it or F to broker coal-based feedstock to P.

       P also has entered into an Asphalt Binder Supply Agreement with H, a wholly-
owned subsidiary of G. Under this agreement, H will be the exclusive provider to P of
the needed petroleum-based binder material (consisting of asphalt cement, chemicals
and other additives). The price for the asphalt cement component of the binder is
adjusted monthly to reflect changes in the average posted price for asphalt cement at
an appropriate location with agreed quality factors as reported in an industry weekly.

         P and A have entered into a Facilities Operating Agreement under which A will
serve as contract operator and provide manpower for the facility. As contract operator,
A will be subject to the direction and control of P, which will have sole authority to set
overall production levels and to make other strategic decisions. This agreement has an
initial term ending on Date 4 (or, if earlier, the last date on which solid synthetic fuel
qualifying for tax credits may be produced at the facility). A’s compensation for serving
as contract operator will be limited to recovery of costs plus a fixed fee, adjusted for
inflation.

       Following the purchase, the New Members own all of the membership interests
in P, and the Sellers have no voting rights with respect to P. C serves as the managing
member of P, and is responsible for all major operational decisions of P.

       Under the Limited Liability Company Agreement of P, all items of income, gain,
loss, and deduction will be shared, and all cash distributions made, in proportion to the
members’ ownership percentages.

        In connection with the purchase, the New Members determined that the future
operations of P could involve using feedstock from a wide variety of sources and using
varying concentrations of binder, adjusted over time in accordance with the demands of
the marketplace for synthetic fuel as well as the costs of the feedstock and binder. P
commissioned studies on various feedstock sources and binder concentrations.
Experts have conducted numerous tests on synthetic fuel samples produced from such
types of feedstock and such binder concentrations . These tests are described in detail
in P’s letter ruling request. By the preponderance of the test results, the experts have
concluded that there was a measurable, significant change in the chemical composition
of the resulting fuel compared to the corresponding coal-based feedstock.

                            RULING REQUESTS #1 AND #2
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        Section 29(a) allows a credit for qualified fuels sold by the taxpayer to an
unrelated person during the taxable year, the production of which is attributable to the
taxpayer. The credit for the taxable year is an amount equal to $3.00 (adjusted for
inflation) multiplied by the barrel-of-oil equivalent of qualified fuels sold.

      Section 29(c)(1)(C) defines "qualified fuels" to include liquid, gaseous, or solid
synthetic fuels produced from coal (including lignite), including such fuels when used as
feedstocks.

        In Rev. Rul. 86-100, 1986-2 C.B. 3, the Internal Revenue Service ruled that the
definition of the term "synthetic fuel" under section 48(l) and its regulations are relevant
to the interpretation of the term under section 29(c)(1)(C). Former section 48(l)(3)(A)(iii)
provided a credit for the cost of equipment used for converting an alternate substance
into a synthetic liquid, gaseous, or solid fuel. Rev. Rul. 86-100 notes that both section
29 and former section 48(l) contain almost identical language and have the same
overall congressional intent, namely to encourage energy conservation and aid
development of domestic energy production. Under section 1.48-9(c)(5)(ii) of the
Income Tax Regulations, a synthetic fuel "differs significantly in chemical composition,"
as opposed to physical composition, from the alternate substance used to produce it.
Coal is an alternate substance under section 1.48-9(c)(2)(i).

         Based on the representations of P and P’s authorized representative, including
the preponderance of P’s test results, we agree that the fuel to be produced in P’s
facilities using the process on the coal feedstock will result from a significant chemical
change in coal, transforming the coal feedstock into a solid synthetic fuel from coal.
Because P will own the facilities and because A on behalf of P will operate and
maintain the facilities, we conclude that P will be entitled to the section 29 credit for the
production of the qualified fuel from the facilities that is sold to an unrelated person.

                                  RULING REQUEST #3

       Section 29(a) allows a credit for qualified fuels sold by the taxpayer to an
unrelated person during the taxable year, the production of which is attributable to the
taxpayer.

       Section 7701(a)(14) provides that “taxpayer” means any person subject to any
internal revenue tax. Generally, under section 7701(a)(1), the term “person” includes
an individual, a trust, estate, partnership, association, company, or corporation.

        Section 702(a)(7) provides that each partner determines the partner’s income tax
by taking into account separately the partner’s distributive share of the partnership’s
other items of income, gain, loss, deduction, or credit to the extent provided by
regulations prescribed by the Secretary. Section 1.702-1(a) provides that the
distributive share is determined as provided in section 704 and section 1.704-1.
                                              6


      Section 704(a) provides that a partner’s distributive share of income, gain, loss,
deduction, or credit is, except as otherwise provided in chapter 1 of subtitle A of title 26,
determined by the partnership agreement.

        Section 704(b) provides that a partner’s distributive share of income, gain, loss,
deduction, or credit (or item thereof) is determined in accordance with the partner’s
interest in the partnership (determined by taking into account all facts and
circumstances) if (1) the partnership agreement does not provide as to the partner’s
distributive share of income, gain, loss, deduction, or credit (or item thereof), or (2) the
allocation to a partner under the agreement of income, gain, loss, deduction, or credit
(or item thereof) does not have substantial economic effect.

       Section 1.704-1(b)(4)(ii) provides that allocations of tax credits and tax credit
recapture are not reflected by adjustments to the partners’ capital accounts (except to
the extent that adjustments to the adjusted tax basis of partnership section 38 property
in respect of tax credits and tax credit recapture give rise to capital account adjustments
under section 1.704-1(b)(2)(iv)(j)). Thus, these allocations cannot have economic effect
under section 1.704-1(b)(2)(ii)(b)(1), and the tax credits and tax credit recapture must
be allocated in accordance with the partners’ interests in the partnership as of the time
the tax credit or credit recapture arises. If a partnership expenditure (whether or not
deductible) that gives rise to a tax credit in a partnership tax year also gives rise to valid
allocations of partnership loss or deduction (or other downward capital account
adjustments) for the year, then the partners’ interests in the partnership with respect to
such credit (or the cost giving rise to it) are in the same proportion as the partners’
respective distributive shares of the loss or deduction (and adjustments). See section
1.704-1(b)(5), example (11). Identical principles apply in determining the partners’
interests in the partnership with respect to tax credits that arise from receipts of the
partnership (whether or not taxable).

       Based on the information submitted and the representations made, we conclude
that, assuming the solid synthetic fuel produced qualifies for the section 29 credit, the
credit will be allowed to P and the credit may be passed through to and allocated to the
partners of P under the principles of section 702(a)(7) in accordance with each
partner’s interest in P as of the time the tax credit arises. We express no opinion,
however, regarding how the partners’ interests in P are determined.

                                  RULING REQUEST #4

      Section 708(b)(1)(B) provides that a partnership shall be considered as
terminated if within a twelve-month period there is a sale or exchange of 50 percent or
more of the total interest in partnership capital and profits.

      Section 1.708-1(b)(1)(iv) provides that if a partnership is terminated by a sale or
exchange of an interest, the following is deemed to occur: The partnership contributes
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all of its assets and liabilities to a new partnership in exchange for an interest in the new
partnership; and, immediately thereafter, the terminated partnership distributes interests
in the new partnership to the purchasing partner and the other remaining partners in
proportion to their respective interests in the terminated partnership in liquidation of the
terminated partnership, either for the continuation of the business by the new
partnership or for its dissolution and winding up.

       The placed-in-service deadline in sections 29(f)(1)(B) and 29(g)(1)(A) must be
read as applying to when the facility is first placed in service within the applicable dates.
The placed-in-service deadlines contained in sections 29(f)(1)(B) and 29(g)(1)(A) focus
on the facility, and not the taxpayer owning the facility.

        Section 29(g)(2) demonstrates that Congress knows how to preclude transferees
of facilities from claiming the section 29 credit. That provision provides that extension
of the period for placing facilities in service after 1992 does not apply to any facility that
produces coke or coke gas unless the original use of the facility commences with the
taxpayer.

       Accordingly, the determination of whether a facility has satisfied the placed-in-
service deadline under sections 29(f)(1)(B) and 29(g)(1)(A) is made by reference to
when the facility is first placed in service, not when the facility is placed in service by a
transferee taxpayer.

                                  RULING REQUEST #5

       To qualify for the section 29 credit, P’s facilities must be placed in service before
July 1, 1998, pursuant to a binding written contract in effect before January 1, 1997.
While section 29 does not define "placed in service," the term has been defined for
purposes of the deduction for depreciation and the investment tax credit. Property is
"placed in service" in the taxable year the property is placed in a condition or state of
readiness and availability for a specifically assigned function. Sections
1.167(a)-11(e)(1)(i) and 1.46-3(d)(1)(ii) of the Income Tax Regulations. "Placed in
service" has consistently been construed as having the same meaning for purposes of
the deduction for depreciation and the investment tax credit. See Rev. Rul. 76-256,
1976-2 C.B. 46. When property is placed in service is a factual determination, and we
express no opinion on when P’s facilities were placed in service.

        Rev. Rul. 94-31, 1994-1 C.B. 16, concerns section 45, which provides a credit for
electricity produced from certain renewable resources, including wind. The credit is
based on the amount of electricity produced by the taxpayer at a qualified facility during
the 10-year period beginning on the date the facility was originally placed in service,
and sold by the taxpayer to an unrelated person during the taxable year. Rev. Rul.
94-31 holds that, for purposes of section 45, a facility qualifies as originally placed in
service even though it contains some used property, provided the fair market value of
                                              8


the used property is not more than 20 percent of the facility’s total value (the cost of the
new property plus the value of the used property).

        Rev. Rul. 94-31 concerns a factual context similar to the present situation.
Consistent with the holding in Rev. Rul. 94-31, the relocation of any of P’s facilities after
June 30, 1998, will not prevent the relocated facility from continuing to be treated as
originally placed in service prior to July 1, 1998, for purposes of section 29 provided the
fair market value of the used property is more than 20 percent of the relocated facility’s
total fair market value at the time of the relocation.

                                      CONCLUSIONS

      Accordingly, based on the representations of P and P’s authorized
representative, we conclude as follows:

       (1) P, with use of the process, will produce a "qualified fuel" within the meaning
of section 29(c)(1)(C);

        (2) P will be entitled to the section 29 credit for the production of the qualified
fuel from the facilities that is sold to an unrelated person;

     (3) the credit allowed under section 29 may be passed through to and allocated
among the partners in P in accordance with the principles of section 702(a)(7);

      (4) any termination of P under section 708(b)(1)(B) arising from prior sales or
exchanges of interests in P will not preclude P from taking the section 29 credit for the
production of the qualified fuel from the facilities that is sold to an unrelated person; and

       (5) if a facility was "placed in service" prior to July 1, 1998, within the meaning of
section 29(g)(1), relocation of the facility after June 30, 1998, will not result in a new
placed in service date for the facility for purposes of section 29 provided the fair market
value of the used property is more than 20 percent of the relocated facility’s total fair
market value at the time of the relocation.

       Except as specifically ruled upon above, we express no opinion concerning the
federal income tax consequences of the transaction described above. Specifically, we
express no opinion on when P’s facilities were placed in service or how the partners'
interests in P are determined.

       This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent. Temporary or final regulations
pertaining to one or more of the issues addressed in this ruling have not yet been
adopted. Therefore, this ruling may be modified or revoked by the adoption of
temporary or final regulations to the extent the regulations are inconsistent with any
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conclusion in this ruling. See section 12.04 of Rev. Proc. 2000-1, 2000-1 I.R.B. 4, 46.
However, when the criteria in section 12.05 of Rev. Proc. 2000-1 are satisfied, a ruling
is not revoked or modified retroactively, except in rare or unusual circumstances.

         In accordance with the power of attorney on file with this office, a copy of this
letter is being sent to P’s authorized representative.

                                           Sincerely yours,



                                           CHARLES B. RAMSEY
                                           Branch Chief, Branch 6
                                           Office of Assistant Chief
                                            Counsel
                                           (Passthroughs and Special
                                            Industries)

Enclosure:
  Copy for section 6110 purposes