Federal Circuit Affirms, But Narrows Potential Scope of, Trial Court Decision Disallowing Section 1603 Grant for Development Fees in California Ridge and Bishop Hill
The Court of Appeals for the Federal Circuit has affirmed the trial court’s holding that developer fees paid by an affiliate for the development of a wind farm were not substantiated for purposes of including the fees in the costs of a renewable energy facility that are eligible for a grant under section 1603 of the American Recovery and Reinvestment Act of 2009. California Ridge Wind Energy LLC, Invenergy Wind LLC, Bishop Hill Energy LLC v. United States, Nos. 1:14-cv-00250-RHH, 1:14-cv-00251-RHH, May 21, 2020. Although the 1603 grant program has expired, the decision is significant because the same rules for determining eligible 1603 grant costs apply to costs eligible for the energy credit under Code Section 48 as well as depreciable basis. Our prior coverage of the trial court cases is available here.
In both cases, wind farms were developed by what the court described as a “family of related entities” referred to generally by the Court as “Invenergy”, which is in the business of developing, owning, financing, and operating windfarms. Invenergy uses various subsidiaries to perform different functions relative to the development of wind farms, two of which, Invenergy Wind North America LLC (IWNA) and Invenergy Wind Development North America LLC (IWDNA), are relevant to the cases. The relevant wind farms are controlled by Invenergy and owned through a tax equity partnership between Invenergy and Firstar Development (a subsidiary of U.S. Bank).
Because the facts in both cases are materially identical, this article will focus on California Ridge. Development of the California Ridge wind farm began in 2008. In 2012, California Ridge entered into a development agreement with IWDNA. According to the agreement, “IWDNA has provided and agrees to provide further development services” that included negotiating construction financing terms, negotiating the project operational documents necessary or appropriate for the Project, obtaining permits and performing other services relating to the Project. In exchange for these services, California Ridge was obligated to pay IWDNA a $50 million fee. The Court of Appeals noted that the development agreement was entered into long after development of the windfarm began.
Payment of the $50 million fee due under the California Ridge agreement occurred in November 2012 by way of a “round trip” of funds starting and ending with IWDNA. Specifically, IWDNA wired $50 million to California Ridge, which then wired the $50 million back to IWDNA on the same day.
In November 2012, California Ridge applied to Treasury for a 1603 grant totaling $136,858,980. The request included a breakdown of direct and indirect costs of constructing the wind farm. California Ridge included the $50 million development fee in its indirect costs and allocated $49,315,067 to qualified section 1603 grant costs.
Treasury awarded California Ridge $127,699,997 based on its conclusion that the cost of the project was higher than other projects of its size and in its location and the transaction involved related parties or related transactions. Accordingly, Treasury reduced the eligible costs to allow for an “appropriate markup” to more closely match what would have been paid in an arm’s length transaction.
California Ridge filed a complaint in the U.S. Court of Federal Claims on the grounds that Treasury had unlawfully withheld payment mandated by section 1603. The government counterclaimed on the grounds that none of the $50 million developer fee should have been included in 1603 grant eligible basis given the circumstances and characteristics of the non-arm’s length transaction and described it as a “sham” transaction.
The trial court ruled in favor of the government based on its finding that California Ridge failed to show that the development agreement between it and IWDNA had economic substance and therefore was a sham transaction. According to the trial court, the evidence presented—an “independent certification” of the development fees by the Deloitte firm, the development agreement itself, which it found had no quantifiable services, and the round trip transfer of cash between related parties that began and ended on the same day in the same bank account—fell “well short” of proving that the development agreement was not a sham and that the fees charged in that agreement were eligible costs.
The Court of Appeals agreed with the trial court that California Ridge had the burden of proving the amount of the project’s costs that qualified for the 1603 grant. Because the trial court found that California Ridge had not met that burden, that decision could only be reversed by the Court of Appeals if, applying a clearly erroneous standard, it found that the trial court had committed reversable error in its findings of fact.
Beginning its analysis, the Court of Appeals noted that section 1603 measures the amount of the grant by the “expense” of putting certain renewable energy facilities into service, which is measured by the basis of such property as determined under Code Section 1012(a). Thus, to support its claim, California Ridge had to prove that the dollar amounts of the development fees that were between related parties “reliably measured the actual development costs for the windfarms.” Thus framed, the Court of Appeals agreed with the trial court’s finding that “the development agreements do not reliably indicate the development costs.” That finding was not clearly erroneous because it was supported by the evidence in the record, i.e., the round-trip nature of the payment, the failure of the agreement to provide any meaningful description of the services to be provided, and the fact that most or all of the development services had already been performed at contract execution.
California Ridge argued that the trial court’s conclusion that the development agreement was a sham transaction based in part on the fact that California Ridge and IWDNA were related parties, eliminated the ability for one related party to transfer value to another related party by selling services at fair market value. On this point the Court of Appeals disagreed, holding that on the particular facts of the case, the trial court could reasonably find that the $50 million figure that was agreed to in the development agreement did not accurately value that portion of the 1603 grant eligible cost of the project. The Court of Appeals specifically noted that it was not endorsing a per se prohibition on related party transactions, stating that the conclusion that the “agreement-stated figures do not accurately value eligible costs … is hardly a general bar to properly valued transactions within the Invenergy family.”
California Ridge also argued that the development agreement had economic substance because the round-trip payment made under the agreement affected the economic position of the third-party partner, U.S. Bank. The Court of Appeals declined to consider this argument as it was raised for the first time on appeal.
This case spotlights the point that related party transactions that create energy credit basis must pass a fair market value standard, whether the transaction involves goods or services. In order to do so, credible, contemporaneous evidence of the value of the goods or services provided between related parties should be developed and maintained. When possible, this evidence should be in the form of a well-reasoned appraisal by a firm qualified in the subject matter. The court noted that Invenergy failed to do so here, stating: “Deloitte did not independently examine and determine whether the dollar amounts of the development fees accurately reflected the value of the premiums on development work, as California Ridge claims.”
The fact that the payment of the fees in both cases were “round-tripped” troubled the trial court, which found that neither the payor nor the payee was materially affected by the transaction. California Ridge argued that the trial court ignored Invenergy’s book accounting treatment of the transaction. However, the Court of Appeals disagreed, finding that the trial court could readily find that the transaction “did not change the economic position of IWDNA or California Ridge in anything like the amount stated in the agreement.” This conclusion by the court does not state that the fact that the cash was round-tripped caused the transaction to lack economic substance. Rather, the fact that the payment did not change the economic position of the payor or payee meant that the amount of the payment itself was “not a reliable indicator of [the] value” of the services provided.
Although the Federal Circuit decision is adverse to Invenergy, it represents a welcome clarification of the scope of the trial court’s holding. As we noted in our prior coverage, the trial court’s analysis was cursory and opaque. Viewed broadly, it could have imposed significant (and poorly justified) limitations on properly structured tax equity transactions. The Federal Circuit opinion makes clear that its affirmance was based on Invenergy’s failure to support the amount and nature of the development fee and should not be read to prohibit basis step-up transactions involving related parties or round-tripped cash payments.