[00:00:00] Speaker 00: Phase number 20-1015, cross-refine coal LLC et al. [00:00:05] Speaker 00: versus Commissioner of Internal Revenue, a balance. [00:00:08] Speaker 00: Ms. [00:00:08] Speaker 00: Bringer for the appellant, Mr. Bishop for the appellees. [00:00:16] Speaker 02: You may proceed, Ms. [00:00:17] Speaker 02: Bringer. [00:00:17] Speaker 02: Thank you, Your Honor. [00:00:19] Speaker 02: Bringer? [00:00:20] Speaker 01: Bringer, yes, that's correct, Your Honor. [00:00:21] Speaker 01: Thank you. [00:00:22] Speaker 01: Good morning, and may it please the court. [00:00:24] Speaker 01: My name is Nora Bringer, and I represent the Commissioner of Internal Revenue in this appeal. [00:00:30] Speaker 01: The issues the commissioner raises on appeal concern the organization of Cross Refined Coal as a partnership. [00:00:36] Speaker 01: It is especially tempting to abuse the partnership form to transfer tax benefits among taxpayers, so partnerships come under special scrutiny for federal tax purposes. [00:00:46] Speaker 01: This appeal is not about whether Cross engaged in actual business activities that qualified for refined coal credits. [00:00:53] Speaker 01: The IRS agrees that it did, and that AJGC, which had all of the non-tax upside from CROSS and the lion's share of the downside, may claim the tax benefits from CROSS. [00:01:06] Speaker 01: A key element in a partnership, the Supreme Court tells us in the Tower case, is that there is a community of interest in the profits and losses. [00:01:15] Speaker 01: Here, there was not. [00:01:17] Speaker 02: Your argument was that Gallagher had the lion's share of risk. [00:01:22] Speaker 02: And I'm not sure what the lion's share has a technical definition or not. [00:01:30] Speaker 02: As long as the other partners had a material risk of losing their investment or a significant portion of it, would that suffice or could it still be considered an improper partnership for tax purposes? [00:01:46] Speaker 01: Well, Your Honor, the Colbertson test is a holistic test, looks at all of the facts. [00:01:50] Speaker 02: And an important piece of that- So I'm focusing on your lion's share argument. [00:01:55] Speaker 01: Yes, Your Honor. [00:01:56] Speaker 01: So an important piece of that is the downside risk. [00:01:59] Speaker 01: It's not the whole story, but it is an important piece of that. [00:02:02] Speaker 01: And here, the tax court grossly overstated the amounts that Fidelity and Schneider had at risk in Cross. [00:02:10] Speaker 02: But if they had, just under my question, let's just, apart from this case, the lion's share may well be in one partner. [00:02:19] Speaker 02: But if the other partners have a material risk of losing substantial amounts of their investment. [00:02:28] Speaker 02: Your Honor, a material risk is, I'm sorry. [00:02:31] Speaker 02: Would that be, I don't know one factors dispositive, but for your concern here where you're not challenging, you're only challenging two of the factors. [00:02:44] Speaker 02: What role does it play if they have material risk, but someone else has most of the risk? [00:02:51] Speaker 01: Your Honor, partners certainly can have differing levels of risk and partnership. [00:02:56] Speaker 01: That's permissible. [00:02:57] Speaker 01: Here, the concern is that on the risk side, [00:03:01] Speaker 01: The balance was so out of balance, especially compared to the anticipated tax benefits that Fidelity and Schneider anticipated out of this partnership, that the risk at the end of the day is more like de minimis. [00:03:15] Speaker 01: But a material risk would weigh in favor of a partnership. [00:03:18] Speaker 01: That's true, even if there was an imbalance in risk among the partners. [00:03:24] Speaker 01: The other side of the coin, though, on the economic upside, we acknowledge that Fidelity and Schneider had [00:03:30] Speaker 01: some level of risk. [00:03:32] Speaker 01: The commissioners never argued that there was no risk in their investment in CROSS. [00:03:38] Speaker 01: The argument is rather that there's this huge imbalance between the downside risk and the anticipated tax benefits. [00:03:45] Speaker 01: But on the upside of the story, looking at the business operations of CROSS, AJGC is the only entity here with an upside potential from the underlying business of refining coal. [00:04:00] Speaker 01: In the Culbertson case, the Supreme Court tells us that whether a partner enjoys the fruits of the partnership is strongly indicative of the reality of his participation in the enterprise. [00:04:12] Speaker 01: The historic BoardWalk and the TAFD case in Chemtech, those are- Can I ask you something back on, again, these risks? [00:04:18] Speaker 02: Yes. [00:04:18] Speaker 02: I'm sure I'm not going to pronounce it right, but there was, they went into, I think, three or four of these partnerships simultaneously. [00:04:27] Speaker 02: Three, is it right? [00:04:29] Speaker 02: Three? [00:04:29] Speaker 02: Yes. [00:04:30] Speaker 02: And one of them, is it Jyfreeze? [00:04:33] Speaker 02: Jeffreeze? [00:04:33] Speaker 01: Jeffreeze, I believe. [00:04:35] Speaker 02: Jeffreeze. [00:04:37] Speaker 02: Do you dispute that they lost money and lost their investment? [00:04:44] Speaker 02: They made no profit at all under that one? [00:04:47] Speaker 01: Well, the facts of this case are really focused on the cross partnership. [00:04:52] Speaker 01: That is the only partnership at issue here. [00:04:53] Speaker 02: I understand, but do you dispute what happened in that partnership, which was doing the same thing as this one? [00:04:59] Speaker 01: Uh, no, your honor, but a critical piece is that the, um, the protections with respect to the initial investments in particular, uh, for fidelity were quite different in those partnerships, uh, with respect to cross fidelity had liquidated damages provisions that didn't have any limited. [00:05:20] Speaker 02: It didn't have that in the Jeffries. [00:05:21] Speaker 01: I don't believe so, your honor. [00:05:23] Speaker 01: I'm not certain about that, but I don't believe so. [00:05:25] Speaker 02: Your counsel for the other side can. [00:05:27] Speaker 02: answer that question. [00:05:29] Speaker 02: But if they did. [00:05:31] Speaker 01: Your Honor, there certainly was some downside risk in these partnerships. [00:05:38] Speaker 01: The commissioner doesn't dispute that. [00:05:41] Speaker 01: The issue is rather that, on the one hand, the tax court grossly overstated the amount at risk. [00:05:48] Speaker 01: And given how important that was to the tax court case here and to looking at the overall partnership [00:05:56] Speaker 02: the errors of the tax court on the downside really- But I'm trying to get to this grossly overstated when we know they lost, it looks like everything on the Jefferies partnership. [00:06:08] Speaker 02: And at the time, I take it we look at the time they entered into the partnership. [00:06:15] Speaker 01: Is that the- Well, Your Honor, certainly the question is what was their intent in entering the partnership? [00:06:21] Speaker 01: And when they enter the cross partnership, [00:06:24] Speaker 01: Schneider thought based on projections from AGHC that a $7 million investment would result in $140 million of tax benefits. [00:06:33] Speaker 02: If everything went perfectly for 10 years. [00:06:36] Speaker 01: Yes, that's correct, Your Honor. [00:06:38] Speaker 02: And what evidence was there that everything would go perfectly for 10 years at the time they entered into the partnership? [00:06:44] Speaker 01: Well, Your Honor, the evidence and the record about what the investors anticipated would happen [00:06:52] Speaker 01: Is their internal documents projecting the anticipated upside from these partnerships? [00:07:00] Speaker 01: There is not evidence in the record. [00:07:04] Speaker 02: Do those projections describe it as sort of a best case or hope for scenario, or do they say this is kind of a lock? [00:07:11] Speaker 01: So the projections from AJGC, the tax board, did describe them as a best case scenario. [00:07:16] Speaker 01: Fidelity's projections included a range of minimum production and maximum production from about $100 million to about $150 million. [00:07:25] Speaker 01: But either way, as the tax court found, they anticipated very high returns from this. [00:07:33] Speaker 00: Why is that a problem in a case like this where, as you say, the IRS is not contesting that there are actual transactions going on, right? [00:07:44] Speaker 00: I mean, a number of our cases talking about the relationship of the economic substance or where there's sort of sham transactions, but here no one disputes that there was actually coal that was refined and then sold and used to produce energy, right? [00:08:01] Speaker 00: the actual activity that Congress sought to incentivize. [00:08:05] Speaker 00: And so why exactly should we be focusing on the various economic decisions that the partners made about the type of risk to undertake? [00:08:15] Speaker 01: Well, Your Honor, there is no dispute here that Cross did refine coal and did sell that coal to Santee Cooper. [00:08:22] Speaker 01: That's absolutely right. [00:08:23] Speaker 01: But economic substance is not sufficient to sustain the validity of a partnership. [00:08:28] Speaker 01: This court was very clear about that in the ASA Investorings case, even if there was economic substance there, that wasn't enough to save the partnership. [00:08:36] Speaker 01: In the Southgate Master Fund case, the Fifth Circuit put it this way, that the sham partnership analysis focuses solely on the question of whether there was a non-tax business purpose that necessitated the partnership's existence. [00:08:50] Speaker 01: So the question here is not, did Cross actually refine coal? [00:08:54] Speaker 01: The question is, were Fidelity, Schneider, and AJGC [00:08:58] Speaker 01: truly partners in that underlying business of refining coal. [00:09:02] Speaker 01: We've discussed the downside. [00:09:04] Speaker 02: Habsport found that Gallagher sought out partners, found as a matter of fact that Gallagher sought out partners for the purpose of spreading its investment risk. [00:09:15] Speaker 02: This is on JA 1794. [00:09:17] Speaker 02: Spreading its investment risk over a larger number of projects, not exceeding his parents company limited appetite for coal, allowing Gallagher to learn from lessons [00:09:29] Speaker 02: spreading across facilities. [00:09:30] Speaker 02: You can learn from what's going wrong at one project or the other. [00:09:32] Speaker 02: And to expand its royalty earnings on the ChemMed technology. [00:09:37] Speaker 02: You haven't challenged those factual findings. [00:09:40] Speaker 01: No, you're right. [00:09:40] Speaker 01: That's correct. [00:09:41] Speaker 01: We haven't. [00:09:41] Speaker 02: So as to Gallagher was looking for partners for legitimate non-tax reason, correct? [00:09:47] Speaker 01: So the tax court found that Gallagher was looking for entities to share its risk. [00:09:52] Speaker 01: But Fidelity and Schneider did not. [00:09:53] Speaker 02: Let me ask this one more time. [00:09:55] Speaker 02: So Gallagher was looking for partners for legitimate business reasons, non-tax reasons. [00:10:01] Speaker 01: It is what the tax court found and we don't challenge that enough yet. [00:10:03] Speaker 02: So we're taking that as a given. [00:10:06] Speaker 02: And then the district court, sorry, the tax court also found that these other confedeli and insider came in and did due diligence and kept themselves updated on all types of information. [00:10:22] Speaker 02: were being involved in what was going on with the refining of this cleaned up coal. [00:10:30] Speaker 02: They weren't just sort of passively mailing it in. [00:10:34] Speaker 02: You don't dispute those facts, do you? [00:10:36] Speaker 02: No, we don't, Your Honor. [00:10:40] Speaker 02: But you don't dispute the fact that they got wiped out on one of the three partnerships. [00:10:46] Speaker 02: You don't dispute that fact. [00:10:48] Speaker 01: That's correct, Your Honor. [00:10:49] Speaker 01: But focusing here on what happened with Crest. [00:10:53] Speaker 02: Schneider didn't have the protection, the liquidated damages protection that Fidelity did. [00:10:59] Speaker 02: You don't just get that either. [00:11:00] Speaker 01: That's correct, Your Honor. [00:11:02] Speaker 01: They had different provisions in their membership purchase agreements. [00:11:05] Speaker 02: Fidelity and Schneider had stuck with this partnership for its 10-year term. [00:11:11] Speaker 02: They'd stuck with it despite everything that was going on. [00:11:15] Speaker 02: They would have lost money. [00:11:17] Speaker 02: Do you dispute that? [00:11:18] Speaker 01: Your honor, there's no support in the record for that conclusion. [00:11:22] Speaker 02: No one was buying any more coal. [00:11:24] Speaker 02: They were just paying ongoing operating expenses. [00:11:29] Speaker 02: No one was buying the coal. [00:11:30] Speaker 02: It stopped. [00:11:31] Speaker 01: Well, that's not correct, your honor. [00:11:33] Speaker 01: It's my understanding, and I believe this is in the record, that Cross did eventually begin refining coal again after Fidelity and Schneider exited. [00:11:43] Speaker 01: How long after? [00:11:46] Speaker 01: I'd have to get you the specific date, Your Honor. [00:11:49] Speaker 01: I believe it was in 2014, but I'm not certain. [00:11:52] Speaker 02: And I'm not sure what year of the park, that 10-year period. [00:11:54] Speaker 02: What was the 10-year period? [00:11:56] Speaker 01: So Fidelity and Schneider exited in 2013. [00:11:58] Speaker 01: They began refining coal in 2010. [00:12:02] Speaker 01: But Fidelity and Schneider didn't join. [00:12:04] Speaker 02: Did they continue refining this from 2014 on? [00:12:07] Speaker 01: Your Honor, that's not in the record, and I don't know. [00:12:10] Speaker 02: The government didn't show that, in fact, had they stuck with it, [00:12:15] Speaker 02: they would have gotten all these profits or at least the lower end of their projections? [00:12:21] Speaker 01: No, Your Honor, the government didn't show that, but neither did Cross, which bore the burden of proof here to show that the IRS's determination was incorrect. [00:12:29] Speaker 01: If I may, Your Honor, I recognize that I'm into my time. [00:12:32] Speaker 01: If I may make a couple of points on the upside. [00:12:35] Speaker 01: So Fidelity and Schneider didn't join Cross to share in Gallagher's risk. [00:12:40] Speaker 03: Sorry, before we go to upside, I might ask you another question about downside. [00:12:46] Speaker 03: Absolutely. [00:12:47] Speaker 03: So, as I understand your theory is that fidelity and Schneider didn't really have much skin in the game. [00:12:57] Speaker 03: And the way you reach that conclusion is by saying [00:13:03] Speaker 03: ignore all of their contributions that were made in months, one month after the tax credit had been realized because they knew they were going to get some benefit. [00:13:18] Speaker 03: But I mean, that's the benefit of 2020 hindsight. [00:13:23] Speaker 03: When they enter into the partnership, they do what [00:13:28] Speaker 03: partners always do, which is they make a commitment to fund the operating expenses on a pro rata basis. [00:13:37] Speaker 03: And they're on the hook for that. [00:13:39] Speaker 03: And if there's a good month, they'll happily do it because it'll produce a profit. [00:13:46] Speaker 03: If there's a bad month, they're still on the hook for funding the expenses as they had to do in many months where they were losing money. [00:13:55] Speaker 03: So why don't we look to the scope of the commitments they made when they formed the partnership instead of ignoring all of the expenses that were funded in months that turned out to be successful? [00:14:13] Speaker 01: Your honor, if you want to look at what the partners understood they were getting into with respect to the operating expenses, [00:14:22] Speaker 01: There are excellent examples of this in Fidelity's internal documents, and this is at page 1480 of the appendix. [00:14:29] Speaker 01: In December 2009, on the cusp of formalizing its investment in CROSS, Fidelity wrote that the ongoing operations expenses were a contingent liability that exists only if qualified tax credits are produced. [00:14:42] Speaker 01: And it also said these expenses would be paid quarterly in arrears as the tax credits are generated. [00:14:48] Speaker 01: So these operating expenses, a fidelity new from the beginning would be paid in arrears. [00:14:53] Speaker 01: And the amount of money committed in the absence of refining coal was minimal compared to the expenses when CROSS was refining coal. [00:15:04] Speaker 03: They were on the hook. [00:15:07] Speaker 03: pay expenses, and they did pay expenses in every month where no coal was being produced. [00:15:15] Speaker 01: Yes, Your Honor. [00:15:16] Speaker 01: As the tax court found, the tax court concluded that there were $2.9 million in expenses, which is a very small portion of the overall operating expense contributions here. [00:15:27] Speaker 03: Which makes sense. [00:15:28] Speaker 03: Most of the costs are variable here. [00:15:31] Speaker 01: Yes, Your Honor. [00:15:31] Speaker 01: The vast majority of them are variable. [00:15:36] Speaker 03: Gist of your objection seems to be that this looks like a really good deal in months where things are working out. [00:15:46] Speaker 01: No, Your Honor, the gist of the commissioner's objection to this is that this looks like a situation where Fidelity and Schneider put a very small amount of money in upfront, had very small amounts at risk from these operations expense contributions. [00:16:01] Speaker 01: And then in the context of the anticipated tax benefits, [00:16:05] Speaker 01: that they thought would result here, that that is not a substantial factor weighing in favor of this being a partnership. [00:16:16] Speaker 01: Okay. [00:16:16] Speaker 01: On the upside part of this, if I may just say a couple of things. [00:16:22] Speaker 01: First, Fidelity and Schneider did not join Cross to share in Gallagher's risk. [00:16:28] Speaker 01: So the tax court did find that that was an interest of Gallagher. [00:16:32] Speaker 01: But Fidelity and Schneider as rational economic actors needed an economic upside out of this investment. [00:16:39] Speaker 01: And they were totally indifferent to the economic upside of Cross's operations except for the tax credits. [00:16:48] Speaker 01: Now it's not the IRS's position that there must be a pre-tax profit in this kind of situation. [00:16:54] Speaker 01: What is required is some kind of economic upside from the underlying business, not just tax benefits. [00:17:02] Speaker 01: legitimate partners have meaningful upside potential or a meaningful stake in the operations of the company they're invested in. [00:17:09] Speaker 02: I'm trying to figure out how that works when you have as here a tax benefit that's designed to encourage people to do undertake activities that they wouldn't do absent the tax benefit. [00:17:25] Speaker 02: It wouldn't be profitable at least pre-tax. [00:17:28] Speaker 02: and they would have no interest in doing it pre-tax. [00:17:32] Speaker 02: I just don't understand how your pre, you said you don't, you don't have to have a pre-tax benefit, but they have to have some interests apart from the tax benefits. [00:17:40] Speaker 02: Like, maybe I just didn't understand what you were saying. [00:17:42] Speaker 02: They're supposed to have pre-tax. [00:17:44] Speaker 01: So the IRS's position is not that a pre-tax profit is required. [00:17:49] Speaker 01: But the IRS's position is that there must be some kind of economic upside in the underlying activities of the business. [00:17:56] Speaker 01: So as an example, [00:17:57] Speaker 01: In this case, Gallagher. [00:18:00] Speaker 02: There must be an economic upside to the business. [00:18:04] Speaker 01: In the underlying business. [00:18:05] Speaker 01: So in this case, Gallagher had. [00:18:09] Speaker 02: The production of this refined coal. [00:18:11] Speaker 01: Yes, the refining of coal. [00:18:13] Speaker 02: There has to be some upside when? [00:18:14] Speaker 01: Through the operations of the business. [00:18:19] Speaker 01: So if I may, Gallagher is a good counterexample. [00:18:25] Speaker 01: Gallagher had potential upsides and downsides through its ownership of the technology, through its role as a licensor of the technology, through receiving the technology licensing fees from Cross. [00:18:37] Speaker 01: And through the mechanism of that technology licensing fee, Gallagher was solely exposed to the ups and downs of the operating expenses when Cross refined coal, which was the vast majority of the operating expenses. [00:18:50] Speaker 02: I think the difficulty is that [00:18:53] Speaker 02: The way it looked, Gallagher and its lovely technology were going to go nowhere without partners. [00:19:01] Speaker 02: They weren't going to be able to do anything without partners because this thing just isn't going to work financially. [00:19:07] Speaker 02: Even they were not going to be able to do this operationally without other people to come in and share the expenses and share the benefits. [00:19:18] Speaker 02: So it's a little odd to me to say, let's just look at Gallagher when Gallagher said, I thought I have partners. [00:19:25] Speaker 02: And Congress said, you know what? [00:19:27] Speaker 02: We want people to do this and they won't do it. [00:19:31] Speaker 02: People won't jump in and get involved in this unless we give them this tax benefit. [00:19:36] Speaker 02: And I don't understand why it matters that they said, okay, Congress said, we'll make this economically viable for you with a tax benefit. [00:19:47] Speaker 02: We're willing to do it in light of that tax benefit. [00:19:50] Speaker 02: Is that your position that that's when someone says we're willing to do it because of the tax benefit, we wouldn't do it without the tax benefit, that it is therefore not a legitimate decision to enter into the tax partnership? [00:20:03] Speaker 01: No, Your Honor. [00:20:05] Speaker 01: The tax benefit could certainly be part of the calculus. [00:20:09] Speaker 01: But the question is, did these entities really intend [00:20:13] Speaker 01: to enter into the business of refining coal together. [00:20:16] Speaker 00: Why can a tax credit not be the entire reason for getting into it? [00:20:21] Speaker 00: If the tax credit is the only thing that makes this type of business economically feasible, [00:20:27] Speaker 00: Why can't that be the only upside potential for the partners? [00:20:32] Speaker 00: I mean, that seems to be a decision that Congress quite clearly made and then reinforced after 2008 when it took away the, you know, enhanced value of coal provision. [00:20:43] Speaker 00: So I guess, I mean, is the government's position, I mean, I'm just not sure that the government's position is consistent with the creation of these. [00:20:50] Speaker 00: tax credits by Congress. [00:20:52] Speaker 00: I understand the IRS wants to protect the public fisc and get as many tax revenues as it can, but that doesn't seem to be the policy that was pursued by Congress. [00:21:03] Speaker 01: Your Honor, Congress was certainly intending to encourage refined coal through the tax credit. [00:21:09] Speaker 01: There's no question about that. [00:21:10] Speaker 01: What Congress was not encouraging [00:21:13] Speaker 01: was for the creation of partnerships to transfer those tax benefits where the purported partners had minimal skin in the game and no economic upside from the underlying business. [00:21:25] Speaker 01: Here Gallagher had all of the upside from the refining of the coal and the lion's share of the downside risk as we've discussed. [00:21:35] Speaker 01: Now in this court's [00:21:38] Speaker 01: opinion in ASA Investorings. [00:21:42] Speaker 01: This court really focused on the fact that the key is a non-tax business motive for forming the partnership. [00:21:50] Speaker 01: And quoting a 1944 opinion from the Second Circuit and National Investors Corporation, the court wrote that escaping taxation is not business. [00:21:58] Speaker 00: So the business purpose for fidelity and Schneider can't just be to reduce their taxes idea of escaping taxation or evading taxation very different from benefiting from affirmative tax credits. [00:22:14] Speaker 00: Right. [00:22:14] Speaker 00: I mean, isn't that a isn't that a [00:22:17] Speaker 00: I mean, isn't that a different thing in fact? [00:22:19] Speaker 00: I mean, it's a very different thing to create a structure to just simply evade tax versus to create a structure to take advantage of tax credits, right? [00:22:30] Speaker 00: When Congress creates tax credit, it effectively creates a different kind of economic market for the underlying good, right? [00:22:37] Speaker 00: Here, refined coal. [00:22:39] Speaker 00: And so there's a business that's simply taking advantage of that different market incentive that Congress has created. [00:22:46] Speaker 01: Well, Your Honor, with respect to how it works out on the bottom line of a tax return, evading tax and taking advantage of a tax benefit like a tax credit do form the same function. [00:22:59] Speaker 01: Sure. [00:22:59] Speaker 00: I think it might be. [00:23:00] Speaker 00: It's very different public policy, though. [00:23:04] Speaker 01: Well, Your Honor, in terms of encouraging the refining of coal through the tax credit, absolutely. [00:23:10] Speaker 01: There's no question that's what Congress meant to do here. [00:23:13] Speaker 00: Congress wants people to take advantage of tax credits. [00:23:16] Speaker 00: It doesn't want people to evade taxes. [00:23:20] Speaker 01: Yes, Your Honor. [00:23:21] Speaker 01: But AJGC in this constellation of members of CROSS undertook the activity that Congress meant to encourage here. [00:23:30] Speaker 01: Fidelity and Schneider did not. [00:23:32] Speaker 01: AJGC invested in the technology. [00:23:34] Speaker 01: AJGC had all the partnerships with the utilities. [00:23:37] Speaker 01: AJGC took the risk on not only the technology, but the operations of CROSS. [00:23:45] Speaker 01: And so here, AJGC did it. [00:23:48] Speaker 02: Could Gallagher have done it by itself? [00:23:51] Speaker 02: They're finding that Gallagher apps would have done it by itself. [00:23:57] Speaker 01: Well, Your Honor, the tax court did find that Gallagher brought in partners to spread its risk, whether it would have done it without partners. [00:24:05] Speaker 01: But that's probably a fair inference there. [00:24:07] Speaker 02: It wasn't his company didn't have an interest in doing it by itself. [00:24:10] Speaker 02: So what Congress wanted to have happen wouldn't have happened if partners didn't come in or seems unlikely to have happened. [00:24:20] Speaker 01: Your Honor, Congress, in fact, anticipated that people might join together to refine coal. [00:24:26] Speaker 01: What Congress did not anticipate was that entities could come in and put a very small amount of money into a partnership and reap the tax benefits without really being full participants in the business. [00:24:40] Speaker 01: I'm sorry, Your Honor. [00:24:41] Speaker 02: This doesn't feel like a small amount of money, but maybe that's just the salary bracket from which I'm looking at it. [00:24:47] Speaker 02: It looks like a lot of money. [00:24:50] Speaker 01: Well, I understand that. [00:24:51] Speaker 02: Our bottom line is- It's not a token payment. [00:24:54] Speaker 02: And it was ongoing payments, even whether or not tax credits were being generated. [00:25:00] Speaker 01: The vast majority of those payments, though, Your Honor, were not truly at risk. [00:25:03] Speaker 01: And so when looking at the risk of these entities in cross, those payments and arrears for operating expenses simply shouldn't have been part of the equation. [00:25:16] Speaker 01: So in context, which is important to set my salary that this is in the context of, it's in the context of [00:25:24] Speaker 01: you know, how much did they put in and how much did they anticipate out of the partnership? [00:25:29] Speaker 01: And that difference here is quite striking. [00:25:34] Speaker 01: So thank you very much. [00:25:35] Speaker 01: Yes, any other questions? [00:25:39] Speaker 02: Okay, thank you. [00:25:40] Speaker 02: We'll hear from Mr. Bishop now. [00:25:48] Speaker 04: May it please the court. [00:25:49] Speaker 04: I just want to put straight that fidelity [00:25:54] Speaker 04: and the other partners had exactly the same agreement as to Jeffreys, as they did as to Cross. [00:26:03] Speaker 04: And if you look at JA761, that is the membership purchase agreement that applies to all three of the partnerships, Cross, Winyar, and Jeffreys. [00:26:17] Speaker 04: And a page 779 is the liquidated damages clause that applied equally to Jeffreys. [00:26:24] Speaker 04: And the liquidated damages cause has conditions. [00:26:31] Speaker 04: You can't exercise it willy-nilly. [00:26:34] Speaker 04: At Jeffries, the partners did not exercise it within 30 days of the plant being closed down because they had decided that they were going to move the machinery, the plant that they had [00:26:52] Speaker 04: bought to another utility. [00:26:56] Speaker 04: And so they didn't exercise the liquidated damages clause in time. [00:27:00] Speaker 04: When they did pull out, Fidelity lost $2.9 million in after-tax money and Schneider $700,000 in after-tax money. [00:27:13] Speaker 04: And what Judge Gustafson held here is that at the time when the partners entered into the partnership, [00:27:22] Speaker 04: they didn't know if tax credits would ever be generated or in what amounts. [00:27:28] Speaker 04: And they could even have failed to recoup their investment, just what happened at Jeffries. [00:27:34] Speaker 04: Because there were all these risks, demand risks, regulatory risks, environmental risks that stood between them and obtaining the credits. [00:27:46] Speaker 04: So, you know, Jeffries, I think, [00:27:48] Speaker 04: shows with our question that what we put into the partnership was at risk. [00:27:53] Speaker 04: And what we put into the partnership, Ms. [00:27:55] Speaker 04: Springer talks about this being a small amount, what we put into the partnership was exactly what it costs to refine coal. [00:28:05] Speaker 04: We bought a plant that costs $6 million. [00:28:09] Speaker 04: We put in a $1.5 million escrow in advance to cover operating expenses. [00:28:15] Speaker 04: And then we paid those [00:28:18] Speaker 04: operating expenses each month. [00:28:21] Speaker 04: And those are the expenses of running an ordinary business. [00:28:27] Speaker 04: And I can refer the court to JA955, which is a statement of account for the cross partnership for one month for October of 2010. [00:28:46] Speaker 04: And it lists what all those expenses are. [00:28:48] Speaker 04: It indicates the escrow amount at the top and at the bottom. [00:28:52] Speaker 04: And it talks about all the expenses that we pay, which are payroll, rental, materials, chemicals, safety services, the cost of running an ordinary business. [00:29:04] Speaker 04: And that's what we were doing. [00:29:06] Speaker 04: In ASA, I'm sorry, Josh Katz's. [00:29:09] Speaker 03: Yeah, I was just gonna take you to ASA. [00:29:13] Speaker 03: So your position [00:29:17] Speaker 03: makes a lot of intuitive sense for the reasons my colleagues have explored. [00:29:23] Speaker 03: Congress wants this kind of activity to be undertaken, and you all are undertaking it. [00:29:33] Speaker 03: But ASA has this very broad language, which says that either the transaction, which is the underlying [00:29:47] Speaker 03: production of coal or the entity, which is the creation of the partnership here, is a sham in the absence of a non-tax business purpose. [00:30:04] Speaker 03: How do we make sense of that language in these cases where [00:30:14] Speaker 03: no one would have undertaken any of this cross or anybody else without the tax credit. [00:30:22] Speaker 03: So in some sense, none of this happens without a tax purpose. [00:30:30] Speaker 04: Yes, Your Honor. [00:30:30] Speaker 04: Well, it's true that the tax court found that there was no incentive, that it was uneconomic to enter into this business without the credit. [00:30:40] Speaker 04: But at the same time, there is a non-tax business purpose here. [00:30:44] Speaker 04: And that is to refine and sell coal that meets the standards that Congress has laid down. [00:30:51] Speaker 04: And what this court said in ASA and BCP when it was contrasting this non-tax business purpose was it drew a contrast between business in the ordinary meaning. [00:31:03] Speaker 04: That's a quote in ASA from Learned Hand. [00:31:09] Speaker 04: and transactions that are so structured, structured in the extreme such that they are just a facade. [00:31:16] Speaker 04: And then it talks about that sort of business as being essentially a worthless business. [00:31:23] Speaker 04: And again, in BCP, again, this contrast between a non-tax business purpose and a real business, it talks about economic, practical economic effects of the business apart from tax effects. [00:31:39] Speaker 04: Now, if you look at those things, business in the ordinary meaning, was this a facade, are there non-tax business effects? [00:31:48] Speaker 04: The answer is yes, it's not a facade. [00:31:51] Speaker 04: We have a plant, we have employees, we refine coal. [00:31:56] Speaker 04: 94% of our revenue comes from the sale of refined coal to the utility. [00:32:05] Speaker 04: Only 6% of our revenue is from the credits. [00:32:09] Speaker 04: And again, referring the thought to that document at A955, there are an awful lot of economic effects in there that have nothing to do with tax, paying our employees, buying the chemicals. [00:32:21] Speaker 04: We are running a real business. [00:32:24] Speaker 04: We are putting into that business exactly what it takes to run a refining coal business. [00:32:29] Speaker 04: And what we are getting out of it is two streams of revenue. [00:32:32] Speaker 04: One is for the sale of the refined coal, and the other is the tax credit. [00:32:36] Speaker 04: And the tax credit is exactly in the amount that Congress specified you should earn per ton of refined coal. [00:32:44] Speaker 04: So even though, even though the, no one would, no one, not just us, no one would enter this business without the incentives that Congress provided to encourage this activity, [00:32:57] Speaker 04: In order to get there, you have to run a real business which has its own real economic effects. [00:33:05] Speaker 04: So that's my suggestion, Judge Katz. [00:33:07] Speaker 04: And obviously the context in ASA and BCP is nothing like that. [00:33:11] Speaker 04: In those cases, you're on the structured side of the transaction where there is no point to the business other than to exploit [00:33:19] Speaker 04: tax rules that are not incentive rules like the refining credit, but that are for some other purpose entirely. [00:33:27] Speaker 04: In ASA, it was the installment rules. [00:33:31] Speaker 04: In BCP, it was contingent liability rules. [00:33:34] Speaker 04: So nothing to do with the particular activity, but you squeeze a fake business in a papered structured transaction to take advantage of those rules. [00:33:44] Speaker 04: We are doing exactly what Congress incentivized [00:33:49] Speaker 04: and spending exactly the amount of money that it takes to run a real refining coal business on those credits. [00:33:59] Speaker 03: Thank you. [00:34:00] Speaker 02: You had argued about the commission's mistake being that it wasn't looking at a risk adjusted, I think you call it a risk adjusted ratio between the investment and the tax benefits. [00:34:19] Speaker 02: Am I right? [00:34:20] Speaker 02: I might not be describing it just right, but you thought there should be a risk adjust. [00:34:24] Speaker 02: You know, the government sort of had the best. [00:34:26] Speaker 04: No, no, no, no, no, no, no, it's all relevant. [00:34:28] Speaker 04: I mean, that's the beauty of the Culbertson test. [00:34:30] Speaker 04: You take you take all of this into account here. [00:34:33] Speaker 04: And then the court recognized there may be, you know, there may be cases where where the where the disparity could be could be telling or where the lack of [00:34:45] Speaker 04: non-tax profit could be telling, but the beauty of Culbertson is you take everything into account. [00:34:48] Speaker 04: The tax court here made findings as to the projected amount of the benefit, the actual much smaller amount of the tax benefit that was received, and the amount of money that we invested. [00:35:06] Speaker 04: And it didn't [00:35:07] Speaker 04: used the word ratio, which the government seems to think is a legal requirement, but it considered all of those facts. [00:35:14] Speaker 04: And what it found was that in context, we were putting in the amount of money that the investment that was required to run this business and that the after-tax benefits that we got were a fraction of our projections because risks that we knew about [00:35:38] Speaker 04: risks that we knew about as a result of our due diligence came to pass. [00:35:42] Speaker 02: I'm trying to figure out when we're sort of looking at investment and discounting by risk. [00:35:46] Speaker 02: And then in BCP, we looked at not the projected tax benefits, but the claimed tax benefits. [00:35:54] Speaker 02: And yet the inquiry is supposed to be, as I understand it, the intent when entering into the partnerships. [00:36:03] Speaker 02: So is it looking at claim tax benefits or projected tax benefits? [00:36:08] Speaker 04: No, the district, the tax court here found that we were aware when we entered into the partnership as a result of our extensive due diligence of the risk. [00:36:20] Speaker 04: We were even aware of the bromine risk. [00:36:22] Speaker 04: We were aware of the demand risk. [00:36:24] Speaker 04: We were aware of the regulatory risk. [00:36:26] Speaker 04: So those projections, the district court said, were a best case scenario and they depended on [00:36:32] Speaker 04: operating at full production over the full 10 year period, we knew that that wouldn't happen. [00:36:38] Speaker 04: We couldn't put a number on that. [00:36:41] Speaker 04: We did put on an expert at trial who ran Monte Carlo analysis to show what the real range of losses and gains could be. [00:36:52] Speaker 04: The partners didn't do that, but they knew that they had significant risks. [00:36:56] Speaker 04: And so, the best indicator here [00:37:02] Speaker 04: What we could have anticipated at the worst, at the time when we entered into this partnership, the $19 million that all three partners received between them as tax benefits, or the situation in Jefferies where demand dissipated and the partners lost $3.5 million. [00:37:24] Speaker 04: So I agree, Judge Mallette, there's no doubt that [00:37:28] Speaker 04: know, an initial prediction, particularly in a case where everything is structured, where everything is fake, all right, this is a paper transaction where there's no real risk, where there's no upside that isn't controlled, where returns are guaranteed, fixed returns are guaranteed, those sorts of situations that of course, you know, the unvarnished projection may be very, very telling. [00:37:51] Speaker 04: But here, the partners knew of the risks and knew that that projection was subject to actually refining and selling coal. [00:38:00] Speaker 04: And all of these problems that arose, the loss of the permit and the shutdown for three years because of the bromine, those have to be considered as well in this situation. [00:38:12] Speaker 04: And that's the beauty of Culbertson, Your Honor, that Culbertson, which the tax court faithfully applied here, [00:38:19] Speaker 04: allows you to take all of these into account. [00:38:22] Speaker 04: Ms. [00:38:22] Speaker 04: Bringer's theory here, which imposes these sort of fixed rules on top of culverts and doesn't, and really doesn't allow you to account for the fact that this is conduct that Congress is encouraging. [00:38:35] Speaker 02: I'm not sure that that's what she's proposing as opposed to trying to put some meat on the bones of sort of anticipated recoveries and risks factors, you know, prospect, [00:38:48] Speaker 02: of recovery factors under Culbertson. [00:38:51] Speaker 02: I mean, it has to be some meat on the bones in some way of actually comparatively analyzing those. [00:38:57] Speaker 02: If that's what their ratio and stuff is seeking, then that wouldn't be illegitimate. [00:39:02] Speaker 02: It's just whether it was appropriately adjusted for risk or not when they had their best case scenario. [00:39:10] Speaker 04: Well, I agree absolutely, Your Honor, that all of those [00:39:13] Speaker 04: The amount of projections, the amount of actual returns, the knowledge of the partners as to the risk when they made the projections, those are all relevant factors. [00:39:22] Speaker 04: But as I read the government, it thinks that that ratio is determinative. [00:39:28] Speaker 04: And that's just not the case under Culbertson. [00:39:31] Speaker 04: And it doesn't allow courts to take account of the disparate facts in cases like this, which is an unusual case. [00:39:43] Speaker 04: real partners who was the tax court found were engaged day-to-day in the operation of this business. [00:39:50] Speaker 04: Any decision to spend more than $5,000 had to be passed on by all three of the partners. [00:39:56] Speaker 04: They were engaged on a day-to-day basis in operating a business and paying its expenses. [00:40:03] Speaker 04: And I do want to address just on the operating costs issue because Ms. [00:40:08] Speaker 04: Springer did bring up [00:40:10] Speaker 04: this claim again that the operating expenses were not really at risk. [00:40:16] Speaker 04: And that's wrong. [00:40:17] Speaker 04: And it's wrong for two reasons. [00:40:19] Speaker 04: It's wrong because there was an escrow that we funded in advance for a million and a half dollars. [00:40:27] Speaker 04: And as the document at 955 shows that we replenish that escrow each month. [00:40:32] Speaker 04: So we were actually paying in a risk. [00:40:34] Speaker 04: But more important than that, when we refine the coal, [00:40:40] Speaker 04: the credits accrued, they weren't earned. [00:40:44] Speaker 04: And in fact, the government in this case, in its answer, section 7G of its answer, did not concede that the refined coal here was qualified. [00:40:54] Speaker 04: That is that it met the emissions reduction requirements of the statute. [00:41:00] Speaker 04: At trial, it put on an expert witness who said that the lab testing that we did was inadequate and that in order to qualify, [00:41:09] Speaker 04: the testing should be done at the stack. [00:41:12] Speaker 04: Trial counsel tells me that they did not know until the government's closing argument in this case that the government was not going to challenge the qualification of the coal. [00:41:21] Speaker 04: In another one of these cases, which is under audit at the moment, the government is challenging qualification of the coal. [00:41:28] Speaker 04: We had absolutely no guarantee at the time when we produced this coal that we would ultimately [00:41:36] Speaker 04: be allowed the credits over this qualification issue. [00:41:43] Speaker 04: And the trial showed that to be the case. [00:41:46] Speaker 04: So all of those operating contributions were at risk and should not be discounted, essentially ignored altogether, which is what the government would like to do here. [00:42:00] Speaker 02: Okay. [00:42:00] Speaker 02: My colleagues have any other questions? [00:42:03] Speaker 02: All right. [00:42:04] Speaker 02: Thank you very much, Mr. Bishop. [00:42:06] Speaker 02: Ms. [00:42:06] Speaker 02: Bringer, we'll give you two minutes for rebuttal. [00:42:08] Speaker 01: Thank you very much, Your Honor. [00:42:09] Speaker 01: I appreciate that. [00:42:11] Speaker 01: As an initial point, Judge Katz has asked about non-tax business purpose. [00:42:17] Speaker 01: And the non-tax business purpose that is relevant here is for the formation of the partnership. [00:42:24] Speaker 01: Was there a non-tax business purpose to form the partnership? [00:42:27] Speaker 01: As discussed earlier, [00:42:29] Speaker 01: Fidelity and Schneider did not have a non-tax business purpose to join this partnership. [00:42:33] Speaker 01: Their only reason to join this partnership was for the tax benefits. [00:42:39] Speaker 03: In addition to that, they knew- Why do you reach that conclusion with regard to Fidelity, but not with regard to AJC? [00:42:54] Speaker 03: You can look at this one of two ways. [00:42:57] Speaker 03: One way of looking at this is, as Mr. Bishop said, you're doing real stuff. [00:43:04] Speaker 03: They're running a business, they're producing coal, and that counts as a business purpose, even if the business would not be profitable, but for the tax benefits. [00:43:17] Speaker 03: Or the other way you can look at it is you can understand [00:43:23] Speaker 03: the phrase non-tax business purpose to mean that the enterprise or the partnership have to make sense without regard to tax benefits. [00:43:38] Speaker 03: And that seems to prove way too much, including that AJC wasn't legitimately engaged in a business. [00:43:49] Speaker 01: Here in our AJGC had a number of ways to have a possible upside from this business through its investment in the technology, through the possibility of reducing operating expenses, which would have inured entirely to AJGC. [00:44:04] Speaker 01: So AJGC is a really different position from Fidelity and Schneider when it comes to the business of producing coal. [00:44:14] Speaker 01: And the question. [00:44:15] Speaker 03: Sorry, are you saying they might have gotten into this business, but for the tax credits? [00:44:22] Speaker 01: No, Your Honor. [00:44:23] Speaker 01: The point is that AJGC had an economic upside potential, for example, from reducing operating expenses at Cross. [00:44:33] Speaker 01: Fidelity and Schneider both had employees who testified that through the technology licensing fee, [00:44:40] Speaker 01: it provided an incentive for AJGC to reduce costs. [00:44:44] Speaker 01: So Gallagher is really the entity that's engaged in the activity that Congress meant to incentivize here, which is the production and refining of refined coal. [00:44:56] Speaker 01: Now context matters. [00:44:59] Speaker 01: And it seems that there's a fair amount of agreement in the argument today that the tax court should have considered [00:45:08] Speaker 01: the downside risk versus the upside. [00:45:12] Speaker 01: And whether that's the anticipated tax benefits according to the documents that were introduced at trial, whether that's some kind of risk-based assessment, which there's no evidence of in the record here, but even if that's the proper comparison, the fact is the tax experts simply didn't consider that. [00:45:28] Speaker 01: And not only did it not consider that, it mistakenly thought that Culbertson barred that kind of contextual comparison. [00:45:35] Speaker 01: And that was a significant error in the tax experts opinion here. [00:45:39] Speaker 01: At the end of the day, Congress did indeed want entities to refine coal and sought to encourage that through the refined coal credit. [00:45:47] Speaker 01: But Congress did not intend for the formation of invalid partnerships to share those tax credits by abuse of the partnership form. [00:45:55] Speaker 01: And in the commissioner's view, that's what occurred here. [00:45:57] Speaker 01: Are there any further questions? [00:46:02] Speaker 02: All right. [00:46:02] Speaker 02: Thank you very much. [00:46:03] Speaker 02: Thank you very much. [00:46:04] Speaker 02: For the helpful arguments on the cases submitted.