October 9, 2024 | By Dorian Hunt, Head of Renewables
Circles are important parts of everyday life. Your circle of friends keeps you sane and the circle of life defines your very existence. The wheel has been a big help over the past few thousand years. If you’re lost in the woods, it can be smart to walk a series of concentric circles to gradually establish a path of escape. In this article, we’re going to discuss circular cash flows. We think of a circular cash flow as a situation where cash moves from a taxpayer through one or a series of intermediate points and then ends up back with that same taxpayer from whence it originated. Of course, when we use the word “circle” in this context we’re not adhering to a strict geometric definition, and the particular dimensions of the path cash might take are wholly dependent on who drafted your org chart. In most deals I see with this feature, it’s more like an extended polygon than a circle.
Why do we want to talk about circular cash flows? Well, some variety of circular cash flows can be a facet of transactions establishing the tax basis of a renewable energy asset. Developers of renewable energy assets are often related to those entities that operate those assets from the point they are placed into service. This interrelatedness between development and operations can, and often does, introduce circular cash flows. This is the first of a series of articles where we will discuss the various flavors of circular cash flows commonly seen in the renewable energy industry.
Setting the Stage
Here’s an example which I will refer to throughout as “Example 1”:
- Developer (“D”) begins construction on a project (the “Project”).
- D and a tax equity investor (“TEI”) form tax equity partnership (“PRS”) and fund it with the cash necessary to accomplish the next step (here assume $50 each from D and TEI).
- Shortly before the end of construction (but before the Project is placed in service), PRS purchases the Project from D for its fair market value of $100.
- PRS places the Project in service and derives credits based on a percentage of PRS’s basis in the Project, which PRS anticipates will be its $100 purchase price.
In Example 1, $50 begins and ends in the hands of D. Thus, that portion of the cash has completed a circle in which it moves from D to PRS and then from PRS to D in a purported equity contribution followed by a purchase. The fact that the $50 of cash has “circled” because of a series of related transactions raises the question of whether the transactions involving the $50 should be respected when determining their federal tax consequences.
In the typical fact pattern, D, TEI, and PRS treat PRS’s acquisition of the Project in accordance with its form. To illustrate the federal tax consequences of doing so, assume that at the time of the sale (in form) of the Project, D’s tax basis in the project is $75. If the form of the transactions is respected, D will recognize $25 of gain on the sale of the Project and PRS will have a $100 basis in the Project for purposes of determining the allowable credits. What guidance should we consider when assessing whether the form of the transaction should be respected? Let’s begin by having Mr. Peabody set the wayback machine to 1983.
What has the IRS said about circular cash?
In certain situations, the IRS has concluded that a circular flow of cash should be recharacterized in accordance with its substance. For example, in Revenue Ruling 83-142,1 the IRS addresses a situation in which a corporation (Y) wants to distribute the stock of Z to Y’s sole shareholder, X. Ideally, that transaction would qualify for nonrecognition treatment as a § 355 distribution of the Z stock. But what if something like an alternate jurisdiction or a foreign law does not permit Y to distribute the stock of Z to X, so X instead buys the stock of Z from Y for $100, and Y immediately distributes the $100 back to X? In that case, the $100 in cash began with X and ends with X, so it has completed a circle. In substance, the overall transaction is no different than a distribution of the Z stock by Y. So, how should the series of transactions be treated for federal tax purposes? In the revenue ruling, the IRS concludes that substance should control. Thus, on these facts the IRS disregards the circular flow of cash, and treats the transactions as a straight distribution of the Z stock by Y to X. In this situation, circularity was disregarded on the premise of substance, to the taxpayer’s benefit.
Revenue Ruling 83-142 followed the IRS’s issuance of similar advice in Revenue Ruling 78-397.2 In that ruling, the IRS disregards a circular flow of cash instituted solely to comply with minimum state capitalization requirements. In the ruling, the IRS notes that “the relationships created by the initial capitalization are cancelled . . . such that the parties are in a position identical to that which would have obtained if the transitory cash flow had not occurred.”
The IRS also addressed a circular flow of cash in Revenue Ruling 74-564.3 In that ruling, P (a corporation) contributed to Z (a newly formed corporation) its own stock and cash necessary to satisfy relevant capitalization requirements in exchange for Z stock. P then contributed the newly issued Z stock to S, an existing, wholly owned subsidiary of P. Thereafter, Z merged into R, with R’s public shareholders receiving P stock in exchange for their R stock. After the merger, R distributed the cash acquired in the merger to S, which distributed it back to P. At issue in the ruling, was whether the R’s receipt of cash in the merger caused the transaction to violate the “solely for voting stock” requirement requisite for a tax-free reorganization under § 368(a)(1)(B) (a “B reorganization”).4 In the ruling, the IRS ignored P’s contribution of cash to Z, ruling that the transaction qualified as a B reorganization.
Applying the principles derived from the revenue rulings described above to Example 1, one might argue that the circular movement of the $50 of cash should be disregarded such that the transaction is treated as though D contributed (rather than sold) 50 percent of the Project to PRS, with the other 50 percent of the Project being purchased by PRS with the cash provided by TEI. This type of recharacterization could cause material shifts to the tax attributes recognized by the transaction’s participants. To illustrate and compare, assume again that at the time of the sale (in form) of the project, D’s tax basis in the Project is $75. If the form of the transactions is respected, PRS will have a $100 basis in the Project for purposes of determining the allowable credits. In contrast, if the transactions are recharacterized, PRS will have a $87.50 basis in the Project ($50 purchase basis and a $37.50 contributed basis in half the property). Note, however, that if form is respected, then as noted above D will recognize $25 of gain on the sale of the Project. If Example 1 is recharacterized under the principles in the revenue rulings, D recognizes just $12.50 of gain. So which treatment should prevail?
The recharacterized transactions in the described revenue rulings were transitory steps designed to put the taxpayer in the same position as it would have been had the desired transactions (i.e., the transactions the circular flows were recharacterized into) been allowed or were practical under relevant local law. Moreover, recharacterization of the circular cash flow in those situations was beneficial to the taxpayer. But what if – as is the case in the Example 1 – (i) the transactions at issue are specifically intended to result in an exchange of property rather than to comply with local law requirements and recharacterization; and (ii) recharacterizing the transaction by acknowledging the circular cash flows produces both favorable (reduced gain recognized by the developer) and unfavorable (reduced credit basis) for the relevant parties?
In contrast to its conclusions in the revenue rulings, the IRS has refused a taxpayer’s assertion that certain transactions involving a circular flow of cash should be recharacterized consistent with the transactions in the revenue rulings. Specifically, in Field Service Advice 200106004, a taxpayer wanted to recharacterize certain transactions consistent with what it believed was the substance of those transactions. The IRS refused in part, allowing the taxpayer to disregard describing same-day transactions occurring as part of a series of transactions, while simultaneously refusing to disregard other circular cash flows occurring as part of the same series but occurring 12 to 16 months after the initial transactions.
In reaching its conclusion in the field service advice, the IRS appears to have relied on “step transaction” type principles. Such principles have been applied by the IRS and courts in determining whether a transfer of property and money will be treated as a single transaction or as separate transactions and generally look at a variety of factors, including – (i) the relation in time and purpose among the several steps; (ii) the existence of a business purpose for each step taken; (iii) the intention of the parties to the transaction; and (iv) the interdependence of the several steps taken or the existence of an indivisible contract calling for each step subsequently taken.5 Specifically, the IRS described the factors it took into consideration as: 1) no binding agreement for the steps in question to occur at the time of the first transaction; 2) period of time between the steps (which was measured in months rather than days) suggesting that the steps were not transitory; 3) the cash received was not segregated by the person that held it, and instead could be used for general corporate purposes including to earn income or be pledged; 4) disregarding the circular cash would result in one party making funds available to another for a period of time without receiving interest or its equivalent; 5) no intention by one party to pay the cash to another until an independent event occurred (in this case, that the payor had available distributable earnings so that it could avoid foreign tax on the purported distribution); and 6) no apparent legal prohibition for the last steps that occurred to occur well prior to the time at which they actually occurred (i.e., the later steps presumably could have occurred much closer in time to the initial steps).
Application to Example 1
Circling back to the facts in Example 1, how would the contribution of cash to PRS and the use of that cash to buy the project fare under an analysis of the factors in Field Service Advice 200106004? The IRS might assert that, if the sale of property by D to PRS could not have occurred without D’s contribution of cash and the money contributed was not at risk in the business for any meaningful period prior to PRS’s return of it to D, then in substance there was a property contribution to the extent D funded the acquisition. If so, a part sale/part contribution framework might apply resulting in some portion of PRS’s basis in the project simply being a portion of D’s carryover basis.
Planning Opportunities
What steps might PRS take to increase the likelihood that the form of the transaction resulting in $25 of gain for D and $100 of basis for PRS be respected? One tactic may be to arrange the transaction such that the sale of the project should not be simultaneous with the D’s cash contribution, and the cash contributed by D should be at risk in the business for a meaningful period. Some might suggest that the time between the cash contribution and the purchase of the project “straddle” two or more taxable years. However, as a wise man once said, “When applying the step transaction doctrine, if there is not a firm plan in place at the time of the first transaction, waiting ten minutes should be enough. If there is a firm plan in place at the time of the first transaction, a ten-year delay is not sufficient.” However, if the cash contributed by D was used by PRS in other aspects of its business in the interim, then the risk of recharacterization would be reduced as the risk of D actually receiving the funds increases. Therefore, it would seem that the risk of recharacterization is inversely proportional to the extent to which the circled cash is at risk during the intermediate segments of its journey.
The contribution of cash by partners to a newly formed partnership followed by the purchase by the partnership of property from an unrelated party is certainly a common transaction. Should the fact that the property is purchased by the partnership from a partner fundamentally change the consequences of the transactions? What if the cash in question is not contributed to PRS by D, but rather by a wholly owned corporate subsidiary of D? In that case, if cash is derived from the subsidiary’s own activities (as opposed to a contribution to the subsidiary by D), the circle would not be complete and thus arguably not subject to recharacterization. But is this a distinction without a difference? Should there be a difference in federal tax consequences for developer’s that have previously existing subsidiaries with cash on hand as compared to those that do not?
Conclusion
Notwithstanding the above, it is not entirely clear what collection of principles should drive the determination of whether the transactions between D and PRS are in fact circular. So where does that leave us? Do we end up in the winner’s circle? Or in one of Dante’s 7 circles? It all depends on the facts and the situation. In our next segment in this series, we’re going to look at circular cash through the lens of § 707, where a partner does business with a partnership in a capacity other than as a partner. Then, we’re going to explore situations where we have separate development and operational silos transacting with one another (i.e., DevCo/OpCo cross-chain sales). So, don’t touch that dial.
References
1 1983-2 C.B. 68.
2 1978-2 C.B. 150.
3 1974-2 C.B. 124.
4 All “Section” or “§” references herein are to the Internal Revenue Code or the Treasury Regulations promulgated thereunder, as in effect on the date of this article.
5 See, generally, Barksdale Hortenstine and Gregory Marich, A Comprehensive Guide to Interpreting and Living with The Rules Governing Disguised Sales of Property, Tax Notes, March 27, 2006, p. 1421.