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California Ridge Revisited: Federal Circuit Affirms that Wind Project Development Fee in Section 1603 Grant Deal is a Sham

In February 2012, an Invenergy affiliate named California Ridge Wind Energy LLC (“California Ridge”), which owned an Illinois wind farm of the same name that had been under development since 2008, entered into a development agreement with another Invenergy affiliate named Invenergy Wind Development North America (“IWDNA”). Under this agreement, in exchange for a $50 million development fee, IWDNA would provide development services to California Ridge, including negotiating construction financing terms, negotiating project and operational documents, obtaining permits, and performing other services relating to the project. The payment was ultimately made in November 2012, a month after the project placed in service.

California Ridge subsequently claimed a Section 1603 cash grant for 30% of eligible project costs, which claim included almost all of the $50 million development fee. Treasury awarded a Section 1603 cash grant to California Ridge that was some $9.2 million less than the amount claimed; in the ensuing litigation, the government also sought to recover the full amount of the grant amount attributable to the $50 million development fee. The Court of Federal Claims agreed with Treasury’s assertion that the development agreement was a “sham” transaction.

The Federal Circuit affirmed this decision (which also covers a conceptually identical development fee for another project, Bishop Hill) on May 21, and some aspects of its reasoning may prove informative for structuring development fee agreements going forward, particularly in the context of investment tax credit (“ITC”) deals. The California Ridge decision is also highly apposite in today’s COVID-19 environment, where legislative discussions have alluded to the possibility of a refundable ITC. If the ITC were indeed to become a form of cash grant, a wind developer whose production-based section 45 credit deal suddenly transforms into a refundable ITC deal may be much more interested in development fees than may otherwise have been the case. Any attempts to structure development fees for projects close to completion should take California Ridge into account.

  1. Round-trip cash flows cannot be recharacterized solely by internal accounting entries. A key facet of the government’s case was the ultimate fate of the $50 million development fee, which, immediately after being paid by California Ridge, passed through the bank accounts of several Invenergy entities before returning to California Ridge at the end of the day. While Invenergy’s exact argument on appeal is not completely clear from the opinion, the funding of the development fee was originally intended to come from another Invenergy entity, Invenergy Wind Global, such that “moving the money directly from IWDNA to California Ridge was a transactional shortcut, which left out intermediate steps of moving money up one side of the Invenergy organizational chain and then back down another.” One infers that Invenergy presumably made internal accounting adjustments to reflect that the cash came from Invenergy Wind Global for cash pool management purposes (thus giving rise to the “complicated treatment featured in Invenergy’s accounting books” to which the opinion alludes), and claimed that there was no circular cash flow between IWDNA and California Ridge. The Federal Circuit was unimpressed by this argument, stating that “even if Invenergy intended for the money to come from the pocket of one Invenergy subsidiary and end in the pocket of another, both pockets are still Invenergy’s.” In other words, internal accounting entries in themselves do not prevent offsetting cash flows from being stigmatized as “circular.”
     
  2. Development agreements need a “meaningful description” of the services provided.  Both the lower court and the appeals court observed that the development agreement “lack[ed] any meaningful description of the services provided.” Calling the description in the development “highly generic,” the Federal Circuit focused on the lack of “concrete specification of services that, if examined, might lend support to the amount set in the agreement for a premium on those services.” The court did not provide precise suggestions for how an agreement to negotiate construction financing, negotiate project documents and obtain permits can be made more specific. Such commercial endeavors are highly dynamic and the time spent on them, as well as the personnel involved, may change depending on the specific situation; quantifying the development services fee must inevitably be more of an art than a science.
     
  3. Development agreements executed “after the fact” are problematic. At the time that the development agreement was executed, the services had largely been performed. The appeals court states that the $50 million development fee would have gained reliability from being part of a “pre-acquisition market transaction.” The opinion seems to imply that because the fee was structured at a time when the value of the project itself was relatively clear, the fee was more a reflection of the increased value of the project than a reflection of the value of the services provided.
     
  4. Scope of independent accounting firm report. Deloitte provided a report stating that the $50 million development fee was consistent with the amounts paid by other third-party investors in Invenergy projects, but the appeals court observed that this report did not “independently examine and determine whether the dollar amounts of the development fees accurately reflected the value of the premium on development work.”  In some sense, this part of the analysis may be comforting to taxpayers, as it implies that the court might look more kindly on a development fee that is explicitly supported by an independent accounting firm appraisal. On a practical level, however, the California Ridge opinion raises questions about what sort of analysis might satisfy the court’s need for rigor and specificity, particularly if an independent valuator decides to use a market-based approach and simply blesses a development fee based on the development fees used for other projects—especially given the court’s rejection of the taxpayer’s attempt to rely on past Treasury guidance stating that “appropriate markups typically fall in the range of 10 to 20 percent” (U.S. Dep’t of the Treasury, Evaluating Cost Basis for Solar Photovoltaic Properties 1 (2011)).

While at least some aspects of the California Ridge development fee might appear to be avoidable, the factors cited by both the trial court and the Federal Circuit may be relevant to structuring development fees for a wide range of renewables deals. How the market chooses to interpret these factors—in particular, in its use of independent accounting firm reports to support development fees—remains to be seen.

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Judy Kwok

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Judy Kwok is a lawyer in the Mintz Tax Practice who focuses on transactions in the energy and sustainability industry, including tax-sensitive structures for renewable energy investments in the project finance space. In addition to advising on tax issues relating to partnerships, depreciation, and energy credit qualification, she has broad experience in mergers and acquisitions, cross-border transactions, and other commercial deals.