Alcohol Mixture Credit Case Delivers Blow to Taxpayers Based on Economics of Transactions and the Tax Credits

The biofuels industry suffered a blow in the U.S. District Court for the Southern District of New York in a case that pitted the alcohol fuel mixture credit against the economic substance doctrine. The case is Chemoil Corp. v. U.S., No. 19-CV-6314-LTS-JW.

The case relates to a disallowance of the ethanol mixture tax credit resulting from an IRS audit. The government argued that the taxpayer was not allowed the credit because it had no legitimate basis for engaging in the transactions in question and did so only to claim the tax credit. Among the support the government proffered was: (1) the volume of gasoline mixed with ethanol was so small that it didn’t affect the characterization of the product as ethanol; (2) the transactions were consummated after the credit expired and documents were backdated; (3) the counterparties had no need for gasoline to be added to the ethanol being purchased; (4) the taxpayer had no reasonable expectation of pre-tax profit and created the mixtures solely to claim the tax credit. In ruling on cross summary judgment motions, the Court agreed with the government. The Court determined that Chemoil was not entitled to the tax credit under the economic substance doctrine; in other words, Chemoil had no business purpose – other than the ability to qualify for the credit – to engage in the transactions in questions (blending E99).

Future Industry Considerations

Why does this matter? Knowing the economics of fuels such as B100 versus B99, we have to wonder what this ruling means for the industry: Is this the end of blending as we have known it for over a decade? What does a taxpayer need to do to show its blend transactions have economic substance? Do the pricing terms matter? Will this decision open the industry in general to more scrutiny by the IRS? How does a decision on one type of credit affect the new credits under the Inflation Reduction Act, all of which are covered by the codified economic substance doctrine as general business credits under section 38 of the Internal Revenue Code.

Chemoil Corp. Case Background

IRC section 6426 allows a taxpayer that blends a renewable fuel (currently biodiesel, renewable diesel, alternative fuel and sustainable aviation fuel (and formerly alcohol (expired 2011)) with gasoline, diesel or kerosene and sells or uses that mixture as a fuel a credit for the blending activity. IRS section 6427 allows a taxpayer that has no excise tax liability to claim the biodiesel, renewable diesel, sustainable aviation fuel (and formerly alcohol and alternative fuel credits) as a cash refund.

In 2011, Chemoil engaged in several transactions where it created alcohol fuel mixtures and claimed the $0.45 per gallon alcohol fuel mixture credit. Having no excise tax liability, Chemoil claimed these credits as a refund under IRC 6427. In each transaction, Chemoil created an E99 blend. Chemoil structured these transactions wherein it purchased denatured fuel grade ethanol from a supplier, added 0.1% gasoline and resold the blended product back to the same supplier. The contracts described both products as “Fuel Grade Ethanol.” The pricing terms varied but, in all cases, the blended product was sold back to supplier at a price lower than the purchase price of the neat ethanol. In the case of several transactions, court records show that efforts were made to backdate invoices to show that transactions that occurred after the credit had expired in January 2012, had actually taken place in December 2011.

Upon audit, the IRS determined that Chemoil was not entitled to the tax credit on these transactions and proposed an excessive claims penalty. After failing to resolve the matter administratively, Chemoil initiated an action in the U.S. District Court for the Southern District of New York. Chemoil argued that the economic substance doctrine did not apply.

Reasoning

In determining that Chemoil was not entitled to the credits, the court relied on the economic substance doctrine. Citing, Bank of N.Y. Mellon Corp. v. Comm’r (“BONY Mellon”), 801 F.3d 104, 113 (2d Cir. 2015) (citing Gregory v. Helvering, 293 U.S. 465, 468-70 (1935)), the court said, “To be ‘valid’ and not just a ‘sham,’” under the economic substance doctrine, “a transaction must involve more than just tax benefits: it must have independent economic substance.” Id. at 108 (citing DeMartino v. Comm’r, 862 F.2d 400, 406 (2d Cir. 1988)). The court also noted that the U.S. Court of Appeals for the Federal Circuit had previously held that the economic substance doctrine does apply to these types of tax credits (Alternative Carbon Res., LLC v. United States, 939 F.3d 1320, 1330 (Fed. Cir. 2019)).

When applying the economic substance doctrine, the Court evaluates two factors: “1) whether the taxpayer had an objectively reasonable expectation of profit, apart from tax

benefits, from the transaction; and 2) whether the taxpayer had a subjective non-tax business purpose in entering the transaction.” BONY Mellon, 801 F.3d at 115 (citing Gilman v. Comm’r, 933 F.2d 143, 147-48 (2d Cir.1991)). On the first prong of the test, the Court said that Chemoil sold ethanol at a pre-tax loss in each of the transactions in question and therefore had no reasonable expectation of profit from the sale. On the second prong, the Court said that there was no evidence in the record that Chemoil had any motivation to enter into the transactions other than potential tax benefits that could be reaped from obtaining the alcohol mixture excise tax credit.

What Does this Mean for Taxpayers?

This decision potentially has significant implications for taxpayers:

Having determined that the transactions lacked economic substance, taxpayers may find themselves under audit for open years. There is also the consideration of what to do on a forward basis. With added scrutiny to transactions where minimal blending occurs, there is a very heavy onus on taxpayers to be able to show that such transactions have a reasonable expectation of profit without the existence of the tax credit and are therefore not motivated solely by the tax credit. Given the economics of many of these biofuel products, this may be a tall order; a blended product is often sold at a loss as against the purchase price of the neat fuel. Pricing terms may be a factor – fixed pricing versus indexed pricing could show a taxpayer taking a risk of profit or loss, although this alone may not be enough to satisfy economic substance. The ultimate outcome could be that traditional marketers are taken out of the industry and producers will sell direct to entities blending B5 or B20 for retail use. Indeed, despite the IRS guidance allowing 0.1% blends, the government may take a position that the B5/B20 blender was the intended claimant of the credit all along.

In addition to the existing blend credits, it is also important to consider what impact this decision could have on the future producer credits that were enacted in the Inflation Reduction Act, such as the Clean Fuel Production Credit and Carbon Sequestration Credit. It is arguable that these activities are simply not profitable absent the credit. Falling under section 38 of the Internal Revenue Code related to general business credits, these activities are covered by the codified economic substance doctrine. The Chemoil case ought to force industry to take a look at its activities and ask, “What is my business purpose for doing this?”

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