LANDFILL GAS PROJECTS

IN A POST-SECTION 29 WORLD

by Keith Martin\
kmartin@chadborne.com

Landfill gas projects will be structured differently in the future than
they have been in the past.

In the past, the US government provided rich tax subsidies to landfill
gas producers. In the future, less generous subsidies will go to gas
consumers, but only to consumers who use the gas to generate
electricity. This will cause a shift in how projects are structured, but
because there is still some life left in the old subsidy for gas
producers at the same time the new subsidy for gas consumers is starting
up, it is not a simple matter of the industry moving from an old
structure to a single new one. There will be several different ways to
structure deals over the next year depending on the circumstances.

[Background]{.underline}

People usually try to structure deals to take full advantage of tax
subsidies.

In the past, the tax subsidy was a section 29 tax credit of \$1.1036 an
mmBtu for producing gas. The tax credit went to the gas producer.
However, he could only claim it for gas that he sold to an \"unrelated
person.\" Congress worried that if tax credits could be claimed on gas
that a gas producer used himself, then output figures would end up
inflated. Sales to third parties were easier to verify.

This meant that landfill gas projects had to have bifurcated ownership
structures. One company called a \"gasco\" was formed to own the gas
collection equipment and produce gas. A separate \"genco\" or
\"cleanco\" was formed to buy the gas and use it to generate electricity
or clean the gas so that it could be put into a gas pipeline. In some
cases, the gas was sold directly to a nearby food processor or other
factory as a substitute for natural gas. The gasco could own up to 50%
of the genco, cleanco or other purchaser of the gas \-- or vice versa
\-- but not more than that.

Some projects still qualify for section 29 credits. The credits can be
claimed on landfill gas sold through 2007, but only on gas from wells
that went into service by December 1996 or June 1998 depending on the
facts. (Most wells had to be in service by the end of 1996. However, a
landfill owner had until the end of June 1998 to put any wells into
service that were under binding contract by the end of 1996 to be
installed.)

The figure \$1.1036 an mmBtu was the credit for gas produced and sold in
2003. The amount is adjusted each year for inflation. The Internal
Revenue Service will announce the 2004 figure in April 2005.

Future deals will focus on \"production tax credits.\" These are tax
credits of 0.9¢ a kilowatt hour that will be given to companies that use
landfill gas to generate electricity. These credits are found in section
45 of the US tax code. They were enacted as part of a corporate tax bill
that President Bush signed on October 22, 2004. The equipment used to
generate the electricity must be new equipment. It must be originally
put into service during a \"window period\" that runs from October 23,
2004 through December 31, 2005. The industry is hoping that the next
Congress will make the window period longer. The credits can be claimed
on the electricity output from eligible equipment for five years. (There
is a glitch in the statute. It is not clear whether one can claim the
full five years of tax credits for generating equipment put into service
in late 2004. The statute says credits can be claimed for five years,
but it also says that credits can only be claimed on electricity
produced starting in 2005 and that the five years are measured from when
the generating equipment went into service. The Joint Tax Committee
staff is aware of the discrepancy. It is not clear yet whether it will
fix it in a technical corrections bill that is circulating in Congress.)

The electricity must be sold to an unrelated person.

The production tax credits belong to the owner of the generating
equipment. He must also be the \"producer\" of the electricity. Thus,
lease structures where one company owns the generating equipment and
leases it to someone else do not work. No one in such a case will get
the tax credits since there is no one who is both the owner of the
generating equipment and the producer of the electricity.

[Structures]{.underline}

There are enough variations in facts in the landfill gas industry that
no one deal structure will serve projects in the future as it did in the
past.

For example, there are still landfills with gas collection systems that
were put into service in time to qualify for section 29 credits but at
which the gas is being flared. These landfills still offer an
opportunity to anyone who can find an unrelated person to use the gas.
Any such deal would have to use the bifurcated structure with a gasco on
one side and a genco or cleanco on the other.

Anyone with such a project should think about which is worth more \--
the remaining section 29 tax credits over at most three years or five
years worth of less generous production tax credits. Perhaps production
tax credits are not an option; maybe the only use for the gas is to sell
it to a local factory to make steam or to put it into a gas pipeline
after cleaning. Also consider that the tax subsidies go to different
parties. The choice of approach may be driven by who can make better use
of the tax subsidy.

If the goal is to tap into the remaining section 29 tax credits, then it
would be best if the gasco owned the gas collection equipment. One may
be able to get away with having the gasco lease the collection system
for the remaining term of the tax credits, but the IRS has never
addressed whether the lessee of a collection system is entitled to all
the section 29 tax credits. Section 29(d)(3) of the tax code requires
that all persons with an \"interest\" in the collection system must
share in the tax credits in the same ratio in which they share in
\"gross sales\" of gas. A lease leaves some uncertainty about who gets
the tax credits. The landfill owner can continue to operate the
equipment under a standard operating contract of the kind that a
third-party operator would sign.

It is essential that the gasco \-- and not the contract operator \-- be
viewed as the gas \"producer.\" The gasco will be treated as the gas
producer as long as it remains at risk if the collection system fails or
there is no market for the output and it receives the benefits if the
gas output exceeds expectations. The contract operator should not bear
these risks or receive these benefits. The landfill owner can have an
option to buy back the collection system after the credits expire. It
would be best if the price were the market value determined when the
option is exercised.

Future deals will focus more on production tax credits. There are a
number of ways to get value for them.

A landfill owner that is able to use production tax credits itself can
simply add a generator to convert gas into electricity without going to
the trouble of putting the generating equipment into a separate company
with different owners. The electricity can be sold to the local utility
or into a power pool.

A landfill owner who cannot use the tax credits itself has several
options. It can try to benefit indirectly by selling gas for a price
that reflects the production tax credits to a separately-owned genco.
The genco would then use the gas to generate electricity for sale to the
local utility or into a power pool. Alternatively, the landfill owner
might sell the gas directly to the local electric utility. Utilities
that use landfill gas to generate electricity qualify for tax credits,
but only if the gas is used as fuel in *new* equipment that the utility
installs during the 14-month \"window period\" for eligible projects.
The electricity the utility produces is sold to ratepayers.

Production tax credits have been available for electricity produced at
wind farms since 1994. Small wind developers without the ability to use
production tax credits often enter into \"partnership flip\" structures.
The generating equipment is owned by a limited liability company that is
treated as a partnership for tax purposes. The developer owns an 0.1%
interest in the LLC initially and an institutional equity investor with
a tax base owns the other 99.9%. Taxable income, loss and tax credits
are allocated in this ratio until the later of when the tax credits
expire or the institutional equity reaches a target return. After that,
the percentages shift in one or two stages to an 80 or 90% interest for
the developer and the balance to the equity investor. The developer may
have an option to buy out the equity\'s interest after the tax credits
expire for fair market value determined when the option is exercised.
The developer gets some return until the flip in the form of fees for
acting as the general partner and for operating the facility. The LLC
borrows against the future value of the tax credits to help pay the cost
of the generating equipment. The partners agree to make ongoing capital
contributions for the value of the tax credits. It is these future
capital contributions against which the LLC borrows. The bank will not
take tax risk that the credits are not there, but it will take operating
risk.

A current topic in wind deals is whether cash earned by the LLC can be
distributed in a different ratio than 0.1% to 99.9% without dragging
with it a share of the tax credits. IRS regulations require that
partners share in production tax credits in the same ratio as they share
in \"receipts\" from electricity sales.

Many tax counsel believe that partners can share in cash however they
want without affecting tax credits.

The IRS national office has no position yet. IRS officials start with a
sense of uneasiness that a developer might strip out cash while leaving
tax benefits for a tax-base investor.

Cash can clearly be distributed to a partner as a \"guaranteed payment\"
without affecting tax credits. \"Guaranteed payments\" are amounts that
the partnership commits to pay a partner each year as a return on his
capital or as compensation for services. An example is where a
partnership agreement directs that \$250,000 a year be paid to partner X
out of the first available cash. Remaining cash is shared among the
partners in a different ratio. If there is too little cash in a year to
make the guaranteed payment, then the shortfall is made up in later
years. Guaranteed payments have no effect on how tax credits are shared.
The key to a guaranteed payment is the amount owed to the partner does
not depend on how much income the partnership earns. It is treated for
tax purposes like a payment to a third party \-- for example, the
interest the partnership pays a bank. Payments to third parties do not
affect how tax credits are shared among the partners.

There may be hybrid projects in the landfill gas market. Many landfills
may have both good gas that qualifies for section 29 credits and bad gas
that does not. The bad gas is from expansion wells that went into
service too late to qualify for section 29 credits. Such projects ought
to try to tap into production tax credits on the bad gas.

[Issues]{.underline}

A number of issues will come up in deals.

Double Dipping

Anyone hoping to claim production tax credits for generating electricity
from landfill gas should check whether the gas producer is entitled to
section 29 credits on the gas. If so, then there is a risk that the
production tax credits will be disallowed.

The gas producer should represent in the gas sales contract that the gas
is from wells that went into service after the deadline to qualify for
section 29 credits.

Congress tried in the corporate tax bill that President Bush signed in
October to prevent landfill gas projects from doubling up on section 29
and production tax credits. The same project is not supposed to benefit
from both. However, the language aimed at doing this is poorly drafted.
Read literally, it would rule out production tax credits in almost no
case.

Production tax credits can only be claimed on output from a \"qualified
facility.\" The \"*facility\"* in this context is the equipment used to
generate electricity. The corporate tax bill said,

> \"In the case of a facility producing electricity from gas derived
> from the biodegradation of municipal solid waste, the term \'qualified
> facility\' means any facility owned by the taxpayer which is
> originally placed in service after the date of the enactment of this
> paragraph and before January 1, 2006.\"

However, it also said,

> \"The term \'qualified facility\' shall not include any facility the
> production from which is allowed as a credit under section 29 for the
> taxable year or any prior taxable year.\"

Section 29 credits have never been allowed on \"production\" from an
electric generating facility. The conference committee that wrote this
language explained the provision this way in its report:

> \"No facility that previously claimed or currently claims credit under
> section 29 of the Code is a qualifying facility for purposes of
> section 45.\"

Until the IRS provides evidence to the contrary, the safest course is to
assume that the IRS will interpret the provision to deny production tax
credits on gas from wells that benefited at any time in the past from
section 29 credits.

Even this leaves a company using landfill gas to generate electricity
facing several potential risks. The company should consider whether to
get a private letter ruling from the IRS.

One area of risk is what to do in a case where gas from a portion of the
landfill qualified for credits at some time in the past, but there is
also gas from non-qualifying wells. Gas from all wells usually passes
through a central collection system. The tax code talks in terms of a
tainted \"facility.\" The IRS will have to confirm that gas from the
non-qualifying wells is untainted.

Another is that the corporate tax bill denies production tax credits in
cases where section 29 credits were \"allowed\" at any time in
connection with the gas collection system. The conference report uses
the word \"claimed.\" Thus, the better reading is section 29 credits had
actually to be claimed by someone for gas to be tainted, but there is a
risk the IRS might say otherwise. (The tax code often uses the word
\"allowable\" \-- rather than \"allowed\" \-- when it means could have
been claimed.)

Finally, the IRS will also have to address what happens where both
tainted and untainted gas is used by the same generator. A fair approach
would be to allow production tax credits on a portion of the
electricity.

Haircut

Production tax credits are subject to a \"haircut\" to the extent the
electricity generator also benefits from tax-exempt financing, federal,
state or local government grants, other credits, or \"subsidized energy
financing.\" An example of subsidized energy financing is \"governmental
programs to compensate financial intermediaries for extending
low-interest loans to taxpayers who purchase or construct qualifying
facilities.\" Only subsidies paid by a government in the United States
are taken into account. Thus, for example, export credits from France or
Germany on equipment purchased in those countries would apparently not
reduce the credit.

The haircut is calculated by putting in the numerator of a fraction the
amount of tax-exempt bonds, government grants or other benefits. The
denominator is the total capital cost of the project.

Once tainted, the generating equipment remains tainted even in the hands
of future owners. However, additional capital spending on improvements
has the effect of reducing the haircut since this increases the
denominator.

Not all financial assistance that looks like a government grant is in
fact such a grant, at least not as used in the tax law. The IRS said in
a private letter ruling in 2001 that there was no haircut in a case
where a wind developer received a grant from a nonprofit entity set up
and funded by an investor-owned utility. The utility formed the
organization to encourage renewable energy projects. The program was
part of a deal with state regulators in exchange for permission to let
the utility restructure. The IRS said the fact that the organization was
created as part of a deal with state regulators did not transform the
program into a government subsidy. In another ruling in early 2003, the
IRS said that a lump-sum payment by a state agency to help the owner of
a wind farm cover operating costs was not a \"grant.\" The project will
have to repay any money that it fails to spend on operating costs within
a certain time period. Otherwise, the money is \"earned\" by the project
as it generates electricity. The IRS said a grant exists only if there
is no circumstance where the project might have to repay the money.

In general, grants and other credits that are tied to the cost of a
project reduce the production tax credits. Grants and other credits that
are tied to the amount of output should not. The IRS ruled privately in
2001 that the owner of a wind farm did not have to reduce his production
tax credits on account of receiving \"renewable energy credits\" \-- or
RECs \-- from the state where the project is located. The state requires
local utilities to accumulate a certain number of RECs each year.
Generators of electricity from renewable fuels are awarded credits by
the state and then sell them to utilities. The credits are based on
output.

The IRS is studying whether any *state* tax credits cause a haircut or
whether the haircut should be limited to cases where a project benefits
from other *federal* tax credits. Oregon allows wind developers to claim
a business energy credit against state income taxes for 35% of the
capital cost of their projects, but not more than \$10 million per
project. The credit is claimed over five years. Oregon argues that when
the US tax code says there is a haircut for any \"other credit,\"
Congress intended that a project would suffer a haircut only on account
of other *federal* tax credits. There is no clear evidence of what
Congress intended. The IRS has put the issue on its business plan to
address by next June.

\"Landfill Gas\"

The term \"landfill gas\" is more broadly defined than many people
assume. This may open the door to more projects.

Production tax credits can be claimed by a company using landfill gas to
generate electricity. \"Landfill gas\" includes not only gas from
municipal landfills that collect local garbage, but also gas from the
biodegradation of all solid wastes, defined as follows:

> \"The term \'solid waste\' means any garbage, refuse, sludge from a
> waste treatment plant, water supply treatment plant, or air pollution
> control facility and other discarded material, including solid,
> liquid, semisolid, or contained gaseous material resulting from
> industrial, commercial, mining, and agricultural operations, and from
> community activities, but does not include solid or dissolved material
> in domestic sewage, or solid or dissolved materials in irrigation
> return flows or industrial discharges which are point sources subject
> to permits under section 1342 of title 33, or source, special nuclear,
> or byproduct material as defined by the Atomic Energy Act of 1954, as
> amended.\"

Old PPAs

Be careful if electricity will be sold to the local utility under an old
power contract.

Congress voted in 1999, after lobbying by the California utilities, to
deny production tax credits to any wind project that a taxpayer places
in service after June 1999 to the extent the electricity is sold under a
power sales agreement with a utility signed before 1987. The only
exception is if the contract is amended to limit the electricity that
can be sold under the contract at above-market prices to no more than
the average annual quantity of electricity supplied under the contract
in the five years 1994 through 1998 or to the estimate the contract gave
for electricity output. \"Above market\" means for more than the avoided
cost of the electricity to the utility \-- or the amount the utility
would have had to spend itself to generate the electricity \-- at time
of delivery.

AMT

Both section 29 credits and production tax credits are hard for
companies on the alternative minimum tax to use.

The United States has two corporate income tax systems. Corporations
calculate their regular income taxes and they calculate their
\"alternative minimum taxes\" at a lower rate but with a broader tax
base. The company must pay essentially whichever amount is greater.

Section 29 credits that cannot be used because a company is on the
minimum tax convert into minimum tax credits that can be carried forward
and used in the future to reduce regular taxes to the level at which the
minimum tax kicks in.

Until October, production tax credits could not be used by a company to
reduce its corporate income taxes below a floor. The floor is 75% of the
company\'s regular tax liability or the amount it would owe under the
alternative minimum tax. Any credits that went unused because of this
limitation could be carried back one year and forward for 20 years.
However, the corporate tax bill that President Bush signed in October
will let production tax credits be used against minimum taxes in the
future, but only in the first four years after the generating equipment
is originally put into service.

Passive Losses

Both section 29 credits and production tax credits are hard for
individuals, S corporations and small, \"closely-held\" C corporations
to use. (A \"closely-held\" C corporation is one in which five or fewer
individuals own more than half the stock.) That\'s because the credits
are subject to passive loss rules that limit these types of taxpayers to
using them solely to offset income from other \"passive\" investments.
To avoid this problem, the taxpayer must be involved personally in the
day-to-day operation of the generating equipment in a material way. The
passive loss rules do not apply to larger companies.

Tax Reform

President Bush has made simplifying the US tax code a central theme of
his second term. There is considerable skepticism in Washington about
whether a major tax overhaul will occur at all and, if it does occur,
whether it can be done quickly. The President also talked about tax
simplification during his last campaign in 2000, and the Treasury
Department produced an options paper two years ago, but there was no
followup.

Any significant overhaul of the US tax system could reduce or eliminate
the benefit that companies receive from existing tax subsidies.
Institutional investors putting money into deals would be wise to take
this risk into account in their pricing and, in some deals, they may
want to leave themselves an out. There are always transition rules when
Congress changes the tax laws dramatically, but it is hard to preserve
the full value of these tax breaks in a transition to lower tax rates.

Extension?

The window period for putting generating equipment in service to use not
just landfill gas, but also a host of other renewable fuels expires at
the end of 2005. Backers of production tax credits will be pushing in
2005 for a longer window period. There is not the money, given other
priorities, to make these subsidies permanent. An extension is unlikely
until late summer at the earliest, unless it is part of a national
energy bill that moves earlier in the year. The jury is still out on
whether a national energy bill is likely to clear Congress. Some
lobbyists argue that the Republicans picked up too few seats in Congress
in November to pass a national energy bill. The bill failed in the
Senate the last time around in late 2003 by just a few votes. Even if
the energy bill moves this

coming spring, it would have to have a \"tax title\" to offer a vehicle
for extending production tax credits. Otherwise, the more likely vehicle
is an extenders bill late in the year.

Washington\
January 2005