Elliot Pisem and David E. Kahen
Elliot Pisem and David E. Kahen (NYLJ/Rick Kopstein)

Seemingly mundane questions concerning the proper allocation of consideration in determining the basis of purchased assets can have a surprisingly large impact. A recent decision of the Court of Federal Claims in Alta Wind I Owner-Lessor C v. United States, 118 AFTR 2d 2016-____ (Oct. 24, 2016), concluded that six newly constructed wind farm facilities were not “assets which constitute a trade or business” within the scope of Internal Revenue Code §1060; that no part of the purchase price had to be allocated to goodwill, going concern value, or other intangible assets, but, rather, almost all of the purchase price was includible in the basis of tangible property that qualified for federal government grants under §1603 of the American Recovery and Reinvestment Act of 2009 (ARRA); and that, therefore, the plaintiffs were entitled to roughly $200 million more in such grants than the government had initially paid to them by reason of the purchases.

The Facts

The plaintiffs were owners of six wind farm facilities that had been constructed in southern California to generate electricity. A utility had committed in 2006 to buy all the output of multiple not-yet-constructed wind facilities pursuant to a separate power purchase agreement (PPA) to be entered into with respect to each facility. After completion of certain development work, but before construction, the project was sold to Terra-Gen Power, which finished the pre-construction development work and built the facilities.

During the development and construction process, the anticipated value of the wind farm facilities was increased by enactment of a California law requiring that utilities purchase a greater portion of their electricity from renewable sources, and by the enactment in 2009 of ARRA, under which persons who placed in service certain “specified energy property” would be entitled to cash grants equal to 30 percent of their income tax “basis” in such property.

Terra-Gen sold the six facilities in the years 2010 through 2012. One was sold outright, and the others were sold and leased back to Terra-Gen. The sale and sale-leaseback transactions included indemnities under which Terra-Gen indemnified the buyers for losses they might incur in the event the grants paid under ARRA were less than the grants that would be due if the basis of the assets, as used in the calculation of the grants, was less than the full purchase price paid by the purchasers.

In the purchasers’ grant applications, the amounts asserted to qualify for the credit were computed as follows: The developers’ direct costs incurred in constructing qualifying property and in acquiring and constructing non-qualifying property (such as land costs and electrical transmission equipment) were identified. The developers’ indirect costs were then allocated either directly to the asset to which the cost related, or in certain other cases (such as in respect of construction period interest) in a manner proportionate to the allocation of direct costs. Finally, the amount eligible for grants was determined by allocating the purchasers’ purchase price in the same ratio that the developers’ direct and indirect costs determined to be incurred for eligible property bore to the developers’ total costs.

The federal government, however, computed the cash grants on the basis of the developers’ construction and development costs only—that is, without regard to the purchase price paid by the plaintiffs. The plaintiffs brought suit for the difference between the grants actually paid and the grants applied for, as determined by reference to the purchase price.

Discussion

The court observed that, under IRC §1012(a), the income tax basis of property is its cost; and the basis of a purchaser, with respect to property acquired by purchase, is thus the purchase price.

The government argued, however, that the basis of the wind farm facilities should not be determined by reference to the purchase price. More specifically, since the plaintiffs purchased assets that in the government’s view constituted a “trade or business” within the meaning of IRC §1060, that section and relevant regulations required the purchase price in excess of the value of the acquired tangible property to be allocated to intangibles in the nature of goodwill and going concern value. Those intangibles would not be eligible property for purposes of ARRA grants.

Section 1060(a) provides for consideration to be allocated among the assets acquired under the “residual method” of IRC §338 in the context of an “applicable asset acquisition,” which is defined by regulation as any transfer of assets which “constitute a trade or business in the hands of either the seller or the purchaser.” Reg. §1.1060-1(b)(2) in turn provides that a group of assets constitutes a trade or business if: “(A) [t]he use of such assets would constitute an active trade or business under section 355; or (B) [i]ts character is such that goodwill or going concern value could under any circumstances attach to such group.”

The regulations define “goodwill” as “the value of a trade or business attributable to the expectancy of continued patronage,” and “going concern value” as including “the value attributable to the ability of a trade or business (or part of a trade or business) to continue functioning or generating income without interruption notwithstanding a change in ownership.” Factors listed in the regulations to be considered in determining whether goodwill or going concern value could attach to a group of assets include: the presence of intangible assets; the existence of an excess of the total consideration over the book value of the assets purchased (exclusive of goodwill and going concern value) as shown on the records of the purchaser; and the existence of related transactions, such as lease agreements, licenses, and other agreements between the purchaser and the seller.

Goodwill has been found to exist even with respect to a business that has only one customer, if that customer purchases all of the output of the business for an extended period. The court concluded, however, that no goodwill could be found in the circumstances before the court, because the wind farms were not yet in operation when sold to the plaintiffs. The court also rejected the government’s argument that the favorable location of the wind farm facilities itself constituted goodwill, finding the value of location to be inseparable from that of the underlying physical asset; and concluded that there could be no “going concern value” when the facilities were not yet in operation.

The opinion acknowledged that the facilities did have “turn-key” value, in the sense that the facilities were not merely an accumulation of different pieces of equipment, but rather included an installation such that the equipment would function as a whole without further effort, but concluded that such turn-key value is not the same as going concern value.

As the government did not argue that there was the active conduct of a trade or business under §355, and as the court had concluded that goodwill and going concern value could not have inhered in the purchased assets, the court held that there was no applicable asset acquisition, and that §1060, providing for the allocation of consideration under the residual method, which is generally viewed as increasing the allocation to intangibles and decreasing the allocation to the sort of tangible property that qualified for ARRA grants, could not apply. The court did not have to address exactly how calculations under the residual method would have been made in this case, had that method been applicable, particularly with respect to the government’s contention that the purchasers’ bases in the qualifying property would have been limited to the developers’ costs.

The government also argued that, even if section 1060 did not apply, there were “peculiar circumstances” that induced the purchaser to pay a price greater than the fair market value of the qualifying assets acquired, pointing to other agreements between the parties. The opinion briefly discussed the other agreements, including the leasebacks, certain rent prepayments under the leasing transactions, and the indemnities, and concluded that each was either priced on arm’s length terms or otherwise common in the context of the underlying transactions and did not justify a separate allocation of consideration to those agreements.

With respect to the PPAs, in particular, the government argued that those constituted “customer-based intangibles,” one of the categories of “section 197 intangibles” listed in IRC §197(d), and that the purchasers’ allocations were defective in failing to allocate any amount to the PPAs. The court concluded that the PPAs were more in the nature of land leases, which, on the basis of authority cited in the opinion (see also Reg. §1.197-2(c)(8)(i)), are not considered to be assets separate from the underlying land and improvements. Thus, that no separate allocation to such intangibles would be appropriate even if the PPAs had significant independent value.

The court accordingly upheld the plaintiffs’ claim to damages equal to the difference between the grants already paid and the grants computed on the basis of the allocation of the purchase price to eligible assets. In a twist with a bit of human interest (otherwise entirely lacking in this area), it is unclear to what extent the government’s position was undermined by the exclusion of expert testimony it sought to introduce on economics, finance, and valuation matters. The government’s expert witness had omitted, from his list of prior publications, articles he wrote for Marxist and East German publications, and the court concluded that the expert testimony of a witness who attempted to conceal his prior work could not be relied upon.

Observations

The apparent conclusion of the case, to the effect that government grants must be calculated based on purchase prices that were attributable in part to value resulting from the grant program itself, may have been more generous than what Congress intended. However, as the court observed, if Congress intended some narrower definition of “basis” to apply, that could have been set forth in the ARRA legislation.

Seemingly mundane questions concerning the proper allocation of consideration in determining the basis of purchased assets can have a surprisingly large impact. A recent decision of the Court of Federal Claims in Alta Wind I Owner-Lessor C v. United States , 118 AFTR 2d 2016-____ (Oct. 24, 2016), concluded that six newly constructed wind farm facilities were not “assets which constitute a trade or business” within the scope of Internal Revenue Code §1060; that no part of the purchase price had to be allocated to goodwill, going concern value, or other intangible assets, but, rather, almost all of the purchase price was includible in the basis of tangible property that qualified for federal government grants under §1603 of the American Recovery and Reinvestment Act of 2009 (ARRA); and that, therefore, the plaintiffs were entitled to roughly $200 million more in such grants than the government had initially paid to them by reason of the purchases.

The Facts

The plaintiffs were owners of six wind farm facilities that had been constructed in southern California to generate electricity. A utility had committed in 2006 to buy all the output of multiple not-yet-constructed wind facilities pursuant to a separate power purchase agreement (PPA) to be entered into with respect to each facility. After completion of certain development work, but before construction, the project was sold to Terra-Gen Power, which finished the pre-construction development work and built the facilities.

During the development and construction process, the anticipated value of the wind farm facilities was increased by enactment of a California law requiring that utilities purchase a greater portion of their electricity from renewable sources, and by the enactment in 2009 of ARRA, under which persons who placed in service certain “specified energy property” would be entitled to cash grants equal to 30 percent of their income tax “basis” in such property.

Terra-Gen sold the six facilities in the years 2010 through 2012. One was sold outright, and the others were sold and leased back to Terra-Gen. The sale and sale-leaseback transactions included indemnities under which Terra-Gen indemnified the buyers for losses they might incur in the event the grants paid under ARRA were less than the grants that would be due if the basis of the assets, as used in the calculation of the grants, was less than the full purchase price paid by the purchasers.

In the purchasers’ grant applications, the amounts asserted to qualify for the credit were computed as follows: The developers’ direct costs incurred in constructing qualifying property and in acquiring and constructing non-qualifying property (such as land costs and electrical transmission equipment) were identified. The developers’ indirect costs were then allocated either directly to the asset to which the cost related, or in certain other cases (such as in respect of construction period interest) in a manner proportionate to the allocation of direct costs. Finally, the amount eligible for grants was determined by allocating the purchasers’ purchase price in the same ratio that the developers’ direct and indirect costs determined to be incurred for eligible property bore to the developers’ total costs.

The federal government, however, computed the cash grants on the basis of the developers’ construction and development costs only—that is, without regard to the purchase price paid by the plaintiffs. The plaintiffs brought suit for the difference between the grants actually paid and the grants applied for, as determined by reference to the purchase price.

Discussion

The court observed that, under IRC §1012(a), the income tax basis of property is its cost; and the basis of a purchaser, with respect to property acquired by purchase, is thus the purchase price.

The government argued, however, that the basis of the wind farm facilities should not be determined by reference to the purchase price. More specifically, since the plaintiffs purchased assets that in the government’s view constituted a “trade or business” within the meaning of IRC §1060, that section and relevant regulations required the purchase price in excess of the value of the acquired tangible property to be allocated to intangibles in the nature of goodwill and going concern value. Those intangibles would not be eligible property for purposes of ARRA grants.

Section 1060(a) provides for consideration to be allocated among the assets acquired under the “residual method” of IRC §338 in the context of an “applicable asset acquisition,” which is defined by regulation as any transfer of assets which “constitute a trade or business in the hands of either the seller or the purchaser.” Reg. §1.1060-1(b)(2) in turn provides that a group of assets constitutes a trade or business if: “(A) [t]he use of such assets would constitute an active trade or business under section 355; or (B) [i]ts character is such that goodwill or going concern value could under any circumstances attach to such group.”

The regulations define “goodwill” as “the value of a trade or business attributable to the expectancy of continued patronage,” and “going concern value” as including “the value attributable to the ability of a trade or business (or part of a trade or business) to continue functioning or generating income without interruption notwithstanding a change in ownership.” Factors listed in the regulations to be considered in determining whether goodwill or going concern value could attach to a group of assets include: the presence of intangible assets; the existence of an excess of the total consideration over the book value of the assets purchased (exclusive of goodwill and going concern value) as shown on the records of the purchaser; and the existence of related transactions, such as lease agreements, licenses, and other agreements between the purchaser and the seller.

Goodwill has been found to exist even with respect to a business that has only one customer, if that customer purchases all of the output of the business for an extended period. The court concluded, however, that no goodwill could be found in the circumstances before the court, because the wind farms were not yet in operation when sold to the plaintiffs. The court also rejected the government’s argument that the favorable location of the wind farm facilities itself constituted goodwill, finding the value of location to be inseparable from that of the underlying physical asset; and concluded that there could be no “going concern value” when the facilities were not yet in operation.

The opinion acknowledged that the facilities did have “turn-key” value, in the sense that the facilities were not merely an accumulation of different pieces of equipment, but rather included an installation such that the equipment would function as a whole without further effort, but concluded that such turn-key value is not the same as going concern value.

As the government did not argue that there was the active conduct of a trade or business under §355, and as the court had concluded that goodwill and going concern value could not have inhered in the purchased assets, the court held that there was no applicable asset acquisition, and that §1060, providing for the allocation of consideration under the residual method, which is generally viewed as increasing the allocation to intangibles and decreasing the allocation to the sort of tangible property that qualified for ARRA grants, could not apply. The court did not have to address exactly how calculations under the residual method would have been made in this case, had that method been applicable, particularly with respect to the government’s contention that the purchasers’ bases in the qualifying property would have been limited to the developers’ costs.

The government also argued that, even if section 1060 did not apply, there were “peculiar circumstances” that induced the purchaser to pay a price greater than the fair market value of the qualifying assets acquired, pointing to other agreements between the parties. The opinion briefly discussed the other agreements, including the leasebacks, certain rent prepayments under the leasing transactions, and the indemnities, and concluded that each was either priced on arm’s length terms or otherwise common in the context of the underlying transactions and did not justify a separate allocation of consideration to those agreements.

With respect to the PPAs, in particular, the government argued that those constituted “customer-based intangibles,” one of the categories of “section 197 intangibles” listed in IRC §197(d), and that the purchasers’ allocations were defective in failing to allocate any amount to the PPAs. The court concluded that the PPAs were more in the nature of land leases, which, on the basis of authority cited in the opinion (see also Reg. §1.197-2(c)(8)(i)), are not considered to be assets separate from the underlying land and improvements. Thus, that no separate allocation to such intangibles would be appropriate even if the PPAs had significant independent value.

The court accordingly upheld the plaintiffs’ claim to damages equal to the difference between the grants already paid and the grants computed on the basis of the allocation of the purchase price to eligible assets. In a twist with a bit of human interest (otherwise entirely lacking in this area), it is unclear to what extent the government’s position was undermined by the exclusion of expert testimony it sought to introduce on economics, finance, and valuation matters. The government’s expert witness had omitted, from his list of prior publications, articles he wrote for Marxist and East German publications, and the court concluded that the expert testimony of a witness who attempted to conceal his prior work could not be relied upon.

Observations

The apparent conclusion of the case, to the effect that government grants must be calculated based on purchase prices that were attributable in part to value resulting from the grant program itself, may have been more generous than what Congress intended. However, as the court observed, if Congress intended some narrower definition of “basis” to apply, that could have been set forth in the ARRA legislation.