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April 9, 2014
Black Liquor: The Loophole That Won't Quit
by William Hoffman

Full Text Published by Tax Analysts®

This document originally appeared in the April 7, 2014 edition of Tax Notes Today.

Major U.S. paper products manufacturers and distributors are squeezing the last dollars out of a controversial tax credit discontinued years ago but given new life after the IRS declared the refunds would not be taxable income.

International Paper, in its 2013 annual filing with the SEC, recognized an income tax benefit of $753 million regarding the IRS's 2010 decision to treat benefits from the alternative fuel mixture credit (AFMC) as nontaxable income -- a windfall to the company from a tax loophole that was officially closed years ago.

The AFMC is the technical name for one of the more notorious tax schemes of the past decade, the "black liquor" loophole. By adding diesel to black liquor -- a byproduct of the paper manufacturing process that paper mills have long burned as a fuel -- companies created an alternative fuel mixture that the IRS recognized for the section 6426(e) tax credit.

That wasn't what Congress intended. The original plan was a credit useful to innovators of liquid motor fuels from biomass. The Joint Committee on Taxation estimated (JCX-59-05) the original alcohol motor fuel tax credit -- enacted in 2005 as part of an energy bill -- would cost the treasury $194 million over 10 years. But the credit was extended in 2007 to include nonmobile uses of alternative biomass fuels, and the IRS issued a chief counsel advice memorandum (ILM 200941011) in June 2009 making black liquor eligible for the nonrefundable cellulosic biofuel producer credit (and by extension, the refundable AFMC). Paper producers saw their opportunity and took it. The JCT reported that the industry claimed more than $2.5 billion in credits in the first six months of 2009 alone.

Since then, International Paper and other paper industry companies have pulled in an estimated $25 billion in unintended tax benefits from their use of black liquor. In the final act, some of these companies are now acknowledging in their financial statements the tax savings that Treasury and the IRS bestowed on them: $323.3 million in 2013 for Verso Paper Corp.; $165 million for MeadWestvaco Corp.; and $166 million for Packaging Corp. of America (PCA). Some of the claims and claimants may never be publicly known. Koch Industries, the second-largest paper products company in the world with $31.1 billion in sales, is a private company that does not file annual reports with the SEC.

"The AFMC payments were an unintentional mistake by Congress, but I contend that the billions in refunds should have been taxed as income to the claimants," said John Robinson, professor of accounting at the University of Texas at Austin. He coauthored with Lisa De Simone and Bridget Stomberg "Distilling the Reserve for Uncertain Tax Positions: The Revealing Case of Black Liquor" (Review of Accounting Studies, Oct. 2013), which explored the relationship between the loophole and the paper companies' financial accounting.

"There is virtually no support in the Internal Revenue Code for excluding these payments," Robinson said. "However, when Treasury capitulated on challenging these exclusions, the companies were able to report the tax savings as additions to their reported earnings, essentially adding insult to injury."

The paper companies can do this because they are allowed to amend their 2009 returns retroactively to claim the AFMC, and they can use the same product to claim different tax benefits according to their preference. The result has been and will be a loss of untold billions from the treasury for an industry whose refundable tax credit is almost uniquely treated as nontaxable income by the IRS.

IRS's 'Secret Law'

William Henck, an attorney in the IRS chief counsel's office in Richmond, Va., has been calling attention to the black liquor credit almost since its creation. His calls have gone almost entirely unheeded.

At the center of the controversy is the question of the taxability of the cash payments for the refundable black liquor credits, according to Henck. A 26-year IRS veteran, Henck said Rev. Rul. 67-2, 1967-1 C.B. 13, which indicated that the excise tax refunds were taxable and applied to farmers using gasoline and receiving a refund on the excise tax, was assumed to be the Service's position on the cash payments from the black liquor credits. Most companies receiving the credits reported them as income, Henck said. A draft revenue ruling was in process at the IRS stating that the cash payments were taxable income, he added.

But a few companies claimed that the credits should not be taxable. And Henck said that after a high-level meeting between unnamed industry lobbyists, Treasury officials, and "chief counsel-level" IRS executives in spring 2010, the IRS suddenly agreed.

Exam teams scrutinizing claims for the black liquor credit were told to stand down, and the draft revenue ruling was shelved, Henck said. The chief counsel's office told the exam teams there would be no revenue ruling, and indeed, nothing in writing to codify the IRS's new stance, he said.

"The thing that concerns me is that this amounts to secret law," Henck said in an e-mail to IRS managers at the time. He said in the e-mail that the decision was contrary to the law and to published guidance, and that it was wrong to put nothing in writing. He said later that management never responded to his ethical concerns.

Almost no one outside the paper industry uses black liquor, Henck said. Almost no one else's refundable credits are considered nontaxable income by the IRS, he said.

For Henck, who has been battling alleged IRS mismanagement and corruption for more than a dozen years, there is a disturbing conclusion to be drawn.

"The decision-making process for a particular case or type of case is corrupted or compromised by high-level executives basically on a whim or fiat or in an arbitrary fashion," Henck said. "If they inquire, agents and attorneys are told that the matter was 'vetted' at the highest level and that is that. . . . In every case where I have seen this happen, it has benefited well-connected taxpayers. I have never seen this type of corrupted or compromised decision-making benefit the public fisc. Basically, this is a white-collar version of a smash-and-grab robbery."

The IRS did not respond by deadline to requests for an explanation of its reasoning on the nontaxability of AFMC payments. But while black liquor concluded its run as a refundable credit at the end of 2009, and the IRS stopped refunding the AFMC itself at the end of 2011, top paper companies continue to find ways to exploit the loophole.

Paper Profits

Some of the nation's major paper products companies continued to reap benefits from the AFMC in 2013.

Industrywide, the AFMC could have cost the federal treasury $25 billion or more through 2012, Tax Analysts' Martin A. Sullivan estimated in October 2009 ("IRS Allows New $25 Billion Tax Break for Paper Industry," Tax Notes, Oct. 19, 2009, p. 271). The 2013 paper coauthored by Robinson estimated that 14 paper companies reporting the AFMC together were eligible for a federal tax benefit of $1.27 billion in 2009. "Even these estimates are conservative because they ignore the savings from converting AFMC to the cellulose credit. Many of these companies booked some of the tax savings prior to the IRS capitulation, but others waited until 2013 to recognize the savings in their financial reports," Robinson said. More current or comprehensive estimates from federal agencies or private institutions could not be obtained by press time.

The paper manufacturing industry has a long history of generating its own power from its waste products. International Paper alone produced 64 million gallons of black liquor that were ineligible for the AFMC during 2009, so the company amended its 2009 returns to claim those gallons for the cellulosic credit. That resulted in a $40 million net credit to tax expense for International Paper in the fourth quarter of 2010.

Verso Paper's claimed valuation allowance of $323.3 million for deferred tax assets in 2013 was a $127.6 million increase over the previous year's, according to the corporation's annual report to the SEC. The increase was primarily attributable to additional federal and state net operating loss carryforwards for alternative fuel credits taken as taxable income in 2009 and 2010 but since deemed nontaxable, Verso Paper's Form 10-K said.

MeadWestvaco's 2013 results included $165 million of after-tax income from the release of reserves for the AFMC, the company's 10-K filing said. Taking advantage of the IRS's decision -- in the same 2009 memorandum that determined black liquor qualified for the AFMC -- that the byproduct could also qualify for the cellulosic biofuel producer (CBP) credit, MeadWestvaco in the fourth quarter of 2012 decided to claim the CBP credit in 2013 in exchange for repayment of AFMCs received from excise tax filings in 2009 and 2010.

PCA's 2013 Form 10-K reverses a $166 million tax reserve attributable to alternative energy credits. Those include $62.1 million from reserve reversals for the taxability of AFMCs acquired by PCA in its acquisition of Boise Inc. and $103.9 million for the reserve reversal because of completion of an IRS audit of a PCA facility's CBP credits.

"The changes in reserves reported in 2013 represent a conservative estimate of the tax savings each company recognized from the IRS capitulation," Robinson said. "These tax savings increase reported earnings in the same way forgiveness of debt increases a debtor's income. It removes uncertainty, it eases financial pressure, it improves the companies' perceived financial performance. The paper companies continue to find ways -- first directly through the Treasury, now indirectly through their financial reporting -- to benefit from the black liquor loophole."

The High Cost of Refundable Credits

The number of refundable tax credits jumped in the early 2000s, peaking at 11 in 2010 before falling back to six in 2013, according to a Congressional Budget Office report issued in January 2013. The total cost of refundable credits hit $238 billion in 2008, although the CBO estimated that number would fall to $149 billion in 2013. Most of that was for the earned income tax and the child care credits, the CBO said.

If the amount of a refundable credit exceeds a filer's tax liability before the credit is applied, the government pays the excess to the filer. That made the refundable AFMC in 2009 and its black liquor component practically a godsend for paper producers. One industry analysis estimated that 14 of the 16 top paper companies were in the red in 2009, as the industry weathered the start of the computerized tablet revolution (reducing the need for paper books) and a general erosion of consumer demand.

Although black liquor lost its refundability after 2009, and the rest of the AFMC became nonrefundable after 2011, the IRS still allowed the industry to choose between the AFMC and the nonrefundable CBP income tax credit, including retroactively by amending returns.

To Tax or Not to Tax

But it was the IRS's decision in 2010 not to count black liquor refunds and credits as taxable income of the corporations that brought the paper industry billions of dollars more.

Henck said that after the IRS decision was handed down, Service executives advanced two arguments to lower-level employees to bolster management's view that that income should not be taxable.

IRS executives said congressional intent was that other credits were taxable in the past, Henck said. However, those were nonrefundable credits, he pointed out. Executives claimed that Rev. Rul. 67-2, which some had argued made black liquor cash payments taxable under the "accession to wealth" doctrine, in fact was based on the tax benefit rule, he said. That rule, a judicial creation, states that if a taxpayer properly deducts an outlay in one year, and then in a later year recovers the same amount, the subsequent recovery is taxable income, he said. Because no excise tax was paid regarding black liquor, executives argued that the revenue ruling did not apply, Henck said.

However, in relying on the tax benefit rule, the executives had a problem in logic, according to Henck: "If the revenue ruling relied on the tax benefit rule, the revenue ruling would cease to exist. When applying the tax benefit rule with respect to deductions under section 162, the first part of the analysis is to look at the reasonable expectation of reimbursement doctrine. When that is done with Rev. Rul. 67-2, the deductions in the first year, and thus the revenue ruling itself, dissolve."

Henck said the IRS National Office offered to draft a new revenue ruling affirming the nontaxability of black liquor credits. It was rejected, he said. Indeed, IRS executives in 2010 decided to put nothing concerning their decision about the taxability of refundable black liquor cash payments in writing, he said.

That's the way it stayed until a July 2013 Washington Post article called IRS officials out on the substantial revenue losses from black liquor. The IRS issued a chief counsel advice memorandum (ILM 201342010) that explained some of the reasoning on the taxability of credits and payments for producers of biodiesel mixtures.

"We think the fact that sections 6426(c) [biodiesel excise tax credits], 6427 [biodiesel payments], and 40A [nonrefundable alternative income tax credits] were enacted together, yet Congress chose only to specifically provide that the credit under section 40A is includible in gross income, indicates that Congress intended to exclude from gross income the section 6426(c) credit and the section 6427 payment," the IRS said.

Regarding Rev. Rul. 67-2, the IRS memorandum said:


    Congress considered the credit discussed in Rev. Rul. 67-2 to be, in effect, a 'refund of the gasoline tax paid with respect to gasoline used on the farm for farming purposes.' S. Rep. No. 89-324, 1965 U.S.C.C.A.N. 1745-1746. . . . By contrast, Congress did not structure the biodiesel mixture credit as a refund of a previously deducted expense. Instead, 'Congress believed that providing a new income tax credit for biodiesel fuel will promote energy self-sufficiency.' Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress 227 (Comm. Print 2005). [JCS-5-05.]

"Thus Rev. Rul. 67-2 is inapposite," the IRS said.

'Accession to Wealth'

Henck and others disagree.

The IRS memorandum states that there is no authority for the inclusion of alternative fuel credit payments and credits in taxable income, Henck said. He said the "accession to wealth" doctrine under the Supreme Court decision in Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955), declared a taxpayer's ascent to wealth taxable unless the code specifically excludes it from taxable income.

Robinson agreed with Henck's overall argument but claimed that a section 61 rationale would stand on firmer ground. Section 61 provides a default rule that gross income includes "income from all sources derived"; reg. section 1.61-1(a) adds "unless excluded by law."

Henck replied that section 61 is statutory support for the accession to wealth doctrine, and general welfare is an exception -- such as that made for government payments to low-income earners under the EITC -- to that doctrine supporting targeted nontaxability of income. "The important thing about general welfare is that it has only been applied to individuals, not corporations that have had an accession to wealth," Henck said.

Robinson's 2013 article reviewed public financial statements of 19 paper companies and found that the companies made widely varying claims about the taxability or nontaxability of the refundable AFMC. The researchers associated some of the more extreme claims with weak corporate governance.

In an unpublished portion of the paper, the authors said the strongest argument for the excludability of refundable AFMC payments from gross income could apply to taxpayers that elect to receive the payment as an income tax credit. Taxpayers that claim the AFMC that way can make an argument for exclusion based on section 6401(b)(1), which defines refundable income tax credits as "overpayments" that reduce required payments of estimated taxes. Thus, the argument could be made that the indirect benefit from refunds should be excluded from gross income.

Henck asserted that the cash payments arising from the refundable black liquor credits, however, should be taxable income.

A Troubling Precedent

Using the EITC as an analogy for excluding refundable AFMC payments from taxable income, while weaker on the statutory merits, may offer a troubling precedent for the future, Robinson said.

The refundable EITC offsets Social Security taxes for low-wage workers. In fact, before it was repealed in 2010, section 3507(a) let employers make EITC payments to workers before any Social Security taxes were paid. "These advance payments are in essence refundable credits of withholding tax," Robinson and his colleagues wrote in the unpublished article fragment.

Section 3507(d) provided that advance payments "shall not be treated as the payment of compensation," the researchers wrote. Although section 3507 did not exclude other refundable credits from gross income, "it could suggest that Congress does not intend to tax any refundable credits," the authors said. "Paper companies could choose to rely on the IRS' [past] treatment of the earned income credit as evidence of this unstated policy."

Robinson said, "Although section 3507 was repealed in 2010, the exclusion of EITC payments can still serve to support that argument that refundable credits should be excluded from gross income."

The taxability of AFMC payments and credits is only one of the arguments against it. The credit was originally designed to promote biomass fuels for vehicles, said economics professor Gilbert E. Metcalf of Tufts University. "But we're not driving paper boilers down the street," he said. "If the goal is to reduce fossil fuel use . . . this is a credit that is subsidizing more use. It is undoing the goals of the legislature, and costing federal taxpayers at the same time. It's sort of the perfect trifecta of bad policy."


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