COAL-WATER MIXTURE IS NOT SYNTHETIC FUEL PRODUCED FROM COAL ELIGIBLE FOR NONCONVENTIONAL SOURCE FUEL CREDIT

Rev. Rul. 86-100

ISSUE

If a taxpayer produces a viscous, heavy, liquid coal-water mixture that can be used as a substitute for oil, then under section 29(c)(1)(C) (formerly section 44D) of the Internal Revenue Code, is that mixture a "synthetic fuel produced from coal" and therefore a qualified fuel which is eligible for the credit as fuel produced from nonconventional sources?

FACTS

Taxpayer produces a fuel by a process that finely grinds coal, mixes it with water, mechanically removes impurities (such as particles of pyritic sulfer) by flotation, and adds surfactants that adhere to the surface of each coal particle. Because the surfactants give each coal particle a negative electrical charge, the coal particles repel one another and remain in suspension. The resulting coal-water mixture has the physical properties of a viscous, heavy liquid that can be stored, pumped, and burned as a substitute for No. 6 oil in properly modified furnaces or boilers. The coal-water mixture is approximately 70 percent coal, 29 percent water, and 1 percent additives.

LAW AND ANALYSIS

Section 29(a) of the Code provides that there is allowed a credit of $3, multiplied by the barrel-of-oil equivalent of qualified fuels sold by the taxpayer to an unrelated person during the tax year.

Section 29(c)(1)(C) of the Code provides that the term "qualified fuels" includes liquid, gaseous, or solid synthetic fuels produced from coal (including lignite), including such fuels when used as feedstocks.

The credit allowed by section 29 (originally designated as section 44D) of the Code was added by section 231 of the Crude Oil Windfall Profit Tax Act of 1980, 1980-3 C.B. 1, 40. The conference committee report that accompanied that Act outlined the eligible sources for the credit and specifically included liquid, gaseous, or solid synthetic fuel from coal liquefaction or gasification facilities. That report also stated that solid synthetic fuel produced from coal liquefaction or gasification would include solvent refined coal. H.R. Rep. No. 96-817 (Conf. Rep.) 96th Cong., 2d Sess. 138 (1980), 1980-3 C.B. 245, 298.

Section 48(1)(3)(A)(iii) of the Code includes in the definition of alternative energy property (for purposes of allowing an investment tax credit under section 38 of the Code) equipment for converting an alternate substance into a synthetic liquid, gaseous, or solid fuel. This provision was added by section 301 of the Energy Tax Act of 1978, 1978-3 (Vol. 2) C.B. 1, 20. The Senate report that accompanied that Act specifically included, in the definition of alternative energy property, property used in coal liquefaction and gasification. S. Rep. No. 95-529, 95th Cong., 1st Sess. 75 (1977), 1978-3 (Vol. 2) C.B. 203, 267.

Both sections 29(c) and 48(1) reflect a congressional intent to encourage domestic energy conservation and production. In identifying certain fuels that qualify for the production credit, section 29 uses language almost identical to the language in section 48(1) that lists certain property that qualifies as energy property for purposes of the business energy tax credit. Qualified fuels, under section 29, include "liquid, gaseous, or solid synthetic fuels" produced from coal. Alternative energy property, under section 48(1), includes equipment for converting an alternate substance into a "synthetic liquid, gaseous, or solid fuel." Thus, the definition provided for the term "synthetic fuel" under section 48(1) and Income Tax Regulations thereunder is relevant to the interpretation of the term "synthetic fuel" in section 29(c)(1)(C).

Section 1.48-9(c)(5) of the regulations defines a synthetic fuel as one that must differ significantly in chemical composition, as opposed to physical composition, from the alternate substance used to produce it. That section further provides that synthetic fuel equipment does not include equipment that merely mixes an "alternate" substance with another substance. The regulation expressly states that synthetic fuel equipment does not include equipment that mixes coal and water to produce a slurry for purposes of transportation.

The Code and regulations recognize that a synthetic fuel is the result of substantial chemical change. Coal liquefaction and gasification processes, which were discussed in the congressional reports, are examples of processes that involve substantial chemical changes. Coal liquefaction and gasification processes are chemical processes that use pressure, heat, and the addition of hydrogen to change substantially the chemical composition of coal into substances that are chemically similar to oil or natural gas or noncoal-like solids. To produce solvent refined coal, finely ground coal is subjected to pressures up to 4,000 pounds per square inch and temperatures of about 800 degrees Fahrenheit in the presence of hydrogen and an oily hydrocarbon liquid solvent. Under these conditions, the coal is chemically changed by cracking and hydrogenation.

On the other hand, the process at issue in this revenue ruling is not a process similar to liquefaction or gasification because it does not result in a chemical change to the coal. It primarily results in a physical surface change, a coating, to the solid coal. As a result of that coating, mixing the coal with water produces a mixture that can be handled and used like a liquid. The lack of a chemical change to the coal itself precludes, under section 1.48-9(c)(5) of the regulations, a conclusion that the coal-water mixture is a "synthetic fuel" for purposes of the qualified fuels credit.

Section 1.48-9(c)(5) of the regulations clearly provides that equipment that merely mixes an alternate substance with another substance or mixes coal and water to form a slurry for transportation is not synthetic fuel equipment. The coal-water mixture in this situation differs from a slurry only in the manner in which the coal is held in suspension. In a slurry, agitation is used to keep the particles in suspension. Here, it is the polarization that keeps the particles in suspension. However, in both instances the processes produce a coal and water mixture with the required physical separation of particles necessary to produce the characteristics of a liquid. The presence of the surfactants does not contribute any improvement in the characteristics of the mixture as a fuel. Therefore, under the regulations, the equipment used is not synthetic fuel equipment. It follows that the product is not a synthetic fuel.

HOLDING

The coal-water mixture described in this revenue ruling is not a synthetic fuel produced from coal and thus under section 29(c)(1)(C) of the Code is not a qualified fuel eligible for credit.