To Combat Biofuel Tax Credit Fraud, We Need a Proactive Approach

An audit from the Treasury Inspector General for Tax Administration issued last month found ongoing and significant flaws in administration and issuance of biofuel tax credits. The audit showed that many credits are awarded to taxpayers without proper documentation, making the credit system highly susceptible to fraud.

Biofuel tax credits intend to incentivize production and use of renewable fuel and have been a key element of US energy policy since they were enacted in 2004.

The core problem lies in the current law, which only allows the IRS to issue post-hoc deficiency notices once fraudulent claims are filed. This purely reactive approach means the IRS can’t deny biofuel tax credits or enforce any registration requirements at the time of filing. This opens the door for fraudulent schemes that take advantage of this information delay.

A proactive approach is necessary to combat this fraud. The IRS should be empowered—through legislation proposed via the Office of Tax Policy and ultimately passed through Congress—to deny returns that don’t meet registration requirements at the time of filing. The status quo is untenable.

Further, implementing a track-and-trace system could ensure each gallon of biofuel is uniquely identified and tracked as it moves through the production and distribution chain.

Rounding Frauds

Biofuel tax credits have been at the center of a number of frauds over the years—including the Washakie biodiesel fraud, where more than $1 billion in fraudulent refundable fuel credits were sought, and $511 million in credits were actually paid out, to individuals affiliated with Washakie Renewable Energy from 2010 to 2018.

A simple biofuel tax fraud in terms of execution is a plain rounding fraud, where a single tanker of biofuel is cycled repeatedly between refineries and distribution points, each time claiming a new credit as though it were a shipment of newly refined fuel. It is difficult to track whether a given physical gallon of biofuel has been used to claim a credit.

A variation of this rounding fraud involves the recycling of biodiesel for which tax credits have already been paid out back into feedstock to be used to produce more biodiesel. The main feedstocks in biodiesel are soybean oil and recycled cooking oil, but in their stead, already-produced biodiesel will work just fine.

Between sales of fraudulent credits to third parties and fraudulent tax credits paid out to the conspirators—individuals affiliated with Gen-X Energy Group and Southern Resources and Commodities, out of Washington and Georgia respectively—received at least $46.3 million for biodiesel either never actually produced or produced by reprocessing already-refined biodiesel purely for tax purposes.

Section 4101 of the tax code and Reg. 48.4101-1 show that eligibility for a gallon of biofuel must be documented, but the taxpayer claiming the refund needn’t meet any registration requirements at the time of filing.

With this loophole, the IRS is left with the sole recourse of unwinding a fraudulent chain after returns have been filed and examined, and thereafter issuing a notice of deficiency.

If similar overseas frauds that manipulate similar information delays are any guide, the underlying entities will have folded up shop and moved their ill-gotten gains outside the reach of tax authorities.

Track and Trace

“Track and trace” has been used in other industries, including tobacco production and sales and marijuana, for tracking a product through the production chain to the point of sale and ensuring all appropriate taxes and fees are paid along the way.

Such a system could ensure each gallon of biofuel is uniquely identified and tracked throughout its lifecycle, creating multiple checkpoints a potential fraudster would need to avoid to pull off something like a rounding scam. The process would have several checkpoints.

Refining. A unique identifier is created, assigned, and logged in a database at the production facility. This identifier would be connected to information about the underlying biofuel—from date of production and type of biofuel to volume produced.

Shipment. Each movement of the biofuel—whether by truck, rail, pipeline, or other method—would be logged in the database and connected to the unique identifier. The transporting company, route, and destination would be updated at each stop in the journey.

Distribution. At distribution centers, the biofuel’s details would be updated to reflect blending and storage information. Distribution centers could be audited to ensure the total flow through the facility matches what’s indicated in the database.

Consumption. At the end of the production chain, there would be a recording of the receipt of the biofuel and its use. The unique identifier would reflect that the biofuel has completed its production journey, what credits it is eligible for, who has claimed those credits, and other pertinent details.

Such a system would make it difficult for a given gallon of biofuel, for which credits have already been issued, to be injected at a point in the production chain to file for additional tax credits. Without a clear chain of production from refinement to consumption reflected in the database, this “ghost” biofuel wouldn’t be eligible for a credit.

Audits of the refineries creating initial unique identifiers would make it difficult for a gallon of already-credited biofuel to be inserted at that point in the chain, as the output of the refinery wouldn’t match the input of raw materials.

A track-and-trace system would make it administratively burdensome, ideally to the point of it no longer being financially viable, for an energy company to engage in rounding and similar schemes.

Outlook

The vulnerabilities in the biofuel tax credit system are urgent and need to be immediately addressed. Known loopholes that allow for fraudulent schemes such as rounding need to be closed.

More important, the existing right of enforcement must be revised through legislation to allow the IRS to address fraudulent claims immediately at the point of filing.

If the IRS is empowered to deny claims that don’t meet registration requirements, it will have a better opportunity to enforce tax policy throughout the biofuel production chain and police the issuance of tax credits before fraudulent claims are paid out.

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social

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