When the American paper industry came up with a plan to get $2 billion in tax refunds, it first had to get past a guardian of the public’s money: the Internal Revenue Service.

But the IRS, which has been in the news lately for its aggressive targeting of politically affiliated nonprofits, took at look at the paper industry’s efforts and effectively shrugged. With no ruling from the agency, the refunds went through — based on the findings of the companies themselves.

The episode illustrates how much latitude the IRS has in dealing with critical policy questions — and how difficult it can be sometimes to decipher the agency’s position. Moreover, this tax question involved huge sums and appears to have been reviewed at what one internal e-mail described as the “highest levels” of the agency after heavy industry lobbying.

“Lobbying Capitol Hill gets all the attention,” said Martin Sullivan, a former Treasury official and chief economist of the nonprofit group Tax Analysts, “but corporations can lobby the IRS and change regulations and save billions of dollars beneath the radar. The taxpaying public is left outside, even though it is footing the bill.”

The $2 billion in refunds are a new twist in an earlier controversy about U.S. paper companies and an IRS interpretation of a highway bill provision passed by Congress in 2007.

The controversy began in 2009 when the IRS said that paper companies — which had been generating power by burning a pulping byproduct known as “black liquor” since the 1930s — could add a few drops of diesel and qualify for the 50-cent-a-gallon alternative fuel mixture tax credit.

Tax credits are generally used to reduce taxes paid by individuals or companies. But this was a refundable tax credit, which means that money-losing companies that owed no taxes could collect cash payments from the Treasury for the amount of the credits.

As a result, as the economy reeled from the financial crisis, the Treasury ended up paying $8 billion to ailing paper companies in what amounted to a major, but never openly debated, federal bailout. The move riled members of Congress who had intended the credit to promote pioneering techniques for turning plant matter into fuel. But Congress took no action, and the portion of legislation that created the black liquor credit was allowed to expire at the end of 2009.

That’s not where things ended, though.

The IRS in 2010 ruled that black liquor could also qualify retroactively for advanced cellulosic biofuel credits, which were intended to reward innovation in the production of alternative motor fuels. The credit was worth $1.01 a gallon under the 2008 farm bill, but was not refundable and, therefore, only useful for profitable companies. So companies often used a combination of the two tax credits to revise earlier tax returns and maximize income.

‘Substantial revenue losses’

The Obama administration budget proposal in early 2010 said the IRS ruling “could result in substantial revenue losses and a windfall to the paper industry,” and legislation later ended the application of the cellulosic credit to black liquor.

The new twist — largely unnoticed — came in 2011. After the congressional uproar subsided, most paper companies amended their 2009 tax returns to gain further advantage. Initially, paper companies had told shareholders in 2009 and 2010 that the refundable alternative fuel credits would be taxed. But in 2011, they quietly declared that the money shouldn’t be taxed. The Treasury ended up refunding about $2 billion in taxes the companies had paid, according to industry experts.

Was that the right thing to do? Don’t ask the Internal Revenue Service.

“We didn’t produce any guidance on this,” said IRS spokesman Anthony Burke. Burke said the agency hasn’t offered any “private letter rulings” either; those letters can be issued at the request of the companies, but apparently none of them asked.

If the IRS says nothing, the returns will go unchallenged, and the companies will keep the money. The agency still has not issued a ruling — even as the clock runs on the statute of limitations for challenging the companies’ interpretation. For some companies, time could expire this fall.

For the pulp and paper industry, the credits are crucial. The industry is the U.S. manufacturing sector’s third-largest user of energy, according to a World Resources Institute report.

For International Paper alone, this accounting tweak has yielded a significant windfall. Initially International Paper told shareholders that the company would get $2.1 billion in payments from the Treasury, but receive an after-tax benefit of only $1.4 billion from the alternative fuel mixture credits. But on July 19, 2011, it amended its return so that it would not owe taxes on the credits and, therefore, would receive a refund.

In its 10-K filed Feb. 2012, International Paper conceded to shareholders that there was a degree of “uncertainty” about whether the credits should be taxable.

“There were several different advice letters from tax advisors to their clients on the subject, which reached different conclusions” about the alternative fuel mixture tax credit, Jessica McFaul, spokesman for the American Forest & Paper Association, said in an e-mail. So far, the IRS has not challenged the return, McFaul said.

One person who questions the IRS position is William Henck, a 25-year IRS employee who was the legal adviser to a team that looked at the issue for one paper company. (In keeping with agency guidelines, Henck would not identify the taxpayer.)

“Most paper companies initially reported the payments as taxable income, but several companies took an aggressive position, and IRS examination agents were told to stand down and not challenge the position that the refundable credits were not taxable income,” Henck said. He said those instructions came from senior IRS officials.

“Once the other companies found out, they filed refund claims,” he continued. “Once again, exam agents were told not to challenge the claims.”

The paper industry has made a sizable investment in lobbying to protect the refunds.International Paper, for example, spent $1.15 million lobbying the IRS and other parts of government on tax issues in 2010. All lobbying by the company and its outside representatives totaled $3.7 million, according to the Open Secrets Web site. Its efforts were led by a company vice president, Ann B. Wrobleski, who has done a variety of Hill and executive branch jobs, including as the architect of Nancy Reagan’s “Just Say No” anti-drug campaign. She declined to comment.

Amended returns

In 2011, the year many companies amended their tax returns to get the refunds, the forestry and forest products industry spent $14.7 million on lobbying and employed 144 lobbyists, according to the Open Secrets Web site. Tax credits were a key part of that activity, though lobbying also dealt with corporate tax rates and the tax treatment of municipal bonds. International Paper led the way with $4 million in lobbying expenditures.

Tax analysts are divided over whether the credits should be taxed or not.

Sullivan, who writes for the newsletter Tax Notes and earlier worked for one of the major accounting firms, said “they should be taxable under general principles. . . . It’s just like getting any payment from the government. It’s a benefit.”

Some tax credits, such as the earned-income tax credit, food stamps, and low-income housing credits, are not taxed but they serve social goals. For many years, unemployment benefits and Social Security were not included, then Congress said they should be counted as income.

“When companies first filed for AFMTC, there was a difference of opinion on whether or not it was taxable. The tax code was silent on this question,” McFaul said.

The confusion is all the more reason, tax experts say, for the IRS to clarify its position.

Possible guideline

A key issue is whether the agency should model its black liquor policy on a published guideline for tax refunds paid to farmers. Henck contends that treating refundable black liquor credits as tax-exempt violates the agency’s Revenue Ruling 67-2. That ruling says that farmers who receive federal refunds for excise taxes paid on gasoline must treat those refunds as regular income.

In an interview, IRS spokesman Burke said no, that Ruling 67-2 did not apply. He said the alternative fuel mixture credit was “not really same kind of thing as a credit paid up front.” He did not elaborate or reply to follow up e-mails.

Yet it was the chief of the agency’s excise tax section, Holly McCann, who issued two key memorandums about why black liquor qualified as an alternative fuel mixture in the first place. McCann could not be reached for comment.

Martin J. McMahon Jr., a tax expert and professor of law at the University of Florida at Gainesville, believes that Henck’s point has merit and said in an interview that he was “bothered” that one of McCann’s memos makes no reference at all to a key section of the tax code. “Even to say, ‘We think it doesn’t apply here,’ it should have been addressed,” he said.

Henck said he tried to get the agency to do just that. But he said in an e-mail that in June 2012 he spoke to Andy Keyso, a senior official in the IRS counsel’s office, “who stated that the exam team should not assert that the black liquor payments were taxable income. When I asked Mr. Keyso to put this position in writing since it was contrary to published guidance, he declined, stating that the Chief Counselhimself decided that nothing would be put in writing on the subject.”

An e-mail from another IRS official said the treatment of the tax credit income “has been vetted at the highest levels within the IRS” and that Deputy Chief Counsel Clarissa Potter “spoke with Treasury and the IRS Commissioner. National Office indicates that they do not plan on issuing published guidance in regard to this position.”

“What is truly absurd . . . is how the IRS flip-flops between literal and expansive interpretations of the tax credit statutes,” Sullivan wrote in an earlier Tax Notes article about black liquor. At that time the IRS had just ruled that black liquor could also fill the requirements for advanced biofuel credits, worth $1.01 a gallon.

“The only notice it gets at all is an after-the-fact, indecipherable technical ruling buried in the Federal Register,” Sullivan said. “All of this might be tolerable if we could trust the folks at the IRS to protect the public interest. But IRS actions regarding the black liquor credit call that public trust into question.”