Financing Public-Private Partnerships for Infrastructure Assets

Transcription

1 presents Financing Public-Private Partnerships for Infrastructure Assets Mitigating Legal Risks and Anticipating Tax Consequences of PPP Deals A Live 90-Minute Audio Conference with Interactive Q&A Today's panel features: Joel H. Moser, Partner, Fulbright & Jaworski, New York Linda E. Carlisle, Partner, White Case, Washington, D.C. Tomer Pinkusiewicz, Partner, White Case, New York Wednesday, April 8, 2009 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions ed to registrants to access the audio portion of the conference. CLICK ON EACH PDF IN THE LEFT HAND COLUMN TO SEE INDIVIDUAL PRESENTATIONS. If you need assistance or to register for the audio portion, please call Strafford customer service at ext. 10

2 Public-Private Partnerships in the United States: Key Legal Issues Joel H. Moser Co-Chair Global Infrastructure Group Fulbright & Jaworski L.L.P. When You Think INFRASTRUCTURE Think Fulbright. TM

3 Federalism Framework 50 states State Constitutions State Legal Systems 2

4 Local and Regional Government Dillon s Rule Home Rule Powers Regulatory Oversight 3

5 The Authority Creatures of Statute Off-balance Sheet Quasi-Government 4

6 US P3 Transactions State and State Departments Local and Regional Governments Agencies and Authorities 5

7 Concession Structures Real Toll Shadow Toll Availability Payment 6

8 Demand Risk vs. Government Payment Demand Risk Y e s N o Government Payment Yes Shadow Toll Availability Payment No Real Toll 7

9 Appropriation Risk Constitutional Limits on Debt Prop 13/TABOR Payment Obligations Beyond a Year 8

10 Appropriation Credit Rating Agency View PPP Market Acceptance Tools for P3 Transactions 9

11 Security Interest Lien Lease/Leaseback Threat of Service Termination 10

12 Essentiality Factual Essentiality Practical Essentiality Statements of Essentiality 11

13 Non-Substitution Enforceability Non-Competition Practical Compulsion 12

14 Budget Covenant Department of Government Commitment Default v. ENA 13

15 Moral Obligation Public Commitment Detrimental Reliance Market Access 14

16 Impoundment Procedures Reserve Fund Aid Trap Practical Compulsion 15

17 Service Contract Subject to Appropriation Continue to Provide Service Enforceability by Courts 16

18 Conclusion Political Risk Sovereign Risk Legal Risk 17

19 When You Think INFRASTRUCTURE, Think Fulbright. TM

20 Financing Public-Private Partnerships for Infrastructure Assets -- Concession Tax Considerations Strafford Publications Teleconference April 8, 2009 Linda E. Carlisle, White & Case LLP

21 Overview I. Federal Income Tax Treatment of Brownfield Projects II. Federal Income Tax Treatment of Greenfield Projects III. Conclusions WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

22 I. Federal Income Tax Treatment of Brownfield Projects A. Typical Investment Structure. U.S. Shareholders Non-U.S. Shareholders U.S. Corp. U.S. Corp. Holding Company U.S. LLC treated as a partnership. State or Local Gov t Concession and Lease Agreement Concessionaire U.S. LLC treated as a disregarded entity. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

23 I. Federal Income Tax Treatment of Brownfield Projects (cont d) B. Rights Granted by the State or Local Government under the Concession and Lease Agreement. 1. Real property and real property improvements that constitute a public infrastructure asset (the Facility ) are leased to the Concessionaire for a term of years that exceeds the estimated remaining economic life of the improvements (typically between 75 and 99 years). 2. The Concessionaire is conveyed, transferred, or assigned: a. Any personal property that the state or local government owns that it uses in the operation of the Facility; and b. Contracts to which the state or local government is a party that relate to the operation of the Facility. 3. The Concessionaire is granted the right to operate the Facility and collect fees for the use of the Facility. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

24 I. Federal Income Tax Treatment of Brownfield Projects (cont d) C. Concessionaire s Obligations Under the Concession and Lease Agreement. 1. Make an upfront payment to the state or local government. 2. Make additional payments to the state or local government during the term of the agreement if specified windfall revenues or refinancing gains are realized by the Concessionaire. 3. Pay all costs of operating, maintaining, and repairing the Facility, and return the Facility to the state or local government at the end of the agreement in the condition specified in the concession and lease agreement. 4. Bear all operational and financial risks relating to the Facility, including risks of casualty losses, during the term of the agreement. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

25 I. Federal Income Tax Treatment of Brownfield Projects (cont d) D. Typical Financing. 1. The Concessionaire will typically fund the upfront payment with equity capital and debt from third-party lenders. 2. Additional capital improvements to the Facility also may be eligible for taxexempt private activity bond ( PAB ) financing from the state or local government. 3. Additional capital improvements to highway projects also may be eligible for federal loans or federal loan guarantees under the Transportation Infrastructure Finance and Innovation Act ( TIFIA ) program. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

26 I. Federal Income Tax Treatment of Brownfield Projects (cont d) E. Principal Federal Income Tax Issues Relating to Brownfield Projects. 1. Treatment of the arrangement as a de facto partnership between the Concessionaire and the state or local government. 2. Lease versus sale treatment for real property improvements acquired by the Concessionaire. 3. Characterization of the assets acquired by the Concessionaire. 4. Allocation of the upfront payment (and other consideration) among the assets acquired by the Concessionaire. 5. Tax treatment of amounts allocated to the assets acquired by the Concessionaire. 6. Tax treatment of payments made by the Concessionaire. 7. Taxation of non-u.s. investors. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

27 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 1. Treatment of the arrangement as a de facto partnership between the Concessionaire and the state or local government. a. Typically, the parties disavow any intent to form a partnership in the governing documents. b. Revenue sharing payments (if any) with the state or local agency are based on gross, not net, income. c. The Concessionaire is liable for all losses from the project. d. Although the operation of the project is subject to specified standards or regulations, the Concessionaire has exclusive control over how it conducts the venture within the parameters of those regulations or standards. e. On balance, these factors tend to negate the existence of a de facto partnership between the Concessionaire and the state or local government. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

28 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 2. Lease or sale of real property improvements. a. Factors that have been considered by the courts and IRS in determining whether an agreement, which in form is a lease, is in substance a sales contract include: i. Whether legal title passes; ii. How the parties treat the transaction; iii. Whether an equity interest was acquired in the property; iv. Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; v. Whether the right of possession is vested in the purchaser; vi. Which party pays the property taxes; vii. Which party bears the risk of loss or damage to the property; and viii. Which party receives the profits from the operation and sale of the property. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

29 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 2. Lease or sale of real property improvements (cont d). b. The typical concession and lease agreement should be treated as a sale, rather than a lease, of the real property improvements included in the Facility because: i. Possession of the real property improvements is conveyed to the Concessionaire for a period of years that exceeds the remaining economic life of such improvements (e.g., buildings, roads, bridges, sidewalks, parking lots, fences, sewers, landscaping); ii. The Concessionaire bears the risk of loss or damage with respect to the real property improvements; iii. The Concessionaire operates the Facility in a trade or business, maintains the Facility, and is dependent on the profitability of the Facility for the return of its investment; and iv. The Concessionaire makes one or more payments that are not less than the fair market value of the tangible and intangible property leased or conveyed to the Concessionaire. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

30 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 2. Lease or sale of real property improvements (cont d). c. The concession and lease agreement should be treated as a lease of the land on which the Facility is located because the Concessionaire does not acquire possession and use of the land for a period that exceeds the economic useful life of the land. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

31 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 3. Characterization of the assets acquired by the Concessionaire. a. A lease of the land on which the public infrastructure asset is located. b. Ownership of the real property improvements located on the land. c. Ownership of any tangible personal property conveyed to the Concessionaire. d. Assignment of rights and obligations under contracts assigned to the Concessionaire. e. Ownership of any intangible assets conveyed to the Concessionaire, including intangible assets associated with the trade or business assets such as government licenses, customer lists, know-how, goodwill, or going concern value. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

32 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 4. Allocation of consideration among assets acquired by the Concessionaire. a. Because the assets acquired under a concession and lease agreement constitutes a trade or business, the consideration paid by the Concessionaire for such assets must be allocated under section 1060 among such assets under the so-called residual method. i. The consideration paid by the Concessionaire includes consideration it pays to the state or local government and any transaction costs that the Concessionaire is required to capitalize and treat as part of its basis in the acquired assets. ii. If the assets transferred from a seller to a purchaser include more than one trade or business, all of the assets transferred are treated as a single trade or business for purposes of section WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

33 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 4. Allocation of consideration among assets acquired by the Concessionaire (cont d). b. Allocation of consideration under the residual method: i. First to cash and cash equivalents, to the extent thereof; ii. Next to actively traded personal property; i ii. Next to debt instruments and assets that are marked-to-market at least annually; iv. Next to inventory and stock in trade; v. Next to the leasehold interest in the land, ownership of the improvements to the land, ownership of any tangible personal property conveyed to the Concessionaire as part of the public infrastructure asset, and any contracts assigned to the Concessionaire, to the extent of the fair market values of those assets; vi. Next to any section 197 intangibles acquired by the Concessionaire, other than goodwill or going concern value, to the extent of the fair market values of such intangibles; and vii. Finally, any remaining amount of the consideration is allocated to goodwill or going concern value. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

34 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 5. Tax treatment of amounts allocated to assets. a. Leasehold interest in land. i. The portion of the upfront payment made by a Concessionaire that is allocable to the lease of land should be treated as an upfront rental payment under a rental agreement that is subject to section 467. ii. Under section 467, the upfront payment by the Concessionaire generally should be treated as a loan by the Concessionaire to the state or local government, which the state or local government repays, with interest, in level payments over the term of the lease. iii. Under section 467, the Concessionaire would be allowed level payment rent deductions equal to the imputed level loan repayments. However, the Concessionaire s rental deduction net of deemed interest income would be back loaded. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

35 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 5. Tax treatment of amounts allocated to assets (cont d). b. Tangible property acquired by the Concessionaire. i. The Concessionaire may irrevocably elect to use either the Modified Accelerated Cost Recovery System ( MACRS ) or the alternative depreciation system described below in which property is depreciated on a straight-line basis over prescribed recovery periods that are longer than the MACRS recovery periods. ii. Investors may wish to elect to use the alternate depreciation system to reduce the amount of net operating loss carryforwards generated in the early years of a concession and lease agreement. iii. Generally, land improvements, including roads, bridges, drainage, walls, and foundations are eligible for 15-year MACRS using the 150-percent declining balance method. Lighting, signage, and tolling equipment assets generally are depreciated using five- or seven-year MACRS and the 200-percent declining balance method. Nonresidential buildings and their structural components are depreciated over 39 years on a straight-line basis under MACRS. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

36 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 5. Tax treatment of amounts allocated to assets (cont d). b. Tangible assets acquired by the Concessionaire (cont d). i. MACRS depreciation is not allowed for tax-exempt bond financed property, which must be depreciated using the straight-line method over the alternative recovery periods specified in section 168. ii. The term tax-exempt bond financed property is defined as property financed (directly or indirectly) by an obligation the interest on which is exempt from tax under section 103 (relating to interest on state and local bonds). a) In brownfield projects, the original construction and improvements to the Facility have generally been financed with the proceeds of tax-exempt state or local bonds and the state or local government is required to retire or legally defease any outstanding bonds upon entering into the concession agreement. b) It is unclear how the Facility is treated in the hands of a transferee if the bonds (or refunding bonds) are not retired, but are legally defeased. c) TIFIA financing does not constitute tax-exempt bond financing. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

37 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 5. Tax treatment of amounts allocated to assets (cont d). c. Intangible assets acquired by the Concessionaire. i. 15-year amortizable section 197 intangibles include: a) Goodwill and going concern value; b) Workforce in place; c) Business books and records, operating systems, and other information base intangibles; d) Customer lists and other customer-based intangibles; e) Favorable supplier contracts and other supplier-based intangibles; f) Rights, permits, and licenses granted by a governmental unit; and g) Franchises. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

38 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 5. Tax treatment of amounts allocated to assets (cont d). c. Intangible assets acquired by the Concessionaire (cont d). ii. Any intangible that is an interest in land, such as a fee simple interest, life estate, remainder, easement, mineral right, timber right, grazing right, air right, zoning variance, or similar right, is excluded from treatment as an amortizable section 197 intangible and is depreciable on a straight-line basis over the useful life of the asset. iii. In states in which private persons that have a possessory interest in an asset may not charge tolls for the use of such asset without the express authorization of the state, the government authorization to charge tolls should be treated as a separate amortizable section 197 intangible. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

39 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 6. Treatment of payments made by the Concessionaire. a. Frequently, the Concessionaire is required to make regular payments to the state or local government equal to a percentage of gross revenues from the Facility over a threshold amount. i. These payments should be deductible by the Concessionaire under section 162. ii. Note that basing the payments on net profits (rather than gross revenues) would create a risk that the entire arrangement might be treated as a de facto partnership for federal income tax purposes. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

40 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 6. Treatment of payments made by the Concessionaire (cont d). b. The Concessionaire may be required to make payments based on gains from certain refinancings of the Facility. i. To the extent a portion of such a payment is treated as additional rent for the land, such portion should be capitalized and treated as prepaid rent for the remaining term of the lease. ii. To the extent a portion of such a payment is treated as an additional amount paid for a section 197 intangible, such portion should be capitalized and amortized over the remaining portion of the 15-year recovery period or deducted if such 15-year period has expired. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

41 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 7. Taxation of non-u.s. persons. a. Non-U.S. corporations that are members or partners of the Holding Company also would be subject to the U.S. 30-percent branch profits tax under section 884 on the corporation s dividend equivalent amount for each taxable year, which may be eliminated or reduced under an applicable income tax treaty. b. Non-U.S. corporations that are members or partners of the Holding Company also may be subject to the U.S. 30-percent tax on excess interest under section 884(f)(1)(B), which may be reduced or eliminated under an applicable income tax treaty. c. Dividends paid by U.S. corporations to non-u.s. shareholders are subject to the 30-percent U.S. withholding tax on dividends, which may be eliminated or reduced under an applicable income tax treaty. d. Under section 897, non-u.s. shareholders of a U.S. corporation are subject to U.S. federal income tax on gain from the sale or disposition of stock in such U.S. corporation (or distributions from such U.S. corporation that are treated as amounts paid in exchange for stock of the U.S. corporation) if such U.S. corporation is a USRPHC. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

42 I. Federal Income Tax Treatment of Brownfield Projects (cont d) 7. Taxation of non-u.s. persons (cont d). e. A 10% U.S. withholding tax applies to amounts realized by non-u.s. persons from the disposition of stock in a USRPHC. f. A U.S. corporation is a USRPHC if 50 percent or more of the fair market value of its assets is attributable to USRPIs (including the corporation s share of assets held through partnerships and disregarded entities). g. USRPIs include interests in land and real property improvements such as structures, buildings, roads, bridges, and parking lots. h. A government right or franchise that does not convey with a possessory interest in real property should not be treated as a USRPI. i. In an advanced notice of proposed rulemaking published on October 31, 2008, the IRS and Treasury announced they are considering issuing proposed regulations that would treat certain licenses, permits, franchises, and other similar rights granted by a governmental unit with respect to toll roads, toll bridges and other public infrastructure assets as interests in real property. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

43 I. Federal Income Tax Treatment of Greenfield Projects A. Typical Investment Structure. U.S. Shareholder Non-U.S. Shareholder U.S. Corp. U.S. Corp. Holding Company U.S. LLC treated as a partnership. State or Local Gov t Development and Lease Agreement Developer U.S. LLC treated as a disregarded entity. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

44 II. Federal Income Tax Treatment of Greenfield Projects (cont d) B. Rights granted by the state or local government under the Development and Lease Agreement. 1. The Developer is granted the exclusive right to develop and construct a new public-use infrastructure asset (the Facility ) in accordance with specified standards. 2. Upon completion of construction of the Facility, the Developer is granted the right to operate the Facility and collect fees for the use of the Facility for a term of years (typically between 35 and 50 years). WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

45 II. Federal Income Tax Treatment of Greenfield Projects (cont d) C. Developer s obligations under the Development and Lease Agreement. 1. Pay all costs of operating, maintaining, and repairing the Facility and return the Facility to the state or local government at the end of the agreement in the condition specified in the development and lease agreement. 2. Bear all construction, operational, and financial risks relating to the Facility, including risks of casualty losses, during the term of the agreement. 3. Make additional revenue sharing payments to the state or local government during the term of the agreement, if specified windfall revenues or refinancing gains are realized by the Developer. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

46 II. Federal Income Tax Treatment of Greenfield Projects (cont d) D. Typical Financing. 1. The Developer generally is not required to make an upfront payment to the state or local government. 2. The Developer s costs of constructing the asset typically will be funded with equity capital and debt from third-party lenders. 3. The state or local government may be required to invest public funds in the development of the asset. 4. The state or local government also may provide tax-exempt PAB financing to the Developer for qualifying projects. The Facility also may be eligible for federal loans or federal loan guarantees under the TIFIA program. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

47 II. Federal Income Tax Treatment of Greenfield Projects (cont d) E. Principal federal income tax issues that are specific to greenfield projects. 1. Treatment of the Developer s costs of construction as rent, consideration for a share of project revenues, or a tenant s depreciable costs of leasehold improvements. 2. Treatment of public funds as income to the Developer or the costs of leasehold improvements owned by the state or local government. 3. Tax treatment of the Developer s capitalized costs. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

48 II. Federal Income Tax Treatment of Greenfield Projects (cont d) 1. Treatment of the Developer s costs of construction as rent, consideration for a share of project revenues, or a tenant s depreciable costs of leasehold improvements. a. The improvements constructed and paid for by the Developer should not be treated as rent paid to the state or local government unless the agreement expressly provides that the improvements are intended to be treated as rent. See Blatt Co. v. United States. b. Because the Developer has the state law rights of a lessee, it should be treated as constructing the improvements to the Facility for its own use as a tenant and should not be treated as constructing the improvements in consideration for a share of revenues from the project. c. The Developer s costs of constructing the improvements, including its capitalized construction period interest, should be included in the Developer s depreciable tax basis for the improvements. See sections 263 and 263A. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

49 II. Federal Income Tax Treatment of Greenfield Projects (cont d) 2. Treatment of public funds as income to the Developer or the costs of leasehold improvements owned by the state or local government. a. If: i. The public funds must be used to pay or reimburse costs of constructing the improvements and are not required to be repaid by the Developer (even if the Developer terminates the development and lease agreement before the end of its term); ii. The improvements funded with the public funds will revert to the state or local government when the lease is terminated or expires; and iii. The economic usefulness of the improvements funded with the public funds will not cease upon the termination or expiration of the lease: a) The public funds should be treated as amounts paid by the state or local government for leasehold improvements that it owns; b) The public funds should not be treated as income to the Developer; and c) The public funds should not be included in the Developer s depreciable basis for leasehold improvements. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

50 II. Federal Income Tax Treatment of Greenfield Projects (cont d) 2. Treatment of public funds as income to the Developer or the costs of leasehold improvements owned by the state or local government (cont d). b. If public funds are not excluded from the Developer s income as amounts paid by the state or local government for improvements owned by the state or local government: i. The public funds may nevertheless be excluded from the Developer s income as non-shareholder capital contributions under section 118 if the Developer is a corporation. ii. Property acquired with tax-exempt capital contributions has a depreciable basis of zero. iii. Section 118 does not apply to partnerships and the IRS asserts that contributions to the capital of a partnership by a non-partner constitute income to the partnership. Some argue, however, that under Edwards v. Cuba R. Co., there is a common law exception that applies to non-partner contributions to the capital of a partnership. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

51 II. Federal Income Tax Treatment of Greenfield Projects (cont d) 4. Tax treatment of the Developer s capitalized costs. a. The Developer s capitalized costs of constructing the improvements to the Facility (including its capitalized construction period interest) should be treated as its depreciable costs of constructing such property and should be depreciable under MACRS or the alternative depreciation system, as described above with respect to tangible property included in brownfield projects. b. The alternative depreciation system would be mandatory for the portion, if any, of the Facility that is financed with PABs. TIFIA financing does not constitute tax-exempt bond financing. c. Under section 168(i), a tenant s costs of leasehold improvements are recovered under MACRS over the statutory recovery period without regard to the term of the lease and the tenant is allowed a deduction under section 165(a) upon the termination of the lease for any unrecovered costs. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

52 III. Conclusions Privatization of public infrastructure assets provides needed capital to state and local governments with no extraordinary tax benefits for the private investors. 1. The U.S. federal income tax treatment of infrastructure privatization transactions mirrors the tax treatment of other investments in U.S. businesses. 2. There are no unique rules that enhance the tax benefits of infrastructure privatization transactions. 3. Non-U.S. investors are subject to the same tax rules that apply to non- U.S. investors in other U.S. businesses. WHITE & CASE LLP April 8, Strafford Publications Financing Public-Private Partnerships for Infrastructure Assets

53 Worldwide. For Our Clients. White & Case, a New York State registered limited liability partnership, is engaged in the practice of law directly and through entities compliant with regulations Strafford regarding Publications the practice of law Financing the countries Public-Private and jurisdictions Partnerships in which we have for offices. Infrastructure Assets WHITE & CASE LLP April 8,

54 Is a Governmental License to Toll a Public Highway a USRPI? By Linda E. Carlisle Linda E. Carlisle is a partner in the Washington, D.C., office of White & Case LLP. The author gratefully acknowledges the assistance of Geoffrey B. Lanning and Mika Ikeda in the preparation of this article. This report discusses an advanced notice of proposed rulemaking published by the IRS and Treasury on October 31, 2008, addressing whether the IRS and Treasury should revise the definition of an interest in real property to include certain rights granted by a governmental unit that are related to the lease, ownership, or use of toll roads, toll bridges, and certain other physical infrastructure assets. The report examines the structure of typical brownfield and greenfield infrastructure transactions and sets forth the rights and obligations of the parties in those arrangements. Based on a review of the legislative history of the Foreign Investment in Real Property Tax Act and the existing regulations under section 897, this report concludes that, if proposed regulations under section 897 are published to clarify the treatment under section 897 of governmental permits to charge tolls or fees for the use of real property, those proposed regulations should provide that a governmental permit is treated as a United States real property interest (USRPI) only if the fee simple ownership or leasehold interest in that real property includes the right, under applicable state law, to charge tolls or fees for the use of that real property. In states in which the right to charge tolls or fees for the use of public highways or bridges is not part of the fee simple or leasehold interest in the highways or bridges, a government permit to charge tolls or fees is not a USRPI. Copyright 2009 Linda E. Carlisle. All rights reserved. Table of Contents I. Typical Infrastructure Transactions A. Brownfield Transactions B. Greenfield Transactions II. Legal Framework A. Section B. Allocation of Consideration III. Issues Raised in Announcement SPECIAL REPORT tax notes A. Potential Alternative Commercial Uses B. Are Any Governmental Permits USRPIs? C. Are New Allocation Rules Needed? D. When Should New Allocation Rules Be Effective? IV. Conclusions On October 31, 2008, the IRS and Treasury published an advance notice of proposed rulemaking 1 addressing the definition of an interest in real property 2 for purposes of section 897. Announcement states that the IRS and Treasury are considering revising the definition of an interest in real property within the meaning of section 897(c) by amending reg. section In particular, the notice of proposed rulemaking would address specific rights granted by a governmental unit that are related to the lease, ownership, or use of toll roads, toll bridges, and some physical infrastructure assets. Announcement states that the IRS and Treasury are of the view that a governmental permit for specified infrastructure assets that is related to the value of the use or ownership of an interest in real property may properly be characterized as a U.S. real property interest (USRPI) within the meaning of section 897(c). Announcement states that the physical attributes and the terms and conditions related to the specified infrastructure mean that in many cases, there may practically be no potential alternative commercial uses for the specified infrastructure. In those cases, Announcement states that the value of the leasehold interest in the specified infrastructure derives from the right to charge and collect tolls. The IRS and Treasury have specifically requested comments on: the scope of the regulatory project and the types of licenses, permits, franchises, or other similar rights granted by a governmental unit that might be treated as related to the value of the lease, ownership, or use of an interest in real property, for purposes of section 897(c), and what characteristics should be taken into account in making that determination; and whether the proposed regulations should address the allocation of the consideration paid for the lease or purchase of a specified infrastructure and the license, permit, franchise, or other similar right to operate that specified infrastructure for purposes of determining the fair market value of that 1 REG , 73 Fed. Reg. 64,901 (Oct. 31, 2008), Doc , 2008 TNT The ANPR does not reference section 197, which provides for 15-year amortization for governmental licenses, permits, or other rights that do not constitute interests in land. 3 Announcement , IRB 1228, Doc , 2008 TNT (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. TAX NOTES, March 30,

55 COMMENTARY / SPECIAL REPORT property, and for purposes of allocating that consideration, whether the length of the lease (including whether the lease is for the useful life of the property) should be taken into account. Announcement states that if proposed regulations are issued, they will apply for transactions occurring on or after the date of publication in the Federal Register as final or temporary regulations, and that no inference is intended regarding the treatment or characterization of those arrangements under current law. I. Typical Infrastructure Transactions In typical infrastructure transactions, a domestic partnership leases or purchases from an unrelated party infrastructure assets and any land underlying those assets. Also, the domestic partnership is granted a governmental license, permit, franchise, or other similar right (governmental permit) to operate the specified infrastructure and to collect tolls or fees for the use of that infrastructure asset. 4 Privatization of infrastructure projects may involve existing publicly owned infrastructure projects (brownfield privatizations) or the construction and privatization of new infrastructure projects (greenfield privatizations). A. Brownfield Transactions Private investment in an existing publicly owned infrastructure project typically takes the form of an agreement (a concession and lease agreement) between the state or local government and an entity formed by the private investors (the concessionaire) to enter into the agreement. The concessionaire typically is a limited partnership or limited liability company that is treated as a partnership for federal tax purposes. The state or local government leases the real property and improvements that are part of the infrastructure project to the concessionaire and gives the concessionaire possession and use of the property for a term of years that exceeds the estimated remaining economic life of the improvements, typically ranging from 75 to 99 years. The state or local government grants the concessionaire the right to operate the infrastructure project and collect fees for the use of the infrastructure project for the term of the agreement. The state or local government conveys, transfers, or assigns to the concessionaire any personal property that the state or local government owns that is used in the operation of the infrastructure project and contracts relating to the operation of the infrastructure project to which the state or local government is a party. The concessionaire typically is required to make an upfront payment to the state or local government. The concessionaire is required to operate and maintain the infrastructure asset solely as a public highway, bridge, or other public service for which it is intended and may not 4 For a general description of those structures, see Tax and Financing Aspects of Highway Public-Private Partnerships: Hearing Before the Subcomm. on Energy, Natural Resources and Infrastructure of the S. Comm. on Finance, 110th Cong. 1-3 (2008) (testimony of Linda E. Carlisle, partner, White & Case LLP). convert the infrastructure asset to alternative uses. The concessionaire bears all costs of operating, maintaining, and repairing the infrastructure project and assumes all operational and financial risks relating to the project, including risks of casualty losses, during the term of the agreement. The concessionaire agrees to return the infrastructure project to the state or local government at the end of the agreement in the condition specified in the concession and lease agreement. B. Greenfield Transactions Private investment in a greenfield project usually takes the form of an agreement (typically called a development and lease agreement) between the state or local government and an entity formed by the private investors (typically called the developer) to enter into the agreement. The developer usually is a limited partnership or LLC that is treated as a partnership for federal tax purposes. Under a typical development and lease agreement, the state or local government grants the developer the exclusive right to develop and construct a new infrastructure project in accordance with specified standards. On completion of construction of the project, the state or local government grants the developer the right to operate and collect fees for the use of the asset for a term of years that exceeds the estimated remaining economic life of the improvements, typically ranging from 35 to 50 years. Under a development and lease agreement, the developer is required to pay all costs of operating, maintaining, and repairing the infrastructure project, and to return the asset to the state or local government at the end of the agreement in the condition specified in the development and lease agreement. The developer is required to operate and maintain the infrastructure asset solely as a public highway, bridge, or other public service for which it is intended and may not convert the infrastructure asset to alternative uses. The developer bears all construction, operational, and financial risks relating to the infrastructure project, including risks of casualty losses, during the term of the agreement. A. Section 897 II. Legal Framework 1. In general. In 1980, section 897 was added to the code by the Foreign Investment in Real Property Tax Act 5 to provide that gain or loss of a nonresident alien individual or foreign corporation from the disposition of a USRPI is subject to U.S. federal income tax as income that is effectively connected with the conduct of a trade or business in the United States. FIRPTA was prompted by a report issued by Treasury in 1979 that highlighted five ways in which foreign investors engaged in a U.S. trade or business could, under then-existing law, avoid U.S. 5 Omnibus Reconciliation Act of 1980, P.L , section 1122 (Dec. 5, 1980). (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content TAX NOTES, March 30, 2009

56 taxation on gains from investments in U.S. real estate. 6 The House report accompanying FIRPTA noted that, under then-existing law, capital gains realized by foreign investors on the sale of U.S. property are generally not subject to U.S. tax unless the property is held in connection with a U.S. trade or business. 7 The House report then explained that the new provisions of FIRPTA would subject foreign investors to U.S. tax on gains on the sale or other disposition of U.S. real property. 8 Section 897 does not apply to rent and other operating income derived from U.S. real estate by foreign investors because that income is subject to either U.S. withholding tax under sections 871(a) and 881 or to U.S. income tax under sections 871(b) and 882 as income effectively connected with the conduct of a U.S. trade or business. 2. USRPIs. Section 897(c)(1)(A) and reg. section (c)(1) provide that USRPI means: an interest in real property located in the United States or Virgin Islands, and any interest (other than an interest solely as a creditor) in a domestic corporation that was a U.S. real property holding corporation (USRPHC) at any time during a specified period of time. 3. Real property. Reg. section (b)(1) provides that the term real property includes: (1) land and unsevered natural products of the land; (2) improvements to the land; and (3) personal property associated with the use of real property. Reg. section (b)(1) provides that local law definitions will not be controlling for purposes of determining the meaning of the term real property as it is used in section 897 and the regulations thereunder. 4. Interests in real property. Reg. section (d)(2)(i) provides that an interest solely as a creditor in real property is not a USRPI. That section also provides that an interest in real property other than an interest solely as a creditor includes fee simple ownership, coownership, or a leasehold interest in real property; a time sharing interest in real property; and a life estate, remainder, or reversionary interest in the property. Applicable state law determines if a taxpayer has fee simple ownership, co-ownership, a leasehold, or other interest enumerated in reg. section (d)(2)(i). 9 Also, applicable state 6 Department of the Treasury, Taxation of Foreign Investment in Real Estate (1979). 7 H.R. Rep. No at 364 (1980). 8 Id. 9 Drye v. United States, 528 U.S. 49, 58 (1999) ( We look initially to state law to determine what rights the taxpayer has in the property the Government seeks to reach, then to federal law to determine whether the taxpayer s state-delineated rights qualify as property or rights to property within the compass of the federal tax lien legislation ) (citing United States v. Nat l Bank of Commerce, 472 U.S. 713, 727 (1985)); see also Aquilino v. United States, 363 U.S. 509, (1960) ( In the application of a federal revenue act, state law controls in determining the nature of the legal interest which the taxpayer had in the property... sought to be reached by the statute ); United States v. Bess, 357 U.S. 51, 56 (1958) (concluding that a federal statute providing for the attachment of a lien on a taxpayer s property applies only after it has been determined that state law creates a sufficient property interest for such federal statute to apply); Morgan v. Commissioner, 309 U.S. 78, 80 (1940) ( State law creates legal interests and rights. The federal revenue acts designate (Footnote continued in next column.) COMMENTARY / SPECIAL REPORT law determines what rights regarding real property are included within fee simple ownership, co-ownership, leasehold, time sharing, life estate, remainder, or reversionary interest in real property. 10 In many states, a private person s fee simple ownership or leasehold interest in a public highway or bridge does not give the owner or lessee the right to charge tolls or fees for the use of the highway or bridge. In those states, common law or statutes provide that a private person may not operate a toll road or toll bridge or charge tolls for the use thereof without an express grant of authority from the state. For example, toll roads and toll bridges in Alabama, Pennsylvania, Virginia, Indiana, and Texas may be constructed and operated by private persons only on the authorization of the state or state agency, and private persons cannot charge tolls other than as authorized by the state. 11 In other states, there is no common law or statutory limitation on the rights of what interests or rights, so created, shall be taxed... Ifitis found in a given case that an interest or right created by local law was the object intended to be taxes [sic], the federal law must prevail no matter what name is given to the interest or right by state law ); LTR (Oct. 1, 2008), Doc , 2009 TNT 2-35 ( The Service generally looks to state law in determining what property rights constitute real property interests ); LTR (Oct. 30, 2007), Doc , 2008 TNT (relying on state law treatment of property development rights as interests in real property, for purposes of finding a like-kind exchange under section 1031); TAM (July 26, 2006), Doc , 2007 TNT (relying on state law treatment of an access easement as an interest in real property, for purposes of determining whether that property was involuntarily converted under section 1033); ILM (June 1, 2005), Doc , 2005 TNT ( State law determines whether a person has property or rights to property, but federal law determines the priority of the federal tax lien. ); ILM (Sept. 19, 2003), Doc , 2003 TNT (relying on a state law determination that a single-member owner of an LLC does not have an interest in that LLC s property for purposes of determining whether a tax lien may be imposed on that property under section 6321); 1996 FSA Lexis 6 (Jan. 23, 1996) (concluding that a franchise agreement between a municipality and a private party qualified as a lease and created a real property interest under Georgia law for purposes of determining whether the exchange of the franchise agreement for undeveloped land qualified as a like-kind exchange under section 1031); cf. Weir Fdn. v. United States, 362 F. Supp. 928, (S.D.N.Y. 1973) (applying state law to determine the extent of a decedent s interest in property, for purposes of determining deductibility of capital gains realized by a spouse s testamentary trust). 10 See Fair v. Commissioner, 27 T.C. 866 (1957) ( property is the sum of the rights and powers incident to ownership of land, and the right to use the air space superadjacent to land is one of the ownership rights in land). 11 Ala. Code section ; Huntingdon, Ind. and Cambria Tpk. Co. v. Brown, 2 Pen. & W. 462 (Pa. 1831) ( our turnpike roads are public highways, and it is the franchise of the citizen to use them, free of every restriction that is not explicitly imposed by the legislature ); Erie & North-East R.R. v. Casey, 1 Grant 274 (Pa. 1856) (the right to charge tolls is a franchise or privilege derived entirely from the turnpike company s charter and ceases to exist when the charter is repealed); Derry Twp. Road, 30 Pa. Super. 538 (1906) (a turnpike company has a franchise to collect the tolls (Footnote continued on next page.) (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. TAX NOTES, March 30,

57 COMMENTARY / SPECIAL REPORT private persons to charge tolls for the use of public highways or bridges. For example, no Florida statute or case law prohibits a private person from building and operating a public toll road or bridge that was constructed without any state funds or property. Accordingly, that right is part of a private person s fee simple ownership or leasehold interest in the public highway or bridge. State law also determines whether fee simple ownership or a leasehold interest in real property that is not part of a public highway or bridge gives the owner or lessee the right to charge tolls or fees for the use of the real property. For example, in Illinois and Pennsylvania, a private person s fee simple ownership or leasehold interest in a parking lot or parking garage includes the right to charge fees for the use of the parking lot or parking garage. Accordingly, if a private person leases a parking lot from a governmental unit in Illinois, a permit granted by the governmental unit that allows the lessor to charge fees for the use of the parking lot conveys no separate right to the lessee of the parking lot and should be treated as a part of the leasehold interest in the parking lot. Reg. section (d)(2)(i) provides that an interest in real property other than an interest solely as a creditor includes any direct or indirect right to share in the appreciation in the value of, or in the gross or net proceeds or profits generated by, the real property. 12 The regulations do not explicitly define the term gross or net proceeds or profits. The regulations addressing the treatment of commissions from the purchase, sale, or lease of real property, however, are instructive. Reg. section (d)(2)(ii)(E) provides that the right to the payment of a commission or brokerage fee for professional services that is based on a percentage of the purchase price of, or rent for, real property is not a right to share in the appreciation in the value of, or gross or net proceeds or profits generated by, real property. In contrast, a right to a commission earned in connection with authorized by law); Virginia Highway Corporation Act of 1988; Ind. Code section ; Texas Transportation Code section See, e.g., reg. section (d)(2)(i) (Example) (a creditor who makes a 10-year loan for the purchase of real property and receives the right to 35 percent of any appreciation in the value of the real property at the end of 10 years has an interest in the real property other than solely as a creditor); reg. section (d)(2)(ii)(D) (a creditor s right to interest indexed to changes in real property value is an indirect right to share in the appreciation in the value of, or gross or net proceeds or profits generated by real property); see also LTR (Sept. 27, 1999), Doc , 1999 TNT , LTR (Sept. 27, 1999), Doc , 1999 TNT , and LTR (Sept. 27, 1999), Doc , 1999 TNT (some real estate management contracts treated as USRPIs); cf. Rev. Rul , IRB 1180, Doc , 2008 TNT (an interest in a notional principal contract, the return on which is calculated by reference to an index that measures the appreciation and depreciation of real property values within a geographically and numerically broad range of U.S. real estate, does not constitute a direct or indirect right to share in the appreciation of the value of real property). the purchase of a real property interest that is contingent on the amount of gain ultimately realized by the purchaser in a subsequent sale of the property is an interest in real property other than an interest solely as a creditor. 5. USRPHCs. Section 897(c)(2) provides that a USRPHC is any domestic corporation for which the fair market value (FMV) of its USRPIs equals or exceeds 50 percent of the total of the FMVs of: (1) its USRPIs; (2) its interests in real property located outside the United States; and (3) any other assets it uses or holds for use in a trade or business. For purposes of determining whether a corporation is a USRPHC, reg. section (f)(1) provides that assets used or held for use in a trade or business include: 1. property other than a USRPI that is inventory, property held primarily for sale to customers, depreciable property described in section 1231(b), and livestock used for draft, breeding, dairy, or sporting purposes; 2. goodwill and going concern value, patents, inventions, formulas, copyrights, literary, musical, or artistic compositions, trademarks, trade names, franchises, licenses, customer lists, and similar intangible property to the extent such property is used or held for use in the entity s trade or business; and 3. cash, stock, securities, receivables, options or contracts to acquire the foregoing, or options or contracts to acquire commodities, but only to the extent those assets do not constitute USRPIs. The method of determining the FMV of property subject to section 897 is provided in reg. section (o). Reg. section (o)(2) sets forth the general rule for determining the FMV of property for purposes of section 897. Reg. section (o)(3) sets forth the method of calculating the FMV of leases and options. Reg. section (o)(4) sets forth the method of calculating the FMV of intangible assets described in reg. section (f)(1)(ii). B. Allocation of Consideration Section 1060(a) provides that, for any transfer of assets that constitute a trade or business, the consideration paid for the assets acquired in the transaction must be allocated in descending order among seven asset classes. Consideration is allocated to and among the assets in each of the first six asset classes to the extent of the FMV of the assets in each class. Consideration in excess of the FMV of the assets included in the first six asset classes is allocated to any goodwill or going concern value associated with the trade or business (Asset Class VII). The seven asset classes are: 1. Asset Class I: cash and general deposit accounts; 2. Asset Class II: actively traded personal property, certificates of deposit, and foreign currency; 3. Asset Class III: assets that the taxpayer marks to market for federal income tax purposes, and some debt instruments, including accounts receivable; 4. Asset Class IV: inventory; 5. Asset Class V: all assets not included in any other asset class; (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content TAX NOTES, March 30, 2009

58 6. Asset Class VI: section 197 intangibles other than goodwill and going concern value; and 7. Asset Class VII: goodwill and going concern value. For purposes of section 1060, fee simple ownership or a leasehold interest in real property would be treated as a Class V asset. A governmental permit to charge tolls or fees for the use of the real property that is not included in the fee simple ownership or leasehold interest in the real property would be treated as a Class VI asset. III. Issues Raised in Announcement A. Potential Alternative Commercial Uses Announcement suggests that it is the position of the IRS and Treasury that if there are no potential alternative commercial uses for an infrastructure asset, either the right to charge tolls or fees for the use of the real property is not treated as an asset separate from the fee simple ownership or leasehold interest in the real property for purposes of FIRPTA, or the governmental permit to charge tolls or fees is a separate asset treated as a USRPI because it is related to the fee simple ownership or leasehold interest in the real property. As discussed above, the legislative history and the statutory and regulatory framework of FIRPTA provide no authority for the proposition that an interest in real property includes all licenses regarding the commercial uses of real property. FIRPTA was enacted following the publication of a Treasury report in 1979 that highlighted ways in which foreign investors in U.S. real property could avoid U.S. tax on gains from those investments. 13 Thus, section 897 is intended to prevent the avoidance of U.S. tax on gains from dispositions of investments in U.S. real property and not to tax licenses that dictate permitted uses of U.S. real property. Moreover, as noted above, the statutory and regulatory framework of section 897 provides for only two types of interests in real property: (i) an interest in real property other than an interest solely as a creditor ; (ii) an interest in real property other than an interest solely as a creditor Neither definition of an interest in real property would include a separate license with respect to the commercial uses of the real property. Announcement also suggests that, in cases in which there are no alternative commercial uses for an infrastructure asset, a governmental permit to charge tolls or fees may constitute a separate USRPI because it is related to the fee simple ownership or leasehold interest in the real property. Courts have held, however, that even if an asset has economic significance only in the context of other assets acquired in a transaction, it will be treated as a separate asset. 14 For example, in Pensacola Greyhound Racing Inc. v. COMMENTARY / SPECIAL REPORT Commissioner, 15 the court addressed the issue of the amount of depreciation allowable on a dog racing facility that the taxpayer purchased for a lump sum. The issue required the court to analyze what part of the lump sum purchase price was allocable to the tangible depreciable assets and what part was allocable to the nondepreciable tangible assets and intangible assets. The taxpayer acquired three intangible assets a racing permit, a racing license, and a liquor license which the court noted were essential to the successful operation of the plant. Under then-existing state law, dog track owners were required to have a racing permit and a racing license. Racing permits were issued for a particular tract of land for an indefinite period and entitled the land owner to be free from competing dog racetracks within a 100-mile radius. The court noted that the value of the tangible and intangible assets acquired in the purchase of the dog racetrack were so dependent on the successful operation of the dog racing enterprise that one would have little value without the other, but nevertheless allocated a substantial portion of the consideration paid for the assets acquired to the racing permit. Thus, even though the real property acquired in Pensacola Greyhound Racing had no alternative commercial uses, the court nevertheless held that the governmental permit for the use of the real property was a separate asset from the fee simple ownership in the real property, as determined by state law. Thus, there is no statutory, regulatory, or case law support for creating a new type of USRPI for a license that dictates the allowed commercial uses of real property or for incorporating the value of such a separate asset into a USRPI. B. Are Any Governmental Permits USRPIs? Under section 897(c)(1)(A) and reg. section (c)(1), the term USRPI means: an interest (other than an interest solely as a creditor) in real property located in the United States; and any interest (other than an interest solely as a creditor) in a domestic corporation that was a USRPHC at any time during a specified period of time. For purposes of section 897, reg. section (b)(1) provides that the term real property includes: land and unsevered natural products of the land, improvements to land, and certain personal property associated with the use of real property. Reg. section (b)(1) provides that local law definitions will not be controlling for purposes of determining the meaning of the term real property as it is used in sections 897 and the regulations thereunder. Reg. section (d)(1) provides that an interest solely as a creditor in real property is not a USRPI. Reg. section (d)(2)(i) provides that an interest in real property other than an interest solely as a creditor includes fee simple ownership, co-ownership, or a leasehold interest in real property, a time-sharing interest (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. 13 See supra note See, e.g., Pensacola Greyhound Racing Inc. v. Commissioner, T.C. Memo ; Fed. Home Loan Mtg. Corp. v. Commissioner, 121 T.C. 254 (2003) (noting that a below-market financing obtained by a mortgage company may be a separate amortizable intangible asset if such favorable financing has a separate and distinct value ); Laird v. United States, 556 F.2d 1224 (5th Cir. (Footnote continued in next column.) 1977) (players contracts had an ascertainable value separate and distinct from the value of the sports franchise); Citizens and S. Corp. v. Commissioner, 91 T.C. 463 (1988) (bank deposit base had a determinable value separate from goodwill). 15 T.C. Memo TAX NOTES, March 30,

59 COMMENTARY / SPECIAL REPORT in real property, and a life estate, remainder, or reversionary interest in the property. Reg. section (d)(2)(i) further provides that an interest in real property other than an interest solely as a creditor includes any direct or indirect right to share in the appreciation in the value of, or in the gross or net proceeds or profits generated by, the real property. A governmental permit to charge tolls or fees for the use of real property is not fee simple ownership, coownership, a leasehold interest in the real property, a time-sharing interest in the real property, or a life estate, remainder, or reversionary interest in the real property. Accordingly, a governmental permit to charge tolls or fees for the use of real property located in the United States or Virgin Islands that is granted to the taxpayer by a governmental unit should be treated as a USRPI only if the right to charge tolls or fees for the use of the real property is either: a right that is included in the taxpayer s fee simple ownership or leasehold interest in the real property otherwise acquired; or a direct or indirect right to share in the appreciation in the value of, or in the gross or net proceeds or profits generated by, the real property within the meaning of reg. section (d)(2). 1. Right to charge tolls or fees for the use of real property that is included in fee simple ownership or a leasehold interest in that real property. Local law does not determine the meaning of real property for purposes of section Applicable state law does determine, however, a person s substantive legal rights associated with real property. 17 Thus, whether a taxpayer has fee simple ownership, co-ownership, a leasehold, time sharing, life estate, remainder, or reversionary interest in real property is determined under applicable state law. Moreover, applicable state law determines what rights are included in the fee simple ownership or leasehold interest in that real property. If, under state law, a private person s fee simple ownership or leasehold interest in a public highway or bridge does not give the owner or lessee the right to charge tolls or fees for the use of the highway or bridge, a separate grant of such a right must be obtained from the state. In those cases, the governmental permit is a separate intangible right, the value of which is not included in the person s fee simple ownership or leasehold interest in the highway or bridge. Consequently, unless the right to charge tolls or fees is treated as a direct or indirect right to share in the appreciation in the value of, or in the gross or net proceeds or profits generated by, the highway or bridge within the meaning of reg. section (d)(2), it does not constitute an interest in real property for purposes of section 897 and the regulations thereunder Reg. section (b)(1). 17 See supra note This test is consistent with the treatment of franchises and licenses as assets used or held for use in a trade or business under reg. section (f)(ii). For purposes of determining whether a corporation is a USRPHC, reg. section (f)(1)(ii) provides that assets used or held for use in a trade or business include goodwill and going concern value, patents, inventions, formulas, copyrights, literary, musical, or artistic compositions, (Footnote continued in next column.) In contrast, if, under state law, a person s fee simple ownership or leasehold interest in real property gives that person the right to charge tolls or fees for the use of the property, the right to charge tolls or fees for the use of the property is part of the person s fee simple ownership or leasehold interest in the real property. Accordingly, even if a separate governmental permit to charge tolls or fees for the use of the real property is granted to the owner or lessee, there is no separate intangible right to charge tolls or fees, and the FMV of the right is part of the FMV of the fee simple ownership or leasehold interest in the real property. For example, a governmental permit granting the right to charge fees for parking in a parking lot or parking garage leased from a city in Pennsylvania should not be treated as a separate intangible asset. Rather, the value of the leasehold interest in the parking lot should include the value of the right. 2. Rights to share in the appreciation of, or gross or net proceeds or profits generated by, real property. The examples given in reg. section (d)(2) indicate that the phrase gross or net proceeds or profits generated by real property refers to the gross or net proceeds or profits realized from the appreciation or depreciation in the value of the real property realized from the disposition of those assets and does not mean an interest in the current operating income or rent realized from real property. For example, reg. section (d)(2)(ii)(E) provides that the right to the payment of a commission or brokerage fee for professional services rendered in connection with the arrangement or financing of a purchase, sale, or lease of real property is not a right to share in the appreciation in the value of, or gross or net proceeds or profits generated by, real property if the commission is based on a percentage of the purchase price or rent. In contrast, a commission earned in connection with the purchase of a real property interest that is contingent on the amount of gain ultimately realized by the purchaser in a subsequent sale of the property would constitute an interest in real property other than an interest solely as a creditor. In both cases, the commission is paid from the gross proceeds of the sale, but these examples demonstrate that the term gross or net proceeds or profits refers only to rights to share in the appreciation or depreciation of real property. The enactment of section 897 was prompted by the Treasury report that highlighted ways in which foreign investors in U.S. real property could avoid U.S. tax on gains from those investments. 19 Section 897 is intended to trademarks, trade names, franchises, licenses, customer lists, and similar intangible property to the extent that property is used or held for use in the entity s trade or business. Accordingly, if a governmental license, permit, or franchise to charge tolls or fees for the use of real property used in the taxpayer s business is a separate intangible asset and is not part of the taxpayer s fee simple ownership or leasehold interest in that real property, that governmental license, permit, or franchise is treated under reg. section (f)(1)(ii) as an asset used or held for use in the taxpayer s trade or business and is not treated as a USRPI. 19 See supra note 6. (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content TAX NOTES, March 30, 2009

60 prevent the avoidance of U.S. tax on gains from dispositions of investments in U.S. real estate. However, it does not apply to rents and other currently taxed operating income derived from U.S. real estate by foreign investors. Accordingly, reg. section (d)(2) treats a right to share in the appreciation in the value of U.S. real property or share in the gross or net proceeds or profits from a disposition of U.S. real property as an interest in U.S. real property. A right to share in the rents or other currently taxed operating income from real property, however, is not treated as an interest in U.S. real property. Thus, the Treasury regulations and the legislative history of section 897 indicate that FIRPTA was enacted to tax gain from the sale or disposition of real property, which includes a right to share in the appreciation in the value of the real property or share in the gross or net proceeds or profits from a sale or disposition of the real property. The right to charge tolls is a right to current operating income generated from the use of real property, which does not give the holder of that right the ability to share in the appreciation in the value of the real property or share in the gross or net proceeds or profits from a sale or other disposition of the real property. Accordingly, in states in which the right to charge tolls or fees for the use of public highways or bridges is not part of the fee simple ownership or leasehold interest in the highways or bridges, a governmental permit to charge tolls or fees for the use of the highways or bridges is not an interest in real property other than solely as a creditor and is not a USRPI. C. Are New Allocation Rules Needed? Announcement requests comments on whether the proposed regulations should address the allocation of the consideration paid for the lease or purchase of a specified infrastructure asset and the license, permit, franchise, or other similar right to operate that specified infrastructure asset for purposes of determining the FMV of that property. The allocation of consideration paid for the lease or purchase of specified infrastructure assets and the license, permit, franchise, or other similar right to operate the infrastructure assets is set forth in section Section 1060 provides that, for purposes of determining the transferee s cost basis in the acquired assets, the consideration paid for the assets is allocated to and among the assets by allocating consideration successively to the assets in seven asset classes. Consideration is allocated to and among the assets in each of the first six asset classes to the extent of the FMV of each asset. Consideration in excess of the FMV of the assets included in the first six asset classes is allocated to any goodwill or going concern value associated with the trade or business. In a typical infrastructure transaction in which an existing toll road or bridge and related tangible personal property are leased and purchased from a governmental unit and the governmental unit grants a license to charge tolls for the use of the road or bridge, the toll road or bridge, tangible personal property, and governmental license constitute a trade or business. Accordingly, for purposes of determining the transferee s cost basis in the toll road or bridge, tangible personal property, and COMMENTARY / SPECIAL REPORT governmental license, the consideration paid for the assets is subject to the allocation rules under section The allocation rules of section 1060, however, do not determine the FMV of the acquired assets. Rather, the allocation of consideration under section 1060 is based on the FMVs of the acquired assets. If, under applicable state law, the taxpayer s right to charge tolls or fees for the use of real property is included in the taxpayer s fee simple ownership or leasehold interest in such real property, that right is not treated as separate intangible property and no consideration is separately allocable to the right as a Class VI asset under section Rather, the FMV of the right is included in the FMV of the fee simple ownership or leasehold interest, and consideration is allocated to the fee simple ownership or leasehold interest as a Class V asset, to the extent of the FMV thereof. If, however, under applicable state law, the taxpayer s right to charge tolls or charge fees for the use of real property is not included in the taxpayer s fee simple ownership or leasehold interest in that real property, but is a right that must be separately granted by the state or local government, it is treated as separate intangible property and consideration is separately allocable as a Class VI asset under section For purposes of determining the amount of consideration allocable to the fee simple ownership or leasehold interest in the real property and the right to charge tolls or fees for the use of the real property, the FMV of the fee simple ownership or leasehold interest in the real property does not include the FMV of the right to charge tolls or fees for the property s use. Solely for purposes of determining whether a domestic corporation is a USRPHC under section 897, the FMVs of interests in real property and assets used or held for use in a trade or business are determined under the rules in reg. section (o). If, under applicable state law, the right to charge tolls or fees for the use of real property is part of the fee simple ownership or leasehold interest in that real property, the FMV of the fee simple ownership or leasehold interest includes the value of the governmental permit to charge tolls or fees for the use of such real property and is determined under reg. section (o)(2) or (o)(3), respectively. If, under applicable state law, the right to charge tolls or fees for the use of real property is not part of the fee simple ownership or leasehold interest in that real property, but is a separate right that must be granted by the state or local government, the FMV of the separate governmental permit is determined under reg. section (o)(4). Because established statutes and regulatory authority address the allocation of the consideration paid for a specified infrastructure project and the determination of the FMVs for purposes of section 897 of the assets included in the infrastructure project, there is no need for further clarification in the proposed regulations. D. When Should Any New Regs Be Effective? The legislative history of section 897 indicates that FIRPTA was enacted to prevent foreign investors in U.S. real estate from avoiding U.S. tax on gains from their investments in that real estate. The current regulations under section 897 further clarify the purpose of FIRPTA (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. TAX NOTES, March 30,

61 COMMENTARY / SPECIAL REPORT by providing a two-prong test for determining whether a right may be characterized as an interest in real property for purposes of section 897. First, reg. section (d)(2)(i) provides that an interest in real property other than an interest solely as a creditor includes fee simple ownership, co-ownership, or a leasehold interest in real property, a time sharing interest in real property, and a life estate, remainder, or reversionary interest in such property. Second, reg. section (d)(2)(i) provides that an interest in real property other than an interest solely as a creditor includes any direct or indirect right to share in the appreciation in the value of, or in the gross or net proceeds or profits generated by, the real property. In many states, as discussed above, the right to charge fees for the use of public roads and bridges is not part of the fee simple ownership or leasehold interest in that real property, and therefore the value of the right generally is not part of an interest in real property subject to section 897. Also, those rights do not give the holder any right to share in the appreciation in the value of the real property or share in the proceeds or profits from a disposition of the real property. They give the holder only the right to generate operating income from the real property in the form of tolls or fees. Accordingly, changing the regulations under section 897 to treat the right to charge tolls or fees for the use of a road or bridge as an interest in real property if that right is not, under applicable state law, a right included in the fee simple ownership or leasehold interest in that road or bridge, would be contrary to the underlying purpose of and legislative authority conferred by FIRPTA. If the IRS and Treasury were, nonetheless, to adopt amendments to the regulations under section 897 to treat governmental permits as USRPIs, the amendments would change the existing interpretation of section 897 that taxpayers have relied on for over 25 years. Accordingly, amendments should apply only to those governmental permits granted to taxpayers after the publication of final regulations. IV. Conclusions The legislative history and the statutory and regulatory framework of FIRPTA provide no authority for the proposition that an interest in real property includes all licenses regarding the commercial uses of real property. Moreover, nothing in the legislative history, statutory and regulatory framework, or case law provides support for creating a new type of USRPI for a license that dictates commercial uses of real property or for incorporating the value of such a separate asset into a USRPI. If proposed regulations under section 897 are published to clarify the treatment under section 897 of governmental permits to charge tolls or fees for the use of real property, they should provide that a governmental permit is treated as a USRPI only if the fee simple ownership or leasehold interest in the real property includes the right, under applicable state law, to charge tolls or fees for the use of that real property. In states where the right to charge tolls or fees for the use of public highways and bridges is not part of the fee simple ownership or leasehold interest in the highways or bridges, a governmental permit to charge tolls or fees for the use of the highways or bridges is not an interest in real property other than solely as a creditor and is not a USRPI. The right to charge tolls or fees is a right to current operating income generated from the use of real property and does not give the holder of that right the ability to share in the appreciation in the value of the real property or share in the gross or net proceeds or profits from a sale of the real property. If a governmental permit to charge tolls or fees for the use of real property used in the taxpayer s business is a separate intangible asset and is not part of the taxpayer s fee simple ownership or leasehold interest in that real property, the governmental permit is treated under reg. section (f)(1)(ii) as an asset used or held for use in the taxpayer s trade or business and is not treated as a USRPI. The allocation of consideration paid for the lease or purchase of specified infrastructure assets and the license, permit, franchise, or other similar right to operate the infrastructure assets is set forth in section The allocation rules of section 1060, however, do not determine the FMV of the acquired assets. Rather, the allocation of consideration under section 1060 is based on the FMVs of the acquired assets. Solely for purposes of determining whether a domestic corporation is a USRPHC under section 897, the FMVs of interests in real property and assets used or held for use in a trade or business are determined under the rules in reg. section (o). If, under applicable state law, the right to charge tolls or fees is part of the fee simple ownership or leasehold interest in real property, the FMV of the fee simple ownership or leasehold interest includes the value of the governmental permit to charge tolls or fees for the use of such real property. The FMV of that fee simple ownership interest is determined under reg. section (o)(2) and the FMV of such a leasehold interest is determined under reg. section (o)(3). If, under applicable state law, the right to charge tolls or fees for the use of real property is not part of the fee simple ownership or leasehold interest in the real property, but is a separate right that must be granted by the state or local government, the FMV of the fee simple ownership or leasehold interest in the real property does not include the value of the governmental permit to charge tolls or fees. The FMV of the fee simple ownership or leasehold interest is determined under reg. section (o)(2) or (3) as described above, and the FMV of the separate governmental permit is determined under reg. section (o)(4). Changing the regulations under section 897 to treat the right to charge tolls or fees for the use of a road or bridge as an interest in real property if that right is not, under applicable state law, a right included in the fee simple ownership or leasehold interest in that road or bridge, would be contrary to the underlying purpose of and legislative authority conferred by FIRPTA. Accordingly, any potential amendments to the regulations adopted by the IRS and Treasury under section 897 to treat such governmental permits as USRPIs should apply only to those governmental permits granted to taxpayers after the publication of final regulations. (C) Tax Analysts All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content TAX NOTES, March 30, 2009

62 Financing Public-Private Partnerships for Infrastructure Assets Best Practices for Mitigating Legal Risks

63 Concession Agreement Key Risks Grantor Entity Legislative Process Potential Litigation Challenging P3 Transaction Consequences of Failure to Close Revenue Adverse Actions / Change in Law Grantor Retained Rights

64 Concession Agreement Key Risks (continued) Delay Events Change of Control Termination Lender Protections Environmental Issues

65 Grantor Entity Issue: Risk: Mitigants: Does the Grantor have the full faith and credit of the state/municipality? The Grantor has no independent creditworthiness and may not be able to meet payment obligations under the Concession Agreement without financial support Utilize Grantor that is entitled to full faith & credit generally Legislation approving transaction/p3 program provides for full faith & credit Reliance on historical comfort of rating agencies and other counterparties with de facto support of Grantor by sovereign

66 Grantor Entity (continued) Structure Concession Agreement to minimize payment obligations of Grantor and substitute other forms of compensation, e.g., extension of term of concession

67 Legislative Process Issue: In certain cases, including some of the most high-profile procurements in the US to date, no enabling legislation is promulgated prior to bid. Risks: Legislation not approved or is passed but contains terms that materially change the commercial, financial or legal terms of the Concession Agreement. Mitigants: Include in Concession Agreement a condition precedent to effectiveness thereof that the enabling legislation is promulgated and conforms to detailed requirements. For example, that such legislation: doesn t impair ability of Grantor to perform obligations under the Concession Agreement; doesn t impose material additional obligations on the Concessionaire; authorizes grant of rights under Concession Agreement; exempts taxes as provided in Concession Agreement; waives sovereign immunity to the extent the Grantor cannot do so by contract; authorizes enforcement measures (e.g., toll evasion, parking tickets, etc.); exempts Concessionaire from procurement provisions; and exempts Concessionaire from local zoning and land use regulations.

68 Potential Litigation Challenging P3 transaction Issue: Special interest groups or members of the public may not always universally support the P3 transaction and may attempt to prevent consummation even with enabling legislation. Risk: Injunction or other order entered enjoining the P3 transaction or that litigation exists challenging the validity of the Concession Agreement. Mitigants: Enabling legislation may provide that supreme court has exclusive jurisdiction and include a prescription period for the commencement of any action challenging the validity of the Concession Agreement. Mutual condition precedent that prescription period has expired and no action pending. Mutual condition precedent that no preliminary or permanent injunction or similar order enjoining the P3 transaction has been issued. Representation and warranty (the accuracy of which is a condition precedent) that no litigation exists which would have an MAE or would materially affect the validity or enforceability of the Concession Agreement. Concessionaire or Grantor can walk away if litigation/injunction is not dismissed by sunset date

69 Consequences of Failure to Close Issue: Either the Concessionaire or the Grantor may fail to execute the Concession Agreement after it is awarded or may fail to meet the conditions precedent contained therein prior to the date required to do so. Risk: Other party has expended significant political and monetary capital. Mitigants: Concessionaire provides bid letter of credit securing its bid which may be drawn for failure to execute Concession Agreement when required Grantor typically does not provide assurances that it will enter into the Concession Agreement Concessionaire often replaces bid letter of credit upon execution with a closing letter of credit having a higher stated amount (often a % of the bid). Closing letter of credit can be drawn for failure of conditions precedent applicable to Concessionaire. Grantor covenants to pay Concessionaire all or a portion of its costs (often subject to a cap) in the event of a failure of conditions precedent applicable to Grantor.

70 Revenue Issue: Risk: Revenue stream for P3 asset may be subject to political considerations Assumed flexibility of Concessionaire to vary historical toll rates subject to political interference Mitigants: Availability payment model permits Grantor to retain pricing control for service to public, but also relieves Concessionaire from market risk Incorporate tolling formula in Concession Agreement to provide clear contractual basis for regulating tolls within prescribed limits Condition any sharing of revenues with Grantor on achievement of equity IRR hurdle rate Associated risk covenant by Grantor not to implement competing facilities

71 Operating Standards Issue: Most P3 projects are public assets with strong political requirement for superior service Risk: Concessionaire fails to operate at appropriate standard of service Mitigation: Detailed operating standards prescribing the level of service required of the Concessionaire. However, in many transactions, operating standards are explicitly provided to be interpreted flexibly in order to avoid foot fouls. Concessionaire s obligations are tolled in certain brownfield projects for an initial period where the Grantor has not itself been complying with the operating standards. Failure to meet operating standards may result in step-in rights, monetary penalties through reduced availability payments or the assessment of compliance fees or liquidated damages or, in an extreme case, termination.

72 Adverse Actions / Change in Law Issue: Public assets especially subject to expropriation risk and other government actions that may adversely impact base line assumptions for the Concession. Risk: Grantor (or any local govt.) enacts legislation or takes other action that has a material adverse effect on the value of the Concession. Risk: Federal Government takes similar adverse action. Mitigants: Grantor Action: Prior to Closing: condition precedent in favor of Concessionaire that no legislation has been promulgated that would otherwise constitute an Adverse Action.

73 Adverse Actions / Change in Law (continued) After Closing: If Adverse Action is general and not discriminatory to the Concessionaire, treated similar to force majeure and non-monetary compensation, such as extension of contract term, may be granted. If action is discriminatory and directed at Concessionaire (or a class of entities similar to Concessionaire), compensation to Concessionaire and/or termination and payment to Concessionaire of fair market value of the Concession (without giving effect to diminution of fair market value resulting from Adverse Action).

74 Adverse Actions / Change in Law (continued) Federal Government Action: In most cases, Concessionaire bears this risk. In certain cases, e.g., Federal government requires higher operating standards generally for eligibility to receive federal funds for transportation programs, Grantor may bear risk of increased costs so as not to jeopardize continued Federal funding.

75 Grantor Retained Rights Issues: Grantor appropriately requires flexibility during long-term concession to require modification of the asset or the way it is operated; Grantor appropriately needs to retain right to enter the asset for a variety of reasons related to the public good; Risk: Exercise by Grantor of its rights could either reduce revenues (in revenue-based concession) or increase costs of Concessionaire. Mitigant: If exercise results in reduced revenues or increased costs, then Grantor required to pay compensation to Concessionaire sufficient to restore Concessionaire to same after-tax economic position as if event had not occurred.

76 Delay Events Issue: Force majeure and similar events (often referred to as Delay Events ) may affect the viability of the Concession, especially but not exclusively in greenfield projects. Risk: Concessionaire cannot complete construction on time or operate the asset in accordance with requirements of the Concession Agreement. Increase in capital expenditures or drop in revenues may collapse project. Mitigants: Concessionaire is excused from performing during pendency. In certain cases, term of Concession is extended. In certain cases, Concessionaire granted right to increase tolls or other revenue drivers. In limited cases, Grantor pays cash compensation to put Concessionaire in the same economic position as if the Delay Event had not occurred.

77 Change of Control Issues: Equity needs broad flexibility due to nature of consortia. Grantor needs assurance that asset will be operated and managed by competent companies with significant economic interest in the Project. Risk: Upstream transfers of Concessionaire s equity interests unacceptably change the nature of the winning bidder. Mitigant: Typically liberal Change of Control regime: Safe harbor if original members retain 50% or more of the direct or indirect voting or economic interests or the power to direct or cause the direction of management and policy of Concessionaire. Additional broad exemptions included for affiliate transfers, transfers of publicly traded securities, liquidation of funds, and transfers between and among funds. However, at some point, failure to maintain control by broad original Sponsor group is a Concessionaire default. Regime is tightened depending on importance of identity of original Sponsors (generally more tight for greenfield than for brownfield - - at least during construction).

78 Termination Issue: Under what circumstances should the Concession be terminated and what are the consequences? Risk: Grantor terminates Concession and Concessionaire is deprived of revenue source to repay debt and realize anticipated equity return Mitigants: Termination for Convenience: Either limit ability of Grantor to terminate for convenience or provide for compensation that reflects the higher of (i) fair market value of the Concession and (ii) outstanding debt plus equity investment plus base case equity return Termination for Force Majeure: Provide compensation that shares risk as Grantor retains asset upon termination, e.g., debt plus equity investment Termination for Concessionaire Default: Provide compensation that renders project financeable and recognizes that asset has value; e.g., fair market value calculation Termination for Grantor Default: Compensation similar to termination for convenience

79 Lender Protections Issue: Rights of lenders must be recognized, if transaction is to be financeable. Risk: Concessionaire defaults and Grantor terminates. If material risk that Lenders are not made whole, then transaction may not be bankable. Mitigants: Broadly two models: Extensive cure regime: Concessionaire granted extended cure rights that minimize chance of breach crystallizing into a Concessionaire default in the first place. Lenders given extended sequential cure rights upon the occurrence of a Concessionaire default that allow them to step-in and cure on behalf of Concessionaire.

80 Lender Protections (continued) -or - Minimum Termination Value: Grantor pays minimum value upon termination for Concessionaire default that equals or exceeds amount of the debt.

81 Environmental Issues Issue: P3 assets often have environmental impacts Risk: From the Grantor s perspective, that the Concessionaire causes environmental issues on the asset (which remains the property of the Grantor). From the Concessionaire s perspective, that pre-existing conditions exist on the leased property that must be remediated. Mitigant: Concession Agreement typically includes a my watch; your watch bifurcation of responsibility and associated indemnification provisions to appropriately allocate environmental risk between the parties.

82 Environmental Issues (continued) Baseline environmental audits / due diligence In greenfield projects, Grantor may have continuing presence on the asset, whether due to continuing works retained by the Grantor or monitoring activities or otherwise more complicated post-closing apportionment of responsibility Grantor retains generator status as retains legal title to asset

83 END