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Tax Ramifications of Public-Private Partnerships in Infrastructure Projects

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T R ifi ti f P bli P i tTax Ramifications of Public-Private Partnerships in Infrastructure

ProjectsStrafford Publications

Tax Planning Strategies to Maximize Profits in PPP Deals

Strafford PublicationsTeleconferenceDecember 10, 2009

Profits in PPP Deals

Linda E. Carlisle, White & Case LLP

R. David Wheat, Thompson & Knight

O iOverview

I. Federal Income Tax Treatment of Brownfield ProjectsI. Federal Income Tax Treatment of Brownfield ProjectsII. Federal Income Tax Treatment of Greenfield ProjectsIII. Conclusions

8 December 2009April 8, 2009

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I Federal Income Tax Treatment of Brownfield Projects

A. Typical Investment Structure.

I. Federal Income Tax Treatment of Brownfield Projects

U.S. Shareholders Non-U.S. Shareholders

U.S. Corp. U.S. Corp.

Holding Company

U.S. LLC treated as a partnership.

Concessionaire

Concession and Lease Agreement

U.S. LLC treated as a disregarded entity.

State or Local Gov’t

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I Federal Income Tax Treatment of Brownfield Projects (cont’d)I. Federal Income Tax Treatment of Brownfield Projects (cont d)

B. Rights Granted by the State or Local Government under the Concession and Lease Agreementand 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 d th ti t d i i i lif f th i t (t i ll 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 ti f th F ilitoperation of the Facility.

3. The Concessionaire is granted the right to operate the Facility and collect fees for the use of the Facility.

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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.y g g

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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 tax2. Additional capital improvements to the Facility also may be eligible for tax-exempt 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.

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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.q y

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.

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7. Taxation of non-U.S. investors.

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.

I. Federal Income Tax Treatment of Brownfield Projects (cont d)

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. 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 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.

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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; g p ;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

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viii. Which party receives the profits from the operation and sale of the property.

I Federal Income Tax Treatment of Brownfield Projects (cont’d)

2. Lease or sale of real property improvements (cont’d).

b Th t i l i d l t h ld b t t d l th


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 g p p p yimprovements;

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; andp p y y

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.

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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 p pof the land.

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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.p p p y p

c. Ownership of any tangible personal property conveyed to the Concessionaire.

d A i t f i ht d bli ti d t t i d t th d. Assignment of rights and obligations under contracts assigned to the Concessionaire.

e Ownership of any intangible assets conveyed to the Concessionaire including 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.

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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 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 b i ll f th t t f d t t d i l t d b i f business, all of the assets transferred are treated as a single trade or business for purposes of section 1060.

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4. Allocation of consideration among assets acquired by the Concessionaire (cont’d). b Allocation of consideration under the residual method:


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;iii Next to debt instruments and assets that are marked to market at least annually;iii. 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 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 y g q y ,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

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concern value.


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 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 l d d ”

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loaded.”

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


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 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 p g y g y yconcession 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.

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5. Tax treatment of amounts allocated to assets (cont’d).b. Tangible assets acquired by the Concessionaire (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.p p

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

t t di b d t i i t th i t 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.

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c) TIFIA financing does not constitute tax-exempt bond financing.


5. Tax treatment of amounts allocated to assets (cont’d).c Intangible assets acquired by the Concessionaire


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;base intangibles;d) Customer lists and other “customer-based” intangibles;e) Favorable supplier contracts and other “supplier-based” intangibles;) pp pp g ;f) Rights, permits, and licenses granted by a governmental unit; andg) Franchises.

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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 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 g p gover the useful life of the asset.

iii. In states in which private persons that have a possessory interest in an p p p yasset 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.

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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. y

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 g gfacto partnership for federal income tax purposes.

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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.g

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 p g , p pamortized over the remaining portion of the 15-year recovery period or deducted if such 15-year period has expired.

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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


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

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stock of the U.S. corporation) if such U.S. corporation is a USRPHC.

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


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 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. g , , g , p g

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 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

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real property.

I Federal Income Tax Treatment of Greenfield ProjectsI. 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.

Developer

Development and Lease Agreement

U.S. LLC treated as a disregarded entity.

State or Local Gov’t

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II Federal Income Tax Treatment of Greenfield Projects (cont’d)II. Federal Income Tax Treatment of Greenfield Projects (cont d)

B. Rights granted by the state or local government under the Development and Lease Agreementand 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 public-use infrastructure asset (the Facility ) in accordance with specified standards.

2 Upon completion of construction of the Facility the Developer is granted the 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).

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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 agreementcondition 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 agreementincluding 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 the term of the agreement, if specified windfall revenues or refinancing gains are realized by the Developer.

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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.

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E. Principal federal income tax issues that are specific to greenfield j t projects.

1. Treatment of the Developer’s costs of construction as rent, consideration pfor 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.

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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 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 go ernment nless the agreement e pressl pro ides 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. 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

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basis for the improvements. See sections 263 and 263A.


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 p q p y p (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 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 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; andc) The public funds should not be included in the Developer’s depreciable basis

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) p p pfor 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 (cont’d)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 pp y p pto 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

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a partnership.


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 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 Th lt ti d i ti t ld b d t f th ti if f th 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

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any unrecovered costs.

III ConclusionsIII. Conclusions

Privatization of public infrastructure assets provides needed capital to state and Privatization of public infrastructure assets provides needed capital to state and local governments with no extraordinary tax benefits for the private investors.

1 Th U S f d l i t t t t f i f t t i ti ti 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 N U S i t bj t t th t l th t l t 3. Non-U.S. investors are subject to the same tax rules that apply to non-U.S. investors in other U.S. businesses.

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Is a Governmental License to Toll aPublic Highway a USRPI?

By Linda E. Carlisle

Table of Contents

I. Typical Infrastructure Transactions . . . . . 1604A. Brownfield Transactions . . . . . . . . . . . 1604B. Greenfield Transactions . . . . . . . . . . . . 1604

II. Legal Framework . . . . . . . . . . . . . . . . . . 1604A. Section 897 . . . . . . . . . . . . . . . . . . . . 1604B. Allocation of Consideration . . . . . . . . . 1606

III. Issues Raised in Announcement 2008-115 . 1607

A. Potential Alternative Commercial Uses . 1607B. Are Any Governmental Permits

USRPIs? . . . . . . . . . . . . . . . . . . . . . . 1607C. Are New Allocation Rules Needed? . . . 1609D. When Should New Allocation Rules Be

Effective? . . . . . . . . . . . . . . . . . . . . . . 1609IV. Conclusions . . . . . . . . . . . . . . . . . . . . . . 1610

On October 31, 2008, the IRS and Treasury publishedan advance notice of proposed rulemaking1 addressingthe definition of an interest in real property2 for purposesof section 897. Announcement 2008-1153 states that theIRS and Treasury are considering revising the definitionof an interest in real property within the meaning ofsection 897(c) by amending reg. section 1.897-1. In par-ticular, the notice of proposed rulemaking would addressspecific rights granted by a governmental unit that arerelated to the lease, ownership, or use of toll roads, tollbridges, and some physical infrastructure assets.

Announcement 2008-115 states that the IRS and Treas-ury are of the view that a governmental permit forspecified infrastructure assets that is related to the valueof the use or ownership of an interest in real propertymay properly be characterized as a U.S. real propertyinterest (USRPI) within the meaning of section 897(c).Announcement 2008-115 states that the ‘‘physical at-tributes’’ and the ‘‘terms and conditions related to thespecified infrastructure’’ mean that in many cases, ‘‘theremay practically be no potential alternative commercialuses for the specified infrastructure.’’ In those cases,Announcement 2008-115 states that ‘‘the value of theleasehold interest in the specified infrastructure derivesfrom the right to charge and collect tolls.’’

The IRS and Treasury have specifically requestedcomments on: the scope of the regulatory project and thetypes of licenses, permits, franchises, or other similarrights granted by a governmental unit that might betreated as related to the value of the lease, ownership, oruse of an interest in real property, for purposes of section897(c), and what characteristics should be taken intoaccount in making that determination; and whether theproposed regulations should address the allocation of theconsideration paid for the lease or purchase of a specifiedinfrastructure and the license, permit, franchise, or othersimilar right to operate that specified infrastructure forpurposes of determining the fair market value of that

1REG-130342-08, 73 Fed. Reg. 64,901 (Oct. 31, 2008), Doc2008-23073, 2008 TNT 212-9.

2The ANPR does not reference section 197, which providesfor 15-year amortization for governmental licenses, permits, orother rights that do not constitute ‘‘interests in land.’’

3Announcement 2008-115, 2008-48 IRB 1228, Doc 2008-25185,2008 TNT 231-6.

Linda E. Carlisle is a partner in the Washington,D.C., office of White & Case LLP. The author gratefullyacknowledges the assistance of Geoffrey B. Lanningand Mika Ikeda in the preparation of this article.

This report discusses an advanced notice of pro-posed rulemaking published by the IRS and Treasuryon October 31, 2008, addressing whether the IRS andTreasury should revise the definition of an ‘‘interest inreal property’’ to include certain rights granted by agovernmental unit that are related to the lease, own-ership, or use of toll roads, toll bridges, and certainother physical infrastructure assets. The report exam-ines the structure of typical ‘‘brownfield’’ and ‘‘green-field’’ infrastructure transactions and sets forth therights and obligations of the parties in those arrange-ments.

Based on a review of the legislative history of theForeign Investment in Real Property Tax Act and theexisting regulations under section 897, this reportconcludes that, if proposed regulations under section897 are published to clarify the treatment under sec-tion 897 of governmental permits to charge tolls orfees for the use of real property, those proposedregulations should provide that a governmental per-mit is treated as a United States real property interest(USRPI) only if the fee simple ownership or leaseholdinterest in that real property includes the right, underapplicable state law, to charge tolls or fees for the useof that real property. In states in which the right tocharge tolls or fees for the use of public highways orbridges is not part of the fee simple or leaseholdinterest in the highways or bridges, a governmentpermit to charge tolls or fees is not a USRPI.

Copyright 2009 Linda E. Carlisle.All rights reserved.

tax notes®

SPECIAL REPORT

TAX NOTES, March 30, 2009 1603

(C) T

ax Analysts 2009. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

property, and for purposes of allocating that consid-eration, whether the length of the lease (includingwhether the lease is for the useful life of the property)should be taken into account.

Announcement 2008-115 states that if proposed regu-lations are issued, they will apply for transactions occur-ring on or after the date of publication in the FederalRegister as final or temporary regulations, and that noinference is intended regarding the treatment or charac-terization of those arrangements under current law.

I. Typical Infrastructure Transactions

In typical infrastructure transactions, a domestic part-nership leases or purchases from an unrelated partyinfrastructure assets and any land underlying those as-sets. Also, the domestic partnership is granted a govern-mental license, permit, franchise, or other similar right(governmental permit) to operate the specified infra-structure and to collect tolls or fees for the use of thatinfrastructure asset.4

Privatization of infrastructure projects may involveexisting publicly owned infrastructure projects (brown-field privatizations) or the construction and privatizationof new infrastructure projects (greenfield privatizations).

A. Brownfield TransactionsPrivate investment in an existing publicly owned

infrastructure project typically takes the form of anagreement (a concession and lease agreement) betweenthe state or local government and an entity formed by theprivate investors (the concessionaire) to enter into theagreement. The concessionaire typically is a limited part-nership or limited liability company that is treated as apartnership for federal tax purposes.

The state or local government leases the real propertyand improvements that are part of the infrastructureproject to the concessionaire and gives the concessionairepossession and use of the property for a term of yearsthat exceeds the estimated remaining economic life of theimprovements, typically ranging from 75 to 99 years. Thestate or local government grants the concessionaire theright to operate the infrastructure project and collect feesfor the use of the infrastructure project for the term of theagreement. The state or local government conveys, trans-fers, or assigns to the concessionaire any personal prop-erty that the state or local government owns that is usedin the operation of the infrastructure project and con-tracts relating to the operation of the infrastructureproject to which the state or local government is a party.

The concessionaire typically is required to make anupfront payment to the state or local government. Theconcessionaire is required to operate and maintain theinfrastructure asset solely as a public highway, bridge, orother public service for which it is intended and may not

convert the infrastructure asset to alternative uses. Theconcessionaire bears all costs of operating, maintaining,and repairing the infrastructure project and assumes alloperational and financial risks relating to the project,including risks of casualty losses, during the term of theagreement. The concessionaire agrees to return the infra-structure project to the state or local government at theend of the agreement in the condition specified in theconcession and lease agreement.

B. Greenfield TransactionsPrivate investment in a greenfield project usually

takes the form of an agreement (typically called a devel-opment and lease agreement) between the state or localgovernment and an entity formed by the private inves-tors (typically called the developer) to enter into theagreement. The developer usually is a limited partner-ship or LLC that is treated as a partnership for federal taxpurposes.

Under a typical development and lease agreement, thestate or local government grants the developer the exclu-sive right to develop and construct a new infrastructureproject in accordance with specified standards. Oncompletion of construction of the project, the state orlocal government grants the developer the right to oper-ate and collect fees for the use of the asset for a term ofyears that exceeds the estimated remaining economic lifeof the improvements, typically ranging from 35 to 50years.

Under a development and lease agreement, the devel-oper is required to pay all costs of operating, maintain-ing, and repairing the infrastructure project, and to returnthe asset to the state or local government at the end of theagreement in the condition specified in the developmentand lease agreement. The developer is required to oper-ate and maintain the infrastructure asset solely as apublic highway, bridge, or other public service for whichit is intended and may not convert the infrastructureasset to alternative uses. The developer bears all con-struction, operational, and financial risks relating to theinfrastructure project, including risks of casualty losses,during the term of the agreement.

II. Legal Framework

A. Section 897

1. In general. In 1980, section 897 was added to the codeby the Foreign Investment in Real Property Tax Act5 toprovide that gain or loss of a nonresident alien individualor foreign corporation from the disposition of a USRPI issubject to U.S. federal income tax as income that iseffectively connected with the conduct of a trade orbusiness in the United States. FIRPTA was prompted bya report issued by Treasury in 1979 that highlighted fiveways in which foreign investors engaged in a U.S. tradeor business could, under then-existing law, avoid U.S.4For a general description of those structures, see ‘‘Tax and

Financing Aspects of Highway Public-Private Partnerships:Hearing Before the Subcomm. on Energy, Natural Resourcesand Infrastructure of the S. Comm. on Finance,’’ 110th Cong. 1-3(2008) (testimony of Linda E. Carlisle, partner, White & CaseLLP).

5Omnibus Reconciliation Act of 1980, P.L. 96-499, section1122 (Dec. 5, 1980).

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taxation on gains from investments in U.S. real estate.6The House report accompanying FIRPTA noted that,under then-existing law, ‘‘capital gains realized by for-eign investors on the sale of U.S. property are generallynot subject to U.S. tax unless the property is held inconnection with a U.S. trade or business.’’7 The Housereport then explained that the new provisions of FIRPTAwould ‘‘subject foreign investors to U.S. tax on gains onthe sale or other disposition of U.S. real property.’’8

Section 897 does not apply to rent and other operatingincome derived from U.S. real estate by foreign investorsbecause that income is subject to either U.S. withholdingtax under sections 871(a) and 881 or to U.S. income taxunder sections 871(b) and 882 as income effectivelyconnected with the conduct of a U.S. trade or business.2. USRPIs. Section 897(c)(1)(A) and reg. section 1.897-1(c)(1) provide that USRPI means: an interest in realproperty located in the United States or Virgin Islands,and any interest (other than an interest solely as acreditor) in a domestic corporation that was a U.S. realproperty holding corporation (USRPHC) at any timeduring a specified period of time.3. Real property. Reg. section 1.897-1(b)(1) provides thatthe term ‘‘real property’’ includes: (1) land and unseverednatural products of the land; (2) improvements to theland; and (3) personal property associated with the use ofreal property. Reg. section 1.897-1(b)(1) provides thatlocal law definitions will not be controlling for purposesof determining the meaning of the term real property asit is used in section 897 and the regulations thereunder.4. Interests in real property. Reg. section 1.897-1(d)(2)(i)provides that an interest solely as a creditor in realproperty is not a USRPI. That section also provides thatan ‘‘interest in real property other than an interest solelyas a creditor’’ includes fee simple ownership, co-ownership, or a leasehold interest in real property; a timesharing interest in real property; and a life estate, remain-der, or reversionary interest in the property. Applicablestate law determines if a taxpayer has fee simple owner-ship, co-ownership, a leasehold, or other interest enumer-ated in reg. section 1.897-1(d)(2)(i).9 Also, applicable state

law determines what rights regarding real property areincluded within fee simple ownership, co-ownership,leasehold, time sharing, life estate, remainder, or rever-sionary interest in real property.10

In many states, a private person’s fee simple owner-ship or leasehold interest in a public highway or bridgedoes not give the owner or lessee the right to charge tollsor fees for the use of the highway or bridge. In thosestates, common law or statutes provide that a privateperson may not operate a toll road or toll bridge orcharge tolls for the use thereof without an express grantof authority from the state. For example, toll roads andtoll bridges in Alabama, Pennsylvania, Virginia, Indiana,and Texas may be constructed and operated by privatepersons only on the authorization of the state or stateagency, and private persons cannot charge tolls otherthan as authorized by the state.11 In other states, there isno common law or statutory limitation on the rights of

6Department of the Treasury, ‘‘Taxation of Foreign Invest-ment in Real Estate’’ (1979).

7H.R. Rep. No. 96-1167 at 364 (1980).8Id.9Drye v. United States, 528 U.S. 49, 58 (1999) (‘‘We look

initially to state law to determine what rights the taxpayer hasin the property the Government seeks to reach, then to federallaw to determine whether the taxpayer’s state-delineated rightsqualify as ‘property’ or ‘rights to property’ within the compassof the federal tax lien legislation’’) (citing United States v. Nat’lBank of Commerce, 472 U.S. 713, 727 (1985)); see also Aquilino v.United States, 363 U.S. 509, 512-513 (1960) (‘‘In the application ofa federal revenue act, state law controls in determining thenature of the legal interest which the taxpayer had in theproperty . . . sought to be reached by the statute’’); United Statesv. Bess, 357 U.S. 51, 56 (1958) (concluding that a federal statuteproviding for the attachment of a lien on a taxpayer’s propertyapplies only after it has been determined that state law createsa sufficient property interest for such federal statute to apply);Morgan v. Commissioner, 309 U.S. 78, 80 (1940) (‘‘State law createslegal interests and rights. The federal revenue acts designate

what interests or rights, so created, shall be taxed. . . . If it isfound in a given case that an interest or right created by locallaw was the object intended to be taxes [sic], the federal lawmust prevail no matter what name is given to the interest orright by state law’’); LTR 200901020 (Oct. 1, 2008), Doc 2009-20,2009 TNT 2-35 (‘‘The Service generally looks to state law indetermining what property rights constitute real property inter-ests’’); LTR 200805012 (Oct. 30, 2007), Doc 2008-2156, 2008 TNT23-29 (relying on state law treatment of property developmentrights as interests in real property, for purposes of finding alike-kind exchange under section 1031); TAM 200722013 (July26, 2006), Doc 2007-13213, 2007 TNT 107-20 (relying on state lawtreatment of an access easement as an interest in real property,for purposes of determining whether that property was invol-untarily converted under section 1033); ILM 200536032 (June 1,2005), Doc 2005-18612, 2005 TNT 175-24 (‘‘State law determineswhether a person has property or rights to property, but federallaw determines the priority of the federal tax lien.’’); ILM200338012 (Sept. 19, 2003), Doc 2003-20842, 2003 TNT 185-19(relying on a state law determination that a single-memberowner of an LLC does not have an interest in that LLC’sproperty for purposes of determining whether a tax lien may beimposed on that property under section 6321); 1996 FSA Lexis 6(Jan. 23, 1996) (concluding that a franchise agreement between amunicipality and a private party qualified as a lease and createda real property interest under Georgia law for purposes ofdetermining whether the exchange of the franchise agreementfor undeveloped land qualified as a like-kind exchange undersection 1031); cf. Weir Fdn. v. United States, 362 F. Supp. 928,932-934 (S.D.N.Y. 1973) (applying state law to determine theextent of a decedent’s interest in property, for purposes ofdetermining deductibility of capital gains realized by a spouse’stestamentary trust).

10See Fair v. Commissioner, 27 T.C. 866 (1957) (‘‘property’’ isthe sum of the rights and powers incident to ownership of land,and the right to use the air space superadjacent to land is one ofthe ownership rights in land).

11Ala. Code section 23-1-81; Huntingdon, Ind. and CambriaTpk. Co. v. Brown, 2 Pen. & W. 462 (Pa. 1831) (‘‘our turnpike roadsare public highways, and it is the franchise of the citizen to usethem, free of every restriction that is not explicitly imposed bythe legislature’’); Erie & North-East R.R. v. Casey, 1 Grant 274 (Pa.1856) (the right to charge tolls is a franchise or privilege derivedentirely from the turnpike company’s charter and ceases to existwhen the charter is repealed); Derry Twp. Road, 30 Pa. Super. 538(1906) (a turnpike company has a franchise to collect the tolls


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private persons to charge tolls for the use of publichighways or bridges. For example, no Florida statute orcase law prohibits a private person from building andoperating a public toll road or bridge that was con-structed without any state funds or property. Accord-ingly, that right is part of a private person’s fee simpleownership or leasehold interest in the public highway orbridge.

State law also determines whether fee simple owner-ship or a leasehold interest in real property that is notpart of a public highway or bridge gives the owner orlessee the right to charge tolls or fees for the use of thereal property. For example, in Illinois and Pennsylvania,a private person’s fee simple ownership or leaseholdinterest in a parking lot or parking garage includes theright to charge fees for the use of the parking lot orparking garage. Accordingly, if a private person leases aparking lot from a governmental unit in Illinois, a permitgranted by the governmental unit that allows the lessorto charge fees for the use of the parking lot conveys noseparate right to the lessee of the parking lot and shouldbe treated as a part of the leasehold interest in theparking lot.

Reg. section 1.897-1(d)(2)(i) provides that ‘‘an interestin real property other than an interest solely as a credi-tor’’ includes any direct or indirect right to share in theappreciation in the value of, or in the gross or netproceeds or profits generated by, the real property.12 Theregulations do not explicitly define the term ‘‘gross or netproceeds or profits.’’ The regulations addressing thetreatment of commissions from the purchase, sale, orlease of real property, however, are instructive. Reg.section 1.897-1(d)(2)(ii)(E) provides that the right to thepayment of a commission or brokerage fee for profes-sional services that is based on a percentage of thepurchase price of, or rent for, real property is not a rightto share in the appreciation in the value of, or gross or netproceeds or profits generated by, real property. In con-trast, a right to a commission earned in connection with

the purchase of a real property interest that is contingenton the amount of gain ultimately realized by the pur-chaser in a subsequent sale of the property is an interestin real property other than an interest solely as a creditor.

5. USRPHCs. Section 897(c)(2) provides that a USRPHCis any domestic corporation for which the fair marketvalue (FMV) of its USRPIs equals or exceeds 50 percent ofthe total of the FMVs of: (1) its USRPIs; (2) its interests inreal property located outside the United States; and (3)any other assets it uses or holds for use in a trade orbusiness.

For purposes of determining whether a corporation isa USRPHC, reg. section 1.897-1(f)(1) provides that assetsused or held for use in a trade or business include:

1. property other than a USRPI that is inventory, prop-erty held primarily for sale to customers, depreciableproperty described in section 1231(b), and livestockused for draft, breeding, dairy, or sporting purposes;

2. ‘‘goodwill and going concern value, patents, inven-tions, formulas, copyrights, literary, musical, or artisticcompositions, trademarks, trade names, franchises,licenses, customer lists, and similar intangible prop-erty’’ to the extent such property is used or held foruse in the entity’s trade or business; and

3. cash, stock, securities, receivables, options or contractsto acquire the foregoing, or options or contracts toacquire commodities, but only to the extent thoseassets do not constitute USRPIs.The method of determining the FMV of property

subject to section 897 is provided in reg. section 1.897-1(o). Reg. section 1.897-1(o)(2) sets forth the general rulefor determining the FMV of property for purposes ofsection 897. Reg. section 1.897-1(o)(3) sets forth themethod of calculating the FMV of leases and options.Reg. section 1.897-1(o)(4) sets forth the method of calcu-lating the FMV of intangible assets described in reg.section 1.897-1(f)(1)(ii).

B. Allocation of ConsiderationSection 1060(a) provides that, for any transfer of assets

that constitute a trade or business, the consideration paidfor the assets acquired in the transaction must be allo-cated in descending order among seven asset classes.Consideration is allocated to and among the assets ineach of the first six asset classes to the extent of the FMVof the assets in each class. Consideration in excess of theFMV of the assets included in the first six asset classes isallocated to any goodwill or going concern value associ-ated with the trade or business (Asset Class VII). Theseven asset classes are:

1. Asset Class I: cash and general deposit accounts;

2. Asset Class II: actively traded personal property, cer-tificates of deposit, and foreign currency;

3. Asset Class III: assets that the taxpayer marks tomarket for federal income tax purposes, and somedebt instruments, including accounts receivable;

4. Asset Class IV: inventory;

5. Asset Class V: all assets not included in any other assetclass;

authorized by law); Virginia Highway Corporation Act of 1988;Ind. Code section 8-15.5-7-1; Texas Transportation Code section362.102.

12See, e.g., reg. section 1.897-1(d)(2)(i) (Example) (a creditorwho makes a 10-year loan for the purchase of real property andreceives the right to 35 percent of any appreciation in the valueof the real property at the end of 10 years has an interest in thereal property other than solely as a creditor); reg. section1.897-1(d)(2)(ii)(D) (a creditor’s right to interest indexed tochanges in real property value is an indirect right to share in theappreciation in the value of, or gross or net proceeds or profitsgenerated by real property); see also LTR 199951044 (Sept. 27,1999), Doc 2000-44, 1999 TNT 247-20, LTR 199951027 (Sept. 27,1999), Doc 2000-27, 1999 TNT 247-18, and LTR 199951043 (Sept.27, 1999), Doc 2000-43, 1999 TNT 247-19 (some real estatemanagement contracts treated as USRPIs); cf. Rev. Rul. 2008-31,2008-26 IRB 1180, Doc 2008-13032, 2008 TNT 115-8 (an interest ina notional principal contract, the return on which is calculatedby reference to an index that measures the appreciation anddepreciation of real property values within a geographically andnumerically broad range of U.S. real estate, does not constitutea direct or indirect right to share in the appreciation of the valueof real property).



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6. Asset Class VI: section 197 intangibles other thangoodwill 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 asa Class V asset. A governmental permit to charge tolls orfees for the use of the real property that is not included inthe fee simple ownership or leasehold interest in the realproperty would be treated as a Class VI asset.

III. Issues Raised in Announcement 2008-115

A. Potential Alternative Commercial UsesAnnouncement 2008-115 suggests that it is the posi-

tion of the IRS and Treasury that if there are ‘‘no potentialalternative commercial uses’’ for an infrastructure asset,either the right to charge tolls or fees for the use of thereal property is not treated as an asset separate from thefee simple ownership or leasehold interest in the realproperty for purposes of FIRPTA, or the governmentalpermit to charge tolls or fees is a separate asset treated asa USRPI because it is ‘‘related to’’ the fee simple owner-ship or leasehold interest in the real property.

As discussed above, the legislative history and thestatutory and regulatory framework of FIRPTA provideno authority for the proposition that an interest in realproperty includes all licenses regarding the commercialuses of real property. FIRPTA was enacted following thepublication of a Treasury report in 1979 that highlightedways in which foreign investors in U.S. real propertycould avoid U.S. tax on gains from those investments.13

Thus, section 897 is intended to prevent the avoidance ofU.S. tax on gains from dispositions of investments in U.S.real property and not to tax licenses that dictate permit-ted uses of U.S. real property.

Moreover, as noted above, the statutory and regula-tory framework of section 897 provides for only twotypes of interests in real property: (i) an ‘‘interest in realproperty other than an interest solely as a creditor’’; (ii)‘‘an interest in real property other than an interest solelyas a creditor’’ Neither definition of an interest in realproperty would include a separate license with respect tothe commercial uses of the real property.

Announcement 2008-115 also suggests that, in cases inwhich there are ‘‘no alternative commercial uses’’ for aninfrastructure asset, a governmental permit to chargetolls or fees may constitute a separate USRPI because it isrelated to the fee simple ownership or leasehold interestin the real property.

Courts have held, however, that even if an asset haseconomic significance only in the context of other assetsacquired in a transaction, it will be treated as a separateasset.14 For example, in Pensacola Greyhound Racing Inc. v.

Commissioner,15 the court addressed the issue of theamount of depreciation allowable on a dog racing facilitythat the taxpayer purchased for a lump sum. The issuerequired the court to analyze what part of the lump sumpurchase price was allocable to the tangible depreciableassets and what part was allocable to the nondepreciabletangible assets and intangible assets. The taxpayer ac-quired three intangible assets — a racing permit, a racinglicense, and a liquor license — which the court notedwere ‘‘essential to the successful operation of the plant.’’Under then-existing state law, dog track owners wererequired to have a racing permit and a racing license.Racing permits were issued for a particular tract of landfor an indefinite period and entitled the land owner to befree from competing dog racetracks within a 100-mileradius. The court noted that the value of the tangible andintangible assets acquired in the purchase of the dogracetrack were ‘‘so dependent on the successful operationof the dog racing enterprise that one would have littlevalue without the other,’’ but nevertheless allocated asubstantial portion of the consideration paid for theassets acquired to the racing permit. Thus, even thoughthe real property acquired in Pensacola Greyhound Racinghad no ‘‘alternative commercial uses,’’ the court never-theless held that the governmental permit for the use ofthe real property was a separate asset from the fee simpleownership in the real property, as determined by statelaw.

Thus, there is no statutory, regulatory, or case lawsupport for creating a new type of USRPI for a licensethat dictates the allowed commercial uses of real prop-erty or for incorporating the value of such a separateasset into a USRPI.

B. Are Any Governmental Permits USRPIs?Under section 897(c)(1)(A) and reg. section 1.897-

1(c)(1), the term USRPI means: an interest (other than aninterest solely as a creditor) in real property located in theUnited States; and any interest (other than an interestsolely as a creditor) in a domestic corporation that was aUSRPHC at any time during a specified period of time.For purposes of section 897, reg. section 1.897-1(b)(1)provides that the term ‘‘real property’’ includes: land andunsevered natural products of the land, improvements toland, and certain personal property associated with theuse of real property. Reg. section 1.897-1(b)(1) providesthat local law definitions will not be controlling forpurposes of determining the meaning of the term ‘‘realproperty’’ as it is used in sections 897 and the regulationsthereunder. Reg. section 1.897-1(d)(1) provides that aninterest solely as a creditor in real property is not aUSRPI.

Reg. section 1.897-1(d)(2)(i) provides that an ‘‘interestin real property other than an interest solely as a credi-tor’’ includes fee simple ownership, co-ownership, or aleasehold interest in real property, a time-sharing interest

13See supra note 6.14See, e.g., Pensacola Greyhound Racing Inc. v. Commissioner,

T.C. Memo. 1973-225; Fed. Home Loan Mtg. Corp. v. Commissioner,121 T.C. 254 (2003) (noting that a below-market financingobtained by a mortgage company may be a separate amortiz-able intangible asset if such favorable financing has a ‘‘separateand distinct value’’); Laird v. United States, 556 F.2d 1224 (5th Cir.

1977) (players’ contracts had an ascertainable value separateand distinct from the value of the sports franchise); Citizens andS. Corp. v. Commissioner, 91 T.C. 463 (1988) (bank deposit basehad a determinable value separate from goodwill).

15T.C. Memo. 1973-225.


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in real property, and a life estate, remainder, or reversion-ary interest in the property. Reg. section 1.897-1(d)(2)(i)further provides that ‘‘an interest in real property otherthan an interest solely as a creditor’’ includes any director indirect right to share in the appreciation in the valueof, or in the gross or net proceeds or profits generated by,the real property.

A governmental permit to charge tolls or fees for theuse of real property is not fee simple ownership, co-ownership, a leasehold interest in the real property, atime-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 orfees for the use of real property located in the UnitedStates or Virgin Islands that is granted to the taxpayer bya governmental unit should be treated as a USRPI only ifthe right to charge tolls or fees for the use of the realproperty is either: a right that is included in the tax-payer’s fee simple ownership or leasehold interest in thereal property otherwise acquired; or a direct or indirectright to share in the appreciation in the value of, or in thegross or net proceeds or profits generated by, the realproperty within the meaning of reg. section 1.897-1(d)(2).

1. Right to charge tolls or fees for the use of realproperty that is included in fee simple ownership or aleasehold interest in that real property. Local law doesnot determine the meaning of real property for purposesof section 897.16 Applicable state law does determine,however, a person’s substantive legal rights associatedwith real property.17 Thus, whether a taxpayer has feesimple ownership, co-ownership, a leasehold, time shar-ing, life estate, remainder, or reversionary interest in realproperty is determined under applicable state law. More-over, applicable state law determines what rights areincluded in the fee simple ownership or leasehold inter-est in that real property.

If, under state law, a private person’s fee simpleownership or leasehold interest in a public highway orbridge does not give the owner or lessee the right tocharge tolls or fees for the use of the highway or bridge,a separate grant of such a right must be obtained from thestate. In those cases, the governmental permit is a sepa-rate intangible right, the value of which is not included inthe person’s fee simple ownership or leasehold interest inthe highway or bridge. Consequently, unless the right tocharge tolls or fees is treated as a direct or indirect rightto share in the appreciation in the value of, or in the grossor net proceeds or profits generated by, the highway orbridge within the meaning of reg. section 1.897-1(d)(2), itdoes not constitute an interest in real property for pur-poses of section 897 and the regulations thereunder.18

In contrast, if, under state law, a person’s fee simpleownership or leasehold interest in real property givesthat person the right to charge tolls or fees for the use ofthe property, the right to charge tolls or fees for the use ofthe property is part of the person’s fee simple ownershipor leasehold interest in the real property. Accordingly,even if a separate governmental permit to charge tolls orfees for the use of the real property is granted to theowner or lessee, there is no separate intangible right tocharge tolls or fees, and the FMV of the right is part of theFMV of the fee simple ownership or leasehold interest inthe real property. For example, a governmental permitgranting the right to charge fees for parking in a parkinglot or parking garage leased from a city in Pennsylvaniashould not be treated as a separate intangible asset.Rather, the value of the leasehold interest in the parkinglot should include the value of the right.

2. Rights to share in the appreciation of, or gross or netproceeds or profits generated by, real property. Theexamples given in reg. section 1.897-1(d)(2) indicate thatthe phrase ‘‘gross or net proceeds or profits generated byreal property’’ refers to the gross or net proceeds orprofits realized from the appreciation or depreciation inthe value of the real property realized from the disposi-tion of those assets and does not mean an interest in thecurrent operating income or rent realized from realproperty. For example, reg. section 1.897-1(d)(2)(ii)(E)provides that the right to the payment of a commission orbrokerage fee for professional services rendered in con-nection with the arrangement or financing of a purchase,sale, or lease of real property is not a right to share in theappreciation in the value of, or gross or net proceeds orprofits generated by, real property if the commission isbased on a percentage of the purchase price or rent. Incontrast, a commission earned in connection with thepurchase of a real property interest that is contingent onthe amount of gain ultimately realized by the purchaserin a subsequent sale of the property would constitute aninterest in real property other than an interest solely as acreditor. In both cases, the commission is paid from the‘‘gross proceeds’’ of the sale, but these examples demon-strate that the term ‘‘gross or net proceeds or profits’’refers only to rights to share in the appreciation ordepreciation of real property.

The enactment of section 897 was prompted by theTreasury report that highlighted ways in which foreigninvestors in U.S. real property could avoid U.S. tax ongains from those investments.19 Section 897 is intended to

16Reg. section 1.897-1(b)(1).17See supra note 9.18This 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 1.897-1(f)(ii). For purposes of determiningwhether a corporation is a USRPHC, reg. section 1.897-1(f)(1)(ii)provides that assets used or held for use in a trade or businessinclude ‘‘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 that property isused or held for use in the entity’s trade or business. Accord-ingly, if a governmental license, permit, or franchise to chargetolls or fees for the use of real property used in the taxpayer’sbusiness is a separate intangible asset and is not part of thetaxpayer’s fee simple ownership or leasehold interest in that realproperty, that governmental license, permit, or franchise istreated under reg. section 1.897-1(f)(1)(ii) as an asset used orheld for use in the taxpayer’s trade or business and is not treatedas a USRPI.

19See supra note 6.


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prevent the avoidance of U.S. tax on gains from disposi-tions of investments in U.S. real estate. However, it doesnot apply to rents and other currently taxed operatingincome derived from U.S. real estate by foreign investors.Accordingly, reg. section 1.897-1(d)(2) treats a right toshare in the appreciation in the value of U.S. real propertyor share in the gross or net proceeds or profits from adisposition of U.S. real property as an interest in U.S. realproperty. A right to share in the rents or other currentlytaxed operating income from real property, however, isnot treated as an interest in U.S. real property.

Thus, the Treasury regulations and the legislativehistory of section 897 indicate that FIRPTA was enactedto tax gain from the sale or disposition of real property,which includes a right to share in the appreciation in thevalue of the real property or share in the gross or netproceeds or profits from a sale or disposition of the realproperty. The right to charge tolls is a right to currentoperating income generated from the use of real property,which does not give the holder of that right the ability toshare in the appreciation in the value of the real propertyor share in the gross or net proceeds or profits from a saleor other disposition of the real property. Accordingly, instates in which the right to charge tolls or fees for the useof public highways or bridges is not part of the fee simpleownership or leasehold interest in the highways orbridges, a governmental permit to charge tolls or fees forthe use of the highways or bridges is not an interest inreal property other than solely as a creditor and is not aUSRPI.

C. Are New Allocation Rules Needed?Announcement 2008-115 requests comments on

whether the proposed regulations should address theallocation of the consideration paid for the lease orpurchase of a specified infrastructure asset and thelicense, permit, franchise, or other similar right to operatethat specified infrastructure asset for purposes of deter-mining the FMV of that property.

The allocation of consideration paid for the lease orpurchase of specified infrastructure assets and the li-cense, permit, franchise, or other similar right to operatethe infrastructure assets is set forth in section 1060.Section 1060 provides that, for purposes of determiningthe transferee’s cost basis in the acquired assets, theconsideration paid for the assets is allocated to andamong the assets by allocating consideration successivelyto the assets in seven asset classes. Consideration isallocated to and among the assets in each of the first sixasset classes to the extent of the FMV of each asset.Consideration in excess of the FMV of the assets includedin the first six asset classes is allocated to any goodwill orgoing concern value associated with the trade or busi-ness.

In a typical infrastructure transaction in which anexisting toll road or bridge and related tangible personalproperty are leased and purchased from a governmentalunit and the governmental unit grants a license to chargetolls for the use of the road or bridge, the toll road orbridge, tangible personal property, and governmentallicense constitute a trade or business. Accordingly, forpurposes of determining the transferee’s cost basis in thetoll road or bridge, tangible personal property, and

governmental license, the consideration paid for theassets is subject to the allocation rules under section 1060.

The allocation rules of section 1060, however, do notdetermine the FMV of the acquired assets. Rather, theallocation of consideration under section 1060 is based onthe FMVs of the acquired assets. If, under applicable statelaw, the taxpayer’s right to charge tolls or fees for the useof real property is included in the taxpayer’s fee simpleownership or leasehold interest in such real property, thatright is not treated as separate intangible property and noconsideration is separately allocable to the right as aClass VI asset under section 1060. Rather, the FMV of theright is included in the FMV of the fee simple ownershipor leasehold interest, and consideration is allocated to thefee simple ownership or leasehold interest as a Class Vasset, to the extent of the FMV thereof.

If, however, under applicable state law, the taxpayer’sright to charge tolls or charge fees for the use of realproperty is not included in the taxpayer’s fee simpleownership or leasehold interest in that real property, butis a right that must be separately granted by the state orlocal government, it is treated as separate intangibleproperty and consideration is separately allocable as aClass VI asset under section 1060. For purposes ofdetermining the amount of consideration allocable to thefee simple ownership or leasehold interest in the realproperty and the right to charge tolls or fees for the useof the real property, the FMV of the fee simple ownershipor leasehold interest in the real property does not includethe FMV of the right to charge tolls or fees for theproperty’s use.

Solely for purposes of determining whether a domes-tic corporation is a USRPHC under section 897, the FMVsof interests in real property and assets used or held foruse in a trade or business are determined under the rulesin reg. section 1.897-1(o). If, under applicable state law,the right to charge tolls or fees for the use of real propertyis part of the fee simple ownership or leasehold interestin that real property, the FMV of the fee simple owner-ship or leasehold interest includes the value of thegovernmental permit to charge tolls or fees for the use ofsuch real property and is determined under reg. section1.897-1(o)(2) or 1.897-1(o)(3), respectively.

If, under applicable state law, the right to charge tollsor fees for the use of real property is not part of the feesimple ownership or leasehold interest in that real prop-erty, but is a separate right that must be granted by thestate or local government, the FMV of the separategovernmental permit is determined under reg. section1.897-1(o)(4).

Because established statutes and regulatory authorityaddress the allocation of the consideration paid for aspecified infrastructure project and the determination ofthe FMVs for purposes of section 897 of the assetsincluded in the infrastructure project, there is no need forfurther 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 theirinvestments in that real estate. The current regulationsunder section 897 further clarify the purpose of FIRPTA



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by providing a two-prong test for determining whether aright may be characterized as an interest in real propertyfor purposes of section 897. First, reg. section 1.897-1(d)(2)(i) provides that an ‘‘interest in real property otherthan an interest solely as a creditor’’ includes fee simpleownership, co-ownership, or a leasehold interest in realproperty, a time sharing interest in real property, and alife estate, remainder, or reversionary interest in suchproperty. Second, reg. section 1.897-1(d)(2)(i) providesthat ‘‘an interest in real property other than an interestsolely as a creditor’’ includes any direct or indirect rightto share in the appreciation in the value of, or in the grossor net proceeds or profits generated by, the real property.

In many states, as discussed above, the right to chargefees for the use of public roads and bridges is not part ofthe fee simple ownership or leasehold interest in that realproperty, and therefore the value of the right generally isnot part of an interest in real property subject to section897. Also, those rights do not give the holder any right toshare in the appreciation in the value of the real propertyor share in the proceeds or profits from a disposition ofthe real property. They give the holder only the right togenerate operating income from the real property in theform of tolls or fees. Accordingly, changing the regula-tions under section 897 to treat the right to charge tolls orfees for the use of a road or bridge as an interest in realproperty if that right is not, under applicable state law, aright included in the fee simple ownership or leaseholdinterest in that road or bridge, would be contrary to theunderlying purpose of and legislative authority con-ferred by FIRPTA.

If the IRS and Treasury were, nonetheless, to adoptamendments to the regulations under section 897 to treatgovernmental permits as USRPIs, the amendmentswould change the existing interpretation of section 897that taxpayers have relied on for over 25 years. Accord-ingly, amendments should apply only to those govern-mental permits granted to taxpayers after the publicationof final regulations.

IV. ConclusionsThe legislative history and the statutory and regula-

tory framework of FIRPTA provide no authority for theproposition that an interest in real property includes alllicenses regarding the commercial uses of real property.Moreover, nothing in the legislative history, statutory andregulatory framework, or case law provides support forcreating a new type of USRPI for a license that dictatescommercial uses of real property or for incorporating thevalue of such a separate asset into a USRPI.

If proposed regulations under section 897 are pub-lished to clarify the treatment under section 897 ofgovernmental permits to charge tolls or fees for the use ofreal property, they should provide that a governmentalpermit is treated as a USRPI only if the fee simpleownership or leasehold interest in the real propertyincludes the right, under applicable state law, to chargetolls or fees for the use of that real property. In stateswhere the right to charge tolls or fees for the use of publichighways and bridges is not part of the fee simpleownership or leasehold interest in the highways or

bridges, a governmental permit to charge tolls or fees forthe use of the highways or bridges is not an interest inreal property other than solely as a creditor and is not aUSRPI. The right to charge tolls or fees is a right tocurrent operating income generated from the use of realproperty and does not give the holder of that right theability to share in the appreciation in the value of the realproperty or share in the gross or net proceeds or profitsfrom a sale of the real property. If a governmental permitto charge tolls or fees for the use of real property used inthe taxpayer’s business is a separate intangible asset andis not part of the taxpayer’s fee simple ownership orleasehold interest in that real property, the governmentalpermit is treated under reg. section 1.897-1(f)(1)(ii) as anasset used or held for use in the taxpayer’s trade orbusiness and is not treated as a USRPI.

The allocation of consideration paid for the lease orpurchase of specified infrastructure assets and the li-cense, permit, franchise, or other similar right to operatethe infrastructure assets is set forth in section 1060. Theallocation rules of section 1060, however, do not deter-mine the FMV of the acquired assets. Rather, the alloca-tion of consideration under section 1060 is based on theFMVs of the acquired assets. Solely for purposes ofdetermining whether a domestic corporation is aUSRPHC under section 897, the FMVs of interests in realproperty and assets used or held for use in a trade orbusiness are determined under the rules in reg. section1.897-1(o). If, under applicable state law, the right tocharge tolls or fees is part of the fee simple ownership orleasehold interest in real property, the FMV of the feesimple ownership or leasehold interest includes the valueof the governmental permit to charge tolls or fees for theuse of such real property. The FMV of that fee simpleownership interest is determined under reg. section1.897-1(o)(2) and the FMV of such a leasehold interest isdetermined under reg. section 1.897-1(o)(3).

If, under applicable state law, the right to charge tollsor fees for the use of real property is not part of the feesimple ownership or leasehold interest in the real prop-erty, but is a separate right that must be granted by thestate or local government, the FMV of the fee simpleownership or leasehold interest in the real property doesnot include the value of the governmental permit tocharge tolls or fees. The FMV of the fee simple ownershipor leasehold interest is determined under reg. section1.897-1(o)(2) or (3) as described above, and the FMV ofthe separate governmental permit is determined underreg. section 1.897-1(o)(4).

Changing the regulations under section 897 to treat theright to charge tolls or fees for the use of a road or bridgeas an interest in real property if that right is not, underapplicable state law, a right included in the fee simpleownership or leasehold interest in that road or bridge,would be contrary to the underlying purpose of andlegislative authority conferred by FIRPTA. Accordingly,any potential amendments to the regulations adopted bythe IRS and Treasury under section 897 to treat suchgovernmental permits as USRPIs should apply only tothose governmental permits granted to taxpayers afterthe publication of final regulations.



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