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By Kimberly S. Blanchard, Esq. Weil, Gotshal & Manges LLP, New York, NY
On October 31, 2008, perhaps as a Halloween prank, the IRS issued REG-130342-08, an “advanced notice of proposed rulemaking” under §897 (the “ANPR”). The ANPR announces that the IRS is considering proposing regulations relating to infrastructure and FIRPTA, and seeks comments.1 However, it is not entirely clear what legal issue these proposed regulations may be intended to address. The Preamble and the first paragraph of the ANPR, entitled “Overview,” state that the proposed regulations would address whether “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” (hereafter, “government licenses”) are “interests in real property” within the meaning of §897(c). Any such regulations would be issued under Regs. §1.897-1.
However, the ANPR purports to address a “typical” fact pattern in which one or more foreign persons (or a partnership in which they are partners) invest in an infrastructure project through a special-purpose domestic corporate “blocker.” This focus appears to give rise to a second issue: how properly to value a government license for purposes of determining whether the domestic corporation is a U.S. real property holding corporation (“USRPHC”).2 The ANPR states that “the proposed regulations would address how the fair market value of such licenses, permits, franchises, or other similar rights should be taken into account when determining the fair market value of a corporation's USRPIs [United States real property interests] … .”
At first blush, the USRPHC issue appears to be a red herring. Government licenses have to be characterized as interests in real property, or not, whether owned by a domestic corporation or directly by a foreign person. Because the ANPR involved a domestic blocker whose only assets consisted of the underlying real property and the license (all U.S. assets), any conclusion that the license is an interest in real property would lead to the conclusion that 100% of the corporation's assets were USRPIs, rendering the valuation issue moot. It therefore seems hard to understand why the ANPR spills so much ink on the valuation question.
So returning to the main event: Is a government infrastructure license a USRPI? It is clear that a leasehold interest in U.S. real property is a USRPI. Moreover, as noted in the ANPR, FIRPTA treats a direct or indirect right to share in the appreciation of, or in the gross or net profits derived from, real property as an interest in real property.3 Presumably, this means that an interest short of a lease - for example, an easement or other right to use property such as a toll bridge - is an interest in real property if the interest carries with it the right to share in the appreciation of or profits derived by the property. Certainly the ANPR assumed this to be true. But what is “the property”? It is not obvious that the right to collect tolls is the right to share in the profits derived by the toll road or toll bridge; such right may be a separate contract right having very little to do with the intrinsic value of the road or bridge. After all, most roads and many bridges produce no profits of any kind; they are not, intrinsically, income-producing property. It requires government action to make them so.4 Moreover, that there is nothing inherently “real property like” about a government license to collect tolls can readily be appreciated if one considers the fact that governments also license private persons to operate ferries and airplanes and other means of transport that function only on water or in the air.
FIRPTA classifies most types of intangible property as property held for use in a business and not as interests in real property.5 The ANPR may have been focused on the fact that if the government license is treated as a property right separate and apart from the toll road or land to which it relates, this general rule would apply and therefore the license could never be a USRPI. At the least, a difficult classification question would be presented. On the other hand, if the license is indivisible from the underlying real property or right to use real property, there is no FIRPTA issue - the entire undivided interest is clearly an interest in real property.
Consistent with FIRPTA's treatment of intangibles as separate property rights, §197 includes within its definition of an amortizable intangible (subject to exceptions not relevant here) “any license, permit or other right granted by a governmental unit ….” However, neither the statutory language of §197 nor the regulations thereunder appear to address the kind of government license at issue in infrastructure deals. Rather, those rules focus on the type of government permits or licenses granted by a government to a taxpayer to do something that the taxpayer needs to do in order to operate its own business, such as airport landing fees needed by airlines, liquor licenses needed by bar and restaurant owners, water and other subdivision permits needed by a developer in order to build and sell houses, etc. In the infrastructure case, the taxpayer is obtaining a license to do what the state would otherwise do directly. That is, the taxpayer is stepping into the shoes of the state and making it its business to do what the state would normally do. It is deriving income from effectively licensing a state right to collect income.
Nothing in the ANPR mentions or even alludes to the possibility that an investment in an infrastructure project might be bifurcated between the inherent value of the tangible property and the income-producing potential thereof. The “Transactions at Issue” section of the ANPR points out that, in the case specified, “the value of the leasehold interest in the specified infrastructure derives from the right to charge and collect tolls.” This language might be read to suggest that the IRS would reject any bifurcation approach. However, it is not clear that the ANPR's key factual assumption - that one would never be granted a license to operate and collect money from a toll road or similar project without owning some type of interest rising to the level of a USRPI in the underlying land - is necessarily correct in all cases. Imagine, for example, that a governmental entity owns a toll bridge and licenses Party O to maintain the bridge and employ toll collectors, granting Party O a percentage of tolls collected as part of the compensation for its services. It is not easy to conclude that Party O has any legal interest in the underlying bridge, yet economically it might earn the same amounts as it would earn if it did in fact have a lease or easement over the bridge and the toll booths.6
The question whether a license or other intangible right ought to be bifurcated from some underlying property to which it relates is a fraught issue in the tax law. In the Alstores7 case and in other cases, taxpayers have unsuccessfully sought to bifurcate the price paid for leased buildings between the value of the building itself and the value of the (usually above-market) leases or “rent roll.” The IRS's position is and has always been that rights in real property are not divisible, at least for purposes of claiming depreciation or cost recovery. It is not surprising that, in the absence of guidance, most tax advisers have assumed that infrastructure of the type described in the ANPR would be treated as a USRPI in its entirety, and in light of Alstores and other authorities have not been comfortable bifurcating these assets between a pure tangible realty portion and the associated intangible or contract-like rights. Nevertheless, if guidance is to be forthcoming, the issue should be addressed head on. For the reason noted below, I think bifurcation is the right answer from a policy perspective, although I acknowledge the valuation difficulties.
If we were focusing on infrastructure rights held directly by foreign persons, one would not need to assume that such rights were interests in real property to arrive at the conclusion that gains from the sale of such rights would produce effectively-connected income. Infrastructure projects, unlike other holdings in real estate, would virtually always rise to the level of a business. That leaves only the question of how to treat a foreign person's gain on the sale of stock of a domestic corporation that operates infrastructure. The policy behind FIRPTA is to tax foreign persons' gains on sales of real property, including real property embedded in a holding company, not to tax gains on stock of real businesses operating in corporate form.8 In particular, FIRPTA was originally motivated by Congress's distaste for a practice that had developed whereby foreign persons would own a building, make an election to treat that ownership as producing effectively-connected income in order to secure depreciation and other deductions, and then sell the building without “recapture” of the deductions. Those scenarios are not present in the typical infrastructure transaction.
This observation supports the conclusion that, from a policy perspective, it makes sense to try to bifurcate the value of an infrastructure investment, treating the underlying land, buildings, and improvements as an interest in real property and treating the license to collect tolls, etc. as a separate asset in the nature of a contract right that is not an interest in real property. As in the case of goodwill, the correct valuation approach would likely be subtractive - value the underlying real property at its inherent value and then ascribe the balance of the total value to the government permit.9
At bottom, an ordinary contract to earn income is an intangible, not an interest in real property, even if one couldn't collect the income without having some kind of access to real property. The contractual right to earn income is analogous to the goodwill of a business. Even if a widget manufacturer's fixed assets consist principally of USRPIs, once its goodwill and going concern value are factored in (in the case of public companies, often with reference to market cap), it will almost never be a USRPHC, nor would Congress have intended it to be. A license to collect tolls on a toll road should be treated no differently, under FIRPTA, than any other operating intangible.
This commentary also will appear in the March 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Rubin and Hudson, 912 T.M., Federal Taxation of Foreign Investment in U.S. Real Estate, and in Tax Practice Series, see ¶7120, Foreign Persons -- U.S. Activities.
1 The IRS followed up with a second request for comments on the ANPR in Announcement 2008-115, 2008-48 I.R.B. 1228 (Nov. 28, 2008).
2 A corporation is a USRPHC only if 50% or more of its assets consist of U.S. real property interests - that is, interests in real property located in the United States. §897(c)(2).
3 Regs. §1.897-1(d)(2)(i).
4 In many states, private persons are prohibited from operating toll roads without state authorization. In such states, the license to operate a toll road appears not to be treated as an interest in land, because it is not a right that inheres in the fee simple interest in land.
5 Regs. §1.897-1(f)(1)(ii).
6 The IRS could attempt to argue that an arrangement of the type described rises to the level of a deemed partnership, in which event Party O would be deemed to own what the partnership owns. However, this may not be a winning argument in many cases.
7 Alstores Realty Corp., 46 T.C. 363 (1966).
8 Similarly, for purposes of the REIT rules, real property generally does not include property that is inherently an active business, such as hotels, movie theatres, and probably nursing homes.
9 This type of exercise is not unprecedented. Suppose I own a building that was built for the sole purpose of qualifying as a state-licensed emissions testing center and built to precise specifications for such purpose. (Several states require or encourage emissions testing to be done in a special purpose facility.) The building itself - bricks and mortar - has an inherent value separable from the right to use it as an emissions testing facility. (It could be decommissioned and reused as a coffee shop.) The value of the government permit or franchise in this case can be derived by subtracting from the total value of the business as a going concern the value of the bricks and mortar.
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