United States: Breathing New Life into Brownfields Redevelopment: UBTI Exclusions and Benefits

The term "Brownfields," used to describe abandoned, idled or under-used industrial or commercial properties with real or perceived environmental contamination, is now wellentrenched in the American lexicon. However familiar the term, Brownfields redevelopment has not progressed as quickly as our nation’s leaders and business people would like or expected. In 2003, a total of 205 U.S. cities had 24,987 Brownfield sites still awaiting redevelopment, according to a survey by the U.S. Conference of Mayors. Redevelopment of these sites is projected to generate nearly 600,000 new jobs and contribute as much as $1.9 billion annually to the national economy. Nonetheless, these sites continue to languish, largely as a result of economic impediments to their redevelopment, including the expense and risks of remediation.

That may soon change. Brownfields redevelopment received a much-needed boost as a result of a provision in the omnibus "American Jobs Creation Act," passed with little fanfare in the last quarter of 2004. In particular, an amendment to the federal tax code with the clumsy title "Exclusion of Gain or Loss on Sale or Exchange of Certain Brownfield Sites from Unrelated Business Taxable Income," 26 U.S.C. §512(b)(18) (the "Act"), should jumpstart Brownfields redevelopment by offering unparalleled opportunities to reduce the so-called unrelated business taxable income ("UBTI") of certain tax-exempt entities.

To the initiated, UBTI is income from an unrelated trade or business that a tax-exempt organization regularly conducts, and that is not substantially related to its tax-exempt status. To the uninitiated, an illustration offers a better insight into the importance of the acronym to American business: A pension fund or any similar tax-exempt entity that invests $10 million in a venture that acquires a Brownfields property, then cleans up and redevelops that property at a cost of $40 million, converts it into condominiums and sells those units for $100 million, is engaging in activity that may result in UBTI. As a general rule under the federal tax code, organizations that are exempt from taxation nonetheless are required to pay taxes at a corporate or trust tax rate on UBTI. But for the Act, therefore, the gain on the property subject to UBTI taxation is the difference between the sum of the acquisition price of the impaired property, the cleanup and development costs and the sale price of the condominiums – in this case, no less than $50 million of gain, producing a tax of $20 million at a combined federal and state tax rate of 40%.

Under the Act, the situation is very different, and far more favorable to tax-exempt entities. The Act provides an exception to the general rule that tax-exempt organizations are required to pay UBTI, by allowing a tax-exempt organization to exclude "any gain or loss from the qualified sale, exchange, or other disposition of any qualifying Brownfield property" from its UBTI, subject to the limitations in the Act. While we are aware of no official interpretation of the Act’s breadth, the United States Environmental Protection Agency’s ("EPA’s") perspective is that the Act allows qualifying entities to invest in Brownfield cleanup and redevelopment projects without incurring taxes when the property is sold. Consistent with the broad language of the Act, this construction allows the organization to exclude from UBTI the entire gain realized on the sale of a Brownfields property, and not merely take a credit or deduction for costs incurred to clean up the property. Thus, the Act contemplates substantial tax benefits – of at least $20 million in tax in our example.

There are challenges and uncertainties to obtaining these benefits, however, because properties, cleanup expenditures and real estate transactions each must qualify, statutory time frames must be met, and state regulators must be involved. The primary challenge in taking advantage of the Act’s exemption may be the double hurdle of securing two separate certifications from the state in which the target investment property is located, or from EPA in certain circumstances. In the first state certification, a state must timely certify that the property is a "qualifying Brownfield property" under federal law. In the second certification, the state must timely certify that the post-cleanup transfer of the property is a "qualified sale, exchange, or other disposition of [a] qualifying Brownfield property" – that is, that all necessary remedial action is substantially complete at the property, that the property has a comparatively beneficial future use, and that the transferee cannot obtain the tax advantages provided by the Act, among other requirements. Further, requests for the exclusion are subject to mandatory public notice and comment, necessitating a thoughtful public relations strategy. Lastly, of course, any strategy must account for the unfortunate ambiguity of the Act and the risk that the Internal Revenue Service ("IRS") ultimately may adopt a narrower interpretation of the Act than has EPA.

The paragraphs below identify the major requirements of the Act, and reflect our insight in having successfully implemented this new statutory incentive for Brownfields redevelopment in what we understand to be the first such transaction nationwide. The discussion is not exhaustive, but meant to identify important elements of a carefully planned strategy that optimizes available benefits, by focusing on the three essential requirements of the Act: (i) the state’s certification of the target investment property as a "qualifying Brownfield property," (ii) the tax-exempt purchaser’s securing "eligible taxpayer" status," and (iii) the state’s certification of the purchaser’s sale of the property, after remediation, as a qualified property transfer under the Act.

To qualify as an "eligible taxpayer" under the Act, a tax-exempt organization must acquire a "qualifying Brownfield property" from an "unrelated person." A "qualifying Brownfield property" is any real property that is certified as a "Brownfield site" under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA," or Superfund) by the appropriate state agency in the state in which such property is located. Thus, the Act’s benefits are subject to the CERCLA definition of "Brownfield site." This definition appears broadly worded – any "real property, the expansion, redevelopment, or reuse of which may be complicated by the presence or potential presence of a hazardous substance, pollutant, or contaminant." However, it is subject to similarly broad exclusions. These exclusions include any site subject to: (i) a planned or ongoing CERCLA removal action, (ii) listing or proposed listing on the National Priorities List ("NPL"), (iii) federal or state environmental permits, or (iv) a release of polychlorinated biphenyls above federal cleanup standards. Thus, without a creative remediation and development strategy with appropriate phasing, benefits provided by the Act may be limited to tax-exempt purchasers of the middle range of Brownfield properties, i.e., where contamination is not so serious that the property is already on the NPL, but not so minor that less than the threshold amount of "eligible remediation expenditures" (discussed below) will be incurred.

In addition, the requisite certification must be obtained. Three significant hurdles can complicate or compromise efforts to successfully obtain the first state certification: (i) the timing of the issuance of the certification, (ii) implementing procedures for issuing the certification, and (iii) the state’s willingness to certify regarding the substance of federal law, that is, CERCLA. Each of these hurdles is summarized below.

With respect to timing, the Act is circular and therefore ambiguous. It can be read either as requiring a tax-exempt purchaser to obtain the first certification prior to acquiring the target investment property, or as allowing the purchaser to obtain the certification only before it begins making "eligible remediation expenditures" at the property, irrespective of the timing of the acquisition. Given this ambiguity and until IRS clarification is obtained (e.g., through a letter ruling), a prudent approach may be to obtain the first certification prior to acquisition of the property. This pre-acquisition approach also has the advantage of pursuing the first certification based on a Phase I or similarly initial environmental site assessment, i.e., before any significant environmental investigation, so that the "snapshot" of the property for which tax advantages are sought is unlikely to be compromised by site-specific information limiting the benefits otherwise available under the Act.

With respect to implementing procedures, states have had little time to familiarize themselves with the Act, or to designate a person and establish a process for handling requests for certification. In our experience, states want to be responsive. However, the process remains far from seamless. As a related matter, the Act contemplates that states will certify with respect to federal law. Some states may balk at opining on federal law or making the factual determinations necessary to support a fundamentally federal certification. In obtaining the first-ever state certification in the nation, we overcame these hurdles through a creative compromise – one which we expect to set a precedent in other states.

To be an "eligible taxpayer" under the Act, a tax-exempt purchaser must pay or incur "eligible remediation expenditures" at the acquired and certified "qualifying Brownfield property" in an amount that exceeds the greater of $550,000 or 12% of the fair market value ("FMV") of the property "at the time such property was acquired by the eligible taxpayer, determined as if there was not a presence of a hazardous substance, pollutant, or contaminant on the property which is complicating the expansion, redevelopment, or reuse of the property." A fair reading is that this is a threshold amount, the exceedance of which is a prerequisite to obtaining "eligible taxpayer" status, not a limitation or ceiling on the amount of the loss or gain that the purchaser can exclude from UBTI under the Act. Under this reading, a tax-exempt entity must undertake the process of estimating its remediation expenses and comparing them to the threshold amount and the 12% FMV threshold.

Establishing that eligible remediation expenditures will exceed $550,000 or the 12% FMV cap, in particular, will require careful consideration. A prospective purchaser may want to engage: (i) a sophisticated real estate appraiser that can produce a defensible estimate of the property’s fair market value as of the proposed date of acquisition, assuming existing use and no contamination, and (ii) an engineering consultant that can analyze the available known information about contamination at the property and estimate the potential costs of completing all necessary remedial action there.

While these thresholds may appear significant, the Act allows purchasers to include a broad range of expenditures, some surprising, in the total necessary to meet these thresholds. For instance, a tax-exempt purchaser may meet the threshold amount by obtaining certain types of environmental insurance, including remediation cost-cap insurance (or stop-loss) coverage and re-opener coverage. Remediation cost-cap coverage protects an insured against cost overruns above a specified price tag for the covered remedial action, while re-opener coverage protects an insured when additional site cleanup is required due to a future change in cleanup standards. The Act also allows purchasers to include costs they incur to provide the financial guarantees that the Act requires to ensure the completion of remediation and monitoring.

In short, a defensible, but creative approach, should allow the thresholds to be satisfied at many Brownfield properties. Indeed, the Act may have the effect of fostering more comprehensive clean-ups than otherwise might be undertaken – up to the thresholds at least.

Because the Act’s exclusion rests on "any gain or loss from the qualified sale, exchange, or other disposition of any qualifying Brownfield property," the transfer of a "qualifying Brownfield property" is required. To be a qualified property transfer, an "eligible taxpayer" must receive the second certification within one year of the property’s transfer to an unrelated person. This certification may be obtained from a state or EPA, which must certify that "as a result of the eligible taxpayer’s remediation actions, such property would not be treated as a qualifying Brownfield property in the hands of the transferee."

Unless the process for obtaining this second certification is properly managed, several ambiguous and potentially burdensome requirements may hinder a tax-exempt purchaser’s taking advantage of the provision’s tax benefits. In particular:

• A tax-exempt purchaser’s request for the second certification must contain a sworn statement that the purchaser has "substantially completed" all "remedial actions" at the property in accordance with CERCLA. Under the Act, a remedial action is "substantially complete" when "any necessary physical construction is complete, all immediate threats have been eliminated, and all long-term threats are under control." In other words, the term "substantial completion" is ambiguous. Thus, it is imperative to involve states early in the development of a remediation plan for a property that comports with federal law. For the self certification programs (i.e., in which professionals warrant that clean-up activities comply with state law without direct regulatory involvement) that are increasingly commonplace, including in Massachusetts, additional coordination is likely to be required and should be initiated early.

• A request must contain a sworn statement that the tax-exempt purchaser has implemented a remediation plan "to bring the property into compliance with all applicable local, State, and Federal environmental laws, regulations, and standards and to ensure that the remediation protects human health and the environment." While CERCLA standards for remedial actions are fairly wellsettled, the same cannot be said for local "environmental laws, regulations, and standards." Further, local governments may enact cleanup requirements that are more stringent than CERCLA, necessitating significantly greater "remediation expenditures."

• A request for the second certification must contain a sworn statement that the remediation plan for the property in question is complete or substantially complete, and, if substantially complete, that "sufficient monitoring, funding, institutional controls and financial assurances have been put into place to ensure the complete remediation of the property" in accordance with the remediation plan as soon as is "reasonably practicable" after the property transfer. What constitutes "sufficient" post-remedial financial assurances is unclear, but financial assurances are not part of routine Brownfields remediation projects. Environmental insurance may be a cost-effective approach at certain properties, but other creative strategies may need to be considered where environmental insurance is too costly or unavailable, as is increasingly the case.

• A request for the second certification must contain a sworn statement that the "reasonably anticipated future land uses or capacity for uses of the property are more economically productive or environmentally beneficial than the uses of the property in existence" on the date of the first certification.

Finally, a request for the second certification must avow that the tax-exempt purchaser has provided public notice and sought public comment on its request for the second certification before submitting the request, and that this public notice and comment were "in the same form and manner as required for public participation under §117(a)" of CERCLA. In conjunction with issuing the second certification, EPA or the state must respond to the public comments received "in the same form and manner as required under section 117(a)" of CERCLA. Absent careful management, this requirement is potentially problematic for three reasons. First, a purchaser cannot seek to obtain the Act’s tax benefits without meeting the burdensome public participation requirements imposed at NPL sites. Second, such public notice and solicitation of public comment may result in the kind of attention and scrutiny that most developers would prefer to avoid. To minimize this risk, we suggest that the Act does not require public notice and comment on the remediation plan itself, only on the purchaser’s request for the second certification on the basis of its completion or substantial completion of that plan. Thus, carefully constructed notices and a sound public relations plan may offset any risks. Third, CERCLA §117 requires a 30-day public comment period, after which EPA or a state must prepare and issue a "responsiveness summary" to respond to the public comments received. The tax-exempt purchaser will need to build time into its plan for taking advantage of the Act’s tax benefits to account for both the public comment period (and any extensions granted thereto) and the time EPA or a state will need to prepare the responsiveness summary.

In the final analysis, realizing the Act’s potential benefits requires a carefully planned strategy that includes the following essential components:

• Sufficient information about the property, gleaned with the assistance of sophisticated real estate appraisers and remediation consultants, to make a grounded decision regarding whether the tax-exempt purchaser is likely to qualify as an "eligible taxpayer" with regard to the property.

• A plan to obtain the first state certification prior to acquisition of the target investment property, and a certification request that enables the state to certify that the property is a "qualifying Brownfield property" based on the purchaser’s representations about the necessary facts about the property, and legal determinations regarding those facts.

• A plan to obtain the second certification on a timely basis, ideally involving a memorandum of understanding with the regulator which reflects scheduling exigencies.

• A well-crafted public notice and public relations plan. To learn more about Brownfields redevelopment, please contact:

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 650 attorneys and offices in Boston, New York and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

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