Infrastructure projects are no longer exclusively the domain of the government, and momentum is building for private capital investment in U. S. infrastructure projects. Unlike government, however, private investors will evaluate infrastructure investment by the same metric as all other investments: after-tax cash returns. Ultimately, this metric alone will determine whether private capital will be invested. The key to the tax analysis is whether infrastructure constitutes "real estate" or "real property" for various sections of the U.S. Internal Revenue Code (IRC).
For those considering investing in the burgeoning U.S. market (many of whom are either established infrastructure investors with experience in the more well-developed private infrastructure markets of Australia and Western Europe or investors from within the United States with backgrounds in real estate, private equity, or fixed income), it is critical to understand that characterization of investment assets under current law and Internal Revenue Service (IRS) interpretations as real property can be both a benefit and a burden. On the one hand, if infrastructure assets are characterized as real estate, investors may enjoy the substantial tax benefit of real estate investment trusts (REITs). On the other, such a characterization may subject non-U.S. investors to the burden of the Foreign Investment in Real Property Tax Act (FIRPTA).
REITS (Real Estate Giveth . . .)
REITs are tax-advantaged vehicles that have successfully attracted wide sources of capital to real estate. Subject to compliance with a number of asset and income requirements designed to ensure an almost exclusive focus on ownership and operation of real estate, REITs have the benefit of being treated as corporations under the IRC without the corresponding burden of paying entity-level U.S. federal income taxes to the extent they dividend out their net income. REITs have made investing in institutional-quality real estate in a diversified manner available to the public, and may also be used to "block" certain U.S. tax-exempt institutional investors from receiving "unrelated business taxable income" from the operation or leveraging of real estate.
To use REITs to invest in infrastructure, the infrastructure assets must be characterized as real estate under the IRC. As the REIT market has developed over time, the IRS has concluded that certain infrastructure assets — from railroad tracks to broadcasting and cell phone towers — may constitute real property, thereby constituting good REIT assets. Good REIT income will also be created if the revenue streams from such assets are allocated and structured properly — often a challenging task involving an analysis of both the assets held and the income derived from those assets.
The IRS recently concluded that both an electricity transmission and distribution system and the rental payments from the lease of such a system were "REIT-able." The IRS distinguished the transmission and distribution aspects of the system from the generation of the electricity. Similar to railroad tracks, the transmission and distribution assets are passive conduits of a commodity created elsewhere. The IRS concluded that the underlying asset is real estate that is producing rental income and not operating income from a trade or business. This rationale appears to apply equally to the transmission and distribution of water, oil, gas, and new sources of clean energy.
When applied to infrastructure, the distinction between rental income and operating income is reminiscent of the early days of structuring operating leases to facilitate REIT investments in hotels. To avoid characterization as ordinary income from an operating business, the real estate was leased by the REIT to a taxable REIT subsidiary so as to separate the revenue stream and value of the real estate from the revenues derived from the operation of the hotel and its other revenue generating enterprises. Thus, in evaluating infrastructure assets, if the IRS finds that they constitute "good" real property but generate "bad" REIT income, arrangements similar to those employed in the hotel context show great promise for allowing certain private infrastructure investors to realize returns in a tax-efficient manner.
FIRPTA (Real Estate Taketh Away . . .)
Unfortunately, characterizing infrastructure assets as real property may be detrimental to non-U.S. investors subject to substantial federal withholding tax under the FIRPTA rules. Under these rules, withholding tax applies to distributions to non-U.S. investors on proceeds from the sale of "U.S. real property interests" (USRPIs) and from the sale of interests in or liquidation of a "U.S. real property holding corporation," which is an entity with greater than 50% of its value attributable to USRPIs.
The FIRPTA withholding tax analysis hinges upon whether an asset, or a majority in value of the assets of a company, constitutes a USRPI under the IRC. In the case of single companies with multiple assets, only some of which may be real estate, classification is critical to analyzing and structuring the transaction.
Current trends suggest an expansive view by the IRS as to what constitutes an interest in real property for these purposes. In October 2008, the IRS issued a request for comments regarding the status of certain permits, licenses, and other rights granted by a governmental entity that are related to the lease, ownership, or use of toll roads, toll bridges, and other physical infrastructure, sending shivers through the cross-border real estate industry by suggesting that such rights may properly be characterized as USRPIs. Accordingly, allocating value among multiple components of a transaction can be of great consequence. For example, is more than half the value in an electric company attributable to the generation of electricity (an operating business) or the transmission of electricity (a real estate asset)?
While these results can sometimes be mitigated through structuring, classifying infrastructure assets as USRPIs is not a positive development for attracting non- U.S. capital.
The Bottom Line
REITs can be an effective tool to bridge the infrastructure gap, but only if the IRS characterizes the infrastructure assets as real estate. But even if so characterized, FIRPTA presents a formidable challenge to attracting non-U.S. capital. Determining whether real estate is the right label for certain infrastructure assets and revenue streams is the key to successfully marrying capital with infrastructure investment opportunity, and is likely to play a large role in privately capitalizing U.S. infrastructure.
Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco 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.
This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2009 Goodwin Procter LLP. All rights reserved.
