Exhibits
As discussed below, two commonly used P3 concession structures are the: (i) "toll concession" whereby the concessionaire generally assumes the operating risk of the project, and (ii) "availability payment" arrangement whereby the procuring governmental authority generally retains operational risk. 60 A key difference in the tax characterization of a toll concession and an availability payment arrangement is that the developer is generally treated as the owner of the project assets of a toll concession for U.S. federal income tax purposes whereas the procuring authority is generally treated as the owner of the project assets of an availability style project.
One of the central non-tax issues in developing P3 projects is assessing the amount of operating risk taken on by the concessionaire. For the concessionaire, a key consideration is whether the P3 investment provides sufficient risk-adjusted returns. While there are relatively "typical" patterns of P3 arrangements having similar characteristics, there are generally enough variations in P3 terms (driven by economic, legal, and political considerations) so that each P3 project has unique tax characteristics.
In a basic user fee or "toll concession" arrangement, nearly all demand and revenue risk is taken on by the concessionaire. Toll concessions can generally take the form of a "brownfield" project (an existing asset) or a "greenfield" project (a site with no previous development, which often involves significant construction activities). Under a typical toll concession, the concessionaire acquires the right to operate an asset (e.g., a toll road) pursuant to an agreement with the procuring authority. 61 Pursuant to a toll concession agreement, the concessionaire (i) enters into a long-term lease arrangement with the procuring authority for use of the underlying land and tangible personal property and (ii) is granted the right to operate and maintain the asset, including charging and collecting tolls and fees from users of the asset (i.e., motorists).
To balance some of this risk and to make the proposed P3 project investment more attractive to the consortium, particularly where demand uncertainty is high, some projects may implement revenue structuring arrangements with a reduced upfront payment. Such arrangements may, for example, provide that if toll revenues are greater than a negotiated amount, then the concessionaire may be required to share some of the revenue with the procuring authority. 62
In an availability payment arrangement, nearly all demand and revenue risk is taken on by the procuring authority. Under an availability payment arrangement, the concessionaire agrees to operate and maintain the asset; however, the procuring authority may collect the tolls or fees directly from users of the asset and make recurring payments to the concessionaire ("availability payments"). These availability payments are conditioned on the concessionaire's operation and maintenance of the asset in accordance with contractually-set standards. 63 Availability payment arrangements are commonly used in greenfield projects where the concessionaire is required to design, build, finance, operate, and maintain the asset.
A significant portion of a P3 project is typically debt financed. The nature and type of financing arrangement primarily depends on the commercial, legal, and other non-tax aspects of the P3 project. The choice of financing structure may affect financing costs but generally does not directly impact the U.S. federal income tax profile of the project. 64 Interest expense paid to an unrelated lender is generally deductible for U.S. federal income tax purposes. 65 The type of debt used to finance a P3 project varies and can include regular taxable debt (e.g., bank debt) or tax-exempt debt issued by a state or local government on behalf of a private entity (e.g., U.S. Department of Transportation approved Private Activity Bonds (PABs) or through a non-profit corporation pursuant to IRS Revenue Ruling 63-20 ("63-20 Corporation"), which is permitted to issue tax-exempt debt on behalf of the private concessionaire). 66
Although there are some similarities in operating structures among P3 arrangements, the facts and circumstances of each transaction determine the relevant tax treatment. The income tax treatment of concession arrangements is generally subject to heterogeneity. This is because each P3 has a unique tax profile and strategy. In certain circumstances, a lack of relevant guidance or precedents of economically similar transactions will also create uncertainty regarding tax treatment of a P3. Some concession agreements may include a provision describing the intended tax treatment of the transaction. 67 For example, a P3 transaction structured as a toll concession may provide that for income tax purposes the arrangement be treated as, in part, the sale and purchase of certain project assets, lease of land, and a grant from the procuring authority to the concessionaire of a franchise or similar right to collect toll fees. Also, although generally referred to as a "public-private partnership," nearly all concession agreements explicitly state that the transaction does not constitute a partnership between the concessionaire and the procuring authority or government entity for income tax purposes in order to avoid adverse tax consequences to the concessionaire, such as elimination or limitation of certain tax benefits. 68
While there is lack of certainty with respect to the tax treatment of toll concessions and other tax characterizations may be suggested, the intended tax treatment for the majority of toll concession agreements may generally be characterized as the concessionaire's upfront payment 69 to the public entity in exchange for: (i) a lease or purchase of the primary infrastructure assets which include tangible assets (e.g., toll road and toll booths) 70; (ii) a lease of the underlying land associated with the asset; and (iii) the grant of an intangible right to collect tolls (e.g., a franchise or permit). 71 Exhibit F is an example of a contractual provision describing the intended tax treatment as such.
| Nature of Parties' Interests Pursuant to
This Agreement states: "The Department and the Concessionaire acknowledge their mutual intent that, despite the Department's retention of fee title to (or other good and valid real property interest in) the Project Assets and the Project Right of Way, as a result of the Concessionaire's rights and interests therein pursuant to the Permit granted to the Concessionaire under this Agreement, to the maximum extent permitted by Law, for federal income tax purposes the Concessionaire will be treated as having acquired (i) an ownership interest in those Project Assets that have an expected economic useful life equal to or less than the Term, (ii) an interest in the Project Right of Way and those Project Assets that have an expected economic useful life greater than the Term and (iii) a franchise and license permit, or other right within the meaning of Section 197(d)(1)(F) and 197(d)(1)(D) of the Internal Revenue Code of 1986, as amended, and in that regard an amount equal to the Concessionaire's cost of development, design, construction and start-up of the Project represents acquisition cost of such assets (the "Cost") ...The Cost will be allocated for all income tax purposes in the manner determined by the Concessionaire, which allocation shall be consistent with Section 1060 of the Internal Revenue Code..." |
While fee title to tangible personal property may be retained by the procuring authority and the form of legal conveyance of the right to use such property is typically a lease, the concessionaire may be treated as purchasing and owning the assets for federal income tax purposes. A taxpayer must own a depreciable interest in property to be entitled to the related depreciation deductions, either as the owner under U.S. federal income tax principles or as tenant-funded leasehold improvements. 72 The tax benefits associated with the depreciation deductions are often an important consideration in computing the tax cost of a project. Ownership of property for federal income tax purposes does not solely depend on whether a taxpayer holds legal title to the property. Instead, tax ownership generally depends on the concessionaire's economic interest in the assets. One important factor in making this determination is whether the taxpayer possesses the benefits and burdens of ownership of the property, which must be analyzed from the terms of the concession agreement and the underlying economic facts. For example, the anticipated remaining economic useful life of the property relative to the term of the concession may impact tax ownership analysis (a concession term that exceeds the economic useful life of the assets is generally a factor that supports the treatment of the developer as the owner of the project assets for federal income tax purposes). 73 An example of an ownership "burden" is that the concessionaire would suffer an economic loss resulting from the assets' deterioration and physical exhaustion. 74
The lease of an infrastructure asset and other tangible personal property is often long-term 75 and likely to exceed the assets' economic useful lives. Further, the concessionaire has general day-to-day operational control over the assets. This effective control over the assets for all or substantially all of the assets' useful lives is a factor that supports treating the concessionaire as the owner of the assets for federal income tax purposes. 76 As discussed above, if the concessionaire is treated as the owner of tangible project assets for federal income tax purposes, the concessionaire would be entitled to the related depreciation deductions in accordance with applicable income tax rules. 77 The Concessionaire may generally depreciate tangible personal property under the Modified Accelerated Cost Recovery System (MACRS) using the general depreciation system (GDS), although consideration should be given to whether use of the slower alternative depreciation system (ADS) is required for any project asset(s). 78
The amount of the payment allocated to the lease of the underlying land will generally be treated as a pre-payment of rent for federal income tax purposes governed by section 467. These complex rules can be used by taxpayers to allocate rent deductions over the term of the lease by treating the pre-paid lease amount as a deemed loan from the concessionaire to the procuring authority for US federal income tax purposes, and imputing throughout the term of the lease, rent payments to the procuring authority (pursuant to a schedule as computed under applicable tax rules). Concomitantly, the procuring authority is deemed to make interest and principal payments to the concessionaire with respect to the deemed loan in the amount of the imputed rent. 79
For federal income tax purposes, the portion of the concession payment allocated to the tolling right may be characterized as the grant of a "franchise" right 80 from the procuring authority to operate and collect tolls from users of the asset. 81 The portion of the concessionaire's payment allocated to the franchise right is generally capitalized and amortized on a straight-line basis over 15 years for federal income tax purposes. 82
A taxpayer that operates a toll concession will generally report tax losses during the initial years of operation due to the significant (i) accelerated depreciation expense, (ii) amortization expense, (iii) interest expense, and (iv) general operating expenses.
Availability payment concessions are commonly utilized for greenfield projects and may generally be characterized as the concessionaire's agreement to design, build, finance, operate, and maintain an asset in exchange for the receipt of milestone and availability payments from the procuring authority. The concessionaire's right to receive such payments is generally contingent upon the concessionaire satisfying performance standards and other terms and conditions set forth in the concession agreement. For example, the concessionaire may be required to ensure that the asset is available for public use for a certain number of days during a calendar year without undergoing significant repairs or maintenance.
Although an availability payment concession agreement is written as one integrated contract, the concessionaires are likely to separate the agreement into multiple distinct arrangements for purposes of determining the appropriate income tax treatment, including: (i) a construction contract, and (ii) an operation and maintenance ("O&M") contract. 83
During the construction period, which usually extends beyond one tax year, the concessionaire incurs significant costs in connection with the design and construction of the project. The concessionaire may be entitled to receive agreed to milestone payments as construction milestones are achieved. Milestone payments are typically less than the concessionaire's total construction period costs.
During the O&M period (which generally commences when construction is completed), the concessionaire is entitled to receive availability payments from the procuring authority while operating and maintaining the asset.
Under availability payment concessions, in general, a construction arrangement extending beyond one tax year is classified as a "long-term contract" for federal income tax purposes. A long-term contract is generally required to be accounted using the "percentage of completion method" ("PCM") of accounting. 85 In these concessions, the long-term contract does not necessarily convey ownership of property for federal income tax purposes ("tax ownership"), which restricts depreciation allowances for the P3.
Under the PCM, total "contract price" with respect to construction activities is recognized for income tax purposes proportionately as construction costs are incurred. For example, if a concessionaire incurs 40% of the projected total construction services costs by the end of the first year of the concession, then the concessionaire must include 40% of the "total contract price" into income.
Application of the PCM to an availability payment concession agreement is subject to uncertainty. Availability payment concession agreements do not typically allocate or designate payments made by the procuring authority between amounts for construction services and amounts for O&M services. Further, there is currently no tax authority directly on point regarding the determination of "total contract price" if the availability payment concession agreement does not specifically allocate payments between construction services and O&M services. The Regulations only provide that "total contract price" equals an amount that the concessionaire "reasonably expects to receive" for performing construction services, which may be estimated "based upon all the facts and circumstances." Accordingly, the concessionaire will need to establish the total construction contract price based on the specific facts of the availability payment concession.
As the tax rules do not provide a method for computing total contract price, such determination may be complex and potentially subject to different approaches. For example, the concessionaire may decide to obtain a third party valuation or estimate a value based on the consideration the concessionaire reasonably expects to receive for performing the construction services rendered (including oversight services). As the concessionaire typically outsources substantially all construction activities to construction subcontractors, costs paid to the subcontractors may provide a reasonable starting point for purposes of determining the construction contract price. The total gross receipts attributable to the construction period (i.e., the "long-term contract") will depend on the determination of total contract price.
As noted above, for federal income tax purposes the total contract price is included in the concessionaire's income during the construction period in accordance with the PCM. The PCM computes taxable income based on the construction period contract price, which is not dependent on timing of cash receipts (i.e., milestone payments). As milestone payments received during the construction period will likely be less than the total construction contract price included into taxable income, the concessionaire would typically recognize more revenue for federal income tax purposes than cash actually received from the procuring authority during the construction period. Whether the milestone payment is taxable or non-taxable depends on how the payment is characterized (e.g., as a reimbursement or compensation). 86
Typically, during the O&M period the concessionaire is entitled to availability payments. The tax treatment of the availability payment is generally the responsibility of the P3 proposer, and depends on agreed terms in the concession arrangement. Due to a lack of direct guidance under general tax law about how to determine the tax treatment of these payments, the actual tax treatment of availability payments varies across projects. Since payments received during the construction period (i.e., milestone payments) are not adequate to compensate the concessionaire for construction activities, a portion of availability payments likely represent compensation for construction activities, (i.e., for construction activities previously taxed during the construction period under the PCM). Accordingly, it is necessary to allocate the availability payments between: (i) non-taxable payments for unreimbursed construction activities (which had been previously included in revenue for tax purposes), and (ii) taxable payments for O&M services (and depending on Concessionaire's approach, a finance component and perhaps equity return as well). Different methodologies have been considered by taxpayers to tax availability payments, including "front-loading" of amounts representing unpaid construction contract price. It is generally beneficial for taxpayers to treat greater portions of availability payments as attributable to construction services since those amounts may be treated as previously-taxed income (taken into taxable income under the PCM during the construction period). However, the methodology selected must be supported by applicable tax principles and be consistent with Concessionaire's methodology for allocating the total payments amount the various types of income.
Availability payments attributable to O&M services (i.e., "non-long-term contract activities") may be accounted for using the concessionaire's generally applicable method of tax accounting (e.g., accrual method).
Because imposition of non-income tax items are reserved for state and local jurisdictions, non-income tax considerations applicable to P3 projects may be covered by state P3 legislation and therefore vary from state to state. It should be noted that not all states have adopted P3 enabling legislation and that for those states that have, some legislation is broader than others. Nonetheless, some general observations may be made concerning treatment of non-income tax items in P3 transactions based on past projects.
In an attempt to attract and facilitate P3 projects, states often provide relief to the concessionaire from responsibility for payment of various otherwise applicable non-income taxes (including sales, use, and property taxes). This relief has historically been in the form of exemptions and abatements for any project-related non-income taxes, as well as reimbursement to the concessionaire in the event a covered non-income tax is charged. Often these exemptions and abatements are granted to create a more level playing field between the P3 and a traditional public project delivery.
Exemptions from non-income taxes are typically based on specific state and local provisions eliminating the non-income tax due on an item ordinarily subject to the tax. Examples of this form of relief are provided in Exhibit G.
Alternatively, non-income tax relief may take the form of reimbursing the concessionaire in the event a non-income tax is imposed and it makes the related payment. A reimbursement payment for non-income taxes would appear to put the procuring authority in the same position with respect to certain non-income taxes as if it had undertaken the project itself. An example of reimbursement provisions is provided in Exhibit G.
| "With respect to Expendable Materials and Developer-Related
Entity purchases, Developer shall submit or cause the
Developer-Related Entity to submit a "...Sales
and Use Tax Exemption Certification" to the seller
of the Expendable Materials. In the event any Developer-Related
Entity is thereafter required by the State Comptroller
to pay sales tax on Expendable Materials, [Procuring
Authority] shall reimburse Developer for such sales
tax.." "...the Department will provide sales and use tax exemption certificates to the Developer for building and construction materials or other exempt items incorporated in the Project and will cooperate with the Developer to file any real property tax exemption forms for the Project and the Project Right of Way, in each case to the extent the Project is eligible for such tax exemptions under applicable Law and, if so eligible, to the extent the Department is required by applicable Law to provide such certificates and file such forms." "Reimbursable Tax Imposition" means: (a) any State or local property tax or similar ad valorem tax or charge...or recordation tax on a deed, release or other document recorded in connection with this Agreement, unless recorded by or at the behest of the Concessionaire..." and is included as a Compensation Event entitling the Concessionaire to related damages. |
In many jurisdictions, however, there are no P3 specific exemptions and the applicability of the generally-available exemptions is not clear. Further, differences may exist between market risk transactions such as toll concessions (where Concessionaire acquires property rights with respect to public property) and availability payment transactions which typically do not grant any property rights to Concessionaire. In the absence of the procuring authority providing an indemnity, Concessionaire must take the risk of excluding any such potential taxes in its pricing.
60 Other revenue risk allocation arrangements for a specific project may be negotiated.
61 The lease and other rights granted to the concessionaire, as well as other rights and obligations of the parties, are documented in a concession agreement between the concessionaire and the procuring authority.
62 Revenue structuring arrangements require scrutiny to assess the risk they may cause the procuring authority to be considered a partner of or in the concession entity for U.S. federal income tax purposes. These arrangements are generally not intended to constitute a partnership for U.S. federal income tax purposes.
63 Another instance where payment comes directly from the procuring authority is a "shadow toll" or fee paid by the procuring authority for each user of the asset. Note, however, that the "shadow toll" is still contingent on usage and therefore subject to demand risk. According to discussions with knowledgeable practitioners, no "shadow toll" arrangements are in use in the U.S.
64 Application of tax-exempt financing rules could negatively impact depreciation. See Alternative Depreciation System (ADS) discussion below.
65 Complex U.S. federal income tax rules may limit interest expense deductions in certain circumstances (e.g., applicable high yield discount obligation ("AHYDO")). A discussion of these rules is beyond the scope of this white paper.
66 A discussion regarding qualification for tax-exempt financing, including structures utilizing 63-20 Corporations, is beyond the scope of this white paper.
67 An example of such a provision is provided in Exhibit F.
68 For example, requiring a taxpayer to utilize a slower depreciation methodology.
69 An upfront payment to the procuring authority may not always be required.
70 Typically brownfield projects.
71 The parties will need to obtain a valuation of the project assets in order to allocate the upfront payment across each type of assets. The means for conveying property is generally via a lease or, to the extent permitted under state law, a "bill of sale."
72 To the extent that no upfront payment is made by the concessionaire, it is reasonable for the concessionaire to be treated as having a depreciable interest in the project assets constructed by the concessionaire.
73 Durkin v. Commissioner, 87 T.C. 1329, 1367 (1986), aff'd 872 F.2d 1271 (7th Cir. 1989). See also Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981) and Illinois Power Co. v. Commissioner, 87 T.C. 1417 (1986), acq. in result in part, 1990-2 C.B. 1.
74 Commissioner v. Moore, 207 F.2d 265, 268 (9th Cir. 1953), rev'g and remanding 15 T.C. 906 (1950). See also, Weiss v. Weiner, 279 US 333 (1929) and Geneva Drive-In Theatre, Inc. v. Commissioner, 622 F.2d 995 (9th Cir. 1980).
75 E.g., the I-95 HOV/HOT Lanes Project (2012) has a term of 73 years and the MLK Freeway Project (2011) has a term of 58 years.
76 Illinois Power Co. v. Commissioner, 87 T.C. 1417 (1986), acq. in result in part, 1990-2 C.B. 1.
77 IRC §§ 167 and 168.
78 Under MACRS, certain equipment is depreciated over 7 years using the 200% declining balance method under GDS and straight-line over 10 years under ADS. Land improvements are generally depreciated over 15 years using the 150% declining balance method under GDS and straight-line over 20 years under ADS. Also, tolling equipment that is properly classified as information systems would be depreciated over 5 years using the 200% declining balance method under GDS and straight-line over 5 years under ADS.
79 A detailed discussion of section 467 is beyond the scope of this white paper.
80 For federal income tax purposes, a franchise includes an agreement which gives one party to an agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area.
81 There is no direct authority concluding that a tolling concession qualifies as a section 197 asset.
82 IRC § 197.
83 Due to the absence of direct authority, tax advisors have adopted various approaches regarding tax characterization of P3 projects utilizing an availability payment mechanism approach. While most adopt the severing approach and separate the tax accounting for construction activities and O&M as described below, others further separate the arrangement to reflect a financing element after completion of the construction.
84 The below discussion assumes there are no O&M activities during the construction period (which would be accounted for separately).
85 IRC § 460.
86 Describing in specificity how to treat milestone payments for tax purposes exceeds the scope of this paper. It may also be reasonable to treat a government subsidy/milestone payment in a toll risk arrangement as non-taxable (although such payment may reduce the tax basis of the project assets a corresponding amount). However, alternative treatments could characterize the payment as compensation or otherwise taxable income to the concessionaire.
