Announcement 2008-115

This document describes issues that the IRS and the Treasury Department are considering addressing, in a notice of proposed rulemaking, regarding the definition of an interest in real property within the meaning of section 897(c) of the Code. The notice of proposed rulemaking would address 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. The proposed regulations would amend the § 1.897-1 regulations.

In a typical transaction at issue, a domestic partnership (DP) leases or purchases from an unrelated party infrastructure assets and any land underlying these infrastructure assets (together, specified infrastructure) within the United States. The DP’s partners include domestic corporations with foreign shareholders. Examples of specified infrastructure include a toll road or toll bridge.

Often, as a condition to operating the specified infrastructure and to collecting tolls for its use, DP is also required to obtain a governmental license, permit, franchise, or other similar right (governmental permit). The DP may also own or acquire property that would be used in the trade or business of operating the specified infrastructure, such as signs, snow plows, and electronic sensors.

The physical attributes of the specified infrastructure, for example, a relatively narrow roadway, and terms and conditions related to the specified infrastructure, for example, that the lessee is required to maintain and operate a roadway, mean that in many cases there may practically be no potential alternative commercial uses for the specified infrastructure. In those cases, the value of the leasehold interest in the specified infrastructure derives from the right to charge and collect tolls.

Section 897(a)(1) of the Code treats the gain or loss of a nonresident alien or foreign corporation from the disposition of a U.S. real property interest (USRPI) as if the taxpayer were engaged in a trade or business in the United States, and as if such gain or loss were effectively connected with such trade or business under sections 871(b) or 882. In general, a USRPI includes an interest in real property located in the United States or the Virgin Islands, and any interest (other than an interest solely as a creditor) in a domestic corporation unless the taxpayer establishes that the corporation was at no time a U.S. real property holding corporation (USRPHC) within the period described in section 897(c)(1)(A)(ii). Section 897(c)(1)(A).

Real property includes land and unsevered natural products of the land, improvements, and personal property associated with the use of real property. Section 1.897-1(b)(1). Section 1.897-1(b)(1) provides that local law definitions will not be controlling for purposes of determining the meaning of the term “real property” as it is used under section 897 and the regulations thereunder. The regulations define an “improvement” as a building, any other inherently permanent structure, or the structural components of either. Section 1.897-1(b)(3). For this purpose, an inherently permanent structure includes any property not otherwise described in § 1.897-1(b)(3) that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time. Further, § 1.897-1(b)(3)(iii)(B) provides that an inherently permanent structure includes, for example, pavements and bridges.

The Code defines an “interest in real property” to include fee ownership and co-ownership of land or improvements thereon, leaseholds of land or improvements thereon, options to acquire land or improvements thereon, and options to acquire leaseholds of land or improvements thereon. Section 897(c)(6)(A). Section 1.897-1(c)(1) further provides that the term USRPI also includes any interest, other than an interest solely as a creditor, in real property located in the United States or the Virgin Islands. Section 1.897-1(d)(2)(i) provides that an interest in real property other than an interest solely as a creditor includes any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.

A USRPHC is generally defined as a corporation the fair market value of whose USRPIs equals or exceeds 50 percent of the fair market value of its worldwide interests in real property, including its USRPIs, plus its other assets which are used or held for use in a trade or business. Section 897(c)(2). For this purpose, assets used or held for use in a trade or business include, among other things, certain intangible property described in § 1.897-1(f)(1)(ii).

For purposes of determining whether any corporation is a USRPHC, assets held by a partnership, trust, or estate are generally treated as held proportionately by its partners or beneficiaries. Section 897(c)(4)(B) and § 1.897-2(e)(2). The interest in the entity itself is disregarded when a proportionate share of the entity’s assets are attributed to the interest-holder. Section 1.897-2(e)(2). Further, any asset treated as held by a partner or beneficiary by reason of this rule which is used or held for use by the partnership, trust, or estate in a trade or business is treated as so used or held by the partner or beneficiary. Section 897(c)(4)(B) and § 1.897-2(e)(2). The proportionate ownership rules of Section 897(c)(4)(B) and § 1.897-2(e)(2) apply successively upward through a chain of ownership. Section 1.897-2(e)(2).

The IRS and the Treasury Department are aware that in the transactions at issue taxpayers may be taking the position that for purposes of section 897 the governmental permit is not a USRPI within the meaning of section 897(c). Instead, these taxpayers may take the position that the governmental permit is an asset used or held for use in a trade or business. Further, these taxpayers may take the position that a significant portion of the fair market value of a DP’s assets is allocable to the governmental permit rather than to the assets comprising the specified infrastructure.

As noted in the Background section, under section 897(c)(2), a corporation is a USRPHC only if the fair market value of its USRPIs equals or exceeds 50 percent of the fair market value of its USRPIs plus its interests in real property located outside the United States, plus any other of its assets which are used or held for use in a trade or business. Therefore, if the fair market value of the governmental permit were treated as an asset used or held for use in a trade or business, and not a USRPI, the governmental permit would be taken into account in the denominator, but not the numerator, of the calculation provided for in section 897(c)(2) in order to determine whether any domestic corporation that is a partner in a DP is a USRPHC. Accounting for the governmental permit in this manner for purposes of the section 897(c)(2) calculation reduces the likelihood that a domestic corporation to which such a right was attributed under section 897(c)(4)(B) would be treated as a USRPHC under section 897(c)(2).

The IRS and the Treasury Department, however, are of the view that in some of the transactions at issue the governmental permit may properly be characterized as a USRPI. Accordingly, the IRS and the Treasury Department are considering issuing proposed regulations regarding the definition of an interest in real property that would address certain licenses, permits, franchises, or other similar rights granted by a governmental unit (including, for purposes of section 897, an agency or instrumentality thereof) that are related to the value of the use or ownership of an interest in real property. 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 and interests in real property located outside the United States under section 897(c)(2).

The IRS and the Treasury Department anticipate that the proposed regulations would apply for transactions occurring on or after the date of publication in the Federal Register as final or temporary regulations. No inference is intended as to how these arrangements are treated or characterized under current law.

Before the notice of proposed rulemaking is issued, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are timely submitted to the IRS. All comments will be available for public inspection and copying.

The IRS and Treasury Department specifically request comments on: