FIRPTA considerations for power and energy investments

Editor: Christine M. Turgeon, CPA

The surge in demand for energy has attracted diverse investors, including foreign entities, multinational corporations, private–equity firms, and venture capital — all eager to acquire a portfolio company (sometimes at a sizable premium) with access to either traditional or renewable energy and grid infrastructure. Investments in this area take many forms, ranging from independent power producers to data centers.

Various tax issues should be considered when investing in or purchasing a company with access to a significant power supply (e.g., a data center) or a company that is creating a power supply (e.g., an independent power producer). These include issues under the Foreign Investment in Real Property Tax Act (FIRPTA) (Title XI, Subtitle C, of the Omnibus Reconciliation Act of 1980, P.L. 96–499, as amended). While some forms of energy may be more susceptible to FIRPTA risk, this item focuses on general FIRPTA issues for foreign investors (whether investing directly or through private equity) to consider, rather than an analysis of the treatment of specific assets under the FIRPTA rules. This discussion assumes that a foreign investor will invest via a U.S. corporate entity; therefore, a key issue is whether the U.S. corporation is or was a U.S. real property holding corporation (USRPHC), as defined under Sec. 897(c)(2), during the foreign investor’s testing period.

USRPHC determinations

Under Sec. 897(c)(1)(A)(ii), unless an exception applies, a foreign person’s gain from the disposition of a U.S. corporation is subject to U.S. federal income tax if the U.S. corporation is or was a USRPHC during the relevant testing period (the shorter of the ownership period or the five–year period ending on the date of disposition). A USRPHC is any corporation if the fair market value (FMV) of its U.S. real property interests (USRPIs) equals or exceeds 50% of the FMV of all real property and any assets that are used or held for use in a trade or business (the FIRPTA ratio; see Sec. 897(c)(2)). The restriction to trade or business assets prevents the corporation from “building up” the denominator of the FIRPTA ratio fraction with nonbusiness or passive assets to prevent USRPHC status.

The first question to analyze is whether the U.S. corporation has a trade or business and, if so, when that trade or business began, especially if the U.S. corporation does not have any operating assets. If there is no trade or business, then any value in excess of the FMV of the USRPIs cannot be allocated to an asset used or held for use in a trade or business (e.g., a non–USRPI intangible). Although the FIRPTA regulations provide a short startup exception (under which a corporation generally does not have to make a USRPHC determination within the first 120 days of incorporation; see Regs. Sec. 1.897–2(c)(1), flush language), if the corporation cannot establish that it is engaged in a trade or business for purposes of Sec. 897, then one dollar of real property could cause the corporation to be a USRPHC.

Sec. 897 does not define “trade or business,” and no definition appears to control for this purpose. The term can be found in various Internal Revenue Code sections, and its scope can vary depending on the underlying purpose behind each use. One source of guidance to consider in this context is Sec. 864 and the case law determining when a foreign person is engaged in a U.S. trade or business. Regs. Sec. 1.897–1(f) specifically cross–references the Sec. 864 regulations for purposes of determining whether liquid and intangible assets may be treated as used or held for use in a trade or business. Accordingly, if enough activities are taking place in the U.S. corporation such that its operations may be viewed as continuous, considerable, and regular, the U.S. corporation potentially could be considered to have a trade or business for Sec. 897 purposes, although other IRC provisions could conflict with this determination (e.g., Sec. 162 or 195).

Example: Assume a foreign corporation (FC) wholly owns a U.S. corporation (USCo) for the purpose of becoming an independent power producer. USCo’s only assets are land, a spot in the interconnection queue (projects awaiting approval to connect to a power grid), and employees’ performance of research and development (R&D). A third party offers FC a significant premium to buy the U.S. corporation solely to access USCo’s position in the interconnection queue. If USCo cannot prove that its R&D activities plus any other activities that were required to secure a spot in the interconnection queue were beyond the investigatory stage to establish a trade or business have begun, then the premium cannot be allocated to non–USRPIs, and USCo would be a USRPHC. However, if USCo can prove that it is engaged in a trade or business, then any residual value may be allocated to assets that are used or held for use in its trade or business (e.g., intangibles such as goodwill or developer pipeline), even if USCo’s active trade or business has not begun, so that it is capitalizing startup costs under Sec. 195.

Sec. 195 generally requires a taxpayer to capitalize and amortize certain costs that are treated as part of an investigatory stage as well as costs incurred in starting up an active trade or business or an activity engaged in for profit in anticipation of that business becoming active. In contrast to Sec. 195, FIRPTA does not require a U.S. corporation to have an active trade or business, nor does it require that those assets be held in connection with an active trade or business. This distinction is important because it suggests that other IRC provisions such as Sec. 195 or 162 might not be determinative in calculating the denominator of the FIRPTA ratio. However, case law from before the enactment of Sec. 195 addressing when a taxpayer enters a trade or business, such as Seed, 52 T.C. 880 (1969),and Rev. Rul. 77–254, may be informative. In addition, depending on the facts, R&D activities and assets may be viewed as investigatory and should be thoroughly documented.

Valuation

Another issue that often arises is how to allocate value — particularly for assets that are under construction. Renewable energy typically is valued at the project level, using an income approach. The overall value of the project is then allocated to the various assets. If the assets under construction are valued at cost, then it is possible that there is non–USRPI intangible value. If, however, the assets under construction are valued using an income approach and the entire value is allocated to construction, there may be an increased USRPHC risk to the extent the non–USRPI construction assets are not treated as trade or business assets.

Data centers

One type of investment that combines all the above–described issues is a data center, unless it is structured as a domestically controlled real estate investment trust, since such stock is not a USRPI (Secs. 897(h)(2) and (4)). Due to the commercial aspects of obtaining power, many valuation firms value the land and the power purchase contract as a single asset (i.e., so–called powered land) instead of allocating the value between land and the power purchase contract, thereby creating more USRPI value. Once construction starts, it may not be considered a trade or business asset under Sec. 1231(b) because it is not yet depreciable. In such cases, it is unclear whether the cost of construction in progress is included in the FIRPTA ratio denominator. This result could further increase the USRPHC risk, notwithstanding that the construction costs may represent critical infrastructure (e.g., specialized cooling equipment), which, once it is operational, is a non–USRPI business asset.

Additional key issues to consider for data centers are how to value the assets beyond physical land (e.g., the income approach, market approach, or cost approach); whether the tenant contracts are viewed as service contracts or leases; and how to quantify a customer–relationship intangible. These issues play a pivotal role in determining whether a U.S. corporation that owns data centers is or was a USRPHC during a relevant testing period.

Maintaining documentation is key

Given the complexity and various valuation approaches, U.S. corporations should consider keeping detailed documentation regarding their trade or business position for purposes of Sec. 897 to the extent they are looking to attract foreign investment prior to reaching commercialization. Foreign taxpayers should consider how the various valuation methodologies can affect whether their interest is a USRPI.

Editor

Christine M. Turgeon, CPA, is a partner with PwC US Tax LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PwC US Tax LLP.