US toll roads may have slightly less appeal for some foreign bidders after an IRS announcement in late October.

Several US states have sold sections of public highways to private companies who agree to maintain the roads in exchange for the right to collect tolls. Some states have also brought in private companies to build new lanes or new tollways that the states cannot afford to build on their own.

Many of the private companies interested in this business are non-US companies.

One consideration for them is whether they will have to pay US capital gains taxes if they later sell their interests in such projects at a profit.

An IRS announcement in late October makes it more likely the answer is yes.

In a toll road deal, a private developer or consortium of private companies usually enters into a concession and lease agreement with the state giving the developer or consortium control over the road and the right to collect tolls in exchange for an obligation to operate and maintain it. The consortium makes a large upfront payment. The state leases it the land underneath the road. The parties take the position that the consortium bought the road because of the length of the concession agreement. The consortium usually allocates part of what it paid up front to the road. The rest is allocated to the franchise or license to collect tolls.

As a general rule, the US does not tax foreigners on their capital gains lest it discourage them from investing in US stocks and bonds. However, gains from investments in US real estate are taxed. Congress made them subject to tax starting in the mid-1980’s after farmers complained that growing Japanese interest in US real estate was making it hard for their children to be able to afford their own farms.

Non-US companies investing in toll road deals usually hold their interests through special-purpose US corporations. When they exit an investment, it may be through a sale of the US corporation. There is no capital gains tax to pay in the United States as long as less than 50% of the value of corporation is attributable to US real property. The lease of the land and the highway are real property. However, in some deals, more than half the amount paid to the state for the concession is viewed as a payment for the right to collect tolls.

There has been a debate among tax counsel about whether the right to collect tolls is also an interest in US real property.

The IRS said in an “advance notice of proposed rules” in late October that it believes it is in some transactions and intends to issue regulations to that effect.

The IRS asked for comments in the meantime on whether it should also address how to allocate the upfront payment among the different assets the consortium gets in a toll road project and whether how long the concession agreement runs should have any bearing on how the upfront payment is allocated. Comments are due by January 29.

Keith Martin