Several recent high profile infrastructure transactions – the Chicago Skyway financing and the mandating of development rights to Cintra for the Trans-Texas Corridor – have focused attention on the use of public-private-partnerships (PPPs) as a viable means of developing and financing infrastructure projects in the US.

Nevertheless, PPPs still represent a small portion of the infrastructure projects that are currently in development across the US. Traditionally, US infrastructure has been developed and financed by governmental authorities by way of issuing tax-exempt bonds, raising taxes, and creating revenue funds – and that is only just beginning to change.

Recently, a number of factors, including ballooning budget deficits and staggering debt burdens, have caused many States to move away from the traditional financing methods and explore the use of PPPs to supplement their infrastructure development programs.

For example, Governor Pataki of New York recently expressed support for exploring initiatives that use PPPs to privatize existing infrastructure, such as the Tappan Zee Bridge in New York, as a means to bolster the coffers of the State of New York to provide funding sources for various transportation projects without raising taxes. In fact, he even included language in the executive budget submitted to the New York legislature earlier this spring that would encourage such exploration¹.

In addition, the availability of low cost private financing options, due to historically low interest rates, coupled with new and/or more widely accepted credit-enhancing structures and, for foreign investors, the current weakness of the US Dollar, have all conspired with State fiscal constraints to encourage the recent growth of PPPs in the US by providing private developers with lower cost means of raising the private capital to participate in these projects.

While certain of these factors, such as foreign exchange and interest rates, constitute fortuitous products of the current global economy, others, such as credit-enhancement and financing structures that take advantage of available tax benefits, represent tools with which private parties can raise and structure financing, in ways that allow them to more effectively compete with historically low-cost alternatives, such as tax-exempt bonds. With greater use of such strategies, PPPs have the ability to emerge from the isolated spotlight and form part of the mainstay of infrastructure finance in the US.

Financial guaranty wraps

Financial guaranty insurance policies offer an important means for enhancing the credit of an infrastructure project and have been used more and more in recent years to support a variety of infrastructure financing structures.

When a financial guaranty structure supplements a bond offering, an insurance company, such as XL Capital, Ambac or MBIA, will, in exchange for an applicable premium, issue a financial guaranty insurance policy in favor of the bondholders pursuant to which it unconditionally agrees to pay the bondholders all scheduled principal and interest on the bonds when it becomes due, and, in some instances, any amounts that might be payable with respect to such principal and interest payments as the result of any withholding taxes².

The addition of a financial guaranty insurance policy to a bond offering issued to finance an infrastructure project changes the risk profile of that bond offering dramatically. Rather than the bondholders taking the risk that the relevant infrastructure project performs in a manner that permits the project company issuer to repay the bonds, the bondholders will be able to look towards the insurance company and seek repayment pursuant to the terms of the insurance policy. Thus, the bondholders will ultimately bear the credit risk of the insurance company, typically an AAA-rated entity, while the insurance company, on the other hand, bears the risk of the project's performance and the issuer's ability to make debt service payments on the bonds.

This shift in risk profile can transform such bonds from barely investment-grade instruments to high quality debt instruments rated AAA (or its equivalent) by the rating agencies.

The enhanced ratings of this debt will attract bondholders that would not otherwise purchase the bonds and will result in a reduced interest rate payable on the bonds to reflect the reduced risk exposure. Generally, the interest rate is sufficiently reduced that, even with the additional cost of the premium, the interest plus premium result in an overall lower cost of capital.

Federal subsidies

In addition to financial guaranty insurance policies, subsidies available under various Federal statutes can be used in conjunction with private debt financings to reduce the overall cost of financing an infrastructure project.

The most prominent of these Federal programs is provided under the Transportation Infrastructure Finance and Innovation Act of 1998 (TIFIA). TIFIA allows developers to seek direct financing from the US Department of Transportation (DOT) in the form of secured loans, loan guarantees or standby lines of credit in order to finance up to 33% of the total eligible project costs. Projects meeting certain eligibility requirements³ may utilize TIFIA assistance to supplement primary sources of financing.

The TIFIA program contains several features that make it a potentially advantageous source of secondary financing. First, the TIFIA statute permits the DOT lien on project revenues to be subordinated to the liens of senior creditors except in the event of bankruptcy, insolvency or liquidation. This feature may enhance the project's senior debt rating by allowing the project to attain stronger coverage ratios. The subordinate lien on revenues also allows a high-cost project to raise additional capital on attractive terms not generally available in traditional lending or capital markets.

In addition, sponsors may use a single credit instrument or combine any of the three credit instruments available under TIFIA to meet the needs of the project; loans and guarantees may be used to finance initial construction costs or to refinance existing debt within a year of substantial completion, while standby lines of credit are available after substantial completion to cover a revenue shortfall.

Other favorable repayment terms permitted by the statute and open to negotiation include repayments commencing up to five years after substantial completion, final maturity of up to 35 years after substantial completion, deferral of payments in the event of insufficient revenues, and loan prepayments without penalty. Thus, for large capital intensive projects, TIFIA assistance can provide enhanced market access and reduced borrowing cost⁴.

Tax considerations

PPPs appear poised to be attractive financing alternatives for governments and tax-efficient investors alike.

PPPs have the potential to achieve a greater overall benefit and lower all-in cost for a government with 100% private financing as a possibility while also allocating residual risk, tax benefits, and the operation, maintenance, and capital improvement of a project to the party who can do so most efficiently.

Traditionally, the primary alternative considered for financing PPP-type assets has been tax-exempt indebtedness. Discussed below are alternatives in which investors with significant taxable income would be attracted to PPP assets because of the availability of significant tax benefits associated with such assets. Attaining these tax benefits in the appropriate transactional structure hinges on the investor obtaining tax ownership. While this may not be easy and may include increased upfront transaction costs resulting from complicated structuring issues, increased due diligence, and various other increased transaction costs associated with projects in the private sector, we believe the value added to a transaction can be substantial.

Choice of entity

As in any transaction, there are a variety of legal entities with which an investor can structure a PPP. Whether it is a US corporation or special-purpose entity of an affiliated group, a limited liability company (wholly-owned by a US corporation), a partnership (or limited liability partnership), a trust (grantor or Delaware statutory trust), or some combination thereof, choice of entity inevitably plays an important role from both commercial and tax standpoints and is a threshold issue in structuring a viable PPP.

Given its flexibility (i.e., it can include a variety of investors with dissimilar economic goals) and efficiency (i.e., it does not impede the flow-through of tax benefits), many transactions will find a partnership of some sort to be the most appealing entity. It is patent that whichever entity is employed, it have the flexibility to own assets, borrow in the capital markets and not result in a diminution of tax benefits otherwise available (or increase local taxes in the applicable jurisdiction).

Achieving tax ownership

As indicated above, achieving tax ownership is paramount. Under US tax law, the determination of tax ownership turns on whether the purported owner has significant incidence of ownership, i.e., the owner can enjoy upside value in the asset and risks downside loss with respect to its investment. As such, substance, more so than form, governs.

Location of title, however, is not irrelevant or unimportant. Thus, an issue frequently confronted with PPP-type assets is whether title is transferable to an investor. If this is not possible or too difficult, alternatives must be explored so that the investor can conclude that it has acquired an interest in the asset that is tantamount to ownership despite title residing elsewhere.

For example, where a city grants an investor a concession that provides the investor with a 99-year license to operate, maintain, and collect revenue from an asset that will have little, if any, remaining useful life at the end of the concession, the investor will have achieved ownership of the asset even though legal title remains with the city.

Conversely, where a city sells an asset to a investor who then leases the asset back to the city on terms that leave none of the benefits and burden of ownership with the investor, it is likely that the transaction will be recharacterized by the IRS as a financing such that the city, not the investor, would be the owner of the asset.

Accordingly, it is critical to properly consider the following issues so that it can be concluded with a degree of certainty that tax ownership resides with the investor:

• the investor must possess the ability to make a meaningful profit (on a pre-tax basis) from the asset, but such profit can not be guaranteed by the government or a third party;
• the investor must have more than an insubstantial cash flow from the asset;
• the amount of debt raised in the transaction should not exceed 85% of the asset's value, thus the investor makes a meaningful investment in the property;
• the investor cannot have any right to put the asset to the government or a third party;
• any call/purchase right over the asset must be at fair market value or the expected fair market value;
• the investor must be capable of disposing of or transferring the asset to a party other than the government.

Each of these issues, along with others, if not given proper consideration, presents a material risk that the IRS will challenge the investor's tax ownership of the asset, which, if successful, may mean that the investor is not entitled to the tax benefits discussed below.

Tax benefits

Assuming that the PPP is structured so that the investor is the federal income tax owner, a number of tax benefits should be available that will significantly increase the attractiveness of the economics of a PPP. There are, however, numerous pitfalls and limitations that the investor should be aware of, some of which are highlighted below.

One of the principal tax benefits associated with tax ownership of an asset is the right to offset ordinary income with depreciation deductions. To the extent that the assets of a PPP fall within asset classes for which Congress has provided a class life that is shorter than the normal useful life of the asset, the assets will be entitled to accelerated depreciation under the modified accelerated cost recovery system (MACRS) and the investor will be benefited by deductions that are likely to be in excess of the income generated by the asset. (Note that on the disposition of the asset the investor will realize ordinary income (as opposed to capital gains) to the extent of such deductions).

Contrast this result with that in which the governmental unit or foreign person or entity is the owner. In such case, because such entity is not subject to tax, the depreciation deductions go unused.

There are several rules relating to depreciation deductions that diminish such benefit (in some cases quite significantly) depending on the type of arrangement the investor negotiates with the governmental unit. For example, if the investor acquires the asset and then enters into a concession (which is essentially a license to levy a toll) or a service contract with the governmental unit, the depreciation deductions generally described above continue to be available.

If, on the other hand, the investor enters into a lease with the government, the investor is subject to a different depreciation regime that essentially seeks to spread the depreciation deductions over the useful life of the asset. Such rules are also applicable to assets that are predominantly used outside the US as well as for assets to the extent that they are financed through the use of tax-exempt financing.

Additionally, new Code Section 470 (added by the American Jobs Creation Act of 2004) imposes restrictions on tax-exempt use losses. The deduction of losses resulting from the lease of property to a tax-exempt entity is now not permitted until disposition of the property unless the lease meets certain requirements that are designed to insure that the deductions are available only if the lessor retains significant risks of ownership, e.g., the absence of defeasance arrangements for material amounts.

In lease transactions with governmental units, it is therefore critical for the transaction to not be governed by this provision. Code Section 470 may pose an additional obstacle in that it contains a provision that disallows a loss on property a partnership owns, although it remains uncertain whether this would apply to a PPP that has a tax-exempt entity as a partner (or owner).

In addition to the benefits of depreciation, other potential tax benefits that may be available to a properly structured PPP include:

(i) deductions for interest expenses, which are often maximized by structuring the debt so that deductions are taken as the interest accrues, but the interest, rather than being paid, is added to the principal or "rolled up" such that the investor gets to have the benefit of the deduction today, but defers the payment of cash until a future date;
(ii) capitalizing the upfront transaction expenses and deducting them, over the course of the transaction;
(iii) structuring the cash flow and taxable income timing under the transaction so that the early receipt of cash is not considered income until a later point in the transaction, each of which is possible to a certain extent if the PPP is structured as a lease in compliance with Code Section 467.

This section has provided what is the rough equivalent of the tip of an iceberg. It is important, however, to bear in mind that significant tax benefits can be realized if a PPP is structured properly, but the landscape can be deceptive and riddled with pitfalls for the unwary.

Footnotes:
1 Ultimately, his proposed language was not adopted by the New York legislature.
2 Typically, non-scheduled amounts, such as prepayments, redemptions, premiums or amounts due on acceleration would not be included in the insurance policy.
3 For example, anticipated eligible costs must be at least $100 million (or in the case of intelligent transportation systems projects, $30 million) or 50% of the State's federal-aid highway apportionments for the most recently completed fiscal year, whichever is less. In addition, the project must be included in the State's long-range transportation plan and the State Transportation Improvement Program. The project must also have a dedicated revenue source such as tolls or user fees (in which the DOT must be granted a subordinated lien), and the project's senior debt must attain an investment-grade rating. In order to further encourage the use of TIFIA assistance in capital intensive projects, proposals for amending TIFIA to soften some of the eligibility criteria are under consideration.
4 It is important to note, however, that as a federally administered program, the use of TIFIA credit assistance will require a project and its developers to comply with a host of Federal information and reporting requirements.

Betty Cerini and Junaid H. Chida are partners in the Global Project Finance Group of Dewey Ballantine LLP in New York. They can be reached at 212-259-8000. Sean M. Moran is a partner in the Tax Group of Dewey Ballantine LLP in New York and Los Angeles. He can be reached on 212-259-8000 or 213-621-6000. The authors wish to acknowledge the generous assistance of Dewey Ballantine associates Karen Goepfert, Patrick Klein and Elicia Ling.