In this second installment of our series on the Qualified Opportunity Zone (QOZ) final regulations, we focus on clarifying who has capital gains eligible for deferral and the grace periods provided to startups holding working capital as a QOZ asset and substantially improving property.
Eligible Capital Gains for Foreign Persons and Tax-Exempt Entities
As noted briefly in Part I of this series, the final regulations clearly state that eligible taxpayers may only make a qualifying investment in a Qualified Opportunity Fund (QOF) using those capital gains that would have been (except for making the deferral election) taxable for federal income tax purposes. Thus, eligible capital gains must be recognized instead of merely realized. This approach also removes any limitation on the identity of a QOF investor.
For example, nonresident alien individuals and foreign corporations whose capital gains are effectively connected with a U.S. trade or business are subject to U.S. federal income tax and are therefore eligible QOZ investors with respect to those capital gains. Similarly, a domestic tax-exempt organization also qualifies with respect to an item of its capital gain to the extent the capital gain would be included in computing the organization’s unrelated business taxable income (such as rent received from debt-financed property).
On the other hand, foreign persons whose capital gains are not subject to U.S. federal income taxes by operation of a treaty or some other application of federal income tax law may not use such capital gains to make a qualifying investment in a QOF. Domestic organizations whose capital gains are not subject to federal income tax are in the same boat. This approach ensures that all domestic and foreign persons are eligible for the QOZ federal income tax benefits under the same universal condition: they must have capital gains that are subject to U.S. federal income tax.
To prevent foreign eligible taxpayers from taking inconsistent positions with respect to treaty benefits in the taxable year of deferral and the taxable year of inclusion, the final regulations provide that a foreign eligible taxpayer cannot make a deferral election with respect to an eligible gain unless the foreign eligible taxpayer irrevocably waives, in accordance with forms and instructions, any treaty benefits that would exempt that gain from federal income tax at the time of inclusion pursuant to an applicable U.S. income tax convention.
In the event that forms and instructions have not yet been published incorporating the treaty waiver requirement for a foreign eligible taxpayer for the taxable year to which the deferral election applies, the final regulations require a written statement waiving such treaty benefits to be attached to the taxpayers return. Eligible taxpayers other than foreign eligible taxpayers will only be required to make this treaty waiver if and to the extent required in forms and publications.
Another important clarification in the final regulations is how these rules affect partnerships that make the election to defer tax at the entity level. Many partnerships entities are unaware of the tax status of their partners, and do not generally have sufficient information about the tax treatment and positions of their partners to perform this analysis. So the Treasury Department and the IRS determined that it would be unduly burdensome to require a partnership to ascertain the extent to which a capital gain would be, but for a deferral election by the partnership, subject to federal income tax by all of its direct and indirect partners. Thus, in the case of partnerships, the final regulations provide an exception to the general requirement that gain be subject to federal income tax in order to constitute eligible gain.
An anti-abuse rule is included in the event that foreign persons who are not subject to federal income tax plan to enter into transactions including, but not limited to, the use of partnerships formed or availed of to circumvent the rule generally requiring eligible gains to be subject to federal income tax. A partnership formed or availed of with a significant purpose of avoiding the requirement that eligible gains be subject to federal income tax will be disregarded, in whole or in part, to prevent the creation of a qualifying investment by the partnership with respect to any partner that would not otherwise satisfy that requirement. The anti-abuse rule applies even if some of the partners in the partnership are subject to federal income tax.
This specific anti-abuse rule does not explicitly apply to S corporations. It’s unclear why, but perhaps the burden on an S corporation was not significant enough to extend it explicitly to S corporations, given the limitations on the number of shareholders permitted for S corporations and the presence of a general anti-abuse rule already introduced in the proposed regulations.
Safe Harbor for Reasonable Amounts of Working Capital
To be a Qualified Opportunity Zone Business (QOZ Business), for each taxable year, less than five percent of the average aggregate unadjusted bases of the business’ property can be nonqualified financial property, which includes various financial-type assets like cash, cash equivalents, debt, stock, partnership interests and options. However, that definition excludes reasonable amounts of working capital held in cash, cash equivalents or debt instruments with a term of 18 months or less. That safe harbor was included in the proposed regulations.
To qualify, the QOZ Business: (1) must have a written plan that identifies the working capital as property held for the acquisition, construction or substantial improvement of tangible property in the QOZ or the development of a trade or business in the QOZ; (2) must have a written schedule consistent with the ordinary business operations of the business that will use the working capital within 31 months; and (3) must substantially comply with the schedule. The proposed regulations allowed the 31-month period to be exceeded if the delay is attributable to waiting for government action.
The final regulations flesh out the circumstances in which that exception to the 31-month rule applies. If the failure to obtain a governmental permit is the reason for the delay and no other action could be taken to improve the tangible property or complete the project during the permitting process, then the safe harbor can generally be tolled for an amount of time equal to the time that the permit was delayed. In such case, the final regulations require that the application for such permit must be completed during the 31-month period.
To address other delays caused by circumstances outside the business’s control, the final regulations also permit an additional 24 months to be added to the initial 31 months if the QOZ is located in a federally-declared disaster if the project is delayed due to such disaster.
In addition, the final regulations provide clarification regarding how multiple overlapping or sequential safe harbors may be utilized, create a new working capital safe harbor applicable to single items of tangible property, and expand the benefits of qualifying for these safe harbors.
Two Working Capital Safe Harbors
Multiple overlapping or sequential applications of the working capital safe harbor were allowed by the proposed regulations, provided that each application independently satisfies all of the requirements (multiple safe harbor rule). But it was not clear whether the QOZ Business was required to be engaged in an active trade or business at the end of the first 31-month period. This lack of clarity presented issues for startup businesses as well as for very large, transformational projects.
Presumably the QOZ Business must be engaged in an active trade or business at the end of the safe harbor period because the final regulations do not specifically clarify that question or permit otherwise. Instead, they retain the multiple safe harbor rule and create an additional safe harbor rule, ostensibly to provide more time for a startup to reach the status of trade or business.
This second working capital safe harbor applies to a single item of tangible property. It can be utilized multiple times provided each application independently satisfies all of the safe harbor requirements. But this one is limited to a total safe harbor period of 62 months and has two additional prerequisites: (1) the working capital assets from an expiring 31-month period must be expended in accordance with the previously adopted plan; and (2) the subsequent infusions of working capital assets must form an integral part of the plan covered by the initial working capital safe harbor. Meeting the requirements of both of these working capital safe harbors provides the same benefits, which have been expanded from those provided by the proposed regulations.
New Working Capital Safe Harbor Benefit
In its proposed form, meeting the working capital safe harbor treated the working capital assets as qualifying as a reasonable in amount (and not nonqualified financial property, only a very limited amount of which is permitted). In addition, the income earned from qualifying working capital counted toward the 50 percent gross income test, and any intangible assets utilized as working capital counted toward the 40 percent use test.
The final regulations add another benefit to the safe harbors. The tangible property purchased, leased, or improved pursuant to the written plan for their expenditure count toward the 70 percent property test during the safe harbor period if the tangible property is expected to satisfy the QOZ Business property tests upon completion of their planned expenditure at the expiration of the safe harbor period. Thus, the final regulations permit assets covered by a working capital safe harbor to be treated as satisfying all of the requirements of QOZ Business property except the sin business prohibition during the safe harbor period, if the requirements of either of the working capital safe harbors are met.
However, there was a limit on how far the Treasury Department and IRS could expand the working capital safe harbor benefits. Only QOZ Businesses can utilize them.
QOF Are Not Permitted to Use Working Capital Safe Harbor
As passed by Congress, Code section 1400Z-2 applies the 1397C(b) rules (i.e., the 50 percent gross income test, 40 percent intangible use test and 5 percent nonqualified financial property test) to QOZ Businesses but not QOFs. Unfortunately, 1397C(b) also provides the introduction of the working capital safe harbor into the QOZ regime. As such, it did not initially appear that the working capital safe harbor could apply to QOFs but only QOZ Businesses. That concerned practitioners and investors who requested that the final regulations permit QOFs to use the working capital safe harbors notwithstanding the inapplicability of the other 1397C(b) rules to QOFs.
The Treasury Department and IRS reviewed this issue and concluded that the statutory construction of 1400Z-2 prevented the issuance of any interpretive regulations applying the working capital safe harbor to QOFs. The statutory text simply did not allow it.
It has been our consistent recommendation to utilize a two-tiered structure (incorporating a lower-tier QOZ Business) when creating a QOF investment. The inability of a QOF to utilize the working capital safe harbors is another great reason to focus on the two-tier structure when investing in a QOZ.
Expansion of 30-Month Substantial Improvement Period
A QOZ Business must hold 70 percent of its property in the form of QOZ Business property. QOZ Business property includes tangible property that is not new but is used property that is substantially improved once acquired by the QOZ Business. The October 2018 proposed regulations provided a 30-month substantial improvement period of tangible property for purposes of applying the substantial improvement requirement. Under that proposal, tangible property is treated as substantially improved by a QOZ Business only if, during any 30-month period beginning after the date of acquisition of the property, additions to the basis of the property in the hands of the QOZ Business exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period in the hands of the QOZ Business.
Previously, it was unclear whether such property qualified as QOZ Business property while undergoing the substantial improvement. To alleviate this issue, the final regulations provide that tangible property purchased, leased or improved by a trade or business that is undergoing the substantial improvement process, but has not been placed in service or used in a trade or business, will be treated as used in a trade or business and as QOZ Business property during the 30-month substantial improvement period with respect to that property. Such treatment is only available if the property is reasonably expected to be substantially improved and used in a trade or business in the QOZ by the end of the 30-month substantial improvement period.
Part III Preview
In the next installment of this series, we will focus on the new clarity involving the rules for qualifying as a QOF and QOZ Business, including triple net leases as active trades or businesses, brownfield sites as original use property, and compliance with the substantial improvement rules when multiple items of property are being improved.