Seyfarth Synopsis: On April 12, 2021, the Department of Treasury (“Treasury”) published proposed Treasury regulations (the “Proposed Regulations”) that (1) permit qualified opportunity zone businesses (“QOZBs”) to revise or replace their written plans for working capital safe harbor compliance following a Federally declared disaster such as the COVID-19 pandemic, (2) establish requirements that certain foreign persons and foreign-owned partnerships must meet in order to be eligible to make a deferral election (“Deferral Election”) under section 1400Z–2(a) of the Internal Revenue Code of 1986, as amended (the “Code”), and (3) provide for reductions or elimination of withholding under Code sections 1445, 1446(a), and 1446(f) (“FIRPTA Withholding”) for those foreign persons and foreign-owned partnerships that follow the requirements.
While the clarifications of issues relating to foreign investors in qualified opportunity funds (“QOFs”) are welcome, the guidance allowing QOZBs to revise their working capital safe harbor plans belatedly but finally closes a significant hole in the Internal Revenue Service’s (the “IRS”) prior pandemic relief that we previously identified here and here.
Revisions to or Replacements of Working Capital Safe Harbor Plans
Although the final Treasury regulations, Notice 2021-10, and Notice 2020-39 helpfully provide a QOZB with an additional 24 months (on top of the existing 31-month deployment allowance for any single infusion of cash into a QOZB) to expend its working capital assets in light of the COVID-19 pandemic, they do not exempt the QOZB from the requirement that it must do so in a manner substantially consistent with the original, pre-disaster written plan. As we noted here and here at the time of the publication of the pandemic relief for QOFs and QOZBs, given that many such vehicles were formed to facilitate investment in business sectors heavily disrupted by the pandemic, the failure to expressly allow written plan revisions to adapt to the effects of the pandemic was a serious hole in the otherwise favorable IRS pandemic guidance for QOFs and QOZBs, and left many advisors hoping that their clients could make such revisions and rely on general regulatory intent to carry the day if questioned on any such changes (or deviations from prior written plans) by the IRS.
The Proposed Regulations grant flexibility for QOZBs to revise or replace their original written plans, provided that the remaining working capital assets are expended within the 31-month period, increased by the 24 additional months provided in response to the Federally declared disaster. Specifically, the Proposed Regulations will add the following three new sentences at the end of Treas. Reg. Sec. 1.1400Z2(d)-1(d)(3)(v)(D): “For purposes of the preceding sentence, meeting the requirements of paragraph (d)(3)(v) of this section may be determined by reference either to the original amount of working capital assets designated in writing under paragraph (d)(3)(v)(A) of this section and reasonable written schedule under paragraph (d)(3)(v)(B) of this section or to a new or revised written designation and written schedule that satisfy the requirements of paragraph (d)(3)(v)(A) and (B) of this section, respectively. A new or revised written designation of the amount of working capital assets and reasonable written schedule for expending that amount may be used only if adopted not later than 120 days after the close of the incident period, as defined in 44 CFR 206.32(f), with respect to that disaster. In determining whether a new or revised schedule satisfies the requirements of paragraph (d)(3)(v)(B) of this section, the planned completion of spending must take into account the up-to-31 month period originally allowed under paragraph (d)(3)(v)(B) of this section, plus the up to-24 additional months provided in this paragraph (d)(3)(v)(D).” For present purposes, the “incident period” associated with the COVID-19 pandemic disaster declaration, which is national in scope, remains open as of the writing of this alert.
The Proposed Regulations state that the working capital plan modification provision will apply to taxable years beginning after the date that the Proposed Regulations are published as final Treasury regulations in the Federal Register, but a taxpayer may rely on the provision for taxable years beginning after December 31, 2019. Accordingly, with specific reference to the COVID-19 pandemic, given that the Proposed Regulations provide for working capital revisions or replacements to be made up to 120 days after the closure of the pandemic disaster declaration (which has not been closed as of the date of this alert), and further given that it can be relied upon for taxable years beginning on or after January 1, 2020, this guidance should protect all QOFs and QOZBs that were forced to pivot to new business plans following the onset of the COVID-19 pandemic.
Foreign Investments in Qualified Opportunity Funds
Foreign persons are generally subject to US income tax on income that is effectively connected with the conduct of a trade or business within the United States. Under the FIRPTA Withholding provisions, certain transferees or payors are required to withhold a specified percentage of the sales proceeds, distributions or other payments that would be payable to foreign persons and pay the same over to the IRS. The amount of withholding under these provisions is intended to approximate the foreign person’s tax liability on the transfer or payment. The foreign person must file a US income tax return, claim a credit for the withheld amount, and either pay any additional tax due or claim a refund of all or a portion of the withheld amount.
FIRPTA Withholding may be less appropriate when the foreign person intends to defer the realized gain in a QOF for several reasons. First, the withholding would reduce the amount of cash payable to the foreign person and thus make it more difficult for the foreign person to secure and invest in a QOF the amount of cash necessary to achieve full gain deferral. Second, the purpose of the FIRPTA Withholding is to approximate the foreign person’s tax liability on the transfer or payment and such tax liability will be reduced or eliminated if the foreign person makes a timely and proper investment in a QOF. Finally, if FIRPTA Withholding were not reduced or eliminated and the foreign person did defer tax by investing in a QOF, then the foreign person may be able to claim a credit for the withheld amount and use the credit to offset other income or claim a refund when doing so would be inappropriate.
As a result, the Proposed Regulations provide that “security-required persons” (certain foreign persons and certain foreign-owned partnerships described below) investing “security-required gain” (gain from a “covered transfer”, which is generally a transfer subject to FIRPTA Withholding) may not make a Deferral Election unless they obtain an “eligibility certificate” with respect to that gain by the date on which the Deferral Election is filed with the IRS. If a security-required persons obtains an eligibility certificate and provides security to the IRS before the transaction giving rise to the gain, then the FIRPTA Withholding is reduced or eliminated. If a security-required person does not obtain an eligibility certificate before the transfer, then the transfer is subject to normal FIRPTA Withholding. Such a security-required person must still obtain an eligibility certificate to make a Deferral Election, but his, she, or it (or, if applicable, its partner, owner, or beneficiary) will need to claim a credit or refund for the amount withheld and provide a copy of the eligibility certificate when filing his, her or its US income tax return.
A partnership, whether foreign or domestic, is a “security-required person” if it meets three tests: the ownership test, the closely-held test, and the gain or asset test. The ownership test is met if, at the time of transfer, 20% or more of the capital or profits interests in the partnership are owned (directly or indirectly through one or more partnerships, trusts, or estates) by one or more nonresident aliens or foreign corporations. The closely-held test is met if, at any time during a look-back period (the period that begins on the later of the date that is one year before the date of the transfer or the date on which the partnership was formed, and that ends on the date of the transfer), a partnership has 10 or fewer direct partners that own 90% or more of the capital or profits interests in the partnership, with any related partners (within the meaning of Code section 267(b) or 707(b)(1)) being treated as a single partner. The gain or asset test is met if either: (i) the amount of security-required gain from the transfer exceeds $1 million or (ii) at any time during a look-back period (same as above), the value of the partnership’s assets that are US real property interests or assets used in a US trade or business exceeds 25% of the total value of the partnership’s assets. The Proposed Regulations (1) allow the partnership to determine the value of an asset on the last day of the taxable year preceding the year in which the look-back period begins or, for any asset acquired after this date (including upon formation of the partnership), on the date of acquisition, (2) provide rules for looking through interests in other partnerships to value assets that are held indirectly, and (3) state that the value of each asset will be measured according to its gross fair market value.
To obtain an eligibility certificate, a security-required person must submit an application to the IRS. The IRS is considering requiring electronic submission of the application. The IRS would describe the process in forms, instructions, publications, or guidance published in the Internal Revenue Bulletin. The application must generally include the following: (i) certain information about the security-required person, including his, her or its US taxpayer identification number, and the covered transfer; (ii) an agreement for the deferral of tax and provision of security (a “Deferral Agreement”); (iii) an agreement with a US agent; and (iv) acceptable security (an irrevocable standby letter of credit issued by a US bank that meets certain capital and other requirements) that secures the amount of the security-required gain for which the eligibility certificate is being obtained. The Deferral Agreement will require the security-required person to: (a) timely file a Federal income tax return and pay any tax liability due on the security-required gain when required; (b) report any security-required gain in accordance with the Treasury regulations under Code section 1400Z-2; (c) provide security to the IRS with respect to any tax liability due on security-required gain; and (d) appoint a US person to act as the security-required person’s limited agent for certain purposes specified in the Deferral Agreement.
The Proposed Regulations will apply to any covered transfer that occurs after the date that the Proposed Regulations are published as final Treasury regulations in the Federal Register. The Proposed Regulations state that taxpayers should not submit applications for eligibility certificates before such date and any applications submitted before such date will not be processed by the IRS.