By Jill Homan and Joseph B. Darby III

The Treasury and Internal Revenue Service recently provided helpful and practical guidance, in the form of a new set of proposed regulations (the Proposed Regulations), [1] addressing two significant sets of issues that pop up regularly in 2021 when structuring Opportunity Zone transactions. The guidance in the first area – dealing with the “Working Capital Safe Harbor”—is both helpful and will likely have wide and immediate practical application. However, the guidance in the second area – dealing with foreign persons who seek to reinvest U.S. gain into a QOF -- is both a less common situation and a far less helpful set of rules, and indeed may have limited practical benefit in the real world.

  • The more significant guidance addresses the proper application of the so-called “Working Capital Safe Harbor,” particularly considering the massive changes in life and business circumstances caused by the COVID pandemic. The Proposed Regulations provide a package of flexible rules, including a time period within which to revise or entirely replace the original written plan for projects located in an Opportunity Zone affected by a federally declared disaster (including COVID), together with additional guidance on how to implement the existing regulatory extension of up to 24 months in which to spend funds held under the Working Capital Safe Harbor on such projects.
  • The second area of guidance addresses situations where foreign persons and foreign-owned partnerships seek to take advantage of the Opportunity Zone (OZ) tax benefits by electing to exclude U.S. source gain under Code [2] Section 1400Z–2(a). The problem is that the deferred gain is potentially subject to immediate withholding taxes under Code section 1445, 1446(a), or 1446(f) (FIRPTA withholding) at the time of the sale or exchange that generates the gain.  The Proposed Regulations offer a procedure by which these foreign taxpayers can avoid FIRPTA withholding and thus have the full transaction proceeds available to reinvest eligible gain into a QOF. However, the early reviews on this procedure are not good:  many if not most practitioners seem to think that the proposed procedures are so burdensome and cumbersome that few foreign persons are likely to try and take advantage of the opportunity. 
Each of these two areas of guidance is discussed and analyzed in further detail, below. 

Additional Working Capital Safe Harbor Guidance 
 
One of the five statutory requirements of a Qualified Opportunity Zone Business (QOZB) is that it must hold less than 5% of its assets as "nonqualified financial property" of “NQFP.” [3] NQFP includes a wide variety of financial assets but does not include reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less (working capital assets) and debt instruments described in section 1221(a)(4). [4]
 
The final regulations [5] issued under Code Section 14000Z-2 and formally published in early 2020 (the “Final Regulations”) provide for a Working Capital Safe Harbor of up to 31 months [6] that treats working capital as “reasonable” (and thus avoids the dreaded characterization as NQFP) if certain implementation requirements are met. The three requirements to qualify for the Working Capital Safe Harbor are the following: [7]
 
(i)  amounts must be designated in writing for the development of a trade or business in a Qualified Opportunity Zone, including when appropriate the acquisition, construction, and/or substantial improvement of tangible property in such a zone;
(ii) a written schedule (typically referred to as the “Written Plan”) must be created consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets; under the Written Plan, the working capital assets must be spent within 31 months of the receipt by the business of the assets; and
(iii) The working capital assets must actually be used in a manner that is substantially consistent with the Written Plan.
 
The Final Regulations contain two additional sets of rules that offer further flexibility in structing the Working Capital Safe Harbor:
  • In the case of “start up” businesses, the maximum safe harbor period can be extended from 31 months to a maximum period of 62 months, by using multiple overlapping or sequential applications of the safe harbor under sequential or overlapping Written Plans. [8]
  • If an OZ project located in an Opportunity Zone is affected by a federally declared disaster, the project can extend the applicable expenditure period by up to an additional 24 months. [9]
Although the Final Regulations when issued anticipated allowing up to a 24-month extension in the event of a federally declared disaster, the sheer size and magnitude of the COVID Emergency has called out -- make that screamed out -- for further flexibility under the Working Capital Safe Harbor, and these Proposed Regulations reasonably address this need in a comprehensive manner.  One major issue was the degree to which the WCSH can be revised, rewritten – or entirely junked and a new replacement plan developed from scratch – if the COVID Emergency has rendered the original plan unworkable or irrelevant.  The Proposed Regulations provide a QOZB can revise its Written Plan so long as the new Written Plan is adopted within 120 days of the end of a federally declared disaster. However, this “restart” is not a true starting over event but more like an opportunity to change horses in mid-stream: The QOZB remains subject to the original 31-month time period (or 62-month period in the case of a start-up), plus the extension of an additional 24 months due to the federally declared disaster.
 
The Proposed Regulations allow great flexibility to revamp and rewrite an existing Written Plan – including explicit authorization, when appropriate and necessitated by the COVID Emergency, to do a complete restructuring. It even seems to contemplate the possibility of changes as dramatic as moving the QOZB to a new or different QOZ, a complete change in the nature or business purpose of the QOZB, and other major alterations in the structure of the project – so long as the change can be justified by the COVID Emergency. This affords QOZBs upwards of 55 months for their revised Written Plans (31 months plus the additional 24 months due to the federal declared disaster).  Note that while it may be possible to engage in a completely new project, the time limits run for the original starting date of the project, with an extension of up to an additional 24 months that must still be justified as reasonable given the nature of the project. 
 
Note that although the Proposed Regulations are not final, taxpayers are expressly permitted to rely on the guidance for tax years beginning with 2020.
 
Modified Withholding for Foreign Persons and Foreign Owned Partnerships Investing in QOFs
 
The Proposed Regulations start with the confirmatory observation that certain foreign persons and certain foreign-owned partnerships may make a deferral election provided by Code section 1400Z–2(a) with respect to an item of capital gain that is effectively connected with a U.S. trade or business, because this gain otherwise is subject to Federal income tax. (This was an expected conclusion, but it is nice to have it explicitly confirmed in the Proposed Regulations.)
 
The Proposed Regulations then provide procedures by which foreign persons and foreign-owned partnerships who make a deferral election can plan to reduce or eliminate FIRPTA withholding.
 
The Proposed Regulations acknowledge at the outset that the existing section 1400Z-2 regulations do not coordinate the deferral election with FIRPTA Withholding requirements and that, since withholding will not serve its intended purpose, further coordination is needed.  The Proposed Regulations provide that “security-required persons” (certain foreign persons and certain foreign-owned partnerships) investing gain that is “security-required gain” (generally gain from a transfer subject to FIRPTA Withholding) may not make a deferral election unless they obtain an “eligibility certificate” with respect to that gain.  At the same time, the Proposed Regulations eliminate or reduce FIRPTA Withholding on security-required persons that obtain an eligibility certificate and provide security to the IRS before the transaction giving rise to the gain.  This allows immediately withholding relief so that foreign persons have funds available to invest the entire amount of eligible gain into a QOF.  A security-required person that does not obtain an eligibility certificate before the applicable transfer must comply with the withholding requirements and, in addition, must still obtain an eligibility certificate afterwards by the date on which the gain deferral election is filed. [10]  
 
The proposed regulations provide that a taxpayer that is a security-required person may not make a deferral election under Section 1400Z–2(a) with respect to part or all of a security-required gain from a covered transfer unless the taxpayer obtains an eligibility certificate from the IRS with respect to such security-required gain by the date on which the deferral election is filed with the IRS. [11] The eligibility certificate must specify the permitted deferral amount, and the taxpayer may not make a deferral election with respect to the security-required gain in an amount that exceeds the permitted deferral amount. [12]
 
To obtain an eligibility certificate for any security-required gain, a security-required person must submit an application to the IRS. [13]

The Deferral Agreement will require the security-required person to do the following [14]:
 
(i) timely file a federal income tax return and pay any tax liability due on the deferred gain when required;
(ii) report any gain in accordance with the regulations under Code Section 1400Z-2;
(iii) provide security to the IRS with respect to any tax liability due on deferred gain; and
(iv) appoint a U.S. person to act as the security-required person’s limited agent for certain purposes specified in the Deferral Agreement.

The Deferral Agreement must conform to a template to be published in the Internal Revenue Bulletin. [15]
 
The Proposed Regulations relating to covered transfers, including the requirement for eligibility certificates, will apply to any covered transfer that occurs after the date that these regulations are published as final regulations in the Federal Register. Taxpayers should not submit applications for eligibility certificates before the date that these regulations are published as final regulations. Any applications submitted before such date will not be processed by the IRS.
 
The good news is that the IRS has proposed a mechanism that, if implemented in a practical and workable manner, will allow foreign persons and foreign-owned partnership to invest in QOFs and to avoid the FIRPTA withholding regime by providing timely requests for Eligibility Certificates and then posting adequate collateral under a Deferral Agreement. That said, the procedures are very detailed and cumbersome and represent, in the end, a strong desire to collect taxes that will eventually come due – i.e., the same goals and motivations that inspired the FIRPTA withholding requirements in the first place. Note that the withholding obligations can be avoided by obtaining the requisite paperwork and permissions in advance of the taxable transfer or can be offset by refunds and tax credits when the related tax return is filed – although either alternative requires that the Eligibility Certificate and other documentation be put in place timely.
 
Is the process cumbersome and documentation intensive? Yes. Does it represent a reasonable balance between fairness to foreign taxpayers and protection of the collection interests of the Treasury and IRS? Probably. Are we going to spend a lot of time studying these rules and procedures? Certainly.
 
Note:  Comments are due on the Proposed Regulations by June 11, 2021.


 
[1] “Requirements for Certain Foreign Persons and Certain Foreign-Owned Partnerships Investing in Qualified Opportunity Funds and Flexibility for Working Capital Safe Harbor Plans”, Federal Register, Vol. 86, No. 70, Wednesday April 14, 2021, pp, 19585 – 19598.
[2] All references to “Code” refer to the Internal Revenue Code of 1986, as amended.
[3] Code Section 1400Z-2(d)(3)(A)(ii) imports these requirements by cross-reference to Code Section 1397C(b)(8).
[4] Treas. Reg. § 1.1400Z2(d)-1(d)(3)(iv).
[5] Federal Register, Vol. 85, No. 8, pp. 1866 -2001, Monday, January 13, 2020.
[6] The 31-month time period – and indeed the entire concept of the Working Capital Safe Harbor – is not found in the statute but rather was created and then refined by Treasury and the IRS during the evolutionary process of issuing the Final Regulations (defined below).  The IRS during informal discussions with the Authors indicated that the 31-month period was derived so that it could cover the 30-month period allowed for a substantial improvement project under [cite].
[7]  Treas. Reg. § 1.1400Z2(d)-1(d)(3)(v)(A) through (C)
[8] Treas. Reg. § 1.1400Z2(d)-1(d)(3)(vi)(A).
[9] On March 13, 2020, President Trump declared a nationwide emergency pursuant to Sec. 501(b) of Stafford Act, thereby making it unnecessary for the governors of the separate states to request individual emergency declarations, and this formal designation of a nationwide federally declared disaster remains in effect at the publication date of this article.
[10] Proposed Regulations Section 1.140Z2(a)-1(a)(3)
[11] Proposed Regulations § 1.1400Z2(a)–1(a)(3)
[12] Id.
[13] Proposed § 1.1400Z2(a)–2(d)(2).
[14] Proposed § 1.1400Z2(a)–2(d)(4)(ii).
[15] Proposed § 1.1400Z2(a)–2(d)(4)(i).

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