Seyfarth Synopsis: On December 19, 2019, the U.S. Treasury issued final Qualified Opportunity Zone regulations (the “Final QOZ Regulations”). Subject to the commentary in the Preamble to the Final QOZ Regulations on circular cash flows and step transactions more fully discussed below, which commentary raises more questions than it answers, the Final QOZ Regulations clarify and, in some key respects, helpfully liberalize rules established in the two tranches of proposed Qualified Opportunity Zone regulations (the “Proposed QOZ Regulations”). In sum, the Final QOZ Regulations should serve as a catalyst to significant growth in the development of Qualified Opportunity Funds (“QOFs”).
This legal update focuses on issues relating to the capitalization and operation of QOFs and Qualified Opportunity Zone Business subsidiaries (“QOZ Subsidiaries”). In a separate and forthcoming legal update, we will undertake to describe certain key items addressed in the Final QOZ Regulations that are of particular relevance to investors.
A. There were several areas where the U.S. Treasury provided clarification or liberalization, including the following:
1. Exit Strategies Liberalized and (Almost Entirely) Equalized: One of the critical limitations of the Proposed QOZ Regulations was that the only way for investors in a QOF to receive the full benefit of the step-up of their basis in their ownership interest in the QOF (the “FMV Step-Up”) and the resulting elimination of gains after the required 10-year investment period was for them to sell their ownership interests in the QOF (“QOF Interests”). Other exit strategies were disadvantaged from an income tax perspective. The Proposed QOZ Regulations provided that if the QOF sold its QOZ Subsidiary, then investors in the QOF could only exclude capital gain allocable to them as a result of the sale (and not any ordinary income elements arising from such sale such as depreciation recapture) and they did not address the consequences to QOF investors of a sale by a QOZ Subsidiary of its “qualified opportunity zone business property” (“QOZ Property”).
The Final QOZ Regulations almost entirely eliminate the distinction between a sale by a QOF investor of its QOF Interest, on the one hand, and the sale by the QOF of its QOZ Subsidiary or by a QOZ Subsidiary of its QOZ Property, on the other, for purposes of the FMV Step-Up. Under the Final QOZ Regulations, the only item that continues to receive ordinary income treatment (and is not eligible for the FMV Step-Up) is inventory sold in the ordinary course of business.
By requiring nonsensical QOF exit strategies for investors, the rules set forth in the Proposed OZ Regulations significantly hamstrung the initial growth of the QOF industry. The equalization of exit strategies provided for in the Final QOZ Regulations should go a long way to facilitate the development of new QOF investment programs.
2. Working Capital Deployment Rules Facilitate Longer Development Timelines: One of the more helpful elements of the Proposed QOZ Regulations was the promulgation of the 31-month working capital on-ramp (the “Working Capital Safe Harbor”), which allows QOZ Subsidiaries to exclude their cash on hand from treatment as Non-Qualified Financial Property (which treatment may cause the QOZ Subsidiary to fail to qualify as such) so long as when the QOZ Subsidiary receives the cash in question it has a reasonably detailed written plan in place that accounts for its deployment over the 31-month period following receipt, and the cash is actually deployed in a manner substantially consistent with the written plan during the 31-month period following receipt. The Final QOZ Regulations amplify the Working Capital Safe Harbor in two key ways:
a. They provide for the possibility of multiple serial investments of cash into a QOZ Subsidiary, each of which can have its own 31-month deployment schedule so long as the total amount of time covered by all such written plans and cash deployments is no greater than 62 months.
b. They expand upon the “tolling” of the 31-month maximum deployment period caused by zoning and permitting delays by (i) clarifying that permits underlying the delay must be applied for within the original 31-month period and may be extended only for the period of the delay, and (ii) expanding the 31-month period by up to an additional 24 months for projects located in a federally declared disaster area.
3. Offering Expenses, Selling Commissions, and Similar QOF Organizational Costs Are Not Assets (Good or Bad) for Purposes of the 90% Asset Test: Some practitioners were concerned that, due to certain language in Code Section 706 regarding the treatment of organization and offering expenses, the amount of such expenses could be treated as an asset of a QOF structured as a tax law partnership that would not count towards satisfaction of the QOF’s 90% asset test. Our view was that such expenses did not actually create an asset and thus should not be counted, one way or the other, for purposes of the 90% asset test. The Final QOZ Regulations confirmed our view.
4. Buildings May Be Aggregated for Purposes of Satisfying the “Substantial Improvement” Test: The Final QOZ Regulations added a helpful new rule that provides that certain buildings can be aggregated and treated as a single item of property for purposes of satisfying the “substantial improvement” test. Specifically, if two or more buildings are located within a qualified opportunity zone or a single series of contiguous qualified opportunity zones (an “Eligible Building Group”) and can be aggregated and treated as a single property under the rules described below, then the amount of basis required to be added to those buildings to satisfy the substantial improvement requirement will be calculated by aggregating the basis of each such building comprising the single property and additions to the basis of each building comprising the single property.
Generally speaking, the rules permit aggregation and treating multiple buildings as a single property when (i) the buildings are located entirely within the geographic borders of a parcel of land that is described as a single property in a single deed, or (ii) the buildings are located entirely within the geographic borders of contiguous parcels of land described as a single property in separate deeds to the extent each building is operated as part of one or more trades or businesses that meet the following three requirements: (1) the buildings must be operated exclusively by the QOF or by the QOZ Subsidiary; (2) the buildings must share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources; and (3) the buildings must be operated in coordination with, or reliance upon, one or more of the trades or businesses (for example, supply chain interdependencies or mixed-use facilities).
5. Vacancy Period for Property to be Considered “Original Use” Property Reduced: The Final QOZ Regulations provided a helpful reduction in the period of time that property must remain vacant before a purchaser of the property can treated as the original user of the property in the qualified opportunity zone. Under the Proposed QOZ Regulations, property must have remained vacant for 5 years before a new owner could be considered the original user of the property. The Final QOZ Regulations reduce the period to 3 years and further provide that if the land was vacant on the date of publication of the qualified opportunity zone designation notice for the zone in which the property is located, then the vacancy period is only 1 year. The liberalization of the vacancy rules will provide significant incentive for sponsors to seek out vacant property in qualified opportunity zones and purchase and develop the property.
6. Brownfield Site Cleanup Will Cause Property to be “Original Use” Property: The Final QOZ Regulations provide that if a QOF or QOZ Subsidiary purchases a brownfield site and, within a reasonable period of time, makes investments in the brownfield site to ensure that all property composing the brownfield site meets basic safety standards for both human health and the environment, then all property composing the brownfield site (including the land and the structures thereon) will be considered “original use” property.
7. Safe Harbors Partially Clarified for Determining Whether a QOZ Subsidiary’s Business is an Active Trade or Business for Purposes of the 50% Gross Income Test: The Proposed QOZ Regulations provided three safe harbors (and a fallback facts and circumstances test) for determining whether a QOZ Subsidiary’s trade or business in a qualified opportunity zone has generated sufficient income to satisfy the 50 percent gross income requirement. The Final QOZ Regulations address these rules as follows:
a. First, the Final QOZ Regulations clarify that if a QOZ Subsidiary’s trade or business is conducted in multiple qualified opportunity zones, it can aggregate activities for purposes of the safe harbors.
b. Second, with respect to the two safe harbors that are based upon the percentage of services performed in qualified opportunity zones, which are (i) the “hours performed test” (i.e., total number of hours performed by employees and independent contractors and employees of independent contractors in a qualified opportunity zone) and (ii) the “amounts paid test” (i.e., amounts paid to employees and independent contractors and employees of independent contractors in a qualified opportunity zone), the Final QOZ Regulations provide helpful calculation rules and clarify that services performed by certain partners of the QOZ Subsidiary count towards the hours/pay calculation.
However, the Final QOZ Regulations provide no additional guidance with respect to the “center of operations” test (i.e., a trade or business satisfies the 50 percent gross income requirement if each of (i) the tangible property of the trade or business located in a qualified opportunity zone, and (ii) the management or operational functions performed in the qualified opportunity zone, are necessary for the generation of at least 50 percent of the gross income of the trade or business). The Preamble to the Final QOZ Regulations describes several of the issues identified by commenters (difficulty determining when an asset generates income, failure to define “operational functions”, lack of methodology for tracing income generated from tangible property and managerial or operational functions, failure to include administrative functions or address remote and mobile workforces in sufficient detail), and acknowledges that businesses with unconventional management and operational structures, as well as tangible property located both inside and outside of a qualified opportunity zone, would benefit from additional guidance and states that it will continue studying the issues and perhaps issue additional guidance.
8. Self-Constructed Property is Generally QOZ Property Treated as Acquired When Physical Work of a Significant Nature Begins: The Final QOZ Regulations helpfully provide that if a QOZ Subsidiary manufactures, constructs or produces tangible property, then such property will be considered QOZ Property so long as the QOF or QOZ Subsidiary owner of such property intends to use the property in its trade or business within the qualified opportunity zone and the materials and supplies used are QOZ Property. Moreover, the Final QOZ Regulations provide that for purposes of the 90 percent good asset test for QOFs and the 70 percent good tangible asset test for QOZ Subsidiaries, self-constructed property will be treated as acquired on the date physical work of a significant nature begins on the property.
B. There were several areas where the U.S. Treasury declined to liberalize the Qualified Opportunity Zone rules, including the following:
1. No Income Tax Deferral on Dispositions and Reinvestments by QOFs and QOZ Subsidiaries: The Final QOZ Regulations declined to create an income tax deferral mechanism, beyond existing mechanisms such as those that exist under Code Sections 1031 or 1033, that would allow QOFs and QOZ Subsidiaries to sell their QOZ Property and reinvest in other QOZ Property within a reasonable time frame. Accordingly, while cash that a QOF or QOZ Subsidiary receives from such a sale may be held for up to 12 months without triggering adverse QOF qualification issues, the income tax consequences of such sales are only deferred if the QOF or QOZ Subsidiary sells its QOZ Property using an existing tax deferral regime, such as Code Sections 1031 or 1033, and are otherwise taxed on a current basis.
2. Contributed Property is Per Se Not QOZ Property: One of the quirkier elements of the April 2019 Proposed QOZ Regulations was their elaborate discussion of the treatment of property contributed to a QOF or QOZ Subsidiary. The Final QOZ Regulations confirm that, while such property can be received and held by a QOF or QOZ Subsidiary and can count as a qualifying investment by the contributing investor, such property cannot be QOZ Property, and thus will not count as a qualifying asset for purposes of the QOF or QOZ Subsidiary asset tests.
3. Carried/Capital Mixed Investment Allocations Still Unfavorable: The Proposed QOZ Regulations stipulated, and the Final QOZ Regulations have confirmed that, in the case of a mixed investment consisting of both a capital interest and a carried interest in a partnership or LLC, the allocation of tax items between the two interests would be based on the highest share of residual profits allocable to the carried interest under the relevant operating agreement (excepting only residual shares for which there is no reasonable likelihood of application). Because carried interests are not considered investments that qualify for qualified opportunity zone tax benefits and because carried interests rarely have an effective economic value equal to their highest allocation percentage, this rule siphons tax benefits away from otherwise qualifying investments in QOFs. Well-advised investment program sponsors have known for months how to avoid this pothole: by ensuring that a carried interest and a capital interest are held by separate tax-regarded entities.
4. No Relaxation of Non-Qualified Financial Property Rules and No Pronouncements on Debt/Equity Characterization Issues: The Final QOZ Regulations avoided liberalizing the Non-Qualified Financial Property rules, incorporated into the qualified opportunity zone provisions from Code Section 1397C. Among other things, the Final QOZ Regulations create no exception to the rule that a QOZ Subsidiary cannot own any equity interest in another tax-regarded entity, and cannot hold most types of debt instruments. Relatedly, the Final QOZ Regulations decline to make new pronouncements on debt/equity characterization issues, leaving it to investors and their advisors to determine when an interest in a QOF or QOZ Subsidiary is equity or debt based on preexisting jurisprudence.
5. Generally Speaking, Owning Property Subject to a Triple-Net Lease is Still Not a Good Qualified Opportunity Zone Business: The Final QOZ Regulations declined to modify the general rule, originally promulgated in the Proposed QOZ Regulations, that ownership of property subject to a triple-net lease is not considered to be the active conduct of a trade or business. The Final QOZ Regulations contemplate that a QOF or QOZ Subsidiary that owns a single property with multiple leases will not be deprived of active trade or business status merely because a minority of the leases are triple-net leases (one third of leases in an example in the Final QOZ Regulations). Examples in the Final QOZ Regulations also suggest that in order to avoid status as a triple-net lease, the lessor must meaningfully participate in the management and operation of the leased property.
6. Anti-Abuse Rule for Property Purchased by a QOF or QOZ Subsidiary with a Plan, Intent or Expectation to Resell the Property Back to the Sellers for Any Amount Except for Fair Market Value: The Final QOZ Regulations provide a new rule that if, at the time a QOF or QOZ Subsidiary purchases real property, there was a plan, intent, or expectation for the real property to be repurchased by the seller of the real property for an amount of consideration other than the fair market value of the real property, then the purchased real property is not QOZ Property. This rule is identical to the one previously established in the Proposed QOZ Regulations for property leased by a QOF or QOZ Subsidiary.
C. Circular Cash Flow and Step Transaction Commentary in the Preamble to the Final QOZ Regulations Raises More Questions than it Answers:
The Final QOZ Regulations provide significant and generally favorable clarification of the rules applicable to capitalization and operation of QOFs and QOZ Subsidiaries. However, statements in the Preamble to the Final QOZ Regulations and an example added to the anti-abuse rule adopted in the Final QOZ Regulations cast an arguably unnecessary cloud over many active and potential QOZ transactions.
The Final QOZ Regulations add an example (the “QOZ Anti-Abuse Example”) to the general anti-abuse rule (“QOZ Anti-Abuse Rule”) set forth in the Proposed QOZ Regulations. The stated purpose of the QOZ Anti-Abuse Rule was to interdict transactions (or series of transactions) if any one of their significant purposes was to achieve a tax result that is inconsistent with the purposes of the QOF regime. The QOZ Anti-Abuse Example added in the Final QOZ Regulations applies the QOZ Anti-Abuse Rule to a situation in which an otherwise unrelated person sells tangible property to a QOZ Subsidiary with a plan or intent to invest the capital gain resulting from the sale in the QOF that owns the QOZ Subsidiary. The origins of the QOZ Anti-Abuse Example are described in the Preamble to the Final QOZ Regulations as arising from questions received during the regulatory comment period regarding an investor’s investment of qualified gains in a QOF arising from an otherwise non-related-party sale by the investor of property to that QOF (or its QOZ Subsidiary). Specifically, the Preamble states that if, as part of a plan, a person sells QOZ Property to a QOF or a QOZ Subsidiary and then invests cash attributable to the gain he, she or it recognizes on the sale of that QOZ Property into the same QOF or QOZ Subsidiary to which it sold the QOZ Property, then the step transaction doctrine and circular cash flow principles may apply to the sale and investment such that the sale and investment may be disregarded and the transaction may be recharacterized as a contribution of the QOZ Property to the QOF or QOZ Subsidiary. If such recharacterization were to apply, the investor’s cash contribution to the QOF or QOZ Subsidiary will not be treated as a qualifying investment and the property would not be QOZ Property. That is the conclusion of the QOZ Anti-Abuse Example.
The Preamble describes this outcome as a function of the step transaction doctrine and circular cash flow principles, as emblematized by Revenue Rulings 82-142 and 78-397, and thus is problematic for at least two reasons. First, although no specific rules are set forth in the Final QOZ Regulations on these matters beyond the QOZ Anti-Abuse Example itself, it is implied that because these principals arise as part of the background common law of tax law, they apply to all transactions without regard to the otherwise-applicable effective date of the Final QOZ Regulations (described in Section D of this legal update below). Second, because application of both the step transaction doctrine and circular cash flow principles is driven by the facts and circumstances of the transactions to which they are applied, there is bound to be meaningful uncertainty around the scope of these principles and how they operate.
While a full discussion of the step transaction doctrine and circular cash flow principles is outside the scope of this legal update, given the potential impact of the QOZ Anti-Abuse Example to ongoing and closed transactions, a few points about them are worth making. First, there is no clearly stated, commonly accepted set of principals around matters of circular cash flow. Rather, in certain circumstances, the step transaction doctrine can be applied to a circular cash flow pattern to reveal that, because cash ended up where it started, the steps undertaken in the journey of the cash should be ignored. Second, the tests applied by courts in determining whether to invoke the step transaction doctrine generally require the steps to be preplanned and interdependent. Third, against this backdrop lies a general principle of tax law that taxpayers are not required to arrange their business transactions to maximize their income tax obligations.
When this body of the common law of tax law is applied to a potential circular cash flow fact pattern such as the one identified in the Preamble to the Final QOZ Regulations and the QOZ Anti-Abuse Example, a few questions are raised, including:
- Would circular cash flow principles only apply if such a transaction were preplanned and interdependent?
- Would circular cash flow principles not apply if, when a sale of property precedes an investment of cash, the investment occurs more than 180 days after the date of the sale?
- Notwithstanding the fungibility of cash, if an investor is able to trace cash arising from a sale of property to a QOF or QOZ Subsidiary and establish that any investment the investor makes in such purchasing entities did not arise from such sale, would circular cash flow principles be applied?
- Would circular cash flow principles apply if the investor does not claim qualified opportunity zone tax benefits with respect to its investment?
- Assuming that a sale of property would generate both gains and tax basis recovery, and only the gains are reinvested in the QOF or QOZ Subsidiary buyer, would circular cash flow principles require the bifurcation of the transaction into a part sale/part contribution and thus the bifurcation of the property, in the hands of the QOF or QOZ Subsidiary, as part qualifying asset and part nonqualifying asset?
As a result of the foregoing, in any situation potentially involving a reinvestment by a seller of property to a QOF or its QOZ Subsidiary of sales proceeds into the QOF, investment program sponsors and QOF investors will need to coordinate carefully with their tax advisors to ensure, as much as possible, that their transactions either are not subject to the step transaction doctrine and circular cash flow principles or, if they are, that the consequences do not disrupt the qualification of the QOF or QOZ Subsidiary for qualified opportunity zone benefits.
D. Transition Rules for Application of the Proposed and Final QOZ Regulations:
The Preamble to the Final QOZ Regulations provides that they apply to tax years beginning after March 13, 2020 (i.e., 60 days following the publication of the Final QOZ Regulations in the Federal Register on January 13, 2020). With respect to tax periods beginning after the effectiveness of the qualified opportunity zone statute and before March 13, 2020, taxpayers can apply either the Final QOZ Regulations or the Proposed QOZ Regulations, in each case if they are applied consistently for all prior tax periods.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.