The United States Congress enacted the 'Qualified Opportunity Zone' ('QOZ') regime in 2017 as part of its broad package of US federal tax reform legislation. In certain circumstances, the QOZ regime allows investors to defer or permanently avoid US federal income tax on capital gains by 'rolling over' the amount of the potential gain into one or more development projects located in historically low-income regions of the United States.
We have previously highlighted the significant tax-saving opportunities generally available through QOZ investments. For reasons explained in this article, however, investors who are subject to income or capital gains tax in more than one jurisdiction may find themselves unable to take advantage of these potential benefits. It is crucial that cross-border investors carefully consider, before consummating a QOZ investment, whether the US federal tax savings purportedly resulting from the investment will actually leave them better off from a worldwide, aggregate-level tax perspective.
By way of background, if an investor is selling or exchanging an asset at a gain for US tax purposes, the QOZ regime provides for at least three different ways in which he or she may defer or eliminate the US federal income tax that might otherwise be imposed on the transaction:
- First, the investor may defer US federal income tax on a potentially taxable capital gain (an 'eligible gain') by electing to roll over the gain into a 'Qualified Opportunity Fund' ('QOF'). A QOF generally means a fund organized by a sponsor for the express purpose of engaging in business or development activity in one of a number of specifically designated low-income US census tracts. Eligible gain generally means a capital gain that (i) would be 'recognized' for US federal income tax purposes if the investor did not elect to roll it over into a QOF, and (ii) does not arise from a sale or exchange with a party that is related, in certain specific respects, to the investor. An investor is potentially eligible to invest in a QOF regardless of whether he or she is a US income tax resident in the year of the sale.
- Second, the investor can permanently exclude up to 15 percent of the amount of gain initially rolled over into the QOF to the extent he or she holds the QOF investment for seven years or longer.
- Third and lastly, if the investor holds his or her QOF investment for more than 10 years, all of the post-rollover portion of the untaxed appreciation in the investor's QOF interest is permanently excluded from the investor's US federal taxable income, even after the investor has fully exited the QOF.
These benefits may ultimately be for naught, however, in the case of investors who are subject to income or capital gains tax in more than one jurisdiction. Consider, for example, an investor who is both a US citizen and a UK tax resident. Such an investor would nominally be subject to income and capital gains tax in both the US and the UK on a worldwide basis in each jurisdiction. He or she would typically rely on so-called 'foreign tax credits' in order to avoid being taxed twice on the same economic income. Generally speaking, once foreign tax credits are taken into account, the investor would tend to pay income or capital gains tax on the relevant income or gains at the higher of the two countries' respective tax rates.
The problem is that since there is nothing in the UK tax system resembling the US QOZ regime, any gain deferred or excluded for US tax purposes by way of a QOF investment would still generally be subject to UK capital gains tax in the year of the initial sale or exchange. Any deferral or exclusion of US taxable income as a result of a QOF rollover would generally reduce the investor's US tax liability for the sale or exchange year, and hence the amount of UK foreign tax credits available to the investor to offset that year's UK capital gain tax liability. This, in turn, would trigger a commensurate increase in the investor's bottom-line UK capital gains tax bill for that year. The end result of this dynamic is that the nominal US federal tax savings achieved through the QOF structure could be completely offset by a corresponding increase in UK capital gains tax. Even worse, owing to timing restrictions on the use of the US foreign tax credit, if and when the deferred portion of the investor's eligible gain is ultimately subject to US tax, the investor would likely be unable to claim, in that later year, an offsetting US foreign tax credit for the UK capital gains tax previously paid during the initial sale or exchange year. Thus, the investor could ultimately be subject to capital gains tax twice on the same economic gain, with no ability to offset one jurisdiction's tax against that of the other at any point in time. This example illustrates that a cross-border investor who elects to defer gain in a QOF structure could, absent careful planning, actually worsen his or her overall tax position as compared with a conventional, fully taxable investment structure.
The above concerns will not necessarily apply to all cross-border or dual-resident investors. For example, UK-resident investors who claim the remittance basis of taxation, or investors who reside in jurisdictions that impose no or little tax on capital gains, can—with proper advice and structuring—still meaningfully benefit from the QOZ regime. A UK remittance-basis investor who plans never to remit any of his or her gains to the UK is better positioned to reap the QOZ regime's tax-savings opportunities than a regular UK tax resident; he or she would not expect to ever incur any residual UK capital gains tax at any point, and would therefore be unconcerned with the mechanics of the foreign tax credit or double taxation generally. A similar dynamic would apply in the case of a US-citizen (or otherwise US-connected) investor who resides in a jurisdiction that imposes zero or de minimis capital gains on its own residents.
Withers can assist in evaluating potential QOZ investments from a legal point of view, and also to ensure that an investor's QOZ interest is optimally structured from a US and non-US tax perspective.
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.