Safe Harbor for Insurance Assets Sought for Proposed QOF Regs

U.S. Department of the Treasury
Internal Revenue Service
CC:PA:LPD:PR (REG-120186-18)
1111 Constitution Ave., N.W.
Washington, D.C. 20224

Re: Investing in Qualified Opportunity Zone Businesses (QOZBs)

On behalf of our client, Winston & Strawn LLP is pleased to submit comments in response to the second round of proposed rulemaking under new Section 1400Z-2 of the Internal Revenue Code, as amended (the “Code”), regarding qualified opportunity funds and qualified opportunity zone businesses. We believe that certain restrictions in the regulations are inconsistent with the stated purpose of encouraging investment in distressed communities. We propose that certain changes be made in the final regulations that would further the stated statutory purpose.

This memorandum sets forth our position that an insurance company that is otherwise eligible to be treated as a “qualified opportunity zone business” under new Section 1400Z-2 of the Code should not lose its eligibility under the regulations because of the requirement of Section 1400Z-2(d)(3)(A)(ii) and Proposed Treasury Regulations Section 1.1400Z2(d)-1(d)(5)(iii), which requires that less than five percent (5%) of the average of the aggregate unadjusted bases of a business' property be attributable to nonqualified financial property. Specifically, insurance company general account assets should be excluded from the definition of the nonqualified financial property. We believe that the policy reasons generally furthered by this requirement do not apply to insurance companies.

Statement of Law

The 2017 Tax Cuts and Jobs Act created the new “ Opportunity Zone” (or “OZ”) program to encourage economic growth and investment in economically distressed areas. Among other things, the OZ program provides tax incentives for the investment of private capital in businesses located in specially designated communities across the U.S. Specifically, new Sections 1400Z-1 and 1400Z-2 of the Code, permit investors to defer, and potentially avoid entirely, federal income taxes on certain gains to the extent such gains are invested in qualifying OZ investments for a sufficient duration of time. The OZ program builds on the Code's prior efforts to create tax incentives for private investment in distressed communities, including the New Markets Tax Credit, empowerment zones, enterprise communities and renewal communities, with a goal to promote sustainable economic growth.

Under the OZ program, a qualified opportunity fund (“QOF”) must hold at least ninety percent (90%) of its assets in qualified opportunity zone property.¹ Qualified opportunity zone property includes “qualified opportunity zone business property” used in a trade or business of the QOF as well as an interest in a subsidiary corporation or partnership that conducts a “qualified opportunity zone business” (“QOZB”).²

To qualify as a QOZB, the business must satisfy the following requirements: (i) substantially all of the taxpayer's tangible property, whether owned or leased, used in the business must be QOZBP;³ (ii) at least fifty percent (50%) of a business' total gross income must be derived from the active conduct of a qualified business within a qualified opportunity zone⁴; (iii) a substantial portion of a business' intangible property must be used in the active conduct of a qualified business within a qualified opportunity zone;⁵ (iv) less than five percent (5%) of the average of the aggregate unadjusted bases of a business' property must be attributable to nonqualified financial property (the “5% Test”);⁶ and (v) the entity must not engage in, or lease land to, a so-called “sin business” (which includes a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, gambling facility and liquor store).

With respect to the 5% Test, nonqualified financial property generally includes all debt instruments, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts and annuities but excludes reasonable amounts of working capital held in cash, cash equivalents, debt instruments with a term of eighteen (18) months or less and debt instruments described in Section 1221(a)(4) (accounts receivable acquired in the ordinary course of trade or business for services rendered or sales of inventory property).⁷ Currently, there are no exceptions from the limitation of the 5% Test for companies that otherwise satisfy the requirements of QOZB, such as insurance companies, which are required to invest a significant portion of their assets in financial property to satisfy their obligations to policyholders. Specifically, there are no exceptions similar to the working capital exception for general account assets held by insurance companies.

Analysis

Most insurance companies own significant amounts of real estate and/or financial assets and provide funding to other sectors of the economy through their investment activities. In general, insurance companies invest insurance premiums that they receive from policyholders in assets with features that are aligned with the characteristics of the insurance policies that they sell. Because policyholders often make claims on and withdrawals from their policies many years after they are issued, insurance companies must invest the insurance premiums in the types of assets that will enable the insurance companies to satisfy claims and withdrawals in the distant future. In the absence of a specific exemption, an insurance company investing in a portfolio of long-term assets, which, in most cases, would be treated as “nonqualified financial property,” would not be able to qualify as a QOZB.

The preamble to the first set of proposed regulations under Section 1400Z-2 indicates that this limitation on nonqualified financial property prevents “taxpayers from benefitting from the deferral and exclusion of capital gains from income . . . without also locating investment within a qualifying opportunity zone.”⁸ The intent being that OZ tax benefits should not accrue when an investment does not result in “actually investing in tangible assets within a qualified opportunity zone.” However, we believe that treating an insurance company that locates its headquarters in the qualified opportunity zone, even though it does not satisfy the 5% Test, would not be inconsistent with the intent of the language in the preamble.

Unlike a typical financial services entity, an insurance company is not in the business of managing financial assets for a fee or other compensation. Insurance companies typically hold financial assets in their own account in order to have the funding necessary to provide insurance benefits for their policyholders. In other words, unlike an asset manager whose core business is investing its clients' assets in nonqualified financial property for a fee or other compensation, an insurance company's investment in nonqualified financial property is ancillary to its core business of providing insurance policies and is necessary for it to cover its policy obligations. In fact, most insurance companies outsource the management of their investments to asset managers and don't manage their investments internally. Because of this important distinction, an insurance company should not be treated like other financial services companies and, if it meets the requirements of a QOZB but for the 5% Test, it should be treated as a QOZB. For the reasons described above, the policy rationale behind limiting the amount of nonqualified financial assets that a QOZB may have does not apply in the context of an insurance company that otherwise meets the requirements of a QOZB.

An insurance company that locates its headquarters in the qualified opportunity zone, leases, buys or builds a building in the qualified opportunity zone and hires employees and independent contractors to work from the qualified opportunity zone, is very similar to the example in the preamble to the proposed regulations, which describes a startup business that develops software applications for global sale in a campus located in a qualified opportunity zone and concludes that the startup would be treated as a qualified opportunity zone business.⁹ The main difference between the startup business and the insurance company is that the insurance company needs to have sufficient reserves invested in long-term financial assets to cover its obligations. Both companies would serve to promote growth and revitalization of distressed communities by supporting investment in the operation of trades and businesses in distressed communities, and neither company's core business involves investing in nonqualified financial assets for a fee or other compensation.

The analysis set forth in this memorandum is consistent with the policy reflected in a number of provisions of the Code that an insurance company can be engaged in an active trade or business even though its principal assets consist of financial property. For example, this position has been taken in the following provisions: (i) the passive foreign investment company rules;¹⁰ (ii) the personal holding company rules,¹¹ and (iii) the subpart F income rules.¹²

Furthermore, the analysis set forth in this memorandum is directly analogous to the treatment of land under the proposed regulations under Section 1400Z-2. Pursuant to the proposed regulations the IRS has expressly stated that land can be categorized as either a qualified zone business asset or a passive investment asset. Specifically, the preamble to the second set of proposed regulations under Section 1400Z-2 provides that:

“. . . the holding of land for investment does not give rise to a trade or business and such land could not be qualified opportunity zone property. Moreover, land is a crucial business asset for numerous types of operating businesses aside from real estate development, and the degree to which it is necessary or useful for taxpayers seeking to grow their businesses to improve the land that their businesses depend on will vary greatly by region, industry and particular business.”¹³

Applying these rules by analogy to insurance companies, it is clear that the financial assets used by an insurance company in the active conduct of an insurance trade or business also are “crucial business assets” and should be treated as assets used in an opportunity zone business and not “nonqualified financial property” with the meaning of Sections 1397C(b)(8) and 1397C(e).

Proposal

Based on the analysis above, we believe that the final regulations should provide an exception for an insurance company general account assets, similar to the working capital exception. We propose the following additional safe harbor as a new Prop. Reg. § 1.1400Z2(d)-1(d)(5)(v) to read as follows:

(v) Safe harbor for insurance company general account assets. Solely for purposes of applying section 1397C(e) to the definition of a qualified opportunity zone business under section 1400Z-2(d)(3), nonqualified financial property shall not include insurance company general account assets.