QOF Eligibility Certification Ranks High Among Individual’s Concerns

June 9, 2021

CC:PA:LPD:PR (REG-121095-19)
Room 5203
Internal Revenue Service
PO Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Requirements for Certain Foreign Persons and Certain Foreign-Owned Partnerships Investing in Qualified Opportunity Funds and Flexibility for Working Capital Safe Harbor Plans (REG-121095-19)

Dear Sir or Madam,

This letter comments on a few issues in connection with the proposed regulations in REG-121095-19, 86 Fed. Reg. 19585 (April 14, 2021).

1. A widely held foreign partnership should be able to obtain an eligibility certificate, to avoid section 1445 and section 1446(f) withholding when it is making a QOF investment.

The proposed regulations use an “eligibility certificate” for two different goals: (i) foreign persons are permitted to avoid section 1445 and section 1446(f) withholding on their gains effectively connected with the conduct of a U.S. trade or business (ECI gains) by obtaining an eligibility certificate and later investing those gains in a QOF,¹ and (ii) certain foreign persons and foreign-owned domestic partnerships must obtain an eligibility certificate if they are deferring their ECI gains by investing in a QOF, in order to ensure that federal income taxes on the deferred ECI gains are collected in 2026 (or an earlier inclusion event).²

One eligibility certificate addresses both goals, which may be unsuitable in some cases.

As an example, only certain foreign partnerships are permitted to obtain eligibility certificates, even though all foreign partnerships are potentially subject to section 1445 or section 1446(f) withholding on their ECI gains. Specifically, a foreign partnership must meet an ownership test, a closely-held test, and a gain or asset test in order to qualify as a “security-required person” that can request an eligibility certificate.³

All foreign partnerships are subject to section 1445 or 1445 withholding, but not all foreign partnerships meet the three requirements to be a security-required person. There is no reason why section 1445 or section 1446(f) withholding should apply to a foreign partnership that is owned less than 20% directly or indirectly by nonresident aliens or foreign corporations, that is owned more than 90% by an upper-tier partnership or a small set of direct partners, or that fails to meet the gain or asset test's numerical thresholds, if the foreign partnership is willing to meet the requirements to obtain an eligibility certificate. All foreign partnerships should have the option to invest its ECI gains in a QOF without having to be subject to section 1445 or section 1446(f) withholding taxes and then wait for a tax refund.

2. A domestic partnership that has solely domestic partners and is not controlled by a nonresident alien or foreign corporation should not need an eligibility certificate to invest in a QOF.

As another example, some domestic partnerships must obtain an eligibility certificate in order to invest in a QOF. A domestic partnership with ten or fewer direct partners is generally required to obtain an eligibility certificate, even if the direct partners are all domestic, if the domestic partnership has more than 20% foreign indirect partners.

A domestic partnership may experience administrative costs, complexity, and burdens in determining the exact ownership of its minority indirect partners, particularly because the domestic partnership never previously had any reason to investigate its indirect partners when all of its direct partners are domestic entities that are not subject to withholding under sections 1441 through 1446. A domestic partnership and its domestic owners should not be burdened with a requirement of an eligibility certificate merely due to the existence of indirect foreign partners that owns a minority interest in the domestic partnership, particularly if the indirect foreign partners are numerous and dispersed in ownership numbers.

For example, a domestic partnership LTP is owned 90% by a domestic partnership UTP and 10% by a U.S. citizen. UTP is owned by many funds. One fund owns 60% of UTP and is itself owned 4% by each of ten foreign corporations. LTP is indirectly owned 21.6% by the ten foreign corporations and meets the ownership test and the closely-held test. LTP has to obtain an eligibility certificate if it recognizes a certain amount of gains, despite the tenuous link between LTP and its indirect and non-controlling foreign corporate owners. An eligibility certificate should only be necessary if LTP is controlled by a nonresident alien or foreign corporation that owns indirectly more than 50% of LTP's capital and profits.

3. An eligibility certificate should not be required for security-required gains that are not subject to U.S. federal income tax.

A. security-required person needs an eligibility certificate to invest security-required gains, i.e., ECI gains, in a QOF. A domestic or foreign partnership does not need an eligibility certificate to invest its non-ECI gains in a QOF, such as gains from the disposition of the stock of a domestically controlled REIT and many other U.S. stocks and securities, even if some or all of the gains are allocated to foreign persons, subject to the Treas. Reg. 1.1400Z2(f)-1(c)(2) anti-abuse rule.

Non-ECI gains do not require an eligibility certificate because the deferred non-ECI gains are not subject to U.S. federal income tax on December 31, 2026 (or an earlier inclusion event). For the same reason, an eligibility certificate should be unnecessary for any ECI gains that are not subject to federal income tax, such as:

• ECI gains that are not subject to federal income tax under section 892, including a foreign sovereign's or controlled entity's (i) gains from the disposition of the stock of a U.S. real property holding corporation that is not a controlled commercial entity, and (ii) REIT capital gain dividends that are not paid by a controlled commercial entity and are not attributable to section 897(c)(1)(A)(i) gains, such as from the REIT's disposition of corporate subsidiaries and interests in partnerships that own corporate subsidiaries, and

• A domestic partnership's ECI gains that are not subject to federal income tax under a U.S. income tax treaty because the ECI gains are not attributable to a permanent establishment in the United States. The treaty-waiver rule in Treas. Reg. 1.1400Z2(a)-1(b)(11)(ix)(A) does not apply to domestic partnerships.

4. An eligibility certificate's deferral agreement and security should be allowed to terminate earlier if the taxpayer fails to invest in a QOF.

A taxpayer can obtain an eligibility certificate by (i) entering into a deferral agreement that expires on or after 36 months after the extended due date of the taxpayer's federal income tax return for the taxable year that includes an inclusion event or December 31, 2026,⁴ and (ii) providing security to the IRS with a maturity date or expiration on or after the same date.⁵

If the taxpayer never invests in a QOF, it never has an inclusion event and effectively cannot end the deferral agreement and the security before 2030. In contrast, a taxpayer can end the deferral agreement and the security early by investing in a QOF and immediately triggering an inclusion event, after which the deferral agreement and the security can end around 36 months later.

The deferral agreement and the security should be allowed to terminate or expire earlier if the taxpayer never invests in a QOF, such as upon 36 months after the extended due date of the taxpayer's federal income tax return for the taxable year that includes the end of the security-required gain's 180-day investment period (or other period as extended by Treasury Regulations or other IRS guidance). The IRS should not have any need for the taxpayer to maintain the deferral agreement and security beyond that time.

5. The 180-day period to invest in a QOF should be tolled while the taxpayer waits for an eligibility certificate.

The IRS generally will issue an eligibility certificate within 90 days after all the information necessary for the IRS to make a determination is received, although the period may be extended in the IRS's discretion in unusual circumstances.⁶

Given that a taxpayer generally has only around 180 days after realizing the security-required gain to invest in a QOF,⁷ the 180-day investment period should be tolled while the taxpayer applies for an eligibility certificate and waits for the IRS's determination. Absent such tolling, a security-required person may have only a short window of time to invest in a QOF after it receives the eligibility certificate.

Treasury and the IRS were able to think outside the statutory box and extend the 180-day investment period to over 600 days for some partners in partnerships with realized gains. A partner can start its 180-day investment period for a partnership's gains on March 15 of the following year,⁸ which means that a partnership's gains recognized on January 1, 2021 can be deferred by the partner investing in a QOF in September 2022. The rationale for the extended investment period is that the partner may not know about partnership-level gains until the partner receives a Schedule K-1 from the partnership by next year's March 15 (or later with extensions). Similarly, a security-required person will not know whether it is able to invest in a QOF until it has received the eligibility certificate from the IRS.

A security-required person may have both security-required gains and other gains that can be deferred by investing in a QOF, such as a domestic partnership's gains that are allocable to both foreign and domestic partners. A domestic partnership may have a QOF investment that needs both gains to be invested at the same time. The tolling of the 180-day investment period should apply to all of a domestic partnership's eligible gains, whether or not they are security-required gains, while the domestic partnership waits for the eligibility certificate, in order to ensure that the domestic partnership can fully invest in a QOF in a timely manner.

6. If a foreign taxpayer was subject to withholding and later obtains an eligibility certificate, the withheld tax should be refunded when the certificate is issued.

Foreign persons are permitted to avoid section 1445 or section 1446(f) withholding on their ECI Gains by obtaining an eligibility certificate.⁹ But the IRS may take 90 days or more to issue an eligibility certificate, at which point the sale or other disposition has already occurred and was subject to withholding.

The 90 days for the eligibility certificate seems to be modeled upon the 90 days to issue a FIRPTA withholding certificate.¹⁰ However, a foreign person who is obtaining an eligibility certificate may need substantially more time to prepare for the certificate, including negotiations for the required security and U.S. agent. Furthermore, the foreign person who is obtaining an eligibility certificate may need the withheld cash within 180 days or less in order to invest in a QOF and cannot wait for a later tax refund like other foreign taxpayers.

Accordingly, if a taxpayer is subject to section 1445 or section 1446(f) withholding first and obtains an eligibility certificate later, the taxpayer should receive a refund of the withheld taxes when the eligibility certificate is issued. The security and other conditions for the eligibility certificate should be sufficient for the IRS to not worry about whether the taxpayer will pay federal income tax on the security-required gains. In other words, it should not make a difference whether the taxpayer obtains the eligibility certificate first and recognizes the security-required gain later, or vice versa, or vice versa.

7. A partnership should be permitted to specially allocate deferred and non-deferred gains between its domestic and foreign direct and indirect partners.

A domestic or foreign partnership may sometimes be unable or unwilling to obtain an eligibility certificate for its security-required gains. The partnership would likely defer solely its other gains by investing in a QOF, such as its gains allocable to its domestic partners.

The partnership should be able to allocate its deferred gains to the direct and indirect domestic partners and its non-deferred gains to the direct and indirect foreign partners. The partnership's allocations should be deemed to have substantial economic effect under Treas. Reg. 1.704-1(b)(2) and related regulations, even though the allocations do not affect the partners' pre-tax dollars to be received from the partnership. The domestic partners should not be taxed on the gains attributable to the foreign partners who could not benefit from the QOF tax deferral, while the foreign partners should not benefit from the QOF tax deferral that properly belongs to the domestic partners. Similarly, the partnership's basis step-ups under sections 1400Z-2(b) and section 1400Z-2(c) should be allocated solely to the partnership's direct and indirect domestic partners under section 743(b) principles.

I would be happy to discuss the above at your convenience.

Sincerely,

Libin Zhang