Congress created a guidance dilemma when it adopted the term “substantially all” as the metric against which holding periods and use tests should be measured in the Opportunity Zone regime. There are five places in section 1400Z-2 where the phrase is used. In proposed regulations, Treasury and the IRS decided that the same language in the same statute should have two different numerical thresholds, which is a little awkward as a matter of statutory construction, but a necessary distinction to keep the regime’s sometimes competing goals in check.
The statute is silent about what “substantially all” means in section 1400Z-2(d). Section 1400Z-2(d)(2)(B)(i)(III) requires that “during substantially all” of the period that a qualified opportunity fund holds qualified Opportunity Zone (QOZ) stock, the corporation must be a QOZ business (QOZB). Section 1400Z-2(d)(2)(C)(iii) requires the same of an interest in a partnership that is a QOZB. Section 1400Z-2(d)(2)(D)(i)(III) explains that to have QOZB property, substantially all of the use of the property must be in a QOZ during substantially all of the fund’s holding period for the property. And section 1400Z-2(d)(3)(A)(i) provides that a QOZB is a business in which substantially all of the tangible property owned or leased by the taxpayer is QOZB property. For that purpose, the October 2018 proposed regulations (REG-115420-18) established a 70 percent threshold. Thus, under prop. reg. section 1.1400Z-2(d)-1(c)(6), if 70 percent of the tangible property owned or leased by a trade or business is QOZB property, the trade or business is a QOZB. There was some taxpayer grousing about the numerical threshold, but 70 percent still affords enough flexibility to hold tangible property outside the Opportunity Zone, meaning that some of the forgone revenue from the regime will not benefit communities in Opportunity Zones.
The 2018 proposed regs did not address the other instances of “substantially all” referenced in the statute, but the preamble noted that “several requirements of section 1400Z-2(d) use substantially all multiple times in a row,” and that it would be necessary to interpret the phrase in a way that wouldn’t frustrate congressional intent. The concern was that if Treasury adopted a lower threshold for the phrase when it is used multiple times in a row, the resulting fraction would be too small to be a meaningful restriction on what qualifies as QOZB property.
The preamble to the May 2019 proposed regulations (REG-120186-18) noted that many commentators wanted a lower threshold for the use requirement in section 1400Z-2(d)(2)(D)(i)(III) because it would broaden the options for investment in businesses. The counterargument is that a lower threshold would hurt the low-income communities that the statutory regime is supposed to benefit, as Treasury noted in the preamble. Treasury adopted a 70 percent threshold for testing whether QOZB property is used in a QOZ. The preamble explains that a 90 percent threshold is necessary for the holding period in section 1400Z-2(d)(2)(B)(i)(III), (d)(2)(C)(iii), and (d)(2)(D)(i)(III) to reflect the congressional intent that the regime be focused on investment in designated QOZs. “Using a percentage threshold that is higher than 70 percent in the holding period context is warranted as taxpayers are more easily able to control and determine the period for which they hold property,” the preamble notes. The preamble also explains that the “substantially all” threshold needed to be higher for purposes of the holding period than for purposes of the use test and the QOZB property ownership and leasing test because a 70 percent test in the holding period context could result in “much less than half of a qualified opportunity zone business’s tangible property being used in a qualified opportunity zone.” Accordingly, the second set of proposed regs addressed the meaning of “substantially all” in a comprehensive way, but not an entirely consistent one.
The rationale for including both a 70 percent and a 90 percent threshold for “substantially all” is that Congress couldn’t have intended to allow shorter holding periods to reduce the amount of investment in QOZs. The Economic Innovation Group, which was in large part responsible for the development and shepherding of the QOZ regime through Congress, praised the 70 percent test as achieving the right balance “to ensure that qualifying opportunity funds will not be discouraged when investing in operating businesses as Congress intended.” But not everyone is a fan of a blanket 70 percent test for QOZBs in section 1400Z-2(d)(3)(A)(i). Enterprise Community Partners, a nonprofit focused on investments in affordable housing, argued for a higher threshold for real estate projects because they are static and therefore don’t require as much flexibility in locating tangible property outside an Opportunity Zone as an active business. The New York State Bar Association Tax Section noted that setting the 70 percent thresholds much lower would allow QOZBs to hold material tangible assets outside a QOZ, which would be inconsistent with the policy goals of the regime. The NYSBA Tax Section concluded that “the numerical thresholds set with respect to the uses of ‘substantially all’ are generally appropriate.”
Not-So-Substantial Analogies
Treasury and the IRS were essentially working on a blank slate when defining “substantially all” in the regulations because although Congress has used the phrase before, there’s no precedent for a concrete definition. Congress used the phrase “substantially all” in section 502(b)(2) and (3) to define a trade or business for purposes of the exempt organization rules, but neither the statute nor the regulations define the term. The other instances in which Congress used “substantially all” seem to have largely been understood or interpreted to imply a facts and circumstances determination, so it’s an innovation to apply a numerical threshold. The NYSBA Tax Section noted that Treasury didn’t mention whether it considered a facts and circumstances analysis or the possibility of using a percentage threshold as a safe harbor but agreed that a qualitative standard would “put too much selectivity in the hands of the taxpayers.”
Administrative Issues
There are some potential stumbling blocks in administering the 90 percent test for the holding period. The State Bar of Texas Tax Section suggested that prop. reg. section 1.1400Z-2(d)-1(c)(5) “may be difficult to administer in the context of annual tax accounting periods that include only portions of multi-year holding periods.” The Tax Section noted that assessing whether a QOF met the holding period requirement requires a completed holding period, which isn’t available in any year until the year the holding period ends.
The Tax Section’s preferred solution was to allow taxpayers to make an election, choosing either to apply the holding period requirement to the actual holding period as of a testing date, or choosing to apply the threshold to a projected holding period, which would include a reasonable projection of asset qualification in future periods. The projected holding period could be limited to 10 years, or in the case of intangible property, to the remaining useful life of the asset. The Tax Section also suggested an alternative test that would allow a QOF parent to treat an interest in a QOF subsidiary as a QOZB during an initial start-up period, if Treasury doesn’t adopt the election option.
The NYSBA Tax Section also noted the silence in the proposed rules regarding whether the holding period test is applied only retrospectively or whether anticipated circumstances might also be included. It said a prospective approach would better align with the notion of a start-up period by allowing an entity that does not currently meet the threshold tests to qualify as a QOZB, but section members deemed that impractical.
Putting It All Together
There isn’t perfect clarity about how the 70 percent use test and the 90 percent holding period test will interact. The NYSBA Tax Section pointed out that guidance is still needed on how to measure the holding period component of the QOZB property use test, because the use component of the test is supposed to apply to a particular item of property, but the test in the proposed rules uses an aggregate approach.
The Tax Section suggested that Treasury delete prop. reg. section 1.1400Z2(d)-1(c)(9) and replace it with an overall use test that applies to putative QOZB property of both a QOF and a QOZB. The idea is that if a QOZB uses its QOZB property inside the zone a considerable amount but only for a short time, it should still meet the 70 percent test if its use of the property outside the zone is comparatively much less, even if that use spans a longer time. Treasury and the IRS will need to clarify whether they agree that what matters is the amount of use and not the time period over which the use occurs. Similarly, the Novogradac Opportunity Zones Working Group asked Treasury to delete proposed reg. section 1.1400Z2(d)-1(c)(9) and make the determination of where tangible property was used on an asset-by-asset basis.