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‘Corrections’ to Final Opportunity Zone Regulations Do More Than Fix Typos

Posted on Apr. 15, 2020

Aaron S. Gaynor is an associate at Roberts & Holland LLP. He thanks his colleagues for sharing their thoughts on these topics.

In this article, Gaynor discusses some of the substantive changes that were made in corrections to the final qualified Opportunity Zone regulations.

On April 6 Treasury published in the Federal Register “corrections” to T.D. 9889 (published January 13) that promulgated final regulations (the final regulations) regarding qualified Opportunity Zones (QOZs). These regulations finalized proposed regulations that had been published in October 2018 (the first proposed regulations) and May 2019 (the second proposed regulations).

Although the corrections largely contain mundane changes like fixes to typographical errors and paragraph numbering, they also include several substantive corrections — as well as, perhaps, shifts in policy — the most notable of which are discussed below.

Before diving in, a quick review: In general, an investor receives certain tax benefits from capital gain that it reinvests into a qualified opportunity fund within 179 days of the recognition of that gain.1 To take advantage of favorable regulatory rules,2 most QOFs invest through other business entities known as QOZ businesses,3 which, in turn, generally invest in specific tangible property known as QOZ business property.4

Working Capital as Qualifying Property

The corrections expressly state that working capital, for purposes of the relevant regulatory safe harbor, is not treated as QOZ business property.5 To understand the significance of this change, it is first necessary to understand that, in general, at least 70 percent of a QOZ business’s tangible assets must be QOZ business property (the tangible property test).6 Also, generally no more than 5 percent of a QOZ business’s assets may be held in the form of cash or specific securities (the non-qualified financial property test),7 except for “reasonable amounts of working capital.”8

There is a regulatory safe harbor for the treatment of cash and securities as reasonable amounts of working capital for purposes of the non-qualified financial property test.9 There is also a safe harbor that permits property that is in the process of being “substantially improved”10 by use of the working capital to be treated as QOZ business property for purposes of the tangible property test; this safe harbor11 has caused some confusion since the promulgation of the first proposed regulations.12

The practitioner community debated whether the latter safe harbor meant that working capital was treated as QOZ business property, or if it was a “nothing” (that is, because cash is not a tangible asset, it doesn't go into the numerator or the denominator of the tangible property test). For most QOZ businesses, the distinction between working capital being QOZ business property and being a nothing makes no difference — such businesses hold no tangible property other than QOZ business property.13 Thus, a QOZ business that purchased property from an unrelated party and raised cash that it planned to expend by improving the property would generally satisfy the test regardless of how the cash was characterized. In contrast, for QOZ businesses that hold tangible property other than QOZ business property (such as property acquired from a related person or contributed14), treating working capital as QOZ business property could determine whether the tangible property test has been satisfied. The corrections contain an affirmative statement that working capital is a nothing for purposes of the tangible property test, negating the strategy that some QOZ businesses hoped to rely on.

‘Circular Movement of Consideration’

The corrections amplify that Treasury views as abusive some transactions between an investor and a QOF (or its subsidiary QOZ businesses) that involve “circular movement of consideration” (also referred to as “circular cash flow” or “circular flow of funds”).

Treasury first hinted its displeasure with these transactions in the text of the second proposed regulations, which made general reference to receiving an interest in a QOF in exchange for the transfer of property.15 The preamble to the final regulations also gave some consideration to the topic,16 but the operative language of the final regulations did not materially change from the second proposed regulations.17 Now, through a new example added by the corrections, Treasury has spelled out in operative language exactly the type of transaction it views as abusive.18

Slightly simplified, the new example describes a transaction in which, “as part of a plan,” an investor sells property to a QOZ business, reinvests the gain from that sale into the QOZ business’s parent QOF, and the QOF then contributes the amount invested to the QOZ business. Treasury views such a situation as abusive, and would recharacterize it as a contribution of property directly from the taxpayer to the QOZ business. Under that characterization, the investor would not be entitled to receive any of the tax benefits of the QOZ program,19 and the QOZ business would be considered to have a non-qualifying asset (as contributed assets are not QOZ business property20), which in many cases would cause the QOZ business to fail the tangible property test.

The example makes clear that the perceived abuse is not merely taxpayers making an end run around related-party rules21 (which Treasury had already addressed with an example in the final regulations22) because the new example applies to a situation in which the investor owns 20 percent or less of the QOF. Nevertheless, the example presupposes that the steps were “part of a plan,” and that this is an appropriate situation to apply “the step transaction doctrine and circular cash flow principles.” One would expect (or at least hope) to achieve a different outcome when an investor sold property to a QOZ business and later, without any prior agreement to do so on its part or on the part of the QOF parent, elects to invest all or a portion of its gain in the QOF parent. However, taxpayers should be careful in structuring transactions so as not to run afoul of the example.

Valuing Interests in QOZ Businesses

The corrections change a QOF’s method of valuing interests in subsidiary QOZ businesses for QOFs not using certain generally accepted accounting principles statements.23 Of all of the corrections, it is the least clear with respect to this item whether there was a shift in policy or merely a clarification to an intended reading of the rules.

Generally, a QOF must have at least 90 percent qualifying assets (which generally include interests in QOZ businesses) as determined by the average of the ratio of its good assets to its total assets on two annual testing dates.24 Under the final regulations, QOFs generally may value owned assets in accordance with specific GAAP statements, or at unadjusted cost basis.25 However, the final regulations added a special rule for property not purchased or constructed, which required QOFs not using the GAAP method to value these assets at fair market value.26 As a QOF’s interest in a QOZ business must be acquired by contribution (and not by purchase),27 the final regulations seemed to require valuing interests in QOZ businesses at FMV under this method. The corrections permit valuing at cost basis, which generally simplifies testing, as it is easier for a QOF to determine its cost basis in a QOZ business twice a year than to determine the FMV of its interest.

Transition Rules

The corrections modified the language of the transition rules. Under the final regulations, the transition rules (which generally apply to tax years beginning before March 13, 2020) are unclear about whether taxpayers who wanted to rely on the final regulations had to apply them as a whole or whether they could cherry-pick section by section.28 Although the final regulations were generally more favorable than the proposed regulations, applying reg. section 1.1400Z2(a)-1 as set forth in the second proposed regulations is important to taxpayers that recognized section 1231 gains in 2019.

The second proposed regulations generally began the 179-day period to reinvest section 1231 gain on December 31, rather than the date of recognition.29 The final regulations changed the 179-day period to reinvest section 1231 gains to begin on the date of recognition (just like “normal” capital gains),30 which may have been much earlier in the year. This meant that some taxpayers were caught in whipsaw: Under the second proposed regulations, they could not reinvest their section 1231 gains until December 31, 2019, but, by the time the final regulations were issued, more than 179 days had passed since the recognition of their section 1231 gains.

The corrections reworked the language of the transition rules to say that “reliance” on the final regulations for the purposes of the transition rule in a particular section is determined by “disregard[ing] . . . the consistency requirement.”31 This author thinks that the revised transition rules are meant to permit cherry-picking, although others think additional clarity is needed. The corrections did not resolve all outstanding ambiguities regarding QOZ investments. However, Treasury’s continued efforts to give taxpayers clarity are appreciated.

FOOTNOTES

1 See generally section 1400Z-2. The 180-day period to invest in a QOF set forth in section 1400Z-2(a)(1) includes the date the gain would be otherwise recognized. Compare this with the 180-day period set forth in section 1031(a)(3)(B)(i), which begins the day after.

2 See, e.g., reg. section 1.1400Z2(d)-1(d)(3)(v) (“Safe harbor for reasonable amount of working capital”).

3 See generally section 1400Z-2(d)(3).

4 See generally section 1400Z-2(d)(2)(D).

5 85 F.R. 19084 (renumbering and amending current reg. section 1.1400Z2(d)-1(d)(3)(vi)(D)).

6 Section 1400Z-2(d)(3)(A)(i); reg. section 1.1400Z2(a)-1(b)(2) and 1.1400Z2(d)-1(d)(1)(i).

7 Section 1400Z-2(d)(3)(A)(ii) (incorporating by reference section 1397C(b)(8)); and reg. section 1.1400Z2(d)-1(d)(1)(ii) and -1(d)(3)(iv).

8 Section 1397C(e)(1).

9 Reg. section 1.1400Z2(d)-1(d)(3)(v).

10 Generally, a QOZ business must substantially improve (which means to double the basis in 30 months) existing tangible property (other than land) that it acquires. See section 1400Z-2(d)(2)(D)(i)(II) and -2(d)(2)(D)(ii); and reg. section 1.1400Z2(d)-2(b)(2)(i)(B) and (b)(4). Although land does not need to be substantially improved, there is an antiabuse rule to prevent “land banking”; that is, purchasing property without developing it in the hope that the value of the land would appreciate. See generally reg. section 1.1400Z2(d)-2(b)(4)(iv).

11 Reg. section 1.1400Z2(d)-1(d)(3)(vi)(D). In addition to the substantive clarification addressed above, the corrections reworked the language of this provision. See 85 F.R. 19084. Before the corrections, the substance of this provision was contained in reg. section 1.1400Z2(d)-1(d)(3)(viii)(A).

12 See 83 F.R. 54295 (proposing reg. section 1.1400Z-2(d)-1(d)(5)(vii), which was captioned “Safe harbor for property on which working capital is being expended”).

13 This is a slight simplification: QOZ businesses that are in the process of substantially improving property are often merely considered to hold no tangible assets other than QOZ business property. See reg. section 1.1400Z2(d)-1(d)(3)(vi)(D)(2).

14 Under section 1400Z-2(d)(i)(I), for tangible property to be QOZ business property, it must be acquired by “purchase,” as defined in section 179(d)(2). Section 179(d)(2) excludes from the definition of purchase property acquired from a related person or acquired by contribution. For purposes of section 1400Z-2, related persons are generally determined at a greater than 20 percent threshold. See section 1400Z-2(e)(2).

15 84 F.R. 18673 (adding prop. reg. section 1.1400Z2(a)-1(b)(2)(iv)).

16 85 F.R. 1871.

17 See reg. section 1.1400Z2(a)-1(b)(11)(v).

18 85 F.R. 19086 (amending reg. section 1.1400Z2(f)-1(c)(3)(iii)(B)).

19 The investor would have no recognized gain to reinvest because nonrecognition treatment under section 721 would generally govern the transaction.

20 See supra note 14.

21 The concern is essentially that, pursuant to a plan, an investor sells property to a QOF or QOZ business when it is not related and then later becomes related. This is a concern for two reasons: First, capital gain from a sale to a related party is not eligible for reinvestment into a QOF. See section 1400Z-2(a)(1). Second, as discussed in supra note 14, property acquired from a related party is not QOZ business property.

22 Reg. section 1.1400Z2(f)-1(c)(3)(iii)(A) (which the corrections did not substantially alter).

23 85 F.R.  19083 (amending reg. section 1.1400Z2(d)-1(b)(4)(ii)(A)).

24 Section 1400Z-2(d)(1); reg. section 1.1400Z2(d)-1(b)(1)(i).

25 Reg. section 1.1400Z2(d)-1(b)(2)(i), (b)(3).

26 Reg. section 1.1400Z2(d)-1(b)(4)(ii)(B).

27 Section 1400Z-2(d)(2)(A)(ii), (d)(2)(A)(iii), (d)(2)(B)(i)(I), and (d)(2)(C)(i).

28 85 F.R. 19084 (amending reg. section 1.1400Z2(a)-1(g)(2) and 1.1400Z2(b)-1(j)(2)), 85 F.R. 19085 (amending reg. section 1.1400Z2(d)-1(e)(2) and -2(e)(2)), and 85 F.R. 19086 (amending reg. section 1.1400Z2(f)-1(d)(2)).

29 84 F.R. 18673 (adding prop. reg. section 1.1400Z2(a)-1(b)(2)(iii)).

30 Reg. section 1.1400Z2(a)-1(b)(7)(i) and -1(b)(11)(iii)(B).

31 See reg. section 1.1400Z2(a)-1(g)(2), 1.1400Z2(b)-1(j)(2), 1.1400Z2(d)-1(e)(2), 1.1400Z2(d)-2(e)(2), and 1.1400Z2(f)-1(d)(2).

END FOOTNOTES

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