The Wonderful World of OZ: What Proposed Regulations on Opportunity Zones Mean for You|
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At a Glance:
- International Investors, Take Note: The IRS and Treasury have proposed new regulations regarding the requirements around opportunity zones, specifically as they relate to non-U.S. investors and foreign-owned partnerships.
- What’s the Impact? The opportunity zone regime is intended to be a helpful economic development tool, so these new rules could have a significant impact on how non-U.S. investors can take advantage of the tax incentive.
- Next Steps: If you want help understanding the proposed regulations and how they apply to your specific situation, contact Aprio’s International practice today.
The full story:
On April 12, 2021, the IRS and U.S. Department of the Treasury released proposed regulations addressing requirements that certain international investors and foreign-owned partnerships must meet to elect federal income tax benefits with respect to Opportunity Zones and for the reduction or elimination of withholding tax.
First: Here’s a little background on opportunity zones
Enacted in 2017 as part of the Tax Cuts and Jobs Act (TCJA), the Opportunity Zone regime provides tax incentives (i.e., defers or eliminates federal income tax on profits rolled over into opportunity funds) to encourage investment in qualified opportunity zones. There are approximately 8,800 designated census tracts qualifying as opportunity zones across the United States.
Upon making a valid election, a taxpayer generally can defer federal income tax on certain capital gains until the earlier of an inclusion event or December 31, 2026, if they invest a corresponding amount in a qualifying investment in a qualified opportunity fund (QOF) within 180 days of the date of the sale or exchange.
Ten percent of a deferred gain may be excluded from gross income if the taxpayer holds the qualifying investment in the QOF for at least five years. If a second valid election is made, the taxpayer may also exclude from gross income any appreciation on the qualifying investment in the QOF if the qualifying investment is held for at least 10 years.
The Opportunity Zone regime is intended as an economic development tool — that is, it’s designed to spur economic development and job creation in distressed communities.
New proposed regulations
International investors generally are subject to federal income tax on amounts that are effectively connected with the conduct of a trade or business with the U.S. (also known as “effectively connected income,” or “ECI”) and must file a federal income tax return and pay any tax due. To ensure the collection of tax, in certain circumstances, withholding requirements are imposed on payments or allocations of ECI to international investors. The withholding tax is intended to serve as a proxy for the amount of the tax liability and may not match the actual amount due. Any withholding is claimed as a credit against the amount of tax due and shown on a tax return.
Prior to the release of the proposed regulations, the Opportunity Zone rules did not coordinate the deferral election with the withholding rules. Thus, a foreign person subject to withholding that elects to defer gains may be entitled to apply the credit for withholding against tax on other income or claim a refund for the year in which withholding was applied; this is because the person will not be required to pay substantive tax on all or a portion of the deferred gain until an inclusion event or December 31, 2026. In this instance, the withholding does not serve its substantive purpose.
Now, under the proposed regulations, a foreign person subject to federal income tax (including partners in foreign-owned partnerships) may not make a deferral election unless an eligibility certificate is obtained with respect to their gain. In addition, withholding is reduced or eliminated if the person obtains an eligibility certificate and provides security to the IRS before the transaction giving rise to the gain. If it is not obtained before the transfer, withholding will occur and the foreign person must still obtain an eligibility certificate to make a deferral election. A copy of the eligibility certificate will be required to claim a credit or refund of the withholding. The eligibility certificate must specify the permitted deferral amount.
To obtain an eligibility certificate, the foreign person must submit an application to the IRS. Currently, the IRS is considering electronic submissions, but it is expected to release the process in forms, instructions or guidance published in the Internal Revenue Bulletin. The application must include:
- Certain information about the foreign person and the transfer;
- An agreement for deferral of tax and provision of security;
- An agreement with a U.S. agent; and
- Acceptable security that secures the amount of gain for which the eligibility certificate is being obtained.
A U.S. taxpayer identification number will be required if an applicant does not already have one. Acceptable security is an irrevocable standby letter of credit issued by a U.S. bank that meets certain capital and other requirements.
Finally, a foreign person can use an eligibility certificate as a basis for reducing or eliminating withholding on a transfer by providing a copy to the withholding agent prior to a transaction.
The bottom line
While the proposed regulations are somewhat helpful to clarify how international investors can benefit from the Opportunity Zone incentive, it’s still unclear what frequency international investors will adopt and if so, how easily they will be able to take advantage of the new rules. Further, there are valid concerns, especially due to the COVID-19 pandemic, about whether the IRS will be able to effectively and efficiently administer significant amounts of information within required timelines for a foreign investor to avoid withholding tax on a transaction and elect to defer a gain.
In general, international investors will have to spend a fair amount of time to comply with requirements while facing time constraints, so there may be instances where less than material savings may cause a foreign investor to avoid the process.
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At Aprio, our International practice’s tax experts can help investors better understand how the proposed regulations apply to their specific situation. Schedule a call with us today to find out how we can help you.