On April 12, 2021, the Internal Revenue Service (the “IRS”) issued its proposed regulation (the “Proposed Regulation”) which sets forth requirements that certain foreign taxpayers must satisfy in order to elect federal income tax benefits of investing in a qualified opportunity fund (“QOF”) and for the reduction or elimination of withholding tax.
The Tax Cuts and Jobs Act added sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code (the “Code”) to provide specified federal income tax benefits (defers or eliminates federal income tax on profits rolled over into opportunity funds) to owners of QOFs to encourage the making of longer-term investments, through QOFs and qualified opportunity zone businesses, of new capital in one or more qualified opportunity zones designated under section 1400Z-1 and to increase economic growth in such qualified opportunity zones. 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 the 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 prior to December 31, 2021. 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.
Foreign persons are generally subject to US income tax on income that is effectively connected with the conduct of a trade or business within the United States and must file a federal income tax return and pay any tax due. In certain circumstances, withholding requirements are imposed on payments or allocations of such taxes of foreign persons. The amount of withholding is intended to approximate the foreign person’s tax liability on the transfer or payment. The foreign person must file a US income tax return, claim a credit for the withheld amount, and either pay any additional tax due or claim a refund of all or a portion of the withheld amount.
Under the Proposed Regulation, the “security-required persons” (meaning, (i) a foreign person other than a partnership or (ii) a “specified partnership”) investing “security-required gain” (gain from a “covered transfer”, which is generally a transfer subject to withholding rules under Code sections 1445, 1446(a), and 1446(f) (the “FIRPTA Withholding”)) may not make a deferral election unless they obtain an “eligibility certificate” with respect to that gain by the date on which the deferral election is filed with the IRS. If a “security-required person” obtains an eligibility certificate and provides security to the IRS before the transaction giving rise to the gain, then the FIRPTA Withholding is reduced or eliminated. If a security-required person does not obtain an eligibility certificate before the transfer, then the transfer is subject to normal FIRPTA Withholding. Such a security-required person must still obtain an eligibility certificate to make a deferral election, but his, she, or it (or, if applicable, its partner, owner, or beneficiary) will need to claim a credit or refund for the amount withheld and provide a copy of the eligibility certificate when filing his, her or its US income tax return.
“Specified partnership” means a partnership, whether foreign or domestic, if it meets three tests:
ownership test: at the time of transfer, 20% or more of the capital or profits interests in the partnership are owned (directly or indirectly through one or more partnerships, trusts, or estates) by one or more nonresident aliens or foreign corporations;
closely-held test: at any time during a look-back period (the period that begins on the later of the date that is one year before the date of the transfer or the date on which the partnership was formed, and that ends on the date of the transfer), a partnership has 10 or fewer direct partners that own 90% or more of the capital or profits interests in the partnership, with any related partners (within the meaning of Code section 267(b) or 707(b)(1)) being treated as a single partner; and
gain or asset test (meet either): (i) the amount of security-required gain from the transfer exceeds $1 million or (ii) at any time during a look-back period, the value of the partnership’s assets that are US real property interests or assets used in a US trade or business exceeds 25% of the total value of the partnership’s assets.
To obtain an eligibility certificate, a security-required person must submit an application to the IRS. The IRS is considering requiring electronic submission of the application. The IRS would describe the process in forms, instructions, publications, or guidance published in the Internal Revenue Bulletin.