IRS Releases Proposed Regulations on Foreign Investment in Opportunity Zone Funds
2024-09-24 22:20:47
On April 12, 2021, the U.S. Internal Revenue Service ("IRS") issued proposed regulations ("Proposed Regulations") outlining the conditions that certain foreign taxpayers must meet to obtain tax benefits and reduce or eliminate withholding taxes when investing in Qualified Opportunity Funds ("QOFs").
The Tax Cuts and Jobs Act added Sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code ("IRC") to provide specific federal income tax benefits (deferral or elimination of federal income tax on gains rolled into opportunity funds) to owners of QOFs. These benefits aim to encourage long-term investments of new capital in one or more Qualified Opportunity Zones designated under Section 1400Z-1 through QOFs, thereby promoting economic growth in such zones. By making a valid election, taxpayers can defer capital gains taxes if they invest the gains in a QOF within 180 days, with the deferral lasting until December 31, 2026, or until the investor sells the QOF. Investments held in a QOF for more than 5 years by December 31, 2026, receive a 10% reduction in the deferred tax liability. Investments held for more than 10 years qualify for a full exclusion of the deferred tax liability.
Foreign persons are generally subject to U.S. income tax on income effectively connected with a U.S. trade or business and must file federal income tax returns and pay any taxes due. In certain cases, payments or distributions to foreign persons are subject to withholding requirements. The amount withheld is intended to approximate the foreign person's tax liability at the time of the transfer or payment. Foreign persons must file U.S. income tax returns to claim credits for amounts withheld and pay any taxes due or request a refund of all or part of the withheld amounts.
Under the Proposed Regulations, a "person required to furnish security" (i.e., (i) a foreign person other than a partnership or (ii) a "specified partnership") investing "gains required to be secured," which are generally gains from transfers subject to withholding rules under Sections 1445, 1446(a), and 1446(f) of the IRC ("FIRPTA Withholding Rules"), may not make a deferral election for gains acquired before the date of filing the deferral election with the IRS unless they obtain a "security certificate" under the conditions described below. If a "person required to furnish security" obtains a security certificate before the transaction generating the gain and provides security to the IRS, FIRPTA withholding taxes will be reduced or eliminated; if a security certificate is not obtained before the transfer, the transfer must proceed with normal FIRPTA withholding. Such a "person required to furnish security" must still obtain a security certificate to make a deferral election, but he, she, or it (or, if applicable, its partners, owners, or beneficiaries) will need to claim a credit or refund for the withheld amount when filing their U.S. income tax return and provide a copy of the security certificate.
A "specified partnership" is a foreign or domestic partnership that meets the following three conditions:
Ownership Test: At the time of the 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 the lookback period (a period beginning on the later of one year before the transfer date or the partnership's formation date and ending on the transfer date), the partnership has 10 or fewer direct partners who own 90% or more of the capital or profits interests, and any related partners (within the meaning of Sections 267(b) or 707(b)(1) of the IRC) are treated as a single partner; and
Gain or Asset Test (meeting either of the following): (i) the amount of the transfer gain exceeds $1 million, or (ii) at any time during the lookback period, the partnership's property interests or assets used in a U.S. trade or business exceed 25% of the total value of the partnership's assets.
To obtain a security certificate, a "person required to furnish security" must submit an application to the IRS. The IRS is considering requiring electronic submission of the application. The IRS will describe the process in forms, instructions, publications, or guidance published in the Internal Revenue Bulletin.