International Financial Law Prof Blog

Editor: William Byrnes
Texas A&M University
School of Law

Thursday, April 15, 2021

Requirements for Certain Foreign Persons and Certain Foreign-Owned Partnerships Investing in Qualified Opportunity Funds and Flexibility for Working Capital Safe Harbor Plans

Internal Revenue Service on 04/14/2021

Abstract: This document contains proposed regulations that include requirements that certain foreign persons and certain foreign-owned partnerships must meet in order to elect the Federal income tax benefits provided by section 1400Z-2 of the Internal Revenue Code (Code). This document also contains proposed regulations that allow, under certain circumstances, for the reduction or elimination of withholding under section 1445, 1446(a), or 1446(f) of the Code on transfers that give rise to gain that is deferred under section 1400Z-2(a). Finally, this document contains additional guidance regarding the 24-month extension of the working capital safe harbor in the case of Federally declared disasters. The proposed regulations affect qualified opportunity funds and their investors.

Background: This document contains proposed amendments to 26 CFR part 1 under sections 1400Z-2, 1445, and 1446 (proposed regulations). Section 13823 of Public Law 115-97, 131 Stat. 2054, 2184 (2017), commonly referred to as the Tax Cuts and Jobs Act (TCJA), added sections 1400Z-1 and 1400Z-2 to the Code. The purposes of section 1400Z-2 and the section 1400Z-2 regulations (that is, the final regulations set forth in §§ 1.1400Z2(a)-1 through 1.1400Z2(f)-1, 1.1502-14Z, and 1.1504-3) are to provide specified Federal income tax benefits to owners of qualified opportunity funds (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. See § 1.1400Z2(f)-1(c)(1) (describing the purposes of section 1400Z-2 and the section 1400Z-2 regulations; Notice 2018-48, 2018-28 I.R.B. 9, and Notice 2019-42, 2019-29 I.R.B. 352 (setting forth the combined list of population census tracts designated as qualified opportunity zones).

Section 1400Z-1 provides the procedural rules for designating qualified opportunity zones and related definitions. Section 1400Z-2 provides two main tax incentives to encourage investment in qualified opportunity zones. See section 1400Z-2(b) and (c). First, a taxpayer, upon making a valid election, may generally defer, until the earlier of an inclusion event or December 31, 2026, certain gains in gross income that would otherwise be recognized in the tax year if the taxpayer invests a corresponding amount in a qualifying investment in a QOF within 180 days of the date of the sale or exchange. See section 1400Z-2(b)(1)(A) and (B). The taxpayer may potentially exclude ten percent of such deferred gain from gross income if the taxpayer holds the qualifying investment in the QOF for at least five years. See section 1400Z-2(b)(2)(B)(iii). An additional five percent of such gain may potentially be excluded from gross income if the taxpayer holds the qualifying investment for at least seven years. See section 1400Z-2(b)(2)(B)(iv). Second, a taxpayer, upon making a second valid election under section 1400Z-2(c), may also exclude from gross income any appreciation on the taxpayer's qualifying investment in the QOF if the qualifying investment is held for at least ten years. Section 1400Z-2(e)(4) provides that the Secretary of the Treasury or his delegate shall prescribe regulations as may be necessary or appropriate to carry out the purposes of section 1400Z-2, including rules to prevent abuse.

On October 29, 2018, the Treasury Department and the IRS published in the Federal Register (83 FR 54279) a notice of proposed rulemaking (REG-115420-18) providing guidance under section 1400Z-2 for investing in qualified opportunity funds (83 FR 54279 (October 29, 2018)) (October 2018 proposed regulations). A second notice of proposed rulemaking (REG-120186-18) was published in the Federal Register (84 FR 18652) on May 1, 2019, containing additional proposed regulations under section 1400Z-2 (May 2019 proposed regulations). The May 2019 proposed regulations also updated portions of the October 2018 proposed regulations. On January 13, 2020, final regulations (TD 9889) under section 1400Z-2 were published in the Federal Register (85 FR 1866, as corrected at 85 FR 19082), effective for taxable years beginning after March 13, 2020 (section 1400Z-2 regulations).

Under the section 1400Z-2 regulations, a taxpayer qualifies for deferral under section 1400Z-2(a) only if the taxpayer is an eligible taxpayer. Section 1.1400Z2(a)-1(a)(1). An eligible taxpayer is defined as a person that is required to report the recognition of gains during the taxable year under Federal income tax accounting principles. Section 1.1400Z2(a)-1(b)(13). If an eligible taxpayer that is a partnership does not elect to defer gain, a partner of such partnership may elect to defer its distributive share of the gain. Section 1.1400Z2(a)-1(c)(8).

The section 1400Z-2 regulations provide that only gains that are eligible gains may be deferred. Section 1.1400Z2(a)-1(b)(11). In general, an eligible gain is gain that (i) is treated as a capital gain or is a qualified 1231 gain, (ii) would be recognized for Federal income tax purposes and subject to tax under subtitle A of the Code before January 1, 2027, if section 1400Z-2(a)(1) did not apply to defer the gain, and (iii) does not arise from a sale or exchange of property with certain related persons. Id. Thus, for example, a nonresident alien individual or foreign corporation generally may make a deferral election with respect to an item of capital gain that is effectively connected with a U.S. trade or business, because this gain otherwise is subject to Federal income tax. When a partnership chooses to make a deferral election, the section 1400Z-2 regulations provide an exception to the general requirement that gain be subject to Federal income tax in order to constitute eligible gain, subject to an anti-abuse rule. Section 1.1400Z2(a)-1(b)(11)(ix)(B).

Foreign persons are generally subject to U.S. income tax on amounts that are effectively connected with the conduct of a trade or business within the United States (ECI). A foreign person that directly or indirectly is engaged in a trade or business in the United States must file a U.S. income tax return and pay any tax due.

To ensure the collection of tax, in certain circumstances, the Code imposes withholding requirements on payments or allocations of ECI to foreign persons. See sections 1445, 1446(a), and 1446(f). The amount of withholding under these provisions is intended to serve as a proxy for the amount of the foreign person's substantive tax liability and may not match the actual amount of tax due. The amount withheld may be claimed as a credit against the amount of tax due and shown on the foreign person's tax return.

Specifically, section 1445(a) requires a transferee to withhold tax on a disposition of a United States real property interest (as defined in section 897(c)) (U.S. real property interest) by a foreign person. Generally, the transferee must withhold 15 percent of the amount realized and deposit the tax with the IRS within 20 days of the transfer. Certain exceptions and reductions to the rate of withholding can apply, including by the foreign person obtaining a withholding certificate from the IRS to reduce or eliminate the amount required to be withheld on the transfer.

Section 1445(e)(1) requires a domestic partnership, trust, or estate that disposes of a United States real property interest to withhold on any portion of the gain that is allocable to a foreign partner or beneficiary. The rate of withholding is the highest rate of tax in effect under section 11(b) (currently 21 percent).

Section 1445(e)(2) requires a foreign corporation that recognizes gain on the distribution of a United States real property interest to withhold on the gain at the highest rate of tax in effect under section 11(b).

Section 1445(e)(3) requires a domestic corporation that is or has been a United States real property holding corporation to withhold 15 percent of a distribution to a nonresident alien or foreign corporation.

Section 1445(e)(6) requires a qualified investment entity to withhold at the highest rate of tax specified in section 11(b) on the amount of the distribution that is treated as gain from the sale or exchange of a United States real property interest.

Section 1446(a) generally requires a partnership to withhold tax on effectively connected taxable income as determined under § 1.1446-2 (ECTI) allocable to a foreign partner, with limited adjustments, regardless of whether the income is distributed to the partner (section 1446(a) tax). A partnership must generally withhold section 1446(a) tax on a foreign partner's allocable share of ECTI at the highest rate of tax specified in section 1 (for a foreign partner other than a corporation) or section 11(b) (for a foreign partner that is a corporation). A partnership is generally required to pay the section 1446(a) tax in four installment payments. The partnership may consider certain partner-level deductions and losses as a reduction to the ECTI on which it must withhold section 1446(a) tax. See § 1.1446-6.

Section 1446(f) requires withholding under certain circumstances in connection with a disposition of a partnership interest. Specifically, if, on a disposition (which includes a distribution from a partnership to a partner) of a partnership interest, section 864(c)(8) treats any portion of a foreign partner's gain as effectively connected gain, section 1446(f) requires the transferee to withhold tax equal to 10 percent of the amount realized, unless an exemption or reduced rate of withholding applies. The transferee must deposit the tax with the IRS within 20 days of the transfer. See § 1.1446(f)-2. For purposes of section 1446(f), a transferor may in certain cases certify to the transferee that the transfer is not subject to withholding or otherwise qualifies for an exception to withholding or an adjustment to the amount required to be withheld. Id.

Under sections 33 and 1462, a foreign person subject to withholding under section 1445, 1446(a), or 1446(f) may credit the amount withheld against the amount of income tax liability shown on the person's tax return.

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