Proposed Regulations for Certain Foreign Persons and Certain Foreign-Owned Partnerships Investing in Qualified Opportunity Funds

Generally speaking, a person or entity that makes a payment to a foreign person is required to withhold tax from the payment in order to ensure that the foreign person meets its U.S. income tax obligations associated with the foreign person’s realized U.S. source income. The withholding may be claimed as a credit or refunded when the foreign person files their U.S. income tax return and pays the tax due.

On April 12, 2021, the IRS issued proposed regulations that clarified withholding requirements for certain foreign persons and certain foreign-owned partnerships investing in Qualified Opportunity Funds. The regulations under Section 1400Z-2, specifically the deferral election under Section 1400Z-2(a), do not currently align with the withholding rules in Sections 1445, 1446(a) and 1446(f). Under current law, if a foreign person subject to withholding elects to defer a gain under Section 1400Z-2(a), the foreign person is not required to pay the tax on all or a portion of the deferred gain until the gain is recognized, which is upon the earlier of a triggering event or December 31, 2026.

Under the proposed regulations, security-required persons that invest a security-required gain cannot defer their gain under Section 1400Z-2(a) unless they obtain an eligibility certificate from the IRS.

• A security-required person is a person that is either a foreign person other than a partnership, or a specified partnership. A specified partnership is a foreign or domestic partnership that meets three tests with respect to a transfer that produces a security-required gain. The three tests are (i) the ownership test, (ii) a closely-held test, and (iii) a gain or asset test. Not all partnerships that elect to defer gain under Section 1400Z-2(a) are required to obtain an eligibility certificate. But more on that below.
• A security-required gain is a gain that arises from a covered transfer. Nothing like a definition that requires a subsequent definition. A covered transfer is explained as: (i) a disposition by, or a distribution to, a security-required person that is subject to withholding under Section 1445; (ii) a disposition by, or a distribution to, a security- required person that is subject to withholding under Section 1446(f); (iii) a disposition by a specified partnership of property, other than an interest in another partnership or a U.S. real property interest, or a distribution to a specified partnership, if any gain that arises is included in computing effectively connected taxable income (ECTI); or (iv) a disposition by a partnership that is not a specified partnership of property, or a distribution to such a partnership, if any gain that arises is included in determining the allocable share of a security-required person’s ECTI. Section 1446(a) covers the withholding obligations of a U.S. or foreign partnership that has ECTI allocated to a foreign partner.

In order to obtain an eligibility certificate with respect to a security-required gain, a security-required person must submit an application to the IRS. The application for the eligibility certificate must contain the following: information about the security-required person, including a U.S. taxpayer identification number, and about the covered transfer that gave rise to the security-required gain; a deferral agreement specifying the deferral of tax and provision of security; acceptable security to satisfy any tax due; and an acknowledgement from the IRS. The eligibility certificate needs to be secured by the date that the deferral election is filed with the IRS.

Acceptable security is defined as an irrevocable standby letter of credit issued by a U.S. financial institution that has satisfied certain capital requirements, as further defined in the proposed regulations. The proposed regulations also provide rules for determining the maximum amount of security.

Sources: IRS.gov, Bloomberg Tax

Please be sure to check out our previous Opportunity Zone-themed blog posts titled “IRS Notice Spells More Relief for Qualified Opportunity Funds and Investors” and “IRS Sending Letters to Qualified Opportunity Funds and Investors.”

I also recently sat down with colleagues Ben Darwin and Brian Duren to discuss QOF and Qualified Opportunity Zone Business compliance requirements and to answer some of our clients’ most commonly asked questions. Click here to watch.