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Final Regulations on Opportunity Zones

On December 19, 2019, the Internal Revenue Service (the “IRS”) and the U.S. Department of the Treasury (the “Treasury”) issued final regulations (the “Final Regulations”) under section 1400Z-2 of the Internal Revenue Code[1] regarding the opportunity zone program, which was enacted as part of the law commonly referred to as the “Tax Cuts and Jobs Act”.[2] The opportunity zone program is designed to encourage investment in distressed communities designated as “qualified opportunity zones” (“opportunity zones”) by providing tax incentives to invest in “qualified opportunity funds” (“QOFs”) that, in turn, invest directly or indirectly in the opportunity zones.

The opportunity zone statute left many uncertainties regarding the fundamental operations of the opportunity zone program. The IRS and Treasury issued two sets of proposed regulations under section 1400Z-2 in October 2018 and April 2019 (the “Proposed Regulations”). The Proposed Regulations were discussed in two of our earlier blog posts, found here and here. The Final Regulations address the many comments received in response to the Proposed Regulations and retain the basic approach and structure set forth in the Proposed Regulations, but include clarifications and modifications to the Proposed Regulations. The Final Regulations are generally taxpayer-favorable, and incorporate many of the provisions requested by commentators. However, there are certain provisions that are worse for taxpayers than under the Proposed Regulations.

The Final Regulations will be effective on March 13, 2020, and are generally applicable to taxable years beginning after that date. For the portion of a taxpayer’s first taxable year ending after December 21, 2017 that began on December 22, 2017, and for taxable years beginning after December 21, 2017 and on or before March 13, 2020, taxpayers and QOFs generally may choose to apply the Final Regulations or the Proposed Regulations, so long as, in each case, they are applied consistently and in their entirety.

This blog summarizes some of the important aspects of the Final Regulations. It assumes familiarity with the opportunity zone program.

Summary

This section lists some of the most important changes in the Final Regulations.

  •  All gain on the sale of a QOF interest or underlying assets after 10 years is excluded, other than gain from ordinary course sales of inventory. The Proposed Regulations provided that if a taxpayer held an interest in a QOF for at least 10 years, then upon a sale of the QOF, all gain could be excluded, including any gain attributable to depreciation recapture or ordinary income assets. The Proposed Regulations also permitted an investor that held a qualifying interest in a QOF partnership or S corporation for at least 10 years to elect to exclude capital gains (but not other gains) realized by the QOF partnership or S corporation on the sale of underlying qualified opportunity zone property. The Final Regulations very helpfully provide that an investor that has held a qualifying interest in a QOF for at least 10 years may elect to exclude all gain realized upon its sale of an interest in a QOF as well as all gain realized upon the sale of assets by the QOF or a lower-tier partnership or S corporation QOZB, except to the extent the gain arises from the sale of inventory in the ordinary course of business.
  • Eligible gain includes gross section 1231 gain, and not net section 1231 gain. Section 1231 gains and losses generally arise when a taxpayer disposes of depreciable or real property that is used in the taxpayer’s trade or business and held for more than one year. The portion of any section 1231 gain that reflects accelerated appreciation is “recaptured” under sections 1245 or 1250 and is treated as ordinary income. If, at the end of the taxable year, the taxpayer has net section 1231 gains, then all section 1231 gains and losses are treated as long-term capital gains and losses. Alternatively, if, at the end of the taxable year, the taxpayer’s section 1231 losses equal or exceed its section 1231 gains, then all of the taxpayer’s section 1231 gains and losses are treated as ordinary income and losses. The Proposed Regulations provided that only net section 1231 gain would be eligible for deferral under section 1400Z2-(a)(1) (i.e., only section 1231 gain that would be characterized as long-term capital gain after the netting process had been completed). The Final Regulations very helpfully provide that eligible gains include gross section 1231 gains (other than section 1231 gain that is recaptured and treated as ordinary income under sections 1245 or 1250) unreduced by section 1231 losses.
  • New 62-month working capital safe harbor. The Proposed Regulations included a working capital safe harbor that permitted a QOZB that acquires, constructs, and/or substantially rehabilitates tangible business property to treat cash, cash equivalents and debt instruments with a term of 18 months or less as a reasonable amount of working capital for a period of up to 31 months if certain requirements are satisfied. The Final Regulations provide that tangible property may benefit from an additional 31-month safe harbor period, for a maximum of 62 months, in the form of either overlapping or sequential applications of the working capital safe harbor. To qualify for the 62-month safe harbor, the business must receive multiple non-de minimis cash infusions during each 31-month safe harbor period, and the subsequence cash infusion must form an integral part of the plan covered by the first working capital safe harbor.
  • Triple-net-lease. The Final Regulations contain an example concluding that a QOZB that owns a three-story mixed-use building, and (i) leases one floor of the building under a triple-net-lease, (ii) leases the other two floors under leases that are not triple-net-leases, and (iii) has employees with offices located in the building who meaningfully participate in the management and operations of building, is engaged in an active trade or business with respect to the entire leased building solely for purposes of the opportunity zone trade or business requirement. While this example is helpful because it confirms that a portion of an active trade or business may consist of a triple-net-lease, it leaves unanswered what level of activity is necessary for a real property rental business to qualify as a trade or business for purposes of the opportunity zone rules.
  • Asset aggregation approach for determining substantial improvement. In order for non-original use tangible property to be treated as zone business property, it must be “substantially improved”, which generally requires an original use investment of an amount at least equal to the property’s purchase price. For purposes of determining whether non-original use tangible property purchased by a QOZB has been substantially improved, the Final Regulations permit certain original use assets used in the same trade or business as the non-original use property and that improve the functionality of the non-original use property, to be counted for purposes of the substantial improvement test.  For example, a QOF that intends to substantially improve a hotel may now count the cost of mattresses, linens, furniture, and electronic equipment for purposes of the substantial improvement test.
  • Partnership interests valued at fair market value for purposes of the 90% test. For purposes of the 90% test, the Final Regulations require an asset that has a tax basis not based on cost, such as a partnership interest or other intangible asset, to be valued at its fair market value (rather than the unadjusted cost basis).  Accordingly, the fair market value of a carried interest or even a QOZB partnership must be re-determined at each semi-annual testing date.
  • Sin Businesses. The Final Regulations prohibit a QOZB from leasing more than a de minimis amount of its property to a sin business, but also provide that de minimis amounts of gross income (i.e., less than 5% of gross income) attributable to a sin business will not cause the business to fail to be a QOZB (e.g., a hotel with a spa that offers massage services).
  •  Tangible property that ceases to be zone business property.  The statute contains a special rule pursuant to which tangible property that ceases to be zone business property will nonetheless continue to be treated as such for the lesser of: (1) five years after the date such property ceases to be qualified as zone business property; and (2) the date on which the tangible property is no longer held by the zone business. The Final Regulations prohibit a QOZB from relying on this rule unless the zone business property was used by a QOZB in a QOZ for at least two years not counting any period during which the property was being substantially improved or covered by the working capital safe harbor.
  • Expanded anti-abuse rule. The Proposed Regulations included a general anti-abuse rule under which the IRS has broad discretion to disregard or recharacterize any transaction if, based on the facts and circumstances, a significant purpose of the transaction is to achieve tax results inconsistent with the purposes of section 1400Z-2. However, the Proposed Regulations did not explain the purposes of section 1400Z-2. The Final Regulations state that the purposes of section 1400Z-2 are (i) to provide specified tax benefits to owners of QOFs to encourage the making of longer-term investments, through QOFs and QOZBs, of new capital in one or more opportunity zones and (ii) to increase the economic growth of opportunity zones, and include seven new examples illustrating the application of the anti-abuse rule. These examples demonstrate that acquiring land with a significant purpose of selling it at a profit is abusive

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Latest on Abolition of Entrepreneurs’ Relief

There has been much talk recently about “review and reform” (or abolition) of entrepreneurs’ relief. This seems to have moved a step closer this week with Boris Johnson stating that the Treasury are “fulminating” against it on the basis that it made “staggeringly rich” people “even more staggeringly rich”. The debate about this was kicked off last November with an IFS study highlighting that the benefits of the relief were concentrated among the wealthy and Edward Troup, former head of HMRC, saying that it was costing £2bn a year in tax while providing “no incentive for real entrepreneurship”. Continue Reading

Simplification of UK Partnership Tax Reporting for Investment Fund Partnerships

In the Finance Act 2018, the UK Government enacted a number of changes to the information required in partnership returns that raised the concern of undue and impracticable administrative burden being imposed on UK investment fund partnerships.

The changes covered a number of areas, including requiring a UK partnership that had partnerships amongst its partners and could not identify all of its “indirect partners” to provide computation statements on four bases covering UK resident individuals and companies and non-UK resident individuals and companies. Given that many fund partnerships have other partnerships amongst their investors and that it is likely to be difficult (if possible) to obtain information on all indirect partners, this change will increase the return information that must be provided to HM Revenue & Customs (“HMRC”). Continue Reading

UK Government announces review into private sector IR35 rules

As announced by the Chancellor in the run up to the recent General Election, the Government is launching a review into the implementation of the changes to the IR35 rules for private sector workers scheduled to be introduced on 6 April.

We have reported on the changes to the IR35 rules for workers providing services to medium- and large-sized companies in our Tax Talks article. In broad summary, the changes to the rules will mean that the worker’s end client (and not the worker or their personal service company) will be responsible for determining whether or not the worker would have been an employee of the client had she contracted with it directly rather than through an intermediary. Where the determination is that the worker would have been an employee, the client must make payment to the worker’s intermediary entity subject to PAYE and national insurance contributions (NICs) and account for the tax (along with employer’s NICs) to HMRC. Under the current rules, it is the worker’s intermediary that has to account to HMRC for PAYE deductions and NICs.

The proposals have been heavily criticised, principally because of the difficulty in determining whether or not a worker should be treated as an employee or self-employed contractor (as has been highlighted in a number of recent cases on the question) and the concern that private sector end clients will take an overly conservative approach to the question and categorise many self-employed contractors as deemed employees. These concerns have been exacerbated by what is seen as the inadequacy of HMRC’s online Check Employment Status for Tax (CEST) tool to deal with the subtleties of the determination.

The Government says that it will now engage with affected businesses and workers to seek to ensure a smooth and efficient implementation of the new rules, including an evaluation of the CEST tool. There is no indication that there will be significant changes to the rules or the planned date for their introduction in April.

The review will conclude by mid-February in order to allow any changes or improved assistance that is identified to be put in place for April.

Given the short period of the review and the fundamental issue of the difficulty in making the determination of deemed employee or self-employed contractor status, it seems unlikely that this review will be able to address the concerns of the body of contractors providing their services to the private sector without a radical rethink of the proposals or a delay in their implementation. Alternatively, HMRC could consider providing comfort to the private sector organisations engaging workers through intermediaries that HMRC will be sympathetic to assessments that such workers should not be treated as employees in difficult cases.

Democratic Tax Policy Proposals

Recently, several of the presidential candidates and other prominent Democrats have suggested a number of different tax policy proposals, including wealth taxes, mark-to-market taxation, a VAT, additional taxes, increased income tax rates, and increased gift and estate taxes. This chart illustrates the various proposals, and this blog summarizes them.[1]

This blog was updated on January 8, 2020.

Wealth Taxes Mark-to-Market Tax VAT Increased Taxes Financial Transaction Tax Additional Taxes Increased Gift & Estate Tax Repeal of stepped-up basis
Bernie Sanders Cory Booker Andrew Yang Joe Biden Bernie Sanders

 

Bernie Sanders (CEO Pay Tax) Bernie Sanders Romney and Bennet
Elizabeth Warren Pete Buttigieg Cory Booker

 

Elizabeth Warren Elizabeth Warren (Social Security Tax and Lobbying Tax)
Alexandria   Ocasio-Cortez Pete Buttigieg Andrew Yang
Elizabeth Warren Amy Klobuchar
Ron Wyden Alexandra Ocasio-Cortez
Bernie Sanders
Elizabeth Warren
Ron Wyden
Andrew Yang

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Extension of FBAR Filing Deadline for Certain Filers

On December 20, 2019, the Financial Crimes Enforcement Network (“FinCEN”) issued Notice 2019-1, extending the filing deadline for the Report of Foreign Bank and Financial Accounts, FinCEN Form 114 (FBAR), for certain individuals with signature or other authority over (but no financial interest in) employer-owned foreign financial accounts to April 15, 2021. FinCEN has provided similar extensions over the previous eight years.[1] This new extension applies to reporters with signatory authority during the 2019 calendar year and to those individuals whose reporting deadline was extended under prior notices (such as certain employees or officers of investment advisers registered with the U.S. Securities and Exchange Commission (SEC) who have signature authority over, but no financial interest in, certain foreign financial accounts).[2] All other filers must still file by April 15, 2020, although FinCEN will grant an automatic extension until October 15, 2020.

As reported in our prior client alerts,[3] the FBAR must be filed by a U.S. person that holds a financial interest in, or signature or other authority over, a foreign financial account if the aggregate value of all such U.S. person’s foreign financial accounts exceeds $10,000 at any time during the year. FBAR proposed regulations released in March 2016 and referenced by Notice 2019-1 would (i) expand and simplify the category of persons exempted from filing an FBAR who have signature or other authority over, but no financial interest in, a foreign financial account where another U.S. filer is filing an FBAR with respect to the same account, (ii) eliminate the special reporting rule for persons with signature or other authority over, or a financial interest in, 25 or more financial accounts that allows such persons to not disclose information with respect to such accounts that filers with fewer than 25 accounts are required to report, and (iii) for 2016 onward, align the due date for FBAR reporting with the due date for filing individual income tax returns. These FBAR proposed regulations will not take effect until and unless they are adopted in final form. [4] Until such time, the existing procedures for FBAR filings remain in effect, subject to the extension provided in Notice 2019-1.

Potential filers should note that the scope of individuals covered by Notice 2019-1 is broader than that of the FBAR proposed regulations. As described above, the FBAR proposed regulations exempt certain persons with signature or other authority over, but no financial interest in, certain foreign financial accounts from filing an FBAR only if another U.S. filer is filing an FBAR with respect to the same account. Under Notice 2019-1, however, these individuals are not obligated to file an FBAR, regardless of whether another U.S. filer is filing an FBAR with respect to the same account. It is unclear whether the final regulations, when issued, will only excuse an individual with signature or other authority over, but no financial interest in, a foreign financial account where another U.S. filer is filing an FBAR with respect to the same account or will eliminate this requirement to qualify for the exception. As a result, since Notice 2019-1 grants an extension only until 2021, employees of registered investment advisors with signature or other authority over, but no financial interest in, a non-U.S. account could have to file an FBAR if the FBAR proposed regulations are finalized in their current form.

[1] The previous notices granted extensions to (1) officers and employees of covered entities with signature or other authority over, but no financial interest in, a foreign financial account of a controlled person (a controlled person is a United States or foreign entity more than 50 percent owned, directly or indirectly, by a covered entity), (2) officers and employees of a controlled person of a covered entity with signature or other authority over, but no financial interest in, a foreign financial account of the entity, the controlled person, or another controlled person of the entity, and (3) officers and employees of investment advisors registered with the Securities and Exchange Commission with signature or other authority over, but no financial interest in, the foreign financial accounts of persons that are not registered investment companies.

[2] See Notices 2018-1, 2017-1, 2016-1, 2015-1, 2014-1, 2013-1, 2012-1, 2012-2, 2011-1 and 2011-2.

[3] June 16, 2011: “Delayed FBAR Filing For Signatory Authority” (http://www.proskauer.com/publications/client-alert/delayed-fbar-filing-for-signatory-authority) and March 14, 2011: “FinCEN Issues Final Rules on FBAR.” (http://www.proskauer.com/publications/client-alert/fincen-issues-final-rules-on-fbar).

[4] Beginning with the 2016 calendar year, the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (Pub. Law 114-41) aligned the due date for FBAR filings with the due date for filing individual income tax returns. Thus, the rule described in clause (iii) of the immediately preceding sentence is already in effect.

Sun Capital Update: First Circuit Finds Private Equity Funds Not Liable for Portfolio Company’s Pension Liabilities

First Circuit reverses District Court’s decision that co-investing funds were in de facto partnership which controlled portfolio company and could be held liable for portfolio company’s withdrawal liability; decision may be significant for multiemployer pension funds and private investment funds. Read the full alert.

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