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April 29, 2021

US: Proposed regulations would coordinate tax withholding and gain deferral for certain foreign persons and partnerships investing in qualified opportunity funds, clarify working capital safe harbor

The United States (US) Internal Revenue Service (IRS) released proposed regulations (REG-121095-19) that would allow certain non-US persons and non-US-owned partnerships, including private equity, real estate, and other alternative and private capital funds, to reduce or eliminate withholding imposed under Internal Revenue Code1 Sections 1445, 1446(a) and 1446(f) on eligible gains deferred and invested in a qualified opportunity fund (QOF) provided certain requirements are met. These persons or partnerships must timely obtain from the IRS an "eligibility certificate" and meet certain specified requirements to include their "security-required gains" (defined below) in their QOF gain deferral election.

The proposed regulations also clarify the requirements for Qualified Opportunity Zone Businesses (QOZBs) receiving up to an additional 24 months under the working capital safe harbor because of a federally declared disaster.


The Tax Cuts and Jobs Act (TCJA) created opportunity zones (OZs) by adding Section 1400Z-1 and Section 1400Z-2 to encourage investment in economically-distressed areas by giving tax incentives to taxpayers who invest and hold onto investments in OZs through QOFs.

Section 1400Z-1 allows certain areas to be designated as OZs. Section 1400Z-2 provides benefits for investment in QOFs. A QOF is a corporation or partnership that holds at least 90% of its assets in OZ property. Investors in QOFs must make a Section 1400Z-2(a) election to defer eligible gain. The investment interest must be an equity interest and may include preferred stock or a partnership interest. In general, the QOF investment must have been made within 180 days after the deferred gain was realized.

Investors can generally defer tax on eligible gains invested in a QOF until the earlier of the date on which the investment in a QOF is sold or exchanged, or 31 December 2026. If the QOF investment is held for longer than five years by the end of the deferral period, 10% of the deferred gain is excluded; a 15% exclusion applies if the investment is held for more than seven years by the end of the deferral period. If the investment is held for at least 10 years, the investor is eligible for a basis increase equal to the QOF investment's fair market value on the date that the QOF investment is sold or exchanged, thus excluding 100% of the gain that would have been realized from disposing of the appreciated QOF.

Certain non-US persons, including non-US persons who invest in certain partnerships, are subject to withholding under Sections 1445 (disposition of a US real property interest), 1446(a) (taxable income to a foreign partner) and 1446(f) (disposition of a partnership interest). This withholding tax is intended to approximate the non-US person's substantive US tax liability on certain transactions. The withheld amount may be claimed as a credit or refund after the filing and payment of taxes.

The IRS issued proposed regulations on investing in QOFs in October 2018, a second set of proposed regulations in May 2019, and final regulations in January 2020.

Ability to reduce or eliminate US withholding tax as part of a QOF deferral election

The proposed regulations would coordinate the deferral election under Section 1400Z-2(a) with the withholding rules in Sections 1445, 1446(a) and 1446(f).

The proposed regulations would permit certain non-US persons and non-US person-owned partnerships (security-required persons) to reduce or eliminate certain US withholding tax on deferred gains invested in eligible investments in QOFs. The security-required persons would have to timely obtain an "eligibility certificate" from the IRS and submit the appropriate security. The certificate would specify the permitted deferral amount. The proposed regulations would allow non-US partnerships to take into account "the permitted deferral amount" specified in an eligibility certificate when determining whether any withholding liability is imposed under Section 1446.

"Security-required persons," would be defined as either foreign persons that are not partnerships or partnerships that pass the following three tests:

  1. The "ownership test" (at least 20% of the capital or profits interests in the partnership are owned (directly or indirectly) by one or more nonresident aliens or foreign corporations at the time of the transfer resulting in the security-required gain).
  2. The "closely-held test" (during the look-back period, has 10 or fewer direct partners that own 90% or more of the capital or profits interests in the partnership).
  3. The "gain test" or "asset test" (either the security-required gain is US$1 million or more, or the aggregate value of the partnership's US real property interests or assets used in a trade or business in the United States is, at any time during the look-back period, 25% or more of the value of all the assets of the partnership).

Partnerships that pass these tests are referred to as "specified partnerships." The look-back period begins on the later of one year before the date of the transfer resulting in the security-required gain, or the date on which the partnership was formed, and ends on the date of such transfer. In general, a "security-required gain" is gain from certain dispositions or distributions to security-required persons and certain partnerships, including specified partnerships, that would otherwise be subject to withholding under Sections 1445, 1446(a) or 1446(f) or would be included in computing effectively connected taxable income (ECTI). Such transactions are referred to as "covered transfers."

To include security-required gain as part of the QOF deferral election and thereby reduce or eliminate certain US withholding tax, the security-required person would have to apply to the IRS for an eligibility certificate. If the certificate is obtained prior to the transaction giving rise to the security-required gain, the proposed regulations eliminate or reduce withholding under Sections 1445, 1446(a), or 1446(f) on security-required persons. A security-required person that does not obtain an eligibility certificate before the transfer, and thus is withheld upon, must still obtain an eligibility certificate to make a Section 1400Z-2(a) deferral election on any security-required gain. The security-required person must obtain the eligibility certificate from the IRS by the date on which this deferral election is filed with the IRS. The security-required person (or, if applicable, its partner, owner or beneficiary) may also claim a credit or refund for the amount withheld on the deferred gain when filing its return. The application for a certificate must include (1) certain information about the security-required person and the transfer, (2) an agreement for the tax deferral and accompanying security (deferral agreement), (3) an agreement with a US agent, and (4) acceptable security (an irrevocable standby letter of credit issued by a US bank that meets certain capital and other requirements). If a security-related person defaults under the terms of a deferral agreement, then gain previously deferred under the deferral agreement must be included in income.

The proposed regulations give the formula for determining the amount of required security based on the specific circumstances. Once that amount is calculated, if a security-required person provides the maximum security amount, the permitted deferral amount would be the total amount of security-required gain. If a security-required person provides a lesser amount of security, the permitted deferral amount would be the total amount of security-required gain multiplied by the ratio of the amount of security provided over the maximum security amount.

Working capital assets

The proposed regulations would also give QOF investors clarification around flexibility in expending their working capital assets.

Under the Section 1400Z-2 final regulations, QOZBs located in an OZ "within a [f]ederally declared disaster," have up to an additional 24 months to deploy their working capital in line with their written business plan and schedule under a valid working capital safe harbor.

The proposed regulations would allow QOZBs taking advantage of this additional time for capital deployment to revise or replace their original written designation and written plan, provided that the remaining working capital assets are expended within the original regulatorily required 31-month period, increased by no more than the 24 additional months provided in response to the federally declared disaster. Such revision or replacement of a QOZB's written plan and schedule must occur within 120 days of the close of the disaster period.

Applicability Dates

The proposed regulations relating to covered transfers, including the requirements for eligibility certificates, would apply to any covered transfer that occurs after the date that the regulations are published as final regulations in the Federal Register. Taxpayers are not permitted to submit applications for eligibility certificates before the date of publication.

The proposed regulations relating to the flexibility for expending working capital safe harbors would apply to tax years beginning after the date the regulations are published as final regulations in the Federal Register. According to the Preamble, taxpayers may rely on this part of the proposed regulations for tax years beginning after 31 December 2019.


Although an eligibility certificate requirement could present an administrative hurdle, the ability to reduce or eliminate Sections 1445 and 1446 withholding is expected to facilitate inbound investment into OZs. Private equity, real estate and other alternative private capital funds with non-US investors looking to invest in OZs are expected to benefit from this taxpayer favorable change. Security-required persons should be mindful that, to the extent a QOF investment exceeds the permitted deferral amount under an eligibility certificate, the excess investment will not constitute a qualified QOF investment, and will result in "mixed fund" treatment. It will be incumbent on funds and non-US persons to timely obtain, and the IRS to timely provide, these eligibility certificates.

In terms of the proposed working capital safe harbor clarification, taxpayers would likely view the provision on revising or replacing the written designation and schedule favorably. The final regulations contain broad language on this point and many QOZBs have sought guidance in the face of needing to pivot their business during the COVID-19 pandemic. Notably, the proposed regulations provide an end date for when QOZBs in a federally declared disaster can revise or replace their written designation and schedule, indicating that outside of the context of a disaster QOZBs would not be permitted to make revisions or replacements under the working capital safe harbor. This raises a question as to the line between a QOZB making immaterial updates and a QOZB making "revisions" or a "replacement." Additionally, it remains unclear whether QOZBs must demonstrate the impact of a disaster on their trade or business or the extent to which a QOZB will be permitted to benefit from the full 24 months rather than a lesser amount of additional time for capital expenditure.


For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (United States), Tax Credit Investment Advisory Services

Ernst & Young LLP (United States), FSO – Private Equity Tax



  1. All “Section” references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.

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