Can Pillar Two Stop a Tax-Free Exit From the Opportunity Zone?

US corporate groups of US-based or foreign-based multinationals can enjoy the benefits of the qualified opportunity fund, or QOF, program to expand their US business. For example, a US group can invest its eligible gain in a controlling majority interest in a QOF partnership, which in turn can own controlling majority interests in qualified opportunity zone business, or QOZB, partnerships. Under Section 1400Z-2(b)(1)(B), corporate tax on that invested eligible gain would be deferred until 2026.

Under Treas. Reg. 1.1400Z2(c)-1(b)(2)(ii)(A), after 10 years of US group ownership of the QOF interest, a QOZB can generally sell its assets without recognition of taxable gain to the US group. A direct sale of QOZB assets may be the most desirable exit strategy as a business matter where, for example, prospective buyers may be concerned about unknown or contingent liabilities of the QOZB.

OECD Pillar Two—Acquisition of QOF

The possible forthcoming application of OECD Pillar Two rules would, in some cases, effectively impose a special tax on the income of a US corporate group of a large US-based or foreign-based multinational, where such US group’s US effective tax rate on its combined US income is less than 15%. The US ETR is generally determined by dividing the US group’s corporate income tax expense provision by the US group’s pretax income, typically as determined by the ultimate parent’s financial accounting method.

In some cases, the Pillar Two tax could be imposed by the US under a qualified domestic minimum tax. In some cases, the Pillar Two tax could be imposed by foreign countries through an income inclusion rule or undertaxed profits rule.

Under Pillar Two, deferred financial accounting US income taxes are generally favorably considered, though limited to a 15% rate, in the numerator of the US ETR fraction. They are typically not subject to recapture if reversed within five years.

To illustrate, suppose that, in 2025, a US group of a large multinational timely invests in a QOF with eligible gains recognized in 2024. The 2024 US corporate income tax applicable to those 2024 eligible gains will be triggered in 2026. Under the Pillar Two deferred tax financial accounting rules, the prospective 2026 corporate taxes could favorably be taken into account in 2024 at a 15% rate to prevent a marginal less than 15% US ETR in 2024.

Asset Sale by QOZB

Suppose that at least 10 years after the US group’s 2025 purchase of its QOF partnership interest—let’s say in 2037—the QOZB sells its assets. When a line-by-line-consolidated US constituent group entity, which could include a first-tier or lower-tier majority-owned and controlled US partnership, sells its assets, such asset sale triggers includable financial accounting gain or loss to the US group. Under Pillar Two, US C corporate members of a US group that are top-tier or lower-tier partners in a tax-transparent entity, such as a US partnership, take into account their pro-rata financial accounting income of such tax-transparent entity. They also take into account their own associated financial accounting corporate income tax expense on such allocated income.

The US group’s 2037 share of the QOZB’s financial accounting gain on sale would, therefore, generally increase the denominator of the US ETR fraction. Pillar Two does, however, permit an election to spread financial accounting real estate gains over a five-year look-back period.

By contrast, because of the 2037 permanent exemption from US corporate income tax under the QOF rules, the numerator of the US ETR fraction would not increase. For example, if the financial accounting income tax expense of the US group between 2033 and 2037 was small, and the allowable Pillar Two offset to the tax base (relating to 5% of payroll and 5% of the book value of property) was small, the Pillar Two tax could apply to much of that 2037 QOZB asset gain.

The potential adverse application of the Pillar Two tax to QOZB financial accounting asset gain could be viewed as a natural consequence of the worldwide application of the Pillar Two tax to the operations of multinationals that are in special economic zones that reduce the host country’s income tax. The potential adverse application of Pillar Two tax to financial accounting income permanently excluded from the US tax base under the Code is also not unique to QOF-related gain. For example, US members of large multinational groups whose US members own large portfolios of tax-exempt US municipal bonds have expressed concern they will be viewed as having a less-than-15% US ETR and thus possibly face Pillar Two tax on their municipal bond interest.

In connection with its discussion of Pillar Two, the Biden administration’s fiscal year 2023 budget proposal refers to an unspecified “mechanism to ensure US taxpayers would continue to benefit from ... tax incentives that promote US jobs and investment.” Treasury officials have indicated they are aware of Pillar Two issues raised by certain US socially directed tax subsidies, such as the low-income housing credit, that could reduce the US ETR of US groups below 15%. On the other hand, the proposed minimum tax on financial accounting income of very large corporations contained in the Build Back Better Act does not reduce financial accounting income by gain excluded under the QOF rules.

In some cases, a possible method of avoiding the seller’s Pillar Two tax could be to restructure a QOZB asset sale as a sale of the ownership interests, which sales are generally excused from immediate Pillar Two tax. However, sales of ownership interests may raise other business, regular corporate income tax, and Pillar Two issues to the seller and the buyer.

Conclusion

Multinationals whose US groups are contemplating using the QOF program will wish to review the projected US and foreign implementation of Pillar Two, as well as other tax and non-tax aspects, at the time they evaluate possible investments in QOFs, and again at the time of dispositions.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, Fla.

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