Withholding and QOZs: Treasury Withholds Relief, and Non-U.S. Investors Withhold Capital

Not infrequently, we are asked why there hasn’t been greater uptake of the Qualified Opportunity Zone (QOZ) program by non-U.S. taxpayers. Although data is lacking, we note anecdotally that, at least in our tax practice, we encounter far fewer non-U.S. taxpayers investing in qualified opportunity funds than we do in the other funds we advise. We posit that the reasons for this poor uptake are structural in nature, as many non-U.S. taxpayers’ primary exposure to U.S. real estate assets is through U.S. blocker structures set up by pooled investment vehicles, which generally don’t give rise to eligible gains because by design such structures “block” effectively connected income (ECI).

Although non-U.S. taxpayers could seek to restructure U.S. blocker structures to recognize eligible gains, withholding taxes apply to such transactions under the current regulations and are a significant deterrent to potential non-U.S. taxpayers. For these reasons we, like prior commenters, would welcome new guidance providing relief from withholding taxes on eligible gains. At worst, such relief would harmonize QOZ policy in respect of non-U.S. taxpayers; at best it could help catalyze this important source of capital investment into distressed communities.

In this article we examine the following:

1. Intent of the QOZ Program;
2. Rules for non-U.S. taxpayers considering investments in QOZs;
3. Non-U.S. taxpayers’ real estate investments as a share of potential QOZ capital;
4. Potential issues with withholding on such non-U.S. investors’ eligible gains as a general matter;
5. Structural issues associated with common structures for non-U.S. taxpayers’ investments in U.S. real estate (i.e., the use of U.S. blocker corporations) and alternative exits that could be used to address these structural issues;
6. The mechanics of withholding on such alternative exits;
7. Additional areas of uncertainty related to tax return filing requirements and reporting on inclusion events; and
8. Potential solutions.

Intent of the QOZ Program

The QOZ program had bipartisan origins and became law as part of the 2017 Tax Cuts and Jobs Act (TCJA). The goal of the program is to “attract an influx of capital to designated low income communities” by providing tax benefits to investors who invest certain eligible capital gains into qualified opportunity funds (QOFs) within a designated rollover period (generally 180 days). The tax benefits intended to attract this capital include deferral of taxation on an invested gains until Dec. 31, 2026 (or an earlier “inclusion event”); a basis adjustment resulting in a permanent reduction of 10% of the gain if the investor’s interest in the QOF is retained for at least five years; and a permanent gain exclusion with respect to any appreciation in a QOF provided such interest is retained by the investor for at least 10 years.

The QOZ component of the TCJA was scored on the premise that investors would, absent the QOZ tax incentives, continue to hold their existing investments. Although the overall score was negative, more revenue was projected by lawmakers to be raised by tax code Section 1400Z-2 in tax year 2026 than lost in each of the prior deferral years 2018-2025 based on the expectation that taxpayers would sell gain assets they would have retained but for the QOZ tax incentives. Additionally, it has been estimated that $52 billion would not have been invested into QOZs to date without the incentive.

The current program, however, does not provide clear guidance to non-U.S. taxpayers on the consequences of selling their assets in order to invest in a QOF, such as the withholding and reporting consequences of such a sale.

QOZ Rules for Non-U.S. Taxpayers

Although neither the statute nor the proposed QOZ regulations contained any restrictions on non-U.S. taxpayers investing in QOFs, prior to publication of the final QOZ regulations, certain practitioners were hesitant to advise non-U.S. taxpayers that they could avail themselves of QOZ tax benefits. Additionally, commenters raised cash flow concerns about the practicality of non-U.S. taxpayers’ participation in the program in light of the absence of relief from withholding on non-U.S. taxpayers’ eligible gains.

The final QOZ regulations clarified that non-U.S. taxpayers may participate in the QOZ program, but only to the extent they reinvest capital gains that are “effectively connected” with a U.S. trade or business (i.e., subject to tax in the U.S.). However, the final QOZ regulations left open the question of relief from withholding on non-U.S. taxpayer’s eligible gains, noting that “[t]he Treasury Department and the IRS continue to consider … other matters related to the mechanics of applying Section 1400Z-2 in the context of a sale subject to withholding tax.”

As background, a gain deferral election may only be made under Section 1400Z-2(a) by an eligible taxpayer with respect to an eligible gain. The final regulations changed the definition of eligible taxpayer from “a person that may recognize gains for purposes of federal income tax accounting” to “a person that is required to report the recognition of gains during the taxable year under federal income tax accounting principles”, and added the following language to the relevant component of the eligible gains definition—“would be recognized for Federal income tax purposes and subject to tax under subtitle A ofthe Code before Jan. 1, 2027 (subject to Federal income tax), if Section 1400Z-2(a)(1) did not apply to defer recognition of the gain.” The final regulations also added rules for determining whether gain is subject to U.S. federal income tax for this purpose, which effectively remove treaty exempt gains from the definition of eligible gain (whether exempt in the initial year of recognition or when included at the end of 2026 or upon an inclusion event), and a special partnership anti-abuse rule disregarding partnerships “formed or availed of with a significant purpose of avoiding the requirements of Treasury Regulation 1.1400Z2(a)-1(b)(11)(i)(B) that a gain be subject to Federal income tax in order to be an eligible gain.”

The special partnership anti-abuse rule, and two examples, were presumably included in the final regulations because partnerships were added to the definition of eligible taxpayer. The significant purpose requirement presumably permits pre-existing partnerships with a non-U.S. partner(s) to be eligible taxpayers, notwithstanding whether the only partners of the partnership are non-U.S. taxpayers. Non-U.S. partnerships are not generally required to file a federal tax return unless they have gross income that is ECI or U.S.-sourced.

In making these changes (which, as described further below, considerably limit the ability of non-U.S. taxpayers to participate in the program), the preamble to the final QOZ regulations indicated that the new limitations on the definition of eligible gains were imposed due to concerns that (1) the Internal Revenue Service (IRS) be able to confirm deferred gains were capital gains, and (2) U.S. and non-U.S. taxpayers investing in QOFs be treated similarly. The final QOZ regulations did not, however, address commenters’ concerns regarding the mechanics of withholding and reporting on deferred gains of non-U.S. taxpayers.

Non-U.S. Taxpayer Investment in U.S. Real Estate as a Source of Potential QOF Capital

Non-U.S. taxpayers own up to 20% of U.S. stocks and bonds. Gains from the sale of personal property, such as stocks and bonds, are generally sourced to the jurisdiction of the taxpayer (i.e., in this case, non-U.S. source) and not subject to U.S. federal income tax unless this treatment is overridden by another provision in the tax code. The changes in the final QOZ regulations, outlined above, shrunk the pool of available QOF capital considerably by making gains from the sale of these securities ineligible for reinvestment into QOFs.

After stocks and bonds, commercial real estate represents the largest investable asset class, comprising up to 20% of total U.S. investable assets. Non-U.S. taxpayers accounted for approximately 12% of the total U.S. commercial real estate investment volume in 2019. Such non-U.S. investors have historically gravitated toward real estate investment trusts (REITs) and large private equity format investments. Gains from non-U.S. taxpayers’ sale of public REIT shares are generally, like gains from the sale of other stocks and bonds, ineligible gains for the QOZ program.

Unlike stocks and bonds, gains from the sale of U.S. real estate assets are generally eligible gains for the QOZ program. Real estate may be an investment asset, used in a trade or business, or inventory, depending on the intent of the holder and various other facts and circumstances. As early as the second set of proposed regulations under Section 1400Z, the IRS and Treasury clearly established that gains from the sale of real estate used in a trade or business (which are not capital gains in the first instance but rather recharacterized under Section 1231 as capital gains) were eligible gains for purposes of the QOZ program, leaving out only real estate held as inventory or dealer property. And, because real estate capital gains of non-U.S. taxpayers from the sale of investment property or 1231 property gains are deemed to be effectively connected to a U.S. trade or business under the Foreign Investment in Real Property Tax Act (FIRPTA) they will generally be eligible gains for the purpose of the QOZ program.

Gains from the sale by non-U.S. taxpayers of U.S. real estate assets therefore represent a much more significant share of the available pool of non-U.S. taxpayer QOF equity than they might otherwise.

Withholding Issues in General

A notable feature of the QOZ program is that only the taxpayer’s net gain from its disposition of an investment must be reinvested in order to defer tax on the taxpayer’s transaction. For example, if property with a basis of 20 is sold for 50, only 30 (and not the full 50, as would be the case with a like-kind exchange under Section 1031) must be reinvested in order to achieve tax deferral and the other QOZ tax benefits. It is also possible in the QOZ context to reinvest (and make a QOF gain deferral election with respect to) less than the amount of the full gain and achieve a partial deferral. For this reason, withholding tax of up to the amount of return of basis might not be considered punitive (i.e., up to 20 in this example could be withheld before a non-U.S. taxpayer would be “penalized”).

Stated differently, the gain as a percent of proceeds from a transaction would need to exceed the withholding percentage to have the effect of reducing a non-U.S. taxpayer’s ability to invest in a QOF. For example, if property sold for 100, had a basis of 10 and withholding of 15, it would effectively mean that the taxpayer would only have available cash of 85 to invest into a QOF instead of its 90 of eligible gain. Similarly, if cash of 100 were distributed by a partnership to a non-U.S. partner in respect of a transaction in which 85 of gain was recognized, the 17 of ECI withholding in the case of a corporation or 31.45 of ECI withholding in the case of a non-corporation would reduce the non-U.S. taxpayer’s ability to invest into a QOF.

Although we might therefore say that only “low basis” transactions are affected by the cashflow issues associated with an absence of withholding relief, these are precisely the types of transactions the QOZ program was designed to incent (i.e., the “locked-in” gain transactions that might not otherwise happen because the potential tax was too “punitive”). Moreover, these issues become even more challenging when examined in the context of how non-U.S. taxpayers invest into U.S. commercial real estate.

Structural Issues with non-U.S. Taxpayers’ Investments in U.S. Real Estate and other ECI Assets

Given that the QOZ program requires the taxpayer who recognizes the eligible gain to directly invest into the QOF, the mechanics of how most non-U.S. taxpayers invest into U.S. assets are important.

Gain from the disposition of a direct investment in U.S. real estate or an indirect investment through a U.S. operating business structured as a partnership, as well as most or all of the income from such an investment, is subject to U.S. federal income tax and required to be reported by a non-U.S. taxpayer on a U.S. federal income tax return. This remains the case regardless of the non-U.S. investor’s investment intent or how long the investment has been held. Such income and gains are taxable under the U.S. federal income tax rules relating to income that is “effectively connected” with a U.S. trade or business (ECI), including in the case of sales of U.S. real estate under FIRPTA.

U.S. blocker corporations are frequently used by non-U.S. investors in order to reduce the administrative burden associated with U.S. tax return filing requirements, as compared to a direct investment into U.S. real estate or investment through one or more disregarded entities or partnerships. To the extent real estate is held in U.S. trade or business, which would generally be the case where used in a rental real estate business or where FIRPTA would treat gains from the sale of real estate as effectively connected with a U.S. trade or business, the non-U.S. investor is required to file a U.S. federal income tax return. Outside of the context of QOZ investing and the need to generate eligible gains, this is generally viewed as undesirable to the extent the use of a leveraged U.S. blocker corporation would reduce the U.S. federal income taxes otherwise due.

Further, shareholder debt is frequently added to a U.S. blocker corporation in order to reduce the U.S. tax cost of the real estate investment via interest deductions that offset taxable income and gain. In general, the U.S. blocker corporation files a U.S. tax return annually for each year of the investment, and the non-U.S. investors who directly or through one or more partnerships invest in the U.S. blocker corporation do not file U.S. tax returns. After the investment is sold the U.S. blocker corporation is liquidated in order to return proceeds from the sale of real estate to the non-U.S. investors. If a U.S. blocker corporation disposes of its interests in U.S. real estate prior to liquidating it may make liquidating distributions that are not subject to U.S. withholding taxes (that is, they are neither dividends attracting withholding taxes under Section 1442 as “fixed determinable annual and periodic” income or subject to taxes under Sections 1445 or 1446 as FIRPTA gain or ECI).

Non-U.S. investors who participate in U.S. investments, whether in real estate assets or operating businesses, via a U.S. blocker corporation will not generally recognize eligible gains that may be invested into a QOF. Although liquidation proceeds from a U.S. blocker corporation are capital gains, they are unlikely to be “eligible gains” per the restrictive definition in the final regulations—they are not ECI because the blocker either is not, or would not be at the time of liquidation, a U.S. real property holding company (USRPHC). Although a U.S. blocker corporation is itself an eligible taxpayer and could elect to defer gains by investing into a QOF, many U.S. blocker corporations are formed to pool investments from multiple unrelated non-U.S. and U.S. tax-exempt investors, who are unlikely to share a common intention to invest into a particular QOF, or even a QOF in general.

We observe that this effective restriction on non-U.S. taxpayers from reinvesting gains recognized by a U.S. blocker corporation was likely unintentional, resulting from the new restricted definition of eligible gains taken together with the general rule that a taxpayer must direct invest eligible gains into a QOF. The IRS and Treasury could presumably provide through guidance a special rule allowing non-U.S. investors to reinvest gains recognized via a U.S. blocker corporation. Such a rule would be consistent with the stated purpose behind the eligible gains definition noted in the preamble to the final regulations to ensure the IRS could confirm the reinvested gains were capital gains (the IRS would have access to the U.S. blocker corporation’s tax return) and parity between U.S. and non-U.S. taxpayers (presumably the notion here was not to allow non-U.S. taxpayers to reinvest untaxed gains, not gains taxed by virtue of legal entity structuring by another entity).

Although it may be possible to restructure an investment in a U.S. blocker corporation to give rise to eligible gain, several hurdles exist. Consider for example, an investment into a U.S. operating partnership via a U.S. blocker corporation. Assuming that such an restructuring transaction were commercially feasible, if a non-U.S. taxpayer has identified a potential QOF investment it wishes to reinvest gains into it may be too late to restructure the blocked investment; a transaction to liquidate or sell the U.S. blocker corporation would only give rise to ineligible gains and little to no incremental ECI gain may be left to recognize on the sale of the partnership that follows. If, on the other hand, the non-U.S. taxpayer proactively restructures its blocked investment before any appreciation occurs, the non-U.S. taxpayer faces the following challenges: (1) the administrative burden of filing U.S. tax returns in respect of the investment for several years, (2) the risk that the investment may not be sold in time to reinvest before the end of 2026 into a QOF, (3) incrementally higher tax on its income and gain to the extent the U.S. blocker corporation were leveraged, and (4) gain from the ultimate sale of partnership interests would be subject to withholding under Section 1446(f).

It may be more feasible to restructure an investment in real property held via a U.S. blocker corporation to give rise to eligible gain. As FIRPTA will generally cause gains from the sale or liquidation of a U.S. blocker corporation that is a USRPHC to be ECI, any gain recognized on restructuring would be eligible gain. To the extent a blocker corporation is held by non-U.S. investors indirectly through a protective non-U.S. blocker corporation (e.g., a Cayman blocker corporation formed to block FIRPTA gains on a potential distribution in excess of earnings and profits, and basis – a relatively common structure for non-U.S. taxpayers other than Section 892 investors), it will generally not be possible to sell the blocker corporation to recognize eligible gains. However, such strategies will, unless a U.S. blocker corporation is controlled by the non-U.S. taxpayer, require participation from a sponsor and will generally be subject to withholding. In this context, commenters’ concerns about withholding on eligible gains come to life.

Withholding on Eligible Gain in Connection with Alternative Exits

As noted above, commenters have identified FIRPTA and ECI withholding as an issue for non-U.S. taxpayers looking to invest in QOFs, and the IRS and Treasury continue to consider these issues.

In light of the structural issues with non-U.S. taxpayers’ investments in U.S. real estate through U.S. blocker corporations discussed above, a non-U.S. taxpayer may consider restructuring transactions or alternative exit strategies, in either case designed to give rise to eligible gains and therefore subject to withholding.

For example, a non-U.S. taxpayer investor in a U.S. real estate fund, rather than waiting for the fund sponsor to sell U.S. real estate assets and return capital to the non-U.S. taxpayer in the form of ineligible gains, seeks to recognize gains from its U.S. real estate investments in late 2021 in order to invest into a QOF in early 2022 (within the required 180-day rollover period). The investor identifies a willing buyer for an interest in the partnership owning a U.S. blocker corporation, which is a U.S. real property interest (USRPI), and obtains consent from the sponsor to provide information to the purchaser to diligence the transaction, and for the transfer itself (each of which takes time). FIRPTA generally requires a buyer to withhold 15% on the gross proceeds paid in connection with its purchase of a USRPI from a non-U.S. seller unless an exception applies. None of the exceptions from withholding at closing (which generally require a seller to provide documentation establishing its non-foreign status or the non-USRPI status of the interest disposed) can be expected to apply.

Although certain exceptions to withholding at closing are available for non-recognition transactions, Treas. Reg. 1.1445-2(d)(2) is unlikely to apply given that:

(1) Treas. Reg. 1.1400Z2(a)-1(e) specifically provides that Treas. Reg. 1400Z-2 is not a non-recognition provision for purposes of Treas. Reg. 1.897-6T, and even were Section 1400Z-2 considered a non-recognition transaction for this purpose;

(2) Section 1400Z-2 only excludes a portion of the gain (and partial nonrecognition transactions are not eligible for the exception per Treas. Reg. 1.1445-2(d)(2)(ii)(A)); and

(3) Treas. Reg. 1.1445-2(d)(iv) specifically excludes from the withholding exemption at closing deferred like-kind exchanges “where the transferee cannot determine that the exchange has been completed and all the conditions for non-recognition have been satisfied at the time it is otherwise required to pay the Section 1445 withholding tax and file the withholding tax return (Form 8288, “U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests”).”

For all these reasons, the IRS and Treasury would need to provide affirmative relief for purchasers to feel comfortable relying on a non-recognition notice from a non-U.S. seller.

If no exception from FIRPTA withholding applies at closing and the seller’s maximum tax liability is less than 15%, a non-U.S. seller may apply for a withholding certificate. If the non-U.S. taxpayer intends to reinvest 100% of its gain into a QOF within 180 days and make a gain deferral election, its maximum liability should be zero. However, because such application only delays reporting and payment of the tax by the purchaser until after the disposition of the application by the IRS (i.e., the buyer does not remit the tax to the IRS, but neither does the buyer remit the cash to the seller), unless the sale is a related-party transaction, a cashflow issue will be present. Commenters have noted that the 90-day review period for the early refund could be a significant commercial constraint on investing into a QOF given the strict 180-day rollover period in Section 1400Z. Of greater significance, when taking into account the restrictions imposed by the IRS and Treasury on like-kind exchanges as a form of non-recognition transaction exempting a sale from withholding at closing, it is unclear that the IRS would be compelled to issue a withholding certificate. In the QOF context this would potentially leave the non-U.S. taxpayer waiting for its refund until after the tax return on which it makes its gain deferral election for its investment into a QOF is filed.

To complicate matters, the relevant return on which a refund would be requested might not be filed until a subsequent tax year. For example, in the case of a 2022 gain event and a reinvestment into a QOF in 2023, the refund might not be granted until 2024 (two full taxable years after the QOF investment is made). Unless relief is provided by the IRS and Treasury, the non-U.S. seller could, at best, expect an early refund to be granted after it made its investment into a QOF.

Similar withholding issues would arise were a non-U.S. taxpayer to restructure its investment in a U.S. blocker corporation to ensure that gains allocated to the non-U.S. taxpayer when the fund sponsor exits from the real estate assets in the future are eligible gains. For example, if the relevant U.S. blocker corporation is held via a 50/90 partnership formed by a fund sponsor, a redemption transaction would likely give rise to 15% FIRPTA withholding or, were the blocker “above the fund”, withholding would likely apply under Section 1445(e)(3). As described above there is currently no relief from such withholding; we posit this would be a significant deterrent to restructuring an investment in property the sale of which would otherwise give rise to eligible gains via U.S. blocker corporations.

Additionally, the ultimate gains from the sale of such restructured real estate investment remitted to the non-U.S. taxpayer in a non-liquidating distribution would give rise to ECI withholding by the fund sponsor under Section 1446(a) (unless an exception applies). Applicable regulations provide that a non-U.S. taxpayer partner’s allocable share of partnership ECI does not include income or gain exempt from U.S. tax. However, if Section 1400Z is not a non-recognition provision it is unclear whether a partners’ intent to make a gain deferral election under Section 1400Z-2 would qualify its allocated ECI as “exempt” from taxation for purposes of Section 1446 withholding.

Tax Return Filing Requirements and Reporting on Inclusion Events

Underlying the IRS and Treasury’s failure to provide relief on withholding taxes may be a concern that non-U.S. taxpayers may not pay taxes when deferred gains are included in 2026. There is currently no requirement in the tax code or regulations for a QOF to report inclusion events or gains and no withholding regime appears to apply to included gains (that is, inclusion events appear to arise solely at the investor level except to the extent withholding would arise outside the QOZ context, for example, if the inclusion event were due to a sale of the QOF or a distribution in excess of basis).

Commenters have expressed concern as to how inclusion events should be reported by non-U.S. taxpayer investors in QOFs and how any taxes would be collected, recommending that non-U.S. taxpayers investing in QOFs be required to file U.S. federal income tax returns over each year of their holding period for a QOF and certain commenters going so far as to recommend special rules disallowing year 10 benefits unless non-U.S. taxpayers could affirmatively confirm payment of taxes on inclusion events and/or as of Dec. 31, 2026.

Another comment letter recommended that in order to relieve withholding on a non-U.S. taxpayer seller of a USRPI, guidance could be promulgated requiring the seller to file a gain recognition agreement (GRA) with its timely filed U.S. federal income tax return for the taxable year of disposition. In that scenario, gain would presumably be included by the non-U.S. taxpayer in 2026 or upon any earlier inclusion event under the rules of Section 1400Z and withholding could accordingly be relieved on the non-U.S. taxpayer’s eligible gain by providing a buyer with documentation at closing certifying the seller’s intent to file the GRA. The same commenter further recommended that the non-U.S. taxpayer seller file an annual statement detailing the prior disposition, the current ownership of the QOF investment and any inclusion event(s) with its U.S. federal income tax return and file a form similar to the Form 8828 (“Consent to Extend the Time to Assess Tax Under Section 367—Gain Recognition Agreement”), agreeing to extend the period of limitations on assessment of tax with respect to the amount of deferred gain. Another commenter consistent with the general rule that attributes attach to a deferred gain when subsequently recognized, suggested that the IRS consider that the withholding would arise at the time of a subsequent inclusion event and/or Dec. 31, 2026.

There is no reporting of inclusion events at the QOF level, for example on Form 8996. Instead, inclusion events are self-reported by the QOF investor on Forms 8949—“Sales and Other Dispositions of Capital Assets,”and 8997—“Initial and Annual Statement of QOF Investments.” Presumably non-U.S. taxpayers not otherwise required to file U.S. federal income tax returns would generally not file Form 8949. It is unclear whether non-U.S. taxpayers not otherwise required to file U.S. tax returns would be required to file solely for the purpose of remitting Form 8997, and Form 8997 only appears to be required to be filed in a year in which a QOF interest is held (not, for example, in the year a gain deferral election is made, if earlier). Although the instructions to Form 8997 are currently silent on this point, presumably the IRS would have an interest in collecting the information on such form to track payment of tax on inclusion events.

Now that the IRS and Treasury have limited the universe of non-U.S. taxpayers’ eligible gains to ECI, there is relatively more clarity that a gain deferral election would be filed on a non-U.S. taxpayer’s Form 8949. This form is generally filed with such taxpayer’s U.S. federal income tax return for the year of the investment into a QOF, with a “negative gain” recorded on the form. There is relatively less clarity on the mechanics of effecting the gain deferral election if the gain is invested across a straddle period and where the non-U.S. taxpayer is not otherwise required to file a tax return in the year of investment (for example if the eligible ECI gain is recognized in a prior taxable year, and the QOF investment itself is not considered to give rise to a filing obligation). Although it would be helpful to clarify whether a U.S. federal income tax return should be filed by the non-U.S. taxpayer solely for the purpose of remitting the Form 8949 to make a gain deferral election in this circumstance, even less clear is whether non-U.S. taxpayers are, under current law, required to file U.S. federal income tax returns for each year of their holding period in a QOF.

The regulations provide that when previously deferred gain is included by the QOF investor, such gain “has the same attributes in the taxable year of inclusion that the gain would have had if recognition of the gain had not been deferred” and that “[t]hese attributes include those taken into account by Sections 1(h), 1222, 1231(b), 1256, and any other applicable provisions of the Code.” Because deferred gains retain their original character when included by a QOF investor, and non-U.S. taxpayers may only invest ECI gains, at a minimum the non-U.S. investor taxpayer would be required to file a U.S. federal income tax return (presumably including Form 8949 as well as Form 8997), in the year of any inclusion event and/or in 2026.

Additionally, QOF partnerships investing in qualified opportunity zone business (QOZB) partnerships will have a U.S. trade or business by definition, and therefore all non-U.S. taxpayer partners should expect to file U.S. tax returns each year they are partners in the QOF under pre-existing law because they will be partners in a partnership that is engaged in a U.S. trade or business (regardless of whether or not they are allocated ECI for a particular taxable year). However, certain safe harbors may permit QOZBs developing property to qualify provided they expect to have a trade or business as of the end of the safe harbor period and it would be helpful for the IRS and Treasury to clarify whether non-U.S. taxpayer partners in a QOF partnership that has only an anticipatory trade or business are required to file U.S. federal income tax returns.

Potential Solutions

Were the IRS to affirmatively require non-U.S. taxpayers to file Forms 8997 (even in tax years they might not otherwise be required to), this would appear to put non-U.S. investor taxpayers on even footing with U.S. investors. Given that parity between U.S. and non-U.S. taxpayers was a concern noted in the preamble to the final regulations by the IRS and Treasury and one of their reasons for limiting eligible gains of non-U.S. taxpayers, this feels like the right balance. Were the Form 8997 required to be filed beginning in the year the gain deferral election were made (even if a QOF investment were made in a subsequent tax year), it should provide the IRS with sufficient information to track whether the QOF investment is ultimately perfected and if not whether gain is included. Making these relatively simple changes would moot several of the more esoteric tax return filing questions discussed above and provide the IRS with a mechanism to track the payment of taxes on deferred gains in 2026 as well as on any potential inclusion events.

To the extent a non-U.S. taxpayer were required to file U.S. tax returns for each year of its holding period, we believe it would be appropriate for the IRS and Treasury to afford flat relief on withholding provided a taxpayer certified its intent to invest into a QOF within 180 days. Were such investment not in fact made, the taxpayer would generally remit tax on its gain with its return for the year of its eligible gain or may be required to amend a prior year return in certain situations. Presumably the IRS and Treasury could similarly provide a mechanism for a non-U.S. taxpayer partner to certify its intent to reinvest gain in a QOF and obtain a reduction in withholding under Section 1446(a).

Relief may not be needed in situations where a non-U.S. taxpayer makes an investment directly in U.S. assets and therefore has a greater ability to control the structure of its investment. For example, a non-U.S. taxpayer that is a corporation could liquidate its U.S. blocker corporation in a nontaxable transaction under Section 332 and retain control of a U.S. real estate or flow through investment, so that when it exits it recognizes eligible gain. Similarly, a non-U.S. taxpayer invested in pooled U.S. investment vehicles through its own U.S. partnership would have significantly greater flexibility to generate eligible gains for reinvestment into a QOF on account of its controlled U.S. partnership (1) not being a non-U.S. seller for purposes of FIRPTA withholding; (2) being an eligible taxpayer to make a gain deferral election; (3) having a potentially longer 180-day period to invest; and (4) having control over ECI withholding and therefore potentially being able to take its planned gain deferral election into account in calculating its withholding liability.

However, for other non-U.S. taxpayer investors whose exposure to U.S. effectively connected assets is primarily through pooled investment vehicles, the structural issues noted above will generally prevent them from recognizing eligible gains and, absent relief, the withholding issues noted above will be significant disincentive to the alternative exit transactions they might otherwise undertake in order to give rise to eligible gains.

Conclusion

Through the multiple rounds of regulations, participation by non-U.S. taxpayers in the QOZ program raised an interesting set of eligibility, withholding, and reporting questions, and these question in turn generated a number of comment letters. Although the final regulations addressed the eligibility question, questions about withholding and reporting remain unanswered. While we contemplate above several potential solutions providing paths forward in the areas of withholding and reporting, the fact is that the final QOZ regulations did not provide non-U.S. taxpayers the same level of certainty as U.S. investors. As a result, this significant source of capital is likely left to sit on the sidelines.

As the QOZ program approaches its third birthday, we hope to soon see more uptake of the QOZ program by non-U.S. taxpayers. But if the IRS and Treasury continue to withhold relief, due to lingering uncertainty, we expect that non-U.S. investors will continue to withhold QOZ investment dollars.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Orla O’Connor is a principal in the M&A Tax practice, and Chelsea Riedel a senior manager in the New York Financial Real Estate practice of KPMG LLP. The authors would like to acknowledge Tom West of KPMG for his review and helpful comments.

The information in this article is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author(s) only, and does not necessarily represent the views or professional advice of KPMG LLP.