Opportunity Zone Magazine Opportunity Zone Magazine Volume 1, Issue 1 | Page 25
INVESTING IN PRIVATE EQUITY UNDER THE OPPORTUNITY ZONES PROGRAM
The company or the investors
may set up a new entity
to act as an acquisition vehicle
or to ring-fence the new
investment opportunity...
In order to be a QOZ Business, a company must meet one of
two qualitative, company-level tests applicable to “substantially
all” (meaning 70 percent, according to the Treasury’s proposed
interpretation) of its tangible assets. Such assets must be
acquired after Dec. 31, 2017 and either have an “original use”
in the zone or be “substantially improved” by the investment.
An existing business will likely contain substantial existing
tangible assets which themselves do not qualify as QOZ
business property, and so these assets are likely to cause the
company as a whole to fail the QOZ Business test on the
date of issuance. The failure of the target company to meet
the QOZ Business test on day one, in turn, could potentially
compromise the entire tax structure.
There are a number of ways that investors in private
equity can address this issue through effective acquisition
structuring. The company or the investors may set up a new
entity to act as an acquisition vehicle or to ring-fence the new
investment opportunity, and which entity thereby would itself
qualify as a QOZ Business. For example, such an entity could
acquire and/or manage a new operating business of the target
company or a holding company for new tangible assets such as
machinery which satisfy the original use test or the substantial
improvement test. Similarly, such an entity could be used to
acquire a business located outside of any Opportunity Zone
and move it into a zone. The key concept to be aware of here,
is that qualitative requirements apply to the company and
its tangible assets, and so simple capitalization of an existing
company located in the zone does not alone satisfy the
requirements of an eligible asset.
hand, imposes certain qualitative operational requirements
applicable to the company’s business, including that: at
least 50 percent of the total gross income is derived from
the active conduct of such business; a substantial portion of
the intangible property is used in the active conduct of such
business; and less than 5 percent of the company’s property (as
determined by the aggregate unadjusted bases) is nonqualified
financial property, such as stock, bonds and other financial
instruments.
The active conduct test requires that any target business
have a substantive locational nexus to the relevant QOZ,
and not merely be a shell operational center designed
to ta ke adva ntage of t he ta x benefit s of fered u nder
t he O ppor t u nit y Zone regime. T here remai n s some
controversy as to what this will require of QOZ Businesses.
In its proposed regulations on investment in Opportunity
Zones released on Oct. 19, 2018, the Treasury Department
indicated that it would interpret the active conduct test
as requiring a company to derive 50 percent of its gross
income from business activities conducted “in the qualified
opportunity zone.” This additional requirement to derive
income from activities within the zone, not included in
the statutory text, would substantially increase the burden
on businesses operating from within, but selling outside
of, the relevant zone, and has been subject to a number
of critical comments, including from the Congressional
authors of the bill.
3
The latter two requirements as to intangible property and
nonqualified financial property effectively prevent a company
with large intangibles or a solely financial business from
locating an office in a zone in order to shelter its tax liabilities
without engaging in a substantive business there. Such
requirements may, however, result in additional concerns for
investors in companies with large amounts of intangibles and
should be examined carefully.
OPERATIONAL REQUIREMENTS FOR QOZ BUSINESSES
As noted above, any private equity target of a QOF must
qualify as a QOZ Business, which involves a number of
requirements. In particular, the Opportunity Zone regime
is designed to spur investment in tangible assets located in
QOZs. As a result, a QOZ Business must be able to show
that “substantially all” of its tangible property meets the
original use or substantial improvement test, as well as certain
operational requirements. These operational requirements
are incorporated into the Opportunity Zone statute by
reference and include portions of Code sections 144(c)(6)(B)
and 1397C(b). The former provision provides an exclusion
for certain types of sin businesses, such as liquor stores,
casinos and massage parlors. Section 1397(C)(b), on the other
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