United States

Do Opportunity Zones mean opportunity for Canadian companies?

INSIGHT ARTICLE  | 

There’s been a good deal of interest by U.S. companies in the Opportunity Zones (OZ) established with the Tax Cuts and Jobs Act of 2017 – intended to attract investments and stimulate growth in parts of the country where both have been stagnant.

Canadian real estate investment firms, private equity firms and high-net-worth individuals may be eying investments in OZs. However, Canadian tax legislation often does not recognize tax deferral in the United States and in many cases, only Canadian entities with substantial real estate operations in the United States may stand to benefit.

To understand if these zones offer opportunity and to formulate next steps, it helps to first understand the legislation and determine who can benefit from it.

Opportunity Zones intended to spread prosperity wider

The OZ program was developed to help deal with a stubborn problem – parts of the United States were seeing a disproportionate amount of prosperity, while others were being left behind, facing high unemployment, low wages and few prospects.

So, starting in 2017, the U.S. government designated certain areas of the country as “distressed areas.” They then developed a plan to encourage investment in those places. To quote a briefing document from the U.S. Internal Revenue Service:

Opportunity Zones are designed to spur economic development by providing tax benefits to investors. First, investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026.   If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain.  If held for more than 7 years, the 10% becomes 15%.  

In summary – the holding period determines the amount of capital gains tax that can be avoided from investments in a qualified fund and can be up to 15 per cent. Investors can also defer tax on the remaining original gain until the sale of the fund or the end of 2026 – whichever comes first.

Under the OZ program, investors do not invest directly in real estate. Rather, they invest in a QOF, which anyone including an investor or property developer can set up, as either a partnership or a corporation. The fund then finances the development or redevelopment of a property or properties within one or more OZs.

While OZ’s are setup to allow for capital gains tax to be deferred or partially forgiven, benefits to exiting the qualified OZ exist, too. Here’s how it plays out: An investor who recently sold an asset resulting in a capital gain of US$100,000 can elect within 180 days to invest a portion or all of the gain into an QOF. Instead of paying tax during the year of the sale, the taxes on the gain are deferred until the earlier of the sale of the QOF investment or the end of 2026, with potential reductions in the gain if the investment in the QOF is held long enough. Furthermore the subsequent sale of the QOF investment after a 10 year hold period would be tax-free. Here is an example of what the tax benefits could look like:

Hold period

Exclusion of gain

Reduction of gain

Amount taxed

5 years

10%

$10,000

$90,000

7 years

15%

$15,000

$85,000

10 years

Adjustment of the basis of investment to the sales price. No tax is paid on the sale of the OZ investment.

 

It’s important to note that for investors to get the full tax benefits of the OZ program, the money they invest must be related to a gain from the sale of a property or security, in the United States. This program is primarily a way for U.S. investors to defer their capital gains taxes, however Canadian investors may benefit if they meet certain eligibility criteria.

Where and why opportunity zones may put companies at a disadvantage

Canadian investors, whether individuals, trusts or corporations, need to be cognizant of tax on both sides of the border. The achievement of tax deferral on one side of the border does not preclude an amount owing on the other.

Canadian entities that are passive investors, both direct and indirect, in U.S. real estate need to be aware of the limitations on foreign tax credits and Canada’s foreign accrual property income rules. Both sets of rules can have adverse tax consequences for Canadian investors.

While U.S. tax deferral may be achieved via investment in a QOF, the Canadian investor will still be subject to Canadian tax on the gain with no credit for foreign taxes available in the year. In subsequent years, when U.S. tax is ultimately paid, the mismatch in timing can result in double taxation, with Canada offering no credit for the U.S. tax paid.

Which Canadian entities should be interested in the OZ program?

Not all Canadian companies and individuals that have recently sold U.S. real estate or other U.S. assets at a profit may be subject to the above-noted scenarios.

Canadian entities with substantial real estate operations in the United States (i.e. requiring the services of more than 5 full-time employees in the United States) may be able to achieve tax deferral in both jurisdictions. The main beneficiaries will be in the real estate and construction industry, although other organizations can leverage opportunity zones:

Property developers: Canadian companies that develop or refurbish properties may be interested in working with QOFs who have money to spend on development (and as we will see below, will be facing time pressures to get that development started).

Property investors: Within the boundaries of the OZ, there may be increases in property values, as well as the potential for increase in demand for housing, office space, warehouse facilities and other development – spelling opportunity for investors in vacant or currently-occupied lands.

Companies interested in U.S. expansion: Since most industries can qualify for a QOZ, Canadian companies seeking growth in the United States could benefit from office, warehouse or manufacturing space in the zones. They may benefit from the willingness of QOFs to provide the space they need, possibly custom-built to their needs or at a lower-than-expected cost. It is important to note that certain ownership and income thresholds need to be met.

Points to watch for regarding Qualified Opportunity Funds

The rules around QOFs are complex, and companies should consult a qualified advisor before taking action. Some points to consider in this are:

  • The investor must invest the capital gain, into a QOF, within 180 days of when the gain occurred.
  • The investment must meet specific requirements. Funds are tested twice a year, and there are penalties if the funds are not considered adequately deployed – primarily meaning that 90 per cent of its assets must be invested in a qualified OZ property.
  • There is an expectation around the success of the QOF’s ventures. The QOF has 30 months from the start of investing to double the value of the buildings owned by the fund (not of the whole property owned by the QOF – just the buildings). Note that those tangible assets do not have to be an actual building. They could be leasehold improvements to spaces that are then rented or leased out.

To sum up, before investing in a QOF, companies need to investigate. Factors to be considered include:

  • Location risks: sometimes there is good reason why an area is getting passed over. Many QOZs are located in emerging urban markets or near university where transportation links may still be under development.
  • Management risks: Understand the background and expertise of those individuals who will be directing the investments
  • Business risks: There are risks with any business venture, so you need to understand the nature of the planned business venture, and its chances for success – the tax benefits can make a good deal great, but will never make a bad deal better.
  • Regulatory risks: While the OZ program is set up to require less reporting than some incentive programs, there is a lot of misinformation out there. This has meant that some investments have violated that regulations and lost the benefits they might have provided their investors.
  • Tax risks: U.S. and Canadian tax authorities are watching the OZ story closely, and will take action if they think that the program is being abused.

Companies should consult with a qualified professional before taking action – someone who can assess the company’s particular company structure and tax implications, is aware of the U.S. and Canadian tax implications, and has a good understanding of the operation of the Opportunity Zone program.

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