On April 17, the US Department of the Treasury released additional guidance (the “Proposed Regulations”) addressing several areas of uncertainty concerning the operation of the qualified opportunity fund (“QO Fund”) provisions introduced by the Tax Cuts and Jobs Act of 2017. These provisions provide tax incentives to encourage taxpayers to invest in QO Funds that invest in or conduct business in certain low-income areas designated as “qualified opportunity zones” (“QO Zones”). On April 26, we released a client alert discussing the Proposed Regulations generally, and on June 3, we released a client alert addressing the benefits of the Proposed Regulations for operating companies in particular. The discussion below focuses on how some of the key provisions included in the Proposed Regulations may impact potential sports stadium development projects and team operations within a QO Zone.
QO Business Property
Defining “Substantially All”
As discussed in previous client alerts, in order to be treated as a QO Fund, an investment vehicle must hold at least 90% of its assets in “qualified opportunity zone property,” which consists of either (i) “QOZ Business Property”—a direct investment in (a) original use or substantially improved property, (b) that is acquired by purchase after December 31, 2017, and (c) substantially all of the use of which is within a QO Zone during substantially all of the time held by the QO Fund or a “qualified opportunity business” (a “QO Business”); or (ii) equity investments in a QO Business. The term “substantially all” for this purpose was not defined in the statute or prior guidance, but the Proposed Regulations now provide that, for purposes of the use test, “substantially all” means 70% and, for purposes of the holding period test, “substantially all” means 90%.
Treatment of Land
In order to determine whether tangible property qualifies as QO Business Property, the QO Fund provisions require either that (a) the original use of tangible property commence with the QO Fund or that (b) the QO Fund substantially improve the property. However, these tests could be difficult to meet when land represents a material portion of the QO Fund’s assets, as could be the case with stadium development. Fortunately, the Proposed Regulations provide that the original use and substantial improvement tests do not apply to land. Instead, the Proposed Regulations require that land must be used in a trade or business to be treated as QO Business Property, and merely holding land for investment will not give rise to a trade or business.
Property Straddling Opportunity Zones
The Proposed Regulations provide clarity on the treatment of real property that is partially but not wholly within a QO Zone. Specifically, the Proposed Regulations clarify that if the amount of real property (based on square footage) located within the QO Zone is substantial relative to the amount of real property outside of the QO Zone, then all of the property will be treated as located within a QO Zone. The preamble to the Proposed Regulations notes that the amount of real property within the QO Zone should be deemed “substantial” if the relative unadjusted cost of the real property located within the QO Zone is greater than that of the real property outside the QO Zone. This is particularly important for stadium development projects, which often include broad ancillary development. By permitting a development project site to go beyond QO Zone boundaries, the Proposed Regulations provide expanded potential revenue for stadium/ancillary development projects.
Treatment of Leased Property
The Proposed Regulations allow certain leased tangible property to be treated as QO Business Property even though the original use or substantial improvement tests are not satisfied. Leased tangible property will be treated as QO Business Property if (a) it is acquired under a lease entered into after December 31, 2017 and (b) substantially all of the use of the leased tangible property is in a QO Zone during substantially all of the period for which the business leases the property. In addition, the Proposed Regulations provide that improvements to leased property satisfy the original use requirements and are considered purchased property in an amount equal to the unadjusted cost basis of such improvements. The expansion of QO Business Property to include leased tangible property may provide significant flexibility to a team seeking to relocate to a QO Zone where the stadium and facility development costs may have otherwise been prohibitive. In certain cases, it may even permit two separate QO Funds investing in separate assets classes (the stadium and facilities on the one hand, and a team on the other hand) to partner on a project.
Operating Companies and QO Businesses Beyond Real Estate
The legal framework described above is relatively straightforward when applied to real estate developments in QO Zones, and it is no surprise that much of the initial interest in QO Zones was driven by real estate investors. However, this framework is more challenging for companies that have limited tangible assets or seek to sell goods and services regionally and even nationally, like a sports franchise. Fortunately, the Proposed Regulations expand the scope of guidance and provide a number of permissive interpretations that should facilitate investment by QO Funds in QO Businesses outside of real estate, such as a professional sports franchise’s operating companies.
Gross Income Safe Harbors
Prior to the issuance of the Proposed Regulations, minor league sports franchises (e.g., Minor League Baseball, United Soccer League, etc.) were good candidates to take advantage of opportunity zone legislation by relocating to, and operating within, a QO Zone because substantially all of such businesses’ revenue is generated in on-site events. Prior to the Proposed Regulations, however, it was unclear whether teams in the major five American leagues (NFL, NBA, MLB, NHL, and MLS) could take advantage of the legislation, but new “safe harbors” introduced by the Proposed Regulations could make it possible for even major league franchises to take advantage of the QO Business rules. Under the QO Fund provisions and prior guidance, a QO Business must derive at least 50% of its gross income from the active conduct of a trade or business within a QO Zone. The 50% requirement has raised concerns on how sales to customers outside the QO Zone or income from more amorphous sources, such as licensing, will be treated for purposes of qualifying as a trade or business within a QO Zone, especially because some of a team’s operations may go beyond the QO Zone. The Proposed Regulations could provide significant relief to a team’s operating entities by offering three safe harbors to satisfy the 50% gross income requirement:
- 50% of the services performed by employees and independent contractors (based on hours performed) are performed in the QO Zone;
- 50% of the amounts paid for services performed by employees and independent contractors are for services performed in the QO Zone; or
- the tangible property of the QO Business located in the QO Zone and the management or operational functions performed for the QO Business in the QO Zone are each necessary to generate 50% of the gross income of the QO Business.
With these safe harbors, a major league team’s media rights subsidiary leasing an office in a QO Zone would be deemed to satisfy the 50% income requirement if its employees and independent contractors spend more than 50% of their working hours in that office (or if it otherwise met one of the other two safe harbors). This would be the case even when all of the media rights company’s customers and viewers are located outside of a QO Zone. (Of course, the team entity or outside investors must have the capital gains necessary to invest into a QO Fund in order for such qualification to be beneficial.)
While the permissiveness of the 70% tangible property requirement and the 50% income requirement is helpful to many companies, for some operating companies, the most valuable property used in their business tends to be intangible property. Under the QO Fund statute, “substantially all” use of intangible property must take place within a QO Zone. While the Proposed Regulations helpfully set this “substantially all” bar at just 40%, they do not provide much detail as to what it means for intangible property to be used in a trade or business. Nevertheless, the Proposed Regulations suggest that the Treasury Department is pursuing a broad interpretation of the statute that should permit many businesses to meet the 40% intangible property requirement as long as at least 40% of a QO Business’s intangible property is used in the active conduct of a trade or business in a QO Zone.
Prior to the Proposed Regulations, it was not clear whether companies that locate their headquarters or employees in a QO Zone but have a regional, national, or global customer base could be viewed as generating 50% of their total gross income from a trade or business within a QO Zone. However, with the Gross Income Safe Harbors under the Proposed Regulations, a company leasing an office in a QO Zone would be deemed to satisfy the 50% income requirement if its employees and independent contractors spend more than 50% of their working hours in that office (or if it otherwise met one of the other two safe harbors). This would be the case even where all of the company’s customers are located outside of a QO Zone, as identified above in the examples of a team subsidiary company that focuses on media rights or ticket sales. Similarly, a company manufacturing sports merchandise in a plant located in a QO Zone that is sold outside of a QO Zone could also satisfy the 50% income requirement.
Restriction on Gaming
In addition to the foregoing, a QO Business may not be engaged in certain specified businesses, such as private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks or other gambling facilities, or stores primarily selling alcohol for consumption off-premises. The gambling restrictions could have an effect on stadium development and other sports industry related businesses in light of last year’s Supreme Court decision in Murphy v. National Collegiate Athletic Association and the subsequent legalization of sports gaming by numerous states. Whether the expansion of state-regulated sports gaming leads to further comment from the Treasury Department regarding permitted QO Businesses remains to be seen.