Update 348 — O-Zone Protections Paltry;
Road for Investors, Public Still Perilous
The Trump Administration’s putatively anti-poverty program known as the Opportunity Zone initiative seeks to promote economic investment in 8,700 distressed areas throughout the country. It was passed into law as part of the Trump tax cut. Taxpayer money is put to use here as social policy and as such, conditions on its use can be and often are applied by the U.S. Treasury. But there are only paltry protections in the law against financial abuse by O-Zone investors.
Which public protections to ensure against self-dealing, insider trading, and other conflicts of interest should be added to the program? See below.
Last week, Pres. Trump announced the release of the long-awaited second round of Opportunity Zone (O-Zone) Guidance from the IRS. Enacted as part of the Tax Cuts and Jobs Act package, the program aims to increase investment in economically distressed communities. The IRS regulatory process has been slower than anticipated, making it hard for stakeholders to weigh opportunities, risks, and protections in place to ensure that the program delivers on the Administration’s anti-poverty promise.
Following the first Guidance issued last October, the IRS opened a public comment period before holding a joint hearing with the Department of Treasury this February. The second round Guidance will be open to public comment until the IRS and Treasury will hold a hearing on July 9. Neither guidance outlines a full set of protections. Sens. Cory Booker and Tim Scott are planning to introduce a bill next week aimed at improving reporting requirements, and Sens. Maggie Hassan and Todd Young plan to sponsor the bill.
What are Public Protections?
On the whole, good governance groups and corporate watchdogs are decidedly skeptical of the O-Zone program, stemming from the lack of meaningful public protections. When governments intervene in markets, they implement standards and regulations to ensure the rights and safety of citizens. Companies and investors receiving tax benefits are expected to adhere to certain transparency and accountability requirements in order to better safeguard taxpayer money.
The Treasury’s Community Development Financial Institutions (CDFI) Fund, for example, provides underserved communities with access to capital and financial services. The program requires that substantially all (at least 85 percent) of the cash be used to make qualified low-income community investments.
It also mandates creation of a community development entity (CDE) to serve as a regulated intermediary between the low-income community and the investor. CDEs’ primary mission must be to serve or provide investment capital for low-income communities, and at least one resident of the served community must be represented on any governing board or advisory board of the CDE.
Many aspire for improved standards. As social responsibility investing gained traction in the 1980s, the Environmental, Social, and Governance (ESG) model grew to prominence. ESG models measure how corporations treat their workers, adhere to environmental standards, and whether they have a corporate culture that builds trust and fosters innovation. Governments around the world are increasingly implementing ESG principles into their activities, and some business groups are calling for strong, binding ESG requirements for all government investment.
O-Zone Public Protections
The O-Zone program provides investors with preferential tax treatment on capital gains made in ‘economically distressed areas.’ In similar place-based government incentive programs, the potential for abuse is high. Research suggests that program benefits rarely flow down to residents of the area (i.e. the targets of economic development). As with other real-estate-based investment incentives, the structure is highly susceptible to financial impropriety. No protections are yet in place against nepotism, self-dealing, and other misuse of funds.
Unlike the CDFI program, O-Zones do not require community intermediaries like CDEs, they lack stringent reporting requirements, and their “substantially all” threshold is 70 percent, rather than 85 percent. Despite this tranche of rules, the regulations are inadequate to protect against such improprieties.
Of the protections outlined in the recently-proposed guidance, not one addresses financial improprieties. The proposed regulations include measures that ostensibly promote sustainable investment in O-Zones:
- Prohibition on Triple Net Lease: In commercial real estate, a triple net lease puts nearly all of the cost burden (property taxes, insurance, maintenance and repair) on the tenant of a property. The new regulations determine that a property owner must present “active conduct of a trade or business,” though leave unclear what exactly that means.
- Issue: The new Guidance leaves open for interpretation how much commercial activity would suffice for a lease not to be labeled “triple net.” There is wiggle room for structuring investments as relatively passive leasing arrangements that don’t necessarily serve to improve an economically distressed community.
- Safe Harbor Protection: In order for a business bankrolled by a Qualified O-Zone Fund to qualify, it must meet one of the following three ‘safe harbors’ satisfying a “50 percent” test (at least half of the hours worked by employees and contractors must be within the O-Zone, amounts paid to employees and independent contractors for services rendered within the O-Zone must be at least half, and the income generated through the physical property located within the O-Zone must account for at least half of the business’ income).
- Issue: Some of these safe harbors may run the risk of undermining meaningful economic activity within the zones. The last two safe harbors could be viewed as encouraging businesses to locate highly-compensated employees in a zone, which could increase gentrification.
- Potential Revocation of Tax Break: The proposal also includes a clause that would revoke a tax break for any O-Zone project deemed to “achieve a tax result that is inconsistent with the purposes” of the program.
- Issue: The final wording here appears sufficiently vague, raising questions over its sincerity and enforceability. Enforcement will now be Administration-specific, leaving it dangerously up to interpretation.
Just Another Tax Shelter?
It is still unclear whether there will be a third round of guidelines, as originally planned. Last week, Treasury announced that this round would be the last unless they determine a third round is needed. The third round would not be in the form of proposed regulations and would likely address reporting requirements. Meanwhile, there are steps that can be taken to ensure public protections are made part of the O-Zone program.
- Intermediaries, like CDEs, are needed to share best practices, help solve problems, and keep the focus hyperlocal.
- A modernized workforce development system is critical connective tissue to make sure these investments aren’t working in isolation, otherwise businesses would simply relocate high-skill, high-wage workers into the area and bypass economically distressed residents.
- State and local governments need to play a big, intentional role in steering private capital towards where it is most needed.
It’s hard to say more about the final quality of O-Zone public protections without knowing whether a third round of guidance will even come out, let alone include rules that would create reporting standards to track O-Zone performance and impact. Though O-Zones did enjoy bipartisan support, and the aims of the program are laudable, the current lack of guardrails make for potential pitfalls. In a major tax program that may only end up benefiting real estate moguls and investors, undeveloped community and taxpayers will end up footing the bill.