SEC Clarifies: No Special Treatment for Qualified Opportunity Zone Funds
The Tax Cuts and Jobs Act, adopted in December 2017, created a new investment opportunity in economically depressed communities by providing tax benefits for investment in designated “Opportunity Zones.” Investments in Opportunity Zones provide a number of tax benefits, including the deferral and reduction of taxation on capital gains, for investors reinvesting taxable capital gain amounts into a vehicle known as a Qualified Opportunity Fund (QOF) and holding such investment(s) for a specified period of time.
An entity must meet certain requirements to qualify as a QOF, in particular 90% of the assets of a QOF must consist of property located in Opportunity Zones. However, QOFs allow investors to pool eligible capital gains to create a larger capital base for Opportunity Zone investments while still providing each individual investor with the tax benefits of a direct Opportunity Zone investment via the QOF.
On July 15, the staffs of both the Securities and Exchange Commission (SEC) and the North American Securities Administrators Association issued a summary of the Opportunity Zone program focusing on issues of compliance with federal and state securities laws (the Release). In this client alert, we summarize the guidance in the Release and explain what it means for QOF sponsors. The general principle that applies here is that, under securities laws, QOFs should not expect to receive special treatment and should be prepared to meet the same standards and face the same regulatory oversight as any other collective investment vehicle.
Are Interests in QOFs ‘Securities’?
Federal and state securities laws define what constitutes a “security” very broadly. Generally, the interests in a QOF will constitute securities, unless a QOF is established as a partnership where all partners have a substantial role in the management of the partnership. A QOF whose interests are securities will be required to comply with all applicable regulations of the SEC and the securities regulators in the states where they are doing business along with any other applicable regulations.
Are QOF Offerings Required to Be Registered?
As with any other offering or sale of securities, the Securities Act of 1933, as amended (the 1933 Act) requires all offers and sales of securities to be either (1) registered or (2) exempt from registration. State securities laws have similar requirements. The Release confirms that any offering of interests in a QOF will be required to either be registered or properly exempt from registration. So long as the offering of interests in a QOF meets the relevant requirements, however, a number of potential exemptions could apply, and the Release focuses on the following potential exemptions that a QOF issuer might consider availing itself of to be exempt from registration:
Rule 506 — Rule 506 of Regulation D under the 1933 Act provides two separate exemptions for QOFs. Part (b) provides an exemption from registration for a private offering to accredited investors and up to 35 sophisticated investors. Part (c) provides an exemption for a public offering so long as the QOF issuer takes reasonable steps to verify the accredited investor status of each purchaser.
Rule 504 — Rule 504 of Regulation D under the 1933 Act provides an exemption for a QOF issuer to offer and sell up to $5,000,000 of securities in a 12-month period, with certain prohibitions. A QOF is not permitted to rely on the exemption available under Rule 504 if (1) the QOF is subject to reporting under sections 13 or 15(d) of the Securities Exchange Act of 1934, as amended; (2) the QOF is an investment company as defined in the Investment Company Act of 1940, as amended (the Investment Company Act); (3) the QOF has no specific business plan or has indicated an intent to engage in a merger or acquisition; or (4) the QOF is disqualified under the “bad actor” provisions.
Rule 147 — Rule 147 or 147A provide an exemption from registration under the 1933 Act for certain intrastate offerings. These exemptions require the following: (1) the QOF issuer’s principal place of business is in the state where the offering is being made; (2) the QOF is not registered or required to be registered under the Investment Company Act; (3) the QOF is doing business in the state where the offering is being made; and (4) sales are limited to in-state residents, with written representation.
What Broker-Dealer, Investment Company and Adviser Issues Do QOFs Face?
The Release also makes it clear that a QOF issuer should consider broker-dealer registration issues in the lead-up to any offering of interests in a QOF. The requirements surrounding the solicitation of a QOF or the engagement of a person or entity to provide such solicitation are the same as with any other collective investment vehicle. The Release provides additional specifics on what activities could indicate broker status.
As it pertains to whether a QOF is an investment company, the Release notes that QOFs receive the same treatment under the Investment Company Act as any other collective investment vehicle. QOFs will be required to either register as an investment company, or meet the requirements of an exclusion from the definition of investment company. The exclusions most likely to be applicable to a QOF are either the private fund exclusions (Sections 3(c)(1) and 3(c)(7) under the Investment Company Act, based on the number and type of investors) or the mortgage-related pools exclusion (Section 3(c)(5)(C) of the Investment Company Act, which excludes from the definition of an investment company collective investment vehicles that are primarily engaged in purchasing mortgages and other real estate interests).
Similarly, the advisers to a QOF are required to go through the same analysis as the advisers to any other collective investment vehicle. Any person providing advice to a QOF, for compensation, where that advice may include securities advice, needs to be aware of the potential need for registration or exclusion. The assets under management will also be a relevant consideration on this front as it will indicate whether the adviser is dealing with state or federal registration requirements.
The most common federal exclusion that will exist for those advising QOFs will be the private fund adviser registration exemption offered under Rule 203(m)-1 under the Investment Advisers Act of 1940, as amended. This exclusion exists for investment advisers that only advise private funds and have assets under management under $150 million. Investment advisers meeting this exemption, however, are still subject to certain SEC reporting requirements.
A QOF issuer should conduct the same analysis for purposes of broker-dealer, investment company and investment adviser regulation as any other collective investment vehicle would conduct.
While Opportunity Zones and QOFs provide a new, unique investment opportunity for investors who have incurred taxable capital gains and wish to defer or potentially reduce the tax liability on such gains, their treatment from a regulatory standpoint is not different from any other collective investment vehicle. Any person or entity involved in these vehicles needs to keep in mind the full suite of state and federal regulations on collective investment vehicles and those involved with them. If you have any questions or are planning to launch a QOF and would like to discuss your specific situation, please reach out to any of the Stroock attorneys listed on this memo or any other contacts in the Corporate or Private Funds practices.
For More Information:
 Pub. L. No. 115-97, 131 Stat. 2054 (2017).
 See, e.g., “They’re Out! Stroock’s Take on the Second Set of Proposed QOZ Regulations,” Stroock Special Bulletin, April 19, 2019, available here: https://www.stroock.com/publication/theyre-out-stroocks-take-on-the-second-set-of-proposed-qoz-regulations/; “Six Burning Questions on the New Opportunity Zone Guidance,” Stroock Special Bulletin, November 6, 2018, available here: https://www.stroock.com/publication/six-burning-questions-on-the-new-qualified-opportunity-zone-guidance/; and “Stroock’s Take on the New ‘Qualified Opportunity Zone’ Guidance, Oct. 19, 2018, available here: https://www.stroock.com/publication/stroocks-take-on-the-new-qualified-opportunity-zone-guidance/.