As part of the 2017 Tax Cuts and Jobs Act, the U.S. Congress enacted a program that offers certain tax benefits to investments in areas known as qualified opportunity zones (QOZ).
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Individuals and businesses seeking to take advantage of the QOZ program may already be aware of the complex tax rules that they will need to navigate for a project to successfully qualify, but they might be less aware that investments in qualified opportunity funds (QOF), or vehicles required to invest in QOZs, could also be subject to federal and state securities laws. The Securities and Exchange Commission (SEC) and the North American Securities Administrators Association (NASAA) summarized the intersection of those two sets of rules in a new staff statement. The summary examines which investments in QOFs are securities under federal and state securities laws, typical registration requirements for offerings of QOFs, commonly applicable registration exemptions, the potential for persons soliciting investors in QOFs to be considered securities brokers, and the potential for QOFs to be required to be registered as investment companies.
See the SEC’s press release here.
Overview of Opportunity Zones
QOZs are areas designated by the Treasury Department based on their status as low income census tracts. They generally have a poverty rate of at least 20 percent and a median income of no more than 80 percent of the statewide or metropolitan average; though, not all low income census tracks are QOZs. The program incentivizes economic development and investment in these low income areas by offering an investor that reinvests qualifying capital gains in a QOF, which in turn holds assets located in QOZs, the possibility of both deferring that capital gain and reducing capital gain eventually realized by the QOF.
Interests in QOFs as Securities
Opportunity zone statutes provide that a QOF can be any corporation or partnership organized for the purpose of investing in qualified opportunity zone property. The summary notes that those interests in QOFs, if offered and sold to investors, will “typically constitute securities within the meaning of federal and state laws except in limited circumstances.” Because investments in QOFs are likely securities, any person selling interests in a QOF, in addition to complying with tax laws and rules, should be aware of and comply with federal laws and SEC rules, as well as state securities laws and rules (sometimes known as “blue sky” laws), including registration requirements and anti-fraud provisions.
Registration of QOF Offerings
Federal securities laws require all offerings of securities to be either registered with the SEC or conducted under an exemption from registration. The summary cautions that federal and state regulators “interpret broadly the meaning of the term “offer,”” and that “it is prudent to assume that efforts to attract investors to a QOF are offers of a security and subject to federal and state securities laws.”
Available Registration Exemptions
A QOF acts as an “issuer” of securities when it offers or sells investments in the QOF. An issuer need not register a QOF offering if it can conduct the offering under both a federal and state exemption from registration. The summary notes that the federal exemptions from registration under Rules 506(b) and 506(c) are likely to be available for QOF offerings, but also points out that Rule 506 requires issuers of exempt offerings to comply with bad actor disqualification provisions, and to file a Form D with the SEC within 15 days of the first sale of securities in the offering. Because federal law preempts state registration and qualification under Rule 506, an issuer relying on Rule 506 need not ensure it also meets state law registration exemptions, but should remember that “the states have authority to require notice filings and collect state fees.” Thus, an issuer should watch for filing and fee requirements in every state where it conducts a Rule 506 offering.
The summary also notes that the federal Rule 504 exemption under Regulation D, the intrastate offering exemption under Rules 147 and 147A, and the “mini-registration” exemptions under Regulation A or Regulation CF might also be available if the QOF is not also an “investment company” as defined in the Investment Company Act of 1940.
Broker Registration Requirements
Any person who solicits or refers investors to a QOF offering risks being considered a securities “broker” under federal and state securities laws. A broker is a “person engaged in the business of effecting securities transactions for the accounts of others,” and the staff notes that it is generally “unlawful for an unregistered broker (or dealer) to effect any transactions in, or induce or attempt to induce the purchase or sale of, a security.” A person engaged in the business of soliciting investors for QOF offerings will likely be required to register with the SEC and with state regulators as a securities broker. The summary notes that the “question of whether a person is a broker turns on the facts and circumstances of the transaction,” and that where a person receives compensation that depends on the outcome of a securities transaction (transaction-based compensation), the transaction-based compensation is “a strong indication that someone is “engaged in the business” of being a broker.”
Individuals can solicit potential investors in QOFs, however, if they comply with certain broker registration safe harbors. The summary identifies Exchange Act Rule 3a4-1 as a likely-available exemption, which provides “a non-exclusive safe harbor from broker registration for certain associated persons of an issuer,” as long as that person, among other things, has “substantial duties otherwise than in connection with transactions in securities,” participates in “no more than one offering every twelve months,” and is not receiving transaction-based compensation.
Investment Company Registration
An “investment company” is generally defined as an issuer that (1) is engaged primarily in, or holds itself out as being engaged primarily in, the business of investing, reinvesting, or trading in securities; (2) is engaged in the business of issuing face-amount certificates of an installment type; or (3) is engaged in the business of investing, reinvesting, owning, holding, or trading in securities, as well as owns or proposes to acquire investment securities with a value greater than 40 percent of the value of the issuer’s assets. The summary notes that “QOFs typically are pooled investment vehicles through which investors contribute funds to invest in qualified opportunity zones,” that may be required to register unless an exclusion is available.
The summary lists some possibly-available exclusions: such as the “private fund exclusion,” which excludes from the investment company decision an issuer whose outstanding securities are held by fewer than 100 persons, or if a venture capital fund, less than 250 persons, that is not making and is not proposing to make a public offering of its securities. A “mortgage-related pool” is also excluded, defined generally as an issuer that is “primarily engaged in purchasing or otherwise acquiring mortgages or other liens on and interests in real estate.”
Investment Adviser Registration
In addition to QOF issuers facing Investment Company Act registration, investment advisers to QOFs may also face registration. Under federal law, an “investment adviser” is generally defined as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.” An individual or entity is generally excluded from federal registration if it has less than $100 million of assets under management. However, advisers who fall below the $100 million threshold may still be required to register with one or more state securities regulators. Individuals involved in opportunity zone investments, including general and managing partners of partnerships and managing members of LLCs, should consider whether they might be required to register.
Given that QOZ investments fall under two overlapping regulatory regimes, tax and securities, each with a federal and state component, it is vital that individuals and entities engaging in QOZ investments consider both sets of rules and laws carefully. Michael Best has a team of attorneys focused on opportunity zones with expertise in tax, securities, and broker-dealer and investment adviser regulation. Contact us if you have a question about your opportunity zone investment.