New Rules Will Be of Particular Interest to Sovereign Wealth Funds
On November 3, 2011, the US Treasury Department published new proposed regulations that would modify the current US tax rules that apply to US investments by foreign governments, sovereign wealth funds, and other foreign government-controlled investment entities. The new rules would not be effective until publication as final regulations. However, the preamble to the proposed regulations states that taxpayers may rely on the proposed regulations until final regulations are issued. The US Treasury Department requests comments on the proposed regulations by February 1, 2012.
The United States imposes US tax on certain US-connected income of non-US individuals and entities. If the income arises from the conduct of a US trade or business, the income is generally subject to regular US income tax. Dividends, interest, and other investment income from US stocks, debt, or other securities are generally subject to a 30% US withholding tax, although exemptions and lower withholding tax rates may apply as a result of a US tax treaty or a US statutory exception. In particular, US tax treaties often reduce the withholding tax rate on dividends from portfolio investments to 15% and reduce the withholding tax rate on interest to zero. Further, interest that qualifies as "portfolio interest" or "bank deposit interest" is exempt by statute from US tax.
In addition to the rules generally applicable to foreign investors, special US tax rules apply to investments by foreign governments and international organizations. Under section 892 of the US Internal Revenue Code, income of foreign governments received from (a) investments in US securities, (b) financial instruments held in the execution of governmental financial or monetary policy, or (c) U.S. bank deposits is not subject to US income tax or US withholding tax. This US tax exemption is limited to investment income; it does not apply to income that is received (whether directly or indirectly) from commercial activities of the foreign government.
Because many foreign governments do not hold US investments directly, they are subject to the special US tax rules that apply to government-controlled investment entities. If a foreign government receives US investment income through an intermediate entity that the foreign government controls, eligibility for the US tax exemption turns on whether the entity is a "controlled commercial entity." If a foreign government holds a controlling interest in an entity, and that entity conducts commercial activity anywhere in the world, the entity is considered to be a controlled commercial entity and the US investment income that the foreign government receives through the entity is not eligible for the section 892 exemption.
Thus, income received by a foreign government through a "controlled commercial entity" is subject to US tax, even if the income would have been exempt from US tax if received by the foreign government directly. Avoiding this outcome (either by controlling the activities of the investment entity or by controlling whether the entity or the government receives the US investment income) is therefore very important. Detailed rules, including temporary Treasury regulations, provide guidance as to when income of a foreign government is considered to be received from a commercial activity and therefore subject to US tax. These tax rules do not necessarily use the same definitions and tests as other US rules affecting foreign investment.
The proposed regulations published November 3, 2011, would modify the existing regulations in several ways. These modifications are generally favorable to foreign governments, sovereign wealth funds, and other foreign government-controlled investment entities.
The preamble to the proposed regulations notes that the US Treasury Department has received comments that the "commercial activity" exception effectively creates an "all or nothing" rule that creates administrative and operational burdens for foreign governments and a trap for unwary foreign governments. In response to the comments, the proposed regulations:
- Create a "de minimis" exception, so that inadvertent commercial activity by a foreign government-controlled investment entity will not cause the entity to be a "controlled commercial entity," provided the entity has certain procedures in place and takes corrective action. The entity must show that the failure was "reasonable" (as set forth in the proposed regulations), the commercial activity was promptly "cured," and the entity meets certain record maintenance requirements.
- Clarify that the test for commercial activity is applied on an annual basis (i.e., commercial activity in a prior year does not "taint" future years for purposes of the section 892 tax exemption).
Provide guidance as to what constitutes a "commercial activity":
- one looks to nature of activity, not purpose or motivation;
- activities need not rise to level of "a trade or business" to constitute commercial activity;
- investments in financial instruments are not treated as commercial activities; and
- actual and deemed dispositions of US real property interests do not, by themselves, constitute the conduct of a commercial activity.
- Provide a more general exception for investments in limited partnerships, including publicly traded partnerships (PTPs). Investment in a limited partnership will not, by itself, cause a foreign government-controlled investment entity to be considered to be engaged in commercial activities, provided that the limited partnership interest does not confer rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year under the law of the jurisdiction in which the partnership is organized or under the governing agreement.
- State that if a foreign government-controlled investment entity is (directly or indirectly) a partner in a partnership, and that partnership effects transactions in stocks, bonds, other securities, commodities, or financial instruments for the partnership’s own account, the partnership’s trading activity will not by itself cause the foreign government-controlled entity to be considered to be engaged in commercial activity. This safe harbor is not available if the partnership is a dealer in stocks, bonds, other securities, commodities or financial instruments.
Although the proposed regulations provide relief regarding when an entity will be considered to be engaged in commercial activity, it is important to note that the proposed regulations do not expand the categories of income eligible for the US tax exemption. In other words, an exception from the definition of "commercial activity" does not mean that the income itself is free from US tax. Thus, notwithstanding the "commercial activity" exceptions described above for investments in financial instruments, dispositions of US real property interests, and limited partnership interests,
- income from investments in financial instruments will be subject to US tax under section 892 unless held in the execution of governmental financial or monetary policy;
- gain from the disposition of US real property interests generally remains subject to US tax; and
- income from a limited partnership that is attributable to commercial activity will be subject to US tax under section 892.
The proposed regulations will provide some relief from the current regulatory rules, reducing (although not eliminating) existing foot faults and traps for the unwary. Because the preamble to the proposed regulations states that foreign governments (and the investment entities through which they operate) may rely on the proposed regulations, affected foreign governments, sovereign wealth funds, and other foreign government-controlled investment entities may immediately take advantage of the new favorable rules. Nonetheless, the Treasury Department regularly makes changes to proposed regulations when it issues final regulations. Accordingly, foreign governments should evaluate these new rules and, in the appropriate manner, express support for those provisions they believe should be retained and suggest specific changes to those provisions that they believe should be modified. Similarly, the proposed rules should encourage affected foreign governments to re-examine their US and non-US holdings and activities to determine whether restructuring of those holdings or activities is in order.