On November 2, 2011, the U.S. Treasury issued proposed regulations that clarify several issues concerning Section 892 of the Internal Revenue Code (the Code), which provides a limited exemption from U.S. tax for foreign governments (the 892 exemption). The proposed regulations generally represent a favorable development in this area that should help facilitate investment by foreign governments (including sovereign wealth funds) in U.S. assets and investment partnerships (such as private equity funds). Summary
Highlights of the proposed regulations include:
- Controlled entities of foreign governments will not lose their 892 exemption as a result of their disposition of U.S. real property interests;
- Controlled entities of foreign governments will not lose their 892 exemption as a result of investments in, or trading in, financial instruments;
- The determination as to whether a controlled entity of a foreign government is a "controlled commercial entity", and thus ineligible for the 892 exemption, is made annually;
- Commercial activities of a limited partnership generally will not be attributed to a controlled entity of a foreign government that is a limited partner; and
- Controlled entities of foreign governments will not lose their 892 exemption by reason of "inadvertent" commercial activity.
Under Section 892 of the Code, foreign governments enjoy an exemption from U.S. taxation on certain types of investment income (generally, interest and dividends). This exemption applies to the "integral parts" of the foreign government, as well as any "controlled entities" thereof (generally, wholly owned entities organized under the laws of such foreign government). This exemption does not apply, however, to income (1) derived by the foreign government from the conduct of any commercial activity, (2) received by or from a "controlled commercial entity", or (3) derived from the disposition of any interest in a controlled commercial entity. For these purposes, a controlled commercial entity is any controlled entity that engages in commercial activities inside or outside the United States. The net effect of these rules is that an integral part of a foreign government that engages directly in commercial activity loses its 892 exemption only with respect to income from that activity, whereas all income derived by, from, or upon the disposition of an interest in a controlled commercial entity is ineligible for the 892 exemption. Consequently, it is critically important to ensure that activities conducted by a foreign government directly or through its controlled entities avoid a commercial activity "taint" where Section 892 is implicated.
Important Carve-outs Added to Activities Previously Considered Commercial
U.S. Real Property: The proposed regulations provide that the disposition or deemed disposition of an investment in U.S. real property interests will not, by itself, give rise to commercial activity that would cause a controlled entity to lose its 892 exemption. The income derived from dispositions of U.S. real property interests will continue to be ineligible for the 892 exemption, however, and a controlled entity could still lose its 892 exemption if it is treated as a "U.S. real property holding company" (generally, if at least 50% of its assets consist of U.S. real property interests).
Financial Instruments: For purposes of determining whether a controlled entity is a controlled commercial entity, investments and trading in certain financial instruments (including derivatives) do not constitute commercial activities under the proposed regulations. This represents a departure from the current temporary regulations that designate only investments in financial instruments that are held in the execution of governmental financial or monetary policy as not constituting commercial activities. However, only the income derived from investments in, or trading in, financial instruments by governments in the execution of their financial or monetary policies qualifies for the 892 exemption.
Controlled Commercial Entity Status Determined Annually
The proposed regulations state that a controlled entity's status as a controlled commercial entity is determined annually. Thus, commercial activities in a prior year should not taint the controlled entity for subsequent years in which it has engaged in no commercial activities.
Partnership Investments and Activities
Limited Partner Exception: Under the proposed regulations, the general rule that the commercial activities of a partnership are attributed to its partners is suspended for limited partners that have no rights to participate in the management of the partnership's business at any time during the partnership's taxable year. For these purposes, rights to participate in the management of the partnership do not include consent rights that are exercisable in extraordinary circumstances. Although a controlled entity serving as a limited partner will avoid the taint of the partnership's commercial activities, the controlled entity's distributive share of income attributable to such commercial activity still will not be eligible for the 892 exemption. Likewise, if the partnership itself is a controlled commercial entity, no part of the foreign government partner's distributive share of partnership income will be eligible for the 892 exemption.
Partnership Trading Activities: The proposed regulations provide that a controlled entity not otherwise engaged in commercial activities will not be considered to be engaged in commercial activities solely because it is a partner in a partnership that trades in stocks, bonds, other securities, commodities, or financial instruments for its own account. This provision applies to limited and general partners alike, except where the partnership is treated as a dealer in the above-mentioned instruments for U.S. tax purposes.
Relief for Inadvertent Commercial Activity
Under the proposed regulations, an entity will not be classified as a controlled commercial entity merely because it engaged in "inadvertent commercial activities". Commercial activity is inadvertent if (1) the failure to avoid the commercial activity is "reasonable", (2) such activity is discontinued within 120 days and (3) the controlled entity maintains careful records documenting its discovery of and efforts to discontinue the commercial activity. Whether the failure to avoid commercial activity is reasonable will be determined in light of all the surrounding facts and circumstances. Such failure will not be considered reasonable unless the controlled entity undertakes continuing due diligence to prevent commercial activities from taking place within or outside the United States. Adequate due diligence may be established by devising and implementing written policies and operational procedures to monitor the controlled entity's worldwide activities. With these policies and procedures in place, the controlled entity can qualify for a safe harbor under which the failure to avoid commercial activities will be considered reasonable if (1) the value of the assets used in, or held for use in, all commercial activity does not exceed 5% of the controlled entity's total assets and (2) the income earned from all commercial activity does not exceed 5% of the controlled entity's gross income.
Effective Date and Timing for Comments
The proposed regulations are effective when published as final regulations in the Federal Register. However, taxpayers may rely on the proposed regulations until such time.
Before adoption of the proposed regulation as final, the U.S. Treasury will consider any comments to the proposed regulations received by February 1, 2012.