08 Nov, 2011

Hogan Lovells: Proposed regulations liberalize US tax rules on foreign wealth funds and foreign governmental entities


According to a statement from Hogan Lovells, on November 2, 2011, the IRS issued new proposed regulations that, when finalized, will significantly liberalize and clarify the rules under Section 892 of the Internal Revenue Code, which provides a tax exemption under certain circumstances for foreign governments and their controlled entities (which can include sovereign wealth funds).


Under the existing ‘temporary’  regulations (which have been in place since 1988), foreign governments lose the Section 892 tax exemption with respect to income earned by ‘controlled commercial entities’ – that is, entities that are engaged either directly or indirectly through a partnership in commercial activities anywhere in the world – and with respect to income or gain from ‘controlled commercial entities’. Under the existing temporary regulations, a sovereign wealth fund could lose its Section 892 exemption because of a passive investment in a foreign company engaged in business entirely outside the United States merely because the foreign company is classified as a partnership for U.S. tax purposes.


The proposed regulations narrow the circumstances in which a controlled foreign governmental entity will be treated as engaged in commercial activities that would disqualify it from the Section 892 exemption:

  • Trading in financial instruments for the foreign government’s own account will not constitute commercial activity. Although the term “financial instruments” includes instruments such as forward, futures and option contracts, it is not clear whether it encompasses derivatives.
  • A disposition of a U.S. real property interest or deemed disposition (for example, a REIT capital gain dividend) of a U.S. real property interest will not, by itself, constitute the conduct of a commercial activity.
  • The commercial activities of a business entity that is treated as a partnership for U.S. tax purposes will not be attributed to a foreign governmental entity that is a partner in the partnership, provided that the foreign governmental entity is a “limited partner,” meaning that it does not have the right to participate in the management and conduct of the partnership’s business.
  • A foreign governmental entity will not be treated as engaged in commercial activities by virtue of its ownership of a partnership interest (even if it is not a “limited” partnership interest) in a partnership that effects transactions for its own account in stocks, bonds, other securities, commodities or financial instruments.
  • “Inadvertent” commercial activities will not disqualify a foreign governmental entity from the Section 892 exemption (other than with respect to that inadvertent commercial activity). The proposed regulations set forth a number of requirements that must be satisfied for the “inadvertence” exception to apply. Under a proposed safe harbor, a foreign governmental entity that maintains adequate written policies and procedures to avoid and to cure commercial activity will qualify for the “inadvertence” exception if not more than 5% of its assets and not more than 5% of its income in any year are attributable to commercial activities.
  • A controlled foreign governmental entity that is not engaged in commercial activities during a tax year will not be ineligible for the Section 892 exemption in that tax year merely because it engaged in commercial activities in a prior tax year. In other words, eligibility for the exemption will be tested on a year-by-year basis, and failure to qualify in one year will not “infect” subsequent years.

Interested parties may submit written comments and requests for a public hearing to the IRS with respect to the proposed regulations on or before February 1, 2012.

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