IRS Releases Proposed Regulations Under Section 892 Dealing with Income of Foreign Government Entities

On November 2, 2011, the Internal Revenue Service (the “IRS”) issued proposed regulations under section 892 of the Internal Revenue Code that should significantly alleviate certain concerns relating to investments by sovereign wealth funds that are not “integral parts” of a foreign sovereign (“SWFs”) and other foreign government-controlled entities in private equity funds, hedge funds and other investment partnerships as well as unplanned de minimis commercial activities of foreign government-controlled entities. Notably, while the proposed regulations will become effective when finalized, the Preamble indicates that taxpayers may rely on the proposed regulations until final regulations are issued.

Background

Section 892 generally exempts from U.S. tax the income of foreign government entities from investments in stocks, bonds and other securities, except that any such income that is derived from a commercial activity or that is derived by a “controlled commercial entity” is not eligible for the exemption. Under the current regulations, a foreign government-controlled entity (i.e., an entity in which the foreign government owns, directly or indirectly, 50% or more of the value or voting interests or over which it otherwise has effective practical control) will be a controlled commercial entity if it is engaged in any commercial activities, including many kinds of real estate investments (directly or through a partnership), anywhere in the world.

Accordingly, SWFs have typically required investment partnerships in which they invest – whether inside or outside the United States – to limit their activities to non-commercial activities. Thus, for example, if a private equity fund intends to invest in a partnership that conducts an operating business, it may be required to hold that investment through a parallel “alternative investment vehicle” structure and to organize a “blocker corporation” through which section 892 investors hold their interests.

These and other investment restrictions and structures are intended to ensure that the foreign government entity does not become a controlled commercial entity, which would have the tainting effect of depriving it of the benefits of section 892 for all of its U.S. source investment income (which, due to the general exemption of interest income and capital gains from stocks and securities, is primarily relevant for dividend income and gains from the disposition of certain REIT investments). Also, many foreign government entities do not wish to file U.S. tax returns.

The Proposed Regulations

1. Limited partner exception. A government entity that is not otherwise engaged in commercial activities (including by reason of the rules described below) will not be deemed to be engaged in commercial activities solely because it holds an interest as a limited partner in a partnership that conducts a commercial activity (although any U.S. source income from such commercial activity would not be exempt under section 892, and a U.S. tax return would be required for such income that was “effectively connected” income). An interest in an entity (including a LLC) that is classified as a partnership for U.S. federal income tax purposes will be a limited partnership interest if the holder “does not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year under the laws of the jurisdiction in which the partnership is organized or under the governing agreement.” Consent rights with respect to extraordinary events (such as admission or expulsion of a partner, amendment of the partnership agreement, dissolution of the partnership, disposition of substantially all the assets or a merger or conversion of the partnership) are not considered management participation rights.
   
   The proposed regulations do not explicitly address representation on a partnership’s advisory committee, and the particular responsibilities of an advisory committee should be reviewed in each case to ensure that they do not constitute participation in the management and conduct of the partnership’s business under the proposed regulations.
   
   Notwithstanding that a foreign government entity may be protected from being a controlled commercial entity as a result of the limited partner exception, if the partnership itself is a controlled commercial entity of the foreign government partner, no part of the foreign government partner’s distributive share of the partnership’s income will be exempt under section 892.
   
   
2. Real estate. A disposition of a U.S. real property interest does not constitute the conduct of a commercial activity, although the gain will not qualify for the section 892 exemption (except in the case of a disposition of stock of a U.S. real property holding corporation that is not a controlled entity). In addition, since rental real estate is itself a commercial activity, this clarification primarily affects real estate investments made through partnerships that do not qualify for the limited partner exception, REITs and U.S. real property holding corporations.
   
   The proposed regulations do not modify the existing rule that a foreign entity that would be a U.S. real property holding corporation if it were a U.S. corporation (i.e., 50% or more of the value of its business assets are U.S. real property interests) can be a controlled commercial entity if a foreign government owns, directly or indirectly, 50% or more of the value or voting interests of, or otherwise has effective practical control over, the entity. Thus, in the absence of further clarification, foreign government entities could still become controlled commercial entities as a result of holding U.S. real property interests through partnerships.
   
   
3. Inadvertent commercial activity is excused. For purposes of determining whether an entity is a controlled commercial entity, an entity that conducts only inadvertent commercial activity will not be considered engaged in commercial activities. However, any U.S. source income derived from such inadvertent commercial activity will not be exempt under section 892, and thus the entity would need to file a U.S. tax return with respect to any such U.S. source income that is “effectively connected” income. The controlled entity would need to cure an inadvertent failure within 120 days of its discovery (e.g., by discontinuing the conduct of the commercial activity or transferring it to a related or unrelated entity) and would need to have written policies and operational procedures to monitor the entity’s worldwide activities. Under a safe harbor, if the entity has such policies and procedures in place, its failure to avoid commercial activity will be deemed reasonable and inadvertent if the value of the commercial activity assets does not exceed 5% of the entity’s balance sheet assets and the income earned from commercial activity does not exceed 5% of its gross income. However, the proposed regulations do not indicate whether, and if so, how, the safe harbor aggregates the results of affiliated entities, or instead must be applied on a separate entity basis.
   
   
4. Annual test. An entity that is a controlled commercial entity in one year will not be considered a controlled commercial entity in any future year in which it is not engaged in commercial activities.
   
   
5. Trading activities in stocks, securities and financial instruments. The exception from commercial activities for effecting transactions in stocks, bonds, other securities, commodities or financial instruments for an entity’s own account is explicitly extended to non-dealer partnerships trading for their own account. The commercial activities exception for trading in financial instruments (such as foreign currency derivatives) is extended to apply regardless of whether those financial instruments are held in the execution of governmental financial or monetary policy. However, taxpayers should continue to examine particular trading activities (including loan origination or associated activities) – especially if conducted by a hedge fund or other investment partnership – to ensure that they are within the scope of the section 892 exception from commercial activities.

Preliminary Assessment

The proposed regulations provide limited but welcome relief from the “cliff effect” that any commercial activity anywhere in the world, whether conducted directly by a foreign government-controlled entity or by a partnership in which the entity is a partner, results in the entity being a controlled commercial entity and losing the section 892 exemption for all of its U.S. source investment income. SWFs and other foreign government-controlled entities will still need to monitor their activities to ensure that they are not conducting commercial activities anywhere in the world. However, if they meet the conditions for the exceptions set forth in the regulations, they will no longer need to be concerned that investments as a limited partner, inadvertent commercial activity, or gains from the sale of U.S. real property interests will automatically trigger the “cliff effect.”

An important benefit of the limited partner exception is that SWFs will no longer need to be concerned that qualifying limited partner investments in partnerships that do not engage in any U.S. commercial activities might result in the SWF becoming a controlled commercial entity as a result of non-U.S. commercial activities.

In most cases, SWFs should be able to qualify for the limited partner exception. However, as noted, SWFs that are represented on a fund’s advisory committee should examine their eligibility for the limited partner exception.

While the proposed regulations dramatically reduce the stakes under section 892 from investment partnerships being engaged in a commercial activity, they do not exempt foreign government entities from U.S. tax on any U.S. source or other “effectively connected” income that does not qualify for the section 892 exemption. Thus, private equity and other investment partnerships will continue to have to organize alternative investment vehicles and blocker corporations to the extent that its section 892 investors (or other foreign investors) are averse to filing any U.S. tax returns.

If you have any questions, please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed under Tax.