On November 2, 2011, Treasury released proposed revisions to the regulations under Section 892 of the Internal Revenue Code of 1986 (the “Code”). Section 892 provides an exemption from U.S. federal income tax on certain types of U.S.-source investment income derived by foreign government entities, including sovereign wealth funds.
The Section 892 exemption does not apply to (i) income that is derived from the conduct of a “commercial activity” or (ii) income that is received by, or from, a “controlled commercial entity,” including any income that would otherwise qualify for the Section 892 exemption. The proposed regulations provide favorable guidance on the types of activities that constitute “commercial activity” and the types of activities and investments that would cause a controlled entity of a foreign government to be treated as a “controlled commercial entity.”
The proposed regulations modify the current temporary regulations under Section 892 in the following respects:
Expansion of Activities That Are Not Considered Commercial: The proposed regulations would expand the category of activities that are not “commercial” to include the following:
- Financial Instruments: Investments in, and trading in, “financial instruments” would not constitute commercial activity, regardless of whether the financial instruments are held in the execution of governmental financial or monetary policy (as required by the current temporary regulations). However, for this purpose, “financial instruments” include only certain financial instruments in currency and precious metals. The proposed regulations do not clarify whether investments in, or trading in, derivatives in stock and other securities would be treated as non-commercial activity.
- Investments in U.S. real property: The disposition, or deemed disposition, of a “U.S. real property interest” (as defined in Section 897(c) of the Code) would not be treated as commercial activity. However, as in the current temporary regulations, gain derived from the disposition of a “U.S. real property interest” (other than stock of a “U.S. real property holding corporation” that is not a “controlled commercial entity”) would not qualify for the exemption from tax under Section 892.
Annual Determination of Controlled Commercial Entity Status: The proposed regulations provide that the determination of whether an entity is a controlled commercial entity is made on an annual basis. Under the proposed regulations, an entity that is controlled by a foreign government and that is not engaged in commercial activities during a taxable year would not be a controlled commercial entity even if the entity were engaged in commercial activities in a prior taxable year.
Investments in Partnerships: The proposed regulations would provide two new exceptions to the general rule that the commercial activity of an entity that is treated as a partnership for U.S. federal income tax purposes is attributable to its partners.
- Limited Partnership Interests: Under certain circumstances, the commercial activities of a limited partnership would not be attributed to its limited partners. To qualify under this rule, a holder of a limited partner interest could not have rights to participate in the management and conduct of the partnership's business at any time (other than consent rights in the case of extraordinary events).
- Partnerships Engaged in Trading Activity: Even if a partner’s interest in a partnership were not eligible for the limited partner exception, the partner would not be treated as engaged in commercial activity solely as a result of the partnership’s trading in stocks, bonds, certain other securities, commodities or “financial instruments,” provided that the partnership was not a dealer in these assets. For this purpose, “financial instruments” include only certain financial instruments in currency and precious metals. The proposed regulations do not clarify whether this exception would apply to a partnership that trades derivatives in stock or other securities.
Under the proposed regulations, a controlled entity of a foreign government would not be treated as a “controlled commercial entity” as a result of holding a limited partner interest in a partnership engaged in commercial activity or an interest in a partnership engaged in trading activity. As a result, the entity could qualify for the Section 892 exemption with respect to eligible income it received. Allocations derived from a limited partner interest would not qualify for the Section 892 exemption, however, to the extent that they were attributable to commercial activity.
Exception for Inadvertent Commercial Activity: The proposed regulations provide relief from classification as a controlled commercial entity if an entity conducts only "inadvertent commercial activity.” Commercial activity is "inadvertent" if (i) the failure to avoid the commercial activity was reasonable, (ii) the commercial activity is discontinued within 120 days of its discovery and (iii) the entity complies with certain recordkeeping requirements.
To benefit from this new exception, the entity would be required to conduct continuing due diligence to prevent itself from engaging in commercial activities and establish adequate written policies and operational procedures to monitor its worldwide activities. In addition, the management-level employees of the company would be required to undertake reasonable efforts to establish, follow and enforce these policies and procedures.
The proposed regulations also provide a safe harbor that would treat an entity’s failure to avoid commercial activity as reasonable if (i) adequate written policies and operational procedures were in place (as described above) and (ii) the following two conditions were met: (a) the value of the assets used in, or held for use in, all commercial activities did not exceed 5 percent of the total value of the assets reflected on the entity's balance sheet (prepared for financial accounting purposes) and (b) the income earned by the entity from commercial activity did not exceed 5 percent of the entity's gross income as reflected on its income statement (also prepared for financial accounting purposes).
Similar to the exception for limited partner interests described above, this exception would affect only the status of an entity as a "controlled commercial entity." Income derived from inadvertent commercial activity would not be exempt from U.S. federal income tax under Section 892.
This summary is limited to the U.S. federal tax issues addressed herein. It was not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties that may be asserted against you under the Code.