Treasury and IRS Issue Final and Proposed Regulations Under Section 892 of the Code

On Dec. 12, the Treasury Department and the IRS issued final regulations (the Final Regulations) relating to the taxation of income of foreign governments from investments in the United States under Section 892 of the U.S. Internal Revenue Code of 1986, as amended (the Code). The Final Regulations finalize, with certain modifications based on comments previously received, the proposed Treasury regulations released in 2011 (the 2011 Proposed Regulations) and 2022 (the 2022 Proposed Regulations). The Final Regulations focus on providing guidance for determining when a foreign government is engaged in a commercial activity and when an entity is deemed to be a controlled commercial entity.

On the same date, the Treasury Department and the IRS also issued proposed regulations under Section[1] 892 addressing three key areas: (1) whether a partnership can be a “controlled entity” of a foreign government, (2) when the acquisition of “debt” will be considered a commercial activity and (3) when a foreign government will be deemed to have “effective control” of an entity that it does not otherwise own 50% or more of (the Proposed Regulations).

Key Observations and Highlights

• Activities that are “U.S. trade or business activities” are generally considered to be “commercial activities” under the Final Regulations.
• The Final Regulations reaffirm that certain investment activities are not treated as commercial activities when conducted by a foreign government as a non-dealer and for its own account.
• The Final Regulations retain the rule from the 2022 Proposed Regulations that an entity which is a U.S. real property holding corporation (USRPHC) solely by reason of its direct or indirect ownership interest in one or more other corporations that themselves are not controlled by the foreign government is not deemed to be engaged in commercial activities.
• Additionally, non-U.S. entities that are USRPHCs will no longer be deemed to be engaged in commercial activities solely by virtue of being USRPHCs under the Final Regulations.
• The Final Regulations finalize, with modifications, the “limited partner exception” from the 2011 Proposed Regulations, while providing additional rules and a safe harbor for foreign governments that own 5% or less of a partnership.
• The cure period for inadvertent commercial activity is increased from 120 days to 180 days under the Final Regulations.
• The Proposed Regulations clarify that an entity treated as a partnership for U.S. federal income tax purposes cannot be a “controlled entity” for Section 892 purposes.
• The Proposed Regulations provide a safe harbor for determining when an acquisition of debt (whether at original issuance or not) will not be considered a commercial activity. Questions persist, however, on acquisitions of debt that do not meet this safe harbor.
• Examples in the Proposed Regulations illustrate a variety of factors that can lead to a determination that an entity is under the “effective control” of a foreign government, notwithstanding the fact that it is less than 50% owned by such foreign government.

Background on Section 892, the 2011 Proposed Regulations and the 2022 Proposed Regulations

Section 892

Section 892 and the temporary regulations issued thereunder provide that the income of foreign governments (and their controlled entities[2]) derived from investments in the United States in stocks, bonds or other domestic securities is, in general, exempt from U.S. federal taxation. However, this exemption does not apply to income of a foreign government that is (i) derived from the conduct of commercial activities (whether within or outside of the United States), (ii) received by a controlled commercial entity (CCE) or received (directly or indirectly) from a CCE, or (iii) derived from the disposition of an interest in a CCE.

2011 Proposed Regulations

The 2011 Proposed Regulations defined “commercial activities” to include all activities (whether conducted within or outside the United States) that are ordinarily conducted for the current or future production of income or gain, and provided that only the nature of the activity, not the purpose or motivation for conducting it, is determinative of whether the activity is commercial in character. Furthermore, the 2011 Proposed Regulations provided that an activity may be considered a commercial activity even if that activity does not constitute a trade or business for purposes of Section 162 or does not constitute (or would not constitute if undertaken in the United States) the conduct of a trade or business in the United States for purposes of Section 864(b).The 2011 Proposed Regulations also provided for rules allowing a foreign government to cure inadvertent commercial activity.

Finally, the 2011 Proposed Regulations provided a “limited partner exception” to the general rule that commercial activity undertaken by a partnership would be attributed to its partners. The “limited partner exception” applied to a limited partner that did not have rights to participate in the management and conduct of a partnership’s business at any time during the partnership’s taxable year. Such a limited partner would not be deemed to be engaged in a commercial activity solely due to being a limited partner in a partnership that engaged in commercial activities (although any commercial activity income generated by such partnership would not benefit from Section 892 protection).

2022 Proposed Regulations

Treasury Regulation Section 1.892-5T(b)(1), promulgated in 1988, treats a USRPHC[3] or, importantly, a foreign corporation that would be a USRPHC if it were a United States corporation, as engaged in commercial activity (the Deeming Rule). Thus, if a non-U.S. controlled entity of a foreign government were treated as a USRPHC under this regulation, such an entity would automatically also be treated as a CCE by the Deeming Rule. A CCE (and income from a CCE) does not, as noted above, qualify for the benefits of Section 892.

Under this regulation, a controlled entity of a foreign government, whether a U.S. entity or non-U.S. entity, would be deemed to be a CCE if such entity were treated as a USRPHC (i.e., if it owned too great a percentage of United States real property interests (USRPIs)). In practice, the Deeming Rule has resulted in Section 892 investors making extensive information requests from lower-tier investment vehicles/investee companies in order to be able to monitor such investors’ overall USRPI position.

The 2022 Proposed Regulations provided an exception from the Deeming Rule for a corporation that would be a USRPHC solely by reason of its direct or indirect ownership interest in one or more other corporations that themselves are not controlled by a foreign government (the Portfolio Exception). If the Portfolio Exception applies, the corporation in question is not a CCE for purposes of Section 892.

The Final Regulations

Below is a description of the key facets of the Final Regulations:

Commercial Activities Definition

Commercial Activities Broader Than U.S. Trade or Business Activities

The preamble to the Final Regulations makes clear that the term “commercial activities” as used in Section 892 has a different and broader meaning than the term “trade or business” under Sections 162 and 864. Except for limited exceptions, the Final Regulations confirm that an activity which constitutes a U.S. trade or business for purposes of Section 162 and 864(b) is a commercial activity for purposes of Section 892.

Observation: The Final Regulations broaden the scope of commercial activity and, while commercial activities have typically been thought of as broader than U.S. trade or business activities, the Final Regulations make clear that (subject to limited exceptions) activities that constitute U.S. trade or business activities will also be classified as commercial activities.

Activities Remaining Non-Commercial Under the Final Regulations

The Final Regulations reaffirm that certain investment activities are not treated as commercial activities when conducted by a foreign government as a non-dealer and for its own account. These activities are as follows:

• Investments in stocks, bonds and other securities
• Trading in market-standard derivatives and qualifying financial instruments
• Holding bank deposits (including deposits in non-functional currency)
• Holding net leases on real property
• Holding real property that does not produce income (other than upon sale)
• Holding partnership equity interests (subject to partnership attribution rules and the changes to the “limited partner exception” discussed below)

The Final Regulations also provide that the above activities will not cease to be an investment solely because of the volume of transactions of such activity. Additionally, while “loans” are technically included as an exception from commercial activity, the Treasury and IRS separately address loans in the Proposed Regulations (which are discussed below).

Investment and Trading in Financial Instruments

The Final Regulations provide that investing and trading by a foreign government investor in “financial instruments” that are derivatives within the scope of the 2011 Proposed Regulations under Section 864(b) are not commercial activities. Additionally, the Final Regulations adopt comments by revising the definition of the term “financial instrument” under regulation Section 1.892-3(a)(4) to include financial instruments that are derivatives, which the Final Regulations define in a manner that is substantially similar to the definition proposed in regulation Section 1.864(b)-1(b)(2).

Changes to CCE Rules

USRPHC — Deeming Rule

Consistent with the 2022 Proposed Regulations, the Final Regulations retain the Portfolio Exception to the Deeming Rule. Additionally, the Final Regulations have modified the 2022 Proposed Regulations by providing that the Deeming Rule will only apply to domestic corporations. Therefore, a non-U.S. entity that is classified as a USRPHC will not be deemed to be engaged in commercial activity solely by reason of its status as a USRPHC.

Observation: If a foreign government utilizes a controlled entity that is a non-U.S. corporation to invest in U.S. real estate, the non-U.S. corporation should not be a CCE even if it holds only USRPIs. However, it is worth noting that underlying USRPHCs of a non-U.S. blocker corporation may nevertheless be classified as a CCE because a foreign government owns 50% or more of such USRPHC on an indirect basis. In that case, that investment will not qualify for Section 892 benefits (but the non-U.S. corporation’s other U.S. investments should not be tainted, as they would have been prior to the Final Regulations).

Additionally, a foreign government that is also a qualified foreign pension fund (QFPF) (as defined in Section 897(l)) or a qualified holder (as defined in regulation Section 1.897(l)-1(e)(11)) may own 50% or more of a USRPHC and not itself be classified as a CCE (therefore not jeopardizing the Section 892 benefits for its other investments). However, similar to the above, if such qualified foreign pension fund or qualified holder owns a REIT or other USRPHC that is a CCE because the foreign government indirectly owns 50% or more of such entity (or otherwise has “effective control” in accordance with the Proposed Regulations, discussed below), Section 892 benefits will not apply to that investment (but note, QFPF benefits under Section 897(l) will still apply). 

The preamble to the Final Regulations notes that, although the above-described change regarding non-U.S. entities in the Final Regulations renders the Portfolio Exception unnecessary (since foreign governments can invest through non-U.S. entities without fear of the Deeming Rule applying to such non-U.S. entity), foreign government investors have relied upon the 2022 Proposed Regulations and could incur substantial costs to restructure such investments. Therefore, the Treasury and IRS decided not to withdraw the Portfolio Exception from the Final Regulations.

Observation: Foreign governments can continue to invest in U.S. real estate through wholly owned U.S. blocker corporations where the only assets held by the U.S. blocker are interests in USRPHCs that are not controlled by the foreign government under the Portfolio Exception. Foreign governments should review the amendments to the “effective control” (described later in this client alert) portion of the CCE definition for purposes of determining whether or not they control underlying USRPHCs and evaluate the Proposed Regulations impact on their existing investments.

Finally, the Final Regulations provide that for purposes of determining whether an entity is a USRPHC, ownership interests in noncontrolled entities shall be disregarded as assets of the entity (that is, neither taken into account for purposes of the numerator nor the denominator).

Annual CCE Determination

Proposed regulation Section 1.892-5(a)(3) provided that if a controlled entity engages in commercial activities during any time during the taxable year, the controlled entity will be considered to be a CCE for the entire taxable year. The Final Regulations state that for purposes of proposed regulation Section 1.892-5(a)(3), the annual determination of whether an entity is a CCE is made with respect to the entity’s taxable year.

The Final Regulations also provide that for purposes of determining whether an entity is engaged in commercial activities during its taxable year, such entity’s activities during its immediately preceding (but not subsequent) taxable year will also be taken into account to the extent relevant in characterizing the activities of the current taxable year.

Observation: This rule applies in the context of a USRPHC as well. Therefore, if a controlled entity is a USRPHC that is deemed to be engaged in commercial activity during its taxable year, such controlled entity will be a CCE for the whole taxable year (regardless of whether it ceases to be a USRPHC during any portion of the taxable year).

Commercial Activities of Partnerships — Limited Partner Exception

As mentioned above, the 2011 Proposed Regulations provided for a “limited partner exception,” whereby an entity that is not otherwise engaged in commercial activities will not be deemed to be engaged in commercial activities solely because it holds an interest as a limited partner in a limited partnership. These 2011 Proposed Regulations were not limited to state law partnerships; instead, any entity classified as a partnership for U.S. federal income tax purposes (e.g., an LLC with more than one member that does not check the box to be classified as a corporation) would qualify as a partnership for this purpose. Furthermore, to be properly classified as a “limited partner,” the partner could not have rights to participate in the management and conduct of a partnership’s business at any time during the partnership’s taxable year.

The Final Regulations finalize rules similar to the 2011 Proposed Regulations “limited partner exception” with some alterations. First, the term “qualified partnership interest” replaces an “interest as a limited partner in a limited partnership.” Second, the Final Regulations require that a holder of a qualified partnership interest:

• Has limited liability (and, therefore, no personal liability for claims against the partnership)
• Does not possess the legal authority to bind the partnership
• Does not control the partnership
• 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

Rights to participate in the management and conduct of the partnership’s business generally consist of rights to participate in the day-to-day management or operation of the partnership’s business (e.g., participation in ordinary course personnel/compensation decisions or taking active roles in formulating the partnership’s business strategy). Such rights can be provided by law or by contract (e.g., operating documents, side letters, etc.). The Final Regulations note that such rights generally do not include participation rights with respect to monitoring or protecting the partner’s capital investment in the partnership.

Observation: Uncertainty remains as to whether general oversight rights, consultation rights and veto rights are treated as being consistent with holding a qualified partnership interest (and not as participating in the management and conduct of a partnership’s business). Ultimately, the Treasury and IRS view this determination as highly fact intensive. Foreign government investors that are relying on this exception from partnership attribution should carefully evaluate any negotiated rights that may be viewed as participation in management and business operations for this purpose.

Safe Harbor

The Final Regulations contain a safe harbor for attribution from “de minimis” interests in a partnership. A holder of a partnership interest classified as equity is treated as holding a “qualified partnership interest” if the holder at all times during the partnership’s taxable year:

• Has limited liability
• Does not possess the legal authority to bind or act on behalf of the partnership
• Is not the partnership’s managing partner, managing member or an equivalent role
• Does not own, directly or indirectly, more than 5% of the partnership’s capital or profits interests

Observation: Given this new safe harbor, foreign governments should take comfort in claiming the exemption from the attribution of commercial activities from partnerships in which a controlled entity owns a 5% or smaller interest (without a potentially burdensome analysis of management rights). However, (1) because Section 892 benefits will continue to be unavailable for a foreign government’s distributive share of a partnership’s income from the conduct of a commercial activity (nor would a foreign partner in such a partnership avoid U.S. return) and (2) because profit share measures may fluctuate year to year, blocker structuring should still be considered in connection with investments in partnerships that are engaged in commercial activities.

Effect of Holding a Qualified Partnership Interest

The Final Regulations also make clear that, despite holding a qualified partnership interest (whether or not as a result of qualifying for the above-described safe harbor), any commercial activity income generated from such a partnership that is allocable to a foreign government partner will not itself be eligible for Section 892 benefits (though whether such income is subject to U.S. tax will still have to be independently determined).

Inadvertent Commercial Activities

Under the 2011 Proposed Regulations, an entity that conducted only inadvertent commercial activities in a particular year would not be treated as engaged in commercial activities if: (1) the failure to avoid conducting the commercial activity was “reasonable”; (2) the commercial activity was promptly “cured”; and (3) certain record maintenance requirements were met.

The Final Regulations generally follow the rules from the 2011 Proposed Regulations while providing further guidance with respect to prongs (1) and (2). Specifically, the Final Regulations note that a failure to avoid commercial activity will not be considered reasonable unless there is continuing due diligence to prevent the tested entity from engaging in commercial activities within or outside the United States as evidenced by having adequate written policies and operational procedures in place to monitor the tested entity's worldwide activities. Furthermore, a failure to avoid commercial activity will not be considered reasonable if responsible employees have not undertaken reasonable efforts, based on all facts and circumstances, to establish, follow and enforce such written policies and operational procedures with respect to the tested entity. While the preamble to the Final Regulations notes comments had requested that the reasonable reliance on advice of competent tax advisors should constitute a reasonable effort to avoid conducting commercial activity, the Treasury and IRS determined that the receipt of such advice does not supersede the need for employees of the entity to take reasonable efforts to establish, follow and enforce the written policies and operational procedures described above. The Final Regulations also provide a safe harbor for determining reasonableness.[4]

Observation: Section 892 investors are strongly encouraged to implement or, if previously implemented, review written policies and operational procedures with appropriate counsel in order to be able to avail themselves of the above benefit in the Final Regulations.

With respect to promptly “curing” the commercial activity, the major change made by the Final Regulations is extending the cure period from 120 days from the date of discovery to 180 days from the date of discovery. This change is intended to provide foreign governments with the ability to craft a legal plan effectuating the discontinuance of the commercial activity (which could require governmental and/or third-party approvals).

Observation: The extension of the “cure” period is a welcome alteration of the 2011 Proposed Regulations; however, the Treasury and IRS rejected many comments intended to ease the “reasonable” prong of the inadvertent commercial activity exception. Nevertheless, the new safe harbor should provide foreign governments with a helpful mechanism to deal with relatively de minimis foot faults (e.g., inadvertent commercial activity generated from a smaller investment).

Effective Dates of the Rules in the Proposed Regulations

The Final Regulations are generally applicable to taxable years beginning on or after the date the Final Regulations become finalized in the Federal Register. Additionally, with a few exceptions, the Final Regulations provide that a taxpayer may choose to apply the Final Regulations to a taxable year beginning before the date the Final Regulations become finalized in the Federal Register if the period of limitations on assessment of the taxable year is open (and if the taxpayer and, importantly, all its related entities consistently apply the rules of the Final Regulations in their entirety to such taxable year and all succeeding taxable years beginning before the finalization date).

The Proposed Regulations

As noted above, the Proposed Regulations provide the following additional guidance regarding three key areas.

Controlled Entities Do Not Include Entities Taxed as Partnerships

While Section 892 itself does not define the term “foreign government,” temporary regulations provide that a foreign government consists only of “integral parts” and “controlled entities.” Prior to the issuance of the Proposed Regulations, it was unclear whether partnerships were excluded from the definition of a “controlled entity.” The Proposed Regulations make clear that a “controlled entity” does not include any entity treated as a partnership for U.S. federal income tax purposes.

When the Acquisition of Debt is Considered a Commercial Activity

The 2011 Proposed Regulations provided that investments in loans, stocks, bonds and other securities are not commercial activities but also noted that investments (including loans) made by a banking, financing or other similar business constitute commercial activities, even if the income derived by such activities would not rise to the level of a U.S. trade or business.

In response to a comment to the 2011 Proposed Regulations regarding uncertainty as to the circumstances in which loan origination is considered a commercial activity, the Treasury and IRS set forth rules in the Proposed Regulations to deal with when the acquisition of debt is treated as a commercial activity. For these purposes, the term “debt” means an obligation treated as debt for U.S. federal income tax purposes.

In general, the acquisition of debt under the Proposed Regulations is considered a commercial activity unless one of two safe harbors is met or if the acquisition of debt is not considered a commercial activity under a facts-and-circumstances test.

The Safe Harbors

(1) The acquisition of debt is not a commercial activity if an acquisition of bonds or other debt securities is made in an offering registered under the Securities Act of 1933 (provided that the underwriters of the offering are not related to the acquirer under the constructive ownership rules of Section 267(b) and 707(b).

(2) The acquisition of debt is not a commercial activity if the debt acquired is traded on an established securities market (within the meaning of regulation Section 1.7704-1(b)), provided that (i) the acquirer does not acquire the debt directly from the issuer or participate in the negotiation of the terms or issuance of the debt and (ii) the acquisition is not from a person that is under common management or control with the acquirer (subject to certain exceptions).

Observation: Under the second safe harbor, prong (2) suggests that debt acquired by an acquirer through a season-and-sell strategy may not qualify for the safe harbor if the acquisition is deemed to be made from a person that is under common management or control with the acquirer. On the other hand, if the strategy does not cause the investor to be in a U.S. trade or business (whether or not it is a commercial activity) then the only effect of a failure to meet this safe harbor (absent meeting the other safe harbor or the facts-and-circumstances test discussed below) would be on the ability of a given controlled entity to claim Section 892 benefits with respect to other income.

Finally, if neither safe harbor is met, the acquisition of debt may still be deemed not to be a commercial activity based on all of the relevant facts and circumstances, including eight factors listed in the Proposed Regulations. These factors range from the acquirer’s participation in negotiating and structuring the debt, the percentage ownership of the debt issuance and equity of the debt issuer, and the receipt of fees or other compensation by the acquirer. It is worth noting that the number of debt acquisitions is not a listed factor in the Proposed Regulations. Furthermore, there are a number of examples provided in the Proposed Regulations analyzing the factors listed.

Observation: One example in the Proposed Regulations makes clear that even if a non-U.S. entity made only one loan in a given year, if that one loan does not fall under either safe harbor, the non-U.S. entity could be treated as engaged in commercial activity under the facts-and-circumstances test. This lends further credence to the discussion in the preamble to the Final Regulations regarding commercial activity being broader than U.S. trade or business activity, as many tax practitioners take the position that the origination of one loan per year should not give rise to a U.S. trade or business due to a lack of “regular and continuous” activity. As mentioned above, Treasury’s and IRS’ decision to continue to view the “commercial activities” and “trade or business” concepts as not coterminous means that a controlled entity may, in some cases, not be taxed on income attributable to activities that cause such entity to lose the benefits of Section 892 (while integral parts of foreign governments will continue to be taxed on business income that does not taint such integral parts’ ability to qualify for such benefits).

Banking, Finance or Similar Business

Additionally, the Proposed Regulations propose to withdraw the rule on banking, financing or similar businesses in regulation Section 1.892-4T(c)(1)(iii) that provided investments (including loans) made by a banking, financing or similar business constitute commercial activities, even if the income derived from such investments is not considered to be income effectively connected with the active conduct of a banking, financing or similar business in the U.S. by reason of the application of regulation Section 1.864-4(c)(5). This proposed withdrawal is meant to conform with the Proposed Regulations approach regarding providing exclusive rules for determining whether acquiring debt, including at original issuance, is treated as investment and thus not as commercial activity for purposes of Section 892. Furthermore, it is worth noting that the Proposed Regulations do not reference investments in loans made by a banking, finance or similar business, but instead focus on the safe harbor approach and various factors in the facts-and-circumstances analysis.

Observation: Despite not being specifically addressed in the Proposed Regulations, a banking, financing or similar business that is determined to be in a U.S. trade or business will likely be considered to be engaged in commercial activities under the Final Regulations.

Further Guidance on What Constitutes Effective Control for CCE Purposes

Section 892(a)(2)(B) defines a CCE as any entity that is engaged in commercial activities (whether within or outside of the United States) if the government (i) holds 50% (directly or indirectly) of the value or voting interest of such entity or (ii) holds (directly or indirectly) any other interest in the entity that provides the foreign government with effective control of the entity.

Proposed regulations issued in 1988 provided that an entity engaged in commercial activities is a CCE if the foreign government has “effective practical control” that could be achieved through a minority interest which is sufficiently large to achieve effective control, or through creditor, contractual or regulatory relationships that, together with ownership interests, allow a foreign government to achieve effective control. Various comments since then suggested that regulations be issued to provide a more thorough definition of effective practical control with more specific examples.

The Proposed Regulations provide for broad rules defining “effective control” by noting effective control is achieved by any interest in the entity that, directly or indirectly, either separately or in combination with other interests, results in control of the operational, managerial, board-level or investor-level decisions of an entity. While the determination of “effective control” requires a facts-and-circumstances analysis, the Proposed Regulations contain a non-exhaustive list of interests that factor in the analysis, including:

• Equity interests
• Debt interests
• Voting interests (including ability to appoint directors and veto decisions)
• Contractual rights
• Business relationships with the entity
• Regulatory authority over the entity
• Any other interest in or other relationship with the entity “that may provide influence over decisions”

Furthermore, control over (or being) a managing partner or managing member of an entity will constitute effective control for purposes of these Proposed Regulations. Finally, the Proposed Regulations contain a number of examples that analyze and illustrate the application of the factors listed above.

Observation: The examples provided in the Proposed Regulations may be concerning for foreign governments that have traditionally focused primarily on the ownership threshold when evaluating CCE status of blocker entities. One example finds that a foreign government creditor would be deemed to have effective control over an entity where the credit agreement with such entity allows the foreign government to restrict the type of investments that can be made, asset dispositions, levels of future borrowing and dividend distributions (while also providing certain veto rights). Additionally, given the relatively broad language relating to control of operational, managerial, board-level or investor-level decisions of an entity, foreign governments will want to carefully evaluate customary minority consent/block rights and other protective rights could cause an “effective control” determination notwithstanding carefully constructed ownership limits.

Effective Dates of the Rules in the Proposed Regulations

The Proposed Regulations under Section 892 will apply to taxable years beginning on or after the date of publication of the Treasury decision adopting the Proposed Regulations as final regulations in the Federal Register.